Sun Hydraulics Corp.

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934


For the quarterly period ended July 2, 2005		Commission file number 0-21835

SUN HYDRAULICS CORPORATION

(Exact Name of Registration as Specified in its Charter)


FLORIDA		59-2754337

(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)


1500 WEST UNIVERSITY PARKWAY SARASOTA, FLORIDA		34243

(Address of Principal Executive Offices)		(Zip Code)

941/362-1200

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes o No þ

The Registrant had 10,892,021 shares of common stock, par value $.001, outstanding as of August 5, 2005.

PART I: FINANCIAL INFORMATION

Item 1.

Sun Hydraulics Corporation
Consolidated Balance Sheets
(in thousands, except share data)


	July 2, 2005			December 25, 2004
	(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	14,051		$	9,300
Restricted cash		425			462
Accounts receivable, net of allowance for doubtful accounts of $163 and $170		11,490			8,611
Inventories		7,852			7,105
Deferred income taxes		392			392
Other current assets		1,166			776

Total current assets		35,376			26,646

Property, plant and equipment, net		43,187			43,687
Other assets		1,767			1,475


Total assets	$	80,330		$	71,808


Liabilities and shareholders’ equity
Current liabilities:
Accounts payable	$	3,842		$	2,536
Accrued expenses and other liabilities		4,513			4,609
Long-term debt due within one year		1,003			1,058
Dividends payable		545			522
Taxes payable		695			1,198

Total current liabilities		10,598			9,923

Long-term debt due after one year		10,548			11,196
Deferred income taxes		4,984			4,986
Other noncurrent liabilities		290			300

Total liabilities		26,420			26,405

Commitments and contingencies		—			—

Shareholders’ equity:
Preferred stock, 2,000,000 shares authorized, par value $0.001, no shares outstanding		—			—
Common stock, 20,000,000 shares authorized, par value $0.001, 10,889,531 and 10,441,920 shares outstanding		11			10
Capital in excess of par value		32,566			28,579
Unearned compensation related to outstanding restricted stock		(457	)		(608	)
Retained earnings		19,780			13,867
Accumulated other comprehensive income		2,010			3,566
Treasury stock		—			(11	)

Total shareholders’ equity		53,910			45,403


Total liabilities and shareholders’ equity	$	80,330		$	71,808

The accompanying Notes to the Consolidated, Unaudited Financial Statements are an integral part of these financial statements.

Sun Hydraulics Corporation
Consolidated Statements of Operations
(in thousands, except per share data)


	Three months ended
	July 2, 2005			June 26, 2004
	(unaudited)			(unaudited)

Net sales	$	31,014		$	26,522

Cost of sales		20,928			18,136


Gross profit		10,086			8,386

Selling, engineering and administrative expenses		4,524			4,196


Operating income		5,562			4,190

Interest expense		147			134
Foreign currency transaction gain		(145	)		(31	)
Miscellaneous (income)/expense, net		(23	)		(30	)


Income before income taxes		5,583			4,117

Income tax provision		2,047			1,526


Net income	$	3,536		$	2,591


Basic net income per common share	$	0.33		$	0.25

Weighted average basic shares outstanding		10,873			10,170

Diluted net income per common share	$	0.32		$	0.25

Weighted average diluted shares outstanding		10,975			10,250

Dividends declared per share	$	0.050		$	0.050

The accompanying Notes to the Consolidated, Unaudited Financial Statements are an integral part of these financial statements.

Sun Hydraulics Corporation
Consolidated Statements of Operations
(in thousands, except per share data)


	Six months ended
	July 2, 2005			June 26, 2004
	(unaudited)			(unaudited)

Net sales	$	60,093		$	47,912

Cost of sales		40,254			33,221


Gross profit		19,839			14,691

Selling, engineering and administrative expenses		8,743			8,260


Operating income		11,096			6,431

Interest expense		283			282
Foreign currency transaction gain		(257	)		(33	)
Miscellaneous (income)/expense, net		(32	)		(17	)


Income before income taxes		11,102			6,199

Income tax provision		4,100			2,251


Net income	$	7,002		$	3,948


Basic net income per common share	$	0.65		$	0.39

Weighted average basic shares outstanding		10,750			10,154

Diluted net income per common share	$	0.65		$	0.38

Weighted average diluted shares outstanding		10,847			10,310

Dividends declared per share	$	0.125		$	0.090

The accompanying Notes to the Consolidated, Unaudited Financial Statements are an integral part of these financial statements.

Sun Hydraulics Corporation
Consolidated Statement of Changes in Shareholders’ Equity and Comprehensive Income (unaudited)

(in thousands)


													compensation						Accumulated
										Capital in			related to						other
	Preferred		Preferred		Common			Common		excess of			restricted			Retained			comprehensive			Treasury
	shares		stock		shares			stock		par value			stock			earnings			income			stock			Total

Balance, December 25, 2004		—	$	—		10,442		$	10	$	28,579		$	(608	)	$	13,867		$	3,566		$	(11	)	$	45,403
Recognition of unearned compensation, restricted stock														151												151
Shares issued, stock options						333			1		2,287															2,288
Shares issued, ESPP						8					69															69
Shares issued, ESOP						110					1,058															1,058
Purchase and retirement of treasury stock						(3	)				(38	)											11			(27	)
Stock option income tax benefit											611															611
Dividends declared																	(1,089	)								(1,089	)
Comprehensive income:																										—
Net income																	7,002									7,002
Foreign currency translation adjustments																				(1,556	)					(1,556	)

Comprehensive income																										5,446


Balance, July 2, 2005		—	$	—		10,890		$	11	$	32,566		$	(457	)	$	19,780		$	2,010		$	—		$	53,910

The accompanying Notes to the Consolidated, Unaudited Financial Statements are an integral part of this financial statement.

Sun Hydraulics Corporation
Consolidated Statements of Cash Flows

(in thousands)


	Six Months ended
	July 2, 2005			June 26, 2004
	(unaudited)			(unaudited)

Cash flows from operating activities:
Net income	$	7,002		$	3,948
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		2,779			2,687
Loss on disposal of assets		7			43
Provision for deferred income taxes		(2	)		(87	)
Allowance for doubtful accounts		(7	)		11
Stock-based compensation expense		165			130
(Increase) decrease in:
Accounts receivable		(2,872	)		(3,466	)
Inventories		(747	)		(92	)
Other current assets		(390	)		(85	)
Other assets		108			66
Increase (decrease) in:
Accounts payable		1,306			213
Accrued expenses and other liabilities		962			1,572
Taxes payable		108			1,065
Other liabilities		(10	)		(25	)

Net cash provided by operating activities		8,409			5,980

Cash flows from investing activities:
Investment in WhiteOak		(400	)		—
Capital expenditures		(3,638	)		(2,478	)
Proceeds from dispositions of equipment		1			19

Net cash used in investing activities		(4,037	)		(2,459	)

Cash flows from financing activities:
Repayment of debt		(703	)		(3,422	)
Proceeds from exercise of stock options		2,273			1,173
Proceeds from stock issued		69			—
Payments for purchase of treasury stock		(27	)		(558	)
Proceeds from reissuance of treasury stock		—			48
Dividends to shareholders		(1,065	)		(540	)

Net cash provided by (used in) financing activities		547			(3,299	)

Effect of exchange rate changes on cash and cash equivalents		(205	)		269


Net increase in cash and cash equivalents		4,714			491

Cash and cash equivalents, beginning of period		9,762			5,219


Cash and cash equivalents, end of period	$	14,476		$	5,710


Supplemental disclosure of cash flow information:
Cash paid:
Interest	$	283		$	282
Income taxes	$	4,605		$	1,273

The accompanying Notes to the Consolidated, Unaudited Financial Statements are an integral part of these financial statements.

SUN HYDRAULICS CORPORATION

NOTES TO THE CONSOLIDATED, UNAUDITED FINANCIAL STATEMENTS
(Dollars in thousands except per share data)

1. BASIS OF PRESENTATION AND SUMARY OF BUSINESS

Sun Hydraulics Corporation, and its wholly-owned subsidiaries and joint ventures, design, manufacture, and sell screw-in cartridge valves and manifolds used in hydraulic systems. The Company has facilities in the United States, the United Kingdom, Germany, Korea, and China. Sun Hydraulics Corporation (“Sun Hydraulics”), with its main offices located in Sarasota, Florida, designs, manufactures, and sells primarily through distributors. Sun Hydraulik Holdings Limited (“Sun Holdings”), a wholly-owned subsidiary of Sun Hydraulics, was formed to provide a holding company for the European market operations; its wholly-owned subsidiaries are Sun Hydraulics Limited (a British corporation, “Sun Ltd.”) and Sun Hydraulik GmbH (a German corporation, “Sun GmbH”). Sun Ltd. operates a manufacturing and distribution facility located in Coventry, England, and Sun GmbH operates a manufacturing and distribution facility located in Erkelenz, Germany. Sun Hydraulics Korea Corporation (“Sun Korea”), a wholly-owned subsidiary of Sun Hydraulics, located in Inchon, South Korea, operates a manufacturing and distribution facility. Sun Hydraulics, SARL (“Sun France”), a wholly-owned subsidiary of Sun Hydraulics, located in Bordeaux, France, operates a sales and engineering support facility. Sun Hydraulics Systems (Shanghai) Co., Ltd. (“Sun China”), a 50/50 joint venture between Sun Hydraulics and Links Lin, the owner of Sun Hydraulics’ Taiwanese distributor, is located in Shanghai, China, and operates a manufacturing and distribution facility. Sun Hydraulics acquired a 40% equity method investment in WhiteOak Controls, Inc. (“WhiteOak”), on June 28, 2005 (see Note 3). WhiteOak located in Mediapolis, Iowa, designs and produces complementary electronic control products.

The accompanying unaudited interim consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission for reporting on Form 10-Q. Accordingly, certain information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements are not included herein. The financial statements are prepared on a consistent basis (including normal recurring adjustments) and should be read in conjunction with the consolidated financial statements and related notes contained in the Annual Report on Form 10-K for the fiscal year ended December 25, 2004, filed by Sun Hydraulics Corporation (together with its subsidiaries, the “Company”) with the Securities and Exchange Commission on March 24, 2005. In Management’s opinion, all adjustments necessary for a fair presentation of the Company’s financial statements are reflected in the interim periods presented. Operating results for the three and six month periods ended July 2, 2005, are not necessarily indicative of the results that may be expected for the period ended December 31, 2005.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Stock-Based Compensation

The Company has adopted the disclosure only provisions of Statements of Financial Accounting Standards (FAS) No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment to FAS No. 123, Accounting for Stock-Based Compensation (“FAS 148”), and has elected to follow Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees and related interpretations in accounting for its employee stock options. Under APB 25, because the exercise price of employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recorded.

If the company had elected to recognize compensation expense for stock options based on the fair value at grant date, consistent with the method prescribed by FAS No. 123, Accounting for Stock-Based Compensation (“FAS 123”), net income and earnings per share would have been reduced to the pro forma amounts below. The pro forma amounts were determined using the Black-Scholes valuation model with weighted average assumptions as set forth below.


	Three Months Ended						Six Months Ended
	July 2,			June 26,			July 2,			June 26,
	2005			2004			2005			2004


Net Income as Reported	$	3,536		$	2,591		$	7,002		$	3,948

Stock-based compensation reported in net income, net of related taxes		48			41			96			82

Stock compensation expense calculated under FAS 123, net of related taxes		(78	)		(55	)		(156	)		(110	)


Pro Forma Net Income	$	3,506		$	2,577		$	6,942		$	3,920


Basic net income per common share:
As reported	$	0.33		$	0.25		$	0.65		$	0.39
Pro forma	$	0.32		$	0.25		$	0.65		$	0.39

Diluted net income per common share:
As reported	$	0.32		$	0.25		$	0.65		$	0.38
Pro forma	$	0.32		$	0.25		$	0.64		$	0.38

Assumptions Risk-free interest rate		4.22	%		4.64	%		4.22	%		4.64	%
Expected lives (in years)		6.5			6.5			6.5			6.5
Expected volatility		30.32	%		40.00	%		30.32	%		40.00	%
Dividend yield		2.19	%		1.00	%		2.19	%		1.00	%

Earnings per share

The following table represents the computation of basic and diluted earnings per common share as required by FAS No. 128, Earnings Per Share (in thousands, except per share data):


	Three Months Ended				Six Months Ended
	July 2, 2005		June 26, 2004		July 2, 2005		June 26, 2004


Net income	$	3,536	$	2,591	$	7,002	$	3,948
Weighted average basic shares outstanding		10,873		10,170		10,750		10,154
Basic income per common share	$	0.33	$	0.25	$	0.65	$	0.39
Effect of dilutive stock options		102		79		97		156
Weighted average diluted shares outstanding		10,975		10,250		10,847		10,310
Diluted income per common share	$	0.32	$	0.25	$	0.65	$	0.38

Diluted earnings per common share excludes antidilutive stock options of approximately 68,000 for the periods ended June 26, 2004.

Stock Split

On June 10, 2005, the Company declared a three-for-two stock split, effected in the form of a 50% stock dividend, to shareholders of record on June 30, 2005, payable on July 15, 2005. The Company issued approximately 3,600,000 shares of common stock as a result of the stock split. The effect of the stock split on outstanding shares and earnings per share was retroactively applied to all periods presented.

Reclassification

Certain amounts shown in the 2004 consolidated financial statements have been reclassified to conform to the 2005 presentation.

52-53 Week Fiscal Year

The Company’s fiscal year ends on the Saturday nearest to the end of the month of December. Each quarter consists of two 4-week periods and one 5-week period. The 2005 fiscal year will end on December 31, 2005, resulting in a 53-week year. As a result of the 2004 fiscal year ending December 25, 2004, the year-to-date period ending July 2, 2005, consists of three 4-week periods and three 5-week periods.

3. ACQUISITIONS

On June 28, 2005, Sun Hydraulics acquired shares of common stock representing 40% of the outstanding shares of WhiteOak Controls, Inc. (“WhiteOak”). WhiteOak designs and produces electronic amplifiers and other control products. The Company, together with WhiteOak, will co-develop products to be used in and in conjunction with other Company products. The acquisition price paid by the Company was $400,000. The excess paid over pro rata share of net assets of $274,000 is being classified as developed technology and is being amortized over a period of 10 years.

4. RESTRICTED CASH

The restricted cash balance at July 2, 2005, consisted of $425 in reserves as a required deferment for customs and excise taxes in the U.K. operation. The restricted amount was calculated as an estimate of two months of customs and excise taxes for items coming into the Company’s U.K. operations and was held with Lloyd’s TSB in the U.K.

5. INVENTORIES


	July 2, 2005			December 25, 2004

Raw materials	$	2,921		$	2,523
Work in process		3,000			2,487
Finished goods		2,211			2,402
Provision for slow moving inventory		(280	)		(307	)


Total	$	7,852		$	7,105

6. GOODWILL

On July 2, 2005, the Company had $715 of goodwill, related to its acquisition of Sun Korea. Goodwill is held in other assets on the balance sheet. Valuation models reflecting the expected future cash flow projections were used to value Sun Korea at December 25, 2004. The analysis indicated that there was no impairment of the carrying value of the goodwill. As of July 2, 2005, no factors were identified that indicated impairment of the carrying value of the goodwill.

7. LONG-TERM DEBT


	July 2, 2005			December 25, 2004


$11,000 five-year note, collateralized by U.S. real estate and equipment and a 65% stock pledge in the foreign subsidiaries, interest rate Libor + 1.9% or prime rate at Company’s discretion (4.62% at April 2, 2005), due July 23, 2008.	$	9,945		$	10,220
$12,000 revolving line of credit, collateralized by U.S. real estate and equipment and a 65% stock pledge in the foreign subsidiaries, interest rate Libor + 1.9% or prime rate at Company’s discretion (4.62% at April 2, 2005), due July 23, 2006.		—			—

$2,400 12-year mortgage note on the German facility, fixed interest rate of 6.05%, due September 30, 2008.		733			947
10-year notes, fixed interest rates ranging from 3.5-5.1%, collateralized by equipment in Germany, due between 2009 and 2011.		803			1,009

Other		70			78

		11,551			12,254
Less amounts due within one year		(1,003	)		(1,058	)


Total	$	10,548		$	11,196

Certain of these debt instruments are subject to debt covenants including: 1) Fixed Charge Coverage Ratio (as defined) of 2.0 to 1.0, determined quarterly on a rolling four quarters basis, 2) Debt (as defined) to Tangible Net Worth (as defined) of not more than 1.5 to 1.0, determined quarterly, 3) Current Ratio of 1.5 to 1.0, determined quarterly, 4) Funded Debt (as defined) to EBITDA of less than 3.25 to 1.0, determined quarterly on a rolling four quarters basis, and 5) the Company’s primary domestic depository accounts must be held at SouthTrust Bank. As of July 2, 2005, the Company was in compliance with all debt covenants.

On August 11, 2005, the Company completed a refinancing of its existing debt in the U.S. See Note 11.

8. SEGMENT REPORTING

The individual subsidiaries comprising the Company operate predominantly in a single industry as manufacturers and distributors of hydraulic components. The Company is multinational with operations in the United States, and subsidiaries in the United Kingdom, Germany, and Korea. In computing operating profit for the foreign subsidiaries, no allocations of general corporate expenses have been made. Management bases its financial decisions by the geographical location of its operations.

Identifiable assets of the foreign subsidiaries are those assets related to the operation of those companies. United States assets consist of all other operating assets of the Company.

Segment information is as follows:


	United						United
	States		Korea		Germany		Kingdom		Elimination			Consolidated

Three Months Ended July 2, 2005
Sales to unaffiliated customers	$	19,557	$	3,251	$	4,097	$	4,109	$	—		$	31,014
Intercompany sales		5,573		—		20		745		(6,338	)		—
Operating income		3,862		467		915		334		(16	)		5,562
Depreciation		985		38		110		256		—			1,389
Capital expenditures		1,457		2		33		608		—			2,100

Three Months Ended June 26, 2004
Sales to unaffiliated customers	$	16,972	$	2,548	$	3,473	$	3,529	$	—		$	26,522
Intercompany sales		4,195		—		21		480		(4,696	)		—
Operating income		2,949		310		696		238		(3	)		4,190
Depreciation		955		33		110		263		—			1,361
Capital expenditures		1,239		3		36		232		—			1,510

Six Months Ended July 2, 2005
Sales to unaffiliated customers	$	37,703	$	5,917	$	8,179	$	8,294	$	—		$	60,093
Intercompany sales		11,435		—		42		1,348		(12,825	)		—
Operating income		7,734		798		2,089		652		(177	)		11,096
Depreciation		1,962		75		219		523		—			2,779
Capital expenditures		2,832		7		94		705		—			3,638

Six Months Ended June 26, 2004
Sales to unaffiliated customers	$	29,889	$	4,844	$	6,470	$	6,709	$	—		$	47,912
Intercompany sales		7,918		—		33		835		(8,786	)		—
Operating income		4,439		574		1,222		204		(8	)		6,431
Depreciation		1,874		67		210		536		—			2,687
Capital expenditures		2,038		8		66		366		—			2,478

Operating income is total sales and other operating income less operating expenses. Segment operating income does not include interest expense and net miscellaneous income/expense.

9. NEW ACCOUNTING PRONOUNCEMENTS

In November 2004, the FASB issued FAS No. 151 (“FAS 151”), Inventory Costs, an amendment of ARB No. 43, Chapter 4. The amendments made by FAS 151 clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges and requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. While FAS 151 enhances Accounting Research Bulletin No. 43, Restatement and Revision of Accounting Research Bulletins, and clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage), the statement also removes inconsistencies between ARB 43 and International Accounting Standards No. 2 (“IAS 2”) and amends ARB 43 to clarify that abnormal amounts of costs should be recognized as period costs. Under some circumstances, according to ARB 43, the above listed costs may be so abnormal as to require treatment as current period charges. FAS 151 requires these items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal” and requires allocation of fixed production overheads to the costs of conversion.

This standard will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The impact of the adoption of FAS 151 on the Company’s reported operating results, financial position and existing financial statement disclosure is not expected to be material.

In December, 2004, the FASB issued FAS No. 123 (revised 2004) (“FAS 123(R)”), Share-Based Payment, which is a revision of FAS 123. FAS 123(R) supersedes APB 25 and FAS 123, and amends FAS No. 95, Statement of Cash Flows. This Statement requires entities to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards (with limited exceptions). This Statement eliminates the alternative to use APB 25’s intrinsic value method of accounting that was provided in FAS 123 as originally issued. Under APB 25, issuing stock options to employees at or above fair value generally resulted in no recognition of compensation cost.

FAS 123(R) also requires that the Company estimate the number of awards that are expected to vest and to revise the estimate as the actual forfeitures differ from the estimate. This standard is effective as of the beginning of the first annual reporting period that begins after June 15, 2005. The effect of these items and other changes in FAS 123(R) as well as the potential impact on the Company’s reported operating results, financial position and existing financial statement disclosure is currently being evaluated.

FAS 123(R) requires that the benefits of tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow, thus reducing net operating cash flows and increasing net financing cash flows in the periods after the effective date. The Company cannot estimate what these amounts will be in the future because they depend on, among other things, when employees exercise stock options.

The Company currently follows the disclosure only provisions of FAS 148, and has elected to follow APB 25 and related interpretations in accounting for its employee stock options. The Company uses the Black-Scholes formula to estimate the value of stock options granted to employees for disclosure purposes. FAS 123(R) requires that the Company use the valuation technique that best fits the circumstances. The Company is currently evaluating other techniques.

In December 2004, the FASB issued FASB Staff Position (“FSP”) 109-1 (“FSP 109-1”) and 109-2 (“FSP 109-2”). FSP 109-1 provides guidance on the application of FAS No. 109, Accounting for Income Taxes (“FAS 109”), with regard to the tax deduction on qualified production activities provision within H.R. 4520, The American Jobs Creation Act of 2004 (“Act”), that was enacted on October 22, 2004. FSP 109-2 provides guidance on a special one-time dividends received deduction on the repatriation of certain foreign earnings to qualifying U.S. taxpayers. The Act contains numerous provisions related to corporate and international taxation including repeal of the Extraterritorial Income (ETI) regime, creation of a new Domestic Production Activities (DPA) deduction and a temporary dividends received deduction related to repatriation of foreign earnings. The Act contains various effective dates and transition periods. Under the guidance provided in FSP 109-1, the new DPA deduction will be treated as a “special deduction”

as described in FAS 109. As such, the special deduction has no effect on the Company’s deferred tax assets and liabilities existing at the enactment date. Rather, the impact of this deduction will be reported in the period in which the deduction is claimed on the Company’s income tax return. The Company does not expect the net effect of the phase-out of the ETI deduction and phase-in of the new DPA deduction to result in a material impact on its effective income tax rate in 2005.

In FSP 109-2, the FASB acknowledged that, due to the proximity of the Act’s enactment date to many companies’ year-ends and the fact that numerous provisions within the Act are complex and pending further regulatory guidance, many companies might not be in a position to assess the impacts of the Act on their plans for repatriation or reinvestment of foreign earnings. Therefore, the FSP provided companies with a practical exception to the permanent reinvestment standards of FAS 109 and APB No. 23, Accounting for Income Taxes – Special Areas, by providing additional time to determine the amount of earnings, if any, that they intend to repatriate under the Act’s provisions. The Company is not yet in a position to decide whether, and to what extent, it might repatriate foreign earnings to the U.S. Therefore, under the guidance provided in FSP 109-2, no deferred tax liability has been recorded in 2005 in connection with the repatriation provisions of the Act. The Company is currently analyzing the future impact of the temporary dividends received deduction provisions contained in the Act.

10. COMMITMENTS AND CONTINGENCIES

The Company is not a party to any legal proceedings other than routine litigation incidental to its business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the results of operations, financial position or cash flows of the Company.

11. SUBSEQUENT EVENTS

On August 11, 2005, the Company completed a refinancing of its existing debt in the U.S. with Fifth Third Bank (the “Bank”). The new financing consists of a secured revolving line of credit of $35 million. (the “Line of Credit”). The Line of Credit is secured by the Company’s U.S. assets, including its manufacturing facilities, and requires monthly payments of interest. The Line of Credit has a floating interest rate for the first year of 1) 1.5% over the 30-day LIBOR Rate (as defined), or 2) the Bank’s Base Rate (as defined), at the Company’s discretion. Any amount set aside or reserved to sweep nightly against the operating account will be at the Bank's Base Rate. Thereafter, the interest rate will vary based upon the Company’s leverage ratio.

The Line of Credit is payable in full on August 1, 2011, but maturity may be accelerated by the Bank upon an Event of Default (as defined). Prepayment may be made without penalty or premium at any time upon the required notice to the Bank. The Line of Credit has the following debt covenants: 1) Debt (as defined) to Tangible Net Worth (as defined) ratio of not more than 1.5:1.0, 2) Funded Debt (as defined) to EBITDA (as defined) ratio of not more than 2.5:1.0, and 3) EBIT (as defined) to Interest Expense (as defined) ratio of not less than 1.1:1.0; and requires the Company to maintain its primary domestic deposit accounts with the Bank.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

OVERVIEW

Sun Hydraulics Corporation is a leading designer and manufacturer of high-performance screw-in hydraulic cartridge valves and manifolds, which control force, speed and motion as integral components in fluid power systems. The Company sells its products globally through wholly-owned companies and independent distributors with some direct accounts. Sales outside the United States for the Quarter ended July 2, 2005, were 50% of total net sales.

Approximately 66% of product sales are used by the mobile market, which is characterized by applications where the equipment is not fixed in place, the operating environment is often unpredictable, and duty cycles are generally moderate to low. Some examples of mobile equipment include off-road construction equipment, fire and rescue equipment and mining machinery.

The remaining 34% of sales are used by industrial markets, which are characterized by equipment that is fixed in place, typically in a controlled environment, and which operates at higher pressures and duty cycles. Automation machinery, metal cutting machine tools and plastics machinery are some examples of industrial equipment. The Company sells to both markets with a single product line.

Industry conditions

Demand for the Company’s products is dependent on demand for the capital goods into which the products are incorporated. The capital goods industries in general, and the fluid power industry specifically, are subject to economic cycles. According to the National Fluid Power Association (the fluid power industry’s trade association in the United States), the United States index of shipments of hydraulic products decreased -16%, -3% and -2% in 2001, 2002 and 2003, respectively. This trend reversed in 2004 as the United States index of shipments of hydraulics products increased 25%.

The Company’s order trend has historically tracked closely to the United States Purchasing Managers Index (PMI). The index was 53.8 at the end of June 2005 compared to 61.1 at the end of June 2004. When PMI is over 50, it indicates economic expansion; when it is below 50, it indicates contraction in the economy.

Results for the second quarter
(Dollars in millions except net income per share)


	July 2,		June 26,
	2005		2004		Increase

Three Months Ended
Net Sales	$	31.0	$	26.5		17	%
Net Income	$	3.5	$	2.6		35	%
Net Income per share:
Basic	$	0.33	$	0.25		32	%
Fully Diluted	$	0.32	$	0.25		28	%

Six Months Ended
Net Sales	$	60.1	$	47.9		25	%
Net Income	$	7.0	$	3.9		79	%
Net Income per share:
Basic	$	0.65	$	0.39		66	%
Fully Diluted	$	0.65	$	0.38		71	%

Business conditions in the second quarter helped produce strong sales and record earnings. Earnings continued to be bolstered by the high level of productivity throughout the Company. Revenues continued to grow, being driven by delivery performance, the Sun website, the Company’s global channel partners, sales of valve packages and its electrically actuated cartridges.

On June 28, 2005, the Company secured an equity position in White Oak Controls, which designs and produces complementary electronic control products. The Company is working together with White Oak to develop electronic products that will enhance its next generation of valve package offerings.

The Company is pleased that its performance has resulted in its inclusion in this year’s Russell 2000® Index. Management believes that this helps improve the visibility of the Company as an attractive long-term investment.

Outlook

The Company estimates sales for the third quarter will be $28 million, a 20% increase over the third quarter last year. Net income is forecasted to be between $0.24 and $0.27 per share, compared to $0.18 per share in the third quarter last year.

COMPARISON OF THE THREE MONTHS ENDED JULY 2, 2005 AND JUNE 26, 2004

Net Sales

Net sales were $31.0 million, an increase of $4.5 million, or 16.9%, compared to $26.5 million in 2004. The increase was due in large part to the continued growth of the manufacturing sector, particularly in North America where sales increased 15.9%, as shipments within the U.S. increased 14.8% and Canadian shipments increased 27.7%.

European sales increased 19.5%, or $1.4 million, to $8.7 million. Sales to France increased 7.9%, to Germany 20.5%, and to the U.K. 5.1%. Significant increases were also noted in Finland, Italy, Ireland and the Netherlands.

Asian sales increased 20.5%, or $0.8 million, to $4.5 million, led by domestic sales in Korea and China.

Gross Profit

Gross profit increased $1.7 million, or 20.3%, to $10.1 million. Gross profit as a percentage of net sales increased to 32.5% in the second quarter of 2005, compared to 31.6% in the second quarter last year. Gross profit increases related to higher sales volume were partially offset by increased material cost of parts and raw materials, primarily in the U.S.

Selling, Engineering and Administrative Expenses

Selling, engineering and administrative expenses increased 7.8%, or $0.3 million, to $4.5 million compared to the same quarter last year. The increase was primarily due to increased audit and contract labor fees, including Sarbanes-Oxley 404 compliance, personnel related expenses, and costs for a bi-annual European trade show.

Interest Expense

Interest expense for the quarter ended July 2, 2005, remained flat at $0.1 million compared to the quarter ended June 26, 2004. Total average debt for the quarter ended July 2, 2005, was $11.7 million compared to $16.1 million for the quarter ended June 26, 2004. Although average debt outstanding decreased by $4.4 million, the average interest rate during the second quarter of 2005 was 5.0%, compared to 3.3% in 2004.

Foreign Currency Transaction Gain

Foreign currency gains were $0.1 million for the quarter ended July 2, 2005, primarily due to the gains of the Won and Pound in the Korean and U.K. operations, respectively, against the U. S. Dollar. There was no effect on income from foreign currency transactions for the quarter ended June 26, 2004.

Income Taxes

The provision for income taxes for the quarter ended July 2, 2005, was 36.7% of pretax income compared to 37.1% for the quarter ended June 26, 2004. The change was due to the relative mix of income and different tax rates in effect among the countries in which the Company sells its products.

COMPARISON OF THE SIX MONTHS ENDED JULY 2, 2005 AND JUNE 26, 2004

Net Sales

Net sales were $60.1 million, an increase of $12.2 million, or 25.4%. This increase reflected the economic recovery of the manufacturing sector in the United States, increased domestic sales in Korea and China, and strong demand in Europe and Scandinavia.

Gross Profit

Gross profit increased 35%, or $5.1 million. Gross profit as a percentage of net sales increased to 33.0% from 30.7% last year. A moderate and selective sales price increase in January this year, coupled with increased sales volume and improved productivity, offset the increased cost of parts and raw materials.

Selling, Engineering, and Administrative Expenses

Selling, engineering and administrative expenses increased 5.9%, or $0.5 million, to $8.7 million compared to last year. The increase was primarily due to increased audit and contract labor fees related to 2005, including Sarbanes-Oxley 404 compliance, personnel related expenses, and costs for a bi-annual European trade show.

Interest Expense

Interest expense for the six months ended July 2, 2005, remained flat at $0.3 million compared to the six months ended June 28, 2003. Total average debt for the period ended July 2, 2005, was $11.9 million compared to $16.5 million for the period ended June 26, 2004. Although average debt outstanding decreased during the period ended July 2, 2005, the average interest rate on variable debt increased from the period ended June 26, 2004.

Foreign Currency Transaction Gain

Foreign currency gains were $0.3 million for the six months ended July 2, 2005. While the Euro, the Korean Won and the British Pound made gains against the U.S. dollar during the six months ended July 2, 2005, the U.K. operations experienced losses related to sales conducted in U.S. dollars. There was no effect on income from foreign currency transactions for the six months ended June 26, 2004.

Income Taxes

The provision for income taxes for the six months ended July 2, 2005, was 36.9% of pretax income compared to 36.3% for the six months ended June 26, 2004. The change was due to the relative mix of income and different tax rates in effect among the countries in which the Company sells its products.

LIQUIDITY AND CAPITAL RESOURCES

Historically, the Company’s primary source of capital has been cash generated from operations, although fluctuations in working capital requirements have from time to time been met through borrowings under revolving lines of credit. The Company’s principal uses of cash have been to pay operating expenses, make capital expenditures, pay dividends to shareholders, and service debt.

Cash from operations for the six months ended July 2, 2005, was $8.4 million, compared to $6.0 million for the six months ended June 26, 2004. The $3.1 million increase in net income was offset by working capital changes related to increased volume. Days sales outstanding (DSO) were 34 and 33 at July 2, 2005, and June 26, 2004, respectively. Inventory turns were 10.7 as of July 2, 2005, compared to 10.8 as of June 26, 2004.

Capital expenditures, consisting primarily of purchases of machinery and equipment, were $3.6 million for the six months ended July 2, 2005, compared to $2.5 million for the six months ended June 26, 2004. Capital expenditures for the year are projected to be approximately $7.2 million.

The Company declared quarterly dividends of $0.05 per share to shareholders of record June 30, 2005, payable on July 15, 2005. The declaration and payment of future dividends is subject to the sole discretion of the Board of Directors, and any determination as to the payment of future dividends will depend upon the Company’s profitability, financial condition, capital needs, future prospects and other factors deemed pertinent by the Board of Directors.

The Line of Credit is payable in full on August 1, 2011, but maturity may be accelerated by the Bank upon an Event of Default (as defined). Prepayment may be made without penalty or premium at any time upon the required notice to the Bank. The Line of Credit has the following debt covenants: 1) Debt (as defined) to Tangible Net Worth (as defined) ratio of not more than 1.5.1.0, 2) Funded Debt (as defined) to EBITDA (as defined) ratio of not more than 2.5:1.0, and 3) EBIT (as defined) to Interest Expense (as defined) ratio of not less than 1.1:1.0; and requires the Company to maintain its primary domestic deposit accounts with the Bank.

The Company believes that cash generated from operations and its borrowing availability under its revolving Line of Credit will be sufficient to satisfy the Company’s operating expenses and capital expenditures for the foreseeable future. In the event that economic conditions were to severely worsen for a protracted period of time, the Company would have several options available to ensure liquidity in addition to increased borrowing. Capital expenditures could be postponed since they primarily pertain to long-term improvements in operations. Additional operating expense reductions also could be made. Finally, the dividend to shareholders could be reduced or suspended.

Off Balance Sheet Arrangements

The Company uses the equity method of accounting to account for its investments in Sun China and WhiteOak. The Company does not have a majority ownership in or exercise control over either of the entities. The Company does not believe that its investments in Sun China or WhiteOak qualify as Variable Interest Entities, within the scope of FASB Interpretation (FIN) No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 5, nor are they material to the financial statements of the Company at July 2, 2005.

Seasonality

The Company generally has experienced increased sales during the second quarter of the year, largely as a result of the order patterns of our customers. As a result, the Company’s second quarter net sales, income from operations and net income historically are the highest of any quarter during the year.

Inflation

The impact of inflation on the Company’s operating results has been moderate in recent years, reflecting generally lower rates of inflation in the economy. While inflation has not had, and the Company does not expect that it will have, a material impact upon operating results, there is no assurance that the Company’s business will not be affected by inflation in the future.

Critical Accounting Policies and Estimates

The Company currently only applies judgment and estimates which may have a material effect on the eventual outcome of assets, liabilities, revenues and expenses for impairment of long-lived assets, accounts receivable, inventory, goodwill and accruals. The following explains the basis and the procedure for each account where judgment and estimates are applied.

Revenue Recognition

The Company reports revenues, net of sales incentives, when title passes and risk of loss transfers to the customer. The effect of material non-recurring events is provided for when they become known.

Impairment of Long-Lived Assets

In accordance with Statement of Financial Accounting Standards (“FAS”) No. 144, Accounting for Impairment or Disposal of Long-lived Assets (“FAS 144”), long-lived assets, such as property and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of the asset is measured by comparison of its carrying amount to future net cash flows the asset is expected to generate. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the asset exceeds its fair market value.

The Company assesses the recoverability of goodwill and intangible assets not subject to amortization under FAS No. 142, Goodwill and Other Intangible Assets (“FAS 142”). See Goodwill below.

Accounts Receivable

The Company sells to most of its customers on a recurring basis, primarily through distributors with which the Company maintains long-term relationships. As a result, bad debt experience has not been material. The allowance for doubtful accounts is determined on a specific identification basis by a review of those accounts that are significantly in arrears. There can be no assurance that a distributor or a large direct sale customer with overdue accounts receivable balances will not develop financial difficulties and default on payment. See balance sheet for allowance amounts.

Inventory

The Company offers a wide variety of standard products and as a matter of policy does not discontinue products. On an ongoing basis, component parts found to be obsolete through design or process

changes are disposed of and charged to material cost. The Company reviews on-hand balances of products and component parts against specific criteria. Products and component parts without usage or that have excess quantities on hand are evaluated. An inventory reserve is then established for the full inventory carrying value of those products and component parts deemed to be obsolete or slow moving. See Note 4 for inventory reserve amounts.

Goodwill

The Company acquired its Korean operations in September 1998 using the purchase method. As a result, goodwill is reflected on the consolidated balance sheet. A valuation based on the cash flow method was performed at December 25, 2004. It was determined that the value of the goodwill was not impaired. There is no assurance that the value of the acquired company will not decrease in the future due to changing business conditions. See Note 5 for goodwill amounts.

Accruals

The Company makes estimates related to certain employee benefits and miscellaneous accruals. Estimates for employee benefit accruals are based on information received from plan administrators in conjunction with management’s assessments of estimated liabilities related to workers’ compensation, health care benefits, and annual contributions to an employee stock ownership plan (“ESOP”), established in 2004 as part of the Company’s retirement plan. Estimates for miscellaneous accruals are based on management’s assessment of estimated liabilities for costs incurred.

FORWARD-LOOKING INFORMATION

Certain oral statements made by management from time to time and certain statements contained herein that are not historical facts are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934 and, because such statements involve risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements, including those in Management’s Discussion and Analysis of Financial Condition and Results of Operations are statements regarding the intent, belief or current expectations, estimates or projections of the Company, its Directors or its Officers about the Company and the industry in which it operates, and assumptions made by management, and include among other items, (i) the Company’s strategies regarding growth, including its intention to develop new products; (ii) the Company’s financing plans; (iii) trends affecting the Company’s financial condition or results of operations; (iv) the Company’s ability to continue to control costs and to meet its liquidity and other financing needs; (v) the declaration and payment of dividends; and (vi) the Company’s ability to respond to changes in customer demand domestically and internationally, including as a result of standardization. Although the Company believes that its expectations are based on reasonable assumptions, it can give no assurance that the anticipated results will occur.

Important factors that could cause the actual results to differ materially from those in the forward-looking statements include, among other items, (i) the economic cyclicality of the capital goods industry in general and the hydraulic valve and manifold industry in particular, which directly affect customer orders, lead times and sales volume; (ii) conditions in the capital markets, including the interest rate environment and the availability of capital; (iii) changes in the competitive marketplace that could affect the Company’s revenue and/or cost bases, such as increased competition, lack of qualified engineering, marketing, management or other personnel, and increased labor and raw materials costs; (iv) changes in technology or customer requirements, such as standardization of the cavity into which screw-in cartridge valves must fit, which could render the Company’s products or technologies noncompetitive or obsolete; (v) new product introductions, product sales mix and the geographic mix of sales nationally and internationally; and (vi) changes relating to the Company’s international sales, including changes in regulatory requirements or tariffs, trade or currency restrictions, fluctuations in exchange rates, and tax and collection issues. Further information relating to factors that could cause actual results to differ from those anticipated is included but not limited to information under the headings “Business” (including under the subheading “Business Risk Factors”) in the Company’s Form 10-K for the year ended December 25, 2004, and “Management’s Discussion and Analysis of Financial Conditions and Results of Operations” in

this Form 10-Q for the quarter ended July 2, 2005. The Company disclaims any intention or obligation to update or revise forward-looking statements, whether as a result of new information, future events or otherwise.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed to market risk from changes in interest rates on borrowed funds, which could affect its results of operations and financial condition. The Company had approximately $10.0 million in variable-rate debt outstanding at July 2, 2005. The Company has managed this risk by its ability to select the interest rate on its debt financing at LIBOR plus 1.9% or its lender’s prime rate, whichever is more advantageous. Beginning in July 2004, the interest rate on its debt financing will remain variable based upon the Company’s leverage ratio. At July 2, 2005, a 1% change in interest rates up or down would have affected the Company’s income statement on an annual basis by approximately $100,000 at the current, variable-rate outstanding debt level. At June 26, 2004, the Company had $12.7 million in variable-rate debt outstanding and, as such, a 1% change in interest rates up or down would have affected the Company’s income statement on an annual basis by approximately $127,000.

The Company’s exposure to foreign currency exchange fluctuations relates primarily to the direct investment in its facilities in the United Kingdom, Germany, and Korea. The Company does not use financial instruments to hedge foreign currency exchange rate changes.

Item 4. CONTROLS AND PROCEDURES

As of July 2, 2005, the Company’s management, under the direction of its Chief Executive Officer and the Chief Financial Officer, carried out an evaluation of the effectiveness of the design and operation of the disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Company’s Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of July 2, 2005, in timely alerting them to material information required to be included in the Company’s periodic SEC filings.

There were no significant changes in the Company’s internal controls over financial reporting during the period ended July 2, 2005, that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II
OTHER INFORMATION

Item 1. Legal Proceedings.

None.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

In November 2004, the Company’s Board of Directors authorized the repurchase of up to $2.5 million of Company stock, to be completed no later than January 15, 2006. The stock purchases will be made in the open market or through privately negotiated transactions. Market purchases will be made subject to restrictions relating to volume, price and timing in an effort to minimize the impact of the purchases on the market for the Company’s securities. The amount of the stock repurchases was set based upon the anticipated number of shares that will be required to fund the Company’s ESOP, and employee stock purchase plan, through fiscal year 2005.

The Company did not purchase any shares during the second quarter under the plan. The total number of shares that have been purchased through the plan is 7,600. There is approximately $2.4 million of Company stock that may still be purchased by the Company.

Item 3. Defaults upon Senior Securities.

None.

Item 4. Submission of Matters to a Vote of Security Holders.

The Annual Meeting of Shareholders of the Company was held on June 11, 2005. At the meeting, the following actions were taken by the shareholders:

Christine L. Koski, Hirokatsu Sakamoto and David N. Wormley were reelected as Directors until the Annual Meeting in the year 2008, until their respective successors are elected and qualified or until their earlier resignation, removal from office or death. The votes cast for and withheld were as follows:


	Voted For		Withheld
Christine L. Koski		6,603,584		0
Hirokatsu Sakamoto		6,603,584		0
David N. Wormley		6,603,584		0

Item 5. Other Information.

None.


Exhibit
Number		Exhibit Description
10.1+		Sun Hydraulics Corporation 2004 Nonemployee Director Equity and Deferred Compensation Plan (As Amended and Restated Effective January 1, 2005).

31.1		CEO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		CFO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		CEO Certification pursuant to 18 U.S.C. § 1350.

32.2		CFO Certification pursuant to 18 U.S.C. § 1350.


		SUN HYDRAULICS CORPORATION

		By:		/s/ Richard J. Dobbyn

				Richard J. Dobbyn Chief Financial Officer (Principal Financial and Accounting Officer)

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PART I.FINANCIAL INFORMATION

	Item 1.		Financial Statements

		Consolidated Balance Sheets as of July 2, 2005 (unaudited) and December 25, 2004			3

		Consolidated Statements of Operations for the Three Months Ended July 2, 2005 (unaudited) and June 26, 2004 (unaudited)			4

		Consolidated Statements of Operations for the Six Months Ended July 2, 2005 (unaudited) and June 26, 2004 (unaudited)			5

		Consolidated Statement of Changes in Shareholders’ Equity and Comprehensive Income for the Six Months Ended July 2, 2005 (unaudited)			6

		Consolidated Statements of Cash Flows for the Six Months Ended July 2, 2005 (unaudited) and June 26, 2004 (unaudited)			7

		Notes to the Consolidated, Unaudited Financial Statements			8

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations			15

		Forward Looking Information			20

	Item 3.		Quantitative and Qualitative Disclosure About Market Risk		21

	Item 4.		Controls and Procedures		21

PART II. OTHER INFORMATION					22

	Item 1.		Legal Proceedings

	Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds

	Item 3.		Defaults Upon Senior Securities

	Item 4.		Submission of Matters to a Vote of Security Holders

	Item 5.		Other Information

	Item 6.		Exhibits
Ex-10.1 2004 Nonemployee Deferred Compensation Plan
Ex-31.1 Section 302 CEO Certification
Ex-31.2 Section 302 CFO Certification
Ex-32.1 Section 906 CEO Certification
Ex-32.2 Section 906 CFO Certification


+		Executive management contract or compensatory plan or arrangement.