Edgar Filing: LSB INDUSTRIES INC

form_10q.htm

LSB Industries, Inc.

Form 10-Q (6-30-2008)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

Form 10-Q

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

	For the quarterly period ended June 30, 2008

	OR

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

	For the transition period from _____________to______________

	Commission file number 1-7677

LSB Industries, Inc.
Exact name of Registrant as specified in its charter

Delaware		73-1015226
State or other jurisdiction of incorporation or organization		I.R.S. Employer Identification No.

16 South Pennsylvania Avenue, Oklahoma City, Oklahoma 73107
Address of principal executive offices (Zip Code)

(405) 235-4546
Registrant's telephone number, including area code

__ None _ ___
Former name, former address and former fiscal year, if changed since last report.

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 X No___

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer [ ] Accelerated filer [X]

Non-accelerated filer [ ] Smaller reporting company [ ]

(Do not check if a smaller reporting company)

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). [ ] Yes [X] No

The number of shares outstanding of the Registrant's voting common stock, as of August 1, 2008 was 21,245,492 shares, excluding 3,648,518 shares held as treasury stock.

Table of Contents

FORM 10-Q OF LSB INDUSTRIES, INC.

TABLE OF CONTENTS



	PART I – Financial Information	Page

Item 1.	Financial Statements	3

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	37

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	57

Item 4.	Controls and Procedures	58

Special Note	Regarding Forward-Looking Statements	60

	PART II – Other Information

Item 1.	Legal Proceedings	62

Item 1A.	Risk Factors	64

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	64

Item 3.	Defaults Upon Senior Securities	65

Item 4.	Submission of Matters to a Vote of Security Holders	65

Item 5.	Other Information	65

Item 6.	Exhibits	66

Table of Contents

Part 1
FINANCIAL INFORMATION

Item 1. Financial Statements

LSB INDUSTRIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

(Information at June 30, 2008 is unaudited)

June 30,

2008

December 31,

2007

(In Thousands)

Assets
Current assets:
Cash and cash equivalents	$	48,524	$	58,224
Restricted cash		31		203
Accounts receivable, net		95,540		70,577
Inventories:
Finished goods		39,558		28,177
Work in process		2,947		3,569
Raw materials		26,272		25,130
Total inventories		68,777		56,876
Supplies, prepaid items and other:
Deferred rent expense		433		-
Prepaid insurance		1,523		3,350
Precious metals		14,093		10,935
Supplies		4,228		3,849
Other		2,385		1,464
Total supplies, prepaid items and other		22,662		19,598
Deferred income taxes		6,190		10,030
Total current assets		241,724		215,508

Property, plant and equipment, net		89,230		79,692

Other assets:
Debt issuance and other debt-related costs, net		4,942		4,639
Investment in affiliate		3,608		3,426
Goodwill		1,724		1,724
Other, net		2,655		2,565
Total other assets		12,929		12,354
	$	343,883	$	307,554

(Continued on following page)

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LSB INDUSTRIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (continued)

(Information at June 30, 2008 is unaudited)

June 30,

2008

December 31,

2007

(In Thousands)

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	51,508		$	39,060
Short-term financing and drafts payable		131			919
Accrued and other liabilities		34,366			38,942
Current portion of long-term debt		912			1,043
Total current liabilities		86,917			79,964

Long-term debt		120,676			121,064

Noncurrent accrued and other liabilities:
Deferred income taxes		5,675			5,330
Other		7,547			6,913
		13,222			12,243

Contingencies (Note 10)

Stockholders' equity:
Series B 12% cumulative, convertible preferred stock, $100 par value; 20,000 shares issued and outstanding		2,000			2,000
Series D 6% cumulative, convertible Class C preferred stock, no par value; 1,000,000 shares issued		1,000			1,000
Common stock, $.10 par value; 75,000,000 shares authorized, 24,834,010 shares issued (24,466,506 at December 31, 2007)		2,483			2,447
Capital in excess of par value		126,909			123,336
Accumulated other comprehensive loss		(322	)		(411	)
Retained earnings (accumulated deficit)		12,071			(16,437	)
		144,141			111,935
Less treasury stock at cost:
Common stock, 3,648,518 shares (3,448,518 at December 31, 2007)		21,073			17,652
Total stockholders' equity		123,068			94,283
	$	343,883		$	307,554

(See accompanying notes)

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LSB INDUSTRIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

Six and Three Months Ended June 30, 2008 and 2007

Six Months

Three Months

2008

2007

2008

2007

(In Thousands, Except Per Share Amounts)

Net sales	$	358,507		$	304,141		$	198,052		$	156,756
Cost of sales		277,009			237,432			154,311			122,099
Gross profit		81,498			66,709			43,741			34,657

Selling, general and administrative expense		40,222			36,994			21,458			18,693
Provisions for losses on accounts receivable		292			621			202			363
Other expense		657			518			476			494
Other income		(8,329	)		(100	)		(7,719	)		(46	)
Operating income		48,656			28,676			29,324			15,153

Interest expense		3,720			4,580			1,266			1,992
Non-operating other income, net		(862	)		(73	)		(345	)		(31	)
Income from continuing operations before provisions for income taxes and equity in earnings of affiliate		45,798			24,169			28,403			13,192
Provisions for income taxes		17,429			532			10,709			188
Equity in earnings of affiliate		(462	)		(431	)		(230	)		(216	)
Income from continuing operations		28,831			24,068			17,924			13,220

Net loss from discontinued operations		17			29			17			-
Net income		28,814			24,039			17,907			13,220

Dividends, dividend requirements and stock dividend on preferred stocks		306			5,405			-			217
Net income applicable to common stock	$	28,508		$	18,634		$	17,907		$	13,003

Weighted-average common shares:
Basic		21,115			18,615			21,172			19,713

Diluted		24,908			21,950			24,827			22,923

Income per common share:
Basic	$	1.35		$	1.00		$	.85		$	.66

Diluted	$	1.21		$	.87		$	.75		$	.58

(See accompanying notes)

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LSB INDUSTRIES, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(Unaudited)

Six Months Ended June 30, 2008

Common Stock
Shares

Non-
Redeemable Preferred
Stock

Common

Stock Par
Value

Capital in
Excess of
Par Value

Accumulated
Other
Comprehensive

Loss

Retained

Earnings

(Accumulated Deficit)

Treasury
Stock-

Common

Total

(In Thousands)

Balance at December 31, 2007	24,467	$	3,000	$	2,447	$	123,336	$	(411	)	$	(16,437	)	$	(17,652	)	$	94,283

Net income												28,814						28,814
Amortization of cash flow hedge									89									89
Total comprehensive income																		28,903
Dividends paid on preferred stock												(306	)					(306	)
Stock-based compensation							384											384
Exercise of stock options	367				36		637											673
Income tax benefit from exercise of stock options							2,552											2,552
Acquisition of 200,000 shares of common stock															(3,421	)		(3,421	)
Balance at June 30, 2008	24,834	$	3,000	$	2,483	$	126,909	$	(322	)	$	12,071		$	(21,073	)	$	123,068

(See accompanying notes)

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LSB INDUSTRIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

Six Months Ended June 30, 2008 and 2007

2008

2007

(In Thousands)

Cash flows from continuing operating activities:
Net income	$	28,814		$	24,039
Adjustments to reconcile net income to net cash provided by continuing operating activities:
Net loss from discontinued operations		17			29
Deferred income taxes		4,185			-
Gain on litigation judgment associated with property, plant and equipment		(3,943	)		-
Loss on sales of property and equipment		82			431
Depreciation of property, plant and equipment		6,269			6,089
Amortization		554			441
Stock-based compensation		384			36
Provisions for losses on accounts receivable		292			621
Provision for (realization of) losses on inventory		184			(345	)
Provision for impairment of long-lived assets		192			-
Realization of losses on firm sales commitments		-			(328	)
Equity in earnings of affiliate		(462	)		(431	)
Distributions received from affiliate		280			380
Changes in fair value of interest rate caps		(709	)		(307	)
Cash provided (used) by changes in assets and liabilities:
Accounts receivable		(25,338	)		(11,842	)
Inventories		(12,085	)		(365	)
Other supplies and prepaid items		(2,631	)		(2,582	)
Accounts payable		11,129			(5,611	)
Customer deposits		(1,395	)		(567	)
Deferred rent expense		(4,733	)		(4,004	)
Other current and noncurrent liabilities		1,938			2,382
Net cash provided by continuing operating activities		3,024			8,066

Cash flows from continuing investing activities:
Capital expenditures		(14,986	)		(8,131	)
Proceeds from litigation judgment associated with property, plant and equipment		5,948			-
Payment of legal costs relating to litigation judgment associated with property, plant and equipment		(1,884	)		-
Proceeds from sales of property and equipment		58			191
Proceeds from restricted cash		172			2,807
Purchase of interest rate cap contracts		-			(621	)
Other assets		(352	)		17
Net cash used by continuing investing activities		(11,044	)		(5,737	)

(Continued on following page)

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LSB INDUSTRIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

(Unaudited)

Six Months Ended June 30, 2008 and 2007

2008

2007

(In Thousands)

Cash flows from continuing financing activities:
Proceeds from revolving debt facilities	$	288,793		$	248,972
Payments on revolving debt facilities		(288,793	)		(275,356	)
Proceeds from 5.5% convertible debentures, net of fees		-			56,985
Proceeds from other long-term debt, net of fees		-			2,424
Payments on other long-term debt		(284	)		(5,723	)
Payments of debt issuance costs		-			(50	)
Proceeds from short-term financing and drafts payable		-			56
Payments on short-term financing and drafts payable		(788	)		(2,106	)
Proceeds from exercise of stock options		673			858
Acquisition of common stock		(3,421	)		-
Excess income tax benefit on stock options exercised		2,552			-
Dividends paid on preferred stock		(306	)		-
Net cash provided (used) by continuing financing activities		(1,574	)		26,060

Cash flows of discontinued operations:
Operating cash flows		(106	)		(69	)
Net increase (decrease) in cash and cash equivalents		(9,700	)		28,320

Cash and cash equivalents at beginning of period		58,224			2,255
Cash and cash equivalents at end of period	$	48,524		$	30,575

Supplemental cash flow information:

Cash payments for income taxes, net of refunds	$	9,582		$	589

Noncash investing and financing activities:

Accounts payable associated with purchases of property, plant and equipment	$	2,618		$	-
Debt issuance costs	$	-		$	3,131
Debt issuance costs associated with 7% convertible debentures converted to common stock	$	-		$	266
7% convertible debentures converted to common stock	$	-		$	4,000
Series 2 preferred stock converted to common stock of which $12,303,000 was charged to accumulated deficit	$	-		$	27,593

(See accompanying notes)

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LSB INDUSTRIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1: Basis of Presentation The accompanying condensed consolidated financial statements include the accounts of LSB Industries, Inc. (the "Company", "We", "Us", or "Our") and its subsidiaries. We are a manufacturing, marketing and engineering company which is primarily engaged, through our wholly-owned subsidiary ThermaClime, Inc. (“ThermaClime”) and its subsidiaries, in the manufacture and sale of geothermal and water source heat pumps and air handling products (the "Climate Control Business") and the manufacture and sale of chemical products (the "Chemical Business"). The Company and ThermaClime are holding companies with no significant assets or operations other than cash and cash equivalents and our investments in our subsidiaries. Entities that are 20% to 50% owned and for which we have significant influence are accounted for on the equity method. All material intercompany accounts and transactions have been eliminated.

In the opinion of management, the unaudited condensed consolidated financial statements of the Company as of June 30, 2008 and for the six and three-month periods ended June 30, 2008 and 2007 include all adjustments and accruals, consisting only of normal, recurring accrual adjustments which are necessary for a fair presentation of the results for the interim periods. These interim results are not necessarily indicative of results for a full year due, in part, to the seasonality of our sales of agricultural products and the timing of performing our major plant maintenance activities. Our selling seasons for agricultural products are primarily during the spring and fall planting seasons, which typically extend from March through June and from September through November.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles (“GAAP”) have been condensed or omitted in this Form 10-Q pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). These condensed consolidated financial statements should be read in connection with the consolidated financial statements and notes thereto included in our Form 10-K for the year ended December 31, 2007 (“2007 Form 10-K”).

Note 2: Recently Issued Accounting Pronouncements In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157 - Fair Value Measurements (“SFAS 157”). SFAS 157 is definitional and disclosure oriented and addresses how companies should approach measuring fair value when required by GAAP; it does not create or modify any current GAAP requirements to apply fair value accounting. SFAS 157 provides a single definition for fair value that is to be applied consistently for all accounting applications, and also generally describes and prioritizes according to reliability the methods and input used in valuations. SFAS 157 prescribes various disclosures about financial statement categories and amounts which are measured at fair value, if such disclosures are not already specified elsewhere in GAAP. The new measurement and disclosure requirements of SFAS 157 became effective for the Company on January 1, 2008. The provisions of SFAS 157 were applied prospectively. See Note 11 - Derivatives, Hedges and Financial Instruments.

In March 2008, the FASB issued SFAS No. 161 - Disclosures about Derivative Instruments and Hedging Activities; an Amendment of SFAS 133 (“SFAS 161”). SFAS 161 requires enhanced disclosures about an entity’s derivative and hedging activities for the purpose of improving the transparency of financial reporting. The new disclosure requirements of SFAS 161 will become

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LSB INDUSTRIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 2: Recently Issued Accounting Pronouncements (continued)

effective for the Company beginning in the first quarter of 2009. We have not yet determined if the adoption of SFAS 161 will significantly impact our consolidated financial statements and disclosures.

Note 3: Accounts Receivable

June 30,

2008

December 31,

2007

(In Thousands)

Trade receivables	$	95,082		$	68,234
Insurance claims		214			2,469
Other		993			1,182
		96,289			71,885
Allowance for doubtful accounts		(749	)		(1,308	)
	$	95,540		$	70,577

Note 4: Inventories Inventories are priced at the lower of cost or market, with cost being determined using the first-in, first-out (“FIFO”) basis. Finished goods and work-in-process inventories include material, labor, and manufacturing overhead costs. At June 30, 2008 and December 31, 2007, inventory reserves for certain slow-moving inventory items (primarily Climate Control products) were $535,000 and $460,000, respectively. In addition, inventory reserves for certain nitrogen-based inventories provided by our Chemical Business were $48,000 and $13,000, at June 30, 2008 and December 31, 2007, respectively, because cost exceeded the net realizable value.

Changes in our inventory reserves are as follows:

Six Months Ended

June 30,

Three Months Ended

June 30,

2008

2007

2008

2007

(In Thousands)

Balance at beginning of period	$	473		$	1,255		$	610		$	938
Provisions for (realization of) losses		184			(345	)		15			(28	)
Write-offs/disposals		(74	)		(63	)		(42	)		(63	)
Balance at end of period	$	583		$	847		$	583		$	847

The provisions for losses are included in cost of sales (realization of losses is a reduction to cost of sales) in the accompanying condensed consolidated statements of income.

Note 5: Precious Metals Precious metals are used as a catalyst in the Chemical Business manufacturing process. Precious metals are carried at cost, with cost being determined using the FIFO basis. Because some of the catalyst consumed in the production process cannot be readily recovered and the amount and timing of recoveries are not predictable, we follow the practice of expensing precious metals as they are consumed.

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LSB INDUSTRIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5: Precious Metals (continued)

Occasionally, during major maintenance and/or capital projects, we may be able to perform procedures to recover precious metals (previously expensed) which have accumulated over time within our manufacturing equipment. When we accumulate precious metals in excess of our production requirements, we may sell a portion of the excess metals.

Precious metals expense, net, consists of the following:

Six Months Ended

June 30,

Three Months Ended

June 30,

2008

2007

2008

2007

(In Thousands)

Precious metals expense	$	4,354		$	3,114		$	1,894		$	1,431
Recoveries of precious metals		(792	)		(1,233	)		(792	)		(937	)
Gains on sales of precious metals		-			(489	)		-			-
Precious metals expense, net	$	3,562		$	1,392		$	1,102		$	494

Precious metals expense is included in cost of sales (recoveries and gains on sales of precious metals are reductions to cost of sales) in the accompanying condensed consolidated statements of income.

Note 6: Investment in Affiliate Cepolk Holding, Inc. (“CHI”), a subsidiary of the Company, is a limited partner and has a 50% equity interest in Cepolk Limited Partnership (“Partnership”) which is accounted for on the equity method. The Partnership owns an energy savings project located at the Ft. Polk Army base in Louisiana (“Project”). As of June 30, 2008, the Partnership and general partner to the Partnership is indebted to a term lender (“Term Lender”) of the Project. CHI has pledged its limited partnership interest in the Partnership to the Term Lender as part of the Term Lender’s collateral securing all obligations under the loan. This guarantee and pledge is limited to CHI’s limited partnership interest and does not expose CHI or the Company to liability in excess of CHI’s limited partnership interest. No liability has been established for this pledge since it was entered into prior to adoption of FASB Interpretation (“FIN”) 45. CHI has no recourse provisions or available collateral that would enable CHI to recover its partnership interest should the Term Lender be required to perform under this pledge.

Note 7: Product Warranty Our Climate Control Business sells equipment that has an expected life, under normal circumstances and use, that extends over several years. As such, we provide warranties after equipment shipment/start-up covering defects in materials and workmanship.

Generally, the base warranty coverage for most of the manufactured equipment in the Climate Control Business is limited to eighteen months from the date of shipment or twelve months from the date of start-up, whichever is shorter, and to ninety days for spare parts. The warranty provides that most equipment is required to be returned to the factory or an authorized representative and the warranty is limited to the repair and replacement of the defective product, with a maximum warranty of the refund of the purchase price. Furthermore, companies within the Climate Control Business generally disclaim and exclude warranties related to merchantability or fitness for any particular purpose and disclaim and exclude any liability for

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LSB INDUSTRIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 7: Product Warranty (continued)

consequential or incidental damages. In some cases, the customer may purchase or a specific product may be sold with an extended warranty. The above discussion is generally applicable to such extended warranties, but variations do occur depending upon specific contractual obligations, certain system components, and local laws.

Our accounting policy and methodology for warranty arrangements is to periodically measure and recognize the expense and liability for such warranty obligations using a percentage of net sales, based upon our historical warranty costs. It is possible that future warranty costs could exceed our estimates.

Changes in our product warranty obligation are as follows:

Six Months Ended

June 30,

Three Months Ended

June 30,

2008

2007

2008

2007

(In Thousands)

Balance at beginning of period	$	1,944		$	1,251		$	2,056		$	1,227
Add: Charged to costs and expenses		2,287			1,335			1,556			827
Deduct: Costs and expenses incurred		(1,953	)		(1,065	)		(1,334	)		(533	)
Balance at end of period	$	2,278		$	1,521		$	2,278		$	1,521

Note 8: Current and Noncurrent Accrued and Other Liabilities

June 30,

2008

December 31,

2007

(In Thousands)

Customer deposits	$	8,130	$	9,525
Accrued income taxes		5,707		4,540
Deferred income taxes		5,675		5,330
Accrued payroll and benefits		4,439		5,362
Deferred revenue on extended warranty contracts		3,691		3,387
Accrued death benefits		2,365		2,051
Accrued commissions		2,300		2,256
Accrued warranty costs		2,278		1,944
Accrued precious metals costs		1,919		1,359
Accrued contractual manufacturing obligations		1,888		1,548
Accrued insurance		1,873		2,975
Accrued property and franchise taxes		1,475		707
Accrued executive benefits		1,014		1,040
Accrued interest		906		1,056
Deferred rent expense		-		4,300
Other		3,928		3,805
		47,588		51,185
Less noncurrent portion		13,222		12,243
Current portion of accrued and other liabilities	$	34,366	$	38,942

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LSB INDUSTRIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 9: Long-Term Debt

	June 30,		December 31,
	2008		2007

(In Thousands)

Working Capital Revolver Loan due 2012 (A)	$	-	$	-
5.5% Convertible Senior Subordinated Notes due 2012 (B)		60,000		60,000
Secured Term Loan due 2012 (C)		50,000		50,000
Other, with current interest rates of 5.99% to 9.36%, most of which is secured by machinery, equipment and real estate		11,588		12,107
		121,588		122,107
Less current portion of long-term debt		912		1,043
Long-term debt due after one year	$	120,676	$	121,064

(A) ThermaClime and its subsidiaries (the “Borrowers”) are parties to a $50 million revolving credit facility (the “Working Capital Revolver Loan”) that provides for advances based on specified percentages of eligible accounts receivable and inventories for ThermaClime, and its subsidiaries. The Working Capital Revolver Loan, as amended, accrues interest at a base rate (generally equivalent to the prime rate) plus .50% or LIBOR plus 1.75%. The interest rate at June 30, 2008 was 5.5%. Interest is paid monthly. The facility provides for up to $8.5 million of letters of credit. All letters of credit outstanding reduce availability under the facility. At June 30, 2008, amounts available for additional borrowing under the Working Capital Revolver Loan were $49.3 million. Under the Working Capital Revolver Loan, as amended, the lender also requires the Borrowers to pay a letter of credit fee equal to 1% per annum of the undrawn amount of all outstanding letters of credit, an unused line fee equal to .375% per annum for the excess amount available under the facility not drawn and various other audit, appraisal and valuation charges.

The lender may, upon an event of default, as defined, terminate the Working Capital Revolver Loan and make the balance outstanding due and payable in full, if any. The Working Capital Revolver Loan is secured by the assets of all the ThermaClime entities other than El Dorado Nitric Company and its subsidiaries (“EDNC”) but excluding the assets securing the $50 million secured term loan discussed in (C) below and certain distribution-related assets of El Dorado Chemical Company (“EDC”). EDNC is neither a borrower nor guarantor of the Working Capital Revolver Loan. The carrying value of the pledged assets is approximately $215 million at June 30, 2008.

The Working Capital Revolver Loan, as amended, requires ThermaClime to meet certain financial covenants measured quarterly. ThermaClime was in compliance with those covenants for the twelve-month period ended June 30, 2008. The Working Capital Revolver Loan also contains covenants that, among other things, limit the Borrowers’ (which does not include the Company) ability, without consent of the lender, to:

·	incur additional indebtedness,

·	incur liens,

·	make restricted payments or loans to affiliates who are not Borrowers,

·	engage in mergers, consolidations or other forms of recapitalization, or dispose assets.

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LSB INDUSTRIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 9: Long-Term Debt (continued)

The Working Capital Revolver Loan also requires all collections on accounts receivable be made through a bank account in the name of the lender or their agent.

(B) In June 2007, we entered into a purchase agreement with each of twenty two qualified institutional buyers (“QIBs”), pursuant to which we sold $60 million aggregate principal amount of the 5.5% Convertible Senior Subordinated Notes (the “2007 Debentures”) in a private placement to the QIBs pursuant to the exemptions from the registration requirements of the Securities Act of 1933, as amended (the “Act”), afforded by Section 4(2) of the Act and Regulation D promulgated under the Act. The 2007 Debentures are eligible for resale by the investors under Rule144A under the Act. We received net proceeds of approximately $57 million, after discounts and commissions. In connection with the closing, we entered into an indenture (the “Indenture”) with UMB Bank, as trustee (the “Trustee”), governing the 2007 Debentures. The Trustee receives customary compensation from us for such services.

The 2007 Debentures bear interest at the rate of 5.5% per year and mature on July 1, 2012. Interest is payable in arrears on January 1 and July 1 of each year, which began on January 1, 2008.

The 2007 Debentures are unsecured obligations and are subordinated in right of payment to all of our existing and future senior indebtedness, including indebtedness under our revolving debt facilities. The 2007 Debentures are effectively subordinated to all present and future liabilities, including trade payables, of our subsidiaries.

The 2007 Debentures are convertible by the holders in whole or in part into shares of our common stock prior to their maturity. The conversion rate of the 2007 Debentures for the holders electing to convert all or any portion of a debenture is 36.4 shares of our common stock per $1,000 principal amount of debentures (representing a conversion price of $27.47 per share of common stock), subject to adjustment under certain conditions as set forth in the Indenture.

We may redeem some or all of the 2007 Debentures at any time on or after July 2, 2010, at a price equal to 100% of the principal amount of the 2007 Debentures, plus accrued and unpaid interest, all as set forth in the Indenture. The redemption price will be payable at our option in cash or, subject to certain conditions, shares of our common stock (valued at 95% of the weighted average of the closing sale prices of the common stock for the 20 consecutive trading days ending on the fifth trading day prior to the redemption date), subject to certain conditions being met on the date we mail the notice of redemption.

If a designated event (as defined in the Indenture) occurs prior to maturity, holders of the 2007 Debentures may require us to repurchase all or a portion of their 2007 Debentures for cash at a repurchase price equal to 101% of the principal amount of the 2007 Debentures plus any accrued and unpaid interest, as set forth in the Indenture. If a fundamental change (as defined in the Indenture) occurs on or prior to June 30, 2010, under certain circumstances, we will pay, in addition to the repurchase price, a make-whole premium on the 2007 Debentures converted in connection with, or tendered for repurchase upon, the fundamental change. The make-whole premium will be payable in our common stock or the same form of consideration into which our

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common stock has been exchanged or converted in the fundamental change. The amount of the make-whole premium, if any, will be based on our stock price on the effective date of the fundamental change. No make-whole premium will be paid if our stock price in connection with the fundamental change is less than or equal to $23.00 per share.

At maturity, we may elect, subject to certain conditions as set forth in the Indenture, to pay up to 50% of the principal amount of the outstanding 2007 Debentures, plus all accrued and unpaid interest thereon to, but excluding, the maturity date, in shares of our common stock (valued at 95% of the weighted average of the closing sale prices of the common stock for the 20 consecutive trading days ending on the fifth trading day prior to the maturity date), if the common stock is then listed on an eligible market, the shares used to pay the 2007 Debentures and any interest thereon are freely tradable, and certain required opinions of counsel are received.

We have used a portion of the net proceeds to redeem our remaining outstanding shares of Series 2 $3.25 convertible, exchangeable Class C preferred stock (“Series 2 Preferred”); to repay certain outstanding mortgages and equipment loans; to pay dividends in arrears on our outstanding shares of Series B 12% cumulative, convertible preferred stock (“Series B Preferred”) and Series D 6% cumulative, convertible Class C preferred stock (“Series D Preferred”), all of which were owned by an affiliate; and the balance to initially reduce the outstanding borrowings under the Working Capital Revolver Loan. In addition, we have currently invested a portion of the net proceeds in money market investments. We intend to use the remaining portion of the net proceeds for certain discretionary capital expenditures and general working capital purposes.

In conjunction with the 2007 Debentures, we entered into a Registration Rights Agreement with the QIBs. In connection with the Registration Rights Agreement, we filed a post-effective amendment No. 1, to our previously filed registration statement, which amendment was declared effective by the SEC on April 21, 2008.

(C) ThermaClime and certain of its subsidiaries are parties to a $50 million loan agreement (the “Secured Term Loan”) with a certain lender. The Secured Term Loan matures on November 2, 2012. The Secured Term Loan accrues interest at a defined LIBOR rate plus 3%. The interest rate at June 30, 2008 was 5.78%. The Secured Term Loan requires quarterly interest payments with the final payment of interest and principal at maturity.

The Secured Term Loan is secured by the real property and equipment located at our El Dorado, Arkansas and Cherokee, Alabama chemical production facilities. The carrying value of the pledged assets is approximately $54 million at June 30, 2008.

The Secured Term Loan borrowers are subject to numerous covenants under the agreement including, but not limited to, limitation on the incurrence of certain additional indebtedness and liens, limitations on mergers, acquisitions, dissolution and sale of assets, and limitations on declaration of dividends and distributions to us, all with certain exceptions. At June 30, 2008, the carrying value of the restricted net assets of ThermaClime and its subsidiaries was approximately

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$66 million. The Secured Term Loan borrowers are also subject to a minimum fixed charge coverage ratio and a maximum leverage ratio, both measured quarterly on a trailing twelve-month basis. The Secured Term Loan borrowers were in compliance with these financial covenants for the twelve-month period ended June 30, 2008.

Note 10: Contingencies We accrue for contingent losses when such losses are probable and reasonably estimable. In addition, we recognize contingent gains when such gains are realizable.

Following is a summary of certain legal matters involving the Company.

A.	Environmental Matters

Our operations are subject to numerous environmental laws (“Environmental Laws”) and to other federal, state and local laws regarding health and safety matters (“Health Laws”). In particular, the manufacture and distribution of chemical products are activities which entail environmental risks and impose obligations under the Environmental Laws and the Health Laws, many of which provide for certain performance obligations, substantial fines and criminal sanctions for violations. There can be no assurance that material costs or liabilities will not be incurred by us in complying with such laws or in paying fines or penalties for violation of such laws. The Environmental Laws and Health Laws and enforcement policies thereunder relating to our Chemical Business have in the past resulted, and could in the future result, in compliance expenses, cleanup costs, penalties or other liabilities relating to the handling, manufacture, use, emission, discharge or disposal of effluents at or from our facilities or the use or disposal of certain of its chemical products. Historically, significant expenditures have been incurred by subsidiaries within our Chemical Business in order to comply with the Environmental Laws and Health Laws and are reasonably expected to be incurred in the future.

We are required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated in accordance with FIN 47. We are obligated to monitor certain discharge water outlets at our Chemical Business facilities should we discontinue the operations of a facility. We also have certain facilities in our Chemical Business that contain asbestos insulation around certain piping and heated surfaces which we plan to maintain in an adequate condition to prevent leakage through our standard repair and maintenance activities. Since we currently have no plans to discontinue the use of these facilities and the remaining life of the facilities is indeterminable, an asset retirement liability has not been recognized. Currently, there is insufficient information to estimate the fair value of the asset retirement obligations. However, we will continue to review these obligations and record a liability when a reasonable estimate of the fair value can be made.

1. Discharge Water Matters

The chemical production facility located in El Dorado, Arkansas (the “El Dorado Facility”) within our Chemical Business generates process wastewater, which includes storm water. The process water discharge and storm-water run off are governed by a state National Pollutant Discharge Elimination System (“NPDES”) water discharge permit issued by the Arkansas

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Department of Environmental Quality (“ADEQ”), which permit is to be renewed every five years. The ADEQ issued to the El Dorado Facility a NPDES water discharge permit in 2004, and the El Dorado Facility had until June 1, 2007 to meet the compliance deadline for the more restrictive limits under the 2004 NPDES permit. In order to meet the El Dorado Facility’s June 2007 limits, the El Dorado Facility has significantly reduced the contaminant levels of its wastewater.

The El Dorado Facility has demonstrated its ability to comply with the more restrictive permit limits, and the rules which support the more restrictive dissolved minerals rules have been revised to authorize a permit modification to adopt achievable dissolved minerals permit limits. The ADEQ and the El Dorado Facility have entered into a consent administration order to authorize the El Dorado Facility to continue operations without incurring permit violations pending the modification of the permit to implement the revised rule and to dispose of the El Dorado Facility’s wastewater into the creek adjacent to the El Dorado Facility. As of June 30, 2008, the ADEQ has not issued the revised permit.

In addition, the El Dorado Facility has entered into a consent administrative order (“CAO”) that recognizes the presence of nitrate contamination in the shallow groundwater at the El Dorado Facility. A new CAO to address the shallow groundwater contamination became effective on November 16, 2006 and requires the evaluation of the current conditions and remediation based upon a risk assessment. The CAO requires the El Dorado Facility to continue semi-annual groundwater monitoring, to continue operation of a groundwater recovery system and to submit a human health and ecological risk assessment to the ADEQ. The final remedy for shallow groundwater contamination, should any remediation be required, will be selected pursuant to the new CAO and based upon the risk assessment. As an interim measure, the El Dorado Facility has installed two recovery wells to recycle groundwater and to recover nitrates. The cost of any additional remediation that may be required will be determined based on the results of the investigation and risk assessment and cannot currently be reasonably estimated. Therefore, no liability has been established at June 30, 2008.

2. Air Matters

Under the terms of a consent administrative order relating to air matters (“AirCAO”), which became effective in February 2004, resolving certain air regulatory alleged violations associated with the El Dorado Facility’s sulfuric acid plant and certain other alleged air emission violations, the El Dorado Facility is required to implement additional air emission controls at the El Dorado Facility no later than February 2010. We currently estimate the remaining environmental compliance related expenditures to be approximately $2.2 million, which has been committed in the remainder of 2008.

In December 2006, the El Dorado Facility entered into a new CAO (“2006 CAO”) with the ADEQ to resolve a problem with ammonia emissions from certain nitric acid units. The catalyst suppliers had represented the volume of ammonia emissions anticipated. The representation was the basis for the permitted emission limit, but the representation of the catalyst suppliers was not accurate. Under the 2006 CAO, the ADEQ allowed the El Dorado Facility to re-evaluate the catalyst performance and required the El Dorado Facility to submit a permit modification with

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the appropriate ammonia limits. The permit modification was submitted to ADEQ on June 11, 2007, and is currently under review. Until the permit is modified, the 2006 CAO authorizes the El Dorado Facility to continue to operate certain nitric acid units (even though the El Dorado Facility is in non-compliance with the permitted emission limit for ammonia), provided that during this period of time, the El Dorado Facility monitors and reports the ammonia emissions on a monthly basis.

3. Other Environmental Matters

In April 2002, Slurry Explosive Corporation (“Slurry”), later renamed Chemex I Corp., a subsidiary within our Chemical Business, entered into a Consent Administrative Order (“Slurry Consent Order”) with the Kansas Department of Health and Environment (“KDHE”), regarding Slurry’s Hallowell, Kansas manufacturing facility (“Hallowell Facility”). The Slurry Consent Order addressed the release of contaminants from the facility into the soils and groundwater and surface water at the Hallowell Facility. There are no known users of the groundwater in the area. The adjacent strip pit is used for fishing. Under the terms of the Slurry Consent Order, Slurry is required to, among other things, submit an environmental assessment work plan to the KDHE for review and approval, and agree with the KDHE as to any required corrective actions to be performed at the Hallowell Facility.

In December 2002, Slurry and Universal Tech Corporation (“UTeC”), both subsidiaries within our Chemical Business, sold substantially all of their operating assets but retained ownership of the real property. At December 31, 2002, even though we continued to own the real property, we did not assess our continuing involvement with our former Hallowell facility to be significant and therefore accounted for the sale as discontinued operations. In connection with this sale, UTeC leased the real property to the buyer under a triple net long-term lease agreement. However, Slurry retained the obligation to be responsible for, and perform the activities under, the Slurry Consent Order. In addition, certain of our subsidiaries agreed to indemnify the buyer of such assets for these environmental matters. The successor (“Chevron”) of the prior owner of the Hallowell Facility has agreed, within certain limitations, to pay and has been paying one-half of the costs incurred under the Slurry Consent Order subject to reallocation.

Based on additional modeling of the site, Slurry and Chevron are pursuing a course with the KDHE of long-term surface and ground water monitoring to track the natural decline in contamination, instead of the soil excavation proposed previously. On September 12, 2007, the KDHE approved our proposal to perform two years of surface and groundwater monitoring and to implement a Mitigation Work Plan to acquire additional field data in order to more accurately characterize the nature and extent of contaminant migration off-site. The two-year monitoring program will terminate in February 2009.

At June 30, 2008, the total estimated liability (which is included in current accrued and other liabilities) in connection with this remediation matter is approximately $195,000 and Chevron’s share for these costs (which is included in accounts receivable) is approximately $100,000. These amounts are not discounted to their present value. It is reasonably possible that a change in estimate of our liability and receivable will occur in the near term.

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B. Other Pending, Threatened or Settled Litigation

1. Climate Control Business

A proposed class action was filed in the Illinois state district court in September 2007 alleging that certain evaporator coils sold by one of our subsidiaries in the Climate Control Business, Climate Master, Inc. (“Climate Master”) in the state of Illinois from 1990 to approximately 2003 were defective. The complaint requests certification as a class action for the State of Illinois, which request has not yet been heard by the court. The plaintiff asserts claims based upon negligence, strict liability, breach of implied warranties, and the Illinois Consumer Fraud and Deceptive Business Practices Act. Climate Master has timely filed its pleadings to remove this action to federal court. Climate Master has also filed its answer denying the plaintiff’s claims and asserting several affirmative defenses. Climate Master’s insurers have been placed on notice of this matter. Currently the Company is unable to determine the amount of damages or the likelihood of any losses resulting from this claim. In addition, the Company intends to vigorously defend Climate Master in connection with this matter. Therefore, no liability has been established at June 30, 2008.

2. Chemical Business

In 2005, EDC sued the general partners of Dresser Rand Company, Ingersoll-Rand Company and DR Holdings Corp., and an individual employee of Dresser Rand Company, in connection with its faulty repair of a hot gas expander of one of EDC’s nitric acid plants. As a result of defects in the repair, on October 8, 2004, the hot gas expander failed, leading to a fire at the nitric acid plant. The lawsuit was styled El Dorado Chemical Company, et al v. Ingersoll-Rand Company (NJ), et al. in the Union County Arkansas Circuit Court. A trial was held in October 2006 resulting in a jury verdict awarding EDC approximately $9.8 million in damages. During April 2008, the Arkansas Supreme Court affirmed the award granted to EDC by the lower court. On June 6, 2008, we received proceeds of approximately $11.2 million for this litigation judgment, which includes interest of approximately $1.4 million, from which we paid attorneys’ fees of approximately $3.6 million. The payment of attorneys’ fees of 31.67% of our recovery was contingent upon the cash receipt of the litigation judgment. As a result, for the six and three months ended June 30, 2008, we recognized income of approximately $7.6 million, net of attorneys’ fees, which amount is classified as other income in the accompanying condensed consolidated statements of income. In addition, the cash flows relating to this litigation judgment are included in cash flows from continuing operating activities, except for the portion of the judgment associated with the recovery of damages relating to property, plant and equipment and its pro-rata portion of the attorneys’ fees. These cash flows are included in cash flows from continuing investing activities.

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3. Other

Zeller Pension Plan

In February 2000, our board of directors authorized management to proceed with the sale of the automotive products business, since the automotive products business was no longer a “core business” of the Company. In May 2000, the Company sold substantially all of its assets in its automotive products business. After the authorization by the board, but prior to the sale, the automotive products business purchased the assets and assumed certain liabilities of Zeller Corporation (“Zeller”). The liabilities of Zeller assumed by the automotive products business included Zeller’s pension plan, which is not a multi-employer pension plan. In June 2003, the principal owner (“Owner”) of the buyer of the automotive products business was contacted by a representative of the Pension Benefit Guaranty Corporation (“PBGC”) regarding the plan. The Owner was informed by the PBGC of a possible under-funding of the plan and a possible takeover of the plan by the PBGC. The PBGC previously advised the Company that the PBGC may consider the Company potentially liable for the under-funding of the Zeller Plan in the event that the plan is taken over by the PBGC and alleged that the under-funding is approximately $600,000. Our ERISA counsel has advised us that, based on certain assumptions and representations made by us to them, they believe that the possibility of an unfavorable non-appealable verdict against us in a lawsuit if the PBGC attempts to hold us liable for under-funding of the Zeller Plan is remote.

MEI Drafts

Cromus, as an assignee of Masinexportimport Foreign Trade Company (“MEI”), filed a lawsuit against us, our subsidiary, Summit Machine Tool Manufacturing Corp. (“Summit”), certain of our other subsidiaries, our chief executive officer and another officer of our Company, Bank of America, and others, alleging that it was owed $1,533,000, plus interest from 1990, in connection with Cromus’ attempted collection of ten non-negotiable bank drafts payable to the order of MEI. The bank drafts were issued by Aerobit Ltd. (“Aerobit”), a non-U.S. company, which at the time of issuance of the bank drafts, was one of our subsidiaries. Each of the bank drafts has a face value of $153,300, for an aggregate principal face value of $1,533,000. The bank drafts were issued in September 1992, and had a maturity date of December 31, 2001. Each bank draft was endorsed by LSB Corp., which at the time of endorsement, was also one of our subsidiaries. The complaint also seeks $1,000,000 from us and Summit for failure to purchase certain equipment and $1,000,000 in punitive damages. During May 2008, the court dismissed the complaint against us and our subsidiaries and our officers (including our Chief Executive Officer). Cromus has appealed this dismissal.

The Jayhawk Group and the University of Kansas

During July 2007, we mailed to all holders of record of our Series 2 Preferred a notice of redemption of all of the outstanding shares of Series 2 Preferred. The redemption of our Series 2 Preferred was completed on August 27, 2007, the redemption date. The terms of the Series 2 Preferred required that for each share of Series 2 Preferred so redeemed, we would pay, in cash, a redemption price equal to $50.00 plus $26.25 representing dividends in arrears thereon pro-rata

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to the date of redemption. There were 193,295 shares of Series 2 Preferred outstanding, net of treasury stock, as of the date the notice of redemption was mailed. Pursuant to the terms of the Series 2 Preferred, the holders of the Series 2 Preferred could convert each share into 4.329 shares of our common stock. If a holder of the Series 2 Preferred elected to convert his, her or its shares into our common stock pursuant to its terms, the Certificate of Designations for the Series 2 Preferred provided, and it is our position, that the holder that so converts would not be entitled to receive payment of any dividends in arrears on the shares so converted. Jayhawk Capital Management, L.L.C., and certain of its affiliates (the “Jayhawk Group”), a former affiliate of ours, converted 155,012 shares of Series 2 Preferred into 671,046 shares of common stock. The Jayhawk Group has advised us that it may bring legal action against us for all dividends in arrears (approximately $4.0 million) on the shares of Series 2 Preferred that it converted after receipt of the notice of redemption and that it should have been able to tender all of its preferred shares under the tender offer notwithstanding an agreement between the Jayhawk Group and us that the Jayhawk Group would tender only one-half of its preferred shares. The general counsel of the Jayhawk Group orally offered to settle all claims against us in return for a payment of $100,000, representing the approximate legal fees the Jayhawk Group alleged it had incurred investigating these claims. Through counsel, we agreed to the settlement offer. After we agreed to the settlement offer verbally and by e-mail, the Jayhawk Group’s general counsel purported to withdraw the settlement offer and asserted the Jayhawk Group was not bound by any settlement agreement. We believe the likelihood that the Jayhawk Group may recover the dividends in arrears is not probable, and we further believe that the settlement agreement is binding on the Jayhawk Group. As a result, a liability of $100,000 has been established at June 30, 2008.

During the first quarter of 2008, the University of Kansas Endowment Charitable Gift Fund (“KU”) filed a lawsuit against us. KU alleges that we improperly refused to accept 11,200 shares of Series 2 Preferred, which KU received as a gift from the controlling party of the Jayhawk Group, in our issuer exchange tender offer. Under the issuer exchange tender offer, we offered to exchange each outstanding share of Series 2 Preferred for 7.4 shares of our common stock and a waiver of all dividends in arrears, except for certain shares of Series 2 Preferred owned by the Jayhawk Group (including its controlling party, Kent McCarthy) and Jack E. Golsen (Chairman of the Board and CEO of the Company), his wife, children (including Barry H. Golsen, our President) and certain entities controlled by them (the “Golsen Group”) pursuant to an agreement entered into between us, the Golsen Group and the Jayhawk Group (the “Jayhawk Agreement”). The gift to KU by the controlling party of the Jayhawk Group was made after the announcement of the issuer exchange tender offer, and it is our position, among other things, that the tender of the shares given as a gift was made contrary to the Jayhawk Agreement and contrary to the terms of our issuer exchange tender offer. KU alleges, among other things, that it suffered losses because it was required to convert the 11,200 shares of Series 2 Preferred pursuant to the conversion terms of the Series 2 Preferred, which was 4.3 shares of our common stock for each share of Series 2 Preferred, and that the conversion was less favorable than the terms of issuer exchange tender offer. KU alleges that the refusal to accept the 11,200 shares of Series 2 Preferred was in violation of §14(d) of the Securities Exchange Act of 1934 (“1934 Act”), a violation of §10b and Rule 10b-5 and §18 of the 1934 Act, the Kansas Uniform Securities Act and common law fraud. Our insurance carrier under our Executive Organization Liability Insurance Policy Including Securities Liability has agreed to defend this matter under a

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reservation of rights, subject to a $250,000 self-insurance retention for security matters. We have entered in an agreement in principal with KU to settle this claim for $200,000, which amount is included in our accrued and other liabilities at June 30, 2008. The settlement of this claim is subject to the parties entering into a definitive settlement agreement.

Securities and Exchange Commission

We have previously disclosed that the Securities and Exchange Commission (“SEC”) was conducting an informal inquiry of us relating to the change in inventory accounting from LIFO to FIFO during 2004 involving approximately $500,000 by one of our subsidiaries, which change resulted in the restatement of our financial statements for each of the three years in the period ended December 31, 2004 and our March 31, 2005 and June 30, 2005 quarterly financial statements. During April 2008, the staff of the SEC delivered a formal Wells Notice to us informing us that the staff has preliminarily decided to recommend to the SEC that it institute a civil enforcement action against us in connection with the above described matter. All assertions against us involve alleged violations of Section 13 of the 1934 Act and do not assert allegations of fraudulent conduct nor seek a monetary civil fine against us. During May 2008, we made a written submission to the SEC and senior staff of the SEC. In addition, the SEC has also made assertions against our principal accounting officer based on Section 13 of the 1934 Act, and the SEC staff has also stated its intention to recommend civil and/or administrative proceedings against him. Our principal accounting officer also made a Wells submission. As of June 30, 2008, the staff has not made a formal recommendation to the SEC. As previously reported, our current principal accounting officer has resigned as principal accounting officer, effective August 15, 2008, but will remain with the company as a senior vice president in charge of lending compliance and cash management and be involved in our banking relationships, acquisitions and corporate planning.

Other Claims and Legal Actions

We are also involved in various other claims and legal actions which in the opinion of management, after consultation with legal counsel, if determined adversely to us, would not have a material effect on our business, financial condition or results of operations.

Note 11: Derivatives, Hedges and Financial Instruments We account for derivatives in accordance with SFAS 133 which requires the recognition of derivatives in the balance sheet and the measurement of these instruments at fair value. Changes in fair value of derivatives are recorded in results of operations unless the normal purchase or sale exceptions apply or hedge accounting is elected.

In 1997, we entered into an interest rate forward agreement to effectively fix the interest rate of a long-term lease commitment (not for trading purposes). In 1999, we executed a long-term lease agreement (initial lease term of ten years) and terminated the forward agreement at a net cost of $2.8 million. We historically accounted for this cash flow hedge under the deferral method (as an adjustment of the initial term lease rentals). Upon adoption of SFAS 133 in 2001, the remaining deferred cost amount was reclassified from other assets to accumulated other comprehensive loss

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and is being amortized to operations over the term of the lease arrangement. At June 30, 2008 and December 31, 2007, accumulated other comprehensive loss consisted of the remaining deferred cost of $265,000 and $411,000, respectively. The amount amortized to operations was $89,000 (net of minimal income taxes) and $145,000 for the six months ended June 30, 2008 and 2007, respectively, and $44,000 (net of minimal income taxes) and $72,000 for the three months ended June 30, 2008 and 2007, respectively. There were no income tax benefits allocated to these expenses in 2007.

We have three types of contracts that are accounted for on a fair value basis, which are interest rate contracts, commodities futures contracts and foreign currency contracts as discussed below. The valuation of these contracts was determined generally based on quoted market prices. However, in certain instances where market quotes are not available, other valuation techniques or models are used to estimate fair values.

Interest Rate Contracts

As part of our interest rate risk management, we periodically purchase and/or enter into various interest rate contracts. In March 2005, we purchased two interest rate cap contracts for a cost of $590,000. In April 2007, we purchased two interest rate cap contracts for a cost of $621,000, which set a maximum three-month LIBOR base rate of 5.35% on $50 million and matured in April 2012. In April 2008, we exchanged the two interest rate cap contracts purchased in 2007 for an interest rate cap contract, which set a maximum three-month LIBOR base rate of 4.56% on $25 million and matures in April 2012. The cost basis of the new contract is $239,000 based on the estimated fair value of the two contracts surrendered (which was also the carrying value at the time of the exchange) in accordance with Accounting Principle Board Opinion No. 29, as amended. In April 2008, we entered into an interest rate swap, which sets a fixed three-month LIBOR rate of 3.24% on $25 million and matures in April 2012.

These contracts are free-standing derivatives and are accounted for on a mark-to-market basis in accordance with SFAS 133. At June 30, 2008 and December 31, 2007, the fair values of these contracts were $1,135,000 and $426,000, respectively, and are included in other assets in the accompanying consolidated balance sheets. For the six months ended June 30, 2008 and 2007, we recognized gains of $708,000 and $424,000, respectively, and for the three months ended June 30, 2008 and 2007, we recognized gains of $877,000 and $462,000, respectively. In addition, the cash used to purchase these contracts is included in cash flows from continuing investing activities.

Commodities Futures Contracts

Raw materials for use in our manufacturing processes include copper used by our Climate Control Business and natural gas used by our Chemical Business. As part of our raw material price risk management, we periodically enter into futures contracts for these materials, which contracts are generally accounted for on a mark-to-market basis in accordance with SFAS 133. At June 30, 2008, the fair value of these futures contracts (unrealized gain) totaled $867,000 and is included in current assets (supplies, prepaid items and other) and noncurrent assets (other assets). At December 31, 2007, the fair value of these contracts (unrealized loss) was $172,000

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and is included in accrued and other liabilities. Pursuant to the terms of these contracts, the fair values are classified as current or noncurrent assets and liabilities in the accompanying condensed consolidated balance sheets. For the six months ended June 30, 2008 and 2007, we recognized gains of $4,488,000 and $24,000, respectively, and for the three months ended June 30, 2008, we recognized gains of $1,291,000 and for the three months ended June 30, 2007, we recognized losses of $487,000 on such contracts. In addition, the cash flows relating to these contracts are included in cash flows from continuing operating activities.

Foreign Currency Contracts

One of our business operations purchases industrial machinery and related components from vendors outside of the United States. As part of our foreign currency risk management, during the three months ended June 30, 2008, we entered into several foreign currency contracts, which set the U.S. Dollar/Euro exchange rates through December 2008. These contracts are free-standing derivatives and are accounted for on a mark-to-market basis in accordance with SFAS 133. At June 30, 2008, the fair value of these contracts was $15,000 (unrealized loss) and is included in accrued and other liabilities in the accompanying consolidated balance sheet (none at December 31, 2007). For each of the six and three-month periods ended June 30, 2008, we recognized losses of $35,000 (none in 2007) on such contracts. In addition, the cash flows relating to these contracts are included in cash flows from continuing operating activities.

The following details our assets and liabilities at June 30, 2008 that are measured at fair value on a recurring basis:

Fair Value Measurements at

June 30, 2008 Using

Description

June 30,

2008

Quoted Prices

in Active

Markets for

Identical Assets

(Level 1)

Significant

Other

Observable

Inputs

(Level 2)

(In Thousands)

Assets:
Interest rate contracts	$	1,135	$	-	$	1,135
Commodities futures contracts		867		330		537
Total	$	2,002	$	330	$	1,672

Liabilities:
Foreign currency contracts	$	15	$	-	$	15

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 11: Derivatives, Hedges and Financial Instruments (continued)

Gains (realized and unrealized) included in earnings and the income statement classification are as follows:

Six Months

Ended

June 30, 2008

Three Months Ended

June 30, 2008

(In Thousands)

Total gains included in earnings:
Cost of sales	$	4,453	$	1,256
Interest expense		708		877
	$	5,161	$	2,133

Change in unrealized gains and losses relating to contracts still held at June 30, 2008:
Cost of sales	$	846	$	793
Interest expense		709		896
	$	1,555	$	1,689

Note 12: Approval of Stock Incentive Plan During the second quarter of 2008, our board of directors adopted our 2008 Incentive Stock Plan (the “2008 Plan”), which plan was approved by our shareholders at our annual meeting of shareholders held on June 5, 2008. The number of shares of our common stock available for issuance under the 2008 Plan is 1,000,000 shares, subject to adjustment. Under the 2008 Plan, awards may be made to any employee, officer or director of the Company and its affiliated companies. An award may also be granted to any consultant, agent, advisor or independent contractor for bona fide services rendered to the Company or any affiliate (as defined in the 2008 Plan), subject to certain conditions. The 2008 Plan will be administered by the compensation and stock option committee (the “Committee”) of our board of directors.

Our board of directors or the Committee may amend the 2008 Plan, except that if any applicable statute, rule or regulation requires shareholder approval with respect to any amendment of the 2008 Plan, then to the extent so required, shareholder approval will be obtained. Shareholder approval will also be obtained for any amendment that would increase the number of shares stated as available for issuance under the 2008 Plan. Unless sooner terminated by our board of directors, the 2008 Plan expires on June 5, 2018.

The following may be granted by the Committee under the 2008 Plan:

Stock Options - The Committee may grant either incentive stock options or non-qualified stock options. The Committee sets option exercise prices and terms, except that the exercise price of a stock option may be no less than 100% of the fair market value, as defined in the 2008 Plan, of the shares on the date of grant. At the time of grant, the Committee will have sole discretion in determining when stock options are exercisable and when they expire, except that the term of a stock option cannot exceed 10 years.

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LSB INDUSTRIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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Note 12: Approval of Stock Incentive Plan (continued)

Stock Appreciation Rights (“SARs”) - The Committee may grant SARs as a right in tandem with the number of shares underlying stock options granted under the 2008 Plan or on a stand-alone basis. SARs are the right to receive payment per share of the SAR exercised in stock or in cash equal to the excess of the share’s fair market value, as defined in the 2008 Plan, on the date of exercise over its fair market value on the date the SAR was granted. Exercise of an SAR issued in tandem with stock options will result in the reduction of the number of shares underlying the related stock option to the extent of the SAR exercise.

Stock Awards, Restricted Stock, Restricted Stock Units, and Other Awards - The Committee may grant awards of restricted stock, restricted stock units, and other stock and cash-based awards, which may include the payment of stock in lieu of cash (including cash payable under other incentive or bonus programs) or the payment of cash (which may or may not be based on the price of our common stock).

As of June 30, 2008, no awards have been granted under the 2008 Plan.

Note 13: Income Per Common Share Net income applicable to common stock is computed by adjusting net income by the amount of preferred stock dividends, dividend requirements and stock dividend. Basic income per common share is based upon net income applicable to common stock and the weighted-average number of common shares outstanding during each period. Diluted income per share is based on net income applicable to common stock plus preferred stock dividends and dividend requirements on preferred stock assumed to be converted, if dilutive, and interest expense including amortization of debt issuance cost, net of income taxes, on convertible debt assumed to be converted, if dilutive, and the weighted-average number of common shares and dilutive common equivalent shares outstanding, and the assumed conversion of dilutive convertible securities outstanding.

The following is a summary of certain transactions which affected basic income per share or diluted income per share, if dilutive:

During the six months ended June 30, 2008,

·	we acquired 200,000 shares of our common stock;

·	we issued 367,304 shares of our common stock as the result of the exercise of stock options; and

·	we paid cash dividends on our Series B Preferred, Series D Preferred and noncumulative redeemable preferred stock (“Noncumulative Preferred”) totaling approximately $240,000, $60,000 and $6,000, respectively.

During the six months ended June 30, 2007,

·	we sold $60 million of the 2007 Debentures on June 28, 2007;

·	$4,000,000 of the 7% Convertible Senior Subordinated Debentures (the “2006 Debentures”) was converted into 564,789 shares of common stock;

·	we issued 2,262,965 shares of common stock for 305,807 shares of our Series 2 Preferred that were tendered pursuant to a tender offer;

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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Note 13: Income Per Common Share (continued)

·	we received shareholders’ approval in granting 450,000 shares of non-qualified stock options on June 14, 2007; and

·	we issued 245,100 shares of our common stock as the result of the exercise of stock options.

At June 30, 2008, there were no dividends in arrears.

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LSB INDUSTRIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 13: Income Per Common Share (continued)

The following table sets forth the computation of basic and diluted net income per common share:

(Dollars In Thousands, Except Per Share Amounts)

Six Months Ended

June 30,

Three Months Ended

June 30,

2008

2007

2008

2007

Numerator:
Net income	$	28,814		$	24,039		$	17,907	$	13,220
Dividends and dividend requirements on Series B Preferred		(240	)		(120	)		-		(60	)
Dividend requirements on shares of Series 2 Preferred which did not exchange pursuant to tender offer in 2007		-			(314	)		-		(157	)
Stock dividend on shares of Series 2 Preferred pursuant to tender offer in 2007(1)		-			(4,971	)		-		-
Dividends on Series D Preferred		(60	)		-			-		-
Dividends on Noncumulative Preferred		(6	)		-			-		-
Total dividends, dividend requirements and stock dividend on preferred stock		(306	)		(5,405	)		-		(217	)
Numerator for basic net income per common share - net income applicable to common stock		28,508			18,634			17,907		13,003
Dividends and dividend requirements on preferred stock assumed to be converted, if dilutive		306			434			-		217
Interest expense including amortization of debt issuance costs, net of income taxes, on convertible debt assumed to be converted, if dilutive		1,203			83			601		34
Numerator for diluted net income per common share	$	30,017		$	19,151		$	18,508	$	13,254

Denominator:
Denominator for basic net income per common share - weighted-average shares		21,114,506			18,614,835			21,172,227		19,713,471
Effect of dilutive securities:
Convertible notes payable		2,188,000			212,088			2,188,000		111,651
Convertible preferred stock		940,016			1,778,610			939,966		1,777,900
Stock options		665,198			1,255,959			526,801		1,228,399
Warrants		-			88,257			-		92,068
Dilutive potential common shares		3,793,214			3,334,914			3,654,767		3,210,018
Denominator for diluted net income per common share - adjusted weighted-average shares and assumed conversions		24,907,720			21,949,749			24,826,994		22,923,489

Basic net income per common share	$	1.35		$	1.00		$	.85	$	.66

Diluted net income per common share	$	1.21		$	.87		$	.75	$	.58

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 13: Income Per Common Share (continued)

(1) As discussed in our 2007 Form 10-K, in February 2007, we began a tender offer to exchange shares of our common stock for up to 309,807 of the 499,102 outstanding shares of the Series 2 Preferred. The tender offer expired on March 12, 2007 and our board of directors accepted the shares tendered on March 13, 2007. Because the exchanges under the tender offer were pursuant to terms other than the original terms, the transactions were considered extinguishments of the preferred stock. In addition, the transactions qualified as induced conversions under SFAS 84. In accordance with Emerging Issues Task Force (“EITF”) Topic No. D-42, the excess of the fair value of the common stock issued over the fair value of the securities issuable pursuant to the original conversion terms was subtracted from net income in computing net income per share. Because our Series 2 Preferred are cumulative and the dividend requirements have been included in computing net income per share in previous periods and as an element of the exchange transactions, we effectively settled the dividends in arrears, the amount subtracted from net income in 2007 represents the excess of the fair value of the common stock issued over the fair value of the securities issuable pursuant to the original conversion terms less the dividends in arrears as March 13, 2007.

The following weighted-average shares of securities were not included in the computation of diluted net income per common share as their effect would have been antidilutive:

Six Months Ended

June 30,

Three Months Ended

June 30,

2008

2007

2008

2007

Stock options	425,000	42,265	425,000	84,066
Series 2 Preferred pursuant to tender offer in 2007 (2)	-	522,181	-	-
	425,000	564,446	425,000	84,066

(2) In accordance with EITF Topic No. D-53, the shares associated with the tender offer in 2007 were considered separately from other convertible shares of securities in computing net income per common share for the six and three months ended June 30, 2007.

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LSB INDUSTRIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 14: Income Taxes Provisions for income taxes are as follows:

Six Months Ended

June 30,

Three Months Ended

June 30,

2008

2007

2008

2007

(In Thousands)

Current:

Federal	$	11,520	$	446	$	6,625	$	232
State		1,724		86		909		(44	)
Total Current	$	13,244	$	532	$	7,534	$	188

Deferred:

Federal	$	3,539	$	-	$	2,709	$	-
State		646		-		466		-
Total Deferred		4,185		-		3,175		-
Provisions for income taxes	$	17,429	$	532	$	10,709	$	188

For the six and three months ended June 30, 2008, the current provision for federal income taxes of $11,520,000 and $6,625,000, respectively, includes regular federal income tax after the consideration of permanent and temporary differences between income for GAAP and tax purposes. For the six and three months ended June 30, 2007, the current provision for federal income taxes of $446,000 and $232,000, respectively, includes alternative minimum income tax (“AMT”). The current provision for state income taxes in 2008 includes provisions for jurisdictions not previously recognized (See discussion of FIN 48 below). The 2008 current state income tax provision also anticipates the utilization of remaining net operating loss (“NOL”) carryforwards in certain states. In the first six months of 2007, we had a valuation allowance in place against the deferred tax assets arising from the NOL carryforwards and other temporary differences. As a result, a deferred tax provision was not recognized. At December 31, 2007, we had minimal federal and state net operating losses and we anticipate fully utilizing these NOL carryforwards during 2008 and have accrued income taxes at regular corporate tax rates. Our overall effective tax rate in 2008 is reduced by permanent tax differences.

When non-qualified stock options (“NSOs”) are exercised, the grantor of the options is permitted to deduct the spread between the fair market value and the exercise price of the NSOs as compensation expense in determining taxable income. Under SFAS 109, income tax benefits related to stock-based compensation deductions in excess of the compensation expense recorded for financial reporting purposes are not recognized in earnings as a reduction of income tax expense for financial reporting purposes. As a result, the stock-based compensation deduction for the six months ended June 30, 2008 to be recognized in our 2008 income tax return will exceed the related stock-based compensation expense recognized in earnings. The excess tax benefit realized (i.e., the resulting reduction in the current tax liability) related to the excess stock-based compensation tax deduction of $2,552,000 is accounted for as an increase in capital in excess of par value for the six months ended June 30, 2008.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 14: Income Taxes (continued)

We account for income taxes in accordance with FIN 48, which requires that realization of an uncertain income tax position must be “more likely than not” (i.e., greater than 50% likelihood) that the position will be sustained upon examination by taxing authorities before it can be recognized in the financial statements. Further, FIN 48 prescribes the amount to be recorded in the financial statements as the amount most likely to be realized assuming a review by tax authorities having all relevant information and applying current conventions.

We believe that we do not have any material uncertain tax positions that meet the FIN 48 more likely than not recognition criteria other than the failure to file state income tax returns in some jurisdictions where we or some of our subsidiaries may have a filing responsibility. We had approximately $1,441,000 and $1,617,000 accrued for uncertain tax liabilities at June 30, 2008 and December 31, 2007, respectively, which are included in accrued and other liabilities in the accompanying condensed consolidated balance sheets.

We plan to negotiate voluntary disclosure agreements and file prior year tax returns with various taxing authorities in 2008. Therefore, we anticipate that the total amounts of unrecognized tax benefits will decrease by approximately $1,141,000 by December 31, 2008 as a result of state tax payments made as part of the voluntary disclosure agreement process or other resolutions.

We and certain of our subsidiaries file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. The federal tax returns for 1994 through 2003 remain subject to examination for the purpose of determining the amount of remaining tax NOL and other carryforwards. With few exceptions, the 2004-2007 years remain open for all purposes of examination by the IRS and other major tax jurisdictions.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 15: Other Expense, Other Income and Non-Operating Other Income, net

Six Months Ended

June 30,

Three Months Ended

June 30,

2008

2007

2008

2007

(In Thousands)

Other expense:
Potential litigation settlements	$	367		$	-		$	192		$	-
Losses on sales and disposals of property and equipment		82			431			82			431
Impairment of long-lived assets (1)		192			-			192			-
Other miscellaneous expense (2)		16			87			10			63
Total other expense	$	657		$	518		$	476		$	494

Other income:
Litigation judgment and settlements (3)	$	8,235		$	-		$	7,710		$	-
Other miscellaneous income (2)		94			100			9			46
Total other income	$	8,329		$	100		$	7,719		$	46

Non-operating other income, net:
Interest income	$	899		$	58		$	358		$	16
Miscellaneous income (2)		11			65			11			39
Miscellaneous expense (2)		(48	)		(50	)		(24	)		(24	)
Total non-operating other income, net	$	862		$	73		$	345		$	31

(1)	Based on an unsuccessful effort to sell certain corporate assets in an auction, we recognized an impairment of long-lived assets.

(2)	Amounts represent numerous unrelated transactions, none of which are individually significant requiring separate disclosure.

(3)

For the six and three months ended June 30, 2008, income from litigation judgment and settlements includes approximately $7,560,000, net of attorneys’ fees, relating to a litigation judgment involving a subsidiary within our Chemical Business as discussed in Note 10 - Contingencies. In addition, during the six months ended June 30, 2008, a settlement was reached for $400,000 for the recovery of certain environmental-related costs incurred in previous periods relating to property used by Corporate and other business operations.

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LSB INDUSTRIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 16: Segment Information

Six Months Ended

June 30,

Three Months Ended

June 30,

2008

2007

2008

2007

(In Thousands)

Net sales:
Climate Control	$	146,949		$	145,823		$	80,626		$	74,518
Chemical		204,788			153,142			113,458			79,422
Other		6,770			5,176			3,968			2,816
	$	358,507		$	304,141		$	198,052		$	156,756

Gross profit: (1)
Climate Control (2)	$	47,454		$	42,628		$	25,932		$	21,921
Chemical (3)		31,852			22,242			16,499			11,710
Other		2,192			1,839			1,310			1,026
	$	81,498		$	66,709		$	43,741		$	34,657

Operating income (loss): (4)
Climate Control (2)	$	21,182		$	18,125		$	11,855		$	9,617
Chemical (3) (5)		32,627			15,646			20,502			7,936
General corporate expenses and other business operations, net (6)		(5,153	)		(5,095	)		(3,033	)		(2,400	)
		48,656			28,676			29,324			15,153

Interest expense		(3,720	)		(4,580