form_10k.htm
LSB Industries, Inc.

Form 10-K (12-31-2008)

 
 
 
UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 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 of Incorporation)
 
(I.R.S. Employer)
Identification No.)

16 South Pennsylvania Avenue
Oklahoma City, Oklahoma
 
 
73107
(Address of Principal Executive Offices)
 
(Zip Code)

Registrant's Telephone Number, Including Area Code: (405) 235-4546

Securities Registered Pursuant to Section 12(b) of the Act:

 
Title of Each Class
 
Name of Each Exchange
On Which Registered
Common Stock, Par Value $.10
Preferred Share Purchase Rights
 
New York Stock Exchange
New York Stock Exchange
 
 
1


 (Facing Sheet Continued)

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. [ ] Yes [X] No

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. [ ] Yes [X] No

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]

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 aggregate market value of the Registrant’s voting common equity held by non-affiliates of the Registrant, computed by reference to the price at which the voting common stock was last sold as of June 30, 2008, was approximately $338 million. As a result, the Registrant is an accelerated filer as of December 31, 2008. For purposes of this computation, shares of the Registrant’s common stock beneficially owned by each executive officer and director of the Registrant were deemed to be owned by affiliates of the Registrant as of June 30, 2008. Such determination should not be deemed an admission that such executive officers and directors of our common stock are, in fact, affiliates of the Registrant or affiliates as of the date of this Form 10-K.
 
As of March 6, 2009, the Registrant had 21,109,812 shares of common stock outstanding (excluding 3,848,518 shares of common stock held as treasury stock).
 
 
2

FORM 10-K OF LSB INDUSTRIES, INC.

TABLE OF CONTENTS

   
Page
 
     
 
PART I
 
     
5
 
   
17
     
24
     
24
     
26
     
29
     
30
 
   
 
PART II
 
     
32
 
   
36
     
37 
     
72
     
76
     
76
     
76
     
79
     
 
PART III
 
     
84 
     
89
 
 
 
3


 
FORM 10-K OF LSB INDUSTRIES, INC.
 
TABLE OF CONTENTS
 
     
   
Page
     
105
     
111
     
112
     
 
PART IV
 
     
114
 
 
4

PART I

ITEM 1.  BUSINESS

General

LSB Industries, Inc. (the "Company", “Registrant”, “LSB”, "We", "Us", or "Our") was formed in 1968 as an Oklahoma corporation, and became a Delaware corporation in 1977. We are a diversified holding company. Our wholly-owned subsidiary, ThermaClime, Inc. (“ThermaClime”) through its subsidiaries, owns substantially all of our core businesses consisting of the:

·
Climate Control Business engaged in the manufacturing and selling of a broad range of heating, ventilation and air conditioning (“HVAC”) products for the niche markets we serve. These products are used in commercial and residential new building construction, renovation of existing buildings and replacement of existing systems.
·
Chemical Business engaged in the manufacturing and selling of chemical products produced from plants in Texas, Arkansas and Alabama for the industrial, mining and agricultural markets.

Certain statements contained in this Part I may be deemed to be forward-looking statements. See "Special Note Regarding Forward-Looking Statements."

We believe our Climate Control Business has developed leadership positions in certain niche markets by offering extensive product lines, customized products and improved technologies. Under this focused strategy, we have developed what we believe to be the most extensive line of geothermal and water source heat pumps and hydronic fan coils in the United States. Further, we believe that we were a pioneer in the use of geothermal technology in the climate control industry and have used it to create what we believe to be the most energy efficient climate control systems commercially available today. We employ highly flexible production capabilities that allow us to custom design units for new construction as well as the retrofit and replacement markets.

Our Chemical Business has three chemical production facilities located in El Dorado, Arkansas (the “El Dorado Facility”), Cherokee, Alabama (the “Cherokee Facility”) and Baytown, Texas (the “Baytown Facility”). Our products include industrial and fertilizer grade ammonium nitrate (“AN”), urea ammonium nitrate (“UAN”), nitric acid in various concentrations, nitrogen solutions an
d various other products.Our Chemical Business is a supplier to some of the world’s leading chemical and industrial companies. By focusing on specific geographic areas, we have developed freight and distribution advantages over many of our competitors, and we believe our Chemical Business has established leading regional market positions, a key element in the success of this business.
 
Current State of the Economy

The current state of the economy creates significant uncertainty relative to the industrial, construction and agricultural markets that we serve.  We based our 2009 business plan upon our
 
 
assumption that during most of 2009, the economy will continue to contract due to additional loss of jobs, declining consumer demand and limited credit availability. However, our 2009 business plan is a moving target that will be adjusted frequently as we measure customer demand during the first and second quarters. We plan to adjust our controllable costs when and as market conditions dictate. See further discussion relating to the economy under various risk factors under Item 1A of this Part 1 and “Overview-Economic Conditions” of the Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) contained in this report.

Website Access to Company's Reports

Our internet website address is www.lsb-okc.com.  Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to section 13(a) or 15(d) of the Exchange Act are available free of charge through our website as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission.

Segment Information and Foreign and Domestic Operations and Export Sales

Schedules of the amounts of net sales, gross profit, operating income (loss) and identifiable assets attributable to each of our lines of business and of the amount of our export sales in the aggregate and by major geographic area for each of the last three years appear in Note 21 of the Notes to Consolidated Financial Statements included elsewhere in this report.

Climate Control Business

General

Our Climate Control Business manufactures and sells a broad range of standard and custom designed geothermal and water source heat pumps and hydronic fan coils as well as large custom air handlers and modular chiller systems. These products are for use in commercial and residential HVAC systems. Our products are currently installed in some of the most recognizable commercial developments in the country, including Prudential Tower, Rockefeller Plaza, Trump Tower, and Time Warner Center, and are slated to be in a number of developments currently under construction. In addition, we have a significant presence in the lodging industry with installations in numerous Hyatt, Marriott, Four Seasons, Starwood, Ritz Carlton and Hilton hotels. We also have a substantial share of resort destinations in Las Vegas where we have units installed in over 70,000 rooms for a number of premier properties, including the MGM Grand, Luxor, Venetian, Treasure Island, Bellagio, Mandalay Bay, Caesar’s Palace, Monte Carlo, Mirage, Golden Nugget, Hard Rock, Wynn resorts, and many others.

 
6

 
The following table summarizes net sales information relating to our products of the Climate Control Business:

 
2008
 
2007
 
2006
Percentage of net sales of the Climate Control Business:
                 
Geothermal and water source heat pumps
 
61
%
 
58
%
 
61
%
Hydronic fan coils
 
27
%
 
30
%
 
27
%
Other HVAC products
 
12
%
 
12
%
 
12
%
   
100
%
 
100
%
 
100
%
Percentage of our consolidated net sales:
                 
Geothermal and water source heat pumps
 
25
%
 
28
%
 
27
%
Hydronic fan coils
 
11
%
 
15
%
 
12
%
Other HVAC products
 
5
%
 
6
%
 
6
%
   
41
%
 
49
%
 
45
%

Market Conditions for Climate Control Business

We discuss below certain details of our marketing, distribution, production, backlog, competition and new products relative to our geothermal and water source heat pumps, hydronic fan coils and other products produced by our Climate Control Business. At this time, we are unable to assess the possible impact to our Climate Control Business’ sales level as a result of the well documented downturn in commercial and residential construction. For the short term, we do expect to see lower demand for most of our products.

We believe that tax credits and incentives, and certain planned direct spending by the federal government contained in the recently enacted American Reinvestment and Recovery Act of 2009, could stimulate sales of our geothermal heat pump products, as well as other products that could be used to modernize federally owned and operated buildings, military installations, public housing and hospitals.

The longer term outlook after 2009, to a significant extent, will depend on the recovery of the credit and capital markets and the general economy.

Geothermal and Water Source Heat Pumps

We believe we are a leading provider of geothermal and water source heat pumps to the commercial construction and renovation markets in the United States. Water source heat pumps are highly efficient heating and cooling products, which enable individual room climate control through the transfer of heat using a water pipe system, which is connected to a centralized cooling tower or heat injector. Water source heat pumps enjoy a broad range of commercial applications, particularly in medium to large sized buildings with many small, individually controlled spaces. Despite the current economic downturn, we believe the market share for commercial water source heat pumps relative to other types of heating and air-conditioning systems will continue to grow due to the relative efficiency and longevity of such systems, as well as due to the emergence of the replacement market for those systems.
 
 
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Our Climate Control Business has also developed the use of geothermal heat pumps in residential and commercial applications. Geothermal systems, which circulate water and antifreeze through an underground heat exchanger, are among the most energy efficient systems currently available in the market. We believe the energy efficiency, longer life, and relatively short payback periods of geothermal systems, as compared with air-to-air systems, will continue to increase demand for our geothermal products. In addition, we believe the recently enacted American Reinvestment and Recovery Act of 2009 contains significant incentives for the installation of our geothermal products. We specifically target commercial and institutional new construction and renovation and replacements as well as single-family new construction, renovation and replacement.

Hydronic Fan Coils

We believe that our Climate Control Business is a leading provider of hydronic fan coils. Our Climate Control Business targets the commercial and institutional markets. Hydronic fan coils use heated or chilled water provided by a centralized chiller or boiler, through a water pipe system, to condition the air and allow individual room control. Hydronic fan coil systems are quieter, have longer lives and lower maintenance costs than other comparable systems used where individual room control is required. Important components of our strategy for competing in the commercial and institutional renovation and replacement markets include the breadth of our product line coupled with customization capability provided by a flexible manufacturing process. Hydronic fan coils enjoy a broad range of commercial applications, particularly in medium to large sized buildings with many small, individually controlled spaces.
 
Geothermal and Water Source Heat Pump and Hydronic Fan Coil Market

We estimate the annual United States market for water source heat pumps and hydronic fan coils was approximately $700 million in 2008 based on December 2008 data supplied by the Air-Conditioning, Heating and Refrigeration Institute (“AHRI”). Levels of repair, replacement, and new construction activity generally drive demand in these markets. However, this market could be impacted by the current economic conditions.

Production and Backlog

We manufacture our products in many sizes and configurations, as required by the purchaser, to fit the space and capacity requirements of hotels, motels, schools, hospitals, apartment buildings, office buildings and other commercial or residential structures. In addition, most of these customer orders are placed well in advance of required delivery dates.

During 2008, we invested approximately $12.1 million primarily for property, production equipment and other upgrades for additional capacity relating to our Climate Control Business.
 
For 2009, we currently have committed to spend an additional $3.5 million primarily for production equipment and facilities upgrades. Our investment in the Climate Control Business will continue if order intake levels continue to warrant. These investments have and will increase our capacity to produce and distribute our Climate Control products. Additional investments will depend upon our long-term outlook for the economic conditions that might affect our markets.

 
8

 
See discussions under “Liquidity and Capital Resources-Capital Expenditures” of Item 7 of Part II of this report.

As of December 31, 2008 and 2007, the backlog of confirmed orders for our Climate Control Business was approximately $68.5 million and $54.5 million, respectively. We expect to ship substantially all the orders in the backlog within the next twelve months.

Marketing and Distribution

Distribution

Our Climate Control Business sells its products to mechanical contractors, original equipment manufacturers (“OEMs”) and distributors. Our sales to mechanical contractors primarily occur through independent manufacturers' representatives, who also represent complementary product lines not manufactured by us. OEMs generally consist of other air conditioning and heating equipment manufacturers who resell under their own brand name the products purchased from our Climate Control Business in competition with us. The following table summarizes net sales to OEMs relating to our products of the Climate Control Business:

 
2008
 
2007
 
2006
Net sales to OEMs as a percentage of:
               
Net sales of the Climate Control Business
20
%
 
19
%
 
17
%
Consolidated net sales
9
%
 
9
%
 
8
%

Market

Our Climate Control Business depends primarily on the commercial construction industry, including new construction and the remodeling and renovation of older buildings, and on the residential construction industry and existing homes for both new and replacement markets relating to their geothermal products.

Raw Materials

Numerous domestic and foreign sources exist for the materials used by our Climate Control Business, which materials include copper, compressors, steel, aluminum, electric motors, and valves. Periodically, our Climate Control Business enters into futures contracts for copper. We do not anticipate any difficulties in obtaining necessary materials for our Climate Control Business. However, changes in market volatility, supply and demand could result in increased costs, lost production and/or delayed shipments. Although we believe we will be able to pass to our customers the majority of any cost increases in the form of higher prices, the timing of these price increases could lag the increases in the cost of materials. While we believe we will have sufficient sources for materials, a shortage of raw materials could impact production of our Climate Control products.
 
 
9

 
Competition

Our Climate Control Business competes primarily with six companies, some of whom are also our customers. Some of our competitors serve other markets and have greater financial and other resources than we do. Our Climate Control Business manufactures a broader line of geothermal and water source heat pump and fan coil products than any other manufacturer in the United States, and we believe that we are competitive as to price, service, warranty and product performance.

Continue to Introduce New Products

Our Climate Control Business plans to continue to launch new products and product upgrades in an effort to maintain and increase our current market position and to establish a presence in new markets.

Chemical Business

General

Our Chemical Business manufactures products for three principal markets:

·
concentrated, blended and regular nitric acid, mixed nitrating acids, metallurgical grade anhydrous ammonia, sulfuric acid, and high purity ammonium nitrate (“AN”) for industrial applications,
·
anhydrous ammonia, fertilizer grade AN, urea ammonium nitrate (“UAN”), and ammonium nitrate ammonia solution (“ANA”) for the agricultural applications, and
·
industrial grade AN and solutions for the mining industry.

The following table summarizes net sales information relating to our products of the Chemical Business:

 
2008
 
2007
 
2006
Percentage of net sales of the Chemical Business:
                 
Industrial acids and other chemical products
 
38
%
 
33
%
 
37
%
Agricultural products
 
36
%
 
41
%
 
34
%
Mining products
 
26
%
 
26
%
 
29
%
   
100
%
 
100
%
 
100
%
Percentage of our consolidated net sales:
               
 
Industrial acids and other chemical products
 
22
%
 
16
%
 
19
%
Agricultural products
 
20
%
 
20
%
 
18
%
Mining products
 
15
%
 
13
%
 
16
%
   
57
%
 
49
%
 
53
%
 
 
10

 
Market Conditions for Chemical Business

We discuss below certain details of our industrial acids and other chemical products, agricultural products, mining products, major customers, raw materials and other sales and industry issues affecting our Chemical Business.

As discussed in more detail under “Overview-Economic Conditions” of the MD&A contained in this report, we are unable to definitively assess the impact to our Chemical Business sales level as a result of the current economic recession. At this time, we believe that our sales volumes expressed in tons will be lower than in 2008 and our sales dollars per unit will be less due to significantly lower raw material costs and selling prices.

Industrial Acids and Other Chemical Products

Our Chemical Business manufactures and sells industrial acids and other chemical products primarily to the polyurethane, paper, fibers and electronics industries. We are a major supplier of concentrated nitric acid and mixed nitrating acids, specialty products used in the manufacture of fibers, gaskets, fuel additives, ordnance, and other chemical products. In addition, at the El Dorado Facility, we produce and sell blended and regular nitric acid and we are a niche market supplier of sulfuric acid, primarily to the region’s key paper manufacturers. At the Cherokee Facility, we are also a niche market supplier of industrial and high purity ammonia for many specialty applications, including chemicals to treat emissions from power plants.

We compete based upon service, price, location of production and distribution sites, product quality and performance. We also believe we are the largest domestic merchant marketer of concentrated and blended nitric acids and provide inventory management as part of the value-added services offered to certain customers.

The Baytown Facility is one of the two largest nitric acid manufacturing units in the United States, with demonstrated capacity exceeding 1,350 short tons per day. The majority of the Baytown Facility’s production is sold pursuant to a long-term contract. See discussion below under “Bayer Agreement” of this Item 1 concerning the future replacement of the Original Bayer Agreement with the Bayer Agreement.

Agricultural Products

Our Chemical Business produces AN at the El Dorado Facility and anhydrous ammonia, UAN, and ANA at the Cherokee Facility; all of which are nitrogen based fertilizers. The Cherokee Facility also has the ability to produce agricultural grade AN. Although, to some extent, the various forms of nitrogen-based fertilizers are interchangeable, each has its own characteristics, which produce agronomic preferences among end users. Farmers and ranchers decide which type of nitrogen-based fertilizer to apply based on the crop planted, soil and weather conditions, regional farming practices and relative nitrogen fertilizer prices. Our agricultural markets include a high concentration of pastureland and row crops, which favor our products. We sell these agricultural products to farmers, ranchers, fertilizer dealers and distributors located in the Central and Southeastern United States, which are in relatively close proximity to the El Dorado and Cherokee Facilities. We develop our market position in these areas by emphasizing high quality

 
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products, customer service and technical advice. During the past two years, we have been successful in expanding outside our traditional markets by barging to distributors on the Tennessee and Ohio rivers, and by railing into certain Western States. The El Dorado Facility produces a high performance AN fertilizer that, because of its uniform size, is easier to apply than many competing nitrogen-based fertilizer products. The El Dorado Facility establishes long-term relationships with end-users through its network of wholesale and retail distribution centers and the Cherokee Facility sells directly to agricultural customers.

Mining Products

Our Chemical Business manufactures industrial grade AN and 83% AN solution for the mining industry. The El Dorado Facility is a party to a long-term cost-plus supply agreement. Under this supply agreement, the El Dorado Facility supplies Orica USA, Inc. (“Orica”) with a significant volume of industrial grade AN per year for a term through at least June 2011, with provisions for renewal thereafter.

Major Customers

The following summarizes net sales to our major customers relating to our products of the Chemical Business:

 
2008
 
2007
 
2006
Net sales to Bayer as a percentage of:
               
Net sales of the Chemical Business
19
%
 
15
%
 
14
%
Consolidated net sales
11
%
 
7
%
 
7
%
                 
Net sales to Orica as a percentage of:
               
Net sales of the Chemical Business
19
%
 
19
%
 
20
%
Consolidated net sales
11
%
 
9
%
 
10
%

Raw Materials

The products our Chemical Business manufacture are derived from the following raw material feedstocks: anhydrous ammonia, natural gas and sulfur.  These raw material feedstocks are commodities, subject to price fluctuations.

The El Dorado Facility purchases approximately 200,000 tons of anhydrous ammonia and 45,000 tons of sulfur annually and produces and sells approximately 470,000 tons of nitrogen-based products and approximately 150,000 tons of sulfuric acid per year. The anhydrous ammonia is purchased pursuant to a supply agreement whereby the El Dorado Facility secures the majority of its requirements of anhydrous ammonia from one supplier. Although anhydrous ammonia is produced from natural gas, the price does not necessarily follow the spot-price of natural gas in the U.S. because anhydrous ammonia is an internationally traded commodity and the relative price is set in the world market while natural gas is primarily a nationally traded commodity. The ammonia supply to the El Dorado Facility is transported from the Gulf of Mexico by pipeline. Our cost of anhydrous ammonia is based upon formulas indexed to published industry prices, primarily tied to import prices. Prices for anhydrous ammonia were volatile during 2008, ranging from $125 to $931 per metric ton. Historically, the sulfur costs

 
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have been relatively stable; however, the recent world fertilizer market instability has led to significant volatility in the cost of this raw material. During 2008, the average prices for sulfur ranged from $150 to $617 per long ton.

The Cherokee Facility normally consumes 5 to 6 million MMBtu’s of natural gas annually and produces and sells approximately 300,000 to 370,000 tons of nitrogen-based products per year. Natural gas is a primary raw material for anhydrous ammonia. Natural gas prices continue to exhibit volatility. In 2008, daily spot prices per MMBtu, excluding transportation, ranged from $5.36 to $13.16.

The Baytown Facility consumes more than 100,000 tons of purchased anhydrous ammonia per year. The majority of the Baytown Facility’s production is sold pursuant to a long-term contract that provides for a pass-through of certain costs, including the anhydrous ammonia costs, plus a profit. See discussion concerning a new long-term contract below under “Bayer Agreement” of this Item 1.
Spot anhydrous ammonia, natural gas and sulfur costs have fluctuated dramatically in recent years. The following table shows, for the periods indicated, the high and low published prices for:

·
ammonia based upon the low Tampa metric price per ton as published by Fertecon and FMB Ammonia reports,
·
natural gas based upon the daily spot price at the Tennessee 500 pipeline pricing point, and
·
sulfur based upon the average quarterly Tampa price per long ton as published in Green Markets.

 
Ammonia Price
Per Metric Ton
 
Daily Spot Natural Gas
Prices Per MMBtu
 
Sulfur Price
Per Long Ton
 
High
 
Low
 
High
 
Low
 
High
 
Low
2008
$931
 
$125
 
$13.16
 
$5.36
 
$617
 
$150
2007
$460
 
$295
 
$10.59
 
$5.30
 
$112
 
$ 56
2006
$395
 
$270
 
$9.90
 
$3.54
 
$ 75
 
$ 60

As of March 6, 2009, the published price, as described above, for ammonia was $275 per metric ton, natural gas was $4.15 per MMBtu. The price per long ton for sulfur was minimal.

Effective January 1, 2009, under an agreement with its principal supplier of anhydrous ammonia, the El Dorado Facility will purchase the majority of all of its anhydrous ammonia requirements using a market price-based formula plus transportation to the El Dorado Facility through at least December 2010. We believe that we can obtain anhydrous ammonia from other sources in the event of an interruption of service under the above-referenced contract. The Cherokee Facility’s natural gas feedstock requirements are generally purchased at spot market price.  Periodically, the El Dorado and Cherokee Facilities will hedge certain of their anhydrous ammonia and natural gas requirements with futures/forward contracts as discussed below.
 
 
13

 
Sales Strategy

Our Chemical Business has pursued a strategy of developing customers that purchase substantial quantities of products pursuant to sales agreements and/or pricing arrangements that provide for the pass through of raw material costs in order to minimize the impact of the uncertainty of the sales prices of our products in relation to the cost of anhydrous ammonia, natural gas and sulfur. These pricing arrangements help mitigate the commodity risk inherent in the raw material feedstocks of natural gas, anhydrous ammonia and sulfur. For 2008, approximately 62% of the Chemical Business’ sales were made pursuant to these types of arrangements. The remaining sales are primarily into agricultural markets at the price in effect at time of shipment. However, we enter into futures/forward contracts to hedge the cost of natural gas and anhydrous ammonia for the purpose of securing the profit margin on a significant portion of our sales commitments with firm sales prices in our Chemical Business. The sales prices of our agricultural products have only a moderate correlation to the anhydrous ammonia and natural gas feedstock costs and reflect market conditions for like and competing nitrogen sources. This can compromise our ability to recover our full cost to produce the product in this market. Additionally, the lack of sufficient non-seasonal sales volume to operate our manufacturing facilities at optimum levels can preclude the Chemical Business from reaching full performance potential. Our primary efforts to improve the results of our Chemical Business include emphasizing our marketing efforts to customers that will accept the commodity risk inherent with natural gas and anhydrous ammonia, while maintaining a strong presence in the agricultural sector. We are also pursing the opportunity to start an idle chemical process facility as discussed in the MD&A contained in this report.

Bayer Agreement

On October 23, 2008, El Dorado Nitrogen, L.P. (“EDN”), and El Dorado Chemical Company (“EDC”), both subsidiaries of the Company, entered into a new Nitric Acid Supply Operating and Maintenance Agreement (the “Bayer Agreement”) with Bayer MaterialScience, LLC (“Bayer”).  The Bayer Agreement will replace the current Baytown Nitric Acid Project and Supply Agreement, dated June 27, 1997 (the “Original Bayer Agreement”), as of June 24, 2009. The Bayer Agreement is for a term of five years, with renewal options.

Under the terms of the Bayer Agreement, Bayer will purchase from EDN all of Bayer’s requirements for nitric acid for use in Bayer’s chemical manufacturing complex located in Baytown, Texas.  Bayer will also supply ammonia as required for production of nitric acid at the Baytown Facility, in addition to certain utilities, chemical additives and services that are required for such production.  Any surplus nitric acid manufactured at the Baytown Facility that is not required by Bayer may be marketed to third parties by EDN.

Pursuant to the terms of the Original Bayer Agreement, Bayer has provided notice of exercise of its option to purchase from a third party all of the assets comprising the Baytown Facility, except certain assets that are owned by EDN for use in the production process (the “EDN Assets”).  EDN will continue to be responsible for the maintenance and operation of the Baytown Facility in accordance with the terms of the Bayer Agreement. In addition, EDC will continue to guarantee the performance of EDN’s obligations under the Bayer Agreement.

 
14

 
If there is a change in control of EDN, Bayer will have the right to terminate the Bayer Agreement upon payment of certain fees to EDN. See further discussion of the Bayer Agreement under “Liquidity and Capital Resources - Bayer Agreement” of Item 7 of Part II of this report.

Seasonality

We believe that the only significant seasonal products are fertilizer and related chemical products sold by our Chemical Business to the agricultural industry. The selling seasons for those products are primarily during the spring and fall planting seasons, which typically extend from March through June and from September through November in the geographical markets in which the majority of our agricultural products are distributed. As a result, our Chemical Business increases its inventory of AN and UAN prior to the beginning of each planting season. In addition, the amount and timing of sales to the agricultural markets depend upon weather conditions and other circumstances beyond our control.

Regulatory Matters

Our Chemical Business is subject to extensive federal, state and local environmental laws, rules and regulations as discussed under “Environmental Matters" of this Item and various risk factors under Item 1A.

Competition

Our Chemical Business competes with several chemical companies in our markets, such as Agrium, CF Industries, Dyno Nobel North America and Terra Industries, many of whom have greater financial and other resources than we do. We believe that competition within the markets served by our Chemical Business is primarily based upon service, price, location of production and distribution sites, and product quality and performance.

Employees

As of December 31, 2008, we employed 1,878 persons. As of that date, our Climate Control Business employed 1,411 persons, none of whom was represented by a union, and our Chemical Business employed 397 persons, with 129 represented by unions under agreements that expire in July through November of 2010.

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

 
15

 
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 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 or replace, as needed, with non-asbestos insulation through our standard repair and maintenance activities to prevent deterioration.

1.  Discharge Water Matters

The El Dorado Facility 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 Department of Environmental Quality (“ADEQ”), which permit is to be renewed every five years. The ADEQ issued to EDC 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 believes it has demonstrated its ability to comply with the more restrictive permit limits, and the rules that 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 EDC 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. We believe the El Dorado Facility can comply with the revised permit; however, as of December 31, 2008, the ADEQ has not issued the revised permit.

In addition, EDC has entered into a consent administrative order (“CAO”) that recognizes the presence of nitrate contamination in the shallow groundwater at the El Dorado Facility. EDC is addressing the shallow groundwater contamination. 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. 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 December 31, 2008.
 
 
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2.  Air Matters

An air permit modification was issued to EDC by the ADEQ on August 26, 2008, which sets new limits for ammonia emissions for the nitric acid units at the El Dorado Facility. EDC recently completed required compliance testing but the results are still pending.  Based on a previous study, the nitric acid units can meet these new limits.

3.  Other Environmental Matters

In December 2002, two of our subsidiaries within our Chemical Business, sold substantially all of their operating assets relating to a Kansas chemical facility but retained ownership of the real property. In connection with this sale, our subsidiary leased the real property to the buyer under a triple net long-term lease agreement. However, our subsidiary retained the obligation to be responsible for, and perform the activities under, a previously executed consent order with the state of Kansas. In addition, certain of our subsidiaries agreed to indemnify the buyer of such assets for these environmental matters. The successor (“Chevron”) of a prior owner of the facility has agreed, within certain limitations, to pay and has been paying one-half of the costs incurred under the consent order subject to reallocation.

Based on additional modeling of the site, our subsidiary and Chevron are pursuing a course with the state of Kansas of long-term surface and ground water monitoring to track the natural decline in contamination, instead of the soil excavation proposed previously. The state of Kansas 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 requirement expired in February 2009. The data from the monitoring program has not been evaluated by the state of Kansas and the potential costs of additional monitoring or required remediation, if any, is unknown.

At December 31, 2008, the total estimated liability (which is included in current accrued and other liabilities) in connection with this remediation matter is approximately $84,000 and Chevron’s share for these costs (which is included in accounts receivable) is approximately $45,000. 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.

ITEM 1A.  RISK FACTORS

Risks Related to Us and Our Business

Cost and the lack of availability of raw materials could materially affect our profitability and liquidity.

Our sales and profits are heavily affected by the costs and availability of primary raw materials.  These primary raw materials, which are purchased from unrelated third parties, are subject to considerable price volatility. Historically, when there have been rapid increases in the cost of these primary raw materials, we have sometimes been unable to timely increase our sales prices to cover all of the higher costs incurred. While we periodically enter into futures/forward

 
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contracts to hedge against price increases in certain of these raw materials, there can be no assurance that we will effectively manage against price fluctuations in those raw materials.

Anhydrous ammonia, natural gas and sulfur represent the primary raw material feedstocks in the production of most of the products of the Chemical Business. Although our Chemical Business has a program to enter into contracts with certain customers that provide for the pass-through of raw material costs, we have a substantial amount of sales that do not provide for the pass-through of raw material costs. In addition, the Climate Control Business depends on raw materials such as copper and steel, which have shown considerable price volatility. As a result, in the future, we may not be able to pass along to all of our customers the full amount of any increases in raw material costs. There can be no assurance that future price fluctuations in our raw materials will not have an adverse effect on our financial condition, liquidity and results of operations.

Additionally, we depend on certain vendors to deliver the primary raw materials and other key components that are required in the production of our products. Any disruption in the supply of the primary raw materials and other key components could result in lost production or delayed shipments.  We have suspended in the past, and could suspend in the future, production at our chemical facilities due to, among other things, the high cost or lack of availability of such primary raw materials. Accordingly, our financial condition, liquidity and results of operations could be materially affected in the future by the lack of availability of primary raw materials and other key components.

Our Climate Control and Chemical Businesses and their customers are sensitive to adverse economic cycles.

Our Climate Control Business can be affected by cyclical factors, such as interest rates, inflation and economic downturns. Our Climate Control Business depends on sales to customers in the construction and renovation industries, which are particularly sensitive to these factors. Due to the current recession, we expect a decline in both commercial and residential construction. A decline in the economic activity in the United States has in the past, and could in the future, have a material adverse effect on us and our customers in the construction and renovation industries in which our Climate Control Business sells a substantial amount of its products. Such a decline could result in a decrease in revenues and profits, and an increase in bad debts, in our Climate Control Business and could have a material adverse effect on our operating results, financial condition and liquidity.

Our Chemical Business also can be affected by cyclical factors such as inflation, global energy policy and costs, global market conditions and economic downturns in specific industries.  Certain sales of our Chemical Business are sensitive to the level of activity in the agricultural, mining, automotive and housing industries. We expect that certain of our industrial and mining customers will be affected by the current economic recession and could substantially reduce their purchases. A substantial decline in the activity of our Chemical Business has in the past, and could in the future, have a material adverse effect on the results of our Chemical Business and on our liquidity and capital resources.
 
 
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Weather conditions adversely affect our Chemical Business.

The agricultural products produced and sold by our Chemical Business have in the past, and could in the future, be materially affected by adverse weather conditions (such as excessive rains or drought) in the primary markets for our fertilizer and related agricultural products. If any of these unusual weather events occur during the primary seasons for sales of our agricultural products (March-June and September-November), this could have a material adverse effect on the agricultural sales of our Chemical Business and our financial condition and results of operation.

Environmental and regulatory matters entail significant risk for us.

Our Chemical Business is subject to numerous environmental laws and regulations. The manufacture and distribution of chemical products are activities, which entail environmental risks and impose obligations under environmental laws and regulations, many of which provide for substantial fines and potential criminal sanctions for violations. Although we have established processes to monitor, review and manage our businesses to comply with the numerous environmental laws and regulations, our Chemical Business has in the past, and may in the future, be subject to fines, penalties and sanctions for violations and substantial expenditures for cleanup costs and other liabilities relating to the handling, manufacture, use, emission, discharge or disposal of effluents at or from the Chemical Business’ facilities. Further, a number of our Chemical Business’ facilities are dependent on environmental permits to operate, the loss or modification of which could have a material adverse effect on its operations and our financial condition.

We may be required to expand our security procedures and install additional security equipment for our Chemical Business in order to comply with current and possible future government regulations, including the Homeland Security Act of 2002.

The chemical industry in general, and producers and distributors of anhydrous ammonia and AN specifically, are scrutinized by the government, industry and public on security issues.  Under current and proposed regulations, including the Homeland Security Act of 2002, we may be required to incur substantial additional costs relating to security at our chemical facilities, distribution centers, and our customers, as well as in the transportation of our products.  These costs could have a material impact on our financial condition and results of operation. The cost of such regulatory changes, if significant enough, could lead some of our customers to choose alternate products to  anhydrous  ammonia and AN, which would have a significant impact on our Chemical Business.

A substantial portion of our sales is dependent upon a limited number of customers.

During 2008, five customers of our Chemical Business accounted for 51% of its net sales and 29% of our consolidated sales, and our Climate Control Business had one customer that accounted for 18% of its net sales and 7% of our consolidated sales. The loss of, or a material reduction in purchase levels by, one or more of these customers could have a material adverse effect on our business and our results of operations, financial condition and liquidity if we are unable to replace a customer on substantially similar terms.

 
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There is intense competition in the Climate Control and Chemical industries.

Substantially all of the markets in which we participate are highly competitive with respect to product quality, price, design innovations, distribution, service, warranties, reliability and efficiency. We compete with a number of established companies that have greater financial, marketing and other resources. Competitive factors could require us to reduce prices or increase spending on product development, marketing and sales that would have a material adverse effect on our business, results of operation and financial condition.

Potential increase of imported ammonium nitrate from Russia

In 2000, the United States and Russia entered into a suspension agreement limiting the quantity of, and setting the minimum prices for, fertilizer grade AN sold from Russia into the United States.

The Russians have requested that the suspension agreement be changed to only require that the prices of its imported AN reflect the Russian producers full production costs, plus profit.  The Russian producers of AN could benefit from state set prices of natural gas, the principal raw material for AN, which could be less than what U.S. producers are required to pay for their natural gas. Other factors, however, such as transportation costs may partially offset natural gas and production cost advantages. This change, if accepted by the United States, could result in a substantial increase in the amount of AN imported into the United States from Russia at prices that could be less than the cost to produce AN by U.S. producers plus a profit.  Russia is the world’s largest producer of fertilizer grade AN, and we are led to believe that it has substantial excess AN production capacity.

For 2008, net sales of fertilizer grade AN accounted for 18% and 10% of our Chemical Business net sales and consolidated net sales, respectively. If the suspension agreement is changed, as discussed above, this change could result in Russia substantially increasing the amount of AN sold in the United States at prices less than the U.S. producers are required to charge in order to cover their cost plus a profit, and could have an adverse effect on our revenues and operating results.

We are effectively controlled by the Golsen Group.

Jack E. Golsen, our Chairman of the Board and Chief Executive Officer (“CEO”), members of his immediate family (spouse and children), including Barry H. Golsen, our Vice Chairman and President, entities owned by them and trusts for which they possess voting or dispositive power as trustee (collectively, the “Golsen Group”) beneficially owned as of February 28, 2009, an aggregate of 3,624,843 shares of our common stock and 1,020,000 shares of our voting preferred stock (1,000,000 of which shares have .875 votes per share, or 875,000 votes), which together votes as a class and represent approximately 20.5% of the voting power of our issued and outstanding voting securities as of that date.  In addition, the Golsen Group also beneficially owned options and other convertible securities that allowed its members to acquire an additional 208,500 shares of our common stock within 60 days of February 28, 2009. Thus, the Golsen Group may be considered to effectively control us. As a result, the ability of other stockholders to influence our management and policies could be limited.

 
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Loss of key personnel could negatively affect our business.

We believe that our performance has been and will continue to be dependent upon the efforts of our principal executive officers. We cannot promise you that our principal executive officers will continue to be available. Jack E. Golsen has an employment agreement with us. No other principal executive has an employment agreement with us. The loss of some of our principal executive officers could have a material adverse effect on us. We believe that our future success will depend in large part on our continued ability to attract and retain highly skilled and qualified personnel.

We may have inadequate insurance.

While we maintain liability insurance, including certain coverage for environmental contamination, it is subject to coverage limits and policies may exclude coverage for some types of damages (which may include warranty and product liability claims). Although there may currently be sources from which such coverage may be obtained, it may not continue to be available to us on commercially reasonable terms or the possible types of liabilities that may be incurred by us may not be covered by our insurance. In addition, our insurance carriers may not be able to meet their obligations under the policies or the dollar amount of the liabilities may exceed our policy limits. Even a partially uninsured claim, if successful and of significant magnitude, could have a material adverse effect on our business, results of operations, financial condition and liquidity.

Many of our insurance policies are written by AIG, which has experienced and is continuing to experience financial difficulties.

It has been publicly reported that American International Group, Inc. (“AIG”) has experienced significant financial difficulties and is continuing to experience significant financial difficulties.  AIG is a holding company for several different subsidiary insurance companies.  AIG’s insurance subsidiary or subsidiaries provide many of our casualty, workers compensation and other insurance policies, including, but not limited to, our general liability policy, which includes certain pollution coverage, excess umbrella policy, and officer and director liability policy covering us and our officers and directors against certain securities’ law claims.  We and one of our executive officers are currently involved in certain legal proceeding in which AIG or its subsidiaries has agreed to defend and to indemnify against loss under a reservation of rights.  In the event of a failure of AIG and/or its subsidiaries, it is unknown whether AIG or the applicable subsidiary that is the insurer under our policies or the applicable regulatory authorities can comply with the insurer’s obligations under our policies.  Further, in the event of a failure by AIG and/or its subsidiaries, we could be required to replace these policies.  If it becomes necessary to replace the policies written by subsidiaries of AIG, it may difficult or impossible to replace these policies or, if we can replace these policies, to replace them on substantially similar terms as our existing insurance policies.

We have not paid dividends on our outstanding common stock in many years.

We have not paid cash dividends on our outstanding common stock in many years, and we do not currently anticipate paying cash dividends on our outstanding common stock in the

 
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foreseeable future. However, our board of directors has not made a definitive decision whether or not to pay such dividends in 2009.

Terrorist attacks and other acts of violence or war, and natural disasters (such as hurricanes, pandemic health crisis, etc.), have and could negatively impact the U.S. and foreign companies, the financial markets, the industries where we operate, our operations and profitability.

Terrorist attacks and natural disasters (such as hurricanes) have in the past, and can in the future, negatively affect our operations. We cannot predict further terrorist attacks and natural disasters in the United States and elsewhere. These attacks or natural disasters have contributed to economic instability in the United States and elsewhere, and further acts of terrorism, violence, war or natural disasters could further affect the industries where we operate, our ability to purchase raw materials, our business, results of operations and financial condition. In addition, terrorist attacks and natural disasters may directly impact our physical facilities, especially our chemical facilities, or those of our suppliers or customers and could impact our sales, our production capability and our ability to deliver products to our customers.  In the past, hurricanes affecting the Gulf Coast of the United States have negatively impacted our operations and those of our customers.  The consequences of any terrorist attacks or hostilities or natural disasters are unpredictable, and we may not be able to foresee events that could have an adverse effect on our operations.

We are the subject of an SEC enforcement action.

In August 2006, we were notified that the SEC was conducting an informal inquiry primarily in connection with the change in inventory accounting from LIFO to FIFO of approximately $500,000 by one of our subsidiaries that resulted in our restatement of our 2004 audited financial statements and our interim financial statements contained in our Form 10-Q’s for the quarters ended March 31, 2005 and June 30, 2005. We responded to that inquiry. 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 senior staff of the SEC, and we have had discussions with the senior staff after such submission. The staff has indicated that it is still their intention to recommend to the SEC to bring a civil injunction action against us and seek authority from the SEC to file such action. In addition, the SEC has also made assertions against our former principal accounting officer based on Section 13 of the 1934 Act, and the SEC staff has also stated its intention to recommend civil proceedings against him. The former principal accounting officer resigned as principal accounting officer, effective August 15, 2008, but remains with the Company as a senior vice president in charge of lending compliance and cash management and will be involved in our banking relationships, acquisitions and corporate planning. We are currently in discussions with the staff of the SEC regarding the settlement of this matter. There are no assurances this matter will be settled.
 
 
We are a holding company and depend, in large part, on receiving funds from our subsidiaries to fund our indebtedness.

Because we are a holding company and operations are conducted through our subsidiaries, principally ThermaClime and its subsidiaries, our ability to make scheduled payments of principal and interest on our indebtedness depends, in large part, on the operating performance and cash flows of our subsidiaries and the ability of our subsidiaries to make distributions and pay dividends to us. Under its loan agreements, ThermaClime and its subsidiaries may only make distributions and pay dividends to us under limited circumstances and in limited amounts.

Our net operating loss carryforwards are subject to certain limitations and examination.

We had generated significant net operating loss (“NOL”) carryforwards from certain historical losses.  As of December 31, 2008, we have utilized all of the remaining federal NOL carryforwards and a portion of our state NOL carryforwards.  The utilization of these NOL carryforwards has reduced our income tax liabilities.  The federal tax returns for 1994 through 2004 remain subject to examination for the purpose of determining the amount of remaining tax NOL and other carryforwards. With few exceptions, the 2005-2007 years remain open for all purposes of examination by the IRS and other major tax jurisdictions.

Future issuance or potential issuance of our common stock could adversely affect the price of our common stock, our ability to raise funds in new stock offerings and dilute your percentage interest in our common stock.

Future sales of substantial amounts of our common stock or equity-related securities in the public market, or the perception that such sales could occur, could adversely affect prevailing trading prices of our common stock and could impair our ability to raise capital through future offerings of equity or equity-related securities. No prediction can be made as to the effect, if any, that future sales of shares of common stock or the availability of shares of common stock for future sale, will have on the trading price of our common stock. Such future sales could also significantly reduce the percentage ownership of our existing common stockholders.

We are subject to a variety of factors that could discourage other parties from attempting to acquire us.

Our certificate of incorporation provides for a staggered board of directors and, except in limited circumstances, a two-thirds vote of outstanding voting shares to approve a merger, consolidation or sale of all, or substantially all, of our assets. In addition, we have entered into severance agreements with our executive officers and some of the executive officers of our subsidiaries that provide, among other things, that if, within a specified period of time after the occurrence of a change in control of our company, these officers are terminated, other than for cause, or the officer terminates his employment for good reason, we must pay such officer an amount equal to 2.9 times the officer’s average annual gross salary for the last five years preceding the change in control.

We have authorized and unissued (including shares held in treasury) 53,890,188 shares of common stock and 4,229,454 shares of preferred stock as of December 31, 2008. These unissued

 
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shares could be used by our management to make it more difficult, and thereby discourage an attempt to acquire control of us.

We have adopted a preferred share purchase plan, which is designed to protect us against certain creeping acquisitions, open market purchases and certain mergers and other combinations with acquiring companies.

The foregoing provisions and agreements are designed to discourage a third party tender offer, proxy contest, or other attempts to acquire control of us and could have the effect of making it more difficult to remove incumbent management.

Delaware has adopted an anti-takeover law which, among other things, will delay for three years business combinations with acquirers of 15% or more of the outstanding voting stock of publicly-held companies (such as us), unless;

·
prior to such time the board of directors of the corporation approved the business combination that results in the stockholder becoming an invested stockholder;
·
the acquirer owned at least 85% of the outstanding voting stock of such company prior to commencement of the transaction;
·
two-thirds of the stockholders, other than the acquirer, vote to approve the business combination after approval thereof by the board of directors; or
·
the stockholders of the corporation amends its articles of incorporation or by-laws electing not to be governed by this provision.

ITEM 1B.  UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2.  PROPERTIES

Climate Control Business 

Our Climate Control Business manufactures most of its heat pump products in a 270,000 square foot facility in Oklahoma City, Oklahoma. We lease this facility, with an option to buy, through May 2016, with options to renew for three additional five-year periods. For 2008, approximately 78% of the productive capacity of this manufacturing facility was being utilized, based primarily on two ten-hour shifts per day and a four-day work week. In addition, we own a 46,000 square foot building subject to a mortgage, which is adjacent to our existing heat pump manufacturing facility, primarily used for storage of raw material inventory. Also we utilize approximately 110,000 square feet of an existing facility for a distribution center, which facility is subject to a mortgage.

Our Climate Control Business conducts its fan coil manufacturing operation in a facility located in Oklahoma City, Oklahoma, consisting of approximately 265,000 square feet. We own this facility subject to a mortgage. For 2008, our fan coil manufacturing operation was using 81% of the productive capacity, based on one ten-hour shift per day and a four-day work week and a limited second shift in selected areas.

 
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Our Climate Control Business conducts its large air handler manufacturing operation in a facility located in Oklahoma City, Oklahoma, consisting of approximately 110,000 square feet. We own this facility subject to a mortgage. For 2008, approximately 58% of the productive capacity of this manufacturing facility was being utilized, based on one eight-hour shift on a five-day work week and a partial second shift in selected areas.

All of the properties utilized by our Climate Control Business are considered by our management to be suitable to meet the current needs of that business. However, based on our long-term strategy, we are planning an expansion of our geothermal and water source heat pump plant facility with a 78,000 square foot addition and another 40,000 square foot addition to our air coil production facility.

Chemical Business

Our Chemical Business primarily conducts manufacturing operations (a) on 150 acres of a 1,400 acre tract of land located at the El Dorado Facility, (b) on 160 acres of a 1,300 acre tract of land located at the Cherokee Facility and (c) on leased property within Bayer’s complex in the Baytown, Texas. The Company and/or its subsidiaries own all of its manufacturing facilities except the Baytown Facility. The Baytown Facility is currently leased pursuant to a long-term lease with an unrelated third party. See discussion above concerning the notice provided by Bayer to exercise its option to purchase from this third party all of the assets comprising the Baytown Facility, except the EDN assets, under “Bayer Agreement” of Item 1. Certain real property and equipment located at the El Dorado and Cherokee Facilities are being used to secure a $50 million term loan. For 2008, the following facilities were utilized based on continuous operation:

 
Percentage of
Capacity
 
 
El Dorado Facility (1)
86
%
 
 
Cherokee Facility (2)
89
%
 
 
Baytown Facility
81
%
 

(1) The percentage of capacity for the El Dorado Facility relates to its nitric acid capacity. The El Dorado Facility has capacity to produce other nitrogen products in excess of its nitric acid capacity.

(2) The percentage of capacity for the Cherokee Facility relates to its ammonia production capacity. The Cherokee Facility has additional capacity for nitric acid, AN and urea in excess of its ammonia capacity.

In addition to the El Dorado and Cherokee Facilities, our Chemical Business distributes its agricultural products through 15 wholesale and retail distribution centers, with 13 of the centers located in Texas (10 of which we own and 3 of which we lease); 1 center located in Tennessee (owned); and 1 center located in Missouri (owned).

All of the properties utilized by our Chemical Business are considered by our management to be suitable and adequate to meet the current needs of that business.
 
 
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ITEM 3.  LEGAL PROCEEDINGS

1.  Environmental See “Business-Environmental Matters” for a discussion as to:

·
certain environmental matters relating to air and water issues at our El Dorado Facility; and
·
certain environmental remediation matters at our former Hallowell Facility.

2.  Other

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 against our subsidiaries and our officers but did not appeal the dismissal against us. 

The Jayhawk Group

In November 2006, we entered into an agreement with Jayhawk Capital Management, LLC, Jayhawk Investments, L.P., Jayhawk Institutional Partners, L.P. and Kent McCarthy, the manager and sole member of Jayhawk Capital, (collectively, the “Jayhawk Group”), in which the Jayhawk Group agreed, among other things, that if we undertook, in our sole discretion, within one year from the date of agreement a tender offer for our $3.25 Convertible Exchangeable Class C Preferred Stock, Series 2 (“Series 2 Preferred”) or to issue our common stock for a portion of our Series 2 Preferred pursuant to a private exchange, that it would tender or exchange an aggregate of no more than 180,450 shares of the 340,900 shares of the Series 2 Preferred beneficially owned by the Jayhawk Group, subject to, among other things, the entities owned and controlled by Jack E. Golsen, our Chairman and Chief Executive Officer (“Golsen”), and his immediate family, that beneficially own Series 2 Preferred only being able to exchange or tender approximately the same percentage of shares of Series 2 Preferred beneficially owned by them as the Jayhawk Group is able to tender or exchange under the terms of the agreement. In addition, under the agreement, the Jayhawk Group agreed to vote its shares of our common stock and Series 2 Preferred “for” an amendment to the Certificate of Designation covering the Series 2 Preferred to allow us:

 
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·
for a period of five years from the completion of an exchange or tender to repurchase, redeem or otherwise acquire shares of our common stock, without approval of the outstanding Series 2 Preferred irrespective that dividends are accrued and unpaid with respect to the Series 2 Preferred; or
·
to provide that holders of Series 2 Preferred may not elect two directors to our Board of Directors when dividends are unpaid on the Series 2 Preferred if less than 140,000 shares of Series 2 Preferred remain outstanding.

During 2007, we made a tender offer for our outstanding Series 2 Preferred at the rate of 7.4 shares of our common stock for each share of Series 2 Preferred so tendered. In July 2007, we redeemed the balance of our outstanding shares of Series 2 Preferred. Pursuant to its terms, the Series 2 Preferred was convertible into 4.329 shares of our common stock for each share of Series 2 Preferred. As a result of the redemption, the Jayhawk Group converted the balance of its Series 2 Preferred pursuant to the terms of the Series 2 Preferred in lieu of having its shares redeemed.

During November 2008, the Jayhawk Group filed suit against us and Golsen in a lawsuit styled Jayhawk Capital Management, LLC, et al. v. LSB Industries, Inc., et al., in the United States District Court for the District of Kansas at Kansas City. The complaint alleges that the Jayhawk Group should have been able to tender all of its Series 2 Preferred pursuant to the tender offer, notwithstanding the above-described agreement, based on the following claims against us and Golsen:

·
fraudulent inducement and fraud,
·
violation of  14(d) of the Securities and Exchange Act of 1934 and Rule 14d-10,
·
violation of 10(b) of the Exchange Act and Rule 10b-5,
·
violation of 18 of the Exchange Act,
·
violation of 17-12A501 of the Kansas Uniform Securities Act, and
·
breach of fiduciary duty.

The Jayhawk Group seeks damages in an unspecified amount based on the additional number of common shares it allegedly would have received on conversion of all of its Series 2 Preferred through the February 2007 tender offer, plus punitive damages. In May 2008, the General Counsel for the Jayhawk Group offered to settle its claims against us and Golsen in return for a payment of $100,000, representing the approximate legal fees it had incurred investigating the claims at that time. Through counsel, we verbally agreed to the settlement offer and confirmed the agreement by e-mail. Afterward, the Jayhawk Group’s General Counsel purported to withdraw the settlement offer, and asserted that Jayhawk is not bound by any settlement agreement. We contend that the settlement agreement is binding on the Jayhawk Group. We intend to contest the lawsuit vigorously, and will assert that Jayhawk is bound by an agreement to settle the claims for $100,000. Our insurer, a subsidiary of AIG, has agreed to defend this lawsuit on our behalf and on behalf of Golsen and to indemnify under a reservation of rights to deny liability under certain conditions. As of December 31, 2008, a liability of $100,000 has been established for the Jayhawk claims.
 
 
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Securities and Exchange Commission

We have previously disclosed that the 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 senior staff of the SEC, and we have had discussions with the senior staff after such submission. The staff has indicated that it is still their intention to recommend to the SEC to bring a civil injunction action against us and seek authority from the SEC to file such action. In addition, the SEC has also made assertions against our former principal accounting officer based on Section 13 of the 1934 Act, and the SEC staff has also stated its intention to recommend civil proceedings against him. The former principal accounting officer resigned as principal accounting officer, effective August 15, 2008, but remains with the Company as a senior vice president in charge of lending compliance and cash management and will be involved in our banking relationships, acquisitions and corporate planning. We are currently in discussions with the staff of the SEC regarding the settlement of this matter. There are no assurances this matter will be settled.
 
Other Claims and Legal Actions

Wetherall v. Climate Master is  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 plaintiffs asserted claims based upon negligence, strict liability, breach of implied warranties, unjust enrichment and the Illinois Consumer Fraud and Deceptive Business Practices Act.  The plaintiffs have dismissed the first three of these claims and the last two of these claims remain pending. Climate Master has filed a motion for summary judgment as to the remaining claims, and that motion is pending. Climate Master has removed this action to federal court. Climate Master has also filed its answer denying the plaintiffs’ claims and asserting several affirmative defenses. Climate Master’s insurers have been placed on notice of this matter. One of these insurers has denied coverage, and one is out of business and has been liquidated and one insurer advised that it will monitor the litigation subject to a reservation of rights to decline coverage. The policies associated with insurers that have not declined coverage in this matter and remain in business have deductible amounts ranging from $100,000 to $250,000. Climate Master intends to vigorously defend itself in connection with this matter. Currently, the Company is unable to determine the amount of damages or the likelihood of any losses resulting from this claim. Therefore, no liability has been established at December 31, 2008.
 
 
28

 
Patent Litigation Matter - On December 7, 2007, Huntair Inc. filed a lawsuit against our subsidiary, ClimateCraft, Inc., alleging patent infringement in the United States District Court for the Northern District of Illinois, Eastern Division.  In January 2009, this lawsuit was settled and we paid an immaterial amount that was accrued as of December 31, 2008.

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.

ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of our shareholders during the fourth quarter of 2008.

 
29

 
ITEM 4A.  EXECUTIVE OFFICERS OF THE REGISTRANT

Our officers serve one-year terms, renewable on an annual basis by the board of directors. Information regarding the Company's executive officers is as follows:

Jack E. Golsen (1)
Chairman of the Board and Chief Executive Officer.  Mr. Golsen, age 80 first became a director in 1969. His term will expire in 2010. Mr. Golsen, founder of the Company, is our Chairman of the Board of Directors and Chief Executive Officer and has served in those capacities since our inception in 1969. Mr. Golsen served as our President from 1969 until 2004. During 1996, he was inducted into the Oklahoma Commerce and Industry Hall of Honor as one of Oklahoma’s leading industrialists. Mr. Golsen has a Bachelor of Science degree from the University of New Mexico.  Mr. Golsen is a Trustee of Oklahoma City University.  During his career, he acquired or started the companies which formed LSB.  He has served on the boards of insurance companies, several banks and was Board Chairman of Equity Bank for Savings N.A. which was formerly owned by LSB.
   
Barry H. Golsen (1)
Vice Chairman of the Board, President, and President of the Climate Control Business. Mr. Golsen, age 58, first became a director in 1981. His term will expire in 2009. Mr. Golsen was elected President of the Company in 2004. Mr. Golsen has served as our Vice Chairman of the Board of Directors since August 1994, and has been the President of our Climate Control Business for more than five years. Mr. Golsen also served as a director of the Oklahoma branch of the Federal Reserve Bank. Mr. Golsen has both his undergraduate and law degrees from the University of Oklahoma.
   
David R. Goss
Executive Vice President of Operations and Director. Mr. Goss, age 68, first became a director in 1971. His term will expire in 2009. Mr. Goss, a certified public accountant, is our Executive Vice President of Operations and has served in substantially the same capacity for more than five years. Mr. Goss is a graduate of Rutgers University.
   
Tony M. Shelby
Executive Vice President of Finance and Director. Mr. Shelby, age 67, first became a director in 1971. His term will expire in 2011. Mr. Shelby, a certified public accountant, is our Executive Vice President of Finance and Chief Financial Officer, a position he has held for more than five years. Prior to becoming our Executive Vice President of Finance and Chief Financial Officer, he served as Chief Financial Officer of a subsidiary of the Company and was with the accounting firm of Arthur Young & Co., a predecessor to Ernst & Young LLP. Mr. Shelby is a graduate of Oklahoma City University.

 
Jim D. Jones
 
Senior Vice President and Treasurer. Mr. Jones, age 66, has been Senior Vice President and Treasurer since July 2003, and has served as an officer of the Company since April 1977. Mr. Jones is a certified public accountant and was with the accounting firm of Arthur Young & Co., a predecessor to Ernst & Young LLP. Mr. Jones is a graduate of the University of Central Oklahoma.
   
David M. Shear (1)
Senior Vice President and General Counsel. Mr. Shear, age 49, has been Senior Vice President since July 2004 and General Counsel and Secretary since 1990. Mr. Shear attended Brandeis University, graduating cum laude in 1981. At Brandeis University, Mr. Shear was the founding Editor-In-Chief of Chronos, the first journal of undergraduate scholarly articles. Mr. Shear attended the Boston University School of Law, where he was a contributing Editor of the Annual Review of Banking Law. Mr. Shear acted as a staff attorney at the Bureau of Competition with the Federal Trade Commission from 1985 to 1986. From 1986 through 1989, Mr. Shear was an associate in the Boston law firm of Weiss, Angoff, Coltin, Koski and Wolf.
   
Michael G. Adams
 
Vice President and Corporate Controller. Mr. Adams', age 59, was appointed to this position effective October 16, 2008 and has served as an officer of the Company since March 1990. Mr. Adams is a certified public accountant and was with the accounting firm of Arthur Young & Co., a predecessor to Ernst & Young LLP. Mr. Adams is a graduate of the University of Oklahoma.
   
Harold L. Rieker Jr.
 
Vice President and Principal Accounting Officer. Mr. Rieker, age 48, was appointed to this position effective October 16, 2008 and has served as an officer of the Company since March 2006. Mr. Rieker is a certified public accountant and was with the accounting firm of Grant Thornton LLP. Mr. Rieker is a graduate of the University of Central Oklahoma.
 
 (1) Barry H. Golsen is the son of Jack E. Golsen and David M. Shear is married to the niece of Jack E. Golsen.

 
31

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

On October 28, 2008, our common stock began trading on the New York Stock Exchange under the symbol “LXU”. Prior to that date, our common stock traded on the American Stock Exchange under the same symbol. The following table shows, for the periods indicated, the high and low sales prices.

 
Year Ended
 
December 31,
 
2008
 
2007
 
Quarter
 
High
 
Low
 
High
 
Low
 
First
 
$
28.80
 
$
13.80
 
$
15.71
 
$
11.41
 
Second
 
$
20.83
 
$
13.45
 
$
23.70
 
$
14.76
 
Third
 
$
24.59
 
$
13.11
 
$
25.25
 
$
17.00
 
Fourth
 
$
14.67
 
$
6.65
 
$
28.85
 
$
20.54

Stockholders

As of March 6, 2009, we had 679 record holders of our common stock. This number does not include investors whose ownership is recorded in the name of their brokerage company.

Dividends

We are a holding company and, accordingly, our ability to pay cash dividends on our preferred stock and our common stock depends in large part on our ability to obtain funds from our subsidiaries. The ability of ThermaClime (which owns substantially all of the companies comprising the Climate Control Business and Chemical Business) and its wholly-owned subsidiaries to pay dividends and to make distributions to us is restricted by certain covenants contained in the $50 million revolving credit facility (the “Working Capital Revolver Loan”) and the $50 million loan agreement due 2012 (the “Secured Term Loan”). Under the terms of these agreements, ThermaClime cannot transfer funds to us in the form of cash dividends or other distributions or advances, except for:

·
the amount of income taxes that ThermaClime would be required to pay if they were not consolidated with us;
·
an amount not to exceed fifty percent (50%) of ThermaClime's consolidated net income during each fiscal year determined in accordance with generally accepted accounting principles plus amounts paid to us within the first bullet above, provided that certain other conditions are met;
·
the amount of direct and indirect costs and expenses incurred by us on behalf of ThermaClime pursuant to a certain services agreement;

 
·
amounts under a certain management agreement between us and ThermaClime, provided certain conditions are met, and
 
·
outstanding loans entered into subsequent to November 2, 2007 in excess of $2.0 million at any time.
 
In 2001, we issued shares of Series D 6% cumulative, convertible Class C preferred stock (“Series D Preferred”) and in 1985, we issued shares of Series B 12% convertible, cumulative preferred stock ("Series B Preferred"). As of December 31, 2008, we have issued and outstanding 1,000,000 shares of Series D Preferred, 20,000 shares of Series B Preferred, and 547 shares of noncumulative redeemable preferred stock (“Noncumulative Preferred”). Each share of preferred stock is entitled to receive an annual dividend, only when declared by our board of directors, payable as follows:

·
Series D Preferred at the rate of $.06 a share payable on October 9, which dividend is cumulative;
·
Series B Preferred at the rate of $12.00 a share payable January 1, which dividend is cumulative; and
·
Noncumulative Preferred at the rate of $10.00 a share payable April 1, which is noncumulative.

On February 9, 2009, our board of directors declared the following dividends to holders of record on March 20, 2009:

·
$0.06 per share on our outstanding Series D Preferred for an aggregate dividend of $60,000, payable on March 31, 2009;
·
$12.00 per share on our outstanding Series B Preferred for an aggregate dividend of $240,000, payable on March 31, 2009;  and
·
$10.00 per share on our outstanding Noncumulative Preferred for an aggregate dividend of approximately $5,500, payable on April 1, 2009.

All shares of Series D Preferred and Series B Preferred are owned by the Golsen Group.

Holders of our common stock are entitled to receive dividends only when declared by our board of directors. We have not paid cash dividends on our outstanding common stock in many years, and we do not currently anticipate paying cash dividends on our outstanding common stock in the near future. However, our board of directors has not made a definitive decision whether or not to pay such dividends in 2009.

Sale of Unregistered Securities

During the three months ended December 31, 2008, we issued the following unregistered equity securities:

On November 14, 2008, we issued 160 shares of common stock upon the holder’s conversion of 4 shares of our Noncumulative Preferred.  Pursuant to the terms of the Noncumulative Preferred, the conversion rate was 40 shares of common stock for each share of Noncumulative

 
33

 
Preferred.  The common stock was issued pursuant to the exemption from the registration of securities afforded by Section 3(a)(9) of the Securities Act.  No commissions or other remuneration were paid for this issuance.   We did not receive any proceeds upon the conversion of the Noncumulative Preferred.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

During the three months ended December 31, 2008, the Company and affiliated purchasers, as defined, purchased treasury stock as shown in the following table:

 
 
 
 
 
Period
 
(a) Total
number of
shares
of common
stock
a
cquired (1)
 
 
(b) Average
price paid
per share
of common
stock (1)
 
(c) Total number of
 shares of common
stock purchased as
part of publicly
announced plans
or programs (2)
(d) Maximum number
(or approximate
dollar value) of
shares of common
stock that may yet
be purchased under
the plans or programs
October 1, 2008 -
October 31, 2008
 
-
 
 
$
 
-
 
-
 
             
November 1, 2008 -
November 30, 2008
 
260,000
 
 
$
 
7.07
 
200,000
 
             
December 1, 2008 -
December 31, 2008
 
90,000
 
 
$
 
7.02
 
-
 
Total
350,000
 
$
7.06
200,000
See (2)

(1)  During the fourth quarter of 2008, we purchased 200,000 shares of common stock at market prices from an unrelated third party and are being held as treasury stock.  In addition, the Golsen Group purchased 150,000 shares of our common stock in the open market.

(2)  As previously reported, our board of directors enacted a stock repurchase authorization for an unstipulated number of shares for an indefinite period of time commencing March 12, 2008. The stock repurchase authorization will remain in effect until such time as of our board of directors decides to end it.
 
 
34

 
During the three months ended December 31, 2008, the Company and affiliated purchasers, as defined, purchased its 5.5% Convertible Senior Subordinated Notes due 2012 (“2007 Debentures”) as shown in the following table:

 
 
 
 
 
Period
 
 
(a) Total
number
of units
acquired (A)
 
 
 
(b) Average
price paid
per unit (A)
 
(c) Total number of
 units purchased as
part of publicly
announced plans
or programs
(d) Maximum number
(or approximate
dollar value) of
units that may yet
be purchased under
the plans or programs
October 1, 2008 -
October 31, 2008
 
-
 
 
$
 
-
 
-
 
             
November 1, 2008 -
November 30, 2008
 
20,000
 
 
$
 
694.25
 
15,000
 
             
December 1, 2008 -
December 31, 2008
 
4,500
 
 
$
 
649.17
 
  4,500
 
Total
24,500
 
$
685.97
19,500
40,500

(A)  One unit represents a $1,000 principal amount of the debenture. During the fourth quarter of 2008, we acquired $19.5 million aggregate principal amount of the debentures. In addition, the Golsen Group acquired $5.0 million aggregate principal amount of the debentures.

Preferred Share Rights Plan

In December 2008, we adopted a renewed shareholder rights plan which will impact a potential acquirer unless the acquirer negotiates with our Board of Directors and the Board of Directors approves the transaction. The rights plan became effective on January 5, 2009, upon the expiration of our previous shareholder rights plan.  Pursuant to the renewed plan, one preferred share purchase right (a “Right”) is attached to each currently outstanding or subsequently issued share of our common stock. Prior to becoming exercisable, the Rights trade together with our common stock. In general, the Rights will become exercisable if a person or group (other than the acquirer) acquires or announces a tender or exchange offer for 15% or more of our common stock.  Each Right entitles the holder to purchase from us one one-hundredth of a share of Series 4 Junior Participating Preferred Stock, no par value (the “Preferred Stock”), at an exercise price of $47.75 per one one-hundredth of a share, subject to adjustment.  If a person or group acquires 15% or more of our common stock, each Right will entitle the holder (other than the acquirer) to purchase shares of our common stock (or, in certain circumstances, cash or other securities) having a market value of twice the exercise price of a Right at such time. Under certain circumstances, each Right will entitle the holder (other than the acquirer) to purchase the common stock of the acquirer having a market value of twice the exercise price of a Right at such time. In addition, under certain circumstances, our Board of Directors may exchange each Right (other than those held by the acquirer) for one share of our common stock, subject to adjustment. If the Rights become exercisable, holders of our common stock (other than the acquirer), will receive the number of Rights they would have received if their units had been redeemed and the purchase price paid in our common stock. Our Board of Directors may redeem the Rights at a price of $0.01 per Right generally at any time before 10 days after the Rights become exercisable.

 
35

 
ITEM 6.  SELECTED FINANCIAL DATA (1)

 
Years ended December 31,
                   
 
2008
 
2007
 
2006
 
2005
 
2004
 
(Dollars In Thousands, Except Per Share Data)
Selected Statement of Income Data:
                                     
Net sales
$
748,967
   
$
586,407
   
$
491,952
   
$
397,115
   
$
363,984
 
Interest expense (2)
$
11,381
   
$
12,078
   
$
11,915
   
$
11,407
   
$
7,393
 
Provisions for income taxes (3)
$
18,776
   
$
2,540
   
$
901
   
$
118
   
$
-
 
Income from continuing operations before cumulative effect of accounting  change (1) (4)
 
$
 
36,560
   
 
$
 
46,534
   
 
$
 
15,768
   
 
$
 
5,634
   
 
$
 
745
 
Cumulative effect of accounting change
$
-
   
$
-
   
$
-
   
$
-
   
$
(536
)
Net income
$
36,547
   
$
46,882
   
$
15,515
   
$
4,990
   
$
209
 
Net income (loss) applicable to common stock
$
36,241
   
$
41,274
   
$
12,885
   
$
2,707
   
$
(2,113
)
Income (loss) per common share applicable to common stock:
                                     
Basic:
                                     
Income (loss) from continuing operations before cumulative effect of accounting change
 
$
 
1.71
   
 
$
 
2.09
   
 
$
 
.92
   
 
$
 
.25
   
 
$
 
(.12
 
)
Net income (loss) from discontinued operations
$
-
   
$
.02
   
$
(.02
)
 
$
(.05
)
 
$
-
 
Cumulative effect of accounting change
$
-
   
$
-
   
$
-
   
$
-
   
$
(.04
)
Net income (loss)
$
1.71
   
$
2.11
   
$
.90
   
$
.20
   
$
(.16
)
Diluted:
                                     
Income (loss) from continuing operations before cumulative effect of accounting change
 
$
 
1.58
   
 
$
 
1.82
   
 
$
 
.77
   
 
$
 
.22
   
 
$
 
(.12
 
)
Net income (loss) from discontinued operations
$
-
   
$
.02
   
$
(.01
)
 
$
(.04
)
 
$
-
 
Cumulative effect of accounting change
$
-
   
$
-
   
$
-
   
$
-
   
$
(.04
)
Net income (loss)
$
1.58
   
$
1.84
   
$
.76
   
$
.18
   
$
(.16
)
 
Selected Balance Sheet Data:
                                     
Total assets
$
335,767
   
$
307,554
   
$
219,927
 
 
$
188,963
 
 
$
167,568
 
Redeemable preferred stock
$
52
    $
56 
    $
65 
     
83 
   
$
97 
 
Long-term debt, including current portion
$
105,160
   
$
122,107
   
$
97,692
   
$
112,124
   
$
106,507
 
Stockholders' equity
$
130,044
   
$
94,283
   
$
43,634
   
$
14,861
   
$
9,915
 
 
Selected other data:
                               
Cash dividends declared per common share
$
-
 
$
-
 
$
-
   
$
-
   
$
-

(1)
See discussions included in Item 7 of Part II of this report.
(2)
In May 2002, the repurchase of senior unsecured notes using proceeds from a financing agreement was accounted for as a voluntary debt restructuring. As a result, subsequent interest payments associated with the financing agreement debt were recognized against the unrecognized gain on the transaction. The financing agreement debt was repaid in September 2004.
(3)
Beginning in the fourth quarter of 2007, we began recognizing a provision for regular federal income taxes as the result of reversing the valuation allowance on federal NOL carryforwards and other timing differences and the associated utilization of the federal NOL carryforwards.
(4)
Income from continuing operations before cumulative effect of accounting change includes a gain on extinguishment of debt of $5.5 million and $4.4 million for 2008 and 2004, respectively.
 
 
36

 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management's Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with a review of the other Items included in this Form 10-K and our December 31, 2008 Consolidated Financial Statements included elsewhere in this report. Certain statements contained in this MD&A may be deemed to be forward-looking statements. See "Special Note Regarding Forward-Looking Statements."

Overview

General

We are a manufacturing, marketing and engineering company, operating through our subsidiaries. Our wholly-owned subsidiary, ThermaClime, through its subsidiaries, owns substantially all of our core businesses consisting of the:

 
·
Climate Control Business engages in the manufacturing and selling of a broad range of air conditioning and heating products in the niche markets we serve consisting of geothermal and water source heat pumps, hydronic fan coils, large custom air handlers and other related products used in controlling the environment in commercial and residential new building construction, renovation of existing buildings and replacement of existing systems.  For 2008, approximately 41% of our consolidated net sales relates to the Climate Control Business.
 
·
Chemical Business engages in the manufacturing and selling of nitrogen based chemical products produced from three plants located in Arkansas, Alabama and Texas for the industrial, mining and agricultural markets. Our products include industrial and fertilizer grade ammonium nitrate (“AN”), urea ammonium nitrate (“UAN”), nitric acid in various concentrations, nitrogen solutions and various other products. For 2008, approximately 57% of our consolidated net sales relates to the Chemical Business.

Economic Conditions

The current state of the economy creates significant uncertainty relative to the industrial, construction and agricultural markets that we serve.  We based our 2009 business plan upon our assumption that during most of 2009, the economy will continue to contract due to additional loss of jobs, declining consumer demand and limited credit availability.  However, our 2009 business plan is a moving target that will be adjusted frequently as we measure customer demand during the first and second quarters. We plan to adjust our controllable costs when and as market conditions dictate.

Since we serve several diverse markets, we have to consider market fundamentals for each market individually as we plan our production levels.

In our Climate Control Business, approximately 81% of our 2008 Climate Control sales relate to commercial construction and the balance, or 19%, relates to single-family residential geothermal heat pumps. Based on published industry forecasts predicting significant declines in commercial

 
37

 
and residential construction, we expect to see lower volumes in Climate Control sales during 2009, as compared to 2008 for most of our products.

At this time, however, we are unable to assess the impact to our sales level. The longer term outlook after 2009 will, in our opinion, depend upon the recovery of the credit and capital markets and the general economy.

One bright spot is the recently enacted American Reinvestment and Recovery Act of 2009. We believe that tax credits and incentives, and certain planned direct spending by the federal government contained in the Act, could stimulate sales of our geothermal heat pump products, as well as other products that could be used to modernize federally owned and operated buildings, military installations, public housing and hospitals.

Orders received for all Climate Control products in the fourth quarter of 2008 were $59.1 million compared to $53.9 million in the fourth quarter of 2007 and $82.3 million average for the first three quarters of 2008. Our backlog at the end of 2008 was $68.5 million, which provides solid support going into the first quarter of 2009.  Beyond the first quarter, the potential sales level is uncertain.  Our orders for January and February of 2009 averaged $16 million per month compared to a monthly average of $25 million for the same period of 2008.

In our Chemical Business, approximately 64% of our 2008 Chemical Business sales consisted of:

·
nitric acid, sulfuric acid and anhydrous ammonia sold to industrial customers; and
·
industrial grade AN and nitrogen solutions sold to mining customers.

Most of these sales were pursuant to sales contracts and or pricing arrangements on terms that include the cost of raw material feedstock as a pass through component in the sales price.

Approximately 85% of our 2008 industrial and mining sales were to customers that have contractual obligations to purchase a minimum annual quantity or allow us to recover our costs plus a profit, irrespective of the volume of product produced.  We expect that many of these mining and industrial customers will take significantly less product in 2009 than in 2008 due to the downturn in housing, automotive and other sectors.

In 2008, approximately 36% of our Chemical Business sales were nitrogen fertilizer sold in the agricultural markets including:

·
AN produced at our El Dorado Facility from purchased anhydrous ammonia and,
·
UAN produced at our Cherokee Facility from natural gas.

The agricultural product sales, unlike the majority of our industrial and mining sales, are not sold at a formula price but instead at the market price in effect at the time of sale or at a negotiated future price.   Due to the unpredictable volatility in the commodity markets, it is difficult at this point to predict with any certainty the 2009 volume level and profit margins.

 
38

 
We believe that our 2009 sales volume expressed in tons will be lower than in 2008 and, due to the steep market price declines in most commodities in the latter half of 2008, including anhydrous ammonia and natural gas, as well as our selling prices per unit, our sales dollars per unit will also be lower.

Further beginning in June 2009 when the new Bayer Agreement takes effect, net sales will decrease as a result of the reduction in the Baytown Facility’s lease expense that was a pass through cost component in our sales price.  This reduction will be the result of Bayer exercising its option to purchase from a third party all of the assets comprising the Baytown Facility, except certain assets owned by EDN.

We expect agricultural operating margins in dollars to be less based upon the current spread between natural gas cost and UAN market prices and the current spread between anhydrous ammonia cost and AN market prices. Due to unfavorable weather during the fall and the deferral of nitrogen applications because of higher fertilizer prices, the fall fertilizer application was below expectation. A significant amount of nitrogen fertilizer remained in the distribution and storage systems and at very high costs. During the period leading up to the fourth quarter of 2008, the price of natural gas and anhydrous ammonia was very high relative to the preceding 12 months. Significant amounts of nitrogen fertilizer were put into storage and, due to the lower than normal application of these fertilizers in the fall of 2008, the product did not move out of storage. As a result, the distribution and storage systems in North America were full, causing a number of producers to curtail production. Industry sources are predicting that due to plant curtailments, fewer imports, the deferral of the 2008 fall nitrogen application, and low global grain inventories, a decreased supply will be available to meet demand after the initial spring application depletes the fertilizer in storage.   However, we are unable to predict if product prices and margins will respond favorably.

Irrespective of our assumptions, the actual results for agricultural products will depend upon the global and domestic supply of and the demand for nitrogen fertilizer and agricultural products, including but not limited to, corn and wheat.

Recent figures from the Commerce Department reflect that gross domestic product declined at a 6.2% annual rate in the fourth quarter of 2008, which is far worse than previously thought. Economic indicators for the first two months of 2009 point to a deepening recession. These indications would imply that a rebound in 2009 is unlikely. As a result, we will make changes to our controllable cost structure, as conditions dictate.

2008 Results

Our consolidated net sales for 2008 were $749.0 million compared to $586.4 million for 2007, our consolidated operating income was $59.2 million compared to $59.0 million in 2007, and our consolidated net income was $36.5 million, after an income tax provision of $18.8 million, compared to net income of $46.9 million, after an income taxes provision of $2.5 million, for 2007.
 
 
39

 
The sales increase of $162.6 million includes an increase of $25.0 million in our Climate Control Business and an increase of $135.3 million in our Chemical Business. Our Chemical Business’ increase relates to significantly higher selling prices primarily reflecting higher raw material costs. As a result of our ability to pass through most raw material cost increases in the sales price on a significant portion of the sales of our Chemical Business, our Chemical Business was able to maintain a consistent level of gross profit, excluding the significant items discussed below. However, since the increase in sales was primarily a result of increases in raw material costs instead of volume increases, the gross profit as a percent of sales declined significantly. In addition, our Chemical Business recognized other significant items in 2008 that negatively affected gross profit and operating income as discussed in the table below.

With respect to gross profit and operating income, there are a number of factors that affect the comparability of 2008 to 2007.  Our Chemical Business’ gross profit and operating income includes the following significant income (loss) items:

 
2008
 
2007
 
Effect
   
(In Millions)
Unrealized non-cash losses on commodities contracts
$
(5.3
)
 
$
(0.2
)
 
$
(5.1
)
Unplanned maintenance downtime of Cherokee Facility
 
(5.1
)
   
(1.1
)
   
(4.0
)
Insurance recoveries of business interruption claims
 
-
     
3.8
     
(3.8
)
LCM provision on inventory
 
(3.6
)
   
-
     
(3.6
)
Net precious metals expense
 
(6.3
)
   
(2.6
)
   
(3.7
)
Expense for Turnarounds
 
(6.0
)
   
(3.4
)
   
(2.6
)
Total effect on gross profit
 
(26.3
)
   
(3.5
)
   
(22.8
)
Expenses relating to the Pryor Facility
 
(2.4
)
   
(1.0
)
   
(1.4
)
Other income from litigation judgment/settlement
 
7.6
     
3.3
     
4.3
 
    Total effect on operating income (1)
$
(21.1
)
 
$
(1.2
)
 
$
(19.9
)

(1)
See discussion of these items below under “Chemical Business.”

In addition, during 2008, we acquired $19.5 million aggregate principal amount of the 2007 Debentures for $13.2 million and recognized a gain on extinguishment of debt of $5.5 million, after expensing $0.8 million of the unamortized debt issuance costs associated with the 2007 Debentures acquired.

Also income taxes have a significant effect on the comparability of net income for 2008 compared to 2007. For 2008, we recognized a provision for income taxes of $18.8 million compared to $2.5 million in 2007. During 2008, we recognized current and deferred federal and state income taxes due, in part, to increased taxable income, fewer NOL carryforwards available to offset taxable income and higher effective tax rates. In addition during 2008, we performed a detailed analysis of all our deferred tax assets and liabilities and determined that our deferred tax assets were understated by approximately $1.8 million.  As a part of our analysis, we reviewed the realizability of these deferred tax assets and determined that a valuation allowance of approximately $0.3 million was required.  Accordingly, the addition of the deferred tax assets
 
 
and the associated valuation allowance resulted in an income tax benefit (a reduction to our income tax provision) of approximately $1.6 million.  This income tax benefit is included in our net income tax provision of $18.8 million for 2008.

As previously reported, the 2007 provision included a current provision for federal income taxes of approximately $5.3 million for regular federal income tax and alternative minimum income tax (“AMT”).  The 2007 provision also included a current provision of state income taxes of approximately $2.0 million, which included the provision for 2007 state income taxes, as well as, approximately $1.0 million for uncertain state income tax positions recognized in accordance with FIN 48.  The 2007 provisions were partially offset by a benefit for deferred income taxes of approximately $4.7 million resulting from the reversal of valuation allowance on deferred tax assets, the benefit of AMT credits, and other temporary differences as previously reported.

 
Climate Control Business

Our Climate Control Business has consistently generated annual profits and positive cash flows and continued to do so during 2008.

Climate Control’s net sales were approximately $311.4 million compared to $286.4 million for 2007, an increase of $25.0 million or 8.7%. The improvement in net sales relates to a 15.7% increase in geothermal and water source heat pump products and a 4.3% increase in other HVAC products, partially offset by a 2.7% decline in sales of our fan coil products.

For 2008, the order level was $305.9 million as compared to $241.6 million for 2007, an increase of $64.3 million or 26.6%. Consistent with net sales, the increase in orders was primarily for geothermal and water source heat pump products.  There was some softening in the order level for hydronic fan coil products that was offset by orders for other HVAC products.

Due to the increase in net sales, Climate Control’s gross profit in 2008 increased to $96.6 million, or 31.0% of net sales, as compared to $83.6 million, or 29.2% of net sales, in 2007. For 2008, Climate Control’s operating income before allocation of corporate overhead was $38.9 million compared to $34.2 million in 2007. For 2008, gross profit and operating income, as a percentage of net sales, were positively impacted by an increase of $1.3 million in copper futures contracts gains as compared to 2007.

We continue to closely follow the contraction and volatility in the credit markets and have attempted to assess the impact on the commercial construction sectors that we serve, including but not limited to new construction and/or renovation of facilities in the following sectors:

 
·
Multi-Family
 
·
Lodging
 
·
Education
 
·
Healthcare
 
·
Offices
 
·
Manufacturing
 
 
41

 
We expect continued volatility in material costs, especially for copper, steel, aluminum and components that include those metals. Although we continue to monitor and take measures to mitigate and control material cost fluctuations through hedging transactions, contract purchases and volume agreements, there can be no assurance that our selling prices will track raw material and component cost changes. During the fourth quarter of 2008, commodity prices, including copper and aluminum, dropped considerably.

The majority of our Climate Control business is subject to the competitive bid process and the opportunity to pass through cost increases for materials depends on market conditions at the time we are bidding for a job. Once an order is accepted and entered into our backlog, the price usually cannot be adjusted to pass through any subsequent changes in our costs.
 
Our Climate Control Business manufactures most of its products to customer orders that are placed well in advance of required delivery dates. As a result, our Climate Control Business maintains a significant backlog that reduces the amount of inventory required to warehouse. At December 31, 2008, the backlog of confirmed orders was approximately $68.5 million compared to $54.5 million at December 31, 2007. We expect to ship substantially all the orders in the backlog within the next twelve months and have the production capacity in place to do so.

Our Climate Control Business will continue to launch new products and product upgrades in an effort to maintain our current market position and to establish presence in new markets. Our Climate Control Business' profitability over the last few years has been affected by operating losses of certain product lines being developed during that time. Our emphasis has been to increase the sales levels of these operations above the breakeven point. During 2007 and 2008, the results for these products reflected modest improvement. Although these products have not yet achieved profitability, we continue to believe that these products have good long-term prospects.

Management focuses on the following objectives for Climate Control:

·
monitoring and managing to the current economic environment,
·
increasing the sales and operating margins of all products,
·
developing and introducing new and energy efficient products,
·
improving production and product delivery performance, and
·
expanding the markets we serve, both domestic and foreign.

 
Chemical Business

Our Chemical Business has three chemical production facilities: the El Dorado Facility, the Cherokee Facility and the Baytown Facility. The El Dorado and Baytown Facilities produce nitrogen products from anhydrous ammonia that is delivered by pipeline and the El Dorado Facility also produces sulfuric acid from recovered elemental sulfur delivered by truck and rail. The Cherokee Facility produces anhydrous ammonia and nitrogen products from natural gas that is delivered by pipeline. In addition, we own idle ammonia and downstream derivative chemical process facility in Pryor, Oklahoma (the “Pryor Facility”), which we are in the process of activating, subject to the Pryor Facility obtaining a sales or distribution agreement satisfactory to

 
42

 
us. When and if activated, this facility will produce anhydrous ammonia and UAN from natural gas. See additional discussion of the Pryor Facility below under “Liquidity and Capital Resources - Pryor Facility.”

Our Chemical Business reported net sales for 2008 of $424.1 million compared to $288.8 million for 2007, an increase of $135.3 million. Operating income before allocation of corporate overhead was $31.3 million compared to $35.0 million in the same period of 2007.

The increase in sales of $135.3 million is primarily attributable to significantly higher selling prices for our products produced at our facilities.

As shown in the table above and discussed below, our Chemical Business’ operating income for 2008 decreased by a net $21.1 million for unrealized losses on outstanding commodities contracts, costs relating to unplanned maintenance downtime of the Cherokee Facility, a lower of cost or market provision on inventory, net expenses for precious metals, expenses associated with Turnarounds, and expenses associated with the possible start up of the Pryor Facility, partially offset by other income from litigation judgment and settlement. For 2007, significant items decreased operating income by a net $1.2 million. Excluding these significant items for both periods, results for 2008 are favorable compared to 2007.

Our primary raw material feedstocks, anhydrous ammonia, natural gas and sulfur, are commodities subject to significant price fluctuations, and are generally purchased at prices in effect at the time of purchase.  During 2008, natural gas ranged in price from $5.36 to $13.16 per MMBtu and averaged approximately $9.62 per MMBtu compared to an average price in 2007 of $7.37 per MMBtu. At March 6, 2009, the price for natural gas was $4.15 per MMBtu. During 2008, anhydrous ammonia ranged in price based on the low Tampa metric price per ton from $125 to $931 per metric ton and averaged approximately $587, compared to an average price in 2007 of $333 per metric ton. At March 6, 2009, the Tampa price for anhydrous ammonia was $275 per metric ton. During 2008, sulfur ranged in price based on the quarterly Tampa long ton price from $150 to $617 per long ton and averaged approximately $368, compared to an average price in 2007 of $78 per long ton. At March 6, 2009, the Tampa price per long ton for sulfur was minimal. Due to the volatility of these commodity markets, we continue to focus our sales efforts on sales agreements and/or pricing formulas that provide for the pass through of raw material and other variable costs and certain fixed costs.

We have entered into futures/forward contracts to hedge the cost of natural gas and anhydrous ammonia for the purpose of securing the profit margin on a significant portion of our sales commitments with firm sales prices in our Chemical Business. Recent extreme volatility in natural gas and ammonia futures prices has created wide swings in the market value of our natural gas and ammonia hedges.  Due to a steep decline in natural gas and ammonia futures prices, the unrealized non-cash losses on our outstanding natural gas and ammonia hedges totaled approximately $5.3 million at December 31, 2008, of which approximately $2.5 million relate to contracts that will settle during the first quarter of 2009.  These hedges contractually secure a large portion of the profit margin on significant orders for our Chemical Business by locking in the cost of these raw material feedstocks as well as the ultimate sales price of the end product. We believe the customers that have entered into these sales commitments with us will
 
 
fulfill their obligations to purchase the products at contracted prices. The mark-to-market accounting adjustments produce volatility in our consolidated financial statements. The unrealized gains or losses are non-cash items and economically hedge the profit margin of these sales commitments.

During the third quarter of 2008, the Cherokee Facility experienced repeated unplanned maintenance downtime, which downtime reduced production and sales by our Chemical Business. As a result, interim repairs were made at the Cherokee Facility during this period. Due to this repeated downtime, the Cherokee Facility lost approximately 20 days of operation reducing our Chemical Business’ gross profit and operating income by an estimated $5.1 million during the third quarter of 2008. During 2007, the Cherokee Facility experienced unplanned maintenance downtime, which reduced gross profit and operating income by an estimated $1.1 million.

At December 31, 2008, our Chemical Business recognized a lower of cost or market (“LCM”) provision of $3.6 million due to declines in global nitrogen prices as demand fell as the result of buyers’ concerns over volatile commodity prices and the global economic crisis.

Our Chemical Business uses precious metals as a catalyst in the manufacturing process of nitric acid. The market prices of these precious metals were highly volatile during 2008. During major maintenance and capital projects performed in 2008 and 2007, we performed procedures to recover precious metals (previously expensed) which had accumulated over time within our manufacturing equipment. Also during 2007, we sold a portion of our precious metals that exceeded our production requirements.  As the result, precious metals expense, net of recoveries and gains, increased $3.7 million as compared to 2007. Current prices for precious metals are less than half the prices were a year ago and are significantly lower than the peak levels reached in June 2008.

Our Chemical Business expenses the costs of Turnarounds as they are incurred. During 2008, expenses for Turnarounds were approximately $6.0 million compared to $3.4 million during 2007. The increase in Turnaround costs relates primarily to certain Turnarounds that are performed every 18-24 months compared to certain Turnarounds that are performed annually. Based on our current plan for Turnarounds to be performed during 2009, we currently estimate that we will incur approximately $5.0 million of Turnaround costs. However, it is possible that the actual costs could be significantly different than our estimates.

As discussed below under “Liquidity and Capital Resources - Pryor Facility”, we are in the process of activating the Pryor Facility, subject to obtaining a sales or distribution agreement. As a result, our expenses associated with the Pryor Facility increased approximately $1.4 million in 2008 compared to 2007.

As previously reported, in 2008, our Chemical Business recognized income from a litigation judgment of approximately $7.6 million, net of attorneys’ fees.  On June 6, 2008, we received proceeds of approximately $11.2 million for this litigation judgment, which includes interest of approximately $1.4 million and from which we paid attorneys’ fees of approximately $3.6 million. During 2007, our Chemical Business reached a settlement with Dynegy, Inc. and one of its subsidiaries, relating to a previously reported lawsuit. This settlement of $3.3 million reflects

 
44

 
the net proceeds of approximately $2.7 million received and the retention of a disputed accounts payable amount of approximately $0.6 million.

Our Chemical Business continues to focus on growing our non-seasonal industrial customer base with an emphasis on customers accepting the risk inherent with raw material costs, while at the same time, maintaining a strong presence in the seasonal agricultural sector. A significant percentage of the costs to operate process plants, other than costs for raw materials and utilities, are fixed costs.  Our long-term strategy includes optimizing production efficiency of our facilities, thereby lowering the fixed cost of each ton produced.

Repurchase of Portion of 2007 Debentures

During 2008, we acquired $19.5 million aggregate principal amount of the 2007 Debentures for $13.2 million and recognized a gain on extinguishment of debt of $5.5 million, after expensing $0.8 million of the unamortized debt issuance costs associated with the 2007 Debentures acquired. The repurchase of these debentures was funded by our working capital.

Liquidity and Capital Resources

The following is our cash and cash equivalents, total interest bearing debt and stockholders’ equity:

   
December 31,
2008
 
December 31,
2007
 
(In Millions)
Cash and cash equivalents
$
46.2
 
$
58.2
 
             
Long-term debt:
           
2007 Debentures due 2012
$
40.5
 
$
60.0
 
Secured Term Loan due 2012
 
50.0
   
50.0
 
Other
 
14.7
   
12.1
 
Total long-term debt
$
105.2
 
$
122.1
 
             
Total stockholders’ equity
$
130.0
 
$
94.3
 

We believe our capital structure and liquidity reflect a reasonably sound financial position. At December 31, 2008, our cash and cash equivalents were $46.2 million and our $50 million Working Capital Revolver Loan with Wells Fargo Foothill was undrawn and available to fund operations, if needed, subject to the financial viability of the lender. During 2008, we had no outstanding borrowings under the Working Capital Revolver Loan. At December 31, 2008, the ratio between long-term debt, before the use of cash on hand to pay down debt, and stockholders’ equity was approximately 0.8 to 1 as compared to 1.3 to 1 at December 31, 2007.

For 2009, we expect our primary cash needs will be for working capital and capital expenditures. We and our subsidiaries plan to rely upon internally generated cash flows, cash on hand, secured property and equipment financing, and the borrowing availability under the Working Capital Revolver Loan to fund operations and pay obligations. Due to the uncertainty relative to the

 
45

 
current recession, we are evaluating the effect upon our internally generated cash flows that could occur if we experience significant declines in our sales volumes.

The 5.5% Convertible Senior Subordinated Notes due 2012 (the “2007 Debentures”) bear interest at the annual rate of 5.5% and mature on July 1, 2012. Interest is payable in arrears on January 1 and July 1 of each year. As previously reported, our board of directors has granted management the authority, commencing March 12, 2008, to repurchase all or a portion of the 2007 Debentures on favorable terms if an opportunity is presented on terms satisfactory to management. Under this authority, we acquired $19.5 million aggregate principal amount of these debentures during the fourth quarter of 2008 as discussed above under “Repurchase of Portion of 2007 Debentures.”

The Secured Term Loan matures on November 2, 2012 and accrues interest at a defined LIBOR rate plus 3%, which LIBOR rate is adjusted on a quarterly basis. The interest rate at December 31, 2008 was approximately 6.19%. 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 the El Dorado and Cherokee Facilities.

ThermaClime and certain of its subsidiaries are subject to numerous covenants under the Secured Term Loan 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.

ThermaClime’s Working Capital Revolver Loan is available to fund its working capital requirements, if necessary, through April 13, 2012. Under the Working Capital Revolver Loan, ThermaClime and its subsidiaries (the “Borrowers”) may borrow on a revolving basis up to $50.0 million based on specific percentages of eligible accounts receivable and inventories. At December 31, 2008, we had approximately $49.5 million of borrowing availability under the Working Capital Revolver Loan based on eligible collateral and outstanding letters of credit.

The Working Capital Revolver Loan and the Secured Term Loan have financial covenants that are discussed below under “Loan Agreements - Terms and Conditions”. The Borrowers’ ability to maintain borrowing availability under the Working Capital Revolver Loan depends on their ability to comply with the terms and conditions of the loan agreements and their ability to generate cash flow from operations. The Borrowers are restricted under their credit agreements as to the funds they may transfer to the Company and their non-ThermaClime affiliates and certain ThermaClime subsidiaries. This limitation does not prohibit payment to the Company of amounts due under a Services Agreement, Management Agreement and a Tax Sharing Agreement. Based upon our current projections, we believe that cash and borrowing availability under our Working Capital Revolver Loan is adequate to fund operations in 2009, subject to the financial viability of the lender.

Income Taxes

As previously discussed, in 2007 and certain prior years, our effective tax rate had been minimal due to the valuation allowances on federal NOL carryforwards and other deferred tax assets. In the third quarter of 2007, due to our improved operating results, it was determined that the
 
 
valuation allowances were no longer necessary. At December 31, 2007, we had minimal federal NOL carryforwards remaining, which were utilized during 2008. As a result, in 2008, we recognized and paid federal income taxes at regular corporate tax rates, which we expect to continue in 2009.

In addition, the utilization of the NOL carryforwards has reduced our income tax liabilities.  The federal tax returns for 1994 through 2004 remain subject to examination for the purpose of determining the amount of remaining tax NOL and other carryforwards. With few exceptions, the 2005-2007 years remain open for all purposes of examination by the IRS and other major tax jurisdictions.

Capital Expenditures

General

Cash used for capital expenditures during 2008 was $32.6 million, including $8.7 million primarily for property, production equipment, and other upgrades for additional capacity in our Climate Control Business and $23.6 million for our Chemical Business, primarily for process and reliability improvements of existing facilities.
 
As discussed below, our current commitment for 2009 is approximately $10.4 million. Other capital expenditures for 2009 are believed to be discretionary. In addition, although not approved or committed, we are considering numerous capital expenditures related to both our Chemical and Climate Control Businesses that would utilize a significant amount of our existing cash on hand, if not separately financed.
 
Current Commitments
 
As of the date of this report, we have committed capital expenditures of approximately $10.4 million for 2009. The expenditures include $6.9 million for process and reliability improvement in our Chemical Business, including $2.9 million relating to the Pryor Facility (see discussion below regarding our expected costs to activate the Pryor Facility). In addition, our current commitments include $3.5 million primarily for production equipment and facilities upgrades in our Climate Control Business. We plan to fund these expenditures from working capital, which may include utilizing our Working Capital Revolver Loan, and financing arrangements. In addition to committed capital expenditures and other than Pryor Facility’s capital expenditures, we have planned capital expenditures in our Climate Control Business of approximately $10 million and in our Chemical Business of approximately $12 million. These planned expenditures are subject to economic conditions and approval. If these capital expenditures are approved, most of the Climate Control’s expenditures will likely be financed and the Chemical Business’ expenditures will likely be funded from internal cash flows.

Certain events relating to our Chemical Business

Pryor Facility - As previously reported, we have been considering activating a portion of our idle Pryor Facility subject to securing a sales agreement with a strategic customer to purchase

 
47

 
and distribute the majority of the UAN production. Based on our discussions with several large strategic industry customers, we believe that in the near future we will be able to reach an agreement to sell or distribute the UAN production at the Pryor Facility.

We received our permits to operate the Pryor Facility in February 2009. Based on the status of discussions with potential customers and since we have received the necessary permits, we are proceeding with the preparations to start the facility. We have hired key personnel to operate the facility and have positioned the additional necessary personnel to be hired at appropriate intervals during the start-up phases.

Barring unforeseen delays and subject to securing a sales or distribution agreement as discussed above, we expect to start production at the Pryor Facility during the third quarter of 2009. If the Pryor Facility becomes operational, we plan to produce and sell approximately 325,000 tons of UAN and approximately 35,000 tons of anhydrous ammonia annually. As previously disclosed, our initial cost estimate to activate the Pryor Facility was $15 million to $20 million, with approximately 50% being for capital expenditures and the remainder for expenses.  The estimated start up costs include those cost to bring the plant up to  full UAN production status. Our estimate of the total remaining cost to activate the Pryor Facility, including $2.9 million of current commitments discussed above, is approximately $13 million to $17 million. Approximately $6 million to $8 million will be for capital expenditures and the remaining portion will be expensed as incurred. We plan to fund this project from our available cash on hand and working capital. However, the actual timeframe to begin production, the related amount of production and sales and the total remaining cost to activate the facility could be significantly different from our current estimates.

Bayer Agreement - On October 23, 2008, El Dorado Nitrogen, L.P. (“EDN”), and El Dorado Chemical Company (“EDC”), both subsidiaries of the Company, entered into a new Nitric Acid Supply Operating and Maintenance Agreement (the “Bayer Agreement”) with Bayer MaterialScience, LLC (“Bayer”).  The Bayer Agreement will replace the current Baytown Nitric Acid Project and Supply Agreement, dated June 27, 1997 (the “Original Bayer Agreement”), as of June 24, 2009. The Bayer Agreement is for a term of five years, with renewal options.

Under the terms of the Bayer Agreement, Bayer will purchase from EDN all of Bayer’s requirements for nitric acid for use in Bayer’s chemical manufacturing complex located in Baytown, Texas at a price covering EDN’s costs plus a profit, with certain performance obligations on EDN’s part.  Bayer will also supply ammonia as required for production of nitric acid at the Baytown Facility, in addition to certain utilities, chemical additives and services that are required for such production.  Any surplus nitric acid manufactured at the Baytown Facility that is not required by Bayer may be marketed to third parties by EDN.

Pursuant to the terms of the Original Bayer Agreement, Bayer has provided notice of exercise of its option to purchase from a third party all of the assets comprising the Baytown Facility, except certain assets that are owned by EDN for use in the production process (the “EDN Assets”). EDN will continue to be responsible for the maintenance and operation of the Baytown Facility in accordance with the terms of the Bayer Agreement. In addition, EDC will continue to guarantee the performance of EDN’s obligations under the Bayer Agreement.

 
48

 
If there is a change in control of EDN, Bayer will have the right to terminate the Bayer Agreement upon payment to EDN a termination fee of approximately $6.3 million plus 1.1 times the current net book value of the EDN Assets. For 2008, EDN, a subsidiary of El Dorado Nitric Company (“EDNC”), had sales to Bayer of approximately 19% and 11% of the Chemical Business’ and the Company’s consolidated net sales, respectively.

Fire at Cherokee Facility - On February 5, 2009, a small nitric acid plant located at the Cherokee Facility suffered damage due to a fire.  The fire was immediately extinguished and there were no injuries.  The cause of the fire is under investigation and the extent of the damage to the nitric acid plant is not yet determined.  It is also not yet known when repair or replacement will be completed and the nitric acid plant put back in operation.  The nitric acid plant that suffered the fire, with a current 182 ton per day capacity, is the smaller of the two nitric acid plants at the Cherokee Facility.  While the volume of production of finished product at the Cherokee Facility will be impacted, the Cherokee Facility continues production with the larger of the nitric acid plants.  Our insurance provides for business interruption coverage after a 30-day waiting period for lost profits and extra expense coverage and a $1 million property loss deductible.

Stock Repurchase Authorization

As previously reported, our board of directors enacted a stock repurchase authorization for an unstipulated number of shares for an indefinite period of time commencing March 12, 2008. The stock repurchase authorization will remain in effect until such time as of our board of directors decides to end it. During 2008, we repurchased 400,000 shares of our common stock using funds from our working capital.

Stock Options Granted in 2008

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 compensation and stock option committee of our board of directors will administer the 2008 Plan.

During the fourth quarter of 2008, the compensation and stock option committee of our board of directors approved the grants of 372,000 shares of qualified stock options to certain employees and our board of directors (with each recipient abstaining as to himself) approved the grants of 45,000 shares of non-qualified stock options to our outside directors under the 2008 Plan (the “2008 Options”).  The exercise price of the 2008 Options was equal to the market value of our common stock at the date of grant.  The 2008 Options vest at the end of each one-year period at the rate of 16.5% per year for the first five years and the remaining unvested options will vest at the end of the sixth year. Pursuant to the terms of the non-qualified stock options, if a termination event occurs, as defined, the non-vested stock options will become fully vested and

 
49

 
exercisable for a period of one year from the date of the termination event. Excluding non-qualified stock options relating to a termination event, the 2008 Options expire in 2018.

At December 31, 2008, the total stock-based compensation expense not yet recognized is $7.2 million relating to non-vested stock options, which is expected to be amortized through 2016 (adjusted for forfeitures), based on the underlying vesting terms of the non-vested stock options.

Dividends

We are a holding company and, accordingly, our ability to pay cash dividends on our preferred stock and our common stock depends in large part on our ability to obtain funds from our subsidiaries. The ability of ThermaClime (which owns substantially all of the companies comprising the Climate Control Business and Chemical Business) and its wholly-owned subsidiaries to pay dividends and to make distributions to us is restricted by certain covenants contained in the $50 million Working Capital Revolver Loan and the $50 million Secured Term Loan. Under the terms of these agreements, ThermaClime cannot transfer funds to us in the form of cash dividends or other distributions or advances, except for:

·
the amount of income taxes that ThermaClime would be required to pay if they were not consolidated with us;
·
an amount not to exceed fifty percent (50%) of ThermaClime's consolidated net income during each fiscal year determined in accordance with generally accepted accounting principles plus amounts paid to us within the first bullet above, provided that certain other conditions are met;
·
the amount of direct and indirect costs and expenses incurred by us on behalf of ThermaClime pursuant to a certain services agreement;
 
·
amounts under a certain management agreement between us and ThermaClime, provided certain conditions are met, and
 
·
outstanding loans not to exceed $2.0 million at any time.

We have not paid cash dividends on our outstanding common stock in many years and we do not currently anticipate paying cash dividends on our outstanding common stock in the near future. However, our board of directors has not made a definitive decision whether or not to pay such dividends in 2009.

During 2008, the 2008 dividend requirements were declared and paid on our preferred stock using funds from our working capital. Therefore, there were no unpaid dividends in arrears at December 31, 2008. Each share of preferred stock is entitled to receive an annual dividend, only when declared by our board of directors, payable as follows:

·
Series D Preferred at the rate of $.06 a share payable on October 9, which dividend is cumulative;
·
Series B Preferred at the rate of $12.00 a share payable January 1, which dividend is cumulative; and
·
Noncumulative Preferred at the rate of $10.00 a share payable April 1, which is noncumulative.

 
50

 
Compliance with Long-Term Debt Covenants

As discussed below under “Loan Agreements - Terms and Conditions”, the Secured Term Loan and Working Capital Revolver Loan, as amended, of ThermaClime and its subsidiaries require, among other things, that ThermaClime meet certain financial covenants. ThermaClime's forecasts for 2009 indicate that ThermaClime will be able to meet all financial covenant requirements for 2009.

Loan Agreements - Terms and Conditions

5.5% Convertible Senior Subordinated Debentures - As previously reported, on June 28, 2007, we completed a private placement to twenty-two qualified institutional buyers, pursuant to which we sold $60.0 million aggregate principal amount of the 2007 Debentures. We received net proceeds of approximately $57.0 million, after discounts and commissions. As discussed above under “Repurchase of Portion of 2007 Debentures”, we acquired $19.5 million aggregate principal amount of the 2007 Debentures during the fourth quarter of 2008. As a result, only $40.5 million remains outstanding at December 31, 2008.

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. In addition, 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.

Working Capital Revolver Loan - ThermaClime’s Working Capital Revolver Loan is available to fund its working capital requirements, if necessary, through April 13, 2012. Under the Working Capital Revolver Loan, ThermaClime and its subsidiaries may borrow on a revolving basis up to $50.0 million based on specific percentages of eligible accounts receivable and inventories. As a result of using a portion of the proceeds from the 2007 Debentures to pay down the Working Capital Revolver Loan, at December 31, 2008, there were no outstanding borrowings.  In addition, the net credit available for additional borrowings under our Working Capital Revolver Loan was approximately $49.5 million. The Working Capital Revolver Loan requires that ThermaClime meet certain financial covenants, including an EBITDA requirement of greater than $25 million, a minimum fixed charge coverage ratio of not less than 1.10 to 1, and a maximum senior leverage coverage ratio of not greater than 4.50 to 1, which requirements are measured quarterly on a trailing twelve-month basis and as defined in the agreement. ThermaClime was in compliance with those covenants for 2008.


 
51

 
Secured Term Loan - As previously reported, in November 2007, ThermaClime and certain of its subsidiaries entered into the $50.0 million Secured Term Loan with a certain lender.  Proceeds from the Secured Term Loan were used to repay the previous senior secured loan.  The Secured Term Loan matures on November 2, 2012. The Secured Term Loan accrues interest at a defined LIBOR rate plus 3%, which LIBOR rate is adjusted on a quarterly basis. The interest rate at December 31, 2008 was approximately 6.19%. The Secured Term Loan requires only 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 the El Dorado and Cherokee Facilities. The carrying value of the pledged assets is approximately $61 million at December 31, 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 December 31, 2008, the carrying value of the restricted net assets of ThermaClime and its subsidiaries was approximately $75 million. As defined in the agreement, the Secured Term Loan borrowers are also subject to a minimum fixed charge coverage ratio of not less than 1.10 to 1 and a maximum leverage ratio of not greater than 4.50 to 1, both measured quarterly on a trailing twelve-month basis. The Secured Term Loan borrowers were in compliance with these financial covenants for 2008. The maturity date of the Secured Term Loan can be accelerated by the lender upon the occurrence of a continuing event of default, as defined.

Cross - Default Provisions - The Working Capital Revolver Loan agreement and the Secured Term Loan contain cross-default provisions. If ThermaClime fails to meet the financial covenants of the Secured Term Loan, the lender may declare an event of default.

Seasonality

We believe that our only significant seasonal products are fertilizer and related chemical products sold by our Chemical Business to the agricultural industry. The selling seasons for those products are primarily during the spring and fall planting seasons, which typically extend from March through June and from September through November in the geographical markets in which the majority of our agricultural products are distributed. As a result, our Chemical Business increases its inventory of agricultural products prior to the beginning of each planting season. In addition, the amount and timing of sales to the agricultural markets depend upon weather conditions and other circumstances beyond our control.

Related Party Transactions

Golsen Group

During the fourth quarter of 2008, the Golsen Group acquired from an unrelated third party $5,000,000 of the 2007 Debentures.  At December 31, 2008, accrued interest of $137,500 relates to the portion of debentures held by the Golsen Group.


 
52

In March 2008, we paid the dividends totaling approximately $60,000 and $240,000 on our Series D Preferred and Series  B Preferred, respectively, all of the outstanding shares of which are owned by the Golsen Group.
 
Critical Accounting Policies and Estimates

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenues and expenses, and disclosures of contingencies. In addition, the more critical areas of financial reporting impacted by management's judgment, estimates and assumptions include the following:

Accounts Receivable and Credit Risk - Our sales to contractors and independent sales representatives are generally subject to a mechanics lien in the Climate Control Business. Our other sales are generally unsecured. Credit is extended to customers based on an evaluation of the customer's financial condition and other factors. Credit losses are provided for in the financial statements based on historical experience and periodic assessment of outstanding accounts receivable, particularly those accounts which are past due (determined based upon how recently payments have been received). Our periodic assessment of accounts and credit loss provisions are based on our best estimate of amounts that are not recoverable. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising our customer bases and their dispersion across many different industries and geographic areas, however, six customers account for approximately ­­24% of our total net receivables at December 31, 2008. We do not believe this concentration in these six customers represents a significant credit risk due to the financial stability of these customers. At December 31, 2008 and 2007, our allowance for doubtful accounts of $0.7 million and $1.3 million, respectively, were netted against our accounts receivable.

Inventory Valuations - 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 December 31, 2008 and 2007, the carrying value of certain nitrogen-based inventories produced by our Chemical Business was reduced to market because cost exceeded the net realizable value by $3,627,000 and $13,000, respectively. In addition, the carrying value of certain slow-moving inventory items (primarily Climate Control products) was reduced to market because cost exceeded the net realizable value by $514,000 and $460,000 at December 31, 2008 and 2007, respectively.

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. As of December 31, 2008 and 2007, precious metals were $14.7 million and $10.9 million, respectively, and are included in supplies, prepaid items and other in the consolidated balance sheets.  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. For 2008, 2007 and 2006, the amounts expensed for precious metals were approximately $7.8 million, $6.4 million and $4.8 million, respectively. These precious metals expenses are included in cost of sales. 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 the
 
manufacturing equipment. For 2008, 2007 and 2006, we recognized recoveries of precious metals at historical FIFO costs of approximately $1.5 million, $1.8 million and $2.1 million, respectively. When we accumulate precious metals in excess of our production requirements, we may sell a portion of the excess metals. We recognized gains of $2.0 million for 2007 (none in 2008 or 2006) from the sale of excess precious metals. These recoveries and gains are reductions to cost of sales.

Impairment of Long-Lived Assets and Goodwill - Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable and goodwill is reviewed for impairment at least annually. If assets to be held and used are considered to be impaired, the impairment to be recognized is the amount by which the carrying amounts of the assets exceed the fair values of the assets as measured by the present value of future net cash flows expected to be generated by the assets or their appraised value. Assets to be disposed of are reported at the lower of the carrying amounts of the assets or fair values less costs to sell. At December 31, 2008, we had no long-lived assets that met the criteria presented in SFAS 144 – Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”) to be classified as assets held for sale. We have considered impairment of our long-lived assets and goodwill. The timing of impairments cannot be predicted with reasonable certainty and are primarily dependent on market conditions outside our control. Should sales prices permanently decline dramatically without a similar decline in the raw material costs or should other matters, including the environmental requirements and/or operating requirements set by Federal and State agencies change substantially from our current expectations, a provision for impairment may be required based upon such event or events. See Item 1 "Business-Environmental Matters." Based on estimates obtained from external sources and internal estimates based on inquiry and other techniques, we recognized impairments relating to certain non-core equipment of $192,000 relating to Corporate assets during 2008 (none in 2007 and 2006) and $250,000 and $286,000 relating to certain capital spare parts and idle assets in our Chemical Business during 2007 and 2006, respectively (none in 2008). These impairments are included in other expense in the consolidated statements of income.

Accrued Insurance Liabilities - We are self-insured up to certain limits for group health, workers’ compensation and general liability insurance claims. Above these limits, we have commercial insurance coverage for our contractual exposure on group health claims and statutory limits under workers’ compensation obligations. We also carry excess umbrella insurance of $50 million for most general liability risks excluding environmental risks. We have a separate $30 million insurance policy covering pollution liability at our El Dorado and Cherokee Facilities. Our accrued insurance liabilities are based on estimates of claims, which include the incurred claims amounts plus estimates of future claims development calculated by applying our historical claims development factors to our incurred claims amounts. We also consider the reserves established by our insurance adjustors and/or estimates provided by attorneys handling the claims, if any. In addition, our accrued insurance liabilities include estimates of incurred, but not reported, claims and other insurance-related costs. At December 31, 2008 and 2007, our accrued insurance liabilities were $2,971,000 and $2,975,000, respectively, and are included in accrued and other liabilities in the consolidated balance sheets. It is possible that the actual development of claims could exceed our estimates. Amounts recoverable from our insurance carriers over the self-insured limits are included in accounts receivable.


 
54

 
Product Warranty - Our Climate Control Business sells equipment for which we provide warranties covering defects in materials and workmanship. Generally, the base warranty coverage for most of the manufactured equipment is limited to 18 months from the date of shipment or 12 months from the date of start-up, whichever is shorter, and to 90 days for spare parts. In some cases, the customer may purchase an extended warranty. 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 on historical warranty costs. We also recognize the additional warranty expense and liability to cover atypical costs associated with a specific product, or component thereof, or project installation, when such costs are probable and reasonably estimable. It is possible that future warranty costs could exceed our estimates. At December 31, 2008 and 2007, our accrued product warranty obligations were $2.8 million and $1.9 million, respectively and are included in current and noncurrent accrued and other liabilities in the consolidated balance sheets.

Executive Benefit Agreements - We have entered into benefit agreements with certain key executives. Costs associated with these individual benefit agreements are accrued based on the estimated remaining service period when such benefits become probable that they will be paid. Total costs accrued equal the present value of specified payments to be made after benefits become payable. In 1992, we entered into individual benefit agreements with certain key executives (“1992 Agreements”) that provide for annual benefit payments for life (in addition to salary). The liability for these benefits under the 1992 Agreements is approximately $1.1 million and $1.0 million as of December 31, 2008 and 2007, respectively, and is included in current and noncurrent accrued and other liabilities in the consolidated balance sheets.

In 1981, we entered into individual death benefit agreements with certain key executives. In addition, as part of the 1992 Agreements, should the executive die prior to attaining the age of 65, we will pay the beneficiary named in the agreement in 120 equal monthly installments aggregating to an amount specified in the agreement. In 2005, we entered into a death benefit agreement with our CEO. As of December 31, 2008, the liability for death benefits is $2.7 million ($2.1 million at December 31, 2007) which is included in current and noncurrent accrued and noncurrent liabilities in the consolidated balance sheets.

Income Taxes - We account for income taxes in accordance with SFAS 109 – Accounting for Income Taxes (“SFAS 109”) and we adopted FIN No. 48 – Accounting for Uncertainty in Income Taxes (“FIN 48”) on January 1, 2007.  We recognize deferred tax assets and liabilities for the expected future tax consequences attributable to tax net operating loss (“NOL”) carryforwards, tax credit carryforwards, and differences between the financial statement carrying amounts and the tax basis of our assets and liabilities.  We establish valuation allowances if we believe it is more-likely-than-not that some or all of deferred tax assets will not be realized. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We do not recognize a tax benefit unless we conclude that it is more likely than not that the benefit will be sustained on audit by the taxing authority based solely on the technical merits of the associated tax position. If the recognition threshold is met, we recognize a tax benefit measured at the largest amount of the tax benefit that, in our judgment, is greater than 50% likely to be realized.  We record interest related to unrecognized tax positions in interest expense and penalties in operating other expense.
 
 
55

 
Income tax benefits credited to equity relate to tax benefits associated with amounts that are deductible for income tax purposes but do not affect earnings. These benefits are principally generated from exercises of non-qualified stock options.

Contingencies - We accrue for contingent losses when such losses are probable and reasonably estimable. In addition, we recognize contingent gains when such gains are realized or realizable and earned. We are a party to various litigation and other contingencies, the ultimate outcome of which is not presently known. Should the ultimate outcome of these contingencies be adverse, such outcome could create an event of default under ThermaClime's Working Capital Revolver Loan and the  Secured Term Loan and could adversely impact our liquidity and capital resources.

Regulatory Compliance - The Chemical Business is subject to specific federal and state regulatory compliance laws and guidelines. We have developed policies and procedures related to regulatory compliance. We must continually monitor whether we have maintained compliance with such laws and regulations and the operating implications, if any, and amount of penalties, fines and assessments that may result from noncompliance. At December 31, 2008, liabilities totaling $84,000 have been accrued relating to a CAO covering our former Kansas facility. These liabilities are included in accrued and other liabilities and are based on current estimates that may be revised in the near term based on results from our surface and groundwater monitoring and mitigation work plan.

Asset Retirement Obligations - 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 or replace, as needed, with non-asbestos insulation through our standard repair and maintenance activities to prevent deterioration. 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 in accordance with FIN 47 – Accounting for Conditional Asset Retirement Obligations (“FIN 47”).

Revenue Recognition - We recognize revenue for substantially all of our operations at the time title to the goods transfers to the buyer and there remains no significant future performance obligations by us. Revenue relating to construction contracts is recognized using the percentage-of-completion method based primarily on contract costs incurred to date compared with total estimated contract costs. Changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined. Sales of warranty contracts are recognized as revenue ratably over the life of the contract. See discussion above under “Product Warranty” for our accounting policy for recognizing warranty expense.

Derivatives, Hedges and Financial Instruments - We account for derivatives in accordance with SFAS 133 – Accounting for Derivative Instruments and Hedging Activities (“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.

 
56

 
We have three types of contracts that are accounted for on a fair value basis, which are interest rate contracts, commodities futures/forward contracts and foreign currency contracts. The valuation of these contracts was determined based on quoted market prices or, in instances where market quotes are not available, other valuation techniques or models used to estimate fair values.  The valuations of contracts classified as Level 1 are based on quoted prices in active markets for identical contracts.  The valuations of contracts classified as Level 2 are based on quoted prices for similar contracts and valuation inputs other than quoted prices that are observable for these contracts.  The valuations of contracts classified as Level 3 are based on the average ask/bid prices obtained from a broker relating to a low volume market.  However at December 31, 2008, the terms of contracts classified as Level 3 do not exceed three months.  At December 31, 2008, the fair value of Level 3 contracts (unrealized loss) was approximately $1.4 million.

Management's judgment and estimates in these areas are based on information available from internal and external resources at that time. Actual results could differ materially from these estimates and judgments, as additional information becomes known.

 
57

 
Results of Operations

The following Results of Operations should be read in conjunction with our Consolidated Financial Statements for the years ended December 31, 2008, 2007 and 2006 and accompanying notes and the discussions above under “Overview” And “Liquidity and Capital Resources.”

The following information about our results of operations is presented by our two industry segments, Climate Control Business and Chemical Business. Gross profit by industry segment represents net sales less cost of sales.  In addition, our chief operating decision makers use operating income by industry segment for purposes of making decisions that include resource allocations and performance evaluations. Operating income by industry segment represents gross profit by industry segment less selling, general and administrative expense (“SG&A”) incurred by each industry segment plus other income and other expense earned/incurred by each industry segment before general corporate expenses and other business operations, net. General corporate expenses and other business operations, net consist of unallocated portions of gross profit, SG&A, other income and other expense.

The following table contains certain information about our continuing operations in different industry segments for each of the three years ended December 31:

 
2008
 
2007
 
2006
 
(In Thousands)
Net sales:
                     
Climate Control
$
311,380
   
$
286,365
   
$
221,161
 
Chemical
 
424,117
     
288,840
     
260,651
 
Other
 
13,470
     
11,202
     
10,140
 
 
$
748,967
   
$
586,407
   
$
491,952
 
                       
Gross profit:
                     
Climate Control
$
96,633
   
$
83,638
   
$
65,496
 
Chemical
 
37,991
     
44,946
     
22,023
 
Other
 
4,256
     
4,009
     
3,343
 
 
$
138,880
   
$
132,593
   
$
90,862
 
                       
Operating income (loss):
                     
Climate Control
$
38,944
   
$
34,194
   
$
25,428
 
Chemical
 
31,340
     
35,011
     
9,785
 
General corporate expense and other business operations, net
 
(11,129
)
   
(10,194
)
   
(8,074
)
   
59,155
     
59,011
     
27,139
 
Interest expense
 
(11,381
)
   
(12,078
)
   
(11,915
)
Gain on extinguishment of debt
 
5,529
     
-
     
-
 
Non-operating income, net:
                     
Climate Control
 
1
     
2
     
1
 
Chemical
 
27
     
109
     
311
 
Corporate and other business operations
 
1,068
     
1,153
     
312
 
Provisions for income taxes
 
(18,776
)
   
(2,540
)
   
(901
)
Equity in earnings of affiliate - Climate Control
 
937
     
877
     
821
 
Income from continuing operations
$
36,560
   
$
46,534
   
$
15,768
 
 
 
58

 
Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Climate Control Business

The following table contains certain information about our net sales, gross profit and operating income in our Climate Control segment for 2008 and 2007:

 
 
2008
 
 
2007
 
 
Change
 
Percentage
Change
 
(Dollars In Thousands)
 
Net sales:
                           
Geothermal and water source heat pumps
$
190,960
   
$
165,115
   
$
25,845
   
15.7
  %
Hydronic fan coils
 
83,472
     
85,815
     
(2,343
)
 
(2.7
) %
Other HVAC products
 
36,948
     
35,435
     
1,513
   
4.3
 %
Total Climate Control
$
311,380
   
$
286,365
   
$
25,015
   
8.7
 %
                             
Gross profit – Climate Control
$
96,633
   
$
83,638
   
$
12,995
   
15.5
 %
                             
Gross profit percentage – Climate Control (1)
 
31.0
 
%
 
29.2
 
%
 
1.8
 
%
   
                             
Operating income – Climate Control
$
38,944
   
$
34,194
   
$
4,750
   
13.9
 %

(1) As a percentage of net sales

Net Sales – Climate Control

·
Net sales of our geothermal and water source heat pump products increased primarily as a result of a 19% increase in our average selling price per unit due to a change in product mix, primarily more residential products that have higher selling prices and more accessories, partially offset by a 3% decrease in the number of units sold. The number of units sold in 2008 was down slightly due to lower export sales and a decrease in domestic commercial orders as the result of the weaker construction market. During 2008, we continued to maintain a market share leadership position of approximately 40%, based on data supplied by the Air-Conditioning, Heating and Refrigeration Institute (“AHRI”);
·
Net sales of our hydronic fan coils decreased slightly primarily due to a 7% decrease in the number of units sold partially offset by a 4% increase in our average selling price.  During 2008, we continued to maintain a market share leadership position, of approximately 37%, based on data supplied by the AHRI;
·
Net sales of our other HVAC products increased slightly primarily as the result of an increase in sales of large custom air handlers.

Gross Profit – Climate Control

The increase in gross profit in our Climate Control Business was primarily the result of the increase in sales of our geothermal and water source heat pumps as discussed above and the increase of $1.3 million in gains recognized on our futures contracts for copper partially offset by the reduction in sales volumes discussed above.  In addition, the above changes were also the primary reasons for the increase in our gross profit percentage.

 
59

 
Operating Income – Climate Control

The net increase in operating income of our Climate Control Business resulted primarily from the net increase of gross profit of $13.0 million as discussed above. This increase in operating income was partially offset by an increase in variable operating expenses associated with higher sales. Personnel costs increased by $3.9 million as the result of an increase in the number of personnel and costs associated with group insurance and other employee benefits, warranty expenses increased by $2.2 million due to the increase in sales volume and actual costs incurred, and professional fees increased by $1.1 million primarily relating to legal expenses associated with patent defense costs relating to potential new product development in the large air-handler product line.

Chemical Business

The following table contains certain information about our net sales, gross profit and operating income in our Chemical segment for 2008 and 2007:

 
 
2008
 
 
2007
 
 
Change
 
Percentage
Change
 
(Dollars In Thousands)
 
Net sales:
                           
Industrial acids and other chemical products
$
162,941
   
$
95,754
   
$
67,187
   
70.2
 %
Agricultural products
 
152,802
     
117,158
     
35,644
   
30.4
%
Mining products
 
108,374
     
75,928
     
32,446
   
42.7
%
Total Chemical
$
424,117
   
$
288,840
   
$
135,277
   
46.8
%
                             
Gross profit - Chemical
$
37,991
   
$
44,946
   
$
(6,955
)
 
(15.5
) %
                             
Gross profit percentage – Chemical (1)
 
9.0
 
%
 
15.6
 
%
 
(6.6
)
%
   
                             
Operating income - Chemical
$
31,340
   
$
35,011
   
$
(3,671
)
 
(10.5
) %

(1) As a percentage of net sales

Net Sales - Chemical

The El Dorado and Cherokee Facilities produce all the chemical products described in the table above and the Baytown Facility produces only industrial acids products. For 2008, overall sales prices for the Chemical Business increased 59% while the volume of tons sold decreased 6%, compared with 2007.

·
Sales prices at the El Dorado Facility increased 47% related, in part, to the high cost of raw materials, anhydrous ammonia and sulfur, the majority of which we were able to pass through to our customers and also to strong global agricultural market demand relative to supply volumes during this period. Volume at the El Dorado Facility decreased 13% or 86,000 tons. The decrease in tons sold was primarily attributable to (i) 69,000 fewer tons of agricultural AN and other bulk fertilizers sold primarily in the first half of 2008 compared to

 
60


 
the same period of 2007 due to poor weather conditions and lower demand for AN in favor of urea, a competing product in El Dorado’s market area, as well as reduced forage application due to poor conditions in the cattle market and (ii) 11,000 fewer tons of sulfuric acid due primarily to the bi-annual Turnaround of the sulfuric acid plant.
·
Sales prices and volumes at the Cherokee Facility increased 61% and 9%, respectively, primarily related to the market-driven demand for UAN and mining products. Sales prices also increased with the pass through of our higher natural gas costs in 2008 compared to 2007, recoverable under pricing arrangements with certain of our industrial customers. The increase in volume was partially offset by the unplanned maintenance downtime experienced during the third quarter of 2008 as discussed above under “Overview – Chemical Business”;
·
Sales prices increased approximately 96% at the Baytown Facility due to higher global ammonia pricing, which is recoverable under the Original Bayer Agreement but had a minimum impact to gross profit and operating income. Overall volumes decreased 11% as the result of a decline in customer demand after Hurricane Ike and following the economic downturn.

Gross Profit - Chemical

As discussed above under “Overview-Chemical Business,” the decrease in gross profit of our Chemical Business relates to several significant items. We recognized unrealized losses of $5.3 million on our natural gas and ammonia futures/forward contracts outstanding at December 31, 2008. In addition, we have estimated that the Cherokee Facility incurred costs of approximately $5.1 million as the result of unplanned maintenance downtime during 2008 compared to $1.1 million in 2007. Also at December 31, 2008, we recognized a lower of cost or market provision on inventory of $3.6 million due to declines in global nitrogen prices as demand fell as the result of buyers’ concerns over volatile commodity prices and the global economic crisis. In addition during 2008, the amount expensed for precious metals, net of recoveries and gains, was $6.3 million compared to $2.6 million during 2007. In general, other non-raw material manufacturing expenses, including steam (produced from natural gas), maintenance and Turnarounds, electricity and labor, increased during 2008 compared to 2007. Our Chemical Business incurred expenses for Turnarounds of $6.0 million for 2008 compared to $3.4 million for 2007. This decrease in gross profit was partially offset by the increase in sales prices of products sold by the El Dorado and Cherokee Facilities, as discussed above, in relation to raw material costs. During 2007, we realized non-recurring insurance recoveries of $3.8 million relating to a business interruption claim. These recoveries contributed to an increase in gross profit in 2007. As a result of these changes discussed above, our overall gross profit percentage declined for 2008 as compared to 2007.

Operating Income - Chemical

The net decrease of our Chemical Business’ operating income includes the net decrease in gross profit of $7.0 million as discussed above. Also, we incurred an increase in expenses associated with the Pryor Facility of $1.4 million due to the process of activating this facility as discussed above under “Liquidity and Capital Resources – Pryor Facility.” The decrease in operating income was partially offset by other income recognized by our Chemical Business of $7.6 million from a litigation judgment during 2008, as previously reported. During 2007, we recognized income of $3.3 million relating to a litigation settlement.

 
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Other

The business operation classified as “Other” primarily sells industrial machinery and related components to machine tool dealers and end users. General corporate expenses and other business operations, net consist of unallocated portions of gross profit, SG&A, other income and other expense. The following table contains certain information about our net sales and gross profit classified as “Other” and general corporate expenses and other business operations, net, for 2008 and 2007:

 
 
2008
 
 
2007
 
 
Change
 
Percentage
Change
 
(Dollars In Thousands)
 
Net sales - Other
$
13,470
   
$
11,202
   
$
2,268
   
20.2
%
                             
Gross profit - Other
$
4,256
   
$
4,009
   
$
247
   
6.2
%
                             
Gross profit percentage – Other (1)
 
31.6
 
%
 
35.8
 
%
 
(4.2
)
%
   
                             
General corporate expense and other business operations, net
$
(11,129
)
 
$
(10,194
)
 
$
(935
)
 
9.2
%

(1) As a percentage of net sales

Net Sales - Other

The increase in net sales classified as “Other” relates primarily to increased customer demand for our machine tool products.

Gross Profit - Other

The increase in gross profit classified as “Other” is due primarily to the increase in sales as discussed above. The decline in our gross profit percentage was primarily due to additional costs incurred relating to a large customized industrial machine tool, freight costs and the recognition of losses of $0.2 million on our foreign currency contracts.

General Corporate Expense and Other Business Operations, Net

The net increase in our general corporate expense and other business operations, net relates primarily to increased personnel costs of $1.1 million resulting from increased compensation and other employee benefits, professional fees of $0.5 million due, in part, for assistance in our evaluation of our internal controls and procedures and related documentation for Sarbanes-Oxley requirements and to legal fees on various litigation matters and other expense of $0.6 million relating primarily to potential litigation settlements, an impairment of long-lived assets and income tax related penalties, partially offset by an increase in other income of $0.7 million due, in part, to litigation settlements.
 
 
62

 
Interest Expense

Interest expense was $11.4 million for 2008 compared to $12.1 million for 2007, a decrease of $0.7 million. This net decrease primarily relates to a decrease of $3.4 million as the result of obtaining a lower interest rate associated with the Secured Term Loan compared to the interest rate associated with the previous senior secured loan and a decrease of $1.0 million due to the continual pay off of the Working Capital Revolver Loan during 2008, partially offset by the increase in realized and unrealized losses of $2.5 million relating to our interest rate contracts and the increase of $1.7 million relating to the 2007 Debentures.

Gain on Extinguishment of Debt

During 2008, we acquired $19.5 million aggregate principal amount of the 2007 Debentures for $13.2 million and recognized a gain on extinguishment of debt of $5.5 million, after expensing $0.8 million of the unamortized debt issuance costs associated with the 2007 Debentures acquired.

Provision For Income Taxes

The provision for income taxes for 2008 was $18.8 million compared to $2.5 million for 2007. As discussed under “Overview - 2008 Results,” during 2008, we incurred current and deferred federal and state income taxes due, in part, to increased taxable income and higher effective tax rates partially offset by a net deferred income tax benefit of $1.6 million as the result of a detailed analysis performed on all our deferred tax assets and liabilities and the realizability of those deferred tax assets. During 2007, we incurred federal and state income taxes resulting from increased taxable income and additional prior year state income taxes recorded under FIN 48. However, these provisions were partially offset by the benefit of deferred taxes from the reversal of valuation allowances.

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

Climate Control Business

The following table contains certain information about our net sales, gross profit and operating income in our Climate Control segment for 2007 and 2006:

 
 
2007
 
 
2006
 
 
Change
 
Percentage
Change
 
(Dollars In Thousands)
 
Net sales:
                           
Geothermal and water source heat pumps
$
165,115
   
$
134,210
   
$
30,905
   
23.0
 %
Hydronic fan coils
 
85,815
     
59,497
     
26,318
   
44.2
%
Other HVAC products
 
35,435
     
27,454
     
7,981
   
29.1
%
Total Climate Control
$
286,365
   
$
221,161
   
$
65,204
   
29.5
%
                             
Gross profit – Climate Control
$
83,638
   
$
65,496
   
$
18,142
   
27.7
%
                             
Gross profit percentage – Climate Control (1)
 
29.2
 
%
 
29.6
 
%
 
(0.4
)
%
   
                             
Operating income – Climate Control
$
34,194
   
$
25,428
   
$
8,766
   
34.5
%

(1)
As a percentage of net sales

 
63

 
Net Sales – Climate Control

·
Net sales of our geothermal and water source heat pump products increased primarily as a result of increases in OEM, export and commercial sh