Edgar Filing: LSB INDUSTRIES INC

form_10q.htm

LSB Industries, Inc.

Form 10-Q (9-30-2007)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

Form 10-Q

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

	For the quarterly period ended September 30, 2007

	OR

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

	For the transition period from _____________to______________

	Commission file number 1-7677

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

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

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

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

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

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No___

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

Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X]

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 29, 2007, exceeded the $75 million threshold. As a result, the Registrant will become an accelerated filer on December 31, 2007.

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

The number of shares outstanding of the Registrant's voting common stock, as of November 1, 2007 was 20,827,088 shares, excluding 3,448,518 shares held as treasury stock.

Table of Contents

FORM 10-Q OF LSB INDUSTRIES, INC.

TABLE OF CONTENTS



	PART I – Financial Information	Page

Item 1.	Financial Statements	4

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	44

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	73

Item 4.	Controls and Procedures	74

Special Note	Regarding Forward-Looking Statements	75

	PART II – Other Information

Item 1.	Legal Proceedings	77

Item 1A.	Risk Factors	77

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	79

Item 3.	Defaults Upon Senior Securities	80

Item 4.	Submission of Matters to a Vote of Security Holders	80

Item 5.	Other Information	80

Item 6.	Exhibits	80

Table of Contents

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

LSB INDUSTRIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Information at September 30, 2007 is unaudited)

	September 30, 2007		December 31, 2006
	(In Thousands)
Assets
Current assets:
Cash and cash equivalents	$	40,869	$	2,255
Restricted cash		30		2,479
Accounts receivable, net		86,869		67,571
Inventories:
Finished goods		23,265		20,252
Work in process		3,136		3,205
Raw materials		20,995		21,992
Total inventories		47,396		45,449
Supplies, prepaid items and other:
Prepaid insurance		842		3,443
Precious metals		10,533		6,406
Supplies		3,810		3,424
Other		2,230		1,468
Total supplies, prepaid items and other		17,415		14,741
Deferred income taxes		9,700		-
Total current assets		202,279		132,495

Property, plant and equipment, net		78,696		76,404

Other assets:
Noncurrent restricted cash		-		1,202
Debt issuance and other debt-related costs, net		4,884		2,221
Investment in affiliate		3,398		3,314
Goodwill		1,724		1,724
Other, net		2,488		2,567
Total other assets		12,494		11,028
	$	293,469	$	219,927

(Continued on following page)

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LSB INDUSTRIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (continued)

(Information at September 30, 2007 is unaudited)

	September 30, 2007			December 31, 2006
	(In Thousands)
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	40,587		$	42,870
Short-term financing and drafts payable		133			2,986
Accrued and other liabilities		30,272			26,816
Current portion of long-term debt		2,703			11,579
Total current liabilities		73,695			84,251

Long-term debt		119,720			86,113

Noncurrent accrued and other liabilities:
Deferred income taxes		6,550			-
Other		6,576			5,929
		13,126			5,929
Contingencies (Note 13)

Stockholders' equity:
Series B 12% cumulative, convertible preferred stock, $100 par value; 20,000 shares issued and outstanding		2,000			2,000
Series 2 $3.25 convertible, exchangeable Class C preferred stock, $50 stated value; 517,402 shares issued in 2006		-			25,870
Series D 6% cumulative, convertible Class C preferred stock, no par value; 1,000,000 shares issued		1,000			1,000
Common stock, $.10 par value; 75,000,000 shares authorized, 24,063,106 shares issued (20,215,339 in 2006)		2,406			2,022
Capital in excess of par value		120,641			79,838
Accumulated other comprehensive loss		(483	)		(701	)
Accumulated deficit		(20,984	)		(47,962	)
		104,580			62,067
Less treasury stock at cost:
Series 2 Preferred, 18,300 shares in 2006		-			797
Common stock, 3,448,518 shares (3,447,754 in 2006)		17,652			17,636
Total stockholders' equity		86,928			43,634
	$	293,469		$	219,927

(See accompanying notes)

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LSB INDUSTRIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

Nine and Three Months Ended September 30, 2007 and 2006

(As adjusted for 2006, see Note 2)

	Nine Months						Three Months
	2007			2006			2007			2006
	(In Thousands, Except Per Share Amounts)
Net sales	$	451,754		$	368,216		$	147,613		$	123,968
Cost of sales		349,873			299,179			112,441			99,905
Gross profit		101,881			69,037			35,172			24,063

Selling, general and administrative expense		55,821			46,756			18,827			17,034
Provisions for losses on accounts receivable		874			599			253			317
Other expense		853			706			335			15
Other income		(3,440	)		(231	)		(3,340	)		(83	)
Operating income		47,773			21,207			19,097			6,780

Interest expense		8,062			8,957			3,482			3,196
Non-operating other income, net		(605	)		(565	)		(532	)		(68	)
Income from continuing operations before provisions (benefits) for income taxes and equity in earnings of affiliate		40,316			12,815			16,147			3,652
Provisions (benefits) for income taxes		(1,017	)		408			(1,549	)		208
Equity in earnings of affiliate		(654	)		(611	)		(223	)		(206	)
Income from continuing operations		41,987			13,018			17,919			3,650

Net loss (income) from discontinued operations		(348	)		244			(377	)		113
Net income		42,335			12,774			18,296			3,537

Dividend requirements and stock dividends on preferred stock exchanged in March 2007		4,971			746			-			249
Other preferred stock dividends and dividend requirements		637			909			203			302
Net income applicable to common stock	$	36,727		$	11,119		$	18,093		$	2,986

Weighted average common shares:
Basic		19,150			13,839			20,220			13,979

Diluted		22,990			21,058			25,072			21,346

Income (loss) per common share:
Basic:
Income from continuing operations	$	1.90		$	.82		$	.87		$	.22
Net income (loss) from discontinued operations		.02			(.02	)		.02			(.01	)
Net income	$	1.92		$	.80		$	.89		$	.21

Diluted:
Income from continuing operations	$	1.65		$	.66		$	.75		$	.19
Net income (loss) from discontinued operations		.02			(.01	)		.02			(.01	)
Net income	$	1.67		$	.65		$	.77		$	.18

(See accompanying notes)

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LSB INDUSTRIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(Unaudited)
Nine Months Ended September 30, 2007
(In Thousands)

	Common Stock Shares		Non- Redeemable Preferred Stock			Common Stock Par Value		Capital in Excess of Par Value		Accumulated Other Comprehensive Loss			Accumulated Deficit			Treasury Stock- Preferred			Treasury Stock- Common			Total
Balance at December 31, 2006		20,215	$	28,870		$	2,022	$	79,838	$	(701	)	$	(47,962	)	$	(797	)	$	(17,636	)	$	43,634
Net income														42,335									42,335
Amortization of cash flow hedge											218												218
Total comprehensive income																							42,553
Cumulative effect adjustment in accordance with FIN 48														(120	)								(120	)
Stock-based compensation									228														228
Conversion of debentures to common stock		565					57		3,681														3,738
Exercise of stock options		291					29		1,099											(16	)		1,112
Dividends paid on preferred stock														(2,934	)								(2,934	)
Exchange of 305,807 shares of non-redeemable preferred stock for 2,262,965 shares of common stock		2,263		(15,290	)		226		27,367					(12,303	)								-
Conversion of 167,475 shares of non-redeemable preferred stock for 724,993 shares of common stock		725		(8,374	)		72		8,301														(1	)
Redemption of 25,820 shares of non-redeemable preferred stock				(1,291	)																		(1,291	)
Cancellation of 18,300 shares of non-redeemable preferred stock (1)				(915	)				118								797						-
Conversion of 98 shares of redeemable preferred stock to common stock		4							9														9
Balance at September 30, 2007		24,063	$	3,000		$	2,406	$	120,641	$	(483	)	$	(20,984	)	$	-		$	(17,652	)	$	86,928

(1) These shares represent the shares of Series 2 Preferred previously held as treasury stock. As the result of the cancellation, no shares of Series 2 Preferred were issued and outstanding at September 30, 2007.

(See accompanying notes)

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LSB INDUSTRIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended September 30, 2007 and 2006
(As adjusted for 2006, see Note 2)

	2007			2006
	(In Thousands)
Cash flows from continuing operating activities:
Net income	$	42,335		$	12,774
Adjustments to reconcile net income to net cash provided by continuing operating activities:
Net loss (income) from discontinued operations		(348	)		244
Deferred income taxes		(3,150	)		-
Loss (gain) on sales and disposals of property and equipment		446			(10	)
Depreciation of property, plant and equipment		9,201			8,428
Amortization		841			911
Stock-based compensation		228			-
Provisions for losses on accounts receivable		874			599
Realization of losses on inventory		(360	)		(905	)
Provision for impairment on long-lived assets		250			286
Provision for (realization and reversal of) losses on firm sales commitments		(328	)		500
Equity in earnings of affiliate		(654	)		(611	)
Distributions received from affiliate		570			700
Change in fair value of interest rate caps		241			11
Other		(8	)		-
Cash provided (used) by changes in assets and liabilities:
Accounts receivable		(20,656	)		(25,858	)
Inventories		(1,587	)		(3,153	)
Other supplies and prepaid items		(2,674	)		(395	)
Accounts payable		(3,849	)		4,387
Customer deposits		(233	)		1,894
Deferred rent expense		(2,423	)		(550	)
Other current and noncurrent liabilities		7,889			4,634
Net cash provided by continuing operating activities		26,605			3,886

Cash flows from continuing investing activities:
Capital expenditures		(10,300	)		(8,036	)
Proceeds from sales of property and equipment		192			120
Proceeds from (deposits of) restricted cash		3,651			(387	)
Purchase of interest rate cap contracts		(621	)		-
Other assets		(70	)		(221	)
Net cash used by continuing investing activities		(7,148	)		(8,524	)

(Continued on following page)

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LSB INDUSTRIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Unaudited)
Nine Months Ended September 30, 2007 and 2006

(As adjusted for 2006, see Note 2)

	2007			2006
	(In Thousands)
Cash flows from continuing financing activities:
Proceeds from revolving debt facilities	$	381,835		$	343,633
Payments on revolving debt facilities		(408,242	)		(341,462	)
Proceeds from 5.5% convertible debentures, net of fees		56,985			-
Proceeds from 7% convertible debentures, net of fees		-			16,876
Acquisition of 10-3/4% Senior Unsecured Notes		-			(13,300	)
Proceeds from other long-term debt, net of fees		2,424			-
Payments on other long-term debt		(7,629	)		(2,153	)
Payments of debt issuance costs		(143	)		(356	)
Proceeds from short-term financing and drafts payable		56			610
Payments on short-term financing and drafts payable		(2,909	)		(3,036	)
Proceeds from exercise of stock options		1,112			131
Acquisition of non-redeemable preferred stock		(1,292	)		(95	)
Dividends paid on preferred stock		(2,934	)		(204	)
Net cash provided by continuing financing activities		19,263			644

Cash flows of discontinued operations:
Operating cash flows		(106	)		(179	)
Net increase (decrease) in cash and cash equivalents		38,614			(4,173	)

Cash and cash equivalents at beginning of period		2,255			4,653
Cash and cash equivalents at end of period	$	40,869		$	480

Supplemental cash flow information:

Noncash investing and financing activities:

Debt issuance costs	$	3,026		$	1,124
Accounts payable and other long-term debt associated with purchases of property, plant and equipment	$	2,203		$	19
Debt issuance costs associated with 7% convertible debentures converted to common stock	$	266		$	275
7% convertible debentures converted to common stock	$	4,000		$	3,750
Series 2 preferred stock converted to common stock of which $12,303,000 was charged to accumulated deficit	$	27,593		$	-

(See accompanying notes)

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LSB INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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

In the opinion of management, the unaudited condensed consolidated financial statements of the Company as of September 30, 2007 and for the nine and three month periods ended September 30, 2007 and 2006 include all adjustments and accruals, consisting only of normal, recurring accrual adjustments which are necessary for a fair presentation of the results for the interim periods except for the cumulative effect adjustment as discussed in Note 19-Income Taxes. These interim results are not necessarily indicative of results for a full year due, in part, to the seasonality of our sales of agricultural products, the accounting for major plant maintenance costs as discussed in Note 2 and the changes in accounting estimates as discussed in Note 3. Our selling seasons for agricultural products are primarily during the spring and fall planting seasons, which typically extend from March through June and from September through November.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in this Form 10-Q pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). These condensed consolidated financial statements should be read in connection with the consolidated financial statements and notes thereto included in our Form 10-K, as amended by our Form 10-K/A, Amendment No.1, for the year ended December 31, 2006 (“Form 10-K, as amended”).

Certain reclassifications have been made in our condensed consolidated financial statements for 2006 to conform to our condensed consolidated financial statement presentation for 2007.

Note 2: Change in Accounting for Plant Turnaround Costs and Classification Changes As previously disclosed in our Form 10-Q for the quarter ended March 31, 2007 and in our Form 10-K, as amended by our Form 10-K/A, Amendment No. 1, the Financial Accounting Standards Board (“FASB”) completed a project, in September 2006, to clarify guidance on the accounting for planned major maintenance activities (“Turnarounds”). The FASB issued FASB Staff Position No. AUG AIR-1 (“FSP”) which eliminated the accrue-in-advance method of accounting for Turnarounds which was the method we were using. In addition, the adoption of the provisions in the FSP is to be considered a change in accounting principle with retrospective application as described in SFAS 154-Accounting Changes and Error Corrections (“SFAS 154”), if practical. The FSP became effective for us on January 1, 2007. There were three acceptable accounting methods for Turnarounds that we could adopt of which we adopted the direct expensing method which requires us to expense Turnaround costs as they are incurred.

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LSB INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 2: Change in Accounting for Plant Turnaround Costs and Classification Changes (continued)

For the nine months ended September 30, 2007 and 2006, Turnaround costs for the Chemical Business totaled $870,000 and $1,788,000 respectively. Based on our current plan for Turnarounds to be performed during the remainder of 2007, we estimate that we will incur Turnaround costs of approximately $2.4 million during the fourth quarter of 2007. However, it is possible that these Turnarounds could be performed during a different quarter and/or the actual costs could be significantly different than our estimates.

As previously disclosed in our Form 10-K, as amended, we made classification changes relating to extended warranty contracts and warranty expense.

The following condensed consolidated financial statement line items and income per common share were affected by the change in accounting for Turnarounds. The effect by the classification changes for extended warranty contracts and warranty expense are also included but they did not impact operating income, net income, or income per common share:

Condensed Consolidated Statement of Income for the Nine Months Ended September 30, 2006

(in thousands):

Originally

Reported

Adjusted

Effect

Changes

Net sales	$	367,864	$	368,216	$	352

Cost of sales	$	299,787	$	299,179	$	(608	)

Gross profit	$	68,077	$	69,037	$	960

Selling, general and administrative expense	$	46,028	$	46,756	$	728

Operating income	$	20,975	$	21,207	$	232

Income from continuing operations before provision for income taxes and equity in earnings of affiliate	$	12,583	$	12,815	$	232

Income from continuing operations	$	12,786	$	13,018	$	232

Net income	$	12,542	$	12,774	$	232

Net income applicable to common stock	$	10,887	$	11,119	$	232

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LSB INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 2: Change in Accounting for Plant Turnaround Costs and Classification Changes (continued)

Condensed Consolidated Statement of Income for the Three Months Ended September 30, 2006

(in thousands):

Originally

Reported

Adjusted

Effect

Changes

Net sales	$	123,847	$	123,968	$	121

Cost of sales	$	100,280	$	99,905	$	(375	)

Gross profit	$	23,567	$	24,063	$	496

Selling, general and administrative expense	$	16,735	$	17,034	$	299

Operating income	$	6,583	$	6,780	$	197

Income from continuing operations before provision for income taxes and equity in earnings of affiliate	$	3,455	$	3,652	$	197

Income from continuing operations	$	3,453	$	3,650	$	197

Net income	$	3,340	$	3,537	$	197

Net income applicable to common stock	$	2,789	$	2,986	$	197

Income Per Common Share for the Nine Months Ended September 30, 2006:

Originally

Reported

Adjusted

Effect

Change

Income per common share:
Basic	$	.79	$	.80	$	.01

Diluted	$	.64	$	.65	$	.01

Income Per Common Share for the Three Months Ended September 30, 2006:

Originally

Reported

Adjusted

Effect

Change

Income per common share:
Basic	$	.20	$	.21	$	.01

Diluted	$	.17	$	.18	$	.01

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LSB INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 2: Change in Accounting for Plant Turnaround Costs and Classification Changes (continued)

Condensed Consolidated Statement of Cash Flows for the Nine Months Ended September 30, 2006

(in thousands):

Originally

Reported

Adjusted

Effect

Change

Net income	$	12,542	$	12,774	$	232

Cash provided by change in other current and noncurrent liabilities	$	4,866	$	4,634	$	(232	)

Net cash provided by continuing operations activities	$	3,886	$	3,886	$	-

Note 3: Changes in Accounting Estimates During the third quarter of 2007, we had the following changes in accounting estimates:

the recognition of a benefit of $3,150,000 relating to deferred income taxes included in benefits for income taxes as discussed in Note 19 – Income Taxes and

the recognition of a provision of $735,000 relating to additional alternative minimum tax (“AMT”) included in benefits for income taxes as also discussed in Note 19.

The net effect of these changes in accounting estimates increased income from continuing operations by $2,415,000 and net income by $2,415,000 for the nine and three months ended September 30, 2007. In addition, these changes in accounting estimates increased basic and diluted net income per share by $.13 and $.11, respectively, for the nine months ended September 30, 2007 and $.12 and $.10, respectively, for the three months ended September 30, 2007.

Note 4: Cash and Cash Equivalents Short-term investments, which consist of highly liquid investments with average original maturities of three months or less, are considered cash equivalents. We primarily utilize a cash management system with a series of separate accounts consisting of several “zero-balance” disbursement accounts for funding of payroll and accounts payable. As a result of our cash management system, checks issued, but not presented to the banks for payment, may create negative book cash balances. These negative book cash balances are included in current portion of long-term debt since these accounts are funded primarily by our Working Capital Revolver Loan. Outstanding checks in excess of related book cash balances were $5,849,000 at December 31, 2006 (none at September 30, 2007).

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LSB INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5: Accounts Receivable

September 30,

2007

December 31,

2006

(In Thousands)

Trade receivables	$	88,217		$	68,165
Other		1,289			1,675
		89,506			69,840
Allowance for doubtful accounts		(2,637	)		(2,269	)
	$	86,869		$	67,571

Note 6: Inventories Inventories are priced at the lower of cost or market, with cost being determined using the first-in, first-out (“FIFO”) basis. Finished goods and work-in-process inventories include material, labor, and manufacturing overhead costs. At September 30, 2007 and December 31, 2006, inventory reserves for certain slow-moving inventory items (primarily Climate Control products) were $549,000 and $829,000, respectively. In addition, inventory reserves for certain nitrogen-based inventories provided by our Chemical Business were $19,000 and $426,000, at September 30, 2007 and December 31, 2006, respectively, because cost exceeded the net realizable value.

Changes in our inventory reserves are as follows:

Nine Months Ended

September 30,

Three Months Ended

September 30,

2007

2006

2007

2006

(In Thousands)

Balance at beginning of period	$	1,255		$	2,423		$	847		$	1,556
Deduct: Realization of losses		(360	)		(905	)		(15	)		(366	)
Deduct: Write-offs/disposals		(327	)		(328	)		(264	)		-
Balance at end of period	$	568		$	1,190		$	568		$	1,190

The realization of losses is a reduction to cost of sales in the accompanying condensed consolidated statements of income.

Note 7: Precious Metals Precious metals are used as a catalyst in the Chemical Business manufacturing process. Precious metals are carried at cost, with cost being determined using the FIFO basis. Because some of the catalyst consumed in the production process cannot be readily recovered and the amount and timing of recoveries are not predictable, we follow the practice of expensing precious metals as they are consumed. For nine months ended September 30, 2007 and 2006, the amounts expensed for precious metals were approximately $4,779,000 and $3,729,000, respectively. For the three months ended September 30, 2007 and 2006, the amounts expensed were approximately $1,665,000and $1,173,000, respectively. These precious metals expenses are included in cost of sales in the accompanying condensed consolidated statements of income. 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 the nine months ended September 30, 2007

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LSB INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 7: Precious Metals (continued)

and 2006, we recognized recoveries of precious metals at historical FIFO costs of approximately $1,233,000 and $2,082,000, respectively. For the three months ended September 30, 2006, we recognized recoveries of precious metals at historical FIFO costs of approximately $1,077,000. (none in the third quarter of 2007), 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 $1,876,000 and $1,387,000 for the nine and three months ended September 30, 2007 (none in 2006) from the sale of excess precious metals. These recoveries and gains are reductions to cost of sales.

Note 8: Debt Issuance and Other Debt-Related Costs, net During the nine months ended September 30, 2007, we incurred debt issuance costs of $3,169,000 relating primarily to the 5.5% Convertible Senior Subordinated Debentures due 2012 (the “2007 Debentures”). In addition, the remaining portion of the 7% Convertible Senior Subordinated Debentures due 2011 (the “2006 Debentures”) was converted into our common stock as discussed in Note 12 - Long-Term Debt. As a result of the conversions, approximately $266,000 of the remaining debt issuance costs, net of amortization, associated with the 2006 Debentures were charged against capital in excess of par value during the nine months ended September 30, 2007. Also see discussion in Note 17 - Derivatives, Hedges and Financial Instruments concerning our interest rate cap contracts. Also see Note 23 - Subsequent Event for a discussion concerning certain debt-related costs associated with a loan to be repaid.

Note 9: Investment in Affiliate Cepolk Holding, Inc. (“CHI”), a subsidiary of the Company, is a limited partner and has a 50% equity interest in Cepolk Limited Partnership (“Partnership”) which is accounted for on the equity method. The Partnership owns an energy savings project located at the Ft. Polk Army base in Louisiana (“Project”). As of September 30, 2007, the Partnership and general partner to the Partnership is indebted to a term lender (“Term Lender”) of the Project. CHI has pledged its limited partnership interest in the Partnership to the Term Lender as part of the Term Lender’s collateral securing all obligations under the loan. This guarantee and pledge is limited to CHI’s limited partnership interest and does not expose CHI or the Company to a liability in excess of CHI’s limited partnership interest. No liability has been established for this pledge since it was entered into prior to adoption of FASB Interpretation No. 45 (“FIN 45”). CHI has no recourse provisions or available collateral that would enable CHI to recover its partnership interest should the Term Lender be required to perform under this pledge.

Note 10: Product Warranty Our Climate Control Business sells equipment that has an expected life, under normal circumstances and use that extends over several years. As such, we provide warranties after equipment shipment/start-up covering defects in materials and workmanship.

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 10: Product Warranty (continued)

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

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

Changes in our product warranty obligation are as follows:

Nine Months Ended

September 30,

Three Months Ended

September 30,

2007

2006

2007

2006

(In Thousands)

Balance at beginning of period	$	1,251		$	861		$	1,521		$	980
Add: Charged to expenses		2,097			1,362			762			656
Deduct: Expenses incurred		(1,838	)		(1,005	)		(773	)		(418	)
Balance at end of period	$	1,510		$	1,218		$	1,510		$	1,218

Note 11: Accrued and Other Liabilities

September 30,

2007

December 31,

2006

(In Thousands)

Deferred income taxes	$	6,550	$	-
Accrued payroll and benefits		6,452		4,170
Accrued property and income taxes		3,152		1,217
Deferred revenue on extended warranty contracts		3,233		2,426
Accrued commissions		2,809		2,565
Deferred rent expense		2,808		5,231
Customer deposits		2,705		2,938
Accrued insurance		2,385		1,646
Accrued contractual manufacturing obligations		1,946		1,801
Accrued death benefits		1,897		1,446
Accrued precious metals costs		1,659		1,068
Accrued warranty costs		1,510		1,251
Accrued interest		1,059		422
Accrued environmental remediation costs		525		1,432
Other		4,708		5,132
		43,398		32,745
Less noncurrent portion		13,126		5,929
Current portion of accrued and other liabilities	$	30,272	$	26,816

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LSB INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 12: Long-Term Debt

September 30,

2007

December 31,

2006

(In Thousands)

Senior Secured Loan due 2009 (A)	$	50,000	$	50,000
Working Capital Revolver Loan due 2009 - ThermaClime (B)		-		26,048
7% Convertible Senior Subordinated Notes due 2011 (C)		-		4,000
5.5% Convertible Senior Subordinated Notes due 2012 (D)		60,000		-
Other, with interest at rates of 4.25% to 9.36% most of which is secured by machinery, equipment and real estate		12,423		17,644
		122,423		97,692
Less current portion of long-term debt		2,703		11,579
Long-term debt due after one year	$	119,720	$	86,113

(A)

ThermaClime and certain of its subsidiaries (the “Borrowers”) are parties of a $50 million term loan (“Senior Secured Loan”) with a certain lender (the “Lender”). The Senior Secured Loan is to be repaid as follows:

quarterly interest payments which began September 30, 2004;

quarterly principal payments of $312,500 which began October 1, 2007;

a final payment of the remaining outstanding principal of $47.5 million and accrued interest on September 16, 2009.

The Senior Secured Loan accrues interest at a defined LIBOR rate plus a defined LIBOR margin or, at the election of the Borrowers, an alternative defined base rate plus a defined base rate margin with the annual interest rate not to exceed 11% or 11.5% depending on the leverage ratio. At September 30, 2007, the effective interest rate was 11%. See Note 23 - Subsequent Event for discussion of the negotiated new $50 million term loan (“Replacement Term Loan”) of which, the proceeds are to repay the Senior Secured Loan.

The Borrowers are subject to numerous covenants under the Senior Secured Loan 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. The Borrowers are also subject to a minimum fixed charge coverage ratio, measured quarterly on a trailing twelve-month basis. The Borrowers’ fixed charge coverage ratio exceeded the required minimum ratio for the twelve-month period ended September 30, 2007.

The maturity date of the Senior Secured Loan can be accelerated by the Lender upon the occurrence of a continuing event of default, as defined.

Under the terms of the Senior Secured Loan agreement, the prepayment fee of 1% was eliminated as of September 15, 2007.

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Note 12: Long-Term Debt (continued)

The Senior Secured Loan is secured by a first lien on

certain real property and equipment located at the El Dorado, Arkansas facility (“El Dorado Facility”),

certain real property and equipment located at the Cherokee, Alabama facility (“Cherokee Facility”),

certain equipment of the Climate Control Business, and

the equity stock of certain of ThermaClime’s subsidiaries.

The Senior Secured Loan is also secured by a second lien on the assets upon which ThermaClime’s revolving credit facility lender has a first lien. The carrying value of the pledged assets is approximately $228 million at September 30, 2007. The Senior Secured Loan is guaranteed by the Company and is also secured with the stock of ThermaClime.

(B)

ThermaClime and its subsidiaries ("the Borrowers") are parties of a $50 million revolving credit facility (the "Working Capital Revolver Loan") that provides for advances based on specified percentages of eligible accounts receivable and inventories for ThermaClime, and its subsidiaries. The Working Capital Revolver Loan, as amended, matures in April 2009. The Working Capital Revolver Loan accrues interest at a base rate (generally equivalent to the prime rate) plus .75% or LIBOR plus 2%. The interest rate at September 30, 2007 was 6.59% considering the impact of the interest rate cap contracts which set a maximum three-month LIBOR base rate of 4.59% on $30 million and mature on June 30, 2009. Interest is paid monthly. The facility provides for up to $8.5 million of letters of credit. All letters of credit outstanding reduce availability under the facility. As a result of using a portion of the proceeds from the 2007 Debentures to pay down the Working Capital Revolver Loan,

amounts available for additional borrowing under the Working Capital Revolver Loan at September 30, 2007 were $49 million. Under the Working Capital Revolver Loan, as amended, the lender also requires the borrowers to pay a letter of credit fee equal to 1% per annum of the undrawn amount of all outstanding letters of credit, an unused line fee equal to .5% per annum for the excess amount available under the facility not drawn and various other audit, appraisal and valuation charges. As discussed in Note 23 – Subsequent Event, the lenders to the Working Capital Revolver Loan agreed to modify certain conditions to the agreement in connection with the negotiated Replacement Term Loan.

The lender may, upon an event of default, as defined, terminate the Working Capital Revolver Loan and make the balance outstanding due and payable in full. The Working Capital Revolver Loan is secured by receivables, inventories and intangibles of all the ThermaClime entities other than DSN Corporation and El Dorado Nitric Company and its subsidiaries ("EDNC") and a second lien on certain real property and equipment. EDNC is neither a borrower nor guarantor of the Working Capital Revolver Loan. The carrying value of the pledged assets is approximately $213 million at September 30, 2007.

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Note 12: Long-Term Debt (continued)

A prepayment premium equal to 1% of the facility is due to the lender should the borrowers elect to prepay the facility prior to April 13, 2008 and is eliminated thereafter.

The Working Capital Revolver Loan, as amended, requires ThermaClime and its Climate Control Business to meet certain financial covenants measured quarterly. ThermaClime and its Climate Control Business were in compliance with those covenants for the quarter ended September 30, 2007. The Working Capital Revolver Loan also contains covenants that, among other things, limit the Borrowers' (which does not include the Company) ability to:

incur additional indebtedness,

incur liens,

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

engage in mergers, consolidations or other forms of recapitalization,

dispose assets, or

repurchase ThermaClime's 10-3/4% Senior Unsecured Notes (the “Notes”).

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

In connection with the redemption of the Notes in July 2006, the lenders of the Working Capital Revolver Loan and the Senior Secured Loan provided consents to permit ThermaClime to borrow $6.4 million from the Company for the purpose of redeeming the Notes.

(C)

On March 14, 2006, we completed a private placement to six qualified institutional buyers (“QIBs”) pursuant to which we sold $18 million aggregate principal amount of the 2006 Debentures. We used a placement agent for this transaction which we paid a fee of 6% of the aggregate gross proceeds received in the financing. Other offering expenses in connection with the transaction were $.4 million. As a result, the total debt issuance costs related to this transaction were $1.5 million.

During September through December 2006, $14 million of the 2006 Debentures were converted into 1,977,499 shares of our common stock at the conversion price of $7.08 per share. During the first four months of 2007, the remaining $4 million of the 2006 Debentures (which includes $1 million that was held by Jayhawk Capital Management and other Jayhawk entities, through their manager, Kent McCarthy (the “Jayhawk Group”), were converted into 564,790 shares of our common stock at the average conversion price of $7.082 per share.

(D)

On June 28, 2007, we entered into a purchase agreement with each of twenty two QIBs, pursuant to which we sold $60 million aggregate principal amount of the 2007 Debentures in a private placement to the QIBs pursuant to the exemptions from the registration requirements of the Securities Act of 1933, as amended (the “Act”), afforded by Section 4(2) of the Act and Regulation D promulgated under the Act. The 2007 Debentures are eligible for resale by the investors under Rule144A under the Act. We received net proceeds of approximately $57 million, after discounts and commissions. In connection with

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Note 12: Long-Term Debt (continued)

the closing, we entered into an indenture (the “Indenture”) with UMB Bank, as trustee (the “Trustee”), governing the 2007 Debentures. The Trustee receives customary compensation from us for such services.

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

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

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

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

If a designated event (as defined in the Indenture) occurs prior to maturity, holders of the 2007 Debentures may require us to repurchase all or a portion of their 2007 Debentures for cash at a repurchase price equal to 101% of the principal amount of the 2007 Debentures plus any accrued and unpaid interest, as set forth in the Indenture. If a fundamental change (as defined in the Indenture) occurs on or prior to June 30, 2010, under certain circumstances, we will pay, in addition to the repurchase price, a make-whole premium on the 2007 Debentures converted in connection with, or tendered for repurchase upon, the fundamental change. The make-whole premium will be payable in our common stock or the same form of consideration into which our common stock has been exchanged or converted in the fundamental change. The amount of the make-whole premium, if any, will be based on our stock price on the effective date of the fundamental change. No make-whole premium will be paid if our stock price in connection with the fundamental change is less than or equal to $23.00 per share.

At maturity, we may elect, subject to certain conditions as set forth in the Indenture, to pay up to 50% of the principal amount of the outstanding 2007 Debentures, plus all accrued and unpaid interest thereon to, but excluding, the maturity date, in shares of our common stock

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(Unaudited)

Note 12: Long-Term Debt (continued)

(valued at 95% of the weighted average of the closing sale prices of the common stock for the 20 consecutive trading days ending on the fifth trading day prior to the maturity date), if the common stock is then listed on an eligible market, the shares used to pay the 2007 Debentures and any interest thereon are freely tradable, and certain required opinions of counsel are received.

We have currently invested a portion of the net proceeds in money market investments and have used a portion of the net proceeds to redeem our outstanding shares of $3.25 Convertible Exchangeable Class C Preferred Stock, Series 2 (“Series 2 Preferred”); to repay certain outstanding mortgages and equipment loans; to pay accrued and unpaid dividends on our outstanding shares of Series B 12% Cumulative Convertible Preferred Stock (“Series B Preferred”) and Series D 6% Cumulative Convertible Class C Preferred Stock (“Series D Preferred”) all of which were owned by an affiliate; and the balance to initially reduce the outstanding borrowings under the Working Capital Revolver Loan. See Note 22 -Related Party Transactions for a discussion of amounts paid to affiliates and former affiliates in connection with the redemption and the dividends. In addition, we intend to use the remaining portion of the net proceeds for certain discretionary capital expenditures, repay higher interest-bearing debt and general working capital purposes.

In connection with using a portion of the net proceeds of the 2007 Debentures to initially reduce the outstanding borrowings under the Working Capital Revolver Loan, ThermaClime entered into a $25 million demand promissory note (“Demand Note”) with the Company. In addition, the Company, ThermaClime, and certain of its subsidiaries entered into a subordination agreement with the lender of the Senior Secured Loan which, among other things, states that the Demand Note is unsecured and subordinated to the Senior Secured Loan and allows for payments on the Demand Note by ThermaClime to the Company provided there is no potential default or event of default, as defined in the Senior Secured Loan.

In conjunction with the 2007 Debentures, we entered into a Registration Rights Agreement (the “5.5% Registration Rights Agreement”) with the QIBs. The term of the 5.5% Registration Rights Agreement ends on the earlier of the date that all registrable securities, as defined in the agreement, have ceased to be registrable securities and July 1, 2010.

We are required to use commercially reasonable efforts to cause the registration statement (“5.5% Registration Statement”) covering the 2007 Debentures to be declared effective by the SEC as promptly as is practicable, but in any event, no later than November 26, 2007. If the 5.5% Registration Statement is not declared effective by this date, the following liquidated damages, shall accrue for each day thereafter until the 5.5% Registration Statement is declared effective:

0.25% – Damages shall accrue at an annual percentage rate equal to 0.25% of the aggregate principal amount of each debenture, from the first day of the accrual period up to and including the 90^th day (approximately $411 per day or a total of $36,900 at the end of 90 days); and

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(Unaudited)

Note 12: Long-Term Debt (continued)

0.5% – Damages shall accrue at an annual percentage rate equal to 0.5% of the aggregate principal amount of each debenture, from and after the 91st day of the accrual period (approximately $822 per day), until the 5.5% Registration Statement is declared effective. The terms of the 5.5% Registration Rights Agreement provide no limitation to the maximum amount of liquidation damages. The terms of the 5.5% Registration Rights Agreement do not require us to issue shares of our equity securities relating to liquidated damages.

Liquidated damages are payable with respect to debentures that are outstanding as of the beginning of a liquidated damages accrual period. If a debenture has been converted into common stock prior to the beginning of a liquidated damages accrual period, no liquidated damages are payable with respect to the common stock issued upon such conversion.

In addition, we are obligated to update the 5.5% Registration Statement by filing a post-effective amendment. The filing of a post-effective amendment is required upon the filing of a Form 10-K or upon a “fundamental change” in the information described in the 5.5% Registration Statement. Pursuant to the terms of the 5.5% Registration Rights Agreement, the deadline for filing a post-effective amendment is determined by the event that triggers the obligation to file the post-effective amendment, as follows:

within 10 business days after filing a Form 10-K with the SEC;

within 10 business days after filing such report or reports disclosing a fundamental change to the SEC.

We are required to use commercially reasonable efforts to cause the post-effective amendment to be declared effective as promptly as is practicable, but in any event, no later than 60 days (90 days if the post-effective amendment is reviewed by the SEC) after such post-effective amendment is required to be filed. If, in spite of our commercially reasonable efforts, a post-effective amendment is not declared effective within the number of days required, the liquidated damages will accrue under the 5.5% Rights Agreement as described above, beginning on the first day after the post-effective amendment is required to be effective. However, we are permitted to suspend the availability of the 5.5% Registration Statement or prospectus for purposes of updating the information therein (a “Deferral Period”) without incurring or accruing any liquidated damages, unless the Deferral Period exceeds (a) 30 days in any 90 day period, or (b) 90 days in any 12 month period, in which case, beginning on the first day following the last permissible day of the Deferral Period, liquidated damages at the rates of 0.25% and 0.5% shall apply, as described above, until the termination of the Deferral Period.

Because we currently estimate that we will not incur any liquidated damages relating to the 5.5% Registration Rights Agreement, no liability has been established as of September 30, 2007. We have filed the 5.5% Registration Statement, but as of the date of this report, it has not been declared effective by the SEC.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 13: Contingencies We accrue for contingent losses when such losses are probable and reasonably estimable. In addition, we recognize contingent gains when such gains are realizable.

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

A. Environmental Matters

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

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

1. Discharge Water Matters

The El Dorado Facility within our Chemical Business generates process wastewater. 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 the El Dorado Facility a NPDES water discharge permit in 2004, and the El Dorado Facility had until June 1, 2007 to meet the compliance deadline for the more restrictive limits under the 2004 NPDES permit. In order to meet the El Dorado Facility’s June 2007 limits, the El Dorado Facility has significantly reduced the effluent levels of its wastewater.

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Note 13: Contingencies (continued)

In order to directly discharge its wastewater from the El Dorado Facility into the creek and to meet the June 2007 permit limits, the El Dorado Facility has conducted a study of the adjacent stream to determine whether a permit modification is appropriate. On September 22, 2006, the

Arkansas Pollution Control and Ecology Commission approved the results of the study that showed that the proposed permit modification is appropriate. A public hearing was held on the matter on November 13, 2006 with minimal opposition.

The El Dorado Facility has demonstrated its ability to comply with the more restrictive permit limits, and the rules which support the more restrictive dissolved minerals rules have been revised to authorize a permit modification to adopt achievable dissolved minerals permit limits. The ADEQ has orally agreed to issue a consent administrative 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 allow the El Dorado Facility to continue to discharge its wastewater into the creek from and after June 1, 2007.

In addition, the El Dorado Facility has entered into a consent administrative order (“CAO”) that recognizes the presence of nitrate contamination in the shallow groundwater at the El Dorado Facility. A new CAO to address the shallow groundwater contamination became effective on November 16, 2006 and requires the evaluation of the current conditions and remediation based upon a risk assessment. The CAO requires the El Dorado Facility to continue semi-annual groundwater monitoring, to continue operation of a groundwater recovery system and to submit a human health and ecological risk assessment to the ADEQ. The final remedy for shallow groundwater contamination, should any remediation be required, will be selected pursuant to the new CAO and based upon the risk assessment. As an interim measure, the El Dorado Facility has installed two recovery wells to recycle groundwater and to recover nitrates. The cost of any additional remediation that may be required will be determined based on the results of the investigation and risk assessment and cannot currently be reasonably estimated. Therefore, no liability has been established at September 30, 2007.

2. Air Matters

Under the terms of a consent administrative order relating to air matters (“AirCAO”), which became effective in February 2004, resolving certain air regulatory alleged violations associated with the El Dorado Facility’s sulfuric acid plant and certain other alleged air emission violations, the El Dorado Facility is required to implement additional air emission controls at the El Dorado Facility no later than February 2010. We have decided to accelerate this capital expenditure and currently estimate the environmental compliance related expenditures to be between $6.0 and $6.5 million, to be expended through the third quarter of 2008.

In December 2006, the El Dorado Facility entered into a new CAO (“2006 CAO”) with the ADEQ to resolve a problem with ammonia emissions from the East and West Nitric Acid Units. The catalyst suppliers had represented the volume of ammonia emissions anticipated. The representation was the basis for the permitted emission limit, but the representation of the catalyst suppliers was not accurate. The ADEQ allowed the El Dorado Facility to re-evaluate the

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Note 13: Contingencies (continued)

catalyst performance. Until the permit is modified, the 2006 CAO authorizes the El Dorado Facility to continue to operate the East and West Nitric Acid Units (even though the El Dorado Facility is running out of compliance with the permitted emission limit for ammonia), provided that during this period of time, the El Dorado Facility is required to monitor and report the ammonia under the 2006 CAO on a monthly basis.

3. Other Environmental Matters

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

In connection with the sale of substantially all of the operating assets of Slurry and Universal Tech Corporation (“UTeC”) in December 2002, which was accounted for as discontinued operations, both subsidiaries within our Chemical Business, UTeC leased the Hallowell Facility to the buyer under a triple net long-term lease agreement. However, Slurry retained the obligation to be responsible for, and perform the activities under, the Slurry Consent Order. In addition, certain of our subsidiaries agreed to indemnify the buyer of such assets for these environmental matters. The successor (“Chevron”) of the prior owner of the Hallowell Facility has agreed, within certain limitations, to pay and has been paying one-half of the costs of certain interim remediation measures at the site approved by the KDHE, subject to reallocation.

Based on additional modeling of the site, Slurry and Chevron are pursuing a course with the KDHE of long-term surface and ground water monitoring to track the natural decline in contamination, instead of the soil excavation proposed previously. On September 12, 2007, the KDHE approved our proposal to perform two years of surface and groundwater monitoring and to implement a Mitigation Work Plan to acquire additional field data in order to more accurately characterize the nature and extent of contaminant migration off-site. The two-year monitoring program will terminate in February 2009. As a result of receiving approval from the KDHE for our proposal, we recognized a reduction in our share of the estimated costs associated with this remediation by $377,000. This reduction is included in the net income from discontinued operations of $348,000 and $377,000 for the nine and three months ended September 30, 2007, respectively (in accordance with SFAS 144 – Accounting for the Impairment or Disposal of Long-Lived Assets).

At September 30, 2007, the total estimated liability (which is included in current and noncurrent accrued and other liabilities) in connection with this remediation matter is approximately $492,000 and Chevron’s share for one-half of these costs (which is included in accounts receivable and other assets) is approximately $246,000. These amounts are not discounted to

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(Unaudited)

Note 13: Contingencies (continued)

their present value. It is reasonably possible that a change in estimate of our liability and receivable will occur in the near term.

B. Other Pending, Threatened or Settled Litigation

1. Chemical Business

In 2005, El Dorado Company (“EDC”) sued the general partners of Dresser Rand Company, Ingersoll-Rand Company and DR Holdings Corp., and an individual employee of Dresser Rand Company, in connection with its faulty repair of a hot gas expander of one of EDC’s nitric acid plants. As a result of defects in the repair, on October 8, 2004, the hot gas expander failed, leading to a fire at the nitric acid plant. The lawsuit is styled El Dorado Chemical Company, et al v. Ingersoll-Rand Company (NJ), et al. in the Union County Arkansas Circuit Court. A trial was held in October 2006 resulting in a jury verdict awarding EDC approximately $9.8 million in damages. The Defendants filed a Notice to Appeal and filed a $10.7 million bond. EDC will pay attorneys fees equal to approximately 32% of any recovery. We will recognize the jury award if and when realized.

The Company and its subsidiary, Cherokee Nitrogen Company (“CNC”), entered into a Settlement Agreement and Release on September 24, 2007, with Dynegy, Inc. (“Dynegy”), Dynegy’s subsidiary, Dynegy Marketing and Trade (“DMT”), and Nelson Brothers, LLC (“Nelson”), to settle the lawsuit previously reported, titled Nelson Brothers, LLC v. Cherokee Nitrogen v. Dynegy Marketing, which was pending in Alabama state court in Colbert County, Alabama (the “Lawsuit”). Dynegy had filed a counterclaim against CNC for $580,000 allegedly owed on account, which had been recorded by CNC. The settlement resulted in the dismissal with prejudice of all matters in the Lawsuit and the net payment (after payments to Nelson and legal fees and expenses) received by CNC of approximately $2,692,000, as well as allow CNC to retain the disputed $580,000 account payable. As previously disclosed, Nelson agreed to settle its portion of the lawsuit with CNC by CNC agreeing to pay Nelson 25% of the net proceeds (after costs) that are received by CNC from Dynegy in connection with a settlement or resolution of this lawsuit.

As a result of this settlement, for the nine and three months ended September 30, 2007, we recognized income of $3,272,000 which is included in other income in the accompanying statements of income.

CNC has filed suit against Meecorp Capital Markets, LLC (“Meecorp”) and Lending Solutions, Inc. in Alabama State Court, in Etowah County, Alabama, for recovery of actual damages of $140,000 plus punitive damages, relating to a loan transaction. Meecorp counterclaimed for the balance of an alleged commitment fee of $100,000, an alleged equity kicker of $200,000 and $3,420,000 for loss of opportunity. CNC is vigorously pursuing this matter, and counsel for CNC has advised that they believe there is a good likelihood CNC will recover from the defendants and that the likelihood of Meecorp recovering from CNC is remote.

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Note 13: Contingencies (continued)

2. Other

Zeller Pension Plan

In February 2000, the Company’s Board of Directors authorized management to proceed with the sale of the automotive products business, since the automotive products business was no longer a “core business” of the Company. In May 2000, the Company sold substantially all of its assets in its automotive products business. After the authorization by the board, but prior to the sale, the automotive products business purchased the assets and assumed certain liabilities of Zeller Corporation (“Zeller”). The liabilities of Zeller assumed by the automotive products business included Zeller’s pension plan, which is not a multi-employer pension plan. In June 2003, the principal owner (“Owner”) of the buyer of the automotive products business was contacted by a representative of the Pension Benefit Guaranty Corporation (“PBGC”) regarding the plan. The Owner was informed by the PBGC of a possible under-funding of the plan and a possible takeover of the plan by the PBGC. The PBGC previously advised the Company that the PBGC may consider the Company to be potentially liable for the under-funding of the Zeller Plan in the event that the plan is taken over by the PBGC and alleged that the under-funding is approximately $600,000. The Company’s ERISA counsel was verbally informed by a PBGC representative that he would probably recommend no further action by the PBGC with respect to the Company’s involvement with the Zeller plan. However, because we have received no written confirmation from the PBGC, there are no assurances that the PBGC will not assert a claim against the Company with respect to the Zeller plan.

MEI Drafts

Masinexportimport Foreign Trade Company (“MEI”) has given notice to the Company and a subsidiary of the Company alleging that it was owed $1,533,000 in connection with MEI’s 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 a subsidiary of the Company. 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 a subsidiary of the Company.

On October 22, 1990, a settlement agreement between the Company, its subsidiary Summit Machine Tool Manufacturing Corp. (“Summit”), and MEI (the “Settlement Agreement”), was entered into, and in connection with the Settlement Agreement, Summit issued to MEI obligations totaling $1,533,000. On May 16, 1992, the Settlement Agreement was rescinded by the Company, Summit, and MEI at the request of MEI, and replaced with an agreement purportedly substantially similar to the Settlement Agreement between MEI and Aerobit, pursuant to which MEI agreed to replace the original $1,533,000 of Summit’s obligations with Aerobit bank drafts totaling $1,533,000, endorsed by LSB Corp. Aerobit previously advised us that MEI has not fulfilled the requirements under the bank drafts for payment thereof. All of the Company’s ownership interest in LSB Corp. was sold to an unrelated third party in September 2002. Further, all of the Company’s interest in Aerobit was sold to a separate unrelated third party, in a transaction completed on or before November 2002. Accordingly, neither Aerobit,

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Note 13: Contingencies (continued)

which was the issuer of the bank drafts, nor LSB Corp., which was the endorser of the bank drafts, are currently subsidiaries of the Company.

The Company has received a letter from an attorney purporting to represent an entity which is purportedly the assignee of claims of MEI demanding payment of the drafts and threatening litigation.

Neither the Company nor any of its currently owned subsidiaries are makers or endorsers of the bank drafts in question. The Company intends to vigorously defend itself in connection with this matter. No liability has been established relating to these bank drafts as of September 30, 2007.

Dividends on Series 2 Preferred

As discussed in Note 15 – Completion of Redemption of Series 2 Preferred, during July 2007, we mailed to all holders of record of our Series 2 Preferred a notice of redemption of all of the outstanding shares of Series 2 Preferred. The redemption of our Series 2 Preferred was completed on August 27, 2007, the redemption date. The terms of the Series 2 Preferred required that for each share of Series 2 Preferred so redeemed, we would pay, in cash, a redemption price equal to $50.00 plus $26.25 representing accrued and unpaid dividends thereon pro-rata to the date of redemption. There were 193,295 shares of Series 2 Preferred outstanding, net of treasury stock, as of the date the notice of redemption was mailed. Pursuant to the terms of the Series 2 Preferred, the holders of the Series 2 Preferred could convert each share into 4.329 shares of our common stock, which right to convert terminated 10 days prior to the redemption date. If a holder of the Series 2 Preferred elected to convert his, her or its shares into our common stock pursuant to its terms, the Certificate of Designations for the Series 2 Preferred provided, and it is our position, that the holder that so converts would not be entitled to receive payment of any accrued and unpaid dividends on the shares so converted. The Jayhawk Group, one of our largest stockholders and former affiliate of ours, converted 155,012 shares of Series 2 Preferred into 671,046 shares of common stock. As of September 30, 2007, the Jayhawk Group beneficially owned 3,002,584 shares of our common stock. The Jayhawk Group has advised us that it may bring legal action against us for all accrued and unpaid dividends on the shares of Series 2 Preferred that it converted after receipt of the notice of redemption.

C. Other Claims and Legal Actions

Short-Swing Profit Claim

We received a letter dated May 23, 2007 from a law firm representing a stockholder of ours demanding that we investigate potential short-swing profit liability under Section 16(b) of the Exchange Act of the Jayhawk Group. The stockholder alleges that the surrender by the Jayhawk Group of 180,450 shares of our Series 2 Preferred in our issuer exchange tender offer in March 2007 was a sale which was subject to Section 16 and matchable against prior purchases of Series 2 Preferred by the Jayhawk Group. The Jayhawk Group advised us that they do not believe that they are liable for short-swing profits under Section 16(b). The provisions of Section 16(b) provide that if we do not file a lawsuit against the Jayhawk Group in connection with these

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Note 13: Contingencies (continued)

Section 16(b) allegations within 60 days from the date of the stockholder’s notice to us, then the stockholder may pursue a Section 16(b) short-swing profit claim on our behalf. We engaged our outside corporate/securities counsel to investigate this matter. After completion of this

investigation, we attempted to settle the matter with the Jayhawk Group but were unable to reach a resolution satisfactory to all parties. On October 9, 2007, the law firm representing the stockholder initiated a lawsuit against the Jayhawk Group pursuing a Section 16(b) short-swing profit claim on our behalf up to approximately $819,000.

Business Interruption and Property Insurance Claims

1. El Dorado Facility

Beginning in October 2004 and continuing into June 2005, the Chemical Business’ results were adversely affected as a result of the loss of production due to a mechanical failure of one of the four nitric acid plants at the El Dorado, Arkansas plant. The plant was restored to normal production in June 2005. We filed a property damage insurance claim for $3.8 million, net of a $1 million deductible. We also filed a business interruption claim for $5 million, net of the forty-five day waiting period. The insurers paid claims totaling $5.5 million; however, the insurers are contesting our remaining claims. For the nine and three months ended September 30, 2006, we realized insurance recoveries of $882,000 and $287,000, respectively, relating to this business interruption claim which is recorded as a reduction to cost of sales.

2. Cherokee Facility

As a result of damage caused by Hurricane Katrina, the natural gas pipeline servicing the Cherokee Facility suffered damage and the owner of the pipeline declared an event of Force Majeure. This event of Force Majeure caused curtailments and interruption in the delivery of natural gas to the Cherokee Facility. CNC’s insurer was promptly put on notice of a claim, but the quantification of the claim amount took time and involved the retention of a gas market expert and a business interruption consultant.

On September 25, 2006, CNC filed a contingent business interruption claim. CNC is in discussions with, and providing additional documentation to, the forensic accountant hired by CNC’s insurers to examine the claim. For the nine and three months ended September 30, 2007, we received insurance recoveries of $1,500,000 relating to this business interruption claim which are recorded as a reduction to cost of sales. Additional recoveries relating to this claim, if any, will be recognized when realized.

Securities and Exchange Commission Inquiry

The Securities and Exchange Commission (“SEC”) made an informal inquiry to the Company by letter dated August 15, 2006. The inquiry relates to the restatement of the Company’s consolidated financial statements for the year ended December 31, 2004 and accounting matters relating to the change in inventory accounting from LIFO to FIFO. The Company has responded to the inquiry. At the present time, the informal inquiry is not a pending proceeding nor does it

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Note 13: Contingencies (continued)

rise to the level of a government investigation. Until further communication and clarification with the SEC, if any, the Company is unable to determine:

if the inquiry will ever rise to the level of an investigation or proceeding, or

the materiality to the Company’s financial position with respect to enforcement actions, if any, the SEC may have available to it.

Other

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

Note 14: Completion of Tender Offer On November 10, 2006, the Company entered into an agreement (“Jayhawk Agreement”) with the Jayhawk Group. Under the Jayhawk Agreement, the Jayhawk Group agreed to tender (discussed below) 180,450 shares of the 346,662 shares of the Series 2 Preferred, if the Company made an exchange or tender offer for the Series 2 Preferred. In addition, as a condition to the Jayhawk Group’s obligation to tender such shares of Series 2 Preferred in an exchange/tender offer, the Jayhawk Agreement further provided that Jack E. Golsen (Chairman of the Board and CEO of the Company), his wife, children (including Barry H. Golsen, our President) and certain entities controlled by them (the “Golsen Group”) would exchange only 26,467 of the 49,550 shares of Series 2 Preferred beneficially owned by them. As a result, only 309,807 of the 499,102 shares of Series 2 Preferred outstanding would be eligible to participate in an exchange/tender offer, with the remaining 189,295 being held by the Jayhawk Group and the Golsen Group.

On January 26, 2007, our Board of Directors approved and on February 9, 2007, we began a tender offer to exchange shares of our common stock for up to 309,807 of the 499,102 outstanding shares of the Series 2 Preferred. The tender offer expired on March 12, 2007 and our Board of Directors accepted the shares tendered on March 13, 2007. The terms of the tender offer provided for the issuance by the Company of 7.4 shares of common stock in exchange for each share of Series 2 Preferred tendered in the tender offer and the waiver of all rights to accrued and unpaid dividends on the Series 2 Preferred tendered. As a result of this tender offer, we issued 2,262,965 shares of our common stock for 305,807 shares of Series 2 Preferred that were tendered. In addition, the total amount of accrued and unpaid dividends waived on the Series 2 Preferred tendered was approximately $7.3 million ($23.975 per share).

Because the exchanges under the tender offer were pursuant to terms other than the original terms, the transactions were considered extinguishments of the preferred stock. Also the transactions qualified as induced conversions under SFAS 84 – Induced Conversions of Convertible Debt. Accordingly, we recorded a charge (stock dividend) to accumulated deficit of approximately $12.3 million which equaled the excess of the fair value of the common stock issued over the fair value of the common stock issuable pursuant to the original conversion terms. To measure fair value, we used the closing price of our common stock on March 13, 2007. For purposes of computing income per common share for the nine months ended September 30, 2007, net income was reduced by approximately $5 million relating to the tender offer which

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Note 14: Completion of Tender Offer (continued)

represents the total amount of stock dividends recorded less the total amount of unpaid dividends waived.

Included in the amounts discussed above and pursuant to the Jayhawk Agreement and the terms of the tender offer, the Jayhawk Group and the Golsen Group tendered 180,450 and 26,467 shares, respectively, of Series 2 Preferred for 1,335,330 and 195,855 shares, respectively, of our common stock. In addition, the total amount of accrued and unpaid dividends waived on these shares of Series 2 Preferred tendered was approximately $4.96 million with the Jayhawk Group waiving a total of $4.33 million and the Golsen Group waiving a total of $0.63 million.

No fractional shares were issued so cash was paid in lieu of any additional shares in an amount equal to the fraction of a share times the closing price per share of our common stock on the last business day immediately preceding the expiration date of the tender offer.

Note 15: Completion of Redemption of Series 2 Preferred On July 11, 2007, our Board of Directors approved the redemption of all of our outstanding Series 2 Preferred. We mailed a notice of redemption to all holders of record of our Series 2 Preferred on July 12, 2007. The redemption date was August 27, 2007, and each share of Series 2 Preferred that was redeemed received a redemption price of $50.00 plus $26.25 per share in accrued and unpaid dividends pro-rata to the date of redemption.

The holders of shares of Series 2 Preferred had the right to convert each share into 4.329 shares of our common stock, which right to convert terminated 10 days prior to the redemption date. If a holder converted its shares of Series 2 Preferred, the holder was not entitled to any accrued and unpaid dividends as to the shares of Series 2 Preferred converted. As a result, 167,475 shares of Series 2 Preferred were converted (of which 155,012 shares were converted by the Jayhawk Group) into 724,993 shares of our common stock (of which 671,046 shares were issued to the Jayhawk Group).

As a result of the conversions, only 25,820 shares of Series 2 Preferred were redeemed (of which 23,083 shares were held by the Golsen Group) for a total redemption price of $1,291,000 (of which approximately $1,154,000 was paid to the Golsen Group). In addition, we paid approximately $678,000 in accrued and unpaid dividends (of which approximately $606,000 was paid to the Golsen Group). The shares of the Series 2 Preferred were redeemed using a portion of the net proceeds of the 2007 Debentures.

Note 16: Stock Options Receiving Stockholders’ Approval We account for stock options in accordance with SFAS 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”) using the modified prospective method. On June 19, 2006, the Compensation and Stock Option Committee of our Board of Directors granted 450,000 shares of non-qualified stock options (the “Options”) to certain Climate Control Business employees which were subject to shareholders’ approval.

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Note 16: Stock Options Receiving Stockholders’ Approval (continued)

The option price of the Options is $8.01 per share which is based on the market value of our common stock at the date the Board of Directors granted the shares (June 19, 2006). The Options vest over a ten-year period at a rate of 10% per year and expire on September 16, 2016 with certain restrictions. Under SFAS 123(R), the fair value for the Options was estimated, using an option pricing model, as of the date we received shareholders’ approval which occurred during our 2007 annual shareholders’ meeting on June 14, 2007. Under SFAS 123(R) for accounting purposes, the grant date and service inception date is June 14, 2007.

The total fair value for the Options was estimated to be $6,924,000, or $15.39 per share, using a Black-Scholes-Merton option pricing model with the following assumptions:

risk-free interest rate of 5.16% based on an U.S. Treasury zero-coupon issue with a term approximating the estimated expected life as of the grant date;

a dividend yield of 0 based on historical data;

volatility factors of the expected market price of our common stock of 24.7% based on historical volatility of our common stock since it has been traded on the American Stock Exchange, and;

a weighted average expected life of the options of 5.76 years based on the historical exercise behavior of these employees.

As of June 14, 2007, we began amortizing the total estimated fair value of the Options to selling, general, and administrative expense (“SG&A”) which will continue through June 2016 (the remaining vesting period). As a result, we incurred stock-based compensation expense of $228,000 and $192,000 (related tax effects were minimal) for the nine and three months ended September 30, 2007, respectively. As of September 30, 2007, 25,000 shares of the Options had been exercised and 20,000 shares of the Options were exercisable. For the nine months ended September 30, 2007, the total fair value of the Options vested was $692,000.

Note 17: Derivatives, Hedges and Financial Instruments We account for derivatives in accordance with SFAS No. 133 which requires the recognition of derivatives in the balance sheet and the measurement of these instruments at fair value. Changes in fair value of derivatives are recorded in results of operations unless the normal purchase or sale exceptions apply or hedge accounting is elected.

In 1997, we entered into an interest rate forward agreement to effectively fix the interest rate of a long-term lease commitment (not for trading purposes). In 1999, we executed a long-term lease agreement (initial lease term of ten years) and terminated the forward agreement at a net cost of $2.8 million. We historically accounted for this cash flow hedge under the deferral method (as an adjustment of the initial term lease rentals). Upon adoption of SFAS No. 133 in 2001, the remaining deferred cost amount was reclassified from other assets to accumulated other comprehensive loss and is being amortized to operations over the term of the lease arrangement. At September 30, 2007 and December 31, 2006, accumulated other comprehensive loss consisted of the remaining deferred cost of $483,000 and $701,000, respectively. The amount amortized to operations was $218,000 and $73,000 for the nine and three-month periods ended September 30, 2007, respectively, and $217,000 and $72,000 for the nine and three months

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Note 17: Derivatives, Hedges and Financial Instruments (continued)

ended September 30, 2006, respectively. There were no income tax benefits related to these expenses.

In 2005, we purchased two interest rate cap contracts for a cost of $590,000 on $30 million of debt which mature in March 2009. In April 2007, we purchased two interest rate cap contracts for a cost of $621,000 on $50 million of debt which mature in April 2012. These contracts are free-standing derivatives and are accounted for on a mark-to-market basis in accordance with SFAS No.133. At September 30, 2007 and December 31, 2006, the market values of these contracts were $765,000 and $385,000, respectively, and are included in other assets in the accompanying condensed consolidated balance sheets. For the nine and three months ended September 30, 2007, the fair value of these contracts decreased $241,000 and $548,000, respectively. For the nine and three months ended September 30, 2006, the fair value decreased $11,000 and $348,000, respectively. The changes in the value of these contracts are included in interest expense. For the nine months ended September 30, 2007, cash used to purchase the 2007 contracts is included in cash used by continuing investing activities in the accompanying consolidated statement of cash flows.

Raw materials for use in our manufacturing processes include copper used by our Climate Control Business and natural gas used by our Chemical Business. As part of our raw material price risk management, we periodically enter into exchange-traded futures contracts for these materials, which contracts are generally accounted for on a mark-to-market basis in accordance with SFAS No. 133. At September 30, 2007, the unrealized gains were $133,000 and are included in supplies, prepaid items and other. At December 31, 2006, the unrealized losses were $408,000 and are included in accrued and other liabilities. The unrealized gains and losses are classified as current in the accompanying condensed consolidated balance sheets as the terms of these contracts are for periods of twelve months or less. For the nine and three months ended September 30, 2007, we incurred losses of $456,000 and $480,000, respectively, on such contracts. For the nine and three months ended September 30, 2006, we incurred losses of $992,000 and $233,000, respectively. These losses are included in cost of sales. In addition, the cash flows relating to these contracts are included in cash flows from continuing operating activities.

Note 18: Income Per Common Share Net income applicable to common stock is computed by adjusting net income by the amount of preferred stock dividend requirements and stock dividends. Basic income per common share is based upon net income applicable to common stock and the weighted average number of common shares outstanding during each period.

Diluted income per share is based on net income applicable to common stock plus preferred stock dividend requirements on preferred stock assumed to be converted, if dilutive, and interest expense including amortization of debt issuance costs, net of income taxes, on convertible debt assumed to be converted, if dilutive, and the weighted average number of common shares and dilutive common equivalent shares outstanding, and the assumed conversion of dilutive convertible securities outstanding.

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Note 18: Income Per Common Share (continued)

On June 28, 2007, we sold $60 million of convertible debt. In addition, we received shareholders’ approval in granting 450,000 shares of non-qualified stock options on June 14, 2007.

During the nine months ended September 30, 2007, the remaining $4,000,000 of the 2006 Debentures was converted into 564,790 shares of common stock. In addition, we issued 2,262,965 shares of common stock for 305,807 shares of our Series 2 Preferred that were tendered pursuant to a tender offer. Also during the nine and three months ended September 30, 2007, pursuant to our notice of redemption, we redeemed 25,820 shares of our Series 2 Preferred and issued 724,993 shares of common stock for 167,475 shares of our Series 2 Preferred.

During the nine and three months ended September 30, 2007, we paid cash dividends of approximately $678,000 on the shares of Series 2 Preferred which we redeemed. In addition, our board of directors declared and we paid dividends on the Series B Preferred, Series D Preferred and noncumulative redeemable preferred stock totaling approximately $1,890,000, $360,000 and $6,000, respectively. As a result, there were no unpaid dividends in arrears at September 30, 2007.

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Note 18: Income Per Common Share (continued)

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

Nine Months Ended

September 30,

Three Months Ended

September 30,

2007

2006

2007

2006

(Dollars In Thousands, Except Per Share Amounts)

Numerator:
Numerator for basic net income per common share - net income applicable to common stock	$	36,727	$	11,119	$	18,093	$	2,986
Preferred stock dividend requirements on preferred stock assumed to be converted, if dilutive		637		1,655		203		551
Interest expense including amortization of debt issuance costs, net of income taxes, on convertible debt assumed to be converted		1,007		858		924		373
Numerator for diluted net income per common share	$	38,371	$	13,632	$	19,220	$	3,910

Denominator:
Denominator for basic net income per common share - weighted-average shares		19,150,030		13,838,989		20,220,419		13,979,342
Effect of dilutive securities:
Convertible preferred stock		1,657,335		3,567,700		1,414,784		3,564,832
Stock options		1,222,133		1,272,219		1,154,480		1,289,617
Convertible notes payable		870,725		2,317,041		2,188,000		2,443,122
Warrants		90,241		62,029		94,209		69,053
Dilutive potential common shares		3,840,434		7,218,989		4,851,473		7,366,624
Denominator for diluted net income per common share - adjusted weighted-average shares and assumed conversions		22,990,464		21,057,978		25,071,892		21,345,966

Basic net income per common share	$	1.92	$	.80	$	.89	$	.21

Diluted net income per common share	$	1.67	$	.65	$	.77	$	.18

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Note 18: Income Per Common Share (continued)

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

Nine Months Ended

September 30,

Three Months Ended

September 30,

2007

2006

2007

2006

Convertible preferred stock	348,120	-	-	-
Stock options	177,747	-	444,293	-
	525,867	-	444,293	-

Note 19: Income Taxes We and certain of our subsidiaries file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. The federal tax returns for 1994 through 2002 remain subject to examination for the purpose of determining the amount of remaining tax net operating loss (“NOL”) and other carryforwards. With few exceptions, the 2004-2007 years remain open for all purposes of examination by the IRS and other major tax jurisdictions.

At December 31, 2006, we had regular NOL carryforwards of approximately $49.9 million that begin expiring in 2019 and alternative minimum tax NOL carryforwards of approximately $31.9 million. We account for income taxes under the provision of SFAS No. 109 - Accounting for Income Taxes (“SFAS 109”) which requires recognition of future tax benefits (NOL carryforwards and other temporary differences), subject to a valuation allowance if it is determined that it is more-likely-than-not that such asset will not be realized. In determining whether it is more-likely-than-not that we will not realize such tax asset, SFAS 109 requires that all negative and positive evidence be considered (with more weight given to evidence that is “objective and verifiable”) in making the determination. Prior to September 30, 2007, we had valuation allowances in place against the net deferred tax assets arising from the NOLs and other temporary differences. However, as the result of improving financial results including some unusual transactions (settlement of pending litigation and insurance recovery of business interruption claim) in the quarter ended September 30, 2007 and our current expectation of generating taxable income in the future, we reversed valuation allowances of approximately $3.2 million as a benefit for income taxes and recognized a deferred tax asset of approximately $9.7 million and a deferred tax liability of approximately $6.5 million.

Provisions (benefits) for income taxes are as follows:

Nine Months Ended

September 30,

Three Months Ended

September 30,

2007

2006

2007

2006

(In Thousands)

Federal AMT provision	$	1,550		$	264	$	1,104		$	89
State income tax provision		583			144		497			119
Deferred tax benefit from reversal of valuation allowance		(3,150	)		-		(3,150	)		-
Provisions (benefits) for income taxes	$	(1,017	)	$	408	$	(1,549	)	$	208

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Note 19: Income Taxes (continued)

Due to regular tax NOL carryforwards, the only provisions for income taxes for the nine and three-month periods of 2007 and 2006 were for federal AMT and for state income taxes as shown above. We anticipate fully utilizing the regular NOL carryforwards in 2008 at which time we will begin recognizing and paying federal income taxes at regular corporate tax rates.

APB Opinion No. 28 - Interim Financial Reporting (“APB 28”) provides guidance on accounting for income taxes in interim periods. The accounting requirements of APB 28 are based on a view that each interim period is primarily an integral part of the annual period. Tax expense for interim periods is measured using an estimated annual effective tax rate for the annual period. The effective tax rate is then used for computing the interim tax provision.

In calculating AMT for 2007, we also have AMT NOL carryforwards that reduce the effective tax rate. Through the second quarter of 2007, we estimated that the AMT NOL carryforwards would not be fully utilized in 2007. However, because of the better than estimated results for the third quarter including some unusual transactions (settlement of pending litigation and insurance recovery of business interruption claim), we now estimate that the AMT NOL carryforwards will be fully utilized in 2007. This resulted in a change in the effective tax rate for 2007. The effect of the change in effective tax rate increased the provision for federal AMT by approximately $735,000. Previously the deferred tax asset related to the AMT credit carryforwards was subject to a valuation allowance which was released as of September 30, 2007 as discussed above.

When non-qualified stock options (NSOs) are exercised, the granter of the options is permitted to deduct the spread between the fair market value and the exercise price of the NSOs as compensation expense in determining taxable income. SFAS 123(R) specifies that if the grantor of NSOs will not benefit from the excess tax benefit deduction taken at the time of the taxable event (option exercised) because it has a NOL carryforward that is increased by the excess tax benefit, then the tax benefit should not be recognized until the deduction actually reduces current taxes payable. As of September 30, 2007, we have approximately $1,300,000 in unrecognized tax benefit resulting from the exercise of NSOs since the effective date of SFAS 123(R) on January 1, 2006. We estimate this benefit will be realized in 2008 when we utilize the remaining NOLs.

In July 2006, the FASB issued FASB Interpretation No. 48 - Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 requires that realization of an uncertain income tax position must be “more likely than not” (i.e. greater than 50% likelihood) the position will be sustained upon examination by taxing authorities before it can be recognized in the financial statements. Further, FIN 48 prescribes the amount to be recorded in the financial statements as the amount most likely to be realized assuming a review by tax authorities having