FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 (Mark One) /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED) For the fiscal year ended: December 31, 1997 or / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) For the transition period from __________ to __________ Commission File Number: 1-7677 LSB INDUSTRIES, INC. (Exact Name of Registrant as Specified in its Charter) Delaware 73-1015226 (State of Incorporation) (I.R.S. Employer Identification No.) 16 South Pennsylvania Avenue Oklahoma City, Oklahoma 73107 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (405) 235-4546 Securities Registered Pursuant to Section 12(b) of the Act: Name of Each Exchange Title of Each Class On Which Registered Common Stock, Par Value $.10 New York Stock Exchange $3.25 Convertible Exchangeable Class C Preferred Stock, Series 2 New York Stock Exchange Preferred Share Purchase Rights New York Stock Exchange (Facing Sheet Continued) Securities Registered Pursuant to Section 12(g) of the Act: Indicate by check mark whether the Registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for the shorter period that the Registrant has had to file the reports), and (2) has been subject to the filing requirements for the past 90 days. YES X NO _____. Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. __________. As of February 28, 1998, the aggregate market value of the 8,543,152 shares of voting stock of the Registrant held by non-affiliates of the Company equaled approximately $35,240,502 based on the closing sales price for the Company's common stock as reported for that date on the New York Stock Exchange. That amount does not include (1) the 1,539 shares of Convertible Non-Cumulative Preferred Stock (the "Non-Cumulative Preferred Stock") held by non-affiliates of the Company, (2) the 20,000 shares of Series B 12% Convertible, Cumulative Preferred Stock (the "Series B Preferred Stock"), and (3) the 915,000 shares of $3.25 Convertible Exchangeable Class C Preferred Stock, Series 2, excluding 5,000 shares held in treasury (the "Series 2 Preferred Stock"). An active trading market does not exist for the shares of Non-Cumulative Preferred Stock or the Series B Preferred Stock. The shares of Series 2 Preferred Stock do not have voting rights except under limited circumstances. As of February 28, 1998, the Registrant had 12,759,226 shares of common stock outstanding (excluding 2,346,390 shares of common stock held as treasury stock). FORM 10-K OF LSB INDUSTRIES, INC. TABLE OF CONTENTS PART I Page Item 1. Business General 1 Segment Information and Foreign and Domestic Operations and Export Sales 1 Chemical Business 1 Climate Control Business 6 Automotive Products Business 10 Industrial Products Business 11 Employees 12 Research and Development 12 Environmental Matters 12 Year 2000 Issues 16 Item 2. Properties Chemical Business 16 Climate Control Business 17 Automotive Products Business 18 Industrial Products Business 18 Item 3. Legal Proceedings 19 Item 4. Submission of Matters to a Vote of Security Holders 23 Item 4A. Executive Officers of the Company 24 PART II Item 5. Market for Company's Common Equity and Related Stockholder Matters Market Information 25 Stockholders 25 Dividends 25 Item 6. Selected Financial Data 29 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview 31 Results of Operations 35 Liquidity and Capital Resources 38 Item 8. Financial Statements and Supplementary Data 45 iii Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 45 Special Note Regarding Forward-Looking Statements 45 PART III 47 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 48 iv PART I ITEM 1. BUSINESS GENERAL LSB Industries, Inc. (the "Company") was formed in 1968 as an Oklahoma corporation, and in 1977 became a Delaware corporation. The Company is a diversified holding company which is engaged, through its subsidiaries, in (i) the manufacture and sale of chemical products for the explosives, agricultural and industrial acids markets (the "Chemical Business"), (ii) the manufacture and sale of a broad range of hydronic fan coils and water source heat pumps as well as other products used in commercial and residential air conditioning systems (the "Climate Control Business"), and (iii) the manufacture or purchase and sale of certain automotive and industrial products, including automotive bearings and other automotive replacement parts (the "Automotive Products Business") and the purchase and sale of machine tools (the "Industrial Products Business"). SEGMENT INFORMATION AND FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Schedules of the amounts of sales, operating profit and loss, and identifiable assets attributable to each of the Company's lines of business and of the amount of export sales of the Company in the aggregate and by major geographic area for each of the Company's last three fiscal years appear in Note 13 of the Notes to Consolidated Financial Statements included elsewhere in this report. A discussion of any risks attendant as a result of a foreign operation or the importing of products from foreign countries appears below in the discussion of each of the Company's business segments. CHEMICAL BUSINESS GENERAL The Company's Chemical Business manufactures three principal product lines that are derived from anhydrous ammonia: (1) fertilizer grade ammonium nitrate for the agricultural industry, (2) explosive grade ammonium nitrate for the mining industry and (3) concentrated, blended and mixed nitric acid for industrial applications. In addition, the Company also produces sulfuric acid for commercial applications primarily in the paper industry. The Chemical Business' products are sold in niche markets where the Company believes it can establish a position as a market leader. See "Special Note Regarding Forward-Looking Statements". The Chemical Business' principal manufacturing facility is located in El Dorado, Arkansas ("El Dorado Facility") and its other manufacturing facilities are located in Hallowell, Kansas, Wilmington, North Carolina, four locations in Australia, and one location in New Zealand. For 1997, approximately 26% of the sales of the Chemical Business consisted of sales of fertilizer and related chemical products for agricultural purposes, which represented approximately 13% of the Company's 1 1997 consolidated sales, and approximately 61% consisted of sales of ammonium nitrate and other chemical-based blasting products for the mining industry, which represented approximately 30.5% of the Company's 1997 consolidated sales. The Chemical Business accounted for approximately 50% and 54% of the Company's 1997 and 1996 consolidated sales, respectively. AGRICULTURAL PRODUCTS The Chemical Business produces ammonium nitrate, a nitrogen-based fertilizer, at the El Dorado Facility. In 1997, the Company sold approximately 184,000 tons of ammonium nitrate fertilizer to farmers, fertilizer dealers and distributors located primarily in the south central United States. Ammonium nitrate is one of several forms of nitrogen-based fertilizers which include anhydrous ammonia and urea. Although, to some extent, the various forms of nitrogen-based fertilizers are interchangeable, each has its own characteristics which produce agronomic preferences among end users. Farmers decide which type of nitrogen-based fertilizer to apply based on the crop planted, soil and weather conditions, regional farming practices and relative nitrogen fertilizer prices. The Chemical Business is a major manufacturer of fertilizer grade ammonium nitrate, which it markets primarily in Texas, Arkansas and the surrounding regions. This market, which is in close proximity to its El Dorado Facility, includes a high concentration of pasture land and row crops which favor ammonium nitrate over other nitrogen-based fertilizers. The Company has developed the leading market position in Texas by emphasizing high quality products, customer service and technical advice. Using a proprietary prilling process, the Company produces a high performance ammonium nitrate fertilizer that, because of its uniform size, is easier to apply than many competing nitrogen-based fertilizer products. The Company believes that its "E-2" brand ammonium nitrate fertilizer is recognized as a premium product within its primary market. In addition, the Company has developed long term relationships with end users through its network of 21 owned and operated wholesale and retail distribution centers. EXPLOSIVES The Chemical Business manufactures low density ammonium nitrate-based explosives including bulk explosives used in surface mining. In addition, the Company manufactures and sells a branded line of packaged explosives used in construction, quarrying and other applications, particularly where controlled explosive charges are required. The Company's bulk explosives are marketed primarily through five Company-owned distribution centers, three of which are located in close proximity to the customers' surface mines in the coal producing states of Kentucky, Missouri, and West Virginia. Additionally, the Company, through its Australian subsidiary, manufactures and distributes bulk and packaged explosives in Australia and New Zealand. The Company emphasizes value-added customer services and specialized product applications for its bulk explosives. Most of the sales of bulk explosives are to customers who work closely with the Company's technical representatives in meeting their specific product needs. In addition, the Company sells bulk explosives to independent wholesalers and to other explosives companies. Packaged explosives are used for application requiring controlled explosive charges and typically command a premium price and produce higher margins. The Company believes its Slurry packaged explosive products are among the most widely recognized in the industry. Slurry packaged explosive products are sold nationally and internationally to other explosive companies and end-users. INDUSTRIAL ACIDS The Chemical Business manufactures and sells industrial acids, primarily to the food, paper, chemical and electronics industries. The Company is the leading supplier to third parties of concentrated nitric acid which is a special grade of nitric acid used in the manufacture of plastics, pharmaceuticals, herbicides, explosives, and other chemical products. In addition, the Company produces and sells regular, blended and mixed nitric acid and a variety of grades of sulfuric acid. The Company competes on the basis of price and service, including on-time reliability and distribution capabilities. The Company operates the largest fleet of tankcars in the concentrated nitric acid industry which provides it with a significant competitive advantage in terms of distribution costs and capabilities. In addition, the company provides inventory management as part of the value-added services it offers to its customers. The Company has identified concentrated nitric acid as a strategic product line for its Chemical Business due to attractive levels of profitability, increased diversity of end markets and the ability to compete on a value added service basis. To support further growth in its nitric acid business, the Company undertook the construction of the DSN Plant located at the El Dorado Facility. The DSN Plant uses a newer and more efficient process to produce concentrated nitric acid directly from anhydrous ammonia, in contrast to the conventional process which requires the input of regular nitric acid, an intermediate step to produce concentrated nitric acid. DSN PLANT Since January 1, 1994, the Chemical Business has spent approximately $32.0 million to install the DSN Plant. The DSN Plant began limited operations in 1995, and such limited operations continued due to certain mechanical and design problems associated with the plant's construction and installation. As a result of such problems, production at the DSN Plant was limited to approximately 170 tons per day (60% of its stated capacity of 285 tons per day assuming 338 days of annual production) during the twelve months ended December 31, 1997. In October 1997, management completed certain corrective actions at the DSN Plant. As a result of these corrective actions, the DSN Plant has the capacity to operate at approximately 285 tons per day, depending upon customer specifications. Due to customer specifications and inventory constraints, among other things, the DSN Plant has been operating at approximately 260 tons per day since the corrective actions were completed. Based on normalized production (assuming 338 days of annual production), at 260 tons per day, the Company believes that it will be able to produce concentrated nitric acid at a cost per ton approximately at $65 per ton lower than at the production levels of 170 tons per day in the prior period. While the Company will seek to market the additional capacity of concentrated nitric acid output to commercial markets, there can be no assurance that the Company will be able to sell all of the additional capacity in this market. However, to the extent that there is insufficient demand for concentrated nitric acid,the Company believes it can profitably use the concentrated nitric acid in the production of mixed and blended acids and ammonium nitrate based fertilizer and explosives (although at lower margins than if the production were sold as concentrated nitric acid). See "Special Note Regarding Forward-Looking Statements". EDNC BAYTOWN PLANT In June 1997, two wholly owned subsidiaries of the Company, El Dorado Chemical Company ("EDC") and El Dorado Nitrogen Company ("EDNC"), entered into a series of agreements with Bayer Corporation ("Bayer")(collectively, the "Bayer Agreement"). Under the Bayer Agreement, EDNC will act as an agent to construct and, upon completion of construction, will operate a nitric acid plant (the "EDNC Baytown Plant") at Bayer's Baytown, Texas chemical facility. EDC has guaranteed the performance of EDNC's obligations under the Bayer Agreement. Under the terms of the Bayer Agreement, EDNC is to lease the EDNC Baytown Plant pursuant to an operating lease from an unrelated third party with an initial lease term of ten years from the date on which the EDNC Baytown Plant becomes fully operational. Bayer will purchase from EDNC all of its requirements for nitric acid to be used by Bayer at its Baytown, Texas facility for ten years from the date on which the EDNC Baytown Plant becomes fully operational. EDNC will purchase from Bayer its requirements for anhydrous ammonia for the manufacture of nitric acid as well as utilities and other services. Subject to certain conditions, EDNC will be entitled to sell the amount of nitric acid manufactured at the EDNC Baytown Plant which is in excess of Bayer's requirements to third parties. The Bayer Agreement provides that Bayer will make certain net monthly payments to EDNC which will be sufficient for EDNC to recover all of its costs plus a profit. Upon expiration of the initial ten-year term from the date the EDNC Baytown Plant becomes operational, the Bayer Agreement may be renewed for up to six renewal terms of five years each; however, prior to each renewal period, either party to the Bayer Agreement may opt against renewal. If operations at the EDNC Baytown Plant are not commenced by February 1, 1999, or upon a change in control of LSB, EDC or EDNC, Bayer has an option to terminate the Bayer Agreement. EDNC has an option to terminate the Bayer Agreement upon the failure of Bayer to complete the construction of certain delivery systems prior to January 1, 1999, and upon the occurrence of certain events of default which remain uncured. Bayer retains the right of first refusal with respect to any bona fide third-party offer to purchase any voting stock of EDNC or any portion of the EDNC Baytown Plant. It is anticipated that construction of the EDNC Baytown Plant will cost approximately $60 million and will be completed by late 1998. Construction financing of the EDNC Baytown Plant is to be provided by an unaffiliated lender. Neither the Company nor EDC has guaranteed any of the lending obligations for the EDNC Baytown Plant. See "Special Note Regarding Forward-Looking Statements". RAW MATERIALS Anhydrous ammonia represents the primary component in the production of most of the products of the Chemical Business. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." The Chemical business currently purchases approximately 220,000 tons of anhydrous ammonia per year for use in its manufacture of its products. The Company has contracts with two suppliers of anhydrous ammonia. One contract expires in December 1998 and the other expires in April 2000. The Chemical Business is required to buy 120,000 tons of its annual requirements of anhydrous ammonia under the contract expiring in 2000 and the balance under the other contract. During 1995, 1996, and 1997, there were substantial increases in the price for anhydrous ammonia. During each of these periods, the Chemical Business was unable to increase its sales prices to cover all of the higher anhydrous ammonia costs incurred by the Company, and in the future the Chemical Business may not be able to pass along to its customers the full amount of increases in anhydrous ammonia costs. Accordingly, the Company's results of operations and financial condition have in the past been, and may in the future be, adversely affected by cost increases of raw materials, including anhydrous ammonia. The Company is not able to predict, as of the date of this report, what impact, if any, will result to the Company and the Company's earnings if the price of anhydrous ammonia continues at or near current levels, which are high on a historical basis, or if the price of anhydrous ammonia continues to increase further. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Special Note Regarding Forward-Looking Statements". The Company believes that it could obtain anhydrous ammonia from other sources in the event of a termination of the above-referenced contracts, but such may not be obtainable on as favorable terms. SEASONALITY The Company believes that the only seasonal products of the Chemical Business are fertilizer and related chemical products sold to the agricultural industry. The selling seasons for those products are primarily during the spring and fall planting seasons, which typically extend from February through May and from September through November in the geographical markets in which the majority of the Company's agricultural products are distributed. As a result, the Chemical Business increases its inventory of ammonium nitrate prior to the beginning of each planting season. Sales to the agricultural markets depend upon weather conditions and other circumstances beyond the control of the Company. PATENTS The Company believes that the Chemical Business does not depend upon any patent or license; however, the Chemical Business does own certain patents that it considers important in connection with the manufacture of certain blasting agents and high explosives. These patents began expiring in 1997 and will expire through 1999. REGULATORY MATTERS Each of the Chemical Business' domestic blasting product distribution centers are licensed by the Bureau of Alcohol, Tobacco and Firearms in order to manufacture and distribute blasting products. The Australian and New Zealand distribution centers are subject to comparable licensing requirements imposed by their respective controlling government authorities. The Chemical Business is also subject to extensive federal, state and local environmental laws, rules and regulations. See "Environmental Compliance", "Environmental Matters" and "Legal Proceedings". COMPETITION The Chemical business competes with other chemical companies in its markets, many of whom have greater financial and other resources than the Company. The Company believes that competition within the markets served by the Chemical Business is primarily based upon price, service, warranty and product performance. The Company believes that the Chemical Business is the leader in the Texas ammonium nitrate market and is the leading producer of concentrated nitric acid in the United States for third party sales. See "Special Note Regarding Forward-Looking Statements". DEVELOPMENTS IN ASIA The Chemical Business' Australian subsidiaries' results of operations have been adversely affected during 1997 due to the recent economic developments in certain countries in Asia. These economic developments in Asia have had a negative impact on the mining industry in Australia which the Chemical Business services. CLIMATE CONTROL BUSINESS BUSINESS STRATEGY The Climate Control Business seeks to establish leadership positions in niche markets by offering extensive product lines, custom tailored products and proprietary new technologies. Under this focused strategy, the Company has developed an extensive line of hydronic fan coils and water source heat pumps. The Company has developed flexible production to allow it to custom design units for the growing retrofit and replacement markets. The Company believes that the Climate Control Business is one of the leaders in commercializing new technology to satisfy increasingly stringent indoor air quality standards. Products recently developed by the Company include heat pipe technology for dehumidification, specialty filters for the removal of airborne particles and gases, ultraviolet light units for bacteria removal and highly energy efficient dual path heat pump products. The Climate Control Business is a pioneer in the use of geothermal water source heat pumps in residential applications. See "Special Note Regarding Forward-Looking Statements". GENERAL The Company's Climate Control Business manufactures and sells a broad range of standard and custom designed hydronic fan coils and water source heat pumps as well as other products for use in commercial and residential HVAC systems. Demand for the Climate Control Business' products is driven by the construction of commercial, institutional and residential buildings, the renovation of existing buildings and the replacement of existing systems. The Climate Control Business' commercial products are used in a wide variety of buildings, such as: hotels, motels, office buildings, schools, universities, apartments, condominiums, hospitals, nursing homes, extended care facilities, supermarkets and superstores. Many of the Company's products are targeted to meet increasingly stringent indoor air quality and energy efficiency standards. The Climate Control Business accounted for approximately 34% and 29% of the Company's 1997 and 1996 consolidated sales, respectively. HYDRONIC FAN COILS The Climate Control Business is the leading provider of hydronic fan coils targeted to the commercial and institutional markets in the U.S. Hydronic fan coils use heated or chilled water, provided by a centralized chiller and boiler through a water pipe system, to condition the air and allow individual room control. Hydronic fan coil systems are quieter and have longer lives and lower maintenance costs than comparable systems used where individual room control is required. The Company believes that its product line of hydronic fan coils is the most extensive offered by any domestic producer. The breadth of this product line coupled with customization capability provided by a flexible manufacturing process are important components of the Company's strategy for competing in the commercial and institutional renovation and replacement markets. See "Special Note Regarding Forward-Looking Statements". WATER SOURCE HEAT PUMPS The Company is a leading U.S. provider of water source heat pumps to the commercial construction and renovation markets. These are highly efficient heating and cooling units which enable individual room climate control through the transfer of heat through a water pipe system which is connected to a centralized cooling tower or heat injector. Water source heat pumps enjoy a broad range of commercial applications, particularly in medium to large sized buildings with many small, individually controlled spaces. The company believes the market for commercial water source heat pumps will continue to grow due to the relative efficiency and long life of such systems as compared to other air conditioning and heating systems, as well as to the emergence of the replacement market for those systems. See "Special Note Regarding Forward-Looking Statements". GEOTHERMAL PRODUCTS The Climate Control Business is a pioneer in the use of geothermal water source heat pumps in residential and commercial applications. Geothermal systems, which circulate water or antifreeze through an underground heat exchanger, are among the most energy efficient systems available. The Company believes that an aging installed base of residential HVAC systems, coupled with the longer life, lower cost to operate, and relatively short payback periods of geothermal systems will continue to increase demand for its geothermal products, particularly in the residential replacement market. See "Special Note Regarding Forward-Looking Statements". HYDRONIC FAN COIL AND WATER SOURCE HEAT PUMP MARKET The Company has pursued a strategy of specializing in hydronic fan coils and water source heat pump products. The annual U.S. market for hydronic fan coils and water source heat pumps is approximately $225 million. Demand in these markets is generally driven by levels of repair, replacement, and new construction activity. The U.S. market for fan coils and water source heat pump products has grown on average 6% per year over the last 5 years. This growth has been fueled by the aging of the installed base of units, the introduction of new energy efficient systems, upgrades to central air conditioning and increased governmental regulations restricting the use of ozone depleting refrigerants in HVAC systems. PRODUCTION AND BACKLOG Most of the Climate Control Business' production of the above-described products occurs on a specific order basis. The Company manufactures the units in many sizes and configurations, as required by the purchaser, to fit the space and capacity requirements of hotels, motels, school, hospitals, apartment buildings, office buildings and other commercial or residential structures. As of December 31, 1997, the backlog of confirmed orders for the Climate Control Business was approximately $28.8 million as compared to approximately $14.9 million at December 31, 1996. A customer generally has the right to cancel an order prior to the order being released to production. Past experience indicates that customers generally do not cancel orders after the Company receives them. As of March 31, 1998, the Climate Control Business had released substantially all of the December 31, 1997 backlog to production. All of the December 31, 1997 backlog is expected to be filled by December 31, 1998. See "Special Note Regarding Forward-Looking Statements". MARKETING AND DISTRIBUTION DISTRIBUTION The Climate Control Business sells its products to mechanical contractors, original equipment manufacturers and distributors. The Company's sales to mechanical contractors primarily occur through independent manufacturer's representatives, who also represent complementary product lines not manufactured by the Company. Original equipment manufacturers generally consist of other air conditioning and heating equipment manufacturers who resell under their own brand name the products purchased from the Climate Control Business in competition with the Company. Sales to original equipment manufacturers accounted for approximately 25% of the sales of the Climate Control Business in 1997 and approximately 8.4% of the Company's 1997 consolidated sales. MARKET The Climate Control Business depends primarily on the commercial construction industry, including new construction and the remodeling and renovation of older buildings. In recent years this Business has introduced geothermal products designed for residential markets for both new and replacement markets. RAW MATERIALS Numerous domestic and foreign sources exist for the materials used by the Climate Control Business, which materials include aluminum, copper, steel, electric motors and compressors. The Company does not expect to have any difficulties in obtaining any necessary materials for the Climate Control Business. COMPETITION The Climate Control Business competes with approximately eight companies, some of whom are also customers of the Company. Some of the competitors have greater financial and other resources than the Company. The Climate Control Business manufactures a broader line of fan coil and water source heat pump products than any other manufacturer in the United States, and the Company believes that it is competitive as to price, service, warranty and product performance. JOINT VENTURES AND OPTIONS TO PURCHASE The Company has obtained an option to acquire 80% of the issued and outstanding stock of an Entity ("Entity") that performs energy savings contracts, primarily on US government facilities (the "Option"). For the Option, the Company has paid $1.2 million as of the date of this report. The term of the Option expires May 4, 1998, but the Company may extend such for one (1) additional year until May 4, 1999 upon payment of $100,000. As of the date of this report, the Company has not decided whether it will exercise the Option. If the Company decides to exercise the Option, the Company has agreed to pay an exercise price of $4.0 million, less the amount already paid toward the Option ("Option Price"), with a portion of the unpaid exercise price being payable in cash and the balance over a certain period of time. The grantors of the Option have entered into an employment agreement with the Entity. Under the terms of the employment agreements, each of the three grantors will receive, among other things, 12 1/2% of the net profits of the Entity for a period of three to five years following the date of exercise of the Option. If the Company decides not to exercise the Option, the grantors of the Option have agreed to repay to the Company the amounts paid by the Company in connection with the Option up to a total of $1.0 million, which obligation is secured by the stock of the Entity and other affiliates of the Entity. If the Company decides not to exercise the Option, there is no assurance that the grantors of the Option will have funds necessary to repay to the Company the amount paid for the Option. The grantors of the Option may, under certain conditions, require the Company to accelerate its decision as to when it exercises the Option. See "Management's Discussion and Analysis of Financial Condition and Results of Operations". Through the date of this report, the Company has loaned the Entity approximately $1.4 million. The Company has recorded reserves of $926,000 against the loans and option payments . For the year ended June 30, 1997, the Entity reported an unaudited net loss of approximately $.5 million. During 1994, a subsidiary of the Company obtained an option to acquire all of the stock of a French manufacturer of air conditioning and heating equipment. The Company's subsidiary was granted the option as a result of the subsidiary loaning to the parent company of the French manufacturer approximately $2.1 million. Subsequent to the loan of $2.1 million, the Company's subsidiary has loaned to the parent of the French manufacturer an additional $1.7 million. The amount loaned is secured by the stock and assets of the French manufacturer. The Company's subsidiary may exercise its option to acquire the French manufacturer by converting approximately $150,000 of the amount loaned into equity. The option is currently exercisable and will expire June 15, 1999. As of the date of this report, the Company has not decided whether it will exercise the option. For 1997 and 1996, the French manufacturer had revenues of $14.3 million and $16.0 million, respectively, and reported an approximate breakeven level of operations in 1996 and a net income of approximately $300,000 in 1997. As a result of cumulative losses by the French manufacturer, the Company has established reserves against the loans aggregating approximately $1.5 million through December 31, 1997. See "Management's Discussion and Analysis of Financial Condition and Results of Operations". AUTOMOTIVE PRODUCTS BUSINESS GENERAL The Automotive Products Business is primarily engaged in the manufacture and sale of a line of anti-friction bearings, which includes straight-thrust and radial-thrust ball bearings, angular contact ball bearings, and certain other automotive replacement parts (including universal joints, motor mounts, and clutches). This Business also manufactures power train and drive line parts for original equipment manufacturers. These products are used in automobiles, trucks, trailers, tractors, farm and industrial machinery, and other equipment. The Automotive Products Business accounted for approximately 11% and 12% of the Company's 1997 and 1996 sales respectively. In 1997, the Automotive Products Business manufactured approximately 40% of the products it sold and approximately 39% in 1996, and purchased the balance of its products from other sources, including foreign sources. DISTRIBUTION AND MARKET The automotive, truck and agricultural equipment replacement markets serve as the principal markets for the Automotive Products Business. This Business sells its products domestically and for export, principally through independent manufacturers' representatives who also sell other automotive products. Those manufacturers' representatives sell to retailers (including major chain stores), wholesalers, distributors and jobbers. The Automotive Products Business also sells its products directly to original equipment manufacturers and certain major chain stores. INVENTORY The Company generally produces or purchases the products sold by the Automotive Products Business in quantities based on a general sales forecast, rather than on specific orders from customers. The Company fills most orders for the automotive replacement market from inventory. The Company generally produces products for original equipment manufacturers after receiving an order from the manufacturer. RAW MATERIALS The principal materials that the Automotive Products Business needs to produce its products consist of high alloy steel tubing, steel bars, flat strip coil steel and bearing components produced to specifications. The Company acquires those materials from a variety of domestic and foreign suppliers at competitive prices. The Company does not anticipate having any difficulty in obtaining those materials in the near future. FOREIGN RISK By purchasing a significant portion of the bearings and other automotive replacement parts that it sells from foreign manufacturers, the Automotive Products Business must bear certain import duties and international economic risks, such as currency fluctuations and exchange controls, and other risks from political upheavals and changes in United States or other countries' trade policies. Contracts for the purchase of foreign-made bearings and other automotive replacement parts provide for payment in United States dollars. Circumstances beyond the control of the Company could eliminate or seriously curtail the supply of bearings or other automotive replacement parts from any one or all of the foreign countries involved. COMPETITION The Automotive Products Business engages in a highly competitive business. Competitors include other domestic and foreign bearing manufacturers, which sell in the original equipment and replacement markets. Many of those manufacturers have greater financial and other resources than the Company. INDUSTRIAL PRODUCTS BUSINESS GENERAL The Industrial Products Business purchases and markets a proprietary line of machine tools. The current line of machine tools distributed by the Industrial Products Business includes milling, drilling, turning and fabricating machines. The Industrial Products Business purchases most of the machine tools marketed by it from foreign companies, which manufacture the machine tools to the Company's specifications. This Business manufactures CNC bed mills and electrical control panels for machine tools. The Industrial Products Business accounted for approximately 5% of the Company's consolidated sales in each of the years 1997 and 1996. DISTRIBUTION AND MARKET The Industrial Products Business distributes its machine tools in the United States, Mexico, Canada and certain other foreign markets. The Industrial Products Business also sells its machine tools through independent machine tool dealers throughout the United States and Canada, who purchase the machine tools for resale to end users. The principal markets for machine tools, other than machine tool dealers, consist of manufacturing and metal working companies, maintenance facilities, and utilities. FOREIGN RISK By purchasing a majority of the machine tools from foreign manufacturers, the Industrial Products Business must bear certain import duties and international economic risks, such as currency fluctuations and exchange controls, and other risks from political upheavals and changes in United States or other countries' trade policies. Contracts for the purchase of foreign-made machine tools provide for payment in United States dollars. Circumstances beyond the control of the Company could eliminate or seriously curtail the supply of machine tools from any one or all of the foreign countries involved. COMPETITION The Industrial Products Business competes with manufacturers, importers, and other distributors of machine tools many of whom have greater financial resources than the Company. The Company's machine tool business generally is competitive as to price, warranty and service, and maintains personnel to install and service machine tools. EMPLOYEES As of December 31, 1997, the Company employed 1,685 persons. As of that date, (a) the Chemical Business employed 563 persons, with 135 represented by unions under agreements expiring in August 1998 and February 1999, (b) the Climate Control Business employed 669 persons, none of whom are represented by a union, and (c) the Automotive Products Business employed 315 persons, with 27 represented by unions under an agreement expiring in July 2000. RESEARCH AND DEVELOPMENT The Company incurred approximately $394,000 in 1997, $532,000 in 1996,and $501,000 in 1995 on research and development relating to the development of new products or the improvement of existing products. All expenditures for research and development related to the development of new products and improvements are sponsored by the Company. ENVIRONMENTAL MATTERS The Company and its operations are subject to numerous 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 substantial fines and criminal sanctions for violations, and there can be no assurance that material costs or liabilities will not be incurred by the Company 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 the Chemical Business have in the past resulted, and could in the future result, in penalties, cleanup costs, or other liabilities relating to the handling, manufacture, use, emission, discharge or disposal of pollutants or other substances at or from the Company's facilities or the use or disposal of certain of its chemical products. Significant expenditures have been incurred by the Chemical Business at the El Dorado Facility in order to comply with the Environmental Laws and Health Laws. The Chemical Business may be required to make additional significant site or operational modifications at the El Dorado Facility, potentially involving substantial expenditures and reduction, suspension or cessation of certain operations. See "Special Note Regarding Forward-Looking Statements;" "Management's Discussion and Analysis of Financial Condition and Results of Operations-Chemical Business" and "Legal Proceedings." The Arkansas Department of Pollution Control & Ecology ("ADPC&E") performed an environmental inspection at the Chemical Business' El Dorado Facility in 1994, which included a review of the plant's compliance with Environmental Laws relating to wastewater and stormwater discharges, air emissions, and solid and hazardous waste practices. The reports prepared by the ADPC&E in connection with the inspection noted, in part, that releases of contaminants to groundwater were suspected to have occurred at the El Dorado Facility. In 1995, the Chemical Business and the ADPC&E entered into an administrative consent order which provided for penalties of $150,000 (including $125,000 to be spent on environmental improvements at the El Dorado Facility), and required the Chemical Business to investigate the nature and extent of the existing groundwater contamination, to take steps to reduce future groundwater contamination, and to address certain other environmental compliance issues at the El Dorado Facility (the "Inspection Consent Order"). Pursuant to the Inspection Consent Order, the Chemical Business installed additional monitoring wells at the El Dorado Facility in accordance with a workplan approved by the ADPC&E, and submitted the test results to ADPC&E. The results indicated that a risk assessment should be conducted on nitrates present in the shallow groundwater. The Chemical Business' consultant has completed this risk assessment, and has forwarded it to the ADPC&E for approval. The risk assessment concludes that, although there are contaminants at the El Dorado Facility and in the groundwater, the levels of such contaminants at the El Dorado Facility and in the groundwater do not present an unacceptable risk to human health and the environment. Based on this conclusion, the Chemical Business' consultant has recommended continued monitoring at the site for five years. The ADPC&E has not yet responded to the Chemical Business' proposal. There can be no assurance that the risk assessment will be approved by the ADPC&E, or that further work will not be required. In addition, in accordance with the Inspection Consent Order, the Chemical Business currently plans to upgrade the El Dorado Facility's wastewater treatment plant, and anticipates that significant related capital expenditures will be incurred to complete this project. Because the Company is still investigating this matter, the Company cannot predict the amount of such expenditures. Furthermore, the El Dorado Facility's new wastewater permit currently is being reviewed for renewal by the ADPC&E. The new permit may impose additional or more stringent limitations on the plant's wastewater discharges. The Company believes, although there can be no assurance, that any such new limitations would not have a material adverse effect on the Company. See "Special Note Regarding Forward-Looking Statements." During May 1997, approximately 2,300 gallons of caustic material spilled when a valve in a storage vessel located at the El Dorado Facility failed, resulting in a release of such material to a stormwater drain, and according to ADPC&E records, a minor fish kill in a creek near the El Dorado Facility. The Chemical Business and the ADPC&E are currently negotiating a proposed civil consent administrative order to resolve this matter, which would require the payment of a civil penalty. The Company has received a draft of a proposed consent administrative order from the ADPC&E that, as part of the settlement of claims by the ADPC&E resulting from the spill, includes a proposed $201,700 civil penalty to be paid by the Chemical Business. The proposed penalty of $201,700 includes $125,000 which previously was agreed could be paid under the Inspection Consent Order in the form of environmental improvements at the El Dorado Facility. The proposed consent administrative order is attempting to require the Chemical Business to pay, in cash, the $125,000 in lieu of allowing the $125,000 to be paid in the form of improvements at the El Dorado Facility as provided in the Inspection Consent Order. The Company believes that the proposed civil penalty is excessive and intends to seek a reduction to such and to allow the Chemical Business to use the $125,000 of the proposed $201,700 penalty in the manner originally provided for in the Inspection Consent Order. The draft of the proposed consent administrative order also requires the Chemical Business to undertake certain additional compliance measures and equipment improvements related to the El Dorado Facility's wastewater treatment system over the next four years. However, in a letter dated March 5, 1998, the U. S. Environmental Protection Agency ("EPA") advised the ADPC&E that the four year time period allowed in the proposed consent administrative order for completion of the additional compliance measures and modifications to the El Dorado Facility's wastewater treatment system may be excessive and has requested further information from the ADPC&E regarding the compliance and modifications. The proposed consent administrative order provides for penalties to be paid by the Chemical Business if it fails to meet any requirements of the proposed order, with such penalties ranging from $500 per day to $2,500 per day depending on the number of days that the Chemical Business is not in compliance with such order. Although the Company does not believe the proposed consent administrative order, if completed, will have a material adverse effect on the Company's business, there can be no assurance that penalties and required expenditures related to the order will not have such an effect. See "Special Note Regarding Forward-Looking Statements." The proposed consent administrative order purports to supersede the Inspection Consent Order. If the proposed consent administrative order is completed in its present form, then, to the extent that the requirements of the proposed consent administrative order have been previously satisfied by the Company (under the Inspection Consent Order or otherwise), the requirements of the proposed consent administrative order will be deemed satisfied upon approval by the ADPC&E. Any consent administrative order settling the spill of nitric acid is subject to final negotiations and finalization of a definitive order. The El Dorado Facility's air permit required it to cease operation of certain older nitric acid concentrators (the "Older Nitric Acid Concentrators") within a certain period of time after the initiation of operations of the DSN Plant. Due to certain start-up problems with the DSN Plant, including excess emissions from various emission sources, the Chemical Business and the ADPC&E entered into certain agreements, including an administrative consent order (the "Air Consent Order") in 1995 to resolve certain of the Chemical Business' past violations and to permit the Chemical Business to operate the Older Nitric Acid Concentrators until the ADPC&E has made a final decision regarding the El Dorado Facility's air permit, including whether the Older Nitric Acid Concentrators may continue to operate. Although the Company expects that the Chemical Business will be able to continue to operate the Older Nitric Acid Concentrators, there can be no assurance that the ADPC&E will allow it to continue to do so. The Air Consent Order also provides for payment of a civil penalty of $50,000, which the Chemical Business has paid, and requires installation of certain pollution control equipment and completion of certain maintenance activities at the El Dorado Facility to eliminate certain off-site hazing problems. The Air Consent Order was amended in 1996 and 1997. The second amendment to the Air Consent Order (the "1997 Amendment") provided for certain stipulated penalties of $1,000 per hour to $10,000 per day for continued off-site emission events and deferred enforcement for other alleged air permit violations. The 1997 Amendment acknowledges that the Chemical Business has completed the installation of the pollution control equipment and maintenance activities required under the Air Consent Order. Nonetheless, the Chemical Business was assessed an additional penalty of $150,000, as well as a payment of an additional $50,000 to fund certain environmental projects, with respect to a number of alleged permit violations relating to off-site emissions and other air permit conditions. The Chemical Business has paid both the penalty and the additional sums required by the 1997 Amendment. Since the 1997 Amendment and as of the date of this Prospectus, the Chemical Business has been assessed stipulated penalties of approximately $67,000 by the ADPC&E for violations of certain provisions of the 1997 Amendment. The Chemical Business believes that the El Dorado Facility has made progress in controlling certain off-site emissions; however, such off-site emissions have occurred, and continue to occur, from time to time, which could result in the assessment of additional penalties against the Chemical Business by the ADPC&E and could have a material adverse effect on the Company. In addition, the El Dorado Facility was identified as one of 33 significant violators of the federal Clean Air Act in a recent review of Arkansas air programs by the EPA Office of Inspector General. The Company is unable to predict the impact, if any, of such designation. See "Special Note Regarding Forward-Looking Statements." During 1996, the Chemical Business expended approximately $6.8 million in connection with capital expenditures relating to compliance with federal, state and local Environmental Laws at its El Dorado Facility, including, but not limited to, compliance with the Air Consent Order, as amended. During 1997, the Chemical Business spent approximately $1.1 million for capital expenditures relating to environmental control facilities at its El Dorado Facility to comply with Environmental Laws, including, but not limited to, the Air Consent Order, as amended, and it is anticipated that such expenditures will total approximately $0.9 million for 1998 (excluding the implementation of any recommendations made in the Audit Report, as defined under "Legal Proceedings"). No assurance can be made that the actual expenditures of the Chemical Business for such matters will not exceed the estimated amounts by a substantial margin, which could have a material adverse effect on the Company and its financial condition. The amount to be spent during 1998 for capital expenditures related to compliance with Environmental Laws is dependent upon a variety of factors, including, but not limited to, the occurrence of additional releases or threatened releases (particularly air emissions) into the environment, or changes in the Environmental Laws (or in the enforcement or interpretation by any federal or state agency or court of competent jurisdiction). See "Special Note Regarding Forward-Looking Statements." Failure to satisfactorily resolve the pending noncompliance issues with the ADPC&E, or additional orders from the ADPC&E imposing penalties, or requiring the Chemical Business to spend more for environmental improvements or curtail production activities at the El Dorado Facility, could have a material adverse effect on the Company. The Chemical Business is also involved in various lawsuits pending in federal court relating to environmental issues at the El Dorado Facility similar to the environmental issues discussed above and covered by the Air Consent Order, as amended, with the ADPC&E. The amounts to be spent during 1998, as discussed herein, for compliance with applicable federal, state and local Environmental Laws at the El Dorado Facility do not include expenditures, if any, that may be required to comply with any court order resulting from such lawsuits. See "Business - Legal Proceedings. YEAR 2000 ISSUES Historically, most computer programs have been written using two digits rather than four to define the applicable year. Any of the Company's programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This, in turn, could result in major system failures or miscalculations and is generally referred to as the "Year 2000" problem. The Company recognizes the need to ensure its operations will not be adversely impacted by the Year 2000 software problem. Starting in 1996 the Company began the process of identifying the changes required to their computer systems to make them Year 2000 compliant. The Company conducted a comprehensive review to identify the systems that could be affected by the Year 2000 problem and developed an implementation plan to address the problem. The Company expects its Year 2000 date implementation plan to be completed by the end of 1998. During the execution of its implementation plan the Company will incur internal staff costs as well as consulting and other expenses related to modifications necessary to prepare the systems for the year 2000. The Company does not anticipate that the Year 2000 problem will pose any significant operational problems or that the expenses incurred will have a material impact on its financial position or results of operation. However, if the modifications and conversions are not completed timely by the Company or its major material and service providers, the Year 2000 problem may have a material impact on the operations of the Company. In addition, the Company has sent to their major material and service providers questionnaires as to whether they are making, or have made, the necessary changes to their computer programs as to the Year 2000 issues. The Company has not received responses to these questionnaires from all of their major material and service providers as of the date of this report. As a result, the Company is unable to determine whether its major material and service providers will have made the necessary modifications in order to comply with the Year 2000 issues or whether such failure to make such modifications will have a material adverse effect on the Company. See "Special Note Regarding Forward-Looking Statements". ITEM 2. PROPERTIES CHEMICAL BUSINESS The Chemical Business primarily conducts manufacturing operations (i) on 150 acres of a 1,400 acre tract of land located in El Dorado, Arkansas (the "El Dorado Facility"), (ii) in a facility of approximately 60,000 square feet located on ten acres of land in Hallowell, Kansas ("Kansas Facility") and (iii) in a mixed acid plant in Wilmington, North Carolina ("Wilmington Plant"). The Chemical Business owns all of its manufacturing facilities, with the El Dorado Facility and the Wilmington Plant subject to mortgages. In addition, the Chemical Business has four manufacturing facilities in Australia and one in New Zealand that produce bulk and packaged explosives. As of December 31, 1997, the El Dorado Facility was utilized at approximately 78% of capacity, based on continuous operation. The Chemical Business operates its Kansas Facility from buildings located on an approximate ten acre site in southeastern Kansas, and a research and testing facility comprising approximately ten acres, including buildings and equipment thereon, located in southeastern Kansas, which it owns. In addition, the Chemical Business distributes its products through 31 agricultural and explosive distribution centers. The Chemical Business currently operates 21 agricultural distribution centers, with 15 of the centers located in Texas (12 of which the Company owns and three of which it leases); one center located in Oklahoma which the Company owns; two centers located in Missouri (one of which the Company owns and one of which it leases); and three centers located in Tennessee (all of which the company owns). The Chemical Business currently operates six domestic explosives distribution centers located in Hallowell, Kansas (owned); Bonne Terre, Missouri (owned); Poca, West Virginia (leased); Owensboro and Combs, Kentucky (leased); and Pryor, Oklahoma (leased). The Chemical Business also has four explosives distribution centers in Australia, all of which are leased, and one explosives distribution center located in New Zealand, which is leased. CLIMATE CONTROL BUSINESS The Climate Control Business conducts its fan coil manufacturing operations in a facility located in Oklahoma City, Oklahoma, consisting of approximately 265,000 square feet. The Company owns this facility subject to a mortgage. As of December 31, 1997, the Climate Control Business was using the productive capacity of the above referenced facilities to the extent of approximately 92%, based on three, eight-hour shifts per day and a five-day week in one department and one and one half eight-hour shifts per day and a five-day week in all other departments. The Climate Control Business manufactures most of its heat pump products in a leased 270,000 square foot facility in Oklahoma City, Oklahoma, which it leases from an unrelated party. The lease term began March 1, 1988, after renewal in October 1997, and expires February 28, 2003, with options to renew for additional five-year periods, and currently provides for the payment of rent in the amount of $52,389 per month. The Company also has an option to acquire the facility at any time in return for the assumption of the then outstanding balance of the lessor's mortgage. As of December 31, 1997, the productive capacity of this manufacturing operation was being utilized to the extent of approximately 75%, based on two twelve-hour shifts per day and a seven-day week in one department and one eight-hour shift per day and a five- day week in all other departments. All of the properties utilized by the Climate Control Business are considered by the Company management to be suitable and adequate to meet the current needs of that Business. AUTOMOTIVE PRODUCTS BUSINESS The Automotive Products Business conducts its operations in plant facilities principally located in Oklahoma City, Oklahoma which are considered by Company management to be suitable and adequate to meet its needs. One of the manufacturing facilities occupies a building owned by the Company, subject to mortgages, totaling approximately 178,000 square feet. The Automotive Products Business also uses additional manufacturing facilities located in Oklahoma City, Oklahoma, owned and leased by the Company totaling approximately 158,000 square feet. During 1997, the Automotive Products Business under utilized the productive capacity of its facilities. International Bearings, Inc. ("IBI"), a subsidiary of the Company operating as a separate entity within the Automotive Products Division, operates from a Company owned warehouse of approximately 45,000 square feet in an industrial park section of Memphis, Tennessee. INDUSTRIAL PRODUCTS BUSINESS The Company owns several buildings, some of which are subject to mortgages, totaling approximately 360,000 square feet located in Oklahoma City and Tulsa, Oklahoma, which the Industrial Products Business uses for showrooms, offices, warehouse and manufacturing facilities. The Company also owns real property located near or adjacent to the above-referenced buildings in Oklahoma City, Oklahoma, which the Industrial Products Business uses for parking and storage. The Company also leases facilities in Middletown, New York containing approximately 25,000 square feet for manufacturing operations. The Industrial Products Business also leases a facility from an entity owned by the immediate family of the Company's President, which facility occupies approximately seven acres in Oklahoma City, Oklahoma, with buildings having approximately 44,000 square feet. The Industrial Products Business also leases an office in Europe to coordinate its European activities. All of the properties utilized by the Industrial Products Business are considered by Company management to be suitable and adequate to meet the needs of the Industrial Products Business. ITEM 3. LEGAL PROCEEDINGS In 1987, the U.S. Environmental Protection Agency ("EPA") notified one of the Company's subsidiaries, along with numerous other companies, of potential responsibility for clean-up of a waste disposal site in Oklahoma. In 1990, the EPA added the site to the National Priorities List. Following the remedial investigation and feasibility study, in 1992 the Regional Administrator of the EPA signed the Record of Decision ("ROD") for the site. The ROD detailed EPA's selected remedial action for the site and estimated the cost of the remedy at $3.6 million. In 1992, the Company made settlement proposals which would have entailed a collective payment by the subsidiaries of $47,000. The site owner rejected this offer and proposed a counteroffer of $245,000 plus a reopener for costs over $12.5 million. The EPA rejected the Company's offer, allocating 60% of the cleanup costs to the potentially responsible parties and 40% to the site operator. The EPA estimated the total cleanup costs at $10.1 million as of February 1993. The site owner rejected all settlements with the EPA, after which the EPA issued an order to the site owner to conduct the remedial design/remedial action approved for the site. In August 1997, the site owner issued an "invitation to settle" to various parties, alleging the total cleanup costs at the site may exceed $22 million. No legal action has yet been filed. The amount of the Company's cost associated with the cleanup of the site is unknown due to continuing changes in the estimated total cost of cleanup of the site and the percentage of the total waste which was alleged to have been contributed to the site by the Company. As of December 31, 1997, the Company has accrued an amount based on a recent preliminary settlement proposal by the alleged potential responsible parties; however, there is no assurance such proposal will be accepted. Such amount is not material to the Company's financial position or results of operations. This estimate is subject to material change in the near term as additional information is obtained. The subsidiary's insurance carriers have been notified of this matter; however, the amount of possible coverage, if any, is not yet determinable. Roy Carr, et al. v. El Dorado Chemical Company ("Carr Case"); Richard Detraz, et al. v. El Dorado Chemical Company ("Detraz Case"); Roy A. Carr, Sr., et al. v. El Dorado Chemical Company ("Citizen Suit"). The Carr Case, which was filed against EDC on June 26, 1996, the Detraz Case, which was filed against EDC on October 14, 1996, and the Citizen Suit, which was filed against EDC on October 17, 1996, are pending in the United States District Court, Western District of Arkansas, El Dorado Division. The plaintiffs in the Carr Case and the Citizen Suit reside in the area surrounding EDC's El Dorado Facility, while the plaintiffs in the Detraz Case reside in various locations throughout the El Dorado, Arkansas, metropolitan area. Because the parties to the Carr Case and the Citizen Suit are substantially the same, and the cases allege similar facts, the court consolidated these two cases, although they are based on different legal theories. The plaintiffs in the Citizen Suit allege violations of the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), as amended by the Emergency Planning Community Right-To-Know Act ("EPCRA"), the Clean Air Act and the Clean Water Act, and permits issued to EDC under certain of these laws. Under the terms of such laws, the plaintiffs in the Citizen Suit are seeking penalties of up to $25,000 for each day in which EDC violated such acts, if any, and injunctive relief requiring EDC to remediate any such alleged violations and relating to future violations. The plaintiffs in the Carr Case seek an unspecified amount of damages under various toxic tort theories for alleged bodily injury and property damage resulting from alleged releases of toxic substances into the environment from the El Dorado Facility, as well as punitive damages and damages for any diminution in the value of plaintiffs' property resulting from the alleged releases. The Detraz Case, like the Carr Case, is based on various toxic tort theories. The plaintiffs in the Detraz Case are seeking to have the case certified as a class action for persons who allegedly have been affected by emissions from the El Dorado Facility, which certification EDC is contesting. During the first quarter of 1998, the Company's Chemical Business agreed in principal to settle the Carr Case, Detraz Case and Citizen Suit. The settlements of the Carr Case and the Detraz Case, if completed, will require certain payments to be made to the plaintiffs, which payments will be funded primarily by the Company's EIL Insurance (as defined below). The settlement of the Citizen Suit, if completed, will require the Company's Chemical Business to implement at the El Dorado Facility and at the Company's expense the reasonable and necessary environmentally related recommendations made in the Audit Report discussed and defined below in connection with the Carr Case. Based on what the Company has been orally advised by the environmental engineering firm performing the evaluation, the Company does not believe that the implementation of such recommendations, if any, will have a material adverse effect on the Company. See "Special Note Regarding Forward- Looking Statements." The settlement in the Carr Case, Detraz Case and Citizen Suit are subject to finalization of definitive settlement agreements. The settlement of the Detraz Case will be subject, among other things, to court approval, while the settlement of the Citizen Suit will be subject, among other things, to approval by the court or the United States Environmental Protection Agency. In January 1997, EDC entered into an agreed order (the "Carr Order") in the Carr Case pursuant to which EDC agreed (i) not to emit substances from the El Dorado Facility which create a nuisance on the plaintiffs' property (as defined in the Carr Order to include any off-site haze that reaches the plaintiffs' property), (ii) to operate in compliance with emission limitations and certain other requirements established by EDC's permit for the El Dorado Facility, (iii) to establish a system for monitoring and reporting (including to the plaintiffs) permit exceedences and releases of reportable quantities of hazardous substances. The Carr Order further provides that the court shall retain jurisdiction of the issues covered by the Carr Order for the purposes of enabling the parties in the Carr Case to apply to the court for any order that may be necessary to interpret, carry out, modify or enforce the Carr Order. In connection with the Carr Order, the plaintiffs have filed two motions for contempt against EDC for violations, or alleged violations, of the Carr Order. On one occasion, the court held that EDC had created a nuisance at the property of one of the plaintiffs as a result of certain emissions from the El Dorado Facility and assessed a $500 penalty against EDC and ordered EDC to pay plaintiffs' attorneys' fees in connection with bringing such motion. The plaintiffs in the Carr Case withdrew the other motion for contempt pending an audit of the operation of the El Dorado Facility. The parties to the Carr Case entered into an audit agreement to evaluate facility operations and emissions by an environmental engineering firm, which environmental engineering firm has issued an audit report as to its findings ("Audit Report"). Other incidents have occurred or may occur in the future which could, if the Carr Case is not settled as discussed above, give rise to the filing of additional motions for contempt alleging violations of the Carr Order, and, if the Company is found to have violated the Carr Order, it could result in the possible assessment of additional fines, penalties and costs against EDC that could have a material adverse effect on the Company and/or the Chemical Business. See "Special Note Regarding Forward-Looking Statements." If the Carr Case is settled as discussed above, then the Carr Order would be terminated as part of such settlement. The Chemical Business maintains an Environmental Impairment Insurance Policy ("EIL Insurance") that provides coverage to the Chemical Business for certain discharges, dispersal, releases, or escapes of certain contaminants and pollutants into or upon land, the atmosphere or any water course or body of water from the El Dorado Facility, which has caused bodily injury, property damage or contamination to others or to other property not located on the El Dorado Facility site. The EIL Insurance provides limits of liability for each loss up to $10 million, except $5 million for all remediation expenses, with the maximum limit of liability for all claims under the EIL Insurance not to exceed $10 million for all losses and remediation expenses. The EIL Insurance also provides for a retention of the first $500,000 per loss or remediation expense to be paid by the Chemical Business. The Chemical Business has given notice of the pending legal actions in the Carr Case, the Detraz Case and the Citizen Suit to the EIL Insurance carrier ("EIL Carrier"), and the EIL Carrier has agreed to provide a defense for the Company in each case. The defense regarding the Citizen Suit has been undertaken by the EIL Carrier subject to a reservation of rights, indicating that the EIL Carrier may make a determination that it does not believe that any liability in the Citizen Suit is covered by the EIL Insurance, and, on that basis, deny coverage regarding the Citizens Suit and seek reimbursement of its related legal expenditures paid in connection with the Citizen Suit. The Company believes that the EIL Insurance will provide coverage for actual damages, if any, sustained by the plaintiffs in the Carr Case and the Detraz Case up to the limits of the policy in excess of the $500,000 retention, but will not provide coverage for punitive damages, and may not provide coverage for the costs of injunctive relief and penalties resulting from the litigation. As of January 26, 1998, the Company had submitted claims to the EIL Carrier of approximately $1.2 million for legal and consulting fees and expenses, or approximately $700,000 in excess of the self-insured retention. The EIL Carrier has reimbursed the Chemical Business for $405,000 of such fees and expenses (after taking into account the amount of the retention under the EIL Insurance) and has agreed to pay such future fees and expenses, subject to reservation of rights relating to the Citizen Suit. The amount of the settlements of the Carr Case and the Detraz Case, if completed, and the amount paid under the EIL Insurance for legal and other expenses relating to the defense of the Carr Case, Detraz Case and Citizen Suit reduce the amount that may be paid under the EIL Insurance. Arch Mineral Corporation, et al. v. ICI Explosives USA, Inc., et al. On May 24, 1996, the plaintiffs filed this civil cause of action against EDC and five other unrelated commercial explosives manufacturers alleging that the defendants allegedly violated certain federal and state antitrust laws in connection with alleged price fixing of certain explosive products. This cause of action is pending in the United States District Court, Southern District of Indiana. The plaintiffs are suing for an unspecified amount of damages, which, pursuant to statute, plaintiffs are seeking be trebled, together with costs. Plaintiffs are also seeking a permanent injunction enjoining defendants from further alleged anti-competitive activities. Based on the information presently available to EDC, EDC does not believe that EDC conspired with any party, including, but not limited to, the five other defendants, to fix prices in connection with the sale of commercial explosives. Discovery has only recently commenced in this matter. EDC intends to vigorously defend itself in this matter. See "Special Note Regarding Forward-Looking Statements." ASARCO v. ICI, et al. The U. S. District Court for the Eastern District of Missouri has granted ASARCO and other plaintiffs in a lawsuit originally brought against various commercial explosives manufacturers in Missouri, and consolidated with other lawsuits in Utah, leave to add EDC as a defendant in that lawsuit. This lawsuit alleges a national conspiracy, as well as a regional conspiracy, directed against explosive customers in Missouri and seeks unspecified damages. EDC has been included in this lawsuit because it sold products to customers in Missouri during a time in which other defendants have admitted to participating in an antitrust conspiracy, and because it has been sued in the Arch case discussed above. Based on the information presently available to EDC, EDC does not believe that EDC conspired with any party, to fix prices in connection with the sale of commercial explosives. EDC intends to vigorously defend itself in this matter. See "Special Note Regarding Forward-Looking Statements." Department of Justice Investigation of Explosives Industry. For several years, certain members of the explosives industry have been the focus of grand jury investigations being conducted by the DOJ in connection with criminal antitrust allegations involving price fixing. Certain explosives companies, other than the Company, including all the Company's major competitors, and individuals employed by certain of those competitors, were indicted and have pled guilty to criminal antitrust violations. The guilty pleas have resulted in a total of nearly $40 million in criminal fines. In connection with the grand jury investigation, the Company's Chemical Business received and has complied with two document subpoenas, certain of the Company's Chemical Business employees have been interviewed by the DOJ under grants of immunity from prosecution, and certain of the Company's Chemical Business employees have testified under subpoena before a grand jury under grants of immunity in connection with the investigation. The Company believes that it has cooperated fully with the government's investigation. Recently, the Company had been informed by an official of the DOJ that it was not currently a target of the above investigation or of any grand jury investigating criminal antitrust activity in the explosives or ammonium nitrate industries. See "Special Note Regarding Forward-Looking Statements." Eugene Lowe, et al. v. Teresa Trucking, Inc., pending in the Circuit Court of Lincoln County, West Virginia. During the third quarter of 1997, EDC was served with this lawsuit in which approximately 27 plaintiffs have sued approximately 13 defendants, including EDC, alleging personal injury and property damage for undifferentiated compensatory and punitive damages of approximately $7,000,000. Specifically, the plaintiffs assert blast damage claims, nuisance (road dust from coal trucks) and personal injury claims (exposure to toxic materials in blasting materials) on behalf of residents living near the Heartland Coal Company ("Heartland") strip mine in Lincoln County, West Virginia. Heartland employed EDC to provide blasting materials and personnel to load and shoot holes drilled by employees of Heartland. Down hole blasting services were provided by EDC at Heartland's premises from approximately August 1991, until approximately August 1994. Subsequent to August 1994, EDC supplied blasting materials to the reclamation contractor at Heartland's mine. In connection with EDC's activities at Heartland, EDC has entered into a contractual indemnity to Heartland to indemnify Heartland under certain conditions for acts or actions taken by EDC or for which EDC failed to take, and Heartland is alleging that EDC is liable thereunder for Heartland's defense costs and any losses to, or damages sustained by, the plaintiffs in this lawsuit. Discovery has only recently begun in this matter, and the Company intends to vigorously defend itself in this matter. EDC has provided notification of this lawsuit to its three insurance carriers providing primary insurance coverage to EDC during the period covered by the plaintiff's allegations. The one insurance carrier whose policy provides for defense has indicated it will share in the defense of this lawsuit. The remaining two insurance carriers have indicated that they will be defending this lawsuit under a reservation of rights. Based on information provided to EDC by its counsel handling this matter, the Company does not believe that this matter will have a material adverse effect on the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 4A. EXECUTIVE OFFICERS OF THE COMPANY IDENTIFICATION OF EXECUTIVE OFFICERS The following table identifies the executive officers of the Company. Position and Served as Offices with an Officer Name Age the Company from Jack E. Golsen 69 Board Chairman December, 1968 and President Barry H. Golsen 47 Board Vice Chairman August, 1981 and President of the Environmental Control Business David R. Goss 57 Senior Vice March, 1969 President of Operations and Director Tony M. Shelby 56 Senior Vice March, 1969 President - Chief Financial Officer, and Director Jim D. Jones 56 Vice President - April, 1977 Treasurer and Corporate Controller David M. Shear 38 Vice President and March, 1990 General Counsel The Company's officers serve one-year terms, renewable on an annual basis by the Board of Directors. All of the individuals listed above have served in substantially the same capacity with the Company and/or its subsidiaries for the last five years. In March 1996, the Company executed an employment agreement (the "Agreement") with Jack E. Golsen for an initial term of three years followed by two additional three year terms. The Agreement automatically renews for each successive three year term unless terminated by either the Company or Jack E. Golsen giving written notice at least one year prior to the expiration of the then three year term. FAMILY RELATIONSHIPS The only family relationship that exists among the executive officers of the Company is that Jack E. Golsen is the father of Barry H. Golsen. PART II ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION The Company's Common Stock trades on the New York Stock Exchange, Inc. ("NYSE"). The following table shows, for the periods indicated, the high and low closing sales prices for the Company's Common Stock. <TABLE> <CAPTION> Fiscal Year Ended December 31, 1997 1996 Quarter High Low High Low <S> <C> <C> <C> <C> First 5 1/4 4 1/8 6 3/8 3 1/2 Second 5 4 6 1/4 4 5/8 Third 5 3 5/8 5 1/8 3 1/2 Fourth 5 13/16 3 5/8 5 3 1/2 </TABLE> STOCKHOLDERS As of February 28, 1998, the Company had 1,058 record holders of its Common Stock. DIVIDENDS Holders of the Company's Common Stock are entitled to receive dividends only when, as, and if declared by the Board of Directors. No dividends may be paid on the Company's Common Stock until all required dividends are paid on the outstanding shares of the Company's Preferred Stock, or declared and amounts set apart for the current period, and, if cumulative, prior periods. The Company has issued and outstanding as of December 31, 1997, 915,000 shares of $3.25 Convertible Exchangeable Class C Preferred Stock, Series 2 ("Series 2 Preferred"), 1,539 shares of a series of Convertible Non Cumulative Preferred Stock ("Non Cumulative Preferred Stock") and 20,000 shares of Series B 12% Convertible, Cumulative Preferred Stock ("Series B Preferred"). Each share of Preferred Stock is entitled to receive an annual dividend, if, as and when declared by the Board of Directors, payable as follows: (i) Series 2 Preferred at the rate of $3.25 a share payable quarterly in arrears on March 15, June 15, September 15 and December 15, which dividend is cumulative, (ii) Non Cumulative Preferred Stock at the rate of $10.00 a share payable April 1, and (iii) Series B Preferred at the rate of $12.00 a share payable January 1, which dividend is cumulative. The Company has a policy as to the payment of annual cash dividends on its outstanding Common Stock of $.06 per share, payable at $.03 per share semiannually, subject to change or termination by the Board of Directors at any time. The Company paid a cash dividend of $.03 a share on its outstanding Common Stock on July 1, 1997, and January 1, 1998; however, there are no assurances that this policy will not be terminated or changed by the Board of Directors. See Notes 8, 9 and 10 of Notes to Consolidated Financial Statements. Under the terms of a loan agreement between the Company and its lender, the Company may, so long as no event of default has occurred and is continuing under the loan agreement, make currently scheduled dividends and pay dividends on its outstanding Preferred Stock and pay annual dividends on its Common Stock equal to $.06 per share. See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of the financial covenants which the Company's failure to maintain could result in an event of default. In addition, the loan agreement with the lender includes as an event of default an ownership change if any Person (except Jack E. Golsen or members of his Immediate Family and any entity controlled by Jack E. Golsen or members of his Immediate Family together with such Person's affiliates and associates), is or becomes the beneficial owner, directly or indirectly, of more than fifty percent (50%) of the outstanding Common Stock of the Company. The term "Immediate Family" of any Person means the spouse, siblings, children, mothers and mothers-in-law, fathers and fathers-in-law, sons and daughters-in-law, daughters and sons-in-law, nieces, nephews, brothers and sisters-in-law, and sisters and brothers-in-law. The Company is a holding company and, accordingly, its ability to pay dividends on its Preferred Stock and its Common Stock is dependent in large part on its ability to obtain funds from its subsidiaries. The ability of ClimaChem and its wholly owned subsidiaries to pay dividends to the Company, to fund the payment of dividends by the Company, or for other purposes, is restricted by certain covenants contained in the Indenture to which they are parties. Under the terms of the Indenture, ClimaChem cannot transfer funds to the Company in the form of cash dividends or other distributions or advances, except for (i) the amount of taxes that ClimaChem would be required to pay if they were not consolidated with the Company and (ii) an amount not to exceed fifty percent (50%) of ClimaChem's net income for the year in question and (iii) the amount of direct and indirect costs and expenses incurred by the Company on behalf of ClimaChem pursuant to a certain services agreement and a certain management agreement to which ClimaChem and the Company are parties. See Note 5 of Notes to Consolidated Financial Statements and Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations". On February 17, 1989, the Company's Board of Directors declared a dividend to its stockholders of record on February 27, 1989, of one Preferred Stock purchase right on each of the Company's outstanding shares of Common Stock. The rights expire on February 27, 1999. The Company issued the rights, among other reasons, in order to assure that all of the Company's stockholders receive fair and equal treatment in the event of any proposed takeover of the Company and to guard against partial tender abusive tactics to gain control of the Company. The rights will become exercisable only if a person or group acquires beneficial ownership of 30% or more of the Company's Common Stock or announces a tender or exchange offer the consummation of which would result in the ownership by a person or group of 30% or more of the Common Stock, except any acquisition by Jack E. Golsen, Chairman of the Board and President of the Company, and certain other related persons or entities. Each right (other than the rights, owned by the acquiring person or members of a group that causes the rights to become exercisable, which became void) will entitle the stockholder to buy one one-hundredth of a share of a new series of participating Preferred Stock at an exercise price of $14.00 per share. Each one one-hundredth of a share of the new Preferred Stock purchasable upon the exercise of a right has economic terms designed to approximate the value of one share of the Company's Common Stock. If another person or group acquires the Company in a merger or other business combination transaction, each right will entitle its holder (other than rights owned by that person or group, which become void) to purchase at the right's then current exercise price, a number of the acquiring company's common shares which at the time of such transaction would have a market value two times the exercise price of the right. In addition, if a person or group (with certain exceptions) acquires 30% or more of the Company's outstanding Common Stock, each right will entitle its holder, (other than the rights owned by the acquiring person or members of the group that results in the rights becoming exercisable, which become void), to purchase at the right's then current exercise price, a number of shares of the Company's Common Stock having a market value of twice the right's exercise price in lieu of the new Preferred Stock. Following the acquisition by a person or group of beneficial ownership of 30% or more of the Company's outstanding Common Stock (with certain exceptions) and prior to an acquisition of 50% or more of the Company's Common Stock by the person or group, the Board of Directors may exchange the rights (other than rights owned by the acquiring person or members of the group that results in the rights becoming exercisable, which become void), in whole or in part, for shares of the Company's Common Stock. That exchange would occur at an exchange ratio of one share of Common Stock, or one one-hundredth of a share of the new series of participating Preferred Stock, per right. Prior to the acquisition by a person or group of beneficial ownership of 30% or more of the Company's Common Stock (with certain exceptions) the Company may redeem the rights for one cent per right at the option of the Company's Board of Directors. The Company's Board of Directors also has the authority to reduce the 30% thresholds to not less than 10%. During 1997, the following securities were sold by the Company in transactions not registered under the Securities Act of 1933, as amended ("Securities Act"): 1. Common Stock sold pursuant to the exercise of Non-Qualified Stock Options; (a) On May 29, 1997, 15,000 shares of Common Stock were sold by the Company to Dr. Robert C. Brown, a director of the Company, in connection with the exercise of a Non-Qualified Stock Option Agreement granted to Dr. Brown on June 1, 1992. The exercise price paid by Dr. Brown was $3.125 per share, being the fair market value of such stock on the date of grant of the Non-Qualified Stock Option. (b) On May 29, 1997, 15,000 shares of Common Stock were sold by the Company to Bernard Ille, a director of the Company, upon the exercise of a Non-Qualified Stock Option Agreement granted to Mr. Ille on June 1, 1992. The exercise price paid by Mr. Ille was $3.125 per share, being the fair market value of such stock on the date of grant of the Non- Qualified Option. (c) On May 29, 1997, 5,000 shares of Common Stock were sold by the Company to Dr. Jerome Shaffer, a director of the Company, upon the exercise of a Non-Qualified Stock Option Agreement, granted to Dr. Shaffer on June 1, 1992. The exercise price paid by Dr. Shaffer was $3.125 per share, being the fair market value of such stock on the date of grant of the Non-Qualified Option. (d) The shares of Common Stock sold to Drs. Brown and Shaffer and Mr. Ille described in (a), (b), and (c) above exempt from registration under Section 4(2) of the Securities Act since Drs. Brown and Shaffer and Mr. Ille are members of the Board of Directors of the Company. 2. On November 26, 1997, the Company's wholly owned subsidiary, ClimaChem, Inc., ("ClimaChem"), sold $105 million of senior notes due 2007 (the "Notes") in a transaction exempt from registration under Section 4(2) of the Securities Act. The Notes were sold by ClimaChem to Wasserstein Perella Securities, Inc., (the "initial Purchaser"), and the Initial Purchaser resold the Notes to qualified institutional buyers in reliance on Rule 144A under the Securities Act. The $105 million in Notes were sold by ClimaChem to the Initial Purchaser at a discount or commission of 3.000% or an aggregate discount or commission of $3,150,000. ITEM 6. SELECTED FINANCIAL DATA <TABLE> <CAPTION> Years ended December 31, ------------------------------------------- 1997 1996 1995 1994 1993 ----- ----- ----- ----- ----- <S> <C> <C> <C> <C> <C> (Dollars in Thousands, except per share data) Selected Statement of Operations Data: Net sales $313,929 $307,160 $267,391 $245,025 $232,616 ======== ======== ======== ======== ======== Total Revenues $320,189 $314,051 $274,115 $249,969 $237,529 ======== ======== ======== ======== ======== Interest expense $ 14,740 $ 10,017 $ 10,131 $ 6,949 $ 7,507 ======== ======== ======== ======== ======== Income (loss) from continuing operations before extraordinary charge $(18,446) $(3,845) $ (3,732) $ 983 $ 11,235 ======== ======== ========= ======== ======== Net income (loss) $(23,065) $ (3,845) $(3,732) $ 24,467 $ 12,399 ======== ========= ======== ======== ======== Net income (loss) applicable to common stock $(26,294) $ (7,074) $(6,961) $ 21,232 $10,357 ========= ========= ======== ======== ======= Basic earnings (loss) per common share (1): Income (loss) from continuing operations before extraordinary charge $ (1.68) $ (.55) $ (.53) $ (.17) $ .77 ========= ======== ======== ======== ======== Net income (loss) $ (2.04) $ (.55) $ (.53) $ 1.57 $ .87 ========= ======== ======== ======== ======== </TABLE> (1) Diluted earnings per common share related to income from continuing operations and net income were $.66 and $.74 in 1993, respectively. 29 <TABLE> <CAPTION> ITEM 6. SELECTED FINANCIAL DATA (CONTINUED) Years ended December 31, -------------------------------------------- 1997 1996 1995 1994 1993 <S> <C> <C> <C> <C> <C> (Dollars in Thousands, except per share data) Selected Balance Sheet Data: Total Assets $270,653 $261,560 $238,176 $221,281 $196,038 ======= ======= ======= ======= ======= Long-term debt, including current portion $180,941 $132,284 $118,280 $ 91,681 $ 90,395 ======= ======= ======= ====== ====== Redeemable preferred stock $ 146 $ 146 $ 149 $ 152 $ 155 ======= ======= ======= ======= ======= Stockholders' Equity $ 44,496 $ 74,018 $ 81,576 $ 90,599 $74,871 ======= ======= ======= ======= ====== Selected other Data: Cash dividends declared per common share $ .06 $ .06 $ .06 $ .06 $ .06 ======= ======= ======= ======= ===== </TABLE> ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with a review of the Company's December 31, 1997 Consolidated Financial Statements, Item 6 "SELECTED FINANCIAL DATA" and Item 1 "BUSINESS" included elsewhere in this report. Certain Statements contained in this "Management's Discussion and Analysis of Financial Conditions and Results of Operations" may be deemed forward-looking statements. See "Special Note Regarding Forward-Looking Statements". OVERVIEW The Company is pursuing a strategy of focusing on its more profitable businesses and concentrating on businesses and product lines in niche markets where the Company has established or can establish a position as a market leader. In addition, the Company is seeking to improve its liquidity and profits through liquidation of selected assets that are on its balance sheet and on which it is not realizing an acceptable return nor does it have the potential to do so. In this connection, the Company is developing a plan, subject to the approval of the Board of Directors, to dispose of all non-core and/or non-earning assets. The Company has been concentrating on reshaping the Automotive Products Business by the liquidation of certain of their assets that don't have the potential to earn an acceptable return and focusing on product lines that management believes have strategic advantages within select niche markets. The Company continues to explore its alternatives to accomplish these goals. In addition, the Company has been liquidating certain slow moving inventory in the Industrial Products Business in the ordinary course of business. It is the present intention of the Company to limit this Business to lines of machine tools which should result in an acceptable return on capital employed. Certain statements contained in this Overview are forward-looking statements, and the results thereof could differ materially from such statements if the Company is unable to liquidate such assets in a reasonable period or on reasonable terms, and if able to liquidate such assets, it may not be able to improve profits in the Automotive Products Business or have an acceptable return on capital employed in these Businesses if general economic conditions deteriorate drastically from the environment these Businesses currently operate in or these Businesses are unable to meet competitive pressures in the market place which restrict these Businesses from manufacturing or purchasing and selling their products at acceptable prices. The following table contains certain of the information from Note 13 of Notes to the Company's Consolidated Financial Statements about the Company's operations in different industry segments for each of the three years in the period ended December 31, 1997. <TABLE> <CAPTION> 1997 1996 1995 --------------------------------- (In Thousands) <S> <C> <C> <C> Sales: Chemical $ 156,949 $ 166,163 $ 136,903 Climate Control 105,909 89,275 83,843 Industrial Products 15,572 13,776 13,375 Automotive Products 35,499 37,946 33,270 ------- ------- ------- $ 313,929 $ 307,160 $ 267,391 ======= ======= ======= Gross profit: (1) Chemical $ 19,320 $ 25,885 $ 26,050 Climate Control 29,552 21,961 21,694 Industrial Products 3,776 3,058 2,953 Automotive Products 3,299 5,868 6,366 ------- ------- -------- $ 55,947 $ 56,772 $ 57,063 ======= ======= ======= Operating profit (loss): (2) Chemical $ 5,479 $ 10,971 $ 13,393 Climate Control 8,895 5,362 4,630 Industrial Products (993) (2,685) (1,199) Automotive Products (7,251) (4,134) (3,704) ------- ------- -------- 6,130 9,514 13,120 General corporate expenses, net (9,786) (3,192) (6,571) Interest Expense (14,740) (10,017) (10,131) -------- -------- ------- Loss from continuing operations before provision for income taxes and extra- ordinary charge $(18,396) $ (3,695) $ (3,582) ======== ======== ======== Identifiable assets: Chemical $ 137,570 $ 132,718 $ 111,890 Climate Control 49,274 50,623 41,331 Industrial Products 9,929 13,614 17,328 Automotive Products 42,718 43,212 43,872 ------- ------- ------- 239,491 240,167 214,421 Corporate assets 31,162 21,393 23,755 ------- -------- ------- Total assets $ 270,653 $ 261,560 $ 238,176 ======= ======= ======= </TABLE> (1) Gross profit by industry segment represents net sales less cost of sales. (2) Operating profit by industry segment represents revenues less operating expenses before deducting general corporate expenses, interest expense and income taxes. CHEMICAL BUSINESS The Company has grown the Chemical Business through the expansion of its El Dorado Facility and the acquisition of new agricultural distribution centers in key geographical markets that are freight logical to the El Dorado Facility. During the period from December 31, 1995 through December 31, 1997, the net investment in assets of the Chemical Business was increased from $111.9 million to $137.6 million primarily due to the construction of additional capacity to benefit future periods. Beginning in 1994, the results of operations of the Chemical Business have been adversely impacted by the high cost of anhydrous ammonia. From its most recent cyclical low in 1986 through 1993, the average Gulf Coast price (the "Spot Price") of anhydrous ammonia was approximately $100 per ton. During 1994 and in each of the years since, a tightness in supply developed which resulted in an increase in the Spot Price of anhydrous ammonia to an average of approximately $195 per ton. The Company believes that the tightness in supply of anhydrous ammonia that emerged in 1994 was a result of increased industrial usage as the U.S. economy grew, a net consolidation of the domestic capacity and a disruption in supply coming from the former Soviet Union. Although prices for anhydrous ammonia vary considerably from month to month, the annual average price has remained high for each of the last three years. The Company currently purchases approximately 220,000 tons of anhydrous ammonia per year under two contracts, both effective as of January 1, 1997. The Company's purchase price of anhydrous ammonia under these contracts can be higher or lower than the Spot Price of anhydrous ammonia. The higher prices have been partially passed on to customers; however, the entire cost increase could not be offset resulting in lower gross profit margins during each of the periods since the increase. The company believes there is approximately 2 million tons of additional capacity being constructed in the western hemisphere scheduled for completion in 1998 and 1999. The Company believes this additional capacity may contribute to a decline in the market price of anhydrous ammonia. During 1994, the Company undertook construction of the DSN Plant. The DSN Plant began operations in 1995, but due to certain mechanical and design problems, production of concentrated nitric acid during the twelve months ended December 31, 1997 was limited to an average of 170 tons per day, assuming 338 days of annual production or 60% of the stated capacity of 285 tons per day. The limitations on production resulted in significant fixed costs being expended as period costs during the second half of 1996, and the first half of 1997, rather than being absorbed as cost of product being produced and sold. In addition, significant amounts were expended for engineering, consulting, and other costs to bring the DSN Plant up to the stated capacity. During the annual maintenance turnaround in September 1997, management implemented corrective actions which it believes allow the DSN Plant to operate at its stated capacity, depending upon customer specifications, and to fully absorb the costs and produce a quality product. In early October 1997, the DSN Plant was restarted and is currently operating at approximately 260 tons per day due to inventory constraints and customer specifications. During July 1997, a subsidiary of the Company entered into an agreement with Bayer Corporation whereby the Company's subsidiaries would act as agent to construct a nitric acid plant located within Bayer's Baytown, Texas chemical plant complex. This plant, when constructed, will be operated by the Company's subsidiary and will supply nitric acid for Bayer's polyurethane units under a long-term supply contract. Management estimates that, after the initial startup phase of operations at the plant, at full production capacity based on terms of the Bayer Agreement and on current market conditions, the plant should generate approximately $50 million in annual revenues. Construction is scheduled to be completed by the end of 1998. The Chemical Business' Australian subsidiary, TES, results of operations have been adversely affected due to the recent economic developments in certain countries in Asia. These economic developments in Asia have had a negative impact on the mining industry in Australia which TES services. If these adverse economic conditions in Asia continue for an extended period of time, such could have an adverse effect on the Company's consolidated results of operations for 1998. CLIMATE CONTROL The Climate Control Business manufactures and sells a broad range of hydronic fan coil, air handling, air conditioning, heating, water source heat pumps, and dehumidification products targeted to both commercial and residential new building construction and renovation. The Climate Control Business focuses on product lines in the specific niche markets of hydronic fan coils and water source heat pumps and has established a significant market share in these specific markets. As indicated in the above table, the Climate Control Business reported improved sales (an increase of 18.6%) and improved operating profit for 1997 as compared to 1996. From December 1995 through December 1997 the net investment in assets of the Climate Control Business was increased from $41.3 million to $49.3 million. During this two year period, additions to property, plant and equipment were $2.7 million and depreciation was approximately $3.1 million. AUTOMOTIVE AND INDUSTRIAL PRODUCTS BUSINESSES As indicated in the above table, during 1997, 1996 and 1995, respectively, the Automotive and Industrial Products Businesses recorded combined sales of $51.1 million, $51.7 million and $ 46.6 million, respectively, and reported operating losses (as defined above) of $8.2 million, $6.8 million, and $4.9 million in 1997 and 1996, and 1995 respectively. The net investment in assets of these Businesses was $52.6 million, $56.8 million and $61.2 million at year end 1997, 1996 and 1995, respectively. While the Company's investment in these businesses has declined from $61.2 million in 1995 to $52.6 million in 1997, the Company expects to realize further reductions in future periods as it implements its proposed plan to dispose of non-core and non-earning assets. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996 REVENUES Total revenues for 1997 and 1996 were $320.2 million and $314.1 million, respectively (an increase of $6.1 million or 1.9%). Sales increased $6.8 million or 2.2%. NET SALES Consolidated net sales for 1997 were $313.9 million, compared to $307.2 million for 1996, an increase of $6.8 million or 2.2%. This sales increase resulted principally from: (i) increased sales in the Climate Control Business of $16.6 million, primarily due to increased sales of heat pumps; and (ii) increased sales of $1.8 million in the Industrial Products Business due to increased machine tool sales; partially offset by (iii) decreased sales of $2.4 million in the Automotive Products Business due to less units being shipped and product mix; and (iv) decreased sales in the Chemical Business of $9.2 million primarily due to reduced sales of the Company's wholly-owned Australian subsidiary, because of the expiration of certain customer contracts and recent economic developments in Asia. GROSS PROFIT Gross profit decreased $.8 million and was 17.8% of net sales for 1997, compared to 18.5% of net sales for 1996. The gross profit percentage declined in the Automotive Products and Chemical Businesses, but improved in the Climate Control and Industrial Products Businesses. The gross profit of the Chemical Business was adversely affected by higher production costs due to (i) the higher cost of anhydrous ammonia which was only partially passed on in the form of higher selling prices, (ii) unabsorbed overhead costs caused by down time related to modifications made to resolve problems associated with mechanical failures, and (iii) environmental matters at the Chemical Business' primary manufacturing plant. These increased costs in 1997 were partially offset by a reduction in cost of sales of $2.1 million through recapture of manufacturing variances of the Chemical Business in the form of business interruption insurance settlements. The primary reasons for the decline in gross profit percentage in the Automotive Products Business were (i) less favorable customer mix i.e. decreased sales to higher margin retail customers, and increased sales to Original Equipment Manufacturer (OEM) customers which are lower margin customers, and (ii) increases in manufacturing expenses in excess of increases in production cost absorption attributable to new product lines that have been developed. These gross profit declines have been partially offset by gross profit percentage increases due to sales of machine tools carrying a higher gross profit percentage in the Industrial Products Business and increased absorption of costs due to higher production volumes and focus on sales of more profitable product lines in the Climate Control Business. SELLING, GENERAL AND ADMINISTRATIVE EXPENSE Selling, general and administrative expenses ("SG&A"), as a percent of net sales, were 21.0% in 1997 and 18.7% in 1996. SG&A, as a percent of sales, was approximately 9.8% in 1997 compared to 9.3% in 1996 for the Chemical Business; 21.0% in 1997 compared to 19.8% in 1996 for the Climate Control Business; 32.1% in 1997 compared to 29.5% in 1996 for the Automotive Products Business; and 33.4 % in 1997 compared to 44.4% in 1996 for the Industrial Products Business. The increase in the Chemical Business was the result of lower sales in 1997 with relatively constant SG&A expenses. Within SG&A of the Chemical Business, lower provisions for uncollectible accounts receivable in 1997 were offset by increased expenses at the Company's Australian subsidiary in anticipation of sustaining a higher level of business activity. The increase in the Climate Control Business' SG&A was the result of increases in sales personnel costs to support higher sales in future periods, additional information technology personnel to support management information systems changes and higher freight costs due to a change in sales mix toward greater domestic sales which carry a higher SG&A percent. The increase in the Automotive Products Business was due to lower sales and increased advertising expenses expected to benefit future periods. The decrease in the Industrial Products Business resulted from lower bad debt expenses and lower advertising expenses compounded by higher sales. In addition to the variances described above, approximately $2.2 million of the total SG&A increase of $8.5 million is due to the operations of the Tower in 1997 as discussed elsewhere in this report and approximately $2.8 million is due to increased legal fees, settlement accruals and loss reserves in 1997 over 1996 to assert the Company's position in various legal proceedings, joint ventures and debt guarantees as discussed more completely elsewhere in this Management's Discussion and Analysis of Financial Condition and Results of Operations. INTEREST EXPENSE Interest expense for the Company, before deducting capitalized interest, was $15.9 million during 1997, compared to $12.4 million during 1996. During 1997, $1.1 million of interest expense was capitalized in connection with construction of the DSN Plant, compared to $2.4 million in 1996. The increase of $3.5 million before the effect of capitalization primarily resulted from increased borrowings and higher interest rates. The increased borrowings were necessary to support capital expenditures, higher accounts receivable balances and to meet the operational requirements of the Company. See "Liquidity and Capital Resources" of this Management's Discussion and Analysis. EXTRAORDINARY CHARGE In 1997, in connection with the issuance of the 10 3/4% unsecured senior notes due 2007 by a subsidiary of the Company, a subsidiary of the Company retired the outstanding principal associated with a certain financing arrangement and incurred a prepayment fee. The prepayment fee and loan origination costs expensed in 1997 related to the financing arrangement aggregated approximately $4.6 million. NET LOSS The Company had a net loss of $23.1 million in 1997 compared to a net loss of $3.8 million in 1996. The increased loss of $19.3 million was primarily due to decreased gross profit, increased SG&A, increased interest expense and the extraordinary charge as discussed above. YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995 REVENUES Total revenues for 1996 and 1995 were $314.1 million and $274.1 million, respectively (an increase of $40.0 million or 14.6%). Sales increased $39.8 million or 14.9%. NET SALES Consolidated net sales for 1996 were $307.2 million, compared to $267.4 million for 1995, an increase of $39.8 million or 14.9%. This sales increase resulted principally from: (i) increased sales in the Climate Control Business of $5.4 million, primarily due to improved market conditions; (ii) increased sales in the Chemical Business, of $29.3 million which were primarily attributable to increased sales of $16.0 million at Total Energy Systems ("TES"), the Company's subsidiary located in Australia and New Zealand, which resulted from an expanded customer base, to higher costs being passed through to customers and higher sales of agricultural products; (iii) increased sales of $.4 million in the Industrial Products Business; and (iv) increased sales of $4.7 million in the Automotive Products Business due to the addition of certain new product lines that the Company believes the Automotive Products Business has a strategic advantage in. GROSS PROFIT Gross profit decreased $.3 million and was 18.5% of net sales for 1996, compared to 21.3% of net sales for 1995. The gross profit percentage declined in the Automotive Products, Chemical, and Climate Control Businesses. The gross profit of the Chemical Business, was adversely affected due to the continued high cost of anhydrous ammonia as discussed above and higher production costs due to unabsorbed overhead costs resulting from excessive downtime at the Chemical Business' El Dorado, Arkansas plant complex related to modifications made to install air emissions abatement equipment and resolve problems associated with mechanical failures at the DSN Plant. The Climate Control Business' gross profit percentage decreased due to production inefficiencies and decreased absorption of costs due to lower production volumes in certain product lines of this Business. The primary reason for the decline in gross profit percentage in the Automotive Products Business was a less favorable customer mix. SELLING, GENERAL AND ADMINISTRATIVE EXPENSE Selling, general and administrative expenses ("SG&A"), as a percent of net sales, were 18.7% in 1996 and 21.4% in 1995. Consolidated SG&A expenses were approximately the same in 1996 as 1995 and consolidated net sales increased by 14.9% resulting in a lower percentage of SG&A to sales. Increased SG&A of the Chemical Business, consistent with sales increases were offset by reductions in SG&A in the Climate Control Business and general corporate expenses. INTEREST EXPENSE Interest expense for the Company, excluding capitalized interest, was $10.0 million during 1996, compared to $10.1 million during 1995. During 1996, $2.4 million of interest expense was capitalized in connection with construction of the DSN Plant, compared to $1.4 million in 1995. The increase of $.9 million before the effect of capitalization primarily resulted from increased borrowings and higher interest rates. The increased borrowings were necessary to support capital expenditures, higher accounts receivable balances and to meet the operational requirements of the Company. NET LOSS The Company had a net loss of $3.8 million in 1996 compared to a net loss of $3.7 million in 1995. Although 1996 consolidated net sales increased, the consolidated gross profit did not increase and the net loss was approximately the same in 1996 as 1995. LIQUIDITY AND CAPITAL RESOURCES CASH FLOW FROM OPERATIONS Historically, the Company's primary cash needs have been for operating expenses, working capital and capital expenditures. The Company has financed its cash requirements primarily through internally generated cash flow and borrowings under its revolving credit facilities, and more recently, by issuance of senior unsecured notes by a wholly owned subsidiary. Net cash used by operations for the year ended December 31, 1997 was $20.5 million, after $12.5 million for noncash depreciation and amortization, $4.0 million in provisions for possible losses on accounts receivable, notes receivable, environmental matters and a loan guarantee and $1.3 million in gains from real estate and other assets and including the following changes in assets and liabilities: (i) accounts receivable increases of $3.8 million; (ii) inventory increases of $1.9 million; (iii) increases in supplies and prepaid items of $.5 million; and (iv) decreases in accounts payable and accrued liabilities of $11.0 million. The increase in accounts receivable is due to increased sales primarily in the Climate Control Business (see "Results of Operations" for discussion of increase in sales). The increase in inventory was due primarily to an increase at the Chemical Business to support anticipated sales increases. These increases were offset by inventory reductions in the Automotive and Industrial Products Businesses resulting from liquidation of excessive inventories. Inventory in the Automotive and Industrial Products Businesses decreased from $30.6 million at December 31, 1996 to $29.4 million at December 31, 1997. The decrease in accounts payable and accrued liabilities resulted primarily from cash flow from financing activities becoming available to reduce accounts payable. CASH FLOW FROM INVESTING AND FINANCING ACTIVITIES Cash used by investing activities for the year ended December 31, 1997 included $12.6 million in capital expenditures. These took place primarily in the Chemical Business to enhance production, quality and environmental safety standards. Also, included in investing activities was cash used to increase other assets $5.3 million offset by cash proceeds received on sales of equipment and real estate properties of $2.0 million. The increase in other assets consisted primarily of (i) a $1.0 million advance to a French manufacturer of HVAC equipment as discussed further under "Joint Ventures and Options to Purchase", $1.7 million of deposits made in connection with an interest rate hedge contract related to the agreement with Bayer and $3.5 million of capitalized loan origination costs associated with the initial offering of the Notes. Net cash provided by financing activities included (i) long-term and other borrowings of $162.5 million, including proceeds from the $105 million initial offering of the 10 3/4% unsecured senior notes due 2007 (the "Notes") and the $50 million John Hancock financing discussed under "Sources of Funds", (ii) payments on long-term and other debt of $75.8 million, including $19.1 million in prepayments of debt with proceeds from the $50 million John Hancock financing and $48.3 million in prepayments of the John Hancock financing with proceeds from the $105 million initial offering of the Notes, (iii) decreases in revolving debt of $37.5 million, (iv) dividends of $4.0 million, (v) treasury stock purchases of $1.4 million, and (vi) a debt prepayment charge of $4.6 million in connection with the prepayment of the John Hancock financing. During 1997, the Company declared and paid the following aggregate dividends: (i) $12.00 per share on each of the outstanding shares of its Series B 12% Cumulative Convertible Preferred Stock; (ii) $3.25 per share on each outstanding share of its $3.25 Convertible Exchangeable Class C Preferred Stock, Series 2; (iii) $10.00 per share on each outstanding share of its Convertible Noncumulative Preferred Stock; and (iv) $.06 per share on its outstanding shares of Common Stock. The Company expects to continue the payment of such dividends in the future in accordance with the policy adopted by the Board of Directors and the terms inherent to the Company's various Preferred Stocks. SOURCE OF FUNDS The Company is a diversified holding Company and its liquidity is dependent, in large part, on the operations of its subsidiaries and credit agreements with lenders. In October 1997, the Company organized a new wholly owned subsidiary, ClimaChem, Inc. ("ClimaChem"). ClimaChem owns substantially all of the Company's Chemical and Climate Control Businesses. On November 26, 1997, ClimaChem issued the Notes in the aggregate amount of $105 million. The Notes are jointly and severally and fully and unconditionally guaranteed on a senior basis by all, but one, of the existing and all of the future subsidiaries of ClimaChem. One current subsidiary of ClimaChem, which is currently inconsequential to ClimaChem, is not a guarantor of the Notes. The Company is neither an issuer of, nor a guarantor under, the Notes. See Note 5 of Notes to Consolidated Financial Statements. Interest on the Notes is payable semiannually on June 1 and December 1 of each year, commencing June 1, 1998. The Notes will mature on December 1, 2007, unless earlier redeemed. The Notes are redeemable at the option of the Company on December 1, 2002 at 105.375% of the principal amount declining to face amount at December 1, 2005 and thereafter under the terms set forth in the Indenture. The Notes are effectively subordinated to all secured indebtedness of ClimaChem and its subsidiaries. The proceeds from the issuance of the Notes were approximately $105 million before deducting commissions and initial purchaser's discounts and estimated expenses thereof. After deducting discounts and commissions to the initial purchaser, but before deducting other expenses, the net proceeds to the Company from the issuance of the Notes were $101.85 million. The net proceeds from the issuance of the Notes were used to (i) repay approximately $53.2 million of borrowings, interest and prepayment fees to retire the loans associated with the financing agreement discussed in the next paragraph; and (ii) reduce by approximately $48.6 million amounts outstanding under the Company's revolving credit facilities. On February 13, 1997 certain of the Company's wholly-owned subsidiaries completed a $50.0 million long-term financing agreement ("Financing") with an institutional lender. Approximately $19.3 million in proceeds from the Financing were used to repay other outstanding term debt including accrued interest, and the remaining $30.7 million in proceeds was used to pay down the Company's revolving credit facilities and thereby create additional borrowing availability for future working capital and other corporate needs. This financing agreement was prepaid in full and terminated in November, 1997 with proceeds from the initial offering of the Notes. In connection with such prepayment, ClimaChem was required to pay a prepayment charge of $4.6 million. The Company and certain of its subsidiaries are parties to a working capital line of credit evidenced by four separate loan agreements ("Revolving Credit Agreements") with an unrelated lender ("Lender") collateralized by receivables, inventory, and proprietary rights of the Company and the subsidiaries that are parties to the Revolving Credit Agreements and the stock of certain of the subsidiaries that are borrowers under the Revolving Credit Agreements. The Revolving Credit Agreements, as amended, provide for revolving credit facilities ("Revolver") for total direct borrowings up to $65.0 million, including the issuance of letters of credit. The Revolver provides for advances at varying percentages of eligible inventory and trade receivables. The Revolving Credit Agreements, as amended, provide for interest at the lender's prime rate plus 1.5% per annum or, at the Company's option, on the Lender's LIBOR rate plus 3.875% per annum (which rates are subject to increase or reduction based upon achieving specified availability and adjusted tangible net worth levels. At December 31, 1997 the effective interest rate was 10.0%. The term of the Revolving Credit Agreements is through December 31, 2000, and is renewable thereafter for successive thirteen month terms. At December 31, 1997, the availability for additional borrowings, based on eligible collateral approximated $33.8 million. Borrowings under the Revolver outstanding at December 31, 1997, were $19.3 million. The Revolving Credit Agreements, as amended, require the Company to maintain certain financial ratios and contain other financial covenants, including tangible net worth requirements and capital expenditure limitations. At December 31, 1997, the Company was not in compliance with certain of these financial covenants. Subsequent to December 31, 1997, the Company obtained waivers of such noncompliance and amendments to reset the financial covenants through maturity. The annual interest on the outstanding debt under the Revolver at December 31, 1997 at the rates then in effect would approximate $1.9 million. The Revolving Credit Agreements also require the payment of an annual facility fee of 0.5% of the unused revolver. In addition to the Revolving Credit Agreements discussed above, the Company had the following term loans in place as of December 31, 1997: (1) As of December 31, 1997, the Company's wholly-owned subsidiary, DSN Corporation ("DSN"), is a party to several loan agreements with a financial company (the "Financing Company") for three projects. At December 31, 1997, DSN had outstanding borrowings of $13.5 million under these loans. The loans have repayment schedules of 84 consecutive monthly installments of principal and interest. The interest rate on each of the loans is fixed and range from 8.2% to 8.9%. Annual interest, for the three notes as a whole, at December 31, 1997, at the agreed to interest rates would approximate $1.2 million. The loans are secured by the various DSN property and equipment. The loan agreements require the Company to maintain certain financial ratios, including tangible net worth requirements. (2) As of December 31, 1997, a subsidiary of the Company ("Prime") was a party to an agreement ("Agreement") with Nations Bank ("Bank"). The Agreement, as modified, requires interest per annum at a rate equal to three quarters of one percent (.75%) above the prime rate in effect from day to day as published in the Wall Street Journal. The outstanding principal balance of the note was payable in sixty (60) monthly payments of principal and interest commencing on June 30, 1996. Payment of the note was secured by a first and priority lien and security interest in and to Prime's right, title, and interest in the loan receivable relating to the real property and office building located in Oklahoma City, Oklahoma (the "Tower"), and the Management Agreement relating to the Tower. In February 1997, a subsidiary of the Company exercised its option to purchase the Tower by foreclosing against the loan receivable and paying approximately $140,000 in related costs. In March 1998, a subsidiary of the Company sold the Tower. The note associated with this Agreement was paid off with part of the proceeds from this sale. The Company realized proceeds of approximately $29 million from the sale, net of transaction costs. Proceeds from the sale were used to retire the outstanding indebtedness on the Agreement of approximately $13 million in March 1998. Approximately $15 million of the remaining proceeds were used to reduce indebtedness outstanding under the Company's Revolving Credit Agreements. See Note 15 of Notes to Consolidated Financial Statements concerning this subsequent event. Future cash requirements include working capital requirements for anticipated sales increases in all Businesses and funding for future capital expenditures. Funding for the higher accounts receivable resulting from anticipated sales increases will be provided by cash flow generated by the Company and the revolving credit facilities discussed elsewhere in this report. Inventory requirements for the higher anticipated sales activity should be met by scheduled reductions in the inventories of the Industrial Products Business and in the inventories of the Automotive Products Business. In 1998, the Company has planned capital expenditures of approximately $9.0 million, primarily in the Chemical and Climate Control Businesses. Management believes that following the issuance of the Notes, cash flows from operations, the Company's revolving credit facilities, and other sources, including proceeds from the sale of the Tower in March 1998, will be adequate to meet its presently anticipated capital expenditure, working capital, debt service, and dividend requirements. The Company currently has no material commitment for capital expenditures, except as discussed under "Overview", "Chemical Business," of this "Management's Discussion and Analysis of Financial Condition and Results of Operations" regarding the agreement with Bayer Corporation to build a new nitric acid plant. FOREIGN SUBSIDIARY The Company's wholly-owned Australian subsidiary, TES, has a revolving credit working capital facility (the "TES Revolving Facility") with Bank of New Zealand, Australia. In February 1998, the TES Revolving Facility was increased from AUS$8.5 million (approximately US$5.5 million) to approximately AUS$10.5 million (approximately US$7.0 million). The TES Revolving Facility allows for borrowings based on specific percentages of qualified eligible assets. Based on the effective exchange rate at December 31, 1997 approximately US$4.6 million (AUS$7.1 million approximately) was borrowed at December 31, 1997. Based on the effective exchange rate at March 18, 1998, approximately US$3.0 million (approximately AUS$4.5 million) was borrowed at March 18, 1998, under the TES Revolving Credit Facility. Such debt is secured by substantially all the assets of TES, plus an unlimited guarantee and indemnity from LSB and certain subsidiaries of TES. The interest rate on this debt is dependent upon the borrowing option elected by TES and had a weighted average rate of 6.9% at December 31, 1997. TES is in technical noncompliance with a certain financial covenant contained in the loan agreement involving the TES Revolving Facility. However, this covenant was not met at the time of closing of this loan and the Bank of New Zealand, Australia has continued to extend credit under the Facility. The outstanding borrowing under the TES Revolving Facility at December 31, 1997, has been classified as due within one year in the accompanying consolidated financial statements. JOINT VENTURES AND OPTIONS TO PURCHASE Prior to 1997, the Company, through a subsidiary, loaned $2.8 million to a French manufacturer of HVAC equipment whose product line is compatible with that of the Company's Climate Control Business in the USA. Under the loan agreement, the Company has the option to exchange its rights under the loan for 100% of the borrower's outstanding common stock. The Company obtained a security interest in the stock of the French manufacturer to secure its loan. During 1997 the Company advanced an additional $1 million to the French manufacturer bringing the total of the loan at December 31, 1997 to $3.8 million. As of the date of this report, the decision has not been made to exercise such option and the $3.8 million loan, less a $1.5 million valuation reserve, is carried on the books as a note receivable in other assets. In 1995, a subsidiary of the Company invested approximately $2.8 million to purchase a fifty percent (50%) equity interest in an energy conservation joint venture (the "Project"). The Project had been awarded a contract to retrofit residential housing units at a US Army base which it completed during 1996. The completed contract was for installation of energy-efficient equipment (including air conditioning and heating equipment), which would reduce utility consumption. For the installation and management, the Project will receive an average of seventy-seven percent (77%) of all energy and maintenance savings during the twenty (20) year contract term. The Project spent approximately $17.5 million to retrofit the residential housing units at the US Army base. The Project received a loan from a lender to finance approximately $14.0 million of the cost of the Project. The Company is not guaranteeing any of the lending obligations of the Project. During 1995, the Company executed a stock option agreement to acquire eighty percent (80%) of the stock of a specialty sales organization ("Optioned Company"), which owns the remaining fifty percent (50%) equity interest in the Project discussed above, to enhance the marketing of the Company's air conditioning products. The stock option has a four (4) year term, and a total option granting price of $1.0 million and annual $100,000 payments for yearly extensions of the stock option thereafter for up to three (3) years. Through the date of this report the Company has made option payments aggregating $1.2 million and has loaned the Optioned Company approximately $1.4 million. The Company has recorded reserves of $926,000 against the loans and option payments. Upon exercise of the stock option by the Company, or upon the occurrence of certain performance criteria which would give the grantors of the stock option the right to accelerate the date on which the Company must elect whether to exercise, the Company shall pay certain cash and issue promissory notes for the balance of the exercise price of the subject shares. The total exercise price of the subject shares is $4.0 million, less the amounts paid for the granting and any extensions of the stock option. As of the date of this report, no decision to exercise this option has been reached by the Company DEBT GUARANTEE The Company and one of its subsidiaries have guaranteed approximately $2.6 million of indebtedness of a startup aviation company in exchange for an ownership interest. The debt guarantee relates to two note instruments. One note for which the subsidiary had guaranteed up to $600,000 had a balance of approximately $1.9 million as of December 31, 1997. The other note in the amount of $2.0 million requires monthly principal payments of $11,111 plus interest beginning in October 1998 through August 8, 1999, at which time all outstanding principal and accrued interest are due. In the event of default of the $2.0 million note, the Company is required to assume payments on the note with the term extended until August 2004. Both notes are current as to principal and interest. During 1996 and 1997, the aviation company received cash infusions of $5.0 million from an unrelated third party investor for a 41.6% ownership interest in the aviation company. During 1997, the investor exercised an option to purchase additional stock of the aviation company in exchange for $4.0 million in scheduled payments. At December 31, 1997, $2.5 million of payments under this option had been received. Accordingly, additional shares of stock were issued pursuant to the option exercise increasing the investor's ownership interest to 46.3%. In February 1998, the aviation company made a capital call on its shareholders. In contemplation of a sale of the aviation company to an additional investor and pursuant to such capital call, the Company invested an additional $241,545 which increased the Company's ownership interest to 35.9%. The unrelated third party investor did not participate in such capital call and their investment was diluted to 23.1%. On March 20, 1998 the Company loaned an additional net amount of $32,000 to the aviation company in exchange for additional stock. This transaction increased the Company's ownership interest to approximately 37.2% AVAILABILITY OF COMPANY'S LOSS CARRY-OVERS The Company anticipates that its cash flow in future years will benefit from its ability to use net operating loss ("NOL") carry-overs from prior periods to reduce the federal income tax payments which it would otherwise be required to make with respect to income generated in such future years. Such benefit, if any is dependent on the Company's ability to generate taxable income in future periods, for which there is no assurance. Such benefit if any, will be limited by the Company's reduced NOL for alternative minimum tax purposes which is approximately $18 million at December 31, 1997. As of December 31, 1997, the Company had available NOL carry-overs of approximately $65 million based on its federal income tax returns as filed with the Internal Revenue Service for taxable years through 1997. These NOL carry-overs will expire beginning in the year 1999. As of December 31, 1997 and 1996, due to its recent history of reporting net losses, the Company has established a valvation allowance on a portion of its NOLs and thus has not recognized the full benefit of its NOLs in the accompanying Consolidated Financial Statements. The amount of these carry-overs has not been audited or approved by the Internal Revenue Service and, accordingly, no assurance can be given that such carry-overs will not be reduced as a result of audits in the future. In addition, the ability of the Company to utilize these carry-overs in the future will be subject to a variety of limitations applicable to corporate taxpayers generally under both the Internal Revenue Code of 1986, as amended, and the Treasury Regulations. These include, in particular, limitations imposed by Code Section 382 and the consolidated return regulations. CONTINGENCIES The Company has several contingencies that could impact its liquidity in the event that the Company is unsuccessful in defending against the claimants. Although management does not anticipate that these claims will result in substantial adverse impacts on its liquidity, it is not possible to determine the outcome. The preceding sentence is a forward-looking statement that involves a number of risks and uncertainties that could cause actual results to differ materially, such as, among other factors, the following: the EIL Insurance does not provide coverage to the Company and the Chemical Business for any material claims made by the claimants, the claimants alleged damages are not covered by the EIL Policy which a court may find the Company and/or the Chemical Business liable for, such as punitive damages or penalties, a court finds the Company and/or the Chemical Business liable for damages to such claimants for a material amount in excess of the limits of coverage of the EIL Insurance or a court finds the Chemical Business liable for a material amount of damages in the antitrust lawsuits pending against the Chemical Business in a manner not presently anticipated by the Company. See "Business", "Legal Proceedings" and Note 10 of Notes to Consolidated Financial Statements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company has included the financial statements and supplementary financial information required by this item immediately following Part IV of this report and hereby incorporates by reference the relevant portions of those statements and information into this Item 8. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No disagreements between the Company and its accountants have occurred within the 24-month period prior to the date of the Company's most recent financial statements. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Certain statements contained within this report may be deemed "Forward- Looking Statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements in this report other than statements of historical fact are Forward-Looking Statements that are subject to known and unknown risks, uncertainties and other factors which could cause actual results and performance of the Company to differ materially from such statements. The words "believe", "expect", "anticipate", "intend", "will", and similar expressions identify Forward-Looking Statements. Forward-Looking Statements contained herein relate to, among other things, (i) ability to improve operations and become profitable on an annualized basis (ii) establish a position as a market lender, (iii) the EDNC Baytown Plant will cost approximately $60 million and will be completed by late 1998, (iv) ability to continue to operate the DSN Plant at the rate of approximately 260 tons per day, and at such rate can produce at a cost per ton of approximately $65 lower than at production levels of $170 tons per day, (v) increase demand for, and growth relating to, the Company's products, (vi) certain of the Company's product lines may be the most extensive offered, (vii) production of backlog, (viii) amount to be spent in 1998 relating to compliance with federal, state and local Environmental laws at the El Dorado Facility, (ix) Year 2000 issues, (x) improve liquidity and profits through liquidation of assets, (xi) the Company's ability to develop or adopt new and existing technologies in the conduct of its operations, (xii) anticipated financial performance, (xiii) ability to comply with the Company's general working capital requirements, and (xiv) ability to be able to continue to borrow under the Company's revolving line of credit. While the Company believes the expectations reflected in such Forward-Looking Statements are reasonable, it can give no assurance such expectations will prove to have been correct. There are a variety of factors which could cause future outcomes to differ materially from those described in this report, including, but not limited to, (i) decline in general economic conditions, both domestic and foreign, (ii) material reduction in revenues, (iii) inability to collect in a timely manner a material amount of receivables, (iv) increased competitive pressures, (v) inability to meet the "Year 2000" compliance of the computer system by the Company, its key suppliers, customers, creditors, and financial service organization, (vi) changes in federal, state and local laws and regulations, especially environmental regulations, or in interpretation of such, pending (vii) additional releases (particularly air emissions into the environment), (viii) potential increases in equipment, maintenance, operating or labor costs not presently anticipated by the Company, (ix) inability to retain management or to develop new management, (x) the requirement to use internally generated funds for purposes not presently anticipated, (xi) inability to become profitable, or if unable to become profitable, the inability to secure additional liquidity in the form of additional equity or debt, (xii) the effect of additional production capacity of anhydrous ammonia in the western hemisphere, (xiii) the cost for the purchase of anhydrous ammonia not reducing or continuing to increase, (xiv) changes in competition, (xv) the loss of any significant customer, (xvi) changes in operating strategy or development plans, (xvii) inability to implement on a permanent basis the corrective actions necessary for the DSN Plant to operate at its stated capacity or inability to produce at the DSN Plant in an efficient manner, (xviii) inability to fund the expansion of the Company's businesses, (xix) adverse results in any of the Company's pending litigation, on claims described under "Legal Proceedings", (xx) inability to finalize the settlements of the environmental litigation in terms described in "Legal Proceedings", and (xxi) other factors described in "Business", "Legal Proceedings" or "Management's Discussion and Analysis of Financial Condition and Results of Operation" contained in this report. Given these uncertainties, all parties are cautioned not to place undue reliance on such Forward-Looking Statements. The Company disclaims any obligation to update any such factors or to publicly announce the result of any revisions to any of the Forward-Looking Statements contained herein to reflect future events or developments. PART III The Company hereby incorporates by reference the information required by Part III of this report except for the information on the Company's executive officers included under Part 4A of Part I of this report, from the definitive proxy statement which the Company intends to file with the Securities and Exchange Commission on or before April 30, 1998, in connection with the Company's 1998 annual meeting of stockholders. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) FINANCIAL STATEMENTS The following consolidated financial statements of the Company appear immediately following this Part IV: Pages Report of Independent Auditors F-1 Consolidated Balance Sheets at December 31, 1997 and 1996 F-2 to F-3 Consolidated Statements of Operations for each of the three years in the period ended December 31, 1997 F-4 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 31, 1997 F-5 to F-7 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1997 F-8 to F-9 Notes to Consolidated Financial Statements F-10 to F-56 Quarterly Financial Data (Unaudited) F-57 (a)(2) FINANCIAL STATEMENT SCHEDULE The Company has included the following schedule in this report: II - Valuation and Qualifying Accounts F-59 The Company has omitted all other schedules because the conditions requiring their filing do not exist or because the required information appears in the Company's Consolidated Financial Statements, including the notes to those statements. (a)(3) EXHIBITS 2.1. Stock Option Agreement dated as of May 4, 1995, between optionee, LSB Holdings, Inc., an Oklahoma Corporation and the shareholders of a specialty sales organization, an option which the Company hereby incorporates hereby by reference from Exhibit 2.1 to the Company's Form 10-K for fiscal year ended December 31, 1995. 2.2. Stock Purchase Agreement and Stock Pledge Agreement between Dr. Hauri AG, a Swiss Corporation, and LSB Chemical Corp., which the Company hereby incorporates by reference from Exhibit 2.2 to the Company's Form 10-K for fiscal year ended December 31, 1994. 3.1. Restated Certificate of Incorporation, the Certificate of Designation dated February 17, 1989, and certificate of Elimination dated April 30, 1993, which the Company hereby incorporates by reference from Exhibit 4.1 to the Company's Registration Statement, No. 33-61640; Certificate of Designation for the Company's $3.25 Convertible Exchangeable Class C Preferred Stock, Series 2, which the Company hereby incorporates by reference from Exhibit 4.6 to the Company's Registration Statement, No. 33-61640. 3.2. Bylaws, as amended, which the Company hereby incorporates by reference from Exhibit 3.02 to the Company's Form 10-K for fiscal year ended December 31, 1990. 4.1. Specimen Certificate for the Company's Non-cumulative Preferred Stock, having a par value of $100 per share, which the Company hereby incorporates by reference from Exhibit 4.1 to the Company's Form 10-Q for the quarter ended June 30, 1983. 4.2. Specimen Certificate for the Company's Series B Preferred Stock, having a par value of $100 per share, which the Company hereby incorporates by reference from Exhibit 4.27 to the Company's Registration Statement No. 33-9848. 4.3. Specimen Certificate for the Company's Series 2 Preferred, which the Company hereby incorporates by reference from Exhibit 4.5 to the Company's Registration Statement No. 33-61640. 4.4. Specimen Certificate for the Company's Common Stock, which the Company incorporates by reference from Exhibit 4.4 to the Company's Registration Statement No. 33-61640. 4.5. Rights Agreement, dated as of February 17, 1989, between the Company and The Liberty National Bank and Trust Company of Oklahoma City, which the Company hereby incorporates by reference from Exhibit 2.1 to the Company's Form 8-A Registration Statement dated February 22, 1989. 4.6. First Amendment to Preferred Share Purchase Rights Plan, dated as of May 24, 1994, between the Company and Liberty National Bank and Trust Company of Oklahoma City, which the Company hereby incorporates by reference from Exhibit 4.2 to the Company's Form 10-Q for the fiscal quarter ended March 31, 1995. 4.7. Indenture, dated as of November 26, 1997, by and among ClimaChem, Inc., the Subsidiary Guarantors and Bank One, NA, as trustee, which the Company hereby incorporates by reference from Exhibit 4.1 to the Company's Form 8-K, dated November 26, 1997. 4.8. Registration Rights Agreement, dated as of November 26, 1997, by and among ClimaChem, Inc., the Guarantors, and the Initial Purchaser, which the Company hereby incorporates by reference from Exhibit 4.2 to the Company's Form 8-K, dated November 26, 1997. 4.9. Form of 10 3/4% Senior Notes due 2007 and 10 3/4% Series B Senior Notes due 2007 which the Company hereby incorporates by reference from Exhibit 4.3 to the ClimaChem Registration Statement, No. 333-44905. 4.10. Amended and Restated Loan and Security Agreement, dated November 21, 1997, by and between BankAmerica Business Credit, Inc., and Climate Master, Inc., International Environmental Corporation, El Dorado Chemical Company and Slurry Explosive Corporation which the Company hereby incorporates by reference from Exhibit 10.2 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. 4.11. Amended and Restated Loan and Security Agreement, dated November 21, 1997, by and between BankAmerica Business Credit, Inc., and the Company. Substantially identical Amended and Restated Loan and Security Agreements dated November 21, 1997, were entered into by each of L&S Bearing Co., and Summit Machine Tool Manufacturing Corp., with BankAmerica Business Credit, Inc., and are hereby omitted and such will be provided upon the Commission's request. 4.12. First Amendment to Amended and Restated Loan and Security Agreement, dated March 12, 1998, between BankAmerica Business Credit, Inc., and Climate Master, Inc., International Environmental Corporation, El Dorado Chemical Company and Slurry Explosive Corporation which the Company hereby incorporates by reference from Exhibit 10.53 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. 4.13. First Amendment to Amended and Restated Loan and Security Agreement, dated March 12, 1998, between BankAmerica Business Credit, Inc., and the Company. Substantially identical First Amendments to Amended and Restated Loan and Security Agreements, dated March 12, 1998, were entered into by each of L&S Bearing Co. and Summit Machine Tool Manufacturing Corp. with BankAmerica Business Credit, Inc., and are hereby omitted and such will be provided upon the Commission's request. 4.14. Waiver Letter, dated March 16, 1998, from BankAmerica Business Credit, Inc. which the Company hereby incorporates by reference from Exhibit 10.55 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. 10.1. Form of Death Benefit Plan Agreement between the Company and the employees covered under the plan, which the Company hereby incorporates by reference from Exhibit 10(c)(1) to the Company's Form 10-K for the year ended December 31, 1980. 10.2. The Company's 1981 Incentive Stock Option Plan, as amended, and 1986 Incentive Stock Option Plan, which the Company hereby incorporates by reference from Exhibits 10.1 and 10.2 to the Company's Registration Statement No. 33-8302. 10.3. Form of Incentive Stock Option Agreement between the Company and employees as to the Company's 1981 Incentive Stock Option Plan, which the Company hereby incorporates by reference from Exhibit 10.10 to the Company's Form 10-K for the fiscal year ended December 31, 1984. 10.4. Form of Incentive Stock Option Agreement between the Company and employees as to the Company's 1986 Incentive Stock Option Plan, which the Company hereby incorporates by reference from Exhibit 10.6 to the Company's Registration Statement No. 33-9848. 10.5. The 1987 Amendments to the Company's 1981 Incentive Stock Option Plan and 1986 Incentive Stock Option Plan, which the Company hereby incorporates by reference from Exhibit 10.7 to the Company's Form 10-K for the fiscal year ended December 31, 1986. 10.6. The Company's 1993 Stock Option and Incentive Plan which the Company hereby incorporates by reference from Exhibit 10.6 to the Company's Form 10-K for the fiscal year ended December 31, 1993. 10.7. The Company's 1993 Non-employee Director Stock Option Plan which the Company hereby incorporates by reference from Exhibit 10.7 to the Company's Form 10-K for the fiscal year ended December 31, 1993. 10.8. Union Contracts, dated August 5, 1995, between EDC and the Oil, Chemical and Atomic Workers, the International Association of Machinists and Aerospace Workers, and the United Steel Workers of America, dated November 1, 1995 which the Company hereby incorporates by reference from Exhibit 10.7 to the Company's Form 10-K for the fiscal year ended December 31, 1995. 10.9. Lease Agreement, dated March 26, 1982, between Mac Venture, Ltd. and Hercules Energy Mfg. Corporation, which the Company hereby incorporates by reference from Exhibit 10.32 to the Company's Form 10-K for the fiscal year ended December 31, 1981. 10.10. Agreement for Purchase and Sale of Anhydrous Ammonia, dated as of January 1, 1997, between El Dorado Chemical Company and Farmland Industries, Inc. which the Company hereby incorporates by reference from Exhibit 10.10 to the Company's Form 10-K for the fiscal year ended December 31, 1996. 10.11. Limited Partnership Agreement dated as of May 4, 1995, between the general partner, and LSB Holdings, Inc., an Oklahoma Corporation, as limited partner which the Company hereby incorporates by reference from Exhibit 10.11 to the Company's Form 10-K for the fiscal year ended December 31, 1995. 10.12. Lease Agreement dated November 12, 1987, between Climate Master, Inc. and West Point Company and amendments thereto, which the Company hereby incorporates by reference from Exhibits 10.32, 10.36, and 10.37, to the Company's Form 10-K for fiscal year ended December 31, 1988. 10.13. Severance Agreement, dated January 17, 1989, between the Company and Jack E. Golsen, which the Company hereby incorporates by reference from Exhibit 10.48 to the Company's Form 10-K for fiscal year ended December 31, 1988. The Company also entered into identical agreements with Tony M. Shelby, David R. Goss, Barry H. Golsen, David M. Shear, and Jim D. Jones and the Company will provide copies thereof to the Commission upon request. 10.14. Third Amendment to Lease Agreement, dated as of December 31, 1987, between Mac Venture, Ltd. and Hercules Energy Mfg. Corporation, which the Company hereby incorporates by reference from Exhibit 10.49 to the Company's Form 10-K for fiscal year ended December 31, 1988. 10.15. Employment Agreement and Amendment to Severance Agreement dated January 12, 1989 between the Company and Jack E. Golsen, dated March 21, 1996 which the Company hereby incorporates by reference from Exhibit 10.15 to the Company's Form 10-K for fiscal year ended December 31, 1995. 10.16. Purchase Agreement, dated November 25, 1997, between ClimaChem, Inc., and certain subsidiaries of ClimaChem, and Wasserstein Perella Securities, Inc. which the Company hereby incorporates by reference from Exhibit 1 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. 10.17. Non-Qualified Stock Option Agreement, dated June 1, 1992, between the Company and Robert C. Brown, M.D. which the Company hereby incorporates by reference from Exhibit 10.38 to the Company's Form 10-K for fiscal year ended December 31, 1992. The Company entered into substantially identical agreements with Bernard G. Ille, Jerome D. Shaffer and C.L.Thurman, and the Company will provide copies thereof to the Commission upon request. 10.18. Loan and Security Agreement (DSN Plant) dated October 31, 1994 between DSN Corporation and the CIT Group which the Company hereby incorporates by reference from Exhibit 10.1 to the Company's Form 10-Q for the fiscal quarter ended September 30, 1994. 10.19. Loan and Security Agreement (Mixed Acid Plant) dated April 5, 1995 between DSN Corporation and the CIT Group, which the Company hereby incorporates by reference from Exhibit 10.25 to the Company's Form 10-K for the fiscal year ended December 31, 1994. 10.20. First Amendment to Loan and Security Agreement (DSN Plant), dated June 1, 1995, between DSN Corporation and The CIT Group/Equipment Financing, Inc. which the Company hereby incorporates by reference from Exhibit 10.13 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. 10.21. First Amendment to Loan and Security Agreement (Mixed Acid Plant), dated November 15, 1995, between DSN Corporation and The CIT Group/Equipment Financing, Inc. which the Company hereby incorporates by reference from Exhibit 10.15 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. 10.22 Loan and Security Agreement (Rail Tank Cars), dated November 15, 1995, between DSN Corporation and The CIT Group/Equipment Financing, Inc. which the Company hereby incorporates by reference from Exhibit 10.16 to the ClimaChem Form S-4 Registration Statement, No. 333- 44905. 10.23. First Amendment to Loan and Security Agreement (Rail Tank Cars), dated November 15, 1995, between DSN Corporation and The CIT Group/Equipment Financing, Inc. which the Company hereby incorporates by reference from Exhibit 10.17 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. 10.24. Letter amendment, dated May 14, 1997, to Loan and Security Agreement between DSN Corporation and The CIT Group/Equipment Financing, Inc. which the Company hereby incorporates by reference from Exhibit 10.1 to the Company's Form 10-Q for the fiscal quarter ended March 31, 1997. 10.25. Amendment to Loan and Security Agreement, dated November 21, 1997, between DSN Corporation and The CIT Group/Equipment Financing, Inc. which the Company hereby incorporates by reference from Exhibit 10.19 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. 10.26. First Amendment to Non-Qualified Stock Option Agreement, dated March 2, 1994, and Second Amendment to Stock Option Agreement, dated April 3, 1995, each between the Company and Jack E. Golsen, which the Company hereby incorporates by reference from Exhibit 10.1 to the Company's Form 10-Q for the fiscal quarter ended March 31, 1995. 10.27. Facility Letter, dated August 20, 1997, between Bank of New Zealand, Australia, and Total Energy Systems Limited which the Company hereby incorporates by reference from Exhibit 10.38 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. 10.28 Variation Letter, dated February 10, 1998, between Bank of New Zealand, Australia, and Total Energy Systems Limited which the Company hereby incorporates by reference from Exhibit 10.39 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. 10.29. Debenture Charge, dated March 7, 1995, between Total Energy Systems Limited and Bank of New Zealand which the Company hereby incorporates by reference from Exhibit 10.40 to the ClimaChem Form S-4 Registration Statement, No. 333-44905. T.E.S. Mining Services Pty. Ltd. and Total Energy Systems (NZ) Limited are each parties to substantially identical Debentures, copies of which will be provided to the Commission upon request. 10.30. Anhydrous Ammonia Sales Agreement, dated May 28, 1997, to be effective January 1, 1997, between Koch Nitrogen Company and El Dorado Chemical Company which the Company hereby incorporates by reference from Exhibit 10.1 to the Companies Form 10-Q for the fiscal quarter ended June 30, 1997. CERTAIN INFORMATION WITHIN THIS EXHIBIT HAS BEEN OMITTED AS IT IS THE SUBJECT OF COMMISSION ORDER CF #5551, DATED SEPTEMBER 25, 1997, GRANTING A REQUEST FOR CONFIDENTIAL TREATMENT UNDER THE FREEDOM OF INFORMATION ACT AND THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. 10.31. Baytown Nitric Acid Project and Supply Agreement dated June 27, 1997, by and among El Dorado Nitrogen Company, El Dorado Chemical Company and Bayer Corporation which the Company hereby incorporates by reference from Exhibit 10.2 to the Company's Form 10-Q for the fiscal quarter ended June 30, 1997. CERTAIN INFORMATION WITHIN THIS EXHIBIT HAS BEEN OMITTED AS IT IS THE SUBJECT OF COMMISSION ORDER CF #5551, DATED SEPTEMBER 25, 1997, GRANTING A REQUEST FOR CONFIDENTIAL TREATMENT UNDER THE FREEDOM OF INFORMATION ACT AND THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. 10.32. Service Agreement, dated June 27, 1997, between Bayer Corporation and El Dorado Nitrogen Company which the Company hereby incorporates by reference from Exhibit 10.3 to the Company's Form 10-Q for the fiscal quarter ended June 30, 1997. CERTAIN INFORMATION WITHIN THIS EXHIBIT HAS BEEN OMITTED AS IT IS THE SUBJECT OF COMMISSION ORDER CF #5551, DATED SEPTEMBER 25, 1997, GRANTING A REQUEST FOR CONFIDENTIAL TREATMENT UNDER THE FREEDOM OF INFORMATION ACT AND THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. 10.33. Ground Lease dated June 27, 1997, between Bayer Corporation and El Dorado Nitrogen Company which the Company hereby incorporates by reference from Exhibit 10.4 to the Company's Form 10-Q for the fiscal quarter ended June 30, 1997. CERTAIN INFORMATION WITHIN THIS EXHIBIT HAS BEEN OMITTED AS IT IS THE SUBJECT OF COMMISSION ORDER CF #5551, DATED SEPTEMBER 25, 1997, GRANTING A REQUEST FOR CONFIDENTIAL TREATMENT UNDER THE FREEDOM OF INFORMATION ACT AND THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. 10.34. Participation Agreement, dated as of June 27, 1997, among El Dorado Nitrogen Company, Boatmen's Trust Company of Texas as Owner Trustee, Security Pacific Leasing corporation, as Owner Participant and a Construction Lender, Wilmington Trust Company, Bayerische Landesbank, New York Branch, as a Construction Lender and the Note Purchaser, and Bank of America National Trust and Savings Association, as Construction Loan Agent which the Company hereby incorporates by reference from Exhibit 10.5 to the Company's Form 10-Q for the fiscal quarter ended June 30, 1997. CERTAIN INFORMATION WITHIN THIS EXHIBIT HAS BEEN OMITTED AS IT IS THE SUBJECT OF COMMISSION ORDER CF #5551, DATED SEPTEMBER 25, 1997, GRANTING A REQUEST FOR CONFIDENTIAL TREATMENT UNDER THE FREEDOM OF INFORMATION ACT AND THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. 10.35. Lease Agreement, dated as of June 27, 1997, between Boatmen's Trust Company of Texas as Owner Trustee and El Dorado Nitrogen Company which the Company hereby incorporates by reference from Exhibit 10.6 to the Company's Form 10-Q for the fiscal quarter ended June 30, 1997. 10.36. Security Agreement and Collateral Assignment of Construction Documents, dated as of June 27, 1997, made by El Dorado Nitrogen Company which the Company hereby incorporates by reference from Exhibit 10.7 to the Company's Form 10-Q for the fiscal quarter ended June 30, 1997. 10.37. Security Agreement and Collateral Assignment of Facility Documents, dated as of June 27, 1997, made by El Dorado Nitrogen Company and consented to by Bayer Corporation which the Company hereby incorporates by reference from Exhibit 10.8 to the Company's Form 10-Q for the fiscal quarter ended June 30, 1997. 10.38. Union Contracts, dated August 5, 1995, by and between EDC and the Oil, Chemical and Atomic Workers, the International Association of Machinists and Aerospace Workers, and the United Steel Workers of America, dated November 1, 1995, which the Company hereby incorporates by reference from Exhibit 10.7 to the Company's Form 10-K for the fiscal year ended December 31, 1995. 10.39. Amendment to Loan and Security Agreement, dated March 15, 1998, between The CIT Group/Equipment Financing, Inc., and DSN Corporation which the Company hereby incorporates by reference from Exhibit 10.54 to the ClimaChem Form S-4 Registration Statement, No. 333- 44905. 21.1. Subsidiaries of the Company 23.1. Consent of Independent Auditors 27.1. Financial Data Schedule (b) REPORTS ON FORM 8-K. The Company filed a report on Form 8-K, date of event reported November 26, 1997, in connection with the issuance of the $105 million 10 3/4% Senior Notes due 2007 by its wholly owned subsidiary, ClimaChem, Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Company has caused the undersigned, duly-authorized, to sign this report on its behalf of this 13th day of April, 1998. LSB INDUSTRIES, INC. By: /s/ Jack E. Golsen Jack E. Golsen Chairman of the Board and President (Principal Executive Officer) By: /s/ Tony M. Shelby Tony M. Shelby Senior Vice President of Finance (Principal Financial Officer) By: /s/ Jim D. Jones Jim D. Jones Vice President, Controller and Treasurer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the undersigned have signed this report on behalf of the Company, in the capacities and on the dates indicated. Dated: April 13, 1998 By: /s/ Jack E. Golsen Jack E. Golsen, Director Dated: April 13, 1998 By: /s/ Tony M. Shelby Tony M. Shelby, Director Dated: April 13, 1998 By: /s/ David R. Goss David R. Goss, Director Dated: April 13, 1998 By: /s/ Barry H. Golsen Barry H. Golsen, Director Dated: April 13, 1998 By: /s/ Robert C. Brown Robert C. Brown, Director Dated: April 13, 1998 By: /s/ Bernard G. Ille Bernard G. Ille, Director Dated: April 13, 1998 By: /s/ Jerome D. Shaffer Jerome D. Shaffer, Director Dated: April 13, 1998 By: /s/ Raymond B. Ackerman Raymond B. Ackerman, Director Dated: April 13, 1998 By: /s/ Horace Rhodes Horace Rhodes, Director Dated: April 13, 1998 By: Gerald J. Gagner, Director Dated: April 13, 1998 By: /s/ Donald W. Munson Donald W. Munson, Director 57 Report of Independent Auditors The Board of Directors and Stockholders LSB Industries, Inc. We have audited the accompanying consolidated balance sheets of LSB Industries, Inc. as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedule listed in the Index at Item 14(a)(2). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of LSB Industries, Inc. at December 31, 1997 and 1996, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. ERNST & YOUNG LLP Oklahoma City, Oklahoma March 16, 1998, except for the fourth paragraph of Note 5(A), as to which the date is April 8, 1998 F-1 LSB Industries, Inc. Consolidated Balance Sheets <TABLE> <CAPTION> DECEMBER 31, 1997 1996 ------------------------ (In Thousands) <S> <C> <C> ASSETS Current assets (Note 5): Cash and cash equivalents $ 4,934 $ 1,620 Trade accounts receivable, net 52,191 50,791 Inventories (Note 3) 68,200 67,982 Supplies and prepaid items 7,595 7,217 --------------------- Total current assets 132,920 127,610 Property, plant and equipment, net (Notes 4, 118,331 103,143 5 and 15) Loans receivable, secured by real estate 664 15,010 Other assets, net 18,738 15,797 --------------------- $ 270,653 $ 261,560 ====================== </TABLE> (continued on following page) F-2 LSB Industries, Inc. Consolidated Balance Sheets (continued) <TABLE> <CAPTION> DECEMBER 31, 1997 1996 ---------------------- (In Thousands) (s) <C> <C> LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Drafts payable $ 737 $ 536 Accounts payable 28,137 41,796 Accrued liabilities 16,196 12,780 Current portion of long-term debt (Note 5) 15,874 13,007 ------------------- Total current liabilities 60,944 68,119 Long-term debt (Note 5) 165,067 119,277 Commitments and contingencies (Note 10) Redeemable, noncumulative, convertible preferred stock, $100 par value; 1,539 shares issued and outstanding (Note 8) 146 146 Stockholders' equity (Notes 5, 7 and 9): 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; 920,000 shares issued 46,000 46,000 Common stock, $.10 par value; 75,000,000 shares authorized, 15,042,356 shares issued 1,504 1,489 (14,888,476 in 1996) Capital in excess of par value 38,257 37,843 Cumulative foreign currency translation adjustment (1,003) 276 Accumulated deficit (29,773) (2,706) -------- ------- 56,985 84,902 LESS TREASURY STOCK, AT COST: Series 2 preferred, 5,000 shares 200 200 Common stock, 2,293,390 shares (1,913,120 in 1996) 12,289 10,684 -------- ------ Total stockholders' equity 44,496 74,018 -------- ------ $270,653 $261,560 ======== ======== </TABLE> See accompanying notes. F-3 LSB Industries, Inc. Consolidated Statements of Operations <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, 1997 1996 1995 ---- ---- ---- (In Thousands, Except Per ShareAmounts) <S> <C> <C> <C> Revenues Net sales $ 313,929 $307,160 $267,391 Other income 6,260 6,891 6,724 ------- ------- ------- 320,189 314,051 274,115 Costs and expenses: Cost of sales 257,982 250,388 210,328 Selling, general and administrative 65,863 57,341 57,238 Interest 14,740 10,017 10,131 ------- ------- ------ 338,585 317,746 277,697 Loss before provision for income taxes and extraordinary charge (18,396) (3,695) (3,582) Provision for income taxes (Note 6) 50 150 150 ------- ------- ------- Loss before extraordinary charge (18,446) (3,845) (3,732) Extraordinary charge (Note 14) 4,619 -------- ------- ------- Net loss (23,065) (3,845) (3,732) Preferred stock dividends 3,229 3,229 3,229 ------- ------- ------- Net loss applicable to common stock$ (26,294) $ (7,074) $6,961) ======== ======== ====== Loss per common share - basic and diluted: Loss before extraordinary charge $ (1.68) $ (.55) $ (.53) Extraordinary charge (.36) ------ -------- -------- Net loss $ (2.04) $ (.55) $ (.53) ====== ======= ======= </TABLE> See accompanying notes. F-4 LSB Industries, Inc. Consolidated Statements of Stockholders' Equity <TABLE> <CAPTION> CUMULATIVE NON- FOREIGN RETAINED COMMON STOCK REDEEMABLE CAPITAL CURRENCY EARNINGS TREASURY TREASURY IN PAR PREFERRED EXCESS of TRANSLATION (ACCUMULATED STOCK STOCK SHARES VALUE STOCK PAR VALUE ADJUSTMENT DEFICIT) COMMON PREFERRED TOTAL (In Thousands) - ------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> Balance at December 31, 1994 14,620 $1,462 $48,000 $37,369 - $12,883 $(8,915) $(200) $90,599 Net loss (3,732) (3,732) Translation adjustment 278 278 Conversion of 31 shares of redeemable preferred 1 2 2 stock to common stock Exercise of stock options: Cash received 100 10 145 155 Stock tendered and added to treasury at market value 36 4 51 (55) Dividends declared: Series B 12% preferred stock ($12.00 per share) (240) (240) Redeemable preferred stock ($10.00 per share) (16) (16) Common stock ($.06 per share) (774) (774) Series 2 preferred stock($3.25 per share) (2,973) (2,973) Purchase of treasury stock (1,445) (1,445) Balance at December 31,1995 - --------------------------------------------------------------------------- 14,757 1,476 48,000 37,567 278 5,148 (10,415) (200) 81,854 </TABLE> (Continued on following page) F-5 <TABLE> <CAPTION> LSB Industries, Inc. Consolidated Statements of Stockholders' Equity (continued) CUMULATIVE NON- FOREIGN RETAINED COMMON STOCK REDEEMABLE CAPITAL CURRENCY EARNINGS TREASURY TREASURY in PAR PREFERRED EXCESS OF TRANSLATION(ACCUMULATED STOCK STOCK SHARES VALUE STOCK PAR Value ADJUSTMENT DEFICIT) COMMON PREFERRED TOTAL - ------------------------------------------------------------------------------ (In Thousands) <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> Net loss $ $ $ $(3,845) $ $ $(3,845) Translation adjustment (2) (2) Conversion of 27 shares of redeemable preferred stock to common stock 1 2 2 Exercise of stock options: Cash received 85 8 185 193 Stock tendered and added to treasury at market value 45 5 89 (94) Dividends declared: Series B 12% preferred stock ($12.00 per share) (240) (240) Redeemable preferred stock ($10.00 per share) (16) (16) Common stock ($.06 pershare) (780) (780) Series 2 preferred stock($3.25 per share) (2,973) (2,973) Purchase of treasury stock (175) (175) - -------------------------------------------------------------------------- Balance at December 31,1996 14,888 1,489 48,000 37,843 276 (2,706) (10,684) (200) 74,018 F-6 Net loss (23,065) (23,065) Translation adjustment (1,279) (1,279) Exercise of stock options: Cash received 67 6 190 196 Stock tendered and added to treasury at market value 87 9 224 (233) Dividends declared: Series B 12% preferred stock ($12.00 per share) (240) (240) Redeemable preferred stock ($10.00 per share) (16) (16) Common stock ($.06 per share) (773) (773) Series 2 preferred stock($3.25 per share) (2,973) (2,973) Purchase of treasury stock (1,372) (1,372) - --------------------------------------------------------------------------- Balance at December 31,1997 15,042 $1,504 $48,000 $38,257 $(1,003) $(29,773) $(12,289) $(200) $44,496 ========================================================================== </TABLE> See accompanying notes. F-7 LSB Industries, Inc. Consolidated Statements of Cash Flows <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, 1997 1996 1995 ------------------------------- (In Thousands) <S> <C> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES Net loss $(23,065) $ (3,845) $ (3,732) Adjustments to reconcile net loss to net cash provided (used) by operations Extraordinary charge related to financing activities 4,619 - - Depreciation of property, plant and equipment 11,142 8,655 7,909 Amortization 1,308 1,124 1,150 Provision for possible losses Trade accounts receivable 1,544 1,450 1,696 Notes receivable 1,093 1,565 1,350 Environmental matters 300 100 - Loan guarantee 1,093 626 590 Recapture of prior period provisions for loss on loans receivable secured by real estate (1,383) - - (Gain) loss on sales of assets 57 (1,574) (203) Cash provided (used) by changes in assets and liabilities: Trade accounts receivable (3,805) (8,267) (4,092) Inventories (1,892) (1,717) (6,091) Supplies and prepaid items (476) (1,533) 725 Accounts payable (13,549) 13,288 (902) Accrued liabilities 2,530 3,441 1,256 ------- ------- ------- Net cash provided (used) by operating (20,484) 13,313 (344) activities CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures (12,633) (19,950) (17,810) Principal payments on loans receivable 283 742 1,586 Proceeds from sales of equipment and real estate properties 1,957 417 1,345 Proceeds from the sale of investment securities - 1,524 - Other assets (5,293) (3,745) (3,872) ----------------------------------- Net cash used by investing activities (15,686) (21,012) (18,751) </TABLE> (Continued on following page) F-8 LSB Industries, Inc. Consolidated Statements of Cash Flows (continued) <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, 1997 1996 1995 ------------------------------ (In Thousands) <S> <C> <C> <C> CASH FLOWS FROM FINANCING ACTIVITIES Payments on long-term and other debt $(75,846) $(11,985) $ (9,476) Long-term and other borrowings 162,451 25,029 18,471 Debt prepayment charge (4,619) - - Net change in revolving debt facilities (37,525) (1,266) 15,070 Net change in drafts payable 201 112 (867) Dividends paid: Preferred stocks (3,229) (3,229) (3,229) Common stock (773) (780) (774) Purchase of treasury stock (1,372) (175) (1,445) Net proceeds from issuance of common stock 196 193 155 ----------------------------- Net cash provided by financing activities 39,484 7,899 17,905 ----------------------------- Net increase (decrease) in cash and cash equivalents from all activities 3,314 200 (1,190) Cash and cash equivalents at beginning of year 1,620 1,420 2,610 ----------------------------- Cash and cash equivalents at end of year $ 4,934 $ 1,620 $ 1,420 ============================== </TABLE> F-9 See accompanying notes. LSB Industries, Inc. Notes to Consolidated Financial Statements December 31, 1997, 1996 and 1995 1. BASIS OF PRESENTATION The accompanying consolidated financial statements include the accounts of LSB Industries, Inc. (the "Company") and its subsidiaries. The Company is a diversified holding company which is engaged in, through its subsidiaries, the manufacture and sale of chemical products (the "Chemical Business"), the manufacture and sale of a broad range of air handling and heat pump products (the "Climate Control Business"), the manufacture or purchase and sale of certain automotive products (the "Automotive Business") and the purchase and sale of machine tools (the "Industrial Products Business"). See Note 13 - Segment Information 2. ACCOUNTING POLICIES USE OF ESTIMATES The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. INVENTORIES Purchased machinery and equipment are carried at specific cost plus duty, freight and other charges, not in excess of net realizable value. All other inventory is priced at the lower of cost or market, with cost being determined using the first-in, first-out (FIFO) basis, except for certain heat pump products with a value of $8,151,000 at December 31, 1997 ($8,595,000 at December 31, 1996), which are priced at the lower of cost or market, with cost being determined using the last-in, first-out (LIFO) basis. The difference between the LIFO basis and current cost was $1,223,000 and $1,013,000 at December 31, 1997 and 1996, respectively. DEPRECIATION For financial reporting purposes, depreciation, depletion and amortization is primarily computed using the straight-line method over the estimated useful lives of the assets. CAPITALIZATION OF INTEREST Interest costs of $1,113,000, $2,405,000 and $1,357,000 related to the construction of a nitric acid plant were capitalized in 1997, 1996 and 1995, respectively, and are amortized over the plant's estimated useful life. LOANS RECEIVABLE Loans receivable are stated at unpaid principal balances, less allowances for loan losses, if any (none in 1997, 1996 or 1995). Management's periodic evaluation of the adequacy of the allowance is based on past loan loss F-10 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 2. ACCOUNTING POLICIES (CONTINUED) experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of the underlying collateral, and current economic conditions. In February 1997, the Company foreclosed on a loan receivable with a carrying amount of $14.0 million and exercised its option to acquire the related office building located in Oklahoma City, known as "The Tower." The estimated fair value of The Tower at the date of acquisition exceeds the Company's carrying amount at December 31, 1997 plus the exercise payment. See Note 15 - Subsequent Event. EXCESS OF PURCHASE PRICE OVER NET ASSETS ACQUIRED The excess of purchase price over net assets acquired, which is included in other assets in the accompanying balance sheets, were $3,287,000 and $3,941,000, net of accumulated amortization, of $3,641,000 and $3,400,000 at December 31, 1997 and 1996, respectively, and is amortized by the straight- line method over periods of 10 to 22 years. The carrying value of the excess of purchase price over net assets acquired is reviewed (using estimated future net cash flows, including proceeds from disposal) if the facts and circumstances indicate that it may be impaired. No significant impairment provisions were required in 1997, 1996 or 1995. DEBT ISSUANCE COST Debt issuance costs are amortized over the term of the associated debt instrument using the straight-line method. Such costs, which are included in other assets in the accompanying balance sheet, were $4,272,000 and $1,224,000 net of accumulated amortization of $683,000 and $1,257,000 as of December 31, 1997 and 1996, respectively. RESEARCH AND DEVELOPMENT COSTS Costs incurred in connection with product research and development are expensed as incurred. Such costs amounted to $394,000 in 1997, $532,000 in 1996 and $501,000 in 1995. ADVERTISING COSTS Costs incurred in connection with advertising and promotion of the Company's products are expensed as incurred. Such costs amounted to $2,430,000 in 1997, $1,814,000 in 1996 and $1,658,000 in 1995. F-11 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 2. ACCOUNTING POLICIES (CONTINUED) TRANSLATION OF FOREIGN CURRENCY Assets and liabilities of foreign operations, where the functional currency is the local currency, are translated into U.S. dollars at the fiscal year end exchange rate. The related translation adjustments are recorded as cumulative translation adjustments, a separate component of shareholders' equity. Revenues and expenses are translated using average exchange rates prevailing during the year. HEDGING In 1997, the Company entered into an interest rate forward agreement to effectively fix the interest rate on a long-term lease commitment to become effective August 1998 (not for trading purposes). The Company accounts for this agreement under the deferral method, whereby the net gain or loss upon settlement will adjust the item being hedged, the minimum lease rentals in periods commencing with the lease execution. If the necessary correlation (generally a correlation coefficient of between 80% and 125%) ceases, the differential between the market value and the carrying value will be recognized in operations as a gain or loss. Under the interest rate forward agreement, the Company is the fixed rate payor on notional amounts aggregating $50 million with a weighted average interest rate of 7.12%. The agreement requires a net settlement on maturity in August 1998, of which an unrelated third party is contractually obligated for 50%. The Company is required to post margin in the form of bank letters of credit or treasury bills under this interest rate hedge agreement. At December 31, 1997, the Company had issued margin in the form of letters of credit and treasury bills of approximately $3.6 million. See Note 10 - Commitments and Contingencies and Note - 12 - Fair Value of Financial Instruments. F-12 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 2.ACCOUNTING POLICIES (CONTINUED) In November 1997, the Company entered into a three month natural gas swap agreement at a price of $2.94 per MMBtu for the months of December 1997 through February 1998 to hedge the price volatility of ammonia(not for trading purposes). Under these swap agreements, the Company is the fixed-price payor. Monthly payments are made or received based on the differential between the fixed price and the specified index price of natural gas on the settlement date. Gains or losses resulting from the settlement of the swap transactions are recognized in cost of sales when the inventory is sold. At December 31,1997, commodity contracts involving notional amounts of 236,000 MMBtu were outstanding and are not reflected in the accompanying balance sheet. These notional amounts do not represent amounts exchanged by the parties; rather, they are used as the basis to calculate the amounts due under the agreements. LOSS PER SHARE In 1997, the Financial Accounting Standards Board issued Statement No. 128, Earnings Per Share. Statement 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to the Statement 128 requirements. Net loss applicable to common stock is computed by adjusting net loss by the amount of preferred stock dividends. Basic loss per common share is based upon the weighted average number of common shares outstanding during each period after giving appropriate effect to preferred stock dividends. Diluted loss per share is based on the weighted average number of common shares and dilutive common equivalent shares outstanding and the assumed conversion of dilutive F-13 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 2. ACCOUNTING POLICIES (CONTINUED) convertible securities outstanding, if any, after appropriate adjustment for interest, net of related income tax effects on convertible notes payable, as applicable. All potentially dilutive securities were antidilutive for all periods presented and have thus, been excluded from diluted loss per share. See Note 7- Stockholder's Equity, Notes 8 - Redeemable Preferred Stock, and Note 9 Nonredeemable Preferred Stock for a full description of securities which may have a dilutive effect in future periods. Average common shares outstanding used in computing loss per share are as follows: <TABLE> <CAPTION> 1997 1996 1995 ------------------------------ <S> <C> <C> <C> Basic and diluted 12,876,064 12,925,649 13,020,677 </TABLE> RECENTLY ISSUED PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income ("Statement 130"), which is effective for fiscal years beginning after December 15, 1997. Reclassifications of financial statements for earlier periods presented for comparative purposes will be required when adopted by the Company in 1998. The Statement establishes standards for reporting and displaying comprehensive income. Comprehensive income is defined as the change in equity of an enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investment by owners and distributions to owners. The primary impact of the new Statement will be related to the inclusion of foreign currency translation gains or losses in determining "Comprehensive Income" as compared with the current statement of operations which does not give effect to this item. F-14 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 2.ACCOUNTING POLICIES (CONTINUED) In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information ("Statement 131"), which is effective for years beginning after December 15, 1997. Statement 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. Statement 131 is effective for financial statements for fiscal years beginning after December 15, 1997 and, therefore, the Company will adopt the new requirements retroactively in 1998. Management has not completed its review of Statement 131, but does not anticipate that the adoption of this Statement will have a significant effect on the Company's reported segments. STATEMENTS OF CASH FLOWS For purposes of reporting cash flows, cash and cash equivalents include cash, overnight funds and interest bearing deposits with maturities when purchased by the Company of 90 days or less. Supplemental cash flow information includes: <TABLE> <CAPTION> 1997 1996 1995 -------------------------- (In Thousands) <S> <C> <C> <C> Cash payments for: Interest on long-term debt and other $ 14,804 $ 12,038 $10,613 Income taxes, net of refunds 86 345 191 Noncash financing and investing activities Long-term debt issued for property, plant and equipment 1,108 2,226 2,534 </TABLE> F-15 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 3. INVENTORIES Inventories at December 31, 1997 and 1996 consist of: <TABLE> <CAPTION> FINISHED (OR WORK-IN- RAW PURCHASED) GOODS PROCESS MATERIALS TOTAL -------------------------------------- (In Thousands) <S> <C> <C> <C> <C> 1997: Chemical products $ 10,314 $ 4,556 $ 11,020 $ 25,890 Climate Control products 2,941 3,246 6,748 12,935 Automotive products 16,478 780 5,421 22,679 Machinery and industrial 6,696 - - 6,696 supplies ----------------------------------------------- Total $ 36,429 $ 8,582 $ 23,189 $ 68,200 =============================================== 1996 total $ 37,646 $ 10,742 $ 19,594 $ 67,982 =============================================== </TABLE> F-16 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 4. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment, at cost, consist of: <TABLE> <CAPTION> DECEMBER 31, 1997 1996 ------------------------ (In Thousands) <S> <C> <C> Land and improvements $ 5,425 $ 4,860 Buildings and improvements (A) 34,648 21,540 Machinery, equipment and automotive 154,727 141,972 Furniture, fixtures and store equipment 7,159 6,399 Producing oil and gas properties 3,246 3,279 ------------------ 205,205 178,050 Less accumulated depreciation, depletion and 86,874 74,907 amortization ------------------ $ 118,331 $ 103,143 ================== </TABLE> (A) Includes The Tower in 1997 acquired through foreclosure in February 1997 as discussed in Note 2 - Accounting Policies, Loans Receivable. See Note 15 - Subsequent Event. F-17 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5.LONG - TERM DEBT Long - term debt consists of the following: <TABLE> <CAPTION> DECEMBER 31, 1997 1996 ----------------------- (In Thousands) <S> <C> <C> Secured revolving credit facility with interest at a base rate plus a specified percentage (10.0% aggregate rate at December 31, 1997) (A) $ 19,275 $ 57,248 10-3/4% Senior Notes due 2007 (B) 105,000 Secured loan with interest payable monthly (C) 11,806 13,855 Note payable to bank, due in monthly installments of principal and interest through May 2001, interest at a rate equal to the Wall Street Journal prime rate plus .75% (aggregate rate of 9.25% at December 31, 1997 (D) 12,622 12,866 Secured loan due in monthly installments Of principal and interest through July 31, 2003,interest at a rate equal to the "Three-month adjusted - 11,820 Libor rate plus 4.25%" (E) Secured loans with institutional lender (F): 10.415% TO 12.72% term loans - 5,542 Revolving credit facility - 1,944 Other, with interest at rates of 7.5% to 12.25%,most of which is secured by machinery And equipment(G) 32,238 29,009 -------------------- 180,941 132,284 LESS CURRENT PORTION OF LONG-TERM DEBT 15,874 13,007 --------------------- LONG-TERM DEBT DUE AFTER ONE YEAR $ 165,067 $ 119,277 ===================== </TABLE> F-18 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5.LONG - TERM DEBT (CONTINUED) (A) In December 1994, the Company, certain subsidiaries of the Company (the "Borrowing Group") and a bank entered into a series of six asset-based revolving credit facilities which provided for an initial term of three years. In November 1997, the Company amended the agreement. The amended agreement provides for a $65 million revolving credit facility (the "Revolving Credit Facility") with four separate loan agreements (the "Credit Facility Agreement"'), for the Company and its subsidiaries. Under the Revolving Credit Facility, certain conditions exist which restrict intercompany transfers of amounts borrowed between subsidiaries. Borrowings under the Revolving Credit Facility bear an annual rate of interest at a floating rate based on the lender's prime rate plus 1.5% per annum or, at the Company's option, on the lender's LIBOR rate plus 3.875% per annum (which rates are subject to increase or reduction based upon specified availability and adjusted tangible net worth levels). The agreement will terminate on December 31, 2000, subject to automatic renewal for terms of 13 months each, unless terminated by either party. The Credit Facility Agreement also requires the payment of an annual facility fee equal to 0.5% of the unused Revolving Credit Facility. The Company may terminate the Revolving Credit Facility prior to maturity; however, should the Company do so, it would be required to pay a termination fee equal to 1% of the average daily balance of loans and letters of credit outstanding during the 180 day period immediately prior to termination. Each of the Credit Facility Agreements specify a number of events of default and requires the Company to maintain certain financial ratios (including adjusted tangible net worth and debt ratios), limits the amount of capital expenditures, and contains other covenants which restrict, among other things, (i) the incurrence of additional debt; (ii) the payment of dividends and other distributions; (iii) the making of certain investments; (iv) certain mergers, acquisitions and dispositions; (v) the issuance of secured guarantees; and (vi) the granting of certain liens. Events of default under the Revolving Credit Facility include, among other things, (i) the failure to make payments of principal, interest, and fees, when due; (ii) the failure to perform covenants contained therein; (iii) the occurrence of a change in control if any party is or becomes the beneficial owner of more than 50% of the total voting securities of the Company, except for Jack E. Golsen or members of his immediate family; (iv) default under any material agreement or instrument (other than an agreement or instrument evidencing the lending F-19 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5.LONG - TERM DEBT (CONTINUED) of money) which would have a material adverse effect on the Company and its subsidiaries which are borrowers under the Revolving Credit Facility, taken as a whole, and which is not cured within the grace period; (v) a default under any other agreement relating to borrowed money exceeding certain limits; and (vi) customary bankruptcy or insolvency defaults. At December 31, 1997, the Company and its subsidiaries were not in compliance with certain of its financial covenants of the Revolving Credit Facility. In April 1998, the Company obtained a waiver of noncompliance and an amendment to reset the financial covenants through maturity. The Revolving Credit Facility is secured by the accounts receivable, inventory, proprietary rights, general intangibles, books and records, and proceeds thereof of the Company. See Note 15 - Subsequent Event. (B) On November 26, 1997, a subsidiary of the Company (ClimaChem, Inc., "CCI") completed the sale of $105 million principal amount of 10 3/4% Senior Notes due 2007 (the "Notes"). The proceeds of the Notes of $101.8 million, net of underwriter's fees, were used to (a) fully repay the principal and prepayment fees of a $50 million John Hancock Mutual Life Insurance Company ("John Hancock") financing arrangement described in Note 14-Extraordinary Charge, (b) reduce amount outstanding under F-20 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5.LONG TERM DEBT (CONTINUED) various revolving credit facilities with respect to the chemical business and the Climate Control Business, and (c) fund a loan to the Company of $10 million. The Notes bear interest at an annual rate of 10 3/4% payable semiannually in arrears on June 1 and December 1 of each year. The Notes are Senior unsecured obligations of CCI and rank pari passu in right of payment to all existing senior unsecured indebtedness of CCI and its subsidiaries. The Notes are effectively subordinated to all existing and future senior secured indebtedness of CCI. The Notes were issued pursuant to an Indenture, which contains certain covenants that, among other things, limit the ability of CCI and its subsidiaries to: (i) incur additional indebtedness; (ii) incur certain liens; (iii) engage in certain transactions with affiliates; (iv) make certain restricted payments; (v) agree to payment restrictions affecting subsidiaries; (vi) engage in unrelated lines of business; or (vii) engage in mergers, consolidations or the transfer of all or substantially all of the assets of CCI to another person. In addition, in the event of certain asset sales, CCI will be required to use the proceeds to reinvest in the Company's business, to repay certain debt or to offer to purchase Notes at 100% of the principal amount thereof, plus accrued and unpaid interest, if any, thereon, plus liquidated damages, if any, to the date of purchase. Except as described below, the Notes are not redeemable at CCI's option prior to December 1, 2002. After December 1, 2002, the Notes will be subject to redemption at the option of CCI, in whole or in part, at the redemption prices set forth in the Indenture, plus accrued and unpaid interest thereon, plus liquidated damages, if any, to the applicable redemption date. In addition, until December 1, 2000, up to $35 million in aggregate principal amount of Notes are redeemable, at the option of CCI, at a price of 110.75% of the principal amount of the Notes, together with accrued and unpaid interest, if any, thereon, plus liquidated damages, if any, to the date of the redemption, with the net cash proceeds of a public equity offering; provided, however, that at least $65 million in aggregate principal amount of the Notes remain outstanding following such redemption. F-21 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5.LONG TERM DEBT (CONTINUED) In the event of a change of control of the Company or CCI, holders of the Notes will have the right to require CCI to repurchase the Notes, in whole or in part, at a redemption price of 101% of the principal amount thereof, plus accrued and unpaid interest, if any, thereon, plus liquidated damages, if any, to the date of repurchase. CCI is a holding company with no assets or operations other than its investments in its subsidiaries, and each of its subsidiaries is wholly owned, directly or indirectly. CCI's payment obligations under the Notes are fully, unconditionally and joint and severally guaranteed by all of the existing subsidiaries of CCI, except for El Dorado Nitrogen Company ("EDNC"). The assets, equity, and earnings of EDNC are inconsequential for all periods presented. Separate financial statements and other disclosures concerning the guarantors are not presented herein because management has determined they are not material to investors. Summarized financial information of CCI and its subsidiaries as of December 31, 1997 and 1996 and the results of operations for each of the three years ended December 31, 1997 is as follows: <TABLE> <CAPTION> DECEMBER 31, 1997 1996 ----------------- (In Thousands) <S> <C> <C> BALANCE SHEET DATA: Current assets $ 88,442 $ 84,492 Property, plant and equipment 84,329 82,676 Notes receivable from LSB and affiliates 13,443 - Other assets 14,661 6,586 ------------------------ Total assets $ 200,875 $ 173,754 ========================== Current liabilities $ 38,004 $ 52,342 Long-term debt 126,346 71,763 Other 9,236 16,806 Stockholders' equity 27,289 32,843 -------------------------- Total liabilities and stockholders' equity $ 200,875 $ 173,754 =========================== </TABLE> F-22 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5.LONG-TERM DEBT (CONTINUED) <TABLE> <CAPTION> DECEMBER 31, 1997 1996 1995 ------------------------ (In Thousands) <S> <C> <C> <C> OPERATIONS DATA: Total revenues $ 263,321$ 255,618 $ 221,541 Costs and expenses: Costs of sales 213,772 207,828 172,858 Selling, general and administrative 37,854 33,122 30,344 Interest 9,369 6,247 7,185 ------------------------------- 260,995 247,197 210,387 ------------------------------- Income before provision for income taxes and extraordinary charge 2,326 8,421 11,154 Provision for income taxes 1,429 2,668 5,255 ------------------------------ Income before extraordinary charge 897 5,753 5,899 Extraordinary charge, net of income tax benefit of $1,750,000 2,869 - - ------------------------------- Net income (loss) $ (1,972) $ 5,753 $ 5,899 =============================== </TABLE> F-23 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5.LONG TERM DEBT (CONTINUED) (C) This agreement, as amended, between a subsidiary of the Company and an institutional lender provided for a loan, the proceeds of which were used in the construction of a nitric acid plant, in the aggregate amount of $16.5 million requiring 84 equal monthly payments of principal plus interest, with interest at a fixed rate of 8.86% through maturity in 2002. This agreement is secured by the plant, equipment and machinery, and proprietary rights associated with the plant which has an approximate carrying value of $30.3 million at December 31, 1997. In November 1997, the Company amended this agreement to restate the financial and restrictive covenants to be applicable to the subsidiary of the Company. This agreement, as amended, contains covenants (i) requiring maintenance of an escalating tangible net worth, (ii) restricting distributions and dividends, (iii) restricting a change of control of the subsidiary and the Company and (iv) requiring maintenance of a reducing debt to F-24 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5.LONG TERM DEBT (CONTINUED) tangible net worth ratio. At December 31, 1997, the subsidiary of the Company was not in compliance with certain of the financial covenants of the agreement. In March 1998, the subsidiary of the Company obtained a waiver of the noncompliance and an amendment to reset the financial covenants through maturity. (D) In May 1995, a subsidiary of the Company entered into a term loan agreement with a bank in the amount of $9 million. The agreement was amended in May 1996 to increase the loan to $13 million. The loan, which matured in May 2001, was payable in 60 monthly payments of principal and interest, commencing on June 30, 1996. The monthly principal and interest payment was based on a 240-month period ("Amortization Period") at a rate of interest equal to .75% in excess of the prime rate of a certain bank. The loan was secured by The Tower, subsequent to its acquisition in February 1997. See Note 15-Subsequent Event. (E) This agreement between a subsidiary of the Company and a subsidiary of a bank required monthly installments of principal and interest through July 31, 2003 at the three-month adjusted LIBOR rate plus 4.25%. The outstanding balance was paid in February 1997 in connection with the John Hancock financing arrangement. See Note 14-Extraordinary Charge. (F) This agreement between a subsidiary of the Company and two institutional lenders provided for two series of term loans and a revolving credit facility. The outstanding balance was paid in February 1997 in connection with the John Hancock financing arrangement. See Note 14-Extraordinary Charge. (G) Includes a $3.0 million note payable to SBL Corporation, a related party owned by the Golsen family. The note bears interest at 10.75% per annum, is unsecured and due on demand. Maturities of long-term debt for each of the five years after December 31, 1997 are: 1998 - $15,874; 1999 - $8,167; 2000 - $27,498; 2001 - $19,296; 2002 - - $2,912 and thereafter - $107,194. F-25 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 6.INCOME TAXES The provision for income taxes before extraordinary charge consists of the following for the year indicated: <TABLE> <CAPTION> 1997 1996 1995 ------------------------------ (In Thousands) <S> <C> <C> <C> Current: Federal $ - $ 54 $ - State 50 96 150 ---------------------------- $50 $150 $150 =========================== </TABLE> F-26 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 6.INCOME TAXES (CONTINUED) The approximate tax effects of each type of temporary difference and carryforward that are used in computing deferred tax assets and liabilities and the valuation allowance related to deferred tax assets at December 31, 1997 and 1996 are as follows: <TABLE> <CAPTION> 1997 1996 ------------------- (IN THOUSANDS) <S> <C> <C> DEFERRED TAX ASSETS Allowances for doubtful accounts and other asset impairments not deductible for tax purpose $ 5,361 $ 4,896 Capitalization of certain costs as inventory for tax purposes 2,835 3,415 Net operating loss carryforward 26,334 17,642 Investment tax and alternative minimum tax credit carryforwards 1,397 1,397 Other 956 1,079 ------------------- Total deferred tax assets 36,884 28,429 Less valuation allowance on deferred tax assets 26,455 17,363 ------------------- Net deferred tax assets $ 10,429 $ 11,066 =================== DEFERRED TAX LIABILITIES Accelerated depreciation used for tax purposes $ 8,288 $ 8,918 Inventory basis difference resulting from a business combination 2,139 2,139 Other 2 9 ------------------ Total deferred tax liabilities $ 10,429 $ 11,066 ================== </TABLE> The Company is able to realize deferred tax assets up to an amount equal to the future reversals of existing taxable temporary differences. The taxable temporary differences will turn around in the loss carryforward period as the differences are depreciated or amortized. Other differences will turn F-27 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 6. INCOME TAXES (CONTINUED) around as the assets are disposed in the normal course of business. The differences between the amount of the provision for income taxes and the amount which would result from the application of the federal statutory rate to "Loss before provision for income taxes and extraordinary charge" for each of the three years in the period ended December 31, 1997 are detailed below: <TABLE> <CAPTION> 1997 1996 1995 -------------------------------------- (In Thousands) (s> <C> <C> <C> Benefit for income taxes at federal statutory rate $ (8,055) $ (1,293) $ (1,254) Changes in the valuation allowance related to deferred tax assets, 7,313 1,591 409 net of rate differential State income taxes, net of federal 33 62 99 benefit Permanent differences 534 364 283 Foreign subsidiary loss (income) 191 (635) 615 Alternate minimum tax - 54 - Other 34 7 (2) ------------------------------------- Provision for income taxes $ 50 $ 150 $ 150 ===================================== </TABLE> At december 31, 1997, the company has regular-tax net operating loss ("NOL") carryforwards of approximately $65 million (approximately $18 Million alternative minimum tax NOLs). Certain amounts of regular-tax NOL Expire beginning in 1999. F-28 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 7. STOCKHOLDERS' EQUITY STOCK OPTIONS The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under FASB Statement No. 123, "Accounting for Stock-Based Compensation," requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is generally recognized. Pro forma information regarding net income and earnings per share is required by Statement 123, which also requires that the information be determined as if the Company has accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black- Scholes option pricing model with the following weighted average assumptions for 1997, 1996 and 1995, respectively: risk-free interest rates of 6.2%, 6.0% and 6.4%; a dividend yield of 1.43%, 1.38% and 1.04%; volatility factors of the expected market price of the Company's common stock of .42, .41 and .41; and a weighted average expected life of the option of 8.0, 6.8 and 7.3 years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. F-29 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 7. STOCKHOLDERS' EQUITY (CONTINUED) For purposes of pro forma disclosures, the estimated fair value of the qualified and non-qualified stock options is amortized to expense over the options' vesting period. The Company's pro forma information follows: <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, 1997 1996 1995 --------------------------------- (In Thousands, Except Per Share Data) <S> <C> <C> <C> Net loss applicable to $(26,715) $(7,184) $(7,036) common stock Loss per common share (2.07) (.56) (.54) </TABLE> Because Statement 123 is applicable only to options granted subsequent to December 31, 1994, its pro forma effect will not be fully reflected until 1998. F-30 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 7.STOCKHOLDERS' EQUITY (CONTINUED) QUALIFIED STOCK OPTION PLANS In November 1981, the Company adopted the 1981 Incentive Stock Option Plan (1,350,000 shares), in March 1986, the Company adopted the 1986 Incentive Stock Option Plan (1,500,000 shares) and, in September 1993, the Company adopted the 1993 Stock Option and Incentive Plan (850,000 shares). Under these plans, the Company is authorized to grant options to purchase up to 3,700,000 shares of the Company's common stock to key employees of the Company and its subsidiaries. The 1981 and 1986 Incentive Stock Option Plans have expired and, accordingly, no additional options may be granted from these plans. Options granted prior to the expiration of these plans continue to remain valid thereafter in accordance with their terms. At December 31, 1997, there are 212,260 of options outstanding related to these two plans. At December 31, 1997, there are 836,500 options outstanding related to the 1993 Incentive Stock Option Plan which continues to be effective. These options become exercisable 20% after one year from date of grant, 40% after two years, 70% after three years, 100% after four years and lapse at the end of ten years. The exercise price of options to be granted under this plan is equal to the fair market value of the Company's common stock at the date of grant. For participants who own 10% or more of the Company's common stock at the date of grant, the option price is 110% of the fair market value at the date of grant and the options lapse after five years from the date of grant. F-31 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 7.STOCKHOLDERS' EQUITY (CONTINUED) Activity in the Company's qualified stock option plans during each of the three years in the period ended December 31, 1997 is as follows: <TABLE> <CAPTION> 1997 1996 1995 --------------------------------------------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price ---------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Outstanding at 1,176,640 $4.08 611,140 $3.40 581,140 $ 2.84 beginning of year Granted - - 720,500 4.33 91,000 5.88 Exercised (118,880) 2.81 (120,000) 2.13 (61,000) 1.74 Surrendered, Forfeited or expired (9,000) 6.05 (35,000) 4.21 - - ---------- ----- ---------- ----- ---------- ----- Outstanding at End of year 1,048,760 4.25 1,176,640 4.08 611,140 3.40 ========== ===== ========== ===== ========== ===== Exercisable at end of year 414,960 3.81 354,540 3.76 390,540 2.39 ========== ===== ========== ===== ========== ===== Weighted average Fair value of options Granted during year - 2.00 3.01 </TABLE> F-32 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 7.STOCKHOLDERS' EQUITY (CONTINUED) Outstanding options to acquire 868,260 shares of stock at December 31, 1997 Had exercise prices ranging from $1.13 to $4.13 per share (337,660 of which Are exercisable at a weighted average price of $3.15 per share) and had a Weighted average exercise price of $3.86 and remaining contractual life of 5.4 Years. The balance of options outstanding at December 31, 1997 had exercise Prices ranging from $5.36 to $9.00 per share (77,300 of which are exercisable At a weighted average price of $6.69 per share) and had a weighted average Exercise price of $6.15 and remaining contractual life of 7.0 years. NON-QUALIFIED STOCK OPTION PLANS The Company's Board of Directors approved the grant of non-qualified stock options to the Company's outside directors, President and certain key employees, as detailed below. The option price was based on the market value of the Company's common stock at the date of grant. These options have vesting terms and lives specific to each grant but generally vest over 48 months and expire five or ten years from the grant date (except for the 1994 extension discussed below). In June 1994, the Board of Directors extended the expiration date on the grant of options for 165,000 shares to the Company's Chairman for an additional five years. The option price and terms of the option were unchanged except that, in consideration of the extension of time to exercise, the Chairman agreed to a revised vesting schedule for exercise of 20% of the option shares in each of the years 1995, 1996 and 1997 and 40% of the option shares in 1998. In September 1993, the Company adopted the 1993 Nonemployee Director Stock Option Plan (the "Outside Director Plan"). The Outside Director Plan authorizes the grant of non-qualified stock options to each member of the Company's Board of Directors who is not an officer or employee of the Company or its subsidiaries. The maximum number of shares of common stock of the Company that may be issued under the Outside Director Plan is 150,000 shares (subject to adjustment as provided in the Outside Director Plan). The Company shall automatically grant to each outside director an option to acquire 5,000 shares of the Company's common stock on April 30 following the end of each of the Company's fiscal years in which the Company realizes net income of $9.2 million or more for such fiscal year. The exercise price for an option granted under this plan shall be the fair market value of the shares of common stock at the time the option is granted. Each option granted under this plan to the extent not exercised shall terminate upon the earlier of the F-33 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 7.STOCKHOLDERS' EQUITY (CONTINUED) termination as a member of the Company's Board of Directors or the fifth anniversary of the date such option was granted. During 1997 and 1995, the Company granted 50,000 options and 25,000 options, respectively, under the Outside Director Plan. Activity in the Company's non-qualified stock option plans during each of the three years in the period ended December 31, 1997 is as follows: <TABLE> <CAPTION> 1997 1996 1995 ------------------- -------------------- ------------------ Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price ------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Outstanding at 265,000 $3.31 285,000 $3.44 335,000 $ 2.83 beginning of year Granted 50,000 4.19 25,000 5.38 Exercised (35,000) 3.13 (10,000) 3.13 (75,000) 1.38 Surrendered, forfeited, or expired - - (10,000) 7.19 - - --------- ----- -------- ----- --------- ------ Outstanding at end of year 280,000 3.44 265,000 3.31 285,000 3.44 ========= ===== ========== ===== ========== ===== Exercisable at end of year 164,000 3.55 166,000 3.64 153,000 4.06 ========= ===== ========= ===== ========== ===== Weighted average fair value of options granted during year 2.00 2.14 </TABLE> F-34 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 7.STOCKHOLDERS' EQUITY (CONTINUED) Outstanding options to acquire 240,000 shares of stock at December 31, 1997 had exercise prices ranging from $1.38 to $4.25 per share (124,000 of which are exercisable at a weighted average price of $2.97 per share) and had a weighted average exercise price of $2.82 and remaining contractual life of 3.2 years. The balance of options outstanding at December 31, 1997 had exercise prices ranging from $5.38 to $9.00 per share (40,000 of which are exercisable at a weighted average price of $7.19 per share) and a weighted average exercise price of $7.19 and remaining contractual life of 1.8 years. PREFERRED SHARE PURCHASE RIGHTS In February 1989, the Company's Board of Directors declared a dividend distribution of one Preferred Share Purchase Right (the "Preferred Right") for each outstanding share of the Company's common stock. The Preferred Rights are designed to ensure that all of the Company's stockholders receive fair and equal treatment in the event of a proposed takeover or abusive tender offer. The Preferred Rights are generally exercisable when a person or group, other than the Company's Chairman and his affiliates, acquire beneficial ownership of 30% or more of the Company's common stock (such a person or group will be referred to as the "Acquirer"). Each Preferred Right (excluding Preferred Rights owned by the Acquirer) entitles stockholders to buy one one-hundredth (1/100) of a share of a new series of participating preferred stock at an exercise price of $14. Following the acquisition by the Acquirer of beneficial ownership of 30% or more of the Company's common stock, and prior to the acquisition of 50% or more of the Company's common stock by the Acquirer, the Company's Board of Directors may exchange all or a portion of the Preferred Rights (other than Preferred Rights owned by the Acquirer) for the Company's common stock at the rate of one share of common stock per Preferred Right. Following acquisition by the Acquirer of 30% or more of the Company's common stock, each Preferred Right (other than the Preferred Rights owned by the Acquirer) will entitle its holder to purchase a number of the Company's common shares having a market value of two times the Preferred Right's exercise price. If the Company is acquired, each Preferred Right (other than the Preferred Rights owned by the Acquirer) will entitle its holder to purchase a number of the Acquirer's common shares having a market value at the time of two times the Preferred Right's exercise price. Prior to the acquisition by the Acquirer of beneficial ownership of 30% or F-35 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 7.STOCKHOLDERS' EQUITY (CONTINUED) more of the Company's stock, the Company's Board of Directors may redeem the Preferred Rights for $.01 per Preferred Right. 8. REDEEMABLE PREFERRED STOCK Each share of the noncumulative redeemable preferred stock, $100 par value, is convertible into 40 shares of the Company's common stock at any time at the option of the holder; entitles the holder to one vote and is redeemable at par. The redeemable preferred stock provides for a noncumulative annual dividend of 10%, payable when and as declared. Dividend payments were current at December 31, 1997 and 1996. 9. NON-REDEEMABLE PREFERRED STOCK The 20,000 shares of Series B cumulative, convertible preferred stock, $100 par value, are convertible, in whole or in part, into 666,666 shares of the Company's common stock (33.3333 shares of common stock for each share of preferred stock) at any time at the option of the holder and entitles the holder to one vote per share. The Series B preferred stock provides for annual cumulative dividends of 12% from date of issue, payable when and as declared. Dividend payments were current at December 31, 1997 and 1996. The Class C preferred stock, designated as a $3.25 convertible exchangeable Class C preferred stock, Series 2, has no par value ("Series 2 Preferred"). The Series 2 Preferred has a liquidation preference of $50.00 per share plus accrued and unpaid dividends and is convertible at the option of the holder at any time, unless previously redeemed, into common stock of the Company at an initial conversion price of $11.55 per share (equivalent to a conversion rate of approximately 4.3 shares of common stock for each share of Series 2 Preferred), subject to adjustment under certain conditions. Upon the mailing of notice of certain corporate actions, holders will have special conversion rights for a 45-day period. The Series 2 Preferred is redeemable subsequent to June 15, 1996. The Series 2 Preferred is redeemable at the option of the Company, in whole or in part, at $52.28 per share if redeemed on or after June 15, 1996, and thereafter at prices decreasing ratably annually to $50.00 per share on or after June 15, 2003, plus accrued and unpaid dividends to the redemption date. Dividends on the Series 2 Preferred are cumulative and are payable quarterly in arrears. Dividend payments were current at December 31, 1997 and 1996. F-36 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 9. NON-REDEEMABLE PREFERRED STOCK (CONTINUED) The Series 2 Preferred also is exchangeable in whole, but not in part, at the option of the Company on any dividend payment date beginning June 15, 1996, for the Company's 6.50% Convertible Subordinated Debentures due 2018 (the "Debentures") at the rate of $50.00 principal amount of Debentures for each share of Series 2 Preferred. Interest on the Debentures, if issued, will be payable semiannually in arrears. The Debentures will, if issued, contain conversion and optional redemption provisions similar to those of the Series 2 Preferred and will be subject to a mandatory annual sinking fund redemption of five percent of the amount of Debentures initially issued, commencing June 15, 2003 (or the June 15 following their issuance, if later). At December 31, 1997, the Company is authorized to issue an additional 248,461 shares of $100 par value preferred stock and an additional 5,000,000 shares of no par value preferred stock. Upon issuance, the Board of Directors of the Company is to determine the specific terms and conditions of such preferred stock. 10. COMMITMENTS AND CONTINGENCIES OPERATING LEASES The Company leases certain property, plant and equipment under noncancelable operating leases. Future minimum payments on operating leases with initial or remaining terms of one year or more at December 31, 1997 are as follows: <TABLE> <CAPTION> (In Thousands) <S> <C> 1998 $ 2,323 1999 1,930 2000 1,667 2001 1,604 2002 1,544 After 2002 5,751 ---------- $ 14,819 ========== </TABLE> Rent expense under all operating lease agreements, including month-to-month leases, was $4,085,000 in 1997, $4,337,000 in 1996 and $3,400,000 in 1995. F-37 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10. COMMITMENTS AND CONTINGENCIES (CONTINUED) Renewal options are available under certain of the lease agreements for various periods at approximately the existing annual rental amounts. Rent expense paid to related parties was $90,000 in 1997, 1996 and 1995. In June 1997, two wholly owned subsidiaries of the Company, El Dorado Chemical Company ("EDC"), and El Dorado Nitrogen Company ("EDNC"), entered into a series of agreements with Bayer Corporation ("Bayer") (collectively, the "Bayer Agreement"). Under the Bayer Agreement, EDNC will act as an agent to construct, and upon completion of construction, will operate a nitric acid plant (the "EDNC Baytown Plant") at Bayer's Baytown, Texas chemical facility. EDC has guaranteed the performance of EDNC's obligations under the Bayer Agreement. Under the terms of the Bayer Agreement, EDNC is to lease the EDNC Baytown Plant pursuant to a leveraged lease from an unrelated third party with an initial lease term of ten years from the date on which the EDNC Baytown Plant becomes fully operational. Upon expiration of the initial ten-year term from the date the EDNC Baytown Plant becomes operational, the Bayer Agreement may be renewed for up to six renewal terms of five years each; however, prior to each renewal period, either party to the Bayer Agreement may opt against renewal. It is anticipated that construction of the EDNC Baytown Plant will cost approximately $60 million and will be completed by the end of 1998. Construction financing of the EDNC Baytown Plant is to be provided by an unaffiliated lender. Neither the Company nor EDC has guaranteed any of the lending obligations for the EDNC Baytown Plant. F-38 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10.COMMITMENTS AND CONTINGENCIES (CONTINUED) PURCHASE COMMITMENTS A subsidiary of the Company purchases substantial quantities of anhydrous ammonia for use in manufacturing its products. A subsidiary of the Company has contracts with two suppliers of ammonia. One contract requires a subsidiary of the Company to purchase not less than 75,000 tons nor more than 140,000 tons of anhydrous ammonia each contract year and is for a term expiring in December 1998. The other requires a subsidiary of the Company to take or pay for an average of 10,000 tons of anhydrous ammonia per month and expires April 2000. These contracts are at floating prices. Purchases of anhydrous ammonia under these two contracts aggregated $40.1 million in 1997 ($30.4 million and $23.8 million for the one contract effective in 1996 and 1995, respectively). The pricing volatility of such raw material directly affects the operating profitability of a subsidiary of the Company. A subsidiary of the Company also enters into agreements with suppliers of raw materials which require a subsidiary of the Company to provide finished goods in exchange therefore. At December 31, 1997, the subsidiary of the Company had received quantities of anhydrous ammonia in exchange for which the subsidiary of the Company has a commitment to provide 12,020 tons of ammonium nitrate and 20,250 tons of nitric acid. The Company believes these agreements are generally favorable to the subsidiary of the Company and the delivery commitments will be met in the ordinary course of business. At December 31, 1997, the Company has a standby letter of credit outstanding related to its Chemical Business of $3.5 million. A subsidiary of the Company leases certain precious metals for use in the subsidiary's manufacturing process under 90 day agreements. The agreement at December 31, 1997 requires rentals generally based on 17% of the leased metals' market values from January 1998 through March 1998, contract expiration. The agreements also require the subsidiary to purchase 900 ounces of platinum at $450 per ounce if the spot price for platinum is $450 per ounce or lower at the end of the lease term. In January 1996, a subsidiary negotiated an amendment to an agreement with a foreign customer, modifying the subsidiary's firm commitment to purchase $30 million of bearing products over a five-year period in exchange for waiver of the foreign customer's commitment to provide bearing products without charge to the subsidiary at a future date. Under this amendment the Company is not required to purchase more bearing products each year than it can sell in its normal course of business. During 1995, the subsidiary purchased approximately F-39 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10.COMMITMENTS AND CONTINGENCIES (CONTINUED) $3.1 million of product in connection with such requirement. As a result of the elimination of the subsidiary's future bearing product commitment, the Company recognized the remaining $1.8 million of contract revenue in 1995 which had been previously deferred pending completion of the subsidiary's firm purchase commitment. In July 1995, a subsidiary of the Company entered into a product supply agreement with a third party whereby the subsidiary is required to make monthly facility fee and other payments which aggregate $71,965. In return for this payment, the subsidiary is entitled to certain quantities of compressed oxygen produced by the third party. Except in circumstances as defined by the agreement, the monthly payment is payable regardless of the quantity of compressed oxygen used by the subsidiary. The term of this agreement, which has been included in the above minimum operating lease commitments, is for a term of 15 years; however, after the agreement has been in effect for 60 months, the subsidiary can terminate the agreement without cause at a cost of approximately $4.5 million. Based on the subsidiary's estimate of compressed oxygen demands of the plant, the cost of the oxygen under this agreement is expected to be favorable compared to floating market prices. F-40 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) DEBT GUARANTEE The Company has guaranteed approximately $2.6 million of indebtedness of a start-up aviation company, Kestrel Aircraft Company, in exchange for a 25.6% ownership interest, to which no value has been assigned as of December 31, 1997. The Company has advanced the aviation company $341,000 as of December 31, 1997 and 1996 and is accruing losses of the aviation company based on its ownership percentage. In February and March 1998, the Company purchased an additional 11.6% ownership interest in the aviation company in exchange for approximately $287,000. The Company has recorded losses of $2,309,000 ($1,093,000 in 1997, $626,000 in 1996 and $590,000 in 1995) related to the debt guarantee. The debt guarantee relates to a $2 million term note and a $2 million revolving credit facility. The $2 million term note requires interest only payments through September 1998; thereafter, it requires monthly principal payments of $11,111 plus interest beginning in October 1998 until it matures on August 8, 1999, at which time all outstanding principal and unpaid interest are due. In the event of default of this note, the Company is required to assume payments on the note with the term extended until August 2004. The $2 million revolving credit facility, on which a subsidiary of the Company has guaranteed up to $600,000 of indebtedness, has an outstanding balance of $1.9 million at December 31, 1997. The aviation company expects to complete the Federal Aviation Authority certification process in the second half of 1998, at which time commercial production may begin, subject to successfully obtaining additional financing required to complete the certification process and to establish commercial production facilities. At December 31, 1997, the aviation company is in technical violation of certain of its debt covenants; however, no demand has been made on the aviation company nor the guarantors. In March 1998, the aviation company is in negotiations with two potential inventors, both of which have indicated they have adequate resources to complete the certification process and begin commercial production; however, there are no assurances that the aviation company will close with either potential investor. If the aviation company is not successful in completing the certification process and obtaining additional external funding, the Company is likely to become responsible for the $2.6 million indebtedness guarantee and may not be able to recover amounts advanced. F-41 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10. COMMITMENTS AND CONTINGENCIES (CONTINUED) LEGAL MATTERS Following is a summary of certain legal actions involving the Company: A. In 1987, the U.S. Environmental Protection Agency ("EPA") notified one of the Company's subsidiaries, along with numerous other companies, of potential responsibility for clean-up of a waste disposal site in Oklahoma. In 1990, the EPA added the site to the National Priorities List. Following the remedial investigation and feasibility study, in 1992 the Regional Administrator of the EPA signed the Record of Decision ("ROD") for the site. The ROD detailed EPA's selected remedial action for the site and estimated the cost of the remedy at $3.6 million. In 1992, the Company made settlement proposals which would have entailed a collective payment by the subsidiaries of $47,000. The site owner rejected this offer and proposed a counteroffer of $245,000 plus a reopener for costs over $12.5 million. The EPA rejected the Company's offer, allocating 60% of the cleanup costs to the potentially responsible parties and 40% to the site operator. The EPA estimated the total cleanup costs at $10.1 million as of February 1993. The site owner rejected all settlements with the EPA, after which the EPA issued an order to the site owner to conduct the remedial design/remedial action approved for the site. In August 1997, the site owner issued an "invitation to settle" to various parties, alleging the total cleanup costs at the site may exceed $22 million. No legal action has yet been filed. The amount of the Company's cost associated with the clean-up of the site is unknown due to continuing changes in the estimated total cost of clean-up of the site and the percentage of the total waste which was alleged to have been contributed to the site by the Company. As of December 31, 1997, the Company has accrued an amount based on a recent preliminary settlement proposal by the alleged potential responsible parties; however, there is no assurance such proposal will be accepted. Such amount is not material to the Company's financial position or results of operations. This estimate is subject to material change in the near term as additional information is obtained. The subsidiary's insurance carriers have been notified of this matter; however, the amount of possible coverage, if any, is not yet determinable. F-42 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10.COMMITMENTS AND CONTINGENCIES (CONTINUED) B. A subsidiary of the Company submitted to the State of Arkansas a "Groundwater Monitoring Work Plan" which was approved by the State of Arkansas. Pursuant to the Groundwater Monitoring Work Plan, the subsidiary has performed phase I and II groundwater investigations, and submitted a risk assessment report to the State of Arkansas. The risk assessment report is currently being reviewed by the State of Arkansas. On February 12, 1996, the subsidiary entered into a Consent Administrative Agreement ("Administrative Agreement") with the state of Arkansas to resolve certain compliance issues associated with nitric acid concentrators. Pursuant to the Administrative Agreement, the subsidiary installed additional pollution control equipment to address the compliance issues. The subsidiary was assessed $50,000 in civil penalties associated with the Administrative Agreement. In the summer of 1996 and then on January 28, 1997, the subsidiary executed amendments to the Administrative Agreement ("Amended Agreements"). The Amended Agreements imposed a $150,000 civil penalty, which penalty has been paid. Since the 1997 amendment, the Chemical Business has been assessed stipulated penalties of approximately $67,000 by the ADPC&E for violations of certain provisions of the 1997 Amendment. The Chemical Business believes that the El Dorado Plant has made progress in controlling certain off-site emissions; however, such off-site emissions have occurred and continue to occur from time to time, which could result in the assessment of additional penalties against the Chemical Business by the ADPC&E for violation of the 1997 Amendment. During May 1997, approximately 2,300 gallons of caustic material spilled when a valve in a storage vessel failed, which was released to a stormwater drain, and according to ADPC&E records, resulted in a minor fish kill in a drainage ditch near the El Dorado Plant. ADPC&E has proposed a Consent Administrative Order to resolve the event. The proposed CAO is currently being drafted by ADPC&E, and EDC has been advised that it will include a civil penalty in the amount of $201,700 which includes $125,000 which was previously agreed to be paid in the form of environmental improvements at the El Dorado Plant. The Company believes the proposed civil penalty is excessive and intends to seek reduction of such amount to allow the Chemical Business to use the $125,000 as originally proposed. The draft of the proposed consent administrative order also requires the Chemical Business to undertake certain additional compliance measures and equipment improvements related to the El Dorado Plant's wastewater treatment system. F-43 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10.COMMITMENTS AND CONTINGENCIES (CONTINUED) C. In 1996, a lawsuit was filed against the Company's Chemical Business by a group of residents of El Dorado, Arkansas, asserting a citizens' suit against the Chemical Business as a result of certain alleged violations of the Clean Air Act, the Clean Water Act, the Chemical Business' air and water permits and certain other environmental laws, rules and regulations. The citizens' suit requests the court to order the Chemical Business to cure such alleged violations, if any, plus penalties as provided under the applicable statutes. The Company's Chemical Business will assert all defenses available to it and will vigorously defend itself. In July 1996, several of the same individuals who are plaintiffs in the citizens' suit referenced above filed a toxic tort lawsuit against the Company's Chemical Business alleging that they suffered certain injuries and damages as a result of alleged releases of toxic substances from the Chemical Business' El Dorado, Arkansas manufacturing facility. In October 1996, another toxic tort lawsuit was filed against the Company's Chemical Business. This subsequent action asserts similar damage theories as the previously discussed lawsuit, except this action attempts to have a class certified to represent substantially all allegedly affected persons. The plaintiffs are suing for an unspecified amount of actual and punitive damages. The Company's insurance carriers have been notified of these matters. The Company and the Chemical Business maintain an Environmental Impairment Insurance Policy ("EIL Insurance") that provides coverage to the Company and the Chemical Business for certain discharges, dispersals, releases, or escapes of certain contaminants and pollutants into or upon land, the atmosphere or any water course or body of water from the Site, which has caused bodily injury, property damage or contamination to others or to other property not on the Site. The EIL Insurance provides limits of liability for each loss up to $10.0 million and a similar $10.0 million limit for all losses due to bodily injury or property damage, except $5.0 million for all remediation expenses, with the maximum limit of liability for all claims under the EIL Insurance not to exceed $10.0 million for each loss or remediation expense and $10.0 million for all losses and remediation expenses. The EIL Insurance also provides a retention of the first $500,000 per loss or remediation expense that is to be paid by the Company. The Company's Chemical Business has spent an amount in excess of $500,000 in legal, expert and F-44 LSB Industries, Inc. Notes to Consolidted Financial Statements (continued) 10.COMMITMENTS AND CONTINGENCIES (CONTINUED) other costs in connection with the toxic tort and citizen lawsuits described above, which the Company expensed. The EIL Insurance carrier has assumed responsibility for all subsequent legal, expert and other costs of defense and is paying such legal, expert and other costs on an on-going basis, subject to a reservation of rights relating to the citizens' suit. During the first quarter of 1998, the Company's Chemical Business agreed in principle to settle the toxic tort lawsuits discussed above. Settlement of the class action toxic tort lawsuits and the citizens' suit are subject to definitive settlement agreements. Settlement of the toxic tort lawsuit filed in October 1996 is subject, among other things, to court approval, while settlement of the citizens' suit is subject, among other things, to approval by the court or the United States Environmental Protection Agency. Substantially all of such settlement payments, upon satisfaction of the conditions, are to be funded directly by the Company's EIL Insurance carrier. The settlement of the citizens' suit, if completed, will require the Company's Chemical Business to implement at the El Dorado Facility and at the Company's expense reasonable and necessary environmentally related recommendations, if any, to be made in an environmental audit report to be issued by an independent third party retained by the Company to evaluate facility operations and emissions. The audit report has not yet been completed and, as a result, the costs, if any, to implement such recommendations, if any, are not known to the Company. However, the Company does not believe that the implementation of such recommendations, if any, that might be contained in the audit report will have a material adverse effect on the Company. The amount of the settlements of these cases, if completed, and the amount paid under the EIL Insurance for legal and other expenses relating to the defense of these matters reduce the coverage amount available under the EIL insurance. D. A civil cause of action has been filed against the Company's Chemical Business and five (5) other unrelated commercial explosives manufacturers alleging that the defendants allegedly violated certain federal and state antitrust laws in connection with alleged price fixing of certain explosive products. The plaintiffs are suing for an unspecified amount of damages, which, pursuant to statute, plaintiffs are requesting be trebled, together with costs. Based on the information presently available to the Company, the Company does not believe that F-45 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10.COMMITMENTS AND CONTINGENCIES (CONTINUED) the Chemical Business conspired with any party, including but not limited to, the five (5) other defendants, to fix prices in connection with the sale of commercial explosives. Discovery has only recently commenced in this matter. The Chemical Business intends to vigorously defend itself in this matter. The Company's Chemical Business has been added as a defendant in a separate lawsuit pending in Missouri. This lawsuit alleges a national conspiracy, as well as a regional conspiracy, directed against explosive customers in Missouri and seeks unspecified damages. The Company's Chemical Business has been included in this lawsuit because it sold products to customers in Missouri during a time in which other defendants have admitted to participating in an antitrust conspiracy, and because it has been sued in the preceding described lawsuit. Based on the information presently available to the Company, the Company does not believe that the Chemical Business conspired with any party, to fix prices in connection with the sale of commercial explosives. The Chemical Business intends to vigorously defend itself in this matter. For several years, certain members of the explosives industry have been the focus of a grand jury investigation being supervised by the U.S. Department of Justice ("DOJ") in connection with criminal antitrust allegations involving price fixing. Certain explosives companies, other than the Company, including all the Company's major competitors, and individuals employed by certain of those competitors, were indicted and have pled guilty to antitrust violations. The guilty pleas have resulted in nearly $40 million in criminal fines. In connection with the grand jury investigation, the Company's Chemical Business received and has complied with two document subpoenas, certain of the Company's Chemical Business' employees have been interviewed by the DOJ under grants of immunity from prosecution, and certain of the Company's Chemical Business employees have testified under subpoena before the grand jury under grants of immunity in connection with the investigation. The Company believes that it has cooperated fully with the government's investigation. Recently, the Company has been informed by an official of the DOJ that it is not currently a target of the above investigation or of any grand jury investigating criminal antitrust activity in the explosives or ammonium nitrate industries. F-46 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10.COMMITMENTS AND CONTINGENCIES (CONTINUED) During the third quarter of 1997, a subsidiary of the Company was served with a lawsuit in which approximately 27 plaintiffs have sued approximately 13 defendants, including a subsidiary of the Company alleging personal injury and property damage for undifferentiated compensatory and punitive damages of approximately $7,000,000. Specifically, the plaintiffs assert blast damage claims, nuisance (road dust from coal trucks) and personal injury claims (exposure to toxic materials in blasting materials) on behalf of residents living near the Heartland Coal Company ("Heartland") strip mine in Lincoln County, West Virginia. Heartland employed the subsidiary to provide blasting materials and personnel to load and shoot holes drilled by employees of Heartland. Down hole blasting services were provided by the subsidiary at Heartland's premises from approximately August 1991, until approximately August 1994. Subsequent to August 1994, the subsidiary supplied blasting materials to the reclamation contractor at Heartland's mine. In connection with the subsidiary's activities at Heartland, the subsidiary has entered into a contractual indemnity to Heartland to indemnify Heartland under certain conditions for acts or actions taken by the subsidiary for which the subsidiary failed to take, and Heartland is alleging that the subsidiary is liable thereunder for Heartland's defense costs and any losses to or damages sustained by, the plaintiffs in this lawsuit. Discovery has only recently begun in this matter, and the Company intends to vigorously defend itself in this matter. Based on limited information available, the subsidiary's counsel believes that the exposure, if any, to the subsidiary related to this litigation is in the $100,000 range. The Company, including its subsidiaries, is a party to various other claims, legal actions, and complaints arising in the ordinary course of business. In the opinion of management after consultation with counsel, all claims, legal actions (including those described above) and complaints are adequately covered by insurance, or if not so covered, are without merit or are of such kind, or involve such amounts that unfavorable disposition is not presently expected to have a material effect on the financial position of the Company, but could have a material impact to the net loss of a particular quarter or year, if resolved unfavorably. F-47 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10.COMMITMENTS AND CONTINGENCIES (CONTINUED) OTHER In 1989 and 1991, the Company entered into severance agreements with certain of its executive officers that become effective after the occurrence of a change in control, as defined, if the Company terminates the officer's employment or if the officer terminates employment with the Company for good reason, as defined. These agreements require the Company to pay the executive officers an amount equal to 2.9 times their average annual base compensation, as defined, upon such termination. The Company has retained certain risks associated with its operations, choosing to self-insure up to various specified amounts under its automobile, workers' compensation, health and general liability programs. The Company reviews such programs on at least an annual basis to balance the cost/benefit between its coverage and retained exposure. 11.EMPLOYEE BENEFIT PLAN The Company sponsors a retirement plan under Section 401(k) of the Internal Revenue Code under which participation is available to substantially all full- time employees. The Company does not presently contribute to this plan. 12.FAIR VALUE OF FINANCIAL INSTRUMENTS The following discussion of fair values is not indicative of the overall fair value of the Company's balance sheet since the provisions of the SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," do not apply to all assets, including intangibles. F-48 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 12.FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) The following methods and assumptions were used by the Company in estimating its fair value of financial instruments: LOANS RECEIVABLE: For variable-rate loans with no significant change in credit risk since loan origination, fair values approximate carrying amounts. Fair values for fixed-rate loans are estimated using discounted cash flow analyses, using interest rates which would currently be offered for loans with similar terms to borrowers of similar credit quality and for the same remaining maturities (interest rates range from 7% to 11% at December 31, 1997). In 1996, the fair values of loans which are collateral dependent for realization are estimated using the fair value of the underlying collateral. As of December 31, 1997 and 1996, the net book value of loans receivable was $.7 million and $15.0 million and fair values of loans receivable were approximately $.7 million and $18.9 million, respectively (assuming an estimated fair value of the underlying collateral for collateral dependent loans of $18.0 million in 1996). BORROWED FUNDS: Fair values for fixed rate borrowings are estimated using a discounted cash flow analysis that applies interest rates currently being offered on borrowings of similar amounts and terms to those currently outstanding. Carrying values for variable rate borrowings approximate their fair value. As of December 31, 1997 and 1996, carrying values of variable rate and fixed-rate long-term debt which aggregated $180.9 million and $132.3 million, respectively, approximated their estimated fair value. HEDGING AGREEMENTS: The fair value of the interest rate forward agreement is estimated based on quoted market prices of instruments with similar terms. As of December 31, 1997, the financial instruments' fair value (which is not reflected on the accompanying balance sheet), net to the Company's 50% interest, represented a liability of approximately $1.8 million. A change in the settlement index (the seven year U.S. Treasury bond) of .25% will change the fair value of the hedge agreement by approximately $350,000, net to the Company's interest. The fair value of the natural gas swap agreement was estimated based on market prices of natural gas for the periods covered by the agreement. At December 31, 1997, the fair values of such agreement represented a liability of approximately $165,000. F-49 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 12. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) As of December 31, 1997, the carrying values of cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities approximated their estimated fair value. 13. SEGMENT INFORMATION The Company and its subsidiaries operate principally in four industries. CHEMICAL This segment manufactures and sells chemical products for mining, agricultural, electronic, paper and other industries. Production from the Company's primary manufacturing facility in El Dorado, Arkansas, for the year ended December 31, 1997 comprises approximately 76% of the chemical segment's sales. Sales to customers of this segment primarily include coal mining companies in Kentucky, Missouri and West Virginia and farmers in Texas and Arkansas. The Chemical Business is subject to various federal, state and local environmental regulations. Although the Company has designed policies and procedures to help reduce or minimize the likelihood of significant chemical accidents and/or environmental contamination, there can be no assurances that the Company will not sustain a significant future operating loss related thereto. In May 1997, the Chemical Business completed constructing a concentrated nitric acid plant (carrying value of $30.3 million at December 31, 1997); which has a stated production capacity of 285 tons per day. The Company incurred significant delays and costs in attempting to achieve the plant's stated capacity. The Company anticipates maintaining an economically feasible rate of production. If such rate of production is not maintained, the Company may sustain significant future operating losses and possible impairment related thereto. The Chemical Business' Australian subsidiary's results of operations have been adversely affected due to the recent economic developments in certain countries in Asia. These economic developments in Asia have had a negative impact on the mining industry in Australia, which this subsidiary services. If these adverse economic conditions in Asia continue for an extended period of time, such could have an adverse F-50 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 13. SEGMENT INFORMATION (CONTINUED) effect on the Company's consolidated results of operations for future periods resulting in possible impairment of its long-lived assets. Further, the Company purchases substantial quantities of anhydrous ammonia for use in manufacturing its products. The pricing volatility of such raw material directly affects the operating profitability of the chemical segment. CLIMATE CONTROL This business segment manufactures and sells, primarily from its various facilities in Oklahoma City, a variety of hydronic fan coil, water source heat pump products as well as other HVAC products for use in commercial and residential air conditioning and heating systems. The Company's various facilities in Oklahoma City comprise substantially all of the environment control operations. Sales to customers of this segment primarily include original equipment manufacturers, contractors and independent sales representatives located throughout the world, are generally secured by a mechanic's lien, except for sales to original equipment manufacturers. AUTOMOTIVE PRODUCTS This segment manufactures and sells anti-friction bearings and other products for automotive applications to wholesalers, retailers and original equipment manufacturers located throughout the world. Net sales from the Company's primary facility in Oklahoma City comprises approximately 90% of the automotive products segment sales. At December 31, 1997, the automotive segment has $22.7 million of inventory, a portion of which is in excess of current requirements based on recent sales levels. Management has developed a program to reduce this inventory to desired levels over the near term and believes no significant loss will be incurred on disposition. F-51 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 13.SEGMENT INFORMATION (CONTINUED) INDUSTRIAL PRODUCTS This segment manufactures and purchases machine tools and purchases industrial supplies for sale to machine tool dealers and end users throughout the world. Sales of industrial supplies are generally unsecured, whereas the Company generally retains a security interest in machine tools sold until payment is received. The industrial products segment attempts to maintain a full line of certain product lines, which necessitates maintaining certain products in excess of management's successive year expected sales levels. Inasmuch as these products are not susceptible to rapid technological changes, management believes no loss will be incurred on disposition. Credit, which is generally unsecured, is extended to customers based on an evaluation of the customer's financial condition and other factors. Credit losses are provided for in the financial statements based on historical experience and periodic assessment of outstanding accounts receivable, particularly those accounts which are past due. The Company's periodic assessment of accounts and credit loss provisions are based on the Company's best estimate of amounts which are not recoverable. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer bases, and their dispersion across many different industries and geographic areas. As of December 31, 1997 and 1996, the Company's accounts and notes receivable are shown net of allowance for doubtful accounts of $9.2 million and $7.4 million, respectively. Information about the Company's operations in different industry segments for each of the three years in the period ended December 31, 1997 is detailed below. <TABLE> <CAPTION> 1997 1996 1995 ------------------------------------ (In Thousands) <S> <C> <C> <C> Sales: Chemical $ 156,949 $ 166,163 $ 136,903 Climate Control 105,909 89,275 83,843 Automotive Products 35,499 37,946 33,270 Industrial Products 15,572 13,776 13,375 ------------------------------------ $ 313,929 $ 307,160 $ 267,391 ==================================== </TABLE> F-52 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 13.SEGMENT INFORMATION (CONTINUED) <TABLE> <CAPTION> <S> <C> <C> <C> Gross profit: Chemical $ 19,320 $ 25,885 $ 26,050 Climate Control 29,552 21,961 21,694 Automotive Products 3,299 5,868 6,366 Industrial Products 3,776 3,058 2,953 ------------------------------------ $ 55,947 $ 56,772 $ 57,063 ==================================== Operating profit (loss): Chemical $ 5,479 $ 10,971 $ 13,393 Climate Control 8,895 5,362 4,630 Automotive Products (7,251) (4,134) (3,704) Industrial Products (993) (2,685) (1,199) ------------------------------------ 6,130 9,514 13,120 General corporate expenses, net (9,786) (3,192) (6,571) Interest expense (14,740) (10,017) (10,131) ------------------------------------ Loss before provision for income taxes and extraordinary charge $ (18,396) $ (3,695) $ (3,582) ===================================== </TABLE> F-53 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 13. SEGMENT INFORMATION (CONTINUED) <TABLE> <CAPTION> 1997 1996 1995 -------------------------------------- (In Thousands) <S> <C> <C> <C> Depreciation of property, plant and equipment: Chemical $ 6,436 $ 5,504 $ 4,532 ===== ===== ===== Climate Control $ 1,544 $ 1,552 $ 1,582 ===== ===== ===== Automotive Products $ 1,568 $ 1,050 $ 986 ===== ===== ===== Industrial Products $ 190 $ 126 $ 124 ===== ===== ===== Additions to property, plant and equipment: Chemical $ 8,390 $ 19,137 $ 17,979 ===== ====== ====== Climate Control $ 1,127 $ 1,551 $ 447 ===== ====== ====== Automotive Products $ 936 $ 1,306 $ 1,341 ===== ====== ====== Industrial Products $ 109 $ 37 $ 265 ===== ====== ======= Identifiable assets: Chemical $ 137,570 $ 132,718 111,890 Climate Control 49,274 50,623 41,331 Automotive Products 42,718 43,212 43,872 Industrial Products 9,929 13,614 17,328 ------- ------- ------ 239,491 240,167 214,421 Corporate assets and other 31,162 21,393 23,755 ------- ------- -------- Total assets $ 270,653 $ 261,560 $ 238,176 ======= ======= ======= </TABLE> Revenues by industry segment include revenues from unaffiliated customers, as reported in the consolidated financial statements. Intersegment revenues, which are accounted for at transfer prices ranging from the cost of producing or acquiring the product or service to normal prices to unaffiliated customers, are not significant. Gross profit by industry segment represents net sales less cost of sales. Operating profit by industry segment represents revenues less operating F-54 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 13.SEGMENT INFORMATION (CONTINUED) expenses. In computing operating profit, none of the following items have been added or deducted: general corporate expenses, income taxes or interest expense. Identifiable assets by industry segment are those assets used in the operations of each industry. Corporate assets are those principally owned by the parent company or by subsidiaries not involved in the four identified industries. Information about the Company's domestic and foreign operations for each of the three years in the period ended December 31, 1997 is detailed below: <TABLE> <CAPTION> GEOGRAPHIC REGION 1997 1996 1995 - ------------------------------------------------------------------------ (In Thousands) <S> <C> <C> <C> Sales: Domestic $ 265,320 $ 270,675 $ 250,028 Foreign: Australia/New Zealand 26,482 32,917 16,884 Others 22,127 3,568 479 ------- ------- ------- $ 313,929 $ 307,160 $ 267,391 ======= ======= ======= Income (loss) before provision for income taxes and extraordinary charge: Domestic $ (17,270) $ (5,174) $ (693) Foreign: Australia/New Zealand (772) 1,705 (1,871) Others (354) (226) (1,018) -------- -------- ------- $ (18,396) $ (3,695) $ (3,582) Identifiable assets: Domestic $ 248,205 $ 237,833 $ 221,656 Foreign: Australia/New Zealand 19,899 19,740 13,757 Others 2,549 3,987 2,763 ------- ------- ------- $ 270,653 $ 261,560 $ 238,176 ======= ======= ======= </TABLE> F-55 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 13.SEGMENT INFORMATION (CONTINUED) Revenues by geographic region include revenues from unaffiliated customers, as reported in the consolidated financial statements. Revenues earned from sales or transfers between affiliates in different geographic regions are shown as revenues of the transferring region and are eliminated in consolidation. Revenues from unaffiliated customers include foreign export sales as follows: <TABLE> <CAPTION> GEOGRAPHIC AREA 1997 1996 1995 - ----------------------------------------------------------------------- (In Thousands) <S> <C> <C> <C> Mexico and Central and South America $ 8,604 $ 9,084 $ 5,955 Canada 5,609 9,703 10,311 Other 7,913 14,517 18,447 ------ ------ ------ $ 22,126 $ 33,304 $ 34,713 ====== ====== ====== </TABLE> 14. EXTRAORDINARY CHARGE In February 1997, certain subsidiaries of the Company entered into a $50 million financing arrangement with John Hancock. The financing arrangement consisted of $25 million of fixed rate notes and $25 million of floating rate notes. In November 1997, in connection with the issuance of the Notes described in Note 5(B)-Term Debt, a subsidiary of the Company retired the outstanding principal associated with the John Hancock financing arrangement and incurred a prepayment fee. The prepayment fee paid and loan origination costs expensed in 1997 related to the John Hancock financing arrangement aggregated approximately $4.6 million. 15. SUBSEQUENT EVENT In March 1998, a subsidiary of the Company closed the sale of The Tower acquired through foreclosure in February 1997. The Company realized proceeds of approximately $29 million from the sale, net of transaction costs. Proceeds from the sale were used to retire the outstanding indebtedness of approximately $13 million in March 1998, for which this property served as collateral. Approximately $15 million of the remaining proceeds were used to reduce indebtedness outstanding under the Company's Revolving Credit Facility. The Company will recognize a gain on the sale of the property of approximately $13 million in the first quarter of 1998. F-56 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 13.SEGMENT INFORMATION (CONTINUED) The Company will recognize a gain on the sale of the property of approximately $13 million in the first quarter of 1998. LSB Industries, Inc. Supplementary Financial Data Quarterly Financial Data (Unaudited) (In Thousands, Except Per Share Amounts) <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31 JUNE 30 SEPTEMBER DECEMBER 30 31 ------------------------------------------ <S> <C> <C> <C> <C> 1997 Total revenues $ 74,864 $ 91,437 $ 77,927 $ 75,961 =========================================== Gross profit on net sales $ 10,922 $ 19,380 $ 14,541 $ 11,104 =========================================== Income (loss) before $ (5,438) $ 1,467 $ (4,779) $ (9,696) extraordinary charge =========================================== Net income (loss) $ (5,438) $ 1,467 $ (4,779) $ (14,315) ============================================ Net income (loss) applicable to common stock $ (6,241) $ 648 $ (5,582) $ (15,119) ============================================= Basic and diluted earnings(loss) per common share: Earnings (loss) before extraordinary charge $ (0.48) $ 0.05 $ (0.43) $ (0.82) Extraordinary charge (0.36) -------------------------------------------- Net income (loss) $ (0.48) $ 0.05 $ (0.43) $ (1.18) ============================================ 1996 Total revenues $ 70,906 $ 91,460 $ 76,841 $ 74,844 ============================================ Gross profit on net sales $ 14,807 $ 17,233 $ 13,529 $ 11,203 ============================================ Net income (loss) $ (531) $ 2,372 $ (3,218) $ (2,468) ============================================= </TABLE> F-57 LSB Industries, Inc. Supplementary Financial Data Quarterly Financial Data (Unaudited) (In Thousands, Except Per Share Amounts) <TABLE> <CAPTION> <S> <C> <C> <C> <C> Net income (loss) applicable to common stock $ (1,350) $ 1,568 $ (4,021) $ (3,271) ============================================= Basic and diluted earnings(loss) per common share $ (.10) $ .12 $ (.31) $ (.25) ============================================= </TABLE> In the fourth quarter of 1997, in connection with the issuance of $105 million, 10 3/4% Senior Notes due in 2007, a subsidiary of the Company retired the outstanding principal associated with a $50 million financing arrangement and incurred a prepayment fee. The prepayment fee paid and loan origination costs expensed in 1997 relating to the financing arrangement aggregated approximately $4.6 million. In the fourth quarter of 1996, the Company recorded adjustments to the cost of the DSN plant for depreciation, interest capitalization, excess cost accruals and advances on an insurance settlement. These adjustments increased gross profit on net sales by approximately $3.7 million for the three months ended December 31,1996. In the fourth quarter of 1996, the Company also sustained a loss of $1.0 million related to writing-off a note receivable from a customer in the Chemical Business. F-58 LSB Industries, Inc. Schedule II - Valuation and Qualifying Accounts Years ended December 31, 1997, 1996 and 1995 (Dollars in Thousands) <TABLE> <CAPTION> ADDITIONS DEDUCTIONS BALANCE AT CHARGED TO WRITE- BALANCE BEGINNING Costs and OFFS/ AT END DESCRIPTION of Year Expenses COSTS OF YEAR INCURRED - ------------------------------------------------------------------------------ - - <S> <C> <C> <C> <C> Accounts receivable- allowance for doubtful accounts (1): 1997 $ 3,291 $ 1,544 $ 828 $ 4,007 ================================================ 1996 $ 2,584 $ 1,451 $ 744 $ 3,291 ================================================ 1995 $ 2,000 $ 1,696 $ 1,112 $ 2,584 ================================================ Inventory-reserve for slow- moving items: 1997 $ 1,709 $ 68 $ 246 $ 1,531 ================================================ 1996 $ 1,318 $ 578 $ 187 $ 1,709 ================================================ 1995 $ 915 $ 437 $ 34 $ 1,318 ================================================ Notes receivable-allowance for doubtful accounts: 1997 $ 4,065 $ 1,093 $ $ 5,158 ================================================ 1996 $ 2,500 $ 1,565 $ $ 4,065 ================================================ 1995 $ 1,150 $ 1,350 $ $ 2,500 ================================================ </TABLE> (1) Deducted in the balance sheet from the related assets to which the reserve applies. Other valuation and qualifying accounts are detailed in the Company's notes to consolidated financial statements. F-59