LSB Industries - 10-Q quarterly report FY

A. Our operations are subject to numerous environmental laws ("Environmental Laws") and to other federal, state and local laws regarding health and safety matters ("Health Laws"). In particular, the manufacture and distribution of chemical products are activities which entail environmental risks and impose obligations under the Environmental Laws and the Health Laws, many of which provide for substantial fines and criminal sanctions for violations. There can be no assurance that material costs or liabilities will not be incurred by us in complying with such laws or in paying fines or penalties for violation of such laws. The Environmental Laws and Health Laws and enforcement policies thereunder relating to 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 our 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 could be required to make significant additional site or operational modifications at the El Dorado Facility, involving substantial expenditures.

The Chemical Business' El Dorado, Arkansas facility generates process wastewater consisting of cooling tower and boiler blowdowns, contact stormwater (rainfall inside the plant area which picks up contaminants), and miscellaneous spills and leaks from process equipment. This wastewater has historically been collected in a chemical sewer and transported to a small pond for pH adjustment and then to a large pond for biological oxidation. Primary contaminants are ammonia, nitrate and sulfate.

The wastewater discharge is governed by a State permit renewed every five (5) years. The current permit expired in 1995, and the State was preparing to issue the facility a new permit in early 1997, which included much more stringent limits which the current treatment system could not meet. Negotiations were held with the Director of the State agency in March, 1997, and he agreed to a formal Consent Administrative Order ("CAO") in September, 1998, which CAO contained certain deadlines for the completion of activities at the EDC plant site pending issuance of a new permit. The ADEQ did not timely issue the permit and agreed to extend the CAO deadlines. A draft of the permit has now been issued for public comment. EDC timely submitted its comments on April 25, 2002. The draft permit includes a three year period of time for the El Dorado plant to come into compliance with the new more restrictive limits. Alternative methods for meeting these requirements are continuing to be examined b y EDC. Installation of additional facilities will be required to comply with the new limits, and depending upon the alternative selected, the cost could be several million dollars. Should the facility be unable to operate in compliance with the new limits, such would have a material adverse effect upon our financial position and operating results and may result in the recognition of impairment of certain long-lived assets.

The CAO recognizes the presence of nitrate contamination in the groundwater, and requires EDC to undertake onsite bioremediation. The bioremediation has not proven to be effective, and EDC is currently undertaking a comprehensive evaluation of the groundwater trends in contamination reduction and movement. The final remedy for groundwater contamination will be selected in the near future. There are no known users of groundwater in the area, and preliminary risk assessments have not identified any risk that would require additional remediation.

The CAO included a $183,700 penalty assessment of which $125,000 will be satisfied over five years by expenditures of $25,000 per year for waste minimization activities. EDC has documented in excess of $25,000 on expenditures for the first four years, 1998, 1999, 2000 and 2001. An additional $57,000 was satisfied by funding approved supplemental environmental projects. The monetary civil penalty payment required, $1,700, has been paid.

In September 2001, the large equalization pond located at the Chemical Business' El Dorado, Arkansas manufacturing facility was drained to accommodate repairs to a corroded underground discharge pipe. This event began when a hole developed in the pond's discharge pipe, allowing the release of water up stream of the permitted outfall. It was determined to allow water to be released through the valve into the permitted discharge to avoid erosion of a levy, to permit monitoring and sampling of discharged water, and to direct the discharge to the permitted outfall. No adverse environmental conditions were noted at the discharge, however, the sustained discharge was allegedly out of compliance with the mass effluent limits contained in the permit. The Chemical Business and the ADEQ have agreed to a Consent Administrative Order to settle any civil penalty claims relating to this discharge event whereby the Chemical Business will pay a $50,000 civil penalty to the ADEQ and will spend another $50,000 on supplemental environmental projects with the Local Emergency Planning Committee.

EDC and two EDC employees received letters dated April 4, 2002, from the United States Attorney's office in Fort Smith, Arkansas indicating that a criminal charge could be brought against EDC and the two employees as a result of the draining of the equalization pond. The letter further requests that the recipients, through counsel, contact the Assistant United States Attorney ("AUSA"). EDC has retained counsel and has arranged for counsel for the two employees. In discussions between such counsel and the AUSA, the AUSA expressed satisfaction that EDC and the employees responded promptly to the letters, indicated that he had not formed an opinion as to any criminal culpability, and indicated that he desired a communication with EDC to ensure that EDC was adequately addressing its environmental obligations. The AUSA further stated that he was busy with other matters until mid-May, and that this matter could be addressed at that time. EDC believes that neither it nor its employees have c riminal exposure in the equalization pond matter.

In February 2002, Slurry Explosive Corporation ("Slurry") received a proposed consent administrative order ("Slurry Consent Order") from the Kansas Department of Health and Environment ("KDHE"), regarding Slurry's Hallowell, Kansas manufacturing facility ("Hallowell Facility"). The proposed Slurry Consent Order states that there exists soil and groundwater contamination, and there exists surface water contamination in the lake adjacent to the Hallowell Facility. There are no known users of the groundwater in the area. The adjacent lake is used for fishing. The Slurry Consent Order also provides that Slurry has not verified the presence of such contaminants. Under the terms of the Slurry Consent Order, Slurry would be required a) to submit an environmental assessment work plan to the KDHE for review and approval, b) to agree with the KDHE as to any required corrective actions to be performed at the Hallowell Facility, and c) to provide reports to the KDHE, all of the preceding in accord ance with the time frames and formats required in the Slurry Consent Order. We believe, although there can be no assurance, that compliance by Slurry with the anticipated Slurry Consent Order would not have a material adverse effect on the Company.

From March 2001 through January 2002, the Chemical Business experienced eleven alleged air emissions violations. One of the alleged violations involved a malfunctioning continuous air emissions monitor, one of the alleged violations was based on a typographical error, six of the alleged violations involved air emissions point source tests that were allegedly performed in a manner not in compliance with testing procedures, two of the alleged violations involved tests that failed to meet emissions criteria, and one of the alleged violations involved the simultaneous operation of two boilers which is not permitted under the air permit. The Chemical Business and the ADEQ have been in negotiations regarding applicable penalties for certain of these violations. On March 5, 2002, the Chemical Business received a letter from the ADEQ outlining the above alleged violations which, based on past experience, is a preliminary step to proposing a Consent Administrative Order. The Chemical Business a nticipates that it will enter into a Consent Administrative Order with the ADEQ to resolve the above alleged violations. The Chemical Business also anticipates requesting administrative changes to its air permit which, if adopted, would better able us to comply with testing procedures.

B. Due to certain alleged violations of explosives storage and related regulations, in February 2002, the government regulator of explosives companies, Bureau of Alcohol, Tobacco and Firearms ("BATF"), issued an order revoking the manufacturing license of Slurry Explosive Corporation ("Slurry"), a subsidiary of ClimaChem and the Company, for its Hallowell, Kansas facility ("Hallowell Facility") to produce certain explosives products and confiscated certain high explosives inventory. The license revocation order was upheld by an administrative law judge after an administrative trial. Slurry is currently reviewing its legal alternatives regarding the license revocation. In addition, Slurry and the Company have received a grand jury subpoena from the U.S. Attorney's office of Wichita, Kansas requesting business records of Slurry. Slurry is complying with such subpoena. A different subsidiary of ours in the explosive business has filed an application with the BATF to obtain a man ufacturing license for the Hallowell Facility. There is no assurance that the subsidiary will be able to obtain such license. Since February 2002, Slurry has continued to manufacture certain non-explosive products at its Hallowell Facility. Slurry has other production facilities where it can produce some explosives products to service its customers. Although it is our current expectation that we will be able to realize substantially all of our assets related to Slurry, it is not presently known whether we will be allowed to resume use of all of our long-lived assets (net book value of $2.9 million). The ultimate outcome of this matter is not presently known; however, even if we are successful in obtaining the new license, we expect the manufacturing of high-explosive products will not begin until the middle of the third quarter of 2002. For the three months ended March 31, 2002, we recognized a loss of $321,000 related to high-explosive inventory produced during January 2002 that was confiscated by the B ATF. The estimate of ultimate loss associated with this matter may change in the near term and such amount may be material. Slurry's sales for the three months ended March 31, 2002 and 2001 were $3.1 million and $5 million, respectively.

In connection with the closing of the Loans, the investor and its affiliates that participate in making the Loans will be issued warrants to purchase up to 4.99% of the Company's outstanding common stock at a nominal price which warrants would have a term of 10 years, be subject to certain anti-dilution adjustments and entitle the holders of these warrants to certain demand and piggyback registration rights.

The Company and the investor are in the process of attempting to finalize agreements relating to the Loans and the repurchase of the Senior Unsecured Notes owned by the investor and its affiliates. Although there are no assurances, the Company expects the closing of this transaction to occur during the second quarter of 2002. Closing of these transactions are subject to, among other things, completion of definitive agreements and documents, consent of ClimaChem's working capital revolver lender and amendments to ClimaChem's working capital loan agreement acceptable to ClimaChem and its working capital revolver lender and elimination of certain provisions contained in the Indenture covering the Senior Unsecured Notes.

ClimaChem is restricted as to the funds that it may transfer to LSB and the non-ClimaChem companies under the terms contained in an Indenture ("Indenture") covering the Senior Unsecured Notes issued by ClimaChem and the Working Capital Revolver Loan. Under the terms of the Indenture between ClimaChem, the guarantors and the trustee relating to the Senior Unsecured Notes, ClimaChem is permitted to distribute or pay in the form of dividends and other distributions to us in connection with ClimaChem's outstanding equity securities or loans, (a) advances or investments to any person (including us), up to 50% of ClimaChem's consolidated net income for the period (taken as one accounting period), commencing on January 1, 1998 and including the last day of the fiscal quarter ended immediately prior to the date of said calculation (or, in the event consolidated net income for such period is a deficit, then minus 100% of such deficit), plus (b) the aggregate net cash proceeds received by ClimaChem from the sale of it s capital stock. This limitation will not prohibit (i) payment to us under a Services Agreement, Management Agreement and a Tax Sharing Agreement, or (ii) the payment of any dividend within 60 days after the date of its declaration if such dividend could have been made on the date of such declaration. ClimaChem did not declare and pay to the Company a dividend during the three months ended March 31, 2002.

For the three months ended March 31, 2002, we did not earn any management fees under the Management Agreement. It is possible, although not presently anticipated, that ClimaChem could pay up to $1.8 million, plus Consumer Price Index adjustments, of management fees to us in 2002 (if ClimaChem has earnings before interest, income taxes, depreciation and amortization ("EBITDA") in excess of $26 million, as defined by ClimaChem's Working Capital Revolver Loan for the year).

Due to the Company and ClimaChem's previous operating losses and limited borrowing ability under the credit facility then in effect, we discontinued payment of cash dividends on our Common Stock for periods subsequent to January 1, 1999, until the Board of Directors determines otherwise. As of the date of this report, we have not paid the regular quarterly dividend of $.8125 on the outstanding $3.25 Convertible Exchangeable Class C Preferred Stock Series 2 ("Series 2 Preferred") since June 15, 1999, resulting in approximately $5.6 million in total accrued and unpaid dividends on the Series 2 Preferred. In addition, we did not declare and pay the regular annual dividend of $12.00 on the Series B Preferred since 1999, resulting in approximately $.7 million in accrued and unpaid dividends on the Series B Preferred. We do not anticipate having funds available to pay dividends on our stock for the foreseeable future.

Management's plan for the remainder of 2002 anticipates a relatively stable business environment for the Climate Control Business. Based upon the projected order level, the Climate Control Business expects to continue to report positive results.

Management's plan for 2002 for its Chemical Business is to increase the production level at the El Dorado, Arkansas plant facility and the Cherokee, Alabama plant to near practical capacity, improving the 2002 fixed cost absorption and operating results compared to 2001, before considering the impact of the plant damage discussed in Note 10 of Notes to Condensed Consolidated Financial Statements.

The 2002 production level for Industrial Grade Ammonium Nitrate ("IGAN") at the El Dorado plant facility is planned at or near full capacity once production is resumed in May 2002. However, the production level for Agricultural Grade Ammonium Nitrate ("AGAN") is planned at a significantly higher level (50%) in 2002 than in 2001. If the planned production level is achieved, it would be close to the plant's near full capacity for AGAN. Based upon management's assessment of the amount of competitive product available in the Chemical Business agricultural market in the spring of 2002 compared to the same period in 2001, and an expanded geographical market due to competitors' plant closings, management believes that the higher sales volume measured in units can be achieved. Sales dollars and related cost of sales are expected to be lower in 2002 since the unit cost of the plant's feed stock, anhydrous ammonia, is lower and the unit sales price is likewise lower than in the prior year.

We have planned capital expenditures for the remainder of 2002 of approximately $3.8 million, but such capital expenditures are dependent upon obtaining acceptable financing. We will make these expenditures if there is sufficient working capital or available financing. As discussed in Note 6 of Notes to Condensed Consolidated Financial Statements, the wastewater program is not yet finally determined but is currently expected to require capital expenditures of approximately $2 to $3 million over the next 24 to 36 months. Discussions of the nature of the program and means of securing financing are currently underway.

We presently believe we can maintain compliance with the covenants of our working capital revolving credit facilities, if modified as tentatively agreed to with our lender in May 2002, successfully execute the above plan for the remainder of 2002 and meet our obligations as they come due; however, there are no assurances to that effect. If we are not successful in amending our working capital revolving credit agreement, do not achieve our plan for the remainder of 2002, or other adverse unforeseen events occur in 2002, it is reasonably possible that we may not be able to meet our obligations as they come due.

Contingencies

As discussed in Note 6 of Notes to Condensed Consolidated Financial Statements, we have several contingencies that could impact our liquidity in the event that we are unsuccessful in defending against the claimants. Although we do not anticipate that these claims will result in substantial adverse impacts on our 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. See Special Note Regarding Forward-Looking Statements.

Quantitative and Qualitative Disclosure about Market Risk

General

Our results of operations and operating cash flows are impacted by changes in market interest rates and changes in market prices of anhydrous ammonia and natural gas. Our Chemical Business buys substantial quantities of anhydrous ammonia and natural gas as feed stock for use in manufacturing processes generally at spot market prices.

Interest Rate Risk

Our interest rate risk exposure results from our debt portfolio which is impacted by short-term rates, primarily prime rate-based borrowings from commercial banks, and long-term rates, primarily fixed-rate notes, some of which prohibit prepayment or require substantial prepayment penalties.

Reference is made to our Form 10-K for the year ended December 31, 2001, for an expanded analysis of expected maturities of long term debt and its weighted average interest rates.

As of March 31, 2002, our variable rate and fixed rate debt, which aggregated $126.5 million, exceeded the debt's fair market value by approximately $35.3 million ($34.1 million at December 31, 2001). The fair value of the Senior Unsecured Notes of one of our subsidiaries was determined based on a market quotation for such securities.