**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**Form 10-K**

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

**FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006**

**COMMISSION FILE NUMBER 1-12881**

**LONESTAR TECHNOLOGIES, INC.**

(A DELAWARE CORPORATION)

I.R.S. EMPLOYER IDENTIFICATION NUMBER: **75-2085454**

**15660 N. DALLAS PARKWAY, SUITE 500**

**DALLAS, TEXAS 75248**

**(972) 770-6401**

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

| **Title of  each class**       |   | **Name of  each exchange on which registered** |
|--------------------------------|--------|------------------------------------------------|
| Common Stock,  par value $1.00 |   | New York Stock  Exchange                       |

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act.    Yes  x    No  o

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or 15(d) of the Act.    Yes  o    No  x

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filing requirementsfor the past 90 days.    Yes  x    No  o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K.    x

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a nonaccelerated filer. See definition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one): Large acceleratedfiler  x    Acceleratedfiler  o     Nonacceleratedfiler  o.

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).    Yes  o    No  x

Theaggregate market value of common stock on June 30, 2006, held by nonaffiliatesof the registrant was approximately $1,662 million, based on the closing priceof the common stock on the New York Stock Exchange.

As of February 12, 2007, the number of shares of common stockoutstanding was 30,665,490.

DOCUMENTSINCORPORATED BY REFERENCE

 

Portions of registrant’s Proxy Statement for its 2007 Annual Meeting ofShareholders are incorporated by reference into Part III hereof.

 

----

# **TABLE OF CONTENTS**

|            | ** ** | ** **                                                                                                          | ** ** | **Page** |
|------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|----------|
| ** ** |       | **PART I**                                                                                                          |       |     |
| ** ** |       | ** **                                                                                                          |       |     |
| ITEM 1.    |       | BUSINESS                                                                                                            |       | 3        |
|       |       |                                                                                                                |       |     |
| ITEM  1A.  |       | RISK  FACTORS                                                                                                       |       | 18       |
|       |       |                                                                                                                |       |     |
| ITEM 1B.   |       | UNRESOLVED STAFF  COMMENTS                                                                                          |       | 18       |
|       |       |                                                                                                                |       |     |
| ITEM  2.   |       | PROPERTIES                                                                                                          |       | 18       |
|       |       |                                                                                                                |       |     |
| ITEM  3.   |       | LEGAL  PROCEEDINGS                                                                                                  |       | 19       |
|       |       |                                                                                                                |       |     |
| ITEM 4.    |       | SUBMISSION OF  MATTERS TO A VOTE OF SHAREHOLDERS                                                                    |       | 19       |
|       |       |                                                                                                                |       |     |
|       |       |                                                                                                                |       |     |
| ** ** |       | **PART II**                                                                                                         |       |     |
| ** ** |       |                                                                                                                |       |     |
| ITEM 5.    |       | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED  SHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES |       | 19       |
|       |       |                                                                                                                |       |     |
| ITEM 6.    |       | SELECTED FINANCIAL data                                                                                             |       | 21       |
|       |       |                                                                                                                |       |     |
| ITEM 7.    |       | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION                          |       | 23       |
|       |       |                                                                                                                |       |     |
| ITEM 7A.   |       | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                         |       | 36       |
|       |       |                                                                                                                |       |     |
| ITEM 8.    |       | CONSOLIDATED  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                           |       | 37       |
|       |       |                                                                                                                |       |     |
| ITEM 9.    |       | CHANGES IN AND  DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                               |       | 66       |
|       |       |                                                                                                                |       |     |
| ITEM 9A.   |       | CONTROLS AND  PROCEDURES                                                                                            |       | 67       |
|       |       |                                                                                                                |       |     |
| ITEM 9B.   |       | OTHER INFORMATION                                                                                                   |       | 67       |
|       |       |                                                                                                                |       |     |
| ** ** |       | **PART III**                                                                                                        |       |     |
| ** ** |       |                                                                                                                |       |     |
| ITEM 10.   |       | DIRECTORS AND  EXECUTIVE OFFICERS OF THE REGISTRANT                                                                 |       | 67       |
|       |       |                                                                                                                |       |     |
| ITEM 11.   |       | EXECUTIVE  COMPENSATION                                                                                             |       | 67       |
|       |       |                                                                                                                |       |     |
| ITEM 12.   |       | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER  MATTERS                    |       | 67       |
|       |       |                                                                                                                |       |     |
| ITEM 13.   |       | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS                                                                     |       | 67       |
|       |       |                                                                                                                |       |     |
| ITEM 14.   |       | PRINCIPAL  ACCOUNTING FEES AND SERVICES                                                                             |       | 67       |
|       |       |                                                                                                                |       |     |
| ** ** |       | **PART IV**                                                                                                         |       |     |
| ** ** |       |                                                                                                                |       |     |
| ITEM 15.   |       | EXHIBITS AND  FINANCIAL STATEMENT SCHEDULES                                                                         |       | 68       |
|       |       |                                                                                                                |       |     |
| SIGNATURES |       |                                                                                                                |       | 73       |

 

2

----

**PART I**

**ITEM 1.****         ****BUSINESS**

# **General**

**Lone Star Technologies, Inc., a Delaware corporation, is:**

·                  a leading domestic manufacturer and marketerof high-quality welded “oil country tubular goods,” or “OCTG,” which are steeltubular products used in the completion of and production from oil and naturalgas wells;

·                  a major manufacturer and marketer of linepipe, which is used in the gathering and transmission of oil and natural gas;

·                  a major supplier of high-quality threading,thermal treating, end finishing, inspection, and logistics services to theoilfield industry;

·                  one of the largest domestic manufacturers ofhigh-quality couplings used to connect individual sections of oilfield casingand tubing;

·                  a leading manufacturer of specialty tubingproducts used in industrial, automotive, construction, agricultural, and heatrecovery technology applications;

·                  a marketer of oil country tubular goods andline pipe produced by other companies through exclusive marketing arrangements;and

·                  a manufacturer and supplier of hot rolledsteel to the domestic market.

**Lone Star Technologies, Inc. began producing and marketing oil countrytubular goods and other tubular products over 50 years ago, and the holdingcompany was incorporated in 1986.  Asused in this report, the terms “we,” “us,” “our,” and “Lone Star” refer to LoneStar Technologies, Inc. and its subsidiaries and affiliates, unless the contextindicates otherwise.**

**Lone Star’s operating companies include Lone Star Steel Company (“Steel”),a manufacturer of oilfield tubulars, specialty tubing products, and flat-rolledsteel, and Fintube Technologies, Inc. (“Fintube”), a manufacturer of specialtytubulars used in heat recovery technology applications.  Our Star Energy Group enhances our ability toprovide OCTG customers with a full spectrum of pipe finishing, inspection, andlogistics services and consists of four companies:**

·                  Wheeling Machine Products, Inc. and WheelingMachine Products of Texas, Inc. (collectively, “Wheeling”), one of the largestdomestic suppliers of couplings used to connect individual sections of oilfieldcasing and tubing;

·                  Delta Tubular Processing (“DTP”), a leadingprovider of thermal treating and end-finishing services for oilfield productiontubing;

·                  Frank’s Tubular International (since renamedDelta Tubular International, or “DTI”), a leading provider of high-qualitythreading, inspection, and storage services to the OCTG market; and

·                  Bellville TubeCompany, L.P. (“Bellville”), an OCTG manufacturer.

During 2006, Lone Star announced three joint ventures for theproduction of oilfield and other tubular products:

·                  On August 15, 2006, Lone Star entered into adefinitive agreement to form a joint venture to acquire, through a series oftransactions, up to 47% of two subsidiaries of Hunan Valin Steel Tube &Wire Co., Ltd. (“Valin”), a leading Chinese producer of seamless casing,tubing, line pipe, and other tubular products. The completion of this joint venture is subject to relevant regulatoryapprovals and consents, which have yet to be received.

·                  On November 30, 2006, Lone Star acquired a 50%ownership stake in Apolo Mecanica e Estruturas LTDA (“Apolo”), a leadingBrazilian supplier of welded casing, tubing, line pipe, and other tubularproducts.

·                  On December 20, 2006, Lone Star entered into ajoint venture with Welspun Group (“Welspun”) for 40% of a large diameter spiralwelded line pipe manufacturing facility to be constructed in the United Statesduring 2007 and expected to be operational in 2008.

TheCompany has related party transactions that involve our Apolo joint venture andWelspun joint venture.  We purchasecasing, tubing, and line pipe produced by Apolo for resale to ourcustomers.  We sell line pipe produced byWelspun at its facilities in India on a commission basis and in the future willsell products produced by facilities in the United States that the we willjointly own with Welspun.  The purchaseand resale of Apolo products are reflected in our cost of goods sold 

3

----

andrevenues, and during 2006 revenues from these transactions totaled $21.1million.  The commissions from sales ofWelspun produced line pipe are reflected in our revenues and totaled $6.5million in 2006.

# **RISK FACTORS**

In addition to important factors describedelsewhere in this report, Lone Star cautions current and potential investorsthat the following risk factors, among others, sometimes have affected, and inthe future could affect, Lone Star’s actual results and could cause suchresults during fiscal 2007, and beyond, to differ materially from thoseexpressed in any forward-looking statements made by or on behalf of LoneStar.  If any of the following risksactually occur, our business, financial condition, or results of operationscould be materially adversely affected and you may lose all of your investment.

### ***The volatility of oil and gas markets affects demand for our principalproducts, and downturns in these markets could cause our revenues to decrease.**** *Proceeds from the sale of casing, tubing,line pipe, couplings and OCTG finishing services to the oil and gas industryconstitute the majority of our revenues. Downturns in the oil and gas markets and general economic conditionscould cause demand for our principal products and services to decrease, whichwould adversely affect our revenues and results of operations.

Demand for our oilfield products and servicesdepends primarily upon the number of oil and natural gas wells being drilled,completed, and reworked at any given time and the depth and drilling conditionsof these wells.  The level of theseactivities depends primarily on expectations as to future prices for naturalgas and oil.  Natural gas and oil pricesare subject to significant fluctuations in response to relatively minor changesin supply, market uncertainty, and a variety of additional factors that arebeyond our control.  These factorsinclude:

#### ·                  worldwide and domestic supplies of and demand foroil and natural gas;

#### ·                  domestic and foreign natural gas and oilproduction;

#### ·                  political instability or armed conflict in oil andgas producing regions;

#### ·                  the price and amounts of imports of oil and gascasing, tubing and line pipe;

#### ·                  the availability of alternative fuels;

#### ·                  the availability of pipeline capacity;

#### ·                  weather conditions;

#### ·                  domestic and foreign governmental regulations,especially trade laws and taxes; and

#### ·                  the overalleconomic environment, including the demand for electricity.

We expect natural gas and oil prices and thedomestic rig count to continue to be volatile in the future.  A downturn in oil and natural gas pricescould decrease demand for our products and services and cause our revenues todecrease.

### ***Our precision mechanical tubulars andother businesses are sensitive to economic downturns, which could cause ourrevenues to decrease.***  We manufacture and sell high-quality steeltubulars in the form of precision mechanical tubulars used by our customers inthe manufacture of products, such as automotive stabilizers, hydrauliccylinders, and cranes.  The demand forthese products and, in turn, for our precision mechanical tubulars, is dependenton the general economy, the automotive and construction industries, productinventory levels, and other factors affecting domestic goods activity.  If we are not able to adequately predictdemand and if our precision mechanical tubulars inventories (or the inventoriesof other precision tubular manufacturers) become excessive, there could be amaterial adverse effect on price levels, the quantity of precision mechanicaltubulars sold by us, and our revenues.

### ***The competition for raw materials weuse in our business and the volatility of our raw material costs could reduceour profits and constrain our operations, which would reduce our revenues.***   Purchased steel,including slabs, scrap, steel additives, coils, pipe, and related fittings,represents over 60% of cost of goods sold. The price and availability of steel slabs, coils, scrap, and pipe fromcommercial alliances with other pipe mills that we use in our manufacturingprocesses and to supply our customers are highly competitive and cyclical.  The following factors, most of which arebeyond our control, affect the price of steel:

#### ·                  supply and demand factors;

#### ·                  freight costs and transportation availability;

#### ·                  inventory levels of brokers and distributors;

#### ·                  the price and availability of imported steel pipeand tubing;

#### ·                  trade duties and taxes;

#### ·                  market consolidation; and

#### ·                  labor disputes.

4

----

Changes in steel prices can affect the pricinglevels of our products.  We seek tomaintain our profit margin by attempting to increase the price of our productsin response to an increase in steel costs and by sourcing steel from ourflat-rolled steel business, but we do not always succeed in passing these priceincreases through to our customers.  As aresult, we do not always have the ability to recover increases in steelcosts.  Failure to obtain sufficientsteel slabs, coils, and scrap would constrain our operations.

Changes in energy costs also contribute to thevolatility of our business, as electricity and natural gas are approximately5%-10% of cost of goods sold.  Similar toincreases in steel costs, we attempt to increase the price of our products forincreases in our energy costs, but we do not always succeed in passing theseprice increases through to our customers.

In the welded oil and gas casing, tubing andline pipe market, we compete against manufacturers that may be able to purchaseor produce semifinished steel, hot-rolled coils or scrap at a lower cost thanwe can.  Our Steel subsidiary satisfiesits raw material requirements and those of our Bellville subsidiary bypurchasing semifinished steel, using purchased and internally generated scrapto make hot-rolled coils in its melt shop and hot strip mill, and by purchasingcoils.  Our Wheeling subsidiary typicallypurchases its coupling stock from domestic seamless oilfield tubularmanufacturers.  Our Fintube subsidiarymust also compete with manufacturers that may be able to purchase or producecoils more cost effectively than we can. Our Apolo Joint Venture also purchases hot-rolled coils for its rawmaterial requirements.  We may not beable to satisfy our subsidiaries’ raw material requirements as cost effectivelyas our competitors, which may lead to reduced sales.

### ***Excessive inventory levels ofoilfield products could reduce demand for our products and adversely affect oursales.***  Industry-wide inventory levels of tubular goodsfor the oil and gas industry can vary significantly from period to perioddepending on industry cycles.  Thesechanges can have a direct adverse effect on the demand for new production ofoilfield products when customers draw from existing inventory rather thanpurchase new products.  As a result, ouroilfield products sales and results of operations may vary significantly fromperiod to period.  Excessive inventoriescould have a material adverse effect on price levels and the quantity of oiland gas casing, tubing, line pipe, and couplings sold by us.  In addition, any excess domestic capacity maynot necessarily be substantially absorbed during periods of increased domesticdrilling activity since foreign producers of oilfield products may increasetheir exports to the United States market. At the end of 2006, domestic inventory levels of OCTG were estimated tobe approximately six months’ supply. Because of decreases in the price for natural gas and oil in the secondhalf of 2006 and existing inventory levels, distributors of OCTG remainedcautionary in their purchases of OCTG at the end of 2006.  This cautionary purchasing pattern bydistributors is expected to persist in early 2007.

### ***Easing of United States governmentimport trade restrictions could increase foreign competition in our industryand decrease our sales and our profits, particularly in the case of oil and gascasing, tubing, and line pipe.***** **The domestic steelindustry historically has faced significant competition from foreign steelproducers.  The level of imports of OCTG,which has varied significantly over time, affects the domestic market for thesegoods, and was at historically high levels in 2006.  High levels of imports reduce the volume soldby domestic producers and tend to suppress selling prices, both of which havean adverse impact on our business.

The level of imports of oil and gas casing,tubing, and line pipe is affected by numerous factors, including:

#### ·                  overall world demand for oil and gas casing,tubing, and line pipe;

#### ·                  domestic and foreign inventory levels of casing,tubing, and line pipe;

#### ·                  the purchasing pattern of distributors and endusers;

#### ·                  domestic and foreign trade policy; and

#### ·                  the relative value of the United States dollar.

Many foreign steel producers are owned,controlled, or subsidized by their governments, and their decisions withrespect to production and sales may be influenced more by political andeconomic policy considerations than by prevailing market conditions.  Actions motivated by these factors couldincrease competition and cause our sales to decrease.  In 2006, approximately 52% of the apparentdomestic consumption was supplied by imported OCTG.

Antidumping and countervailing duty ordersapplicable to OCTG are limited to specific countries, are largely under appeal,and may be revoked as a result of periodic “sunset reviews.”  In addition, an individual exporter mayobtain revocation as to itself under specific circumstances.  In June 2000, the United States governmentcompleted sunset reviews of orders covering Canada and Taiwan and revoked bothorders.  In 2006, the United Statesgovernment began conducting sunset reviews of orders covering Argentina, Italy,Japan, Korea, and Mexico.  Decisions withrespect to those reviews are expected in mid-2007.  If the existing orders are revoked in full orin part or the duty rates are lowered, we could be exposed 

5

----

to increased competition from imported OCTGthat could decrease our sales and profits.

Imports of line pipe in 2005 and 2006 were athistorically high levels and were also estimated to be in excess of 50% ofapparent domestic consumption.  Thelevels of these imports could increase further in 2007.   Such increased competition could decreaseour sales and profits and have a material adverse effect on our line pipebusiness, operating results, or financial condition.

The United States’ or any other government’sfuture actions regarding import duties or other trade restrictions on importsof oil and gas casing, tubing products, line pipe, or other steel productscould reduce our sales of such products.

***Difficulties inintegrating new and potential joint ventures and other acquisitions couldadversely affect our business, operating results, and financial condition.***  During2006, Lone Star announced three joint ventures for the production of oilfieldand other tubular products:

·                  On August 15, 2006, Lone Star entered into adefinitive agreement to form a joint venture to acquire, through a series oftransactions, up to 47% of two subsidiaries of Valin, a leading Chineseproducer of seamless casing, tubing, line pipe and other tubular products.  The completion of this joint venture is subjectto relevant regulatory approvals and consents, which have yet to be received.

·                  On November 30, 2006, Lone Star acquired a 50%ownership stake in Apolo, a leading Brazilian supplier of welded casing,tubing, line pipe, and other tubular products.

·                  On December 20, 2006, Lone Star entered into ajoint venture with Welspun for 40% of a large diameter spiral welded line pipemanufacturing facility be constructed in the United States during 2007 andexpected to be operational in 2008.

The process of integrating the above jointventures and any newly acquired businesses or other new joint ventureseffectively involves the following risks:

#### ·                  assimilating operations and products may beunexpectedly difficult;

#### ·                  management’s attention may be diverted from otherbusiness concerns;

·                  to the extent we do not have majority controlof the joint ventures, our ability to implement operational, managerial, orother business changes may be adversely affected by the desires andcapabilities of our joint venture partners;

#### ·                  we may enter markets in which we have limited orno direct experience; and

#### ·                  we may lose key employees of an acquired businessor joint venture.

**Moreover, to the extent our businesses or joint venturesare conducting business in foreign countries, we are subject to additionalrisks, including:**

·                  terrorism;

·                  fluctuations in currency exchange rates;

·                  general economic and political conditions ineach country;

·                  loss of revenue, property, and equipment fromexpropriation;

·                  import and export licensing requirements; and

·                  additionalexpenses and risks inherent in conducting operations in geographically distantlocations, including risks arising from differences in language and culturalapproaches to the conduct of business.

### We regularly evaluate potential joint venture and acquisitionopportunities to support and strengthen our business.  We might not be able to locate suitableacquisition candidates, acquire candidates on acceptable terms, or integrateacquired businesses successfully.  Future acquisitions or joint ventures mayrequire us to incur additional debt and contingent liabilities, which maymaterially and adversely affect our business, operating results, and financialcondition.  In addition, we may issueshares of our common stock in order to consummate future acquisitions or jointventures.  Such issuances might have adilutive effect on our current equity holders.

***Our commercial alliances with other OCTG, line pipe, and specialtytubing mills may not continue, which could adversely affect our business,financial condition, and revenues.***   We maintain commercialrelationships with several tubular producers, which we do not own, some ofwhich provide us exclusive distribution rights of their products in specificgeographic regions, principally marketing and sales of oilfield tubular productsin the United States.  These millsproduce specific products that expand our product offerings to our customersand allow us to concentrate our capital expenditures and manufacturingexpertise on our more high-quality products. These alliances accounted for 19% of our total oilfield 

6

----

productssegment revenues in 2006.  A loss of oneor more of these alliance relationships could reduce our ability to offer thesespecific products to our customers and, therefore, adversely affect ourbusiness, financial condition, and revenues.

### ***We are subject to numerous lawsuitsconcerning exposure to asbestos on our premises, which could adversely affectour financial condition.***** **During the lastseven years, our Steel subsidiary has been named as one of a number of defendantsin 47 lawsuits alleging that certain individuals were exposed to asbestos onthe defendants’ premises.  Seven pendingasbestos-related claims have been asserted against another of oursubsidiaries.  We did not manufacture ordistribute any products containing asbestos. Some or all of these claims may not be covered by our insurance.  We do not know the extent to which futureclaims may be filed and, therefore, we cannot estimate our exposure, if any, tounasserted claims.

### ***Failure to renew or reach acceptablenew collective bargaining agreements could result in labor disruptions, whichcould adversely affect our business, financial condition, and revenues*. **Oursubsidiaries are subject to three collective bargaining agreements.  At December 31, 2006, Lone Star hadapproximately 2,784 employees, of whom approximately 1,127, are part ofcollective bargaining agreements with three unions.  The majority of these union workers areproduction, warehouse, and maintenance workers at Steel and Star Tubular Services,Inc., a wholly owned subsidiary of Steel, represented by the United Steel,Paper and Forestry, Rubber, Manufacturing and Energy, Allied IndustrialServices Workers International Union under a contract which expires on July 31,2008.  Our agreement with the Security,Police & Fire Professionals of America, covering an aggregate ofapproximately 13 of our warehouse and plant security workers, expires onSeptember 30, 2010.  The collectivebargaining agreement between Steel and the International Bricklayers of Americaexpires July 31, 2008, and covers four brick masons.

Collective bargaining agreements with ouremployees generally cover wages, health care benefits and retirement plans,seniority, job classes, and work rules. Failure to renew these agreements upon expiration or to establish newcollective bargaining agreements on terms acceptable to us could result in workstoppages or other labor disruptions, which could adversely impact our customerrelationships, financial condition, and results of operations.

We may be subject to work stoppages at our facilities or our customersmay be subjected to work stoppages, which could seriously impact theprofitability of our business.  As ofDecember 31, 2006, approximately 42% of our work force was unionized.  If our unionized workers were to engage in astrike, work stoppage, or other slowdown in the future, we could experience asignificant disruption of our operations, which could have a material adverseeffect on us.  In addition, if a greaterpercentage of our work force becomes unionized, our business and financialresults could be materially adversely affected. Many of our direct or indirect customers have unionized workforces.  Strikes, work stoppages, orslowdowns experienced by these customers could result in a reduction in ordersfor our products.

***We would have greater taxable income and, therefore, would be subjectto increased payments to the FDIC if a portion of our utilized Net OperatingLoss Carryforwards were attributable to “tax benefit items” under theassistance agreement with the FDIC.***    Forthe years ended December 31, 2006, December 31, 2005, and December 31, 2004, weutilized approximately $395 million of federal income tax net operating losscarryforwards to offset payments to the “Internal Revenue Service (“IRS”)” andFederal Deposit Insurance Corporation, or FDIC. A portion of these utilized net operating loss carryforwards may relateto our former subsidiary, American Federal Bank, F.S.B., and may be subject toan agreement with the FDIC under which we are required to pay that governmentagency for the use of certain tax benefits. Discussions with the FDIC concerning these matters are ongoing.

***We have unfunded pension planliabilities and other postretirement benefit obligations of at least $16.9million and $25.1 million, respectively, which could result in claims againstour assets if our assets are insufficient to satisfy these obligations.***  Our three defined benefit pension plans forSteel’s bargaining unit employees were underfunded by an aggregate ofapproximately $16.9 million as of December 31, 2006 using an investment returnassumption of 8% per annum and a discount rate of 5.75% per annum.  Moreover, if the plans were terminated underthe distress termination provisions of the Employee Retirement Income SecurityAct of 1974, as amended, or ERISA, the Pension Benefit Guaranty Corporation, orPBGC, would have claims against our assets for the amount necessary to satisfythe plans’ unfunded benefit liabilities under the PBGC’s actuarial assumptions,which amount may be greater than $16.9 million as of December 31, 2006.  Furthermore, Lone Star had otherpostretirement benefits, principally future retiree medical expenses, whichwere unfunded and estimated to be $25.1 million at year end 2006.

***Various governmental regulations and environmental risks applicable toour business may require us to take actions, which will adversely affect ourresults of operations.*** Our business is subject tonumerous federal, state, local, and foreign laws and regulations, includingregulations with respect to air emissions, wastewater discharges and thegeneration, handling, storage, transportation, treatment, and disposal of wastematerials.  Although, we believe we arein substantial compliance with all applicable laws and regulations, legalrequirements are frequently changed and subject to interpretation, and thepresently unpredictable ultimate cost of compliance with these requirementscould affect our operations.  We may be 

7

----

required to make significant expenditures tocomply with governmental laws and regulations. Existing laws or regulations, as currently interpreted or reinterpretedin the future, or future laws or regulations, could have a material adverseeffect on our results of operations and financial condition.

***Potential casualties and product liability claims relating to theproducts we manufacture, service, and sell to the oil and gas industry and theindustries using our specialty tubulars could harm our business.***  Theoil and gas casing, tubing, coupling, and line pipe products we manufacture andservice are sold primarily for use in oil and gas drilling and transmissionactivities, which are subject to inherent risks, including well failures, linepipe leaks and fires, that could result in death, personal injury, propertydamage, pollution or loss of production. In addition, defects in our specialty tubing products could result indeath, personal injury, property damage, the potential for pollution, damage toequipment and facilities, or inefficient heat recovery.  We warrant our oilfield products, specialtytubing, and the commercial alliance products we sell or distribute to be freeof various defects.  Actual or claimeddefects in our products and services may give rise to claims against us forlosses and expose us to claims for damages. Our insurance may be inadequate or unavailable to protect us in theevent of a claim or our insurance coverage may be canceled or otherwiseterminated.

### ***Market volatility and downturns ofindustries that use our Fintube products for heat recovery applications couldfurther reduce demand for those products and adversely affect our revenues.***   Our Fintube subsidiary is one of the largestdomestic specialty tubing manufacturers of heat recovery finned tubulars, whichare used in various applications including fuel economizers, petrochemicalplants, refineries, and combined-cycle electrical power generation plants.  Our Fintube business is therefore dependenton power plant construction, the cost of alternative fuels for power generationand, to a lesser extent, industrial plant processing and petrochemical plantconstruction.  Demand for these productshas been down since fourth quarter 2001 as construction of new power plants wascurtailed due to lower energy demand attributable to the slowdown in thegeneral economy and constraints on capital to fund the constructionprojects.  Power plant constructioncurtailments and cancellations are expected to continue.  This construction activity and the correspondingdemand for our Fintube products are also related to natural gas, coal, and oilprices and are therefore subject to the volatility of the oil and gasmarket.  Demand for these productsfluctuates significantly in response to a number of economic, market and otherfactors, most of which are beyond our control.

### A further decrease in demand for these Fintubeproducts could adversely affect our results of operations including possibleasset impairments and associated losses. Some additional factors affecting demand are:

#### ·                  the level of consumer and industrial demand forelectrical power generation;

#### ·                  fluctuations in construction levels of gas-fired,combined-cycle power generation plants;

#### ·                  the price and amount of imports of foreign boilertubes, finned tubes, and other products;

#### ·                  worldwide and domestic supplies of natural gas;

#### ·                  weather conditions; and

·                  domestic and foreign governmental regulationsand taxes.

**OUR STRATEGIES**

We believe that the better we serve our customers, the better we serveour shareholders.  Our primaryresponsibility is to grow shareholder value. Thus, our goal is to be the leading provider of both oilfield tubularproducts and specialty tubing products and to increase our market presence inorder to benefit from favorable market conditions. The key elements of ourstrategy to achieve commercial leadership and operational excellence are:

***Achieving increased production,greater productivity, and penetration into new markets through joint venturesand commercial alliances expansion****.* Lone Star is expanding its geographic reachand product offerings to support our customers’ expanding worldwideinitiatives. Our customers are increasingly conducting their exploration andproduction activities on a global basis in diverse geologies requiring a broadoilfield tubular product line and a quick delivery response.  Through our exclusive commercial allianceswith several mills, we have been able to outsource production of specific typesof OCTG, line pipe, and specialty tubing, enabling us to concentrate ourmanufacturing expertise on our high-quality products and new technologies.  Furthermore, our new joint ventures withApolo in Brazil, Welspun for a new large diameter spiral weld pipe mill in theUnited States and our anticipated joint venture with Valin for seamlessoilfield tubulars in China, along with our alliances, will enable us both tooffer a wider variety of tubular products to our customers and to increase ouroffering of high-quality products. Through our joint ventures, alliances, and Star Energy Group, we deliverthe industry’s most complete line of oilfield tubular products andservices.  We will continue to seek newopportunities for joint ventures and alliances to further increase our productofferings on a global basis.

8

----

***Continuing to develop and market newproduct applications and technologies****.* We have the products, the engineeringcapabilities, and the commitment to provide solutions so customers should thinkof Lone Star first when they have a need, even if it is a need that has neverbeen met before.  Commercial leadershipdemands that we continually look for new ways to do business.  We have historically been successful inpioneering new production methods to expand the market acceptance of our oilcountry tubular goods, line pipe, and specialty tubing products. For example,we pioneered the electric resistance welded, full-body normalizedprocess, which, together with our extensive heat-treating capabilities, enablesus to manufacture and sell high-strength alloy grade oil country tubular goodsand line pipe for deep wells and other critical applications. We have alsodeveloped expandable casing products, which are used in critical repair andextended reach drilling applications to save time and costs for our customers.  In addition, we have produced and soldslotted tubes for expandable sand screens and new riser sleeves to providesolutions for completion in unconsolidated sand formations and subseacompletions, respectively.  We willcontinue to invest in new equipment and technologies and develop new productsfor the markets we serve.

***Growing through strategicacquisitions and capital investments****.* Our operational flexibility gives us theability to match production to customer needs and has earned us the reputationof having the shortest order to delivery times in the industry.  We constantly seek to improve our productionefficiency by upgrading our manufacturing methods and processes.  By becoming more efficient, we will be ableto continue offering our products at attractive prices to an increasing numberof customers. In 2006, we invested $44 million to increase productivity,enhance product quality, and upgrade manufacturing capabilities includingcompletion of a new 100,000 ton thermal treating facility to increase ourability to manufacture high-strength alloy grade OCTG.  We plan a further investment of approximately$50 million in our facilities in 2007. Our acquisitions of the companiescomprising our Star Energy Group have further enabled us to broaden our customerbase and expand the selection of products we offer and the markets we serve ata cost significantly less than that required to develop these operations on ourown.  We will continue to pursuestrategic acquisitions, both domestically and internationally, and focusedcapital investments to grow our product offering and capability.

**INDUSTRY BACKGROUND**

***Oilfield Products.***  Theproduct group referred to as oil country tubular goods, or OCTG, includescasing and tubing, which we manufacture, as well as drill pipe.  We do not currently manufacture drillpipe.  Casing acts as a structuralretainer wall in oil and natural gas wellbores to provide support and preventcaving during drilling operations and is used to protect water-bearingformations during the drilling of a well. Casing is generally not removed after it has been installed in a well.Tubing, which is used to transmit oil and natural gas to the surface, may bereplaced during the life of a producing well.

Demand for oil country tubular goods depends on several factors, mostnotably the number of oil and natural gas wells being drilled, completed and re-worked,and the depth and drilling conditions of these wells. The level of theseactivities depends primarily on the demand for natural gas and oil and theexpectation of future prices of these commodities. A key indicator of domesticdemand is the average number of drilling rigs operating in the UnitedStates.  According to the Baker Hughesrig count, the most commonly cited indicator of the level of domestic drillingactivity, the average United States rig count was 1,649 working rigs in 2006,the highest annual average in the last 20 years, compared to 1,383 and 1,192 in2005 and 2004, respectively.  This wasdespite the fact that rigs drilling offshore in the United States in 2006continued to fall to an average of 90 rigs compared to 93 rigs during 2005 and97 rigs during 2004.

9

----

Further, the number of rigs drilling at depths of 8,000 feet and deeper,which is the general depth in which alloy-grade OCTG is employed, was 76% ofthe active rigs at the end of 2006.  Atyear-end 2006, 1,710 rigs were working, of which 83% were drilling for naturalgas.

Demand for oilfield products is influenced by natural gas and crude oilprice expectations.  While the average2006 natural gas price at the Henry Hub decreased approximately 22% from the2005 average to $6.94 per MM BTU, the average price of West Texas Intermediate,or WTI, crude oil increased 17% in 2006 compared to 2005 to $66.02 per barrelWTI.  Overall, prices for natural gas andcrude oil remained at levels to support increased exploration and productionactivities.  However, expectations forfuture prices of natural gas diminished somewhat in the second half of 2006leading to slight declines in purchases of OCTG by distributors.  This pattern of purchasing behavior wasevident at year-end 2006 and is expected to persist in early 2007.

The oil country tubular goods market is also affected by the level ofinventories maintained by manufacturers, distributors, threading companies, andend users.  During downturns in drillingactivity, customers typically utilize the inventory of these products ratherthan purchase new products, causing demand for new production to furtherdecrease.  Conversely, in periods ofincreased drilling activity, increases in oil country tubular goods inventorylevels by distributors and end users typically occur, which can acceleratedemand for new production.  Throughout2006, although drilling activity had increased over the prior year, distributorinventory remained at relatively stable levels. At the end of 2006, industry observers estimated industry-wide OCTGinventories to be at levels of approximately 6 months supply versus 5.5 monthssupply at the 2005 year-end.

The amount of imported oilfield products also affects the oil countrytubular goods market.  According tostatistics from the U.S. Department of Commerce, imported oil country tubulargoods accounted for approximately 52% of the apparent domestic oil countrytubular goods consumption in 2006 compared to 47% in 2005.   Similarly, the quantity of imported electricresistance welded line pipe in sizes up to 16-inches in diameter accounted forover 50% of total consumption in 2006 and 2005.

Protective tariffs on oil country tubular goods from Argentina, Japan,Korea, Italy, and Mexico remain in effect from successful 1995 tradesuits.  The protective tariffs aresubject to sunset reviews, which began in 2006. Decisions on these are expected in mid-2007.

Manufacturers produce oil country tubular goods in numerous sizes,weights, grades, and thread profiles. The grade of pipe used in a particularapplication depends on technical requirements for strength, corrosionresistance, and other performance characteristics. Oil country tubular goodsare generally classified by “carbon” and “alloy” grades. Carbon grades of oilcountry tubular goods have yield strengths of 75,000 pounds per square inch orless and are generally used in oil and natural gas wells drilled to depths lessthan 8,000 feet. Alloy grades of oil country tubular goods, often referred toas high-quality oil country tubular goods, have yield strengths of 75,000pounds per square inch or more and are generally used in oil and natural gaswells drilled to depths in excess of 8,000 feet or for high temperature wells,highly corrosive wells, or other critical applications.

Carbon and alloy grades of oil country tubular goods are available fromboth electric resistance welded and seamless tube producers.  Electric resistance welded tubes are producedby processing flat rolled steel into strips which are cold-formed,welded, full-body normalized or seam-annealed, and end-finishedwith threads and couplings. Seamless products are produced by individuallyheating and piercing solid steel billets into tubes and then end-finishingthose tubes into oil country tubular goods in a manner similar to electricresistance welded pipe.

Based on published industry statistics, electric resistance weldedproducts have accounted for approximately half of total consumption of oilcountry tubular goods.  Electricresistance welded, full-body normalized casing and tubing and seamlesscasing and tubing compete for critical applications such as deep natural gaswells and offshore wells. Customers purchasing products for these applicationsrequire high-performance oil country tubular goods that can sustainenormous pressure as measured by burst, collapse, and yield strength. Recentlysignificant demand for alloy grade OCTG has been associated with production ofnatural gas in unconventional formations, which utilize hydraulic fracturingtechniques to complete the wells. Operators drilling shallow wells generally purchase oil country tubulargoods based primarily on price and availability, as these wells require lessstringent performance characteristics.

Line pipe products are used for surface production flow lines andgathering and transmission of oil, natural gas, and fluids. Line pipe isprimarily produced in welded form. Line pipe markets are dependent not only onthe factors which influence the oil country tubular goods market, but also onpipeline construction activity, line pipe replacement requirements, newresidential construction, and utility purchasing programs.

10

----

Couplings are used to connect individual sections of oilfield casing andtubing.  The end-user demand forcouplings is dependent on the same factors that impact the oil country tubulargoods market.

***Specialty Tubing Product.***  Thespecialty tubing business includes the manufacture, marketing, and sale of abroad variety of steel tubing products, including high-quality and custom-madeproducts.  Applications for specialtytubular products include precision mechanical tubular products for automotive,fluid power, construction, drilling, agricultural, and other industrial marketsfor various mechanical tubing applications, as well as finned tubular productsfor heat recovery applications.

The demand for precision mechanical tubulars and other specialty tubingused for automotive, fluid power, and other mechanical applications is cyclicaland dependent on the general economy, the automotive and constructionindustries, product inventory levels, and other factors affecting generaldomestic industrial activity.  While, thedemand for precision mechanical tubulars in 2005 remained steady as a result ofthe overall relatively strong economic conditions, Lone Star Steel experienceda reduction in the level of revenues from its specialty tubing Drawn OverMandrel (“DOM”) products in 2006 attributable to decreased demand from steelservice centers and lower demand for automotive applications.

Demand for heat recovery tubular products, or finned tubes, depends onseveral factors including industrial processing plant and petrochemical plantconstruction, the cost of alternative fuels for power generation andcombined-cycle electrical power plant construction.  Demand for combined-cycle electricallygenerated power slowed considerably in 2002, and has remained slow since, as constructionof new power plants has significantly decreased and the final assembly of powerplant components has moved to lower cost foreign labor markets.

***Flat Rolled Steel and Other Products******.***  Themarket for flat-rolled steel is affected by a number of factors, includingprice, capacity utilization, and material costs.  Flat-rolled steel is sold in highlycompetitive markets and price, quality, and availability are the maindeterminants of customer purchasing decisions. Lone Star’s sales of flat rolled steel in recent years have principallybeen to certain commercial alliance partners for conversion into oilfieldtubular products.  Other products consistof tubular goods that serve a variety of uses, such as structural pilingapplications in the construction industry.

**OUR OILFIELD PRODUCTS**

We manufacture and market high-quality oil country tubular goods. OurOCTG include casing and production tubing, but not drill pipe. We alsomanufacture and market line pipe and couplings and we provide a complete line ofoilfield tubular finishing services including threading and inspection.

***Oil Country Tubular Goods*****.**** **We manufacture high-quality alloy and carbon welded oil country tubulargoods, including casing, which acts as a structural retainer wall in oil andnatural gas wellbores, and production tubing, which transmits hydrocarbons tothe surface.  We also market and sellunder exclusive arrangements OCTG produced by other manufacturers that we referto as alliance mills.  We offer casingand tubing products with the widest variety of diameters, grades, and wallthicknesses in the United States. This variety provides us with a distinctcompetitive advantage as a single source supplier of a complete range ofoilfield casing and production tubing. As a result of our broad product range and unique heat-treatingcapabilities, we are able to service nearly all typical drilling applicationsfor oil and natural gas wells.

Casing, which historically represents 75% to 80% of our oil countrytubular goods revenues, is the structural retainer wall in oil and natural gaswellbores. It also serves to prevent pollution of nearby water reservoirs andcontamination of a well’s production. Casing is generally not removed after ithas been installed. Production tubing is installed within the casing to conveyoil and natural gas to the surface. We offer the widest range of grades andoutside diameters in casing (31/2” to 20”) and tubing (1.9” to 31/2”) in the United States, including products that have been successfullyused in wells with depths of over 30,000 feet.

Our high-quality product line includes tubulars manufactured with theelectric resistance welded, full-body normalized process, and otherthermal techniques that we pioneered. Because this process gives our tubesbetter performance characteristics than typical seam-annealed casing andtubing, we are able to serve both primary markets for oil country tubulargoods: deep critical wells and shallow wells. Our high-quality productssuccessfully compete both with seamless oil country tubular goods for criticalapplications and with conventional seam-annealed tubular productsmanufactured for shallow wells.  We alsooffer seamless and seam-annealed products through our alliance marketingarrangements with other producers.

Critical applications, such as deep natural gas wells and offshorewells, require high-performance casing and tubing that can withstandenormous pressure as measured by burst strength, collapse strength, and yieldstrength.  Both major and independent oilcompanies that conduct drilling programs of this nature emphasize quality andcompliance with specific standards. In our electric resistance welded, full-bodynormalized manufacturing process, which meets and exceeds API 

11

----

standards, we heat-treat the entire tube and not just the weld area.This process strengthens the entire tube and makes our high-quality casing,tubing, and line pipe interchangeable with seamless tubulars for nearly allcritical applications.  Revenues from ourhigh-strength alloy grade OCTG decreased to 63% of total OCTG revenues in 2006from 71% in 2005 principally due to lower demand for larger diameteralloy-grade OCTG used in the Gulf of Mexico.

Operators drilling shallow wells generally purchase oil country tubulargoods based primarily on price and availability, as wells of this naturerequire less stringent performance characteristics. We compete in this market,which is served primarily by producers of seam-annealed oil countrytubular goods, with our WildcatTM brand of oil country tubular goods and otherbrands produced through our exclusive alliance mills.

***Line Pipe*****.**** **We offer the widest size and chemistry range of line pipe used to gatherand transmit oil and natural gas in the United States with outside diametersfrom 2-3/8” to 60.”  Historically,approximately 15% to 20% of our oilfield product revenues are from line pipesales.

***Couplings*****.**** **Through our Wheeling subsidiary, part of our Star Energy Group, weproduce a full range of coupling products used to connect individual sectionsof oilfield casing and production tubing from 2-3/8” to 20,” includinghigh-strength grades and high-quality threads. We manufacture couplings in both standard oilfield API grades as well ashigh-quality connections.   The demandfor coupling products is correlative to demand for OCTG products.  Prior to its acquisition by Lone Star,Wheeling had a multi-year partnering arrangement with Steel to provide 100% ofSteel’s coupling requirements.  Inaddition to Steel, which comprised approximately 53%, 59%, and 41% of Wheeling’s2006, 2005, and 2004 sales respectively, Wheeling maintains contractdistribution arrangements with other large domestic OCTG producers and sellscoupling products to certain distributors of OCTG products.

***Finishing*****.**** **By acquiring DTP and DTI during 2003, we took another major step towardsproviding complete tubular solutions for our customers.  DTP and DTI provide the full-size range ofOCTG finishing, including high-quality threading, heat-treating, upsetting,inspection, and storage services.  Theyalso are part of our Star Energy Group.

***Sales and Distribution.***  Ourdomestic oil country tubular goods sales distribution network includesapproximately 17 non-exclusive stocking distributors that maintain and deliverproduct inventory to major and independent oil and gas companies that explorefor oil and natural gas. We also sell line pipe through distributors and toend-users. Internationally, oil country tubular goods are sold throughdistributors and trading companies as well as directly to end-users.  Less than 2% each of the shipments of oilcountry tubular goods and line pipe in 2006 were to destinations outside theUnited States.  Our three largestcustomers, all distributors of our oilfield products in 2006, accounted forapproximately 19%, 10%, and 7%, respectively, of the total oilfield productstons we shipped.  Sooner Pipe, L.P.,oilfield distributor, accounted for 13% of our consolidated net revenues in2006.  At the end of 2006, approximately75% of the active drilling rigs were operating within an approximate 750 mileradius of our mills in Texas.

***Alliance Mills.***  Inaddition to production from our mills, we have marketing agreements to sellother steel oilfield tubular products manufactured by several companies.Through commercial alliances with several mills, we have expanded our oilfieldproduct offering. These arrangements enable us to outsource production ofspecific products, allowing us to offer a wider variety of casing, tubing, andline pipe without a permanent capital investment. These alliances allow us toconcentrate our capital expenditures and manufacturing expertise on ourhigh-quality products, while offering our customers a complete size range ofcasing, tubing, and line pipe. These transactions are performed on a commissionbasis and through purchase and resale of the products.  Our alliance arrangements accounted forapproximately 19%, 17%, and 18% of our revenues from oilfield products during2006, 2005, and 2004, respectively.

***Competition.***  Oilcountry tubular goods and line pipe are sold in highly competitive markets.Once users of oil country tubular goods determine which performancecharacteristics are relevant, they base their purchasing decisions on fourfactors: quality, availability, service, and price. We believe that we arecompetitive in all of these areas. We successfully compete with both seamlessoil country tubular goods and seam-annealed electric resistance weldedproducts, as described above under “Business - Industry Background - OilfieldProducts.”  Our electric resistancewelded, full-body normalized casing and tubing products compete withseamless oil country tubular goods, and we offer products with the widestvariety of diameters, grades, and wall thicknesses in the United States.  Several domestic manufacturers producelimited lines of oil country tubular goods, and a number of foreignmanufacturers produce oil country tubular goods for export to the UnitedStates.

The level of imports of oil country tubular goods has been reduced bythe existence of anti-dumping duty orders. Since 1995, the level of imports of oil country tubular goods fromArgentina, Italy, Japan, Korea, and Mexico has been greatly reduced by theexistence of anti-dumping duty orders covering imports from thesecountries.  The orders may also have hada beneficial impact on prices for oil country tubular goods in the domesticmarket. Affected parties can request 

12

----

administrative reviews of imposed duties and tariffs.  Sunset reviews of these protective tariffsbegan in 2006 with decisions expected in mid-2007.

Despite the existence of various anti-dumping duty orders, OCTG importswere 52% of apparent domestic consumption in 2006 and 47% in 2005.  Imports of line pipe in 2005 and 2006 were athistorically high levels and were also estimated to be in excess of 50% ofapparent domestic consumption.  Thelevels of these imports could increase further in 2007.   Such increased competition could decreaseour sales and profits and have a material adverse effect on our line pipebusiness, operating results, or financial condition.

**OUR SPECIALTY TUBING PRODUCTS**

Our specialty tubing business includes the manufacture, marketing, andsale of a variety of tubular products, which are generally value-addedhigh-quality or custom products.  Our specialtytubing products include precision mechanical tubulars used in wide range ofindustrial and automotive applications that require exacting specifications andfinned tubulars used in industrial processing, petrochemical plants, and powertechnology applications.

***Precision Mechanical Tubulars.***** **We have one of the largest production capacities in the world forprecision mechanical tubular products using the DOM manufacturing process. Theuse of the DOM manufacturing process enables us to achieve higher criticaltolerances and dimensional control than other processes. Our precisionmechanical tubular product line includes a wide array of high-quality,custom-made steel tubular products with precise dimensional control andspecial metallurgical properties. Our precision mechanical tubular productshave the widest size range in the world, from 1/2” to 15” in outside diameter, and are made from a variety ofcombinations of chemical compositions, thermal treatments, mechanicalproperties, and surface finishes. Product uses include the manufacture ofhydraulic cylinders for construction and farm equipment; automotiveapplications, such as stabilizers and intrusion tubes; and other uses,including machine parts, bearing races, down-hole pump barrels, heavy-liftcrane boom chords, drill rods, and liner hangers. As a result of the wide rangeof industrial applications for precision mechanical tubular products, salestraditionally follow general domestic economic conditions.

The DOM process uses a drawbench to pull tubing through a die and over amandrel to shape and smooth surfaces and impart precise dimensional tolerancesto tubes. Our production facilities include seven drawbenches. Our 1,000,000pound drawbench, the largest in the Western Hemisphere, combined with our800,000 pound drawbench enable us to access broader markets through themanufacture of larger diameter, thicker wall products. Order quantities for ourprecision mechanical tubular products are typically less than20,000 pounds, and the products are made to exact customer specifications.

***Heat Recovery Tubular Products*****.**** **We manufacture custom-engineered specialty finned tubular productsused in a variety of heat recovery applications. We have the major portion ofdomestic manufacturing capacity of finned tubes that are used in heat recoverysteam generators.  Finned tubes are steeltubes with various types of fins or studs welded to the outside to increase theamount of surface area for maximized recovery of heat.  Our heat recovery products are used in fueleconomizers, petrochemical plants, refineries, and combined-cycle electricalpower generation.

In connection with our production of finned tubes, we design andmanufacture other products relating to large-scale applied heat recoverytechnology, such as boiler tubing and economizers.  Economizers are bundles of finned tubesarranged to maximize the amount of heat captured from boiler exhaustgases.  Economizers are normally used onlarge boilers for office buildings, hospitals, universities, prisons, breweries,and food processing plants. We also manufacture and sell X-ID tubing,which has specific patterns on the interior surface of the tube for enhancedheat transfer.

***Other Specialty Tubing Products*****.******We also produce hot finished specialty tubing.We have developed new thick-wall products using enhanced hot reductiontechnology for applications such as heavy axles for trailers and light axlesfor trucks, including sport utility vehicles that were typically made out ofseamless tubes.  This product is alsoused for other industrial applications.

***Sales and Distribution.*** Domestically, we market and sell our precision mechanical tubularsthrough major nonexclusive steel service centers and directly toend-users.  Our precision mechanicaltubulars have detailed design specifications and are manufactured to extremelyprecise processing requirements.  Ourclosely controlled manufacturing process results in an efficient low costsourcing solution for large purchasers. Internationally, the majority of ourprecision mechanical tubulars are currently sold to end-users.  Exports accounted for approximately 5%, 8%,and 7% in 2006, 2005, and 2004, respectively, of the shipment volume of ourprecision mechanical tubulars.  We marketand sell our finned tubes and other heat recovery products through outsidesales managers providing direct sales to most original equipment manufacturer 

13

----

accounts and through approximately 50 independent sales representativecompanies which sell to end-users and contractors. We have reorganized our heatrecovery tubular products around new marketing and commercial lines directed atmore traditional heat recovery markets including fuel economizers andtraditional boiler applications. Exports of finned tubulars and other heatrecovery tubes accounted for approximately 16%, 7%, and 16% of the revenuesfrom those products in 2006, 2005, and 2004, respectively.

***Competition.***  Themarket for specialty tubing is competitive and is served by severalmanufacturers.  We have one of thelargest capacities in the world to manufacture precision mechanical tubularsusing the DOM manufacturing process.

Since these products are made to end-user specifications and oftenrequire just-in-time delivery, only small quantities are importedinto the United States. In contrast to the oil country tubular goods market,seamless and electric resistance welded specialty tubing products differ intheir applications. Electric resistance welded tubing, such as precisionmechanical tubulars, is preferred for many mechanical tubing applicationsbecause its consistent wall thickness requires less machining in the finishingprocess. In contrast, seamless tubes are often specified in heavy gaugeapplications such as boiler and pressure tubing.

Based on generally available market data, we estimate that we have amajor portion of the domestic manufacturing capacity for finned tubes used forheat recovery steam generation.  We haveone significant domestic competitor and a few smaller domestic competitors, aswell as foreign competitors.

**OUR FLAT ROLLED STEEL ANDOTHER PRODUCTS**

***Products and Services.***  Wealso manufacture and market flat-rolled steel and other miscellaneous productsthat are secondary to our manufacture of oilfield and specialty tubingproducts.  We have a rolling mill thathas the capacity to produce 1.25 million tons of flat-rolled steel peryear.  Participation in flat rolled steelmarkets allows us to maintain flexibility in procurement of lower cost steel.   Flat-rolled steel, produced primarily forthe manufacture of oilfield and specialty tubing products, is also sold to ourexclusive alliance mills for conversion into tubular products and tofabricators of large diameter transmission pipe, storage tanks, rail cars, anda variety of other construction and industrial products.

We also market other products such as tubulars for use in structural andpiling applications in the construction industry, and we providetransportation, storage, and other services.

***Sales and Distribution.***  Wemanufacture and sell flat-rolled steel directly to end-users and throughservice centers, primarily in the Southwestern region of the UnitedStates.  Our largest customer of ourflat-rolled steel and other tubular products accounted for approximately 85% ofour flat-rolled steel sales in 2006, as well as substantially all other salesof miscellaneous tubular products other than oilfield and specialty tubingproducts. This customer, which is an alliance mill, has steel processingfacilities located adjacent to our facilities in Lone Star, Texas, and thosefacilities purchase most of their flat-rolled steel from us.  Sales to this customer representedapproximately 6%, 5%, and 7% of our total revenues in 2006, 2005, and 2004,respectively.

We also provide flat rolled steel slitting and processing services tosteel mills where we receive slitting and processing revenues, but do notpurchase and resell steel.

***Competition.***  Ourflat-rolled steel is sold in highly competitive markets generally concentratedin the Southwestern region of the United States. Sales and earnings areaffected by the cost of raw materials, use of flat-rolled steel by us and ouralliance mills in the manufacture of our tubular products, demand by outsidecustomers, and general economic conditions. Our steel coil slitting services compete against service centers locatedin the Midwest.

**FINANCIAL INFORMATION ABOUTSEGMENTS**

For financial information for each segment regarding revenues, profits,or losses (as applicable) and total assets, see “Business Segments-Note B” ofthe Notes to Consolidated Financial Statements.

**CUSTOMERS**

We sell our oilfield products through our nonexclusive distributors tonumerous end-users, including BP, ChevronTexaco, El Paso Exploration, AnadarkoPetroleum, Devon Energy, Chesapeake Energy, Occidental Petroleum, DominionResources, and XTO Energy. We sell our finned and other heat recovery tubularproducts to over 50 end-users, including Foster Wheeler, Babcock & Wilcox,Rentech, Vogt Power International, and Cerrey. We sell our precision mechanical tubulars to such distributors and endusers as Chicago Tube and Iron, Earle M. Jorgensen Company, Marmon/Keystone,Hyva, DaimlerChrysler, and Ford Motor Company.

14

----

**RESEARCH, DEVELOPMENT,INFORMATION TECHNOLOGY, AND PATENTS**

We are committed to technologically innovative product development. Withrespect to oilfield products, we collaborate with customers and industry groupsto develop new grades of oil country tubular goods as well as new products,such as expandable casing. Our expandable casing product was developed for ajoint venture between Shell Oil Company and Halliburton Company and was firstsuccessfully installed in late 1999 in the Gulf of Mexico.  As of December 2006, there have been morethan 600 successful installations totaling more than 110 miles of expandabletubulars for 80 end-users in 20countries.  We have also developed slotted tubes forexpandable sand screens and riser sleeves to provide new product solutions forour customers.  Our technical knowledgeand high-performance casing products and fit-for-purpose threads are alsobeing applied in an innovative method for drilling wells using casing insteadof drill pipe.  We have also developedother value-added specialty threads, including special flush connections, whichhave been used in over 3 million feet of down-hole applications.  Our expertise has also been used to develophigh-strength, thick-wall line pipe for offshore applications.  In addition, we developed ultrasonic testingmethods to assure the quality of our tubing. In the specialty tubing area, ourproduct developments include the Aeroseg finned tube, a thermal mechanicallyprocessed DOM product called QDOM for applications requiring extreme mechanicalproperties, and thick-wall products using hot reduction technology for applicationssuch as heavy axles that are normally made out of seamless tubes.  Also, new product and process developmentshave resulted in the introduction and commercial manufacturing of a newprecision tubular product known as HCF and a new highly efficient heat exchangertube known as X-ID.  We hold severalUnited States patents covering some of our manufacturing processes andproducts.

We have made significant investments in information technologies thatprovide the platform for internet-based commercial marketing and resourceconstrained production planning. We believe our information technologiescapabilities will allow us to more effectively run our facilities, give ourcustomers excellent service, and facilitate web-based commercialinitiatives.

**MANUFACTURING CAPABILITIES**

We manufacture our oilfield products, precision mechanical tubulars,flat-rolled steel, and other products at our facilities located on anapproximately 2,000-acre site we own in Lone Star, Texas, which containsover 2,000,000 square feet of manufacturing space, and approximately 91,000square feet of oilfield products manufacturing facilities in Bellville,Texas.  We manufacture our finned tubularproducts in approximately 340,000 square feet of manufacturing facilities onapproximately 62.2 acres that we own or lease in the Tulsa, Oklahomametropolitan area; Monterrey, Mexico; and Chonburi, Thailand.   Our coupling products are manufactured atthree owned facilities totaling 231,000 square feet of manufacturing space andlocated in Pine Bluff, Arkansas; Hughes Springs, Texas; and Houston,Texas.   Our finishing and storageservices provided by DTP and DTI are performed at two owned facilities totaling281,500 square feet across 230 acres located in Houston, Texas.

The annual rated capacity of our facilities in Lone Star, Texasapproximates 1,250,000 flat rolled tons and 1,000,000 welded full-bodynormalized pipe tons. The annual rated capacity of our facility in Bellville,Texas approximates 100,000 welded full-body normalized pipe tons.  We have access through our alliances mills,joint venture with Apolo, and other marketing arrangements for additionaloilfield tubular capacity of approximately 700,000 tons per year.  Our electric arc furnaces (“EAF”) have anestimated capacity of 360,000 ingot tons. In 2006, the precision mechanical specialty tubing facilities operatedat 53% of capacity.  The rolling millsand pipe mills generally operated at 84% and approximately 90% of capacity,respectively, while the EAF generally operated at 93% of capacity in 2006.

Wheeling operates PMC high-volume finishers and CNC lathes at facilitiesin Pine Bluff, Arkansas; Hughes Springs, Texas; and Houston, Texas.  Wheeling also maintains finished product atits production facilities as well as warehouses at Steel, and a facilityservicing U.S. Steel operated by Wheeling in Birmingham, Alabama.  The Houston facility was established tohandle high-quality threads that require third-party inspections.  Wheeling offers a wide range of eight roundand buttress couplings for 2-3/8” tubing through 20” casing.

DTP is a licensed API processor for upsetting, threading, and heattreating of OCTG products to API specifications.  DTP has two forging machines that are capableof upsetting tubing, two quench and tempering operations-one at the main plantwith induction austenitizing coils and alternating tempering furnaces and oneat the satellite operation with one austenitizing furnace and one temperingfurnace, that can heat treat tubing and coupling stock through 3.668” outsidediameter (“OD”), and one full-body normalizing line that can normalize tubingup to 4-1/2” OD.  DTP has two hydrostatictubing testers, two high-speed PMC tubing threaders, and two CNC tubingthreaders used as production and repair lines. A Non-Destructive Testing operation at the facility is operated by athird-party contractor.  The facility hasan estimated capacity of 150,000 tons per year with an average mix ofproducts.  DTP operates on a 96-acretract in Houston, Texas with 150,000 square feet of building space and leasesan additional building with 14,500 square feet which houses its second heattreat line.

15

----

DTI is an API licensed threader for OCTG casing and tubing for sizesranging from 3-1/2” to 20” OD. We have two Four-Function Electro MagneticInspection lines that inspect pipe ranging from 2-3/8” through 13-3/8” OD andtwo ultrasonic lines for full body ultrasonic inspection up to 20” OD. We havethree double-ended thread lines capable of threading API and premium threadsfrom 4-1/2” through 20” OD pipe.  One ofthese double ended lines is furnished with two state of the art CNC dual axismachines installed during the second half of 2004. Our annual rated capacityfor casing threading is 225,000 tons and inspection is 450,000 tons.  This facility is located on a 150-acre tractin Houston, Texas with 117,000 square feet of building usage.

Both DTP and DTI facilities have truck and rail access, and are locatedin close proximity to the Houston Ship Channel.

We have a major portion of the North American manufacturing capacity forproduction of finned tubes for heat recovery applications.  Our fully integrated manufacturing facilitiesinclude a welded tubing mill with in-line ultrasonic testing in Tulsa, Oklahoma.  Combined with our manufacturing facilities inMonterrey, Mexico and Laem Chabang, Thailand, we manufacture a wide variety offinned products, including solid and serrated fins for tubing from 1” though6-5/8” OD.  We also manufacture studdedfins and offer bending in various sizes and lengths.

**RAW MATERIALS AND INVENTORY**

In general, we attempt to procure raw materials and manage our finishedgoods inventory in a manner that will provide:

·              significantflexibility in responding to the levels of demand for our various products;

·              ashort lead time in filling our customers’ orders;

·              abroad product range offering; and

·              theability to offer our products at competitive prices.

We generally produce oil country tubular goods and line pipe to fillspecific orders and, accordingly, we maintain the majority of our inventory inthe form of steel slabs and coils, while work-in-process orfinished goods are generally earmarked for specific orders. Some work-in-processand finished goods inventories are maintained in order to provide flexibilityin responding to customer delivery demands.

Steel prices remained volatile in 2006 and at high-average price levelsas in 2005 due in part to continued consolidation of the steel industry andtight balance between supply and demand for steel on a global basis.  Although domestically there were noconstraints on obtaining steel, most international markets experienced anincrease in ore prices of about 19%.  Wecontinue to believe that steel costs could remain volatile in 2007 and thereare currently no strong indicators that steel costs will moderate significantlyin the coming year.

We can use steel slabs, scrap steel, and steel coils in the manufactureof our tubular products. We purchased steel slabs to meet approximately 66% ofour steel needs in 2006, down from 76% in 2005. The decrease in utilization of slabs was    attributable to increased usage of coil andscrap to make our products.  Purchases ofcoil and scrap were up 41% and 48%, respectively, from 2005.  Generally, we commit to purchase slabs 60 to90 days prior to production.  Weanticipate again using steel slabs for the majority of our production needs in2007. Our principal raw material for our internally produced steel slabs isscrap steel, which is internally generated from our operations and available inthe spot market. The volatile price of steel is influenced by a number ofcompetitive market conditions beyond our control, and is not directly relatedto the demand for our products.

Raw materials for our specialty tubing products are readily availablefrom multiple sources. Steel coil is the primary raw material used in themanufacture of our finned and precision mechanical tubular products. We usuallyproduce our specialty tubing products to meet specific orders and, accordingly,inventory is managed to minimize the amount of finished goods on hand. Work-in-processinventories are maintained in order to provide flexibility in responding tocustomer needs.

We manufacture flat-rolled steel primarily for use in producing oilfieldand precision mechanical tubulars, but also for sale to third parties.  We manufacture flat-rolled steel using bothpurchased steel slabs and internally produced slabs on our rolling mill.

**EMPLOYEES**

At December 31, 2006,Lone Star had approximately 2,784 employees, of whom approximately 1,127, arepart of collective bargaining agreements with three unions.  The majority of these union workers areproduction, warehouse, and maintenance workers at Steel and Star TubularServices Inc., a wholly-owned subsidiary of Steel, represented by the UnitedSteel, Paper and Forestry, Rubber, Manufacturing and Energy, Allied IndustrialServices Workers International Union under a contract, which expires on July31, 2008.  Our agreement with theSecurity, Police & Fire Professionals of America, covering an 

16

----

aggregate ofapproximately 13 of our warehouse and plant security workers, expires onSeptember 30, 2010.  The collectivebargaining agreement between Steel and the International Bricklayers of Americaexpires July 31, 2008, and covers four brick masons. Steel considers itsrelationship with these three bargaining units to be good.

We endeavor to provide a safe and healthful work environment for ouremployees, contractors, vendors, and visitors to our facilities.  We frequently evaluate and update ourprograms to ensure compliance.  Weencourage all employees to be involved in our safety efforts.  We utilize a variety of methods to increasethe skills and knowledge of our employees to improve safety performance.

**FOREIGN OPERATIONS**

Our export sales to destinations outside the United States wereapproximately $31.4 million in 2006, $33.6 million in 2005, and $30.0 millionin 2004.  We own an idle manufacturingfacility in Quebec, Canada and lease manufacturing facilities in Monterrey,Mexico and Chonburi, Thailand. Long-lived assets maintained in Quebec, Canada were $1.1 million, $1.2million, and $3.0 million at December 31, 2006, 2005, and 2004, respectively,and are classified as held for sale. Long-lived assets maintained in Monterey, Mexico were $1.3 million, $1.3million, and $1.5 million at December 31, 2006, 2005, and 2004,respectively.  We commenced our Thailandoperations in 2005, and our long-lived assets maintained there were $2.2million and $1.5 million at December 31, 2006 and 2005, respectively.  Our export sales of $31.4 million todestinations outside the United States included $5.4 million from these foreignfacilities in 2005.  On November 30,2006, Lone Star acquired 50% ownership stake in Apolo, a leading Braziliansupplier of welded casing, tubing, line pipe, and other tubular products.

**ENVIRONMENTAL**

***Oilfield Products***.  Steel’soperations are subject to extensive environmental regulations with respect toair emissions, wastewater and storm water discharges, and waste management.  Our environmental protection and improvementexpenditures averaged approximately $1.3 million per year over the past threeyears, including expenditures related to energy efficiency efforts, asbestosabatement, wastewater treatment system upgrades, waste disposal site closures,and out-of-service facilityremediation projects.

In connection with the cleanup of two offsite commercial wastemanagement sites, we, along with many other entities, have been designated apotentially responsible party (“PRP”) by the U.S. Environmental ProtectionAgency under the Comprehensive Environmental Response, Compensation andLiability Act (“CERCLA”).  CERCLAsubjects PRPs to potential liability for such cleanup costs.  Cost estimates have been obtained for each ofthe cleanup actions, and our share has been determined.  Based upon these estimates, we do not believeour liability, individually or in the aggregate, will be material to ourfinancial position and our results of operations.

The solid waste units that received wastes defined as hazardous wasteunder the Resource Conservation and Recovery Act (“RCRA”) have beenclosed.  The two RCRA units requiringcontinued monitoring are undergoing postclosure care.  Lone Star has submitted a letter to the TexasCommission on Environmental Quality (“TCEQ”) guaranteeing the remaining cost ofpost-closure care (estimated to be approximately $0.4 million), which meets ourfinancial assurance requirements.  TheTCEQ is in the process of determining what, if any, corrective action isrequired to address the remaining non-RCRA solid waste management units.

We possess necessary authorizations for air emissions, wastewater andstorm water discharges and waste management. We are presently in substantial compliance with our permits andapplicable air, water and waste management rules and regulations.  We have an environmental management system (“EMS”)in place, which conforms to the internationally recognized ISO 14001:2004standard, to assist in maintaining compliance and improving performance.  In addition, third- party compliance auditsare conducted systematically in accordance with the Texas Audit PrivilegeAct.  We do not expect futureenvironmental expenditures necessary to comply with existing environmentalrules and regulations to have a material impact on our financial position oroperations.

***Star Energy Group.***  The operations of DTP, DTI, Bellville, andWheeling are also subject to environmental regulations in the area of airemissions, wastewater and storm water discharges, and waste management.  The companies possess or have applied fornecessary authorizations for air emissions, wastewater and storm waterdischarges, and waste management.  Allfacilities are classified as either Small Quantity Generators or ConditionallyExempt Small Quantity Generators.  Wastesare temporarily stored onsite, but are disposed of or recycled offsite by athird party.  There are no onsite wastedisposal units.

***Specialty Tubing.***  Steel’sspecialty tubing operations and Fintube’s operations are also subject toenvironmental regulations in the area of air emissions, wastewater and stormwater discharges, and waste management, and possess 

17

----

necessary authorizations for such activities.  Wastes at Fintube are temporarily storedonsite, but are disposed of or recycled offsite by a third party.  Fintube does not use onsite waste disposalunits.

**INTERNET WEBSITE POSTINGS**

Our internet website is www.lonestartech.com.  We make available through our internetwebsite our annual report on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, and amendments to those reports filed or furnishedpursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 assoon as reasonably practicable after we electronically file such material with,or furnish it to, the Securities and Exchange Commission (“SEC”).  The internet website of the SEC iswww.sec.gov.

In addition, our code of business conduct and ethics, CorporateGovernance Guidelines, and Charters of the Audit, Corporate Governance, andHuman Resources Committees are available on our website and in print to anyshareholder who requests a printed copy.

**NEW YORK STOCK EXCHANGECORPORATE GOVERNANCE CERTIFICATION**

Lone Star is a listed company with the New York Stock Exchange (“NYSE”).  The chief executive officer of Lone Starcertified in May 2006 to the NYSE that he is not aware of any violation by LoneStar of NYSE corporate governance listing standards as of the date of thatcertification, which was made without any exception or qualification.

**ITEM 1A.****                              ****RISKFACTORS**

Risk factors are set forth under “Business” beginning on page 4 hereof.

**ITEM 1B.****                              ****UNRESOLVEDSTAFF COMMENTS**

There are no unresolved comments from the SEC.

**ITEM 2.****                                      ****PROPERTIES**

We manufacture our oilfield products, precision mechanical tubulars,flat-rolled steel and other products at our facilities located on anapproximately 2,000-acre site we own in Lone Star, Texas which containsover 2,000,000 square feet of manufacturing space.  The original facilities, constructed in the1940’s and 1950’s, have been expanded and modernized, and include two EAFsequipped with oxy-fuel burners; two rolling mills, a “two-high” mill that rollsthe EAF ingots into slabs and a “four-high” single stand reversing Steckel millthat produces flat-rolled coils; coil slitting and handling equipment; two pipewelding mills; seven draw benches, including the largest specialty tubingdrawbench in the Western Hemisphere; four heat-treating facilities; numeroustypes of ultrasonic and electromagnetic testing and inspection equipment;finishing facilities at which oil country tubular goods are threaded andcouplings are applied; and various support facilities, including a shortlinerailroad and other transportation and storage facilities.

We also have 91,000 square feet of oilfield products manufacturingfacilities in Bellville, Texas.  Wemanufacture our finned tubular products in approximately 364,000 squarefeet of manufacturing facilities on approximately 62.2 acres that we own orlease in the Tulsa, Oklahoma metropolitan area; Monterrey, Mexico; and LaemChabang, Thailand.   Our couplingproducts are manufactured at three owned facilities totaling 267,940 squarefeet of manufacturing, warehouse, and office space located in Pine Bluff,Arkansas on 12.7 acres; Hughes Springs, Texas on 19.4 acres; and Houston, Texason 5.3 acres.

DTP operates in a total of approximately 117,000 square feet situated onapproximately 80 acres of land that we own in Houston, Texas.  DTI utilizes 165,000 square feet located onapproximately 150 acres of land that we own in Houston, Texas.  Both facilities utilize the owned acreage forpipe storage and warehousing.

We own 7,000 acres in Texas that was purchased primarily for iron ore,coal reserves, or water rights; and, mineral interests in an additional 12,000acres in Oklahoma and 60,000 acres in Texas. No minerals have been recovered from these properties for many yearsbecause their use is no longer required in our operations.  We own nominal oil and gas interests in anadditional 18,000 acres in Texas.  Ourheadquarters are located in leased facilities in Dallas, Texas.

Apolo manufacturesits tubular products at facilities located in Lorena, Sao Paulo, Brazil onapproximately 128 acres of land, which contain approximately 340,000 squarefeet of manufacturing space.

18

----

**ITEM 3.****                                      ****LEGALPROCEEDINGS**

During the last eight years, Steel has been named as one of a number ofdefendants in 47 lawsuits alleging that certain individuals were exposed toasbestos on the defendants’ premises. The plaintiffs are seeking unspecified damages.  Of the 47 lawsuits, 23 have been settled orare pending settlement for approximately $0.4 million in the aggregate and 15have been dismissed or are pending dismissal. Steel did not manufacture or distribute any products containingasbestos.  Some or all of these claimsmay not be covered by the Company’s insurance. The Company has accrued for the estimated exposure to known claims, butdoes not know the extent to which future claims may be filed.  Therefore, the Company cannot estimate itsexposure, if any, to unasserted claims.

Beginning in 2003, Lone Star’s subsidiary Zinklahoma, Inc., inactivesince 1989, has been named as one of a number of defendants in seven lawsuitsalleging that the plaintiffs had contracted mesothelioma as the result ofexposure to asbestos in products manufactured by the defendants and John ZinkCompany (“Zink”).  Five of these lawsuitshave been dismissed and one was settled for less than $0.1 million.  Lone Star acquired the stock of Zink in 1987and, in 1989, sold the assets of the former Zink to Koch Industries, Inc. (“Koch”)and renamed the now inactive subsidiary “Zinklahoma, Inc.”  Lone Star retained, and agreed to indemnifyKoch against, certain preclosing liabilities of Zink.  It is Lone Star’s understanding that Zinknever manufactured asbestos and primarily used it only in certain purchasedgaskets that were encapsulated in copper and contained in burners and flaresmade by Zink prior to 1984, when Zink ceased using asbestos-containing productsentirely.  Koch continues to operate thebusiness as John Zink Company, LLC (“Zink LLC”).

In addition, Zink LLC has been named in twelve lawsuits in which theplaintiffs, six of whom have mesothelioma, allege exposure to asbestos in Zink’sproducts (six of these have been dismissed). Koch is seeking indemnification from Lone Star with respect to these sixpending lawsuits alleging exposure to asbestos. The costs of defending and settling the lawsuits alleging exposure toasbestos in Zink’s products have been borne by Zink’s insurance carrier.

**ITEM 4.****                                      ****SUBMISSIONOF MATTERS TO A VOTE OF SHAREHOLDERS**

None.

**   PART II**

**ITEM5.**                                       MARKET FOR REGISTRANT’S COMMON EQUITY, RELATEDSHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

Lone Star’s Common Stock trades on the NYSE under the symbol LSS.  The following table summarizes the range oftrading prices by quarter for the last two years:

|                | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First quarter  |       | $        | 60.10      |     | $          | 46.35 |   | $ | 46.85 |   | $ | 29.70 |   |
| Second quarter |       | $        | 63.96      |     | $          | 42.23 |   | $ | 48.34 |   | $ | 34.69 |   |
| Third quarter  |       | $        | 55.35      |     | $          | 43.45 |   | $ | 59.17 |   | $ | 45.21 |   |
| Fourth quarter |       | $        | 53.66      |     | $          | 45.03 |   | $ | 56.66 |   | $ | 43.18 |   |

 

As of February 8, 2006, we had 2,499 common shareholders of record.  We have not paid dividends on our commonstock since becoming a public company and have no present plan to do so.  On October 24, 2006, Lone Star announced abuyback program of the company’s common stock for a total investment not toexceed $100 million to expire at the end of 2007.  As of February 12, 2007 the company hadpurchased 316,900 shares of its common stock at a total cost of approximately$14.9 million.

19

----

 

|                              | ** ** | ** **            | ** ** | ** **          | ** ** | ** **                        | ** ** | **Maximum**                 | ** ** |
|------------------------------|------------|-----------------------|------------|---------------------|------------|-----------------------------------|------------|-----------------------------|------------|
| ** **                   | ** ** | ** **            | ** ** | ** **          | ** ** | ** **                        | ** ** | **Amount That**        | ** ** |
| ** **                   | ** ** | ** **            | ** ** | ** **          | ** ** | ** **                        | ** ** | **May yet be**    | ** ** |
| ** **                   | ** ** | ** **            | ** ** | ** **          | ** ** | **Total Number of**     | ** ** | **Purchased**               | ** ** |
| ** **                   | ** ** | **Total Number** | ** ** | **Average**         | ** ** | **Shares Purchased as** | ** ** | **Under the**          | ** ** |
| ** **                   | ** ** | **of Shares**    | ** ** | **Price Paid** | ** ** | **Part of Publicly**    | ** ** | **Program ($ in** | ** ** |
| ** **                   | ** ** | **Purchased**         | ** ** | **per Share**  | ** ** | **Announced Program**        | ** ** | **millions)**               | ** ** |
| October 1-October 31, 2006   |       | 10,000                |       | 47.72               |       | 10,000                            |       | $                           | 99.5       |   |
| November 1-November 30, 2006 |       | 70,000                |       | 48.51               |       | 80,000                            |       | $                           | 96.1       |   |
| December 1-December 31, 2006 |       | 31,900                |       | 49.43               |       | 111,900                           |       | $                           | 94.5       |   |

 

Information required under this item with respect to securitiesauthorized for issuance under equity compensation plans is contained in LoneStar’s proxy statement for the 2007 Annual Meeting of Shareholders, and isincorporated herein by reference.

The following graph compares the yearly percentage change for thefive-year period from January 1, 2002 to January 1, 2007, in the cumulativetotal returns on Lone Star’s Common Stock, the S&P 500 Composite StockIndex and the S&P Oil & Gas Equipment & Services Index.  The value of each investment was equal to$100 on January 1, 2002.

20

----

 

**ITEM 6.  SELECTED FINANCIAL DATA*($ and shares in millions, except per shareand employee data)***

 
| ** **                                            | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**(1) | ** ** | **2002**(2) | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|-------------|------------|-------------|------------|
| **Results of Operations Data:**                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** |
| Oilfield products  revenues                           |       | $          | 1,103.6    |       | $          | 1,009.8    |       | $           | 695.4      |        | $          | 364.8 |   | $ | 304.2 |   |
| Specialty tubing  products revenues                   |       | 176.5      |       | 181.5      |       | 175.1      |       | 121.8       |       | 165.4       |       |
| Flat rolled and other  tubular revenues               |       | 97.5       |       | 93.8       |       | 96.3       |       | 47.5        |       | 54.1        |       |
| Total revenues                                        |       | $          | 1,377.6    |       | $          | 1,285.1    |       | $      | 966.8      |        | $     | 534.1 |   | $ | 523.7 |   |
|                                                  |       |       |       |       |       |       |       |        |       |        |       |
| Gross profit                                          |       | $     | 235.0      |       | $     | 272.3      |       | $      | 162.0      |        | $          | 5.2 |   | $  | 7.4 |   |
| Selling, general, and  administrative expenses        |       | (62.2      | )          | (50.5      | )          | (44.6      | )          | (41.8       | )          | (68.2       | )          |
| Goodwill impairment  charge                           |       | —     |       | —     |       | —     |       | (18.7       | )          | —      |       |
| Operating income  (loss)                              |       | $          | 172.8      |       | $     | 221.8      |       | $      | 117.4      |        | $          | (55.3 | ) | $  | (60.8 | ) |
| Net income  (loss)                                    |       | $     | 108.2      |       | $     | 223.6      |       | $      | 101.0      |        | $          | (68.2 | ) | $  | (69.2 | ) |
| Net income  (loss) per common share - basic           |       | $     | 3.54       |       | $     | 7.44       |       | $           | 3.51       |        | $     | (2.40 | ) | $ | (2.52 | ) |
| Net income (loss) per  common share - diluted         |       | $     | 3.47       |       | $     | 7.34       |       | $           | 3.46       |        | $     | (2.40 | ) | $  | (2.52 | ) |
| Common shares used for  diluted EPS                   |       | 31.2       |       | 30.5       |       | 29.2       |       | 28.4        |       | 27.5        |       |
| **Balance  Sheet Data:**                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** |
| Working capital                                       |       | $     | 508.0      |       | $          | 612.5      |       | $           | 285.8      |        | $          | 184.2 |   | $ | 281.9 |   |
| Total assets                                          |       | $          | 1,032.3    |       | $     | 979.3      |       | $           | 646.7      |        | $          | 574.7 |   | $ | 612.1 |   |
| Long-term debt                                        |       | $          | —     |       | $          | 150.0      |       | $           | 150.0      |        | $          | 150.0 |   | $ | 150.0 |   |
| Total liabilities                                     |       | $     | 279.9      |       | $          | 339.1      |       | $           | 292.2      |        | $          | 328.8 |   | $ | 299.5 |   |
| Shareholders’ equity                             |       | $     | 752.4      |       | $          | 640.2      |       | $           | 354.5      |        | $          | 245.9 |   | $ | 312.6 |   |
| Shares issued                                         |       | 31.0       |       | 30.6       |       | 29.2       |       | 28.7        |       | 28.5        |       |
| **Other  Financial and Operating Data:**              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** |
| Cash flows from  operating activities                 |       | $     | 133.8      |       | $     | 148.2      |       | $      | 29.5       |        | $     | (8.4 | ) | $ | (12.4 | ) |
| Cash flows from  investing activities                 |       | $     | (37.1      | )          | $          | (112.9     | )          | $      | (39.2      | )           | $          | (80.2 | ) | $  | (54.0 | ) |
| Cash flows from  financing activities                 |       | $     | 152.9      |       | $     | 36.6       |       | $      | 6.4        |        | $          | 0.5 |   | $  | 81.5 |   |
| Earnings (loss) before  interest, taxes, depreciation |       |       |       |       |       |       |       |        |       |        |       |
| and amortization(3)                                   |       | $     | 202.6      |       | $     | 258.4      |       | $      | 147.2      |        | $     | (27.7 | ) | $ | (36.9 | ) |
| Capital expenditures                                  |       | $     | 44.0       |       | $          | 21.0       |       | $      | 13.0       |        | $          | 14.4 |   | $  | 15.9 |   |
| Active employees at year-end                          |       | 2,784      |       | 2,699      |       | 2,422      |       | 2,270       |       | 1,900       |       |

----

See footnotes at page 22of this Form 10-K.

21

----

**Reconciliationof EBITDA (as defined)****(3)****to Cash Flows from Operations:**
| ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**(1) | ** ** | **2002**(2) | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|-------------|------------|-------------|------------|
| Cash flows from  operating activities              |       | $   | 133.8      |     | $          | 148.2    |       | $           | 29.5       |        | $     | (8.4  | ) | $ | (12.4 | ) |
| Non-cash charge  for stock compensation            |       | (5.9     | )          | (3.5     | )          | (1.6     | )          | (1.1        | )          | 0.1         |       |
| Net loss  (gain)on asset disposals and impairments |       | (0.1     | )          | 0.1      |       | (0.1     | )          | (0.4        | )          | 0.1         |       |
| Goodwill  impairment                               |       | —   |       | —   |       | —   |       | (18.7       | )          | —      |       |
| Changes in  working capital                        |       | 16.1     |       | 119.8    |       | 92.9     |       | (43.7       | )          | (8.6        | )          |
| Other balance  sheet changes                       |       | (0.1     | )          | (13.1    | )          | 8.1      |       | 29.5        |       | (26.6       | )          |
| Write off of  debt issuance costs                  |       | 2.5      |       | —   |       | —   |       | —      |       | —      |       |
| Interest  expense, net                             |       | (3.0     | )          | 10.3     |       | 15.0     |       | 15.0        |       | 11.2        |       |
| Income tax  expense (benefit)                      |       | 59.3     |       | (3.4     | )          | 3.4      |       | 0.1         |       | (0.7        | )          |
| EBITDA                                             |       | $   | 202.6      |     | $     | 258.4    |       | $      | 147.2      |        | $          | (27.7 | ) | $ | (36.9 | ) |

----

(1)    Includes the results of operations of DTP and DTI sincethe acquisitions became effective on May 1, 2003 and June 2, 2003,respectively.

(2)    Includes Wheeling results of operations since the acquisition became effective onOctober 1, 2002.

(3)    EBITDA is a measure of our liquidity that is not requiredby or presented in accordance with GAAP. EBITDA should not be considered as an alternative to cash flow fromoperating activities as a measure of our liquidity or as an alternative to netincome, operating income, or any other performance measures derived inaccordance with GAAP.

EBITDArepresents earnings before interest, taxes, depreciation, andamortization.  We use EBITDA:

·                  as a liquidity measure, because our existingsenior secured credit facility contains covenants relating to our fixed chargecoverage ratio that use EBITDA;

·                  to evaluate and price potential acquisitioncandidates, which are evaluated and priced by other issuers in our industrybased upon EBITDA;

·                  to facilitate company-to-company comparisonsby backing out potential differences caused by variations in capital structures(affecting interest expense), taxation, and the age and book depreciation offacilities and equipment (affecting relative depreciation expense), which mayvary for different companies for reasons unrelated to operating performance;and

·                  because EBITDA is a liquidity measure that iscommonly used by oilfield service and supply companies.

However,EBITDA has limitations as an analytical tool, and you should not considerEBITDA in isolation or as a substitute for analysis of our results as reportedunder GAAP.  For example, EBITDA does notreflect:

·                  our cash expenditures, or future requirements,for capital expenditures or contractual commitments;

·                  changes in, or cash requirements for, ourworking capital needs;

·                  our significant interest expense, or the cashrequirements necessary to service interest and principal payments on our debts;

·                  any cash requirements for the replacement of assetsbeing depreciated and amortized, which will often have to be replaced in thefuture, even though depreciation and amortization are noncash charges; and

·                  the fact that other companies in our industrymay calculate EBITDA differently than we do, which limits its usefulness as acomparative measure.

Becauseof these limitations, you should not consider EBITDA as a measure ofdiscretionary cash available to us to invest in the growth of our business.  We compensate for these limitations byrelying primarily on our GAAP results and by using EBITDA only supplementally.

 

22

----

 

**ITEM 7.****                             ****MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

# **OVERVIEW**

*This MD&A should be read in conjunction with theother sections of this Annual Report on Form 10-K, including “Item 1: Business”;“Item 6: Selected Financial Data”; and “Item 8: Consolidated FinancialStatements and Supplementary Data.” The various sections of this MD&Acontain a number of forward-looking statements, all of which are based on ourcurrent expectations and could be affected by the uncertainties and riskfactors described throughout this filing (including “Business — Risk Factors”),particularly forward-looking statements in the “Overview,” and “Principal Linesof Business, Products, and Services” sections. Our actual results may differ materially.*

Our financial results are impacted by industry-wide trends.  Demand for large diameter high-strength OCTGdecreased somewhat in 2006, as drilling activity further slowed in the Gulf ofMexico, while drilling for natural gas in unconventional land formations whichrequire medium diameter alloy grade and carbon grade OCTG furtherexpanded.  Also, demand for line pipeincreased in the second half of 2006.  Asa result, our mix of revenues from oilfield products shifted in 2006 withcarbon grade OCTG sales making up 37% of OCTG revenues compared to 29% in 2005and line pipe revenues making up 19% of total oilfield tubular product revenuescompared to 12% in 2005.  This shift inproduct mix combined with continued high steel and natural gas costs reducedgross margins from 21% in 2005 to 17% in 2006.

The manufacture of our products is capital intensive. Utilization ratesat our pipe mills in Lone Star, Texas were approximately 90% in 2006 asshipment volumes increased 8% from 2005 principally related to increased linepipe shipments which were up 48% compared to 2005.  Shipment volumes of our high-quality alloygrade tubing and casing decreased 16% in 2006 compared to 2005 shipmentvolumes, while the average price increased 7% over the prior-year average.  Shipment volumes of our carbon grade tubingand casing increased 35% over 2005, while average pricing decreased 6% comparedto the 2005 average price.

Shipment volumes in our specialty tubing business segment were down 6%in 2006 compared to the prior year attributable to decreased demand for ourprecision mechanical tubulars from steel service centers and lower demand forautomotive applications.  Shipmentvolumes in our flat-rolled steel and other products were up 2% in 2006 from2005 due to increased demand from an alliance mill for conversion into OCTG.

Historically, our oilfield products have accounted for the majority ofour total revenues.  For fiscal year2006, they were 80% of total revenues.  As a result, our revenues are largely dependent upon the state of theoil and gas industry, which has historically been volatile.  Demand for oilfield products is influenced bynatural gas and crude oil price expectations. While the average 2006 natural gas price at the Henry Hub decreasedapproximately 22% from the 2005 average to $6.94 per MM BTU, the average priceof West Texas Intermediate crude oil increased 17% in 2006 compared to 2005 to$66.02 per barrel WTI as persistent high global energy demand, relatively lowsupply, and geopolitical instabilities maintained upward pressure on oilprices.  Overall, prices for natural gasand crude oil remained at levels in 2006 to support increased exploration andproduction activities.  According to theBaker Hughes rig count, the most commonly cited indicator of the level ofdomestic drilling activity, the average United States active rig count was1,649 rigs in 2006, the highest annual average in the last 20 years, comparedto 1,383 and 1,192 in 2005 and 2004, respectively.  However, expectations for future prices ofnatural gas diminished somewhat in the second half of 2006 leading to aflattening in drilling activity, albeit at 20-year high levels, and resulted inslight declines in purchases of OCTG by distributors during that time.  This pattern of cautionary purchasingremained evident at year-end 2006 and is expected to persist in early2007.  Rigs drilling offshore in theUnited States in 2006 fell to an average of 90 rigs compared to 93 and 97during 2005 and 2004, respectively, resulting in reduced demand for largediameter alloy grade OCTG in 2006. Demand for large diameter high-strength casing used in the Gulf ofMexico is expected to remain at lower levels in 2007.

As in 2005, the majority of the increased drilling in 2006 remainedbiased toward unconventional gas in tight sand and shale formations.  These wells typically require alloy gradeOCTG, which generally have higher margins than our carbon grade products.  Drilling also continued in shallowdevelopmental fields such as coal seam methane geologies.  Shallow wells use mainly carbon gradeOCTG.  Imports, which accounted forapproximately 52% of the total apparent OCTG consumption in 2006 compared to47% and 40% in 2005 and 2004, respectively, are typically more accepted forthese less critical shallow well applications.

Demand for our oilfield products, particularly casing and tubingproducts, depends on a number of factors; including the number of oil andnatural gas wells being drilled, completed and re-worked; and the depth;and drilling conditions of these wells. The level of these activities depends primarily on expectations as tofuture prices for natural gas and oil. Natural gas and oil prices are subject to significant fluctuations inresponse to even relatively minor changes in supply, market uncertainty, and avariety of additional factors that are beyond Lone Star’s control.  Therefore, no assurance can be given 

 

23

----

 

regarding the extent of future demand for Lone Star’s oilfieldproducts.  Baker Hughes reported theaverage domestic rig count increased in 2006 by 19% compared to the previousyear’s average.    While significantdomestic drilling continues in shallower developmental gas fields, there hasbeen a sustained increase in the number of rigs drilling deeper than 15,000feet, which require high-quality; alloy-grade products with premiumconnections.  According to SmithInternational,****rigs drilling wellsdeeper than 15,000 feet have increased from an average of approximately 230during the second half of 2005, to a level near 245 during the fourth quarterof 2006. Also, rigs drilling at 8,000 feet and deeper, which is the generaldepth where wells begin to require alloy grade OCTG, were approximately 76% ofthe total rigs working at the end of 2006 compared to 77% at the end of 2005.  We believe this trend will continue topositively impact demand for our higher margin alloy grade products.

Demand for our specialty tubing products decreased during 2006 in partdue to adjustments of inventories at steel service centers and a slight downturnin the manufacturing of automotive units. Revenues of specialty tubing products decreased almost 3% in 2006compared to 2005 on 6% lower shipment volumes partially offset by 4% higheraverage prices.  Revenues fromflat-rolled products and other products were up 4% compared to 2005 due to anincrease in shipment volumes of a little over 2% combined with 1% higheraverage selling prices.  Shipment volumesrose due to increased demand from an alliance mill for conversion into OCTG.

Approximately 82% of our inventory on-hand at both December 31, 2006 and2005, is accounted for under the Last-In, First-Out (“LIFO”) method.  The LIFO inventory reserve is determined atyear-end when inventory levels and pricing are finalized.  Cost of goods sold reflected a LIFO reserveincrease of $34.5 million and $24.1 million for the years ended December 31,2006 and 2005, respectively.  Steel costsrepresented over 60% of our total cost of goods sold in 2006 and 2005.

Our future operating results may fluctuate significantly depending upona number of factors, including industry conditions, the level of oil and gasdrilling activity, competition from domestic and foreign manufacturers, andcosts of our raw materials.  Sales of ourfinned tubular products are affected by the level of domestic and foreigndemand for power generation, the relative state of the general industrialeconomy, and domestic and foreign competition.

The level of production volume through our various facilities has asignificant effect on the cost of manufacturing.  As shipment volumes increase, a larger amountof fixed and semi-fixed costs is absorbed over greater units of production;thereby reducing the impact of these costs on cost of goods sold.  Key variable costs include costs of labor andraw materials, including scrap steel, steel slabs, steel coils, electricity,and natural gas.  Most of our finnedtubes and other heat recovery products are manufactured to customerspecifications.  Accordingly, ourmanufacturing costs for heat recovery products are to some extent factored intoproduct prices on an order-by-order basis.

We have entered into marketing alliances and manufacturing arrangementswith several companies that we do not own. These alliances and arrangementsinvolve the sale and marketing of their products which provide us access toadditional manufacturing capacity and products we do not make.  Our exclusive commercial alliances with thesemills allow us to outsource production of specific types of OCTG, line pipe,and specialty tubing and enable us to concentrate our capital expenditures andmanufacturing expertise on our high-quality products and new technologies.  Our Apolo Joint Venture allows us to enterthe Brazilian market and offer our domestic customers additional welded casing,tubing, and line pipe.  With our WelspunJoint Venture, we will begin producing large diameter spiral welded line pipeafter construction of the facilities, which are expected to be operational in2008.  Upon approval of our Valin JointVenture by the Chinese government, which has yet to be received, we will have aposition in the Chinese market and be able to offer our customers seamlesscasing, tubing, line pipe; and other tubular products.  We will continue to explore opportunities toexpand our global alliance partnerships and joint ventures to enable us tooffer our customers a wider variety of tubular products at competitive priceswhile enhancing our margins, and to focus our production on higher margin;high-quality products.

**PRINCIPAL LINES OF BUSINESS, PRODUCTS,AND SERVICES**

***Oilfield Products****. *Our oilfield products and services consist of (1) casing, whichacts as a structural retainer wall in oil and natural gas wellbores,(2) production tubing, which transmits hydrocarbons to the surface,(3) line pipe, which is used in gathering and transmitting hydrocarbons,(4) couplings, which are used to connect individual sections of oilfield casingand tubing, and (5) OCTG finishing services, including threading, thermaltreating, upsetting, nondestructive testing, inspection, and storage services.

Based on industry reports, we expect demand for our oilfield products tocontinue to remain strong throughout 2007 as both crude oil prices and naturalgas prices are expected to sustain the number of active drilling rigs.   The U.S. Energy Information Agency (“EIA”)has projected that the average WTI crude oil price should be approximately $64to $65 per barrel throughout 2007 and 2008. The EIA expects U.S. petroleum demand to grow at an approximate growthrate average of 1.2% and 1.7% in 2007 and 2008, respectively.  While the average 2006 natural gas price atthe Henry Hub decreased 

 

24

----

 

approximately 22% from the 2005 average to $6.94 per MM BTU, the EIAexpects the price range to stabilize at a healthy level of between $7 to $8 perMM BTU during 2007 and 2008 due to high crude oil prices and a relatively tightnatural gas supply coupled with increasing demand.  Furthermore, the EIA’s current estimate ofpotential pipeline capacity additions in 2007 increased 22% over their estimatelast year for 2007, and their estimate for 2008 predicts a 56% increase overtotal capacity additions in 2008.  Webelieve that these are positive indicators of increasing and sustainable demandfor our oilfield products in 2007.

***Specialty Tubing Products***.  Ourspecialty tubing product segment includes two principal product groups:  (1) precision mechanical tubulars and (2)finned tubular products.  Our precisionmechanical tubulars consist of a wide array of high-quality, custom-madesteel tubular products with precise dimensional control and specialmetallurgical properties which are manufactured by the DOM process. Thisprocess allows us to achieve higher critical tolerances and dimensional controlthan other processes. Demand for these products tends to track the generaldomestic economy as they are used for several industrial applications,including the manufacture of hydraulic cylinders for construction and farmequipment; automotive applications, such as stabilizers and intrusion tubes;and other uses, including machine parts, bearing races, down-hole pumpbarrels, heavy-lift crane boom chords, drill rods, and liner hangers.

As the general domestic economy slowed somewhat throughout the year,demand for our precision mechanical tubing decreased during 2006 in part due toadjustments of inventories at steel service centers and a slight downturn inthe   manufacturing of automotiveunits.  The composite Purchasing Managers’Index declined steadily throughout 2006 and was 55.3%, 54.0%, 52.7% and 51.4%;in March, June, September; and December of 2006.  While an index above 50% generally indicatesthat the manufacturing economy is expanding, which should benefit steel servicecenter inventories, we believe that demand for our precision mechanical tubingin the first half of 2007 will remain at approximate second half 2006 levels asautomotive related demand is expected to remain soft.

Our finned tubular products are used in heat recovery applications, suchas fuel economizers, petrochemical plants, refineries, and combined-cycleelectrical power generation plants.  Demand for fuel economizers and related engineered products with finnedtubes increased slightly in 2006 as energy prices have remained at high levelsmaking these investments more attractive for our customers and revenuesincreased 13% from 2005.  We arecontinuing to reorganize our finned tubular business around new marketing andcommercial business lines directed at more traditional heat recovery markets;including fuel economizers and traditional boiler applications.  However, with few exceptions, demand for ourfinned products for installation in new power plant construction projects isnot likely to improve until existing electrical power generation capacity ismore fully utilized.

***Flat-Rolled Steel and Other Products***.  Wemanufacture and market flat-rolled steel, which is primarily used in themanufacture of our oil country tubular products and precision mechanicaltubular products. We also sell flat-rolled steel to our alliance mills for themanufacture of tubular products and to fabricators of large diametertransmission pipe, storage tanks, rail cars and a variety of other constructionand industrial products. Our other products are principally used for structuraland piling applications in the construction industry.  We sell flat-rolled steel directly toend-users and through service centers primarily in the Southwestern region ofthe United States.

We sell flat-rolled steel in highly competitive markets, with price,quality, and availability primarily determining customer purchasedecisions.  Flat-rolled steel processingservices are also sold to steel mills where we receive processing revenues butdo not take title to the steel.

# **CRITICAL ACCOUNTING POLICIES ANDESTIMATES**

Management’s Discussion and Analysis, Results of Operations, andFinancial Condition are based on the related consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of the financial statements requires the use ofestimates and judgments that affect the reported amounts of assets,liabilities, revenues, and expenses. Lone Star evaluates its estimates primarily based on historicalexperience and business knowledge.  Theseestimates are evaluated by management and revised as circumstances change.   A discussion of the critical accountingpolicies and significant estimates made by Lone Star follows:

***Warranty Claims***

Our products are used in applications that are subject to inherent risksincluding well failures, performance deficiencies, line pipe leaks, personalinjury, property damage, environmental contamination, or loss of oil and gasproduction.  We warrant our products tomeet certain specifications.  Actual orclaimed deficiencies in meeting these specifications may give rise toclaims.  We maintain a reserve forasserted and unasserted warranty claims. The warranty claim exposure is evaluated using historical claim trendsand information available on specifically asserted claims. We also maintainproduct and excess 

 

25

----

 

liability insurance subject to certain deductibles that limits ourexposure to these claims.  We considerthe extent of insurance coverage in our estimate of the reserve.  Historically, this reserve has not beensubject to significant fluctuations from period to period.  However, the incurrence of an unusual amountof claims could require an increase to the related reserve.

***Bad Debts***

Our customers are concentrated in markets and industries that aresubject to volatility.  In addition, wesell a substantial amount of products to a few customers, one of whichcomprised 13% of total net revenues in 2006. We maintain a reserve for known and estimated unknown bad debts.  We evaluate credit risk and the adequacy ofour reserve by monitoring the age of our accounts receivable and thecreditworthiness of our customers.  Inaddition, we monitor the overall status of the industries where our productsand services are utilized.  Historically,this reserve has not been subject to significant fluctuations from period toperiod.  However, the incurrence of anunusual amount of bad debt could require an increase to the related reserve.

***Environmental Obligations***

Our business is subject to numerous environmental regulations.  We are actively remediating known exposuresand conducting post closure monitoring activities.  Our environmental department monitors thestatus of our environmental exposures and compliance with regulations throughvarious means.  We maintain anenvironmental reserve to cover the costs of expected remediation and postclosure monitoring.  We estimate thefuture cost for the remediation and post closure based on historicalexperience, results of monitoring and the known extent of exposure.  We evaluate the range of exposure and recordthe reserve. Historically, this reserve has not been subject to significantfluctuations from period to period; although, given the nature of environmentalexposure, significant changes in the reserve are possible.

***Impairment of Goodwill and Long-Lived Assets***

Long-lived assets, which include property, goodwill, intangible assets,and certain other assets comprise a significant amount of our totalassets.  We make judgments and estimatesin conjunction with the carrying value of these assets, including amounts to becapitalized, depreciation and amortization methods, and useful lives.Additionally, the carrying value of goodwill is reviewed annually forimpairment or whenever events or changes in circumstances indicate that thecarrying amount may not be recoverable.  The carrying values of all other long-lived assets are reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amounts may not be recoverable. An impairment loss is recorded in the period in which it is determinedthat the carrying amount is not recoverable. This requires us to make long-termforecasts of our future revenues and costs related to the assets subject toreview. These forecasts require assumptions about demand for our products andservices, future market conditions, and technological developments. Significantchanges to these assumptions or unanticipated events could require a provisionfor impairment.

***Pension and Postretirement Benefit Obligations***

Accounting for pensions and other postretirement benefit plans requiresmanagement to make several estimates and assumptions (see Note J in the Notesto Consolidated Financial Statements).   These include the expected rateof return from investment of the plans’ assets, projected increases in medicalcosts, and the expected retirement age of employees, as well as their projectedmortality.   In addition, the amounts recorded are affected by changes inthe interest rate environment because the associated liabilities are discountedto their present value.   Management makes these estimates based on LoneStar’s historical experience and other information that it deems pertinentunder the circumstances (for example, expectations of future stock market performance).  Management engages an independent consulting actuarial firm to aid it inselecting appropriate assumptions and valuing its pension-related liabilities.

Lone Star’s net pension benefit expense, which is included in “Cost ofgoods sold” on our Consolidated Results of Operations, was $4.8 million for theyear ended December 31, 2006.  In recording this amount, Lone Star assumeda long-term investment rate of return of 8%.   Changes to this rate ofreturn assumption would result in a change to the pension benefit expense and,as a result, an equal change in cost of goods sold.   Changes that arereasonably likely to occur in assumptions concerning retirement age, projectedearnings, and mortality would not be expected to have a material effect on LoneStar’s net pension benefit expense or net pension liability in the future.  The net pension liability is recorded at its net present value using adiscount rate of 5.75% that is based on the current interest rate environment.

At December 31, 2006, Lone Star adopted the recognition and disclosureprovisions of Statement of Financial Accounting Standards No. 158, *Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans* (“SFAS 158”) which requires, among otherthings, the recognition of the funded status of its defined benefit plans onthe balance sheet and that changes in that funded status be recognized in theyear in which the changes occur through comprehensive income.  The 

 

26

----

 

initial impact of the standard due to unrecognized prior service costsand net actuarial losses is recognized as a component of accumulatedcomprehensive loss in shareholders’ equity, net of tax.  This new standard also requires themeasurement of plan assets and benefit obligations to be as of the same date asLone Star’s fiscal year end, with such requirement effective for fiscal yearsending after December 15, 2008.  Theadoption of SFAS 158 had no effect on Lone Star’s consolidated results ofoperations for the year ended December 31, 2006, or for any prior periodpresented, and it will not affect Lone Star’s operating results in futureperiods.  Had Lone Star not been requiredto adopt SFAS 158 at December 31, 2006, it would have recognized an additionalminimum liability adjustment for its pension obligations pursuant to Statementof Financial Standards No. 87.

Lone Star’s net cost for other postretirement benefits, which is alsoincluded in cost of goods sold, was $2.8 million for the year ended December31, 2006.  In recording this expense andvaluing the net liability for other postretirement benefits, which is includedin “Other Benefits” as disclosed in Note J, management estimated futureincreases in healthcare costs.   This and other assumptions, along withthe effect of a one-percentage point change in them, are described in EmployeeBenefit Plans — Note J.

***Income Taxes***

Income taxes have been provided for using the liability method inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 109,*Accounting for Income Taxes* (“SFAS 109”).

In connection with its 1988 acquisition of American Federal Bank, F.S.B.(“AFB”), the Company entered into an agreement (the “Assistance Agreement”)with the Federal Savings and Loan Insurance Corporation (“FSLIC”), whichprovides, in part, that the federal and state tax savings attributable to theCompany’s utilization of AFB’s tax loss carryovers and certain other taxbenefit items attributable to the period of the Company’s ownership of AFB areto be paid by the Company to the FSLIC.  The successor in interest to theFSLIC is the FSLIC Resolution Fund (the “Resolution Fund”), which isadministered by the Federal Deposit Insurance Corporation.  Under theAssistance Agreement, the benefit due to the Resolution Fund is generallycomputed by comparing a hypothetical calculation of what the Company’s taxliability would have been without any of the AFB-related tax benefit items toits actual tax liability for a particular year.  Income tax expenserepresents obligations that may be payable to the FDIC in lieu of payment tothe IRS, in addition to federal and state income taxes.

Significant management judgment is required in determining our provisionfor income taxes and in determining whether deferred tax assets will berealized in full or in part.  When it ismore likely than not that all or some portion of specific deferred tax assets,such as net operating losses or credit carryforwards will not be realized, avaluation allowance must be established for the amount of the deferred taxassets that cannot be realized. Management considers the scheduled reversal of deferred tax items,projected future taxable income, and tax planning strategies in evaluating therealization of deferred tax assets.

Our tax filings for various periods are subject to tax examinations bythe IRS and other tax authorities in various jurisdictions.  These audits may result in assessments ofadditional taxes and management regularly assesses the likelihood of adverseoutcomes resulting from these examinations to determine the adequacy of ourprovision for income taxes.

No provision has been made for income taxes, which may become payableupon distribution of the foreign subsidiaries’ earnings since on a cumulativebasis losses have been generated.

***Stock-Based Compensation.***  LoneStar has a long-term incentive plan which provides for the issuance ofshares of common stock to key employees and outside directors through thegranting of incentive and nonqualified stock options, stock appreciationrights, restricted stock grants, and performance unit grants.

SFAS 123 (revised 2004), *Share-Based Payment*(“SFAS123R”) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair values. UnderSFAS 123R, Lone Star is required to measure the cost of employee servicesreceived in exchange for stock options and similar awards based on thegrant-date fair value of the award and recognize this cost in the incomestatement over the period during which an employee is required to provideservice in exchange for the award.  Thepro forma disclosures previously permitted under SFAS 123 are no longer analternative to financial statement recognition. Lone Star adopted SFAS 123R on January 1, 2006 using themodified prospective method.  Under thismethod, Lone Star recognizes compensation cost, on a prospective basis, for theportion of outstanding awards for which the requisite service had not yet beenrendered as of January 1, 2006 and any new grants, based upon the grant-datefair value of those awards calculated under SFAS 123R.

 

27

----

 

**RESULTS OF OPERATIONS**

***Net Revenues***

Our revenues are derived from three business segments: oilfieldproducts, specialty tubing products, and flat rolled steel and otherproducts.  Inflation did not have asignificant impact on our revenues or net income in 2006, 2005, or 2004.  In the last three years, net revenues andshipments by segment were as follows:

 
| ** **                            | ** ** | ***($ in millions)*** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|
| ** **                            | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | **$**                           | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| Oilfield  products                    |       | 1,103.6                         |       | 80 |   | 1,009.8 |   | 79 |   | 695.4 |   | 72 |   |
| Specialty tubing  products            |       | 176.5                           |       | 13 |   | 181.5 |   | 14 |   | 175.1 |   | 18 |   |
| Flat rolled  steel and other products |       | 97.5                            |       | 7 |   | 93.8 |   | 7 |   | 96.3 |   | 10 |   |
| Total net  revenues                   |       | 1,377.6                         |       | 100 |   | 1,285.1 |   | 100 |   | 966.8 |   | 100 |   |

 
| ** **                            | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **                            | ** ** | **Tons** | ** ** | **%**    | ** ** | **Tons** | ** ** | **%** | ** ** | **Tons** | ** ** | **%** | ** ** |
| Oilfield  products                    |       | 737,600  |       | 74       |       | 665,100  |       | 72 |   | 592,900 |   | 67 |   |
| Specialty tubing  products            |       | 93,400   |       | 9        |       | 99,800   |       | 11 |   | 118,400 |   | 14 |   |
| Flat rolled  steel and other products |       | 164,800  |       | 17       |       | 160,900  |       | 17 |   | 171,100 |   | 19 |   |
| Total shipments                       |       | 995,800  |       | 100      |       | 925,800  |       | 100 |   | 882,400 |   | 100 |   |

 

*2006Compared to 2005 —* Revenues from our oilfield productsincreased by 9% over fiscal year 2005 to $1,103.6 million due to increasedshipment volumes partially offset by slightly lower average pricing.  The table below illustrates the impact ofvolume changes and average price changes on net revenues from oilfield productsfor the year ended December 31, 2006 ($ in millions).

|                               | ** ** | **Oilfield** | ** ** |
|-------------------------------|------------|--------------|------------|
| Year ended  December 31, 2005 |       | $            | 1,009.8    |   |
| Change due to shipment volume |       | 108.5        |       |
| Change due to price           |       | (14.7        | )          |
| Year ended December 31,  2006 |       | $            | 1,103.6    |   |

 

The oilfield products segment comprised 80% of total revenues for theyear ended December 31, 2006, compared to 79% of total revenues for the yearended December 31, 2005.  Shipmentvolumes in 2006 increased almost 11% over 2005, while the average price per tonof our oilfield products decreased a little more than 1% over the prior year.  Average pricing for OCTG in 2006 decreased by2% compared to 2005, while the average price per ton of line pipe increased byapproximately 6% over 2005.

OCTG revenues generally account for approximately 75-85% of our totaloilfield revenues. Our average price per ton of OCTG declined principally dueto a shift in sales mix to a higher percentage of lower-priced carbon gradeOCTG in 2006 compared to 2005.  Sales ofour carbon grade OCTG, comprised nearly 37% of our total OCTG revenues, up from29% in 2005.  Carbon grade OCTG shipmenttons increased approximately 35%, while the average price of these products wasdown 6%, in part due to higher imports. Shipments of alloy grade OCTG decreased 16%, while average prices forthese products increased 7%.  Demand forlarge diameter alloy grade OCTG decreased in the second half of 2006 asdrilling activity further slowed in the Gulf of Mexico.  The average offshore rig count fellfrom a high of 103 in May 2006 to 84 rigs at year end. However, drilling for natural gas in unconventional land formationswhich require medium diameter carbon grade and alloy grade OCTG furtherexpanded, with the 2006 average active land rig count up 19% from 2005.

Line pipe revenues, which were 19% of our total oilfield productrevenues in 2006 compared to 12% in 2005, increased over the prior year on 48%higher volumes and an increase of 6% in average pricing as demand for line pipeincreased for gathering systems and large transmission pipeline projects in thesecond half of 2006.

 

28

----

 

Revenues ofspecialty tubing products decreased almost 3% in 2006 compared to 2005 onslightly more than 6% lower shipment volumes partially offset by 4% higheraverage prices.  The table belowsummarizes the impact of volume and average price changes on specialty tubingproducts revenues for the year ended December 31, 2006 ($ in millions).

|                               | ** ** | **Specialty  Tubing** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| Year ended  December 31, 2005 |       | $                     | 181.5      |   |
| Change due to shipment volume |       | (12.1                 | )          |
| Change due to price           |       | 7.1                   |       |
| Year ended December 31,  2006 |       | $                     | 176.5      |   |

 

Sales of our precision mechanical tubulars accounted for 69% of ourtotal specialty tubing segment revenues in 2006 compared to 73% in 2005.  Revenues from precision mechanical tubing in2006 declined 9% compared to 2005 on 8% lower shipment volumes and relativelyunchanged average selling prices.  As thegeneral domestic economy slowed somewhat throughout 2006, demand for ourprecision mechanical tubing decreased in part due to adjustments of inventoriesat steel service centers and a slight downturn in the manufacturing ofautomotive units.  While a compositePurchasing Managers’ Index reading above 50% generally indicates that themanufacturing economy is expanding, the index declined steadily throughout 2006and was 55.3%, 54.0%, 52.7%, and 51.4% at the end of March, June, September,and December of 2006, respectively.

The decline in revenues from precision mechanical tubing was partiallyoffset by higher revenues from heat recovery tubular products, which comprisedthe remaining 31% of our specialty tubing revenues.  Revenues from these products increased 13% on1% higher shipment volumes.  Demand forfuel economizers and related engineered products with finned tubes increased in2006 and energy prices remained at high levels making these attractiveinvestments for our customers.  Averageselling prices for heat recovery tubular related products increased 12%compared to 2005 due to an increased percentage of sales from higher-pricedengineered heat recovery products relative to other products in this group.

Revenues fromflat-rolled products and other products were up 4% compared to 2005 due to anincrease in shipment volumes of a little over 2% combined with 1% higheraverage selling prices.  Shipment volumesrose due to increased demand from an alliance mill for conversion intoOCTG.  The table below illustrates theimpact of volume and average price changes on flat-rolled and other productsrevenues for the year ended December 31, 2006 ($ in millions).

|                               | ** ** | **Flat-Rolled   and Other   Products** | ** ** |
|-------------------------------|------------|-------------------------------------------------------|------------|
| Year ended  December 31, 2005 |       | $                                                     | 93.8       |   |
| Change due to shipment volume |       | 2.3                                                   |       |
| Change due to price           |       | 1.4                                                   |       |
| Year ended December 31,  2006 |       | $                                                     | 97.5       |   |

 

*2005Compared to 2004* — Revenues from our oilfield productsincreased by 45% over fiscal year 2004 to $1,009.8 million on significantincreases in both shipment volume and average pricing.  The table below illustrates the impact ofvolume changes and average price changes on net revenues from oilfield productsfor the year ended December 31, 2005 ($ in millions).

|                               | ** ** | **Oilfield** | ** ** |
|-------------------------------|------------|--------------|------------|
| Year ended  December 31, 2004 |       | $            | 695.4      |   |
| Change due to shipment volume |       | 109.6        |       |
| Change due to price           |       | 204.8        |       |
| Year ended December 31,  2005 |       | $            | 1,009.8    |   |

 

The oilfield products segment comprised 79% of total revenues for theyear ended December 31, 2005, compared to 72% of total revenues for the yearended December 31, 2004.  Average pricingof our oilfield products increased 29% in 2005 over 

 

29

----

 

the prior year.  Average pricingfor OCTG and line pipe increased by 33% and 17%, respectively, in 2005 comparedto 2004.   OCTG revenues generallyaccount for approximately 75-85% of our total oilfield revenues. Sales of ourhigh-strength alloy grade OCTG, which comprised nearly 71% of our total OCTGrevenues, were up more than 73% as average prices increased 37%.  Sales of carbon grade OCTG products increasednearly 27%, on a 21% increase in average pricing.  Line pipe revenues, which were 12% of ourtotal oilfield product revenues in 2005, were up 15% over the prior year on a17% increase in average pricing. Our increases in average oilfield productpricing are due principally to our success in implementing price increasesassociated with increasing demand, particularly for alloy grade OCTG.  Shipment volumes of our high-strength alloygrade OCTG and carbon grade OCTG increased 26% and 5%, respectively, as highcrude oil and natural gas prices stimulated the number of working drilling rigsto their highest level in 19 years by the end of 2005.

Specialty tubingproduct revenues increased nearly 4% in 2005 compared to 2004 as averagepricing increased more than 23% and shipment volumes were down nearly 16%.  The table below summarizes the impact ofvolume and average price changes on specialty tubing products revenues for theyear ended December 31, 2005 ($ in millions).

|                               | ** ** | **Specialty  Tubing** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| Year ended  December 31, 2004 |       | $                     | 175.1      |   |
| Change due to shipment volume |       | (33.8                 | )          |
| Change due to price           |       | 40.2                  |       |
| Year ended December 31,  2005 |       | $                     | 181.5      |   |

 

We raised prices of our specialty tubing products and instituted rawmaterial surcharges as a result of the increases in our principal raw materialcost, namely steel.  Average prices alsoincreased as we allocated tubular capacity from lower priced specialty tubingproducts to higher-margin oilfield products, thereby removing some lower pricedspecialty tubing products from the product mix in this business segment.  Sales of our precision mechanical tubulars,which accounted for 73% of our total specialty tubing segment revenues in 2005,remained consistent with 2004 sales levels. Average pricing of our precision mechanical tubulars increased 20% andshipment volumes decreased by 16% over the prior year as some tubular capacitywas allocated to oilfield products.  Heat recovery tubular goods revenues increased 14% compared to the prioryear as average pricing increased 31% due to an increased percentage of salesof higher-priced engineered heat recovery products, and to a lesser extentproduct price increases related to increases in raw material costs, namely steel.  Total tons shipped decreased by 13% as excesscapacity in the North American electricity generating market and foreigncompetition continued to negatively impact sales of our heat recovery tubulars.

Sales offlat-rolled and other products decreased by nearly 3% compared to 2004 asincreased supplies of domestic steel reduced demand for our flat-rolledsteel.  Total shipment volume in tonsdecreased by 6% as some capacity was shifted to oilfield products, while averagepricing was up about 4%.  The table belowillustrates the impact of volume and average price changes on flat-rolled andother products revenues for the year ended December 31, 2005 ($ in millions).

|                               | ** ** | **Flat-Rolled  and Other  Products** | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|
| Year ended  December 31, 2004 |       | $                                         | 96.3       |   |
| Change due to shipment volume |       | (5.9                                      | )          |
| Change due to price           |       | 3.4                                       |       |
| Year ended December 31,  2005 |       | $                                         | 93.8       |   |

 

***Gross Margin***

At December 31, 2006, 2005, and 2004, we valued 82% of our inventoriesat the lower of cost or market determined on the LIFO inventory valuationmethod.  In periods of increasing costs,the LIFO method generally results in higher cost of goods sold than under thefirst-in, first-out (“FIFO”) method. Likewise, in periods of decreasing costs, the results are generally theopposite.  Steel costs increased in 2006,2005, and 2004, which negatively impacted gross profit under the LIFO method ascompared to what gross profit would have been had we used the FIFO method.

 

30

----

 

The followingtable illustrates the comparative effect of LIFO and FIFO accounting on ourconsolidated results of operations.  Thistable is provided solely for the purpose of providing comparisons to othercompanies that may use the FIFO method of inventory valuation.  In the following table, the supplemental FIFOearnings reflect the after-tax effect of eliminating the LIFO reserveadjustment as disclosed in the footnotes to the Consolidated FinancialStatements for the years ended December 31, 2006, 2005, and 2004 ($ inmillions):
| ** **         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **         | ** ** | **LIFO** | ** ** | **FIFO** | ** ** | **LIFO** | ** ** | **FIFO** | ** ** | **LIFO** | ** ** | **FIFO** | ** ** |
| Cost of goods sold |       | $        | 1,142.6    |     | $          | 1,108.1  |       | $ | 1,012.8 |   | $ | 988.7 |   | $ | 804.8 |   | $ | 741.4 |   |
| Net income (loss)  |       | 108.2    |       | 130.5    |       | 223.6    |       | 238.5 |   | 101.0 |   | 162.3 |   |
|                    |            |          |            |          |            |          |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The following table shows cost of sales (as reported using the LIFOmethod) and the related gross margin percentages for the last three years ($ inmillions):
| ** **          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **          | ** ** | **$**    | ** ** | **GM%**  | ** ** | **$**    | ** ** | **GM%** | ** ** | **$** | ** ** | **GM%** | ** ** |
| Cost of goods  sold |       | 1,142.6  |       | 17.1     | %          | 1,012.8  |       | 21.2 | % | 804.8 |   | 16.8 | % |

 

*2006 Compared to 2005 —* Our gross margins are impacted byindustry-wide trends in product demand. Demand for higher margin large diameter alloy grade OCTG decreased inthe second half of 2006 as drilling activity further slowed in the Gulf ofMexico causing 2006 shipments of alloy grade OCTG to decrease 16% compared to2005.  However, drilling for natural gasin unconventional land formations, which require medium diameter carbon gradeand alloy grade OCTG further expanded with the 2006 average active land rigcount up 19% from 2005.  This resulted inincreased shipment volumes of lower margin carbon grade OCTG in 2006, up 35%from 2005.  Furthermore, shipment volumesof lower margin line pipe products increased over the prior year on 48% highervolumes as demand for line pipe increased for gathering systems and largetransmission pipeline projects in the second half of 2006.

As a result, our mix of revenues from oilfield products shifted withcarbon grade OCTG sales making up 37% of OCTG revenues compared to 29% in 2005and line pipe revenues making up 19% of total oilfield tubular product revenuescompared to 12% in 2005.  This shift inproduct mix combined with continued high steel costs, which make up 60% of ourcost of goods sold, reduced gross margins from 21.2% in 2005 to 17.1% in 2006.

*2005 Compared to 2004 —* Margins improved in 2005 compared to 2004 asboth increased demand and higher average product pricing more than offsetincreases in raw materials, including steel and natural gas.  Consistent with the increase in crude oilprices, natural gas prices, and active rig counts, increasing demand for ouroilfield products has resulted in 12% increases in shipment volume for the yearended December 31, 2005, when compared to the same periods in the prior year.  Together with 29% higher average sellingprices, these factors have more than offset increases in raw materials costs,including steel and natural gas, thus lowering their proportional impact ontotal cost of goods sold and improving gross margin percentages.  We continue to closely monitor our rawmaterial costs, including their impact on our margins, and to examine the needto further raise product prices as raw material costs increase and asappropriate with market demand.

***Selling, General, and AdministrativeExpenses***

The following table presents consolidated selling, general, andadministrative (“SG&A”) expenses and the related percentage of totalconsolidated revenues for the last three years ($ in millions):
| ** **                            | ** ** | **2006** | ** ** | **2005**               | ** ** | **2004** | ** ** |
|---------------------------------------|------------|----------|------------|------------------------|------------|----------|------------|
| ** **                            | ** ** | **$**    | ** ** | **% of  Revenue** | ** ** | **$**    | ** ** | **% of  Revenue** | ** ** | **$** | ** ** | **% of  Revenue** | ** ** |
| Selling,  general, and administrative |       | 62.2     |       | 4.5                    | %          | 50.5     |       | 3.9 | % | 44.6 |   | 4.6 | % |

 

*2006 Compared to 2005* — SG&A costs increased approximately 23%from 2005 and were up from approximately 4% of revenues in 2005 to 4.5% in2006.  The increase in SG&A costs isprincipally due to higher wages, salaries, incentive compensation, andbenefits, up approximately $6.9 million, related to the expansion of ourbusiness activities; higher professional fees of $2.9 million for corporate purposes,principally relating to joint ventures (see Joint Ventures — Note M);additional travel expenses related to the foreign joint ventures of $1.0million; and increases in miscellaneous SG&A expenses totalingapproximately $0.9 million.

*2005 Compared to 2004* — In 2005, SG&A costs increasedapproximately 13% but fell from approximately 5% to 4% of revenues principallydue to the significant increase in our revenues.  The increase in SG&A costs is principallydue to increases in wages, salaries, incentive compensation, and relatedbenefits of approximately $2.9 million related to the 

 

31

----

 

increase in our business activities; increases in professional fees forseveral corporate purposes of approximately $2.2 million; and increases inother miscellaneous SG&A expenses totaling approximately $0.8 million.

***Interest Expense***

Interest expense decreased in 2006 by $8.7 million principally due tothe early redemption of Lone Star’s $150.0 million 9% senior subordinated noteson June 1, 2006 (see Debt — Note E). Interest expense decreased in 2005 by $0.7 million as interest expensein 2004 included the postjudgment interest on the Cargill verdict (seeCommitments and Contingencies — Note K).

***Interest Income***

Interest income increased by $4.6 million and $4.0 million in 2006 and2005, respectively, as a result of greater investments in debt securities.  Investments in debt securities averaged$178.7 million and $104.6 million in 2006 and 2005, respectively.

***Other Income, Net***

The decrease in other income, net of $7.7 million in 2006 compared to2005 is primarily driven by the $7.8 million gain recognized on the earlytermination of an alliance agreement in 2005, which did not recur in 2006.

***Income Taxes***

For the year ended December 31, 2006, Lone Star’s effective tax rate of35% consisted of a provision for federal and state taxes, benefits fromtax-exempt interest, and other miscellaneous items.  These factors resulted in net income taxexpense of $59.3 million for the year ended December 31, 2006 compared to anincome tax benefit of $3.4 million for the year ended December 31, 2005.

For the year ended December 31, 2005, Lone Star’s effective tax rate wasaffected by management’s belief that it was more likely than not thatsubstantially all of the net deferred tax asset would be realized.  The ultimate realization of deferred taxassets is dependent upon the generation of future taxable income during theperiods in which those temporary differences become deductible.  Management considered the scheduled reversalof deferred tax items, projected future taxable income, and tax planningstrategies in making this assessment.  Based on the substantial utilization of the net deferred tax assetduring 2004 and 2005 and sufficient projected future taxable income, managementdetermined that the remaining federal net operating losses (“NOLs”) and creditcarryforwards will be realized in the future. Accordingly, in 2005, NOLs totaling $196.2 million were utilized toreduce our current federal income tax expense. State income taxes, other miscellaneous items, and the eliminationvaluation allowance resulted in a net tax benefit of $3.4 million for the yearended December 31, 2005.

# **LIQUIDITY AND CAPITAL RESOURCES**

***Overview***

We have historically funded our business through our operating results.  We believe these sources of funds willprovide the liquidity necessary to fund our cash requirements during 2007.  The following table shows our capitalresources at December 31, 2006 and 2005 ($ in millions):

|                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| Cash and cash  equivalents            |       | $        | 46.0       |     | $          | 102.2 |   |
| Total  investments in debt securities |       | $        | 120.4      |     | $          | 153.5 |   |
| Working capital                       |       | $        | 508.0      |     | $          | 612.5 |   |
| Unused credit facility                |       | $        | 224.3      |     | $          | 124.7 |   |

 

At December 31, 2006, our cash and cash equivalents and investments indebt securities totaled $166.4 million, compared to $255.7 million at December31, 2005.  Our cash and cash equivalentsinclude commercial bank accounts and highly liquid money market instrumentsissued by corporations, banks, and the U.S. government or its agencies withoriginal maturities of less than three months. Our investments in debt securities consist of U.S. government andrelated agency debt obligations, debt securities of public companies, andmunicipal securities with maturities at purchase less than two years.  These investments in debt securitiesgenerally earn higher yields than the yields of our cash and cashequivalents.  Our total cash equivalentsand investments in debt securities, the combined weighted-average maturity ofwhich is less than one year, are classified as either held-to-maturity as wehave the positive intent and ability to hold them to maturity, oravailable-for-sale (See Investments —Note D).  The decrease in workingcapital of $104.5 million was primarily due to the decrease in cash andinvestments in debt securities of $89.3 million, which was related to theredemption of our senior notes, and increases in 

 

32

----

 

inventories of $139.9 million, for anticipated production and shipments,partially offset by increases in current liabilities of $105.9 million,decreases in deferred tax assets of $7.2 million, and decreases in accountsreceivable and other current assets of $5.4 million and $5.3 million,respectively.

***Discussion of Changes in Liquidityand Capital Resources***

Cash provided by operating activities was $133.8 million, $148.2million, and $29.5 million for 2006, 2005, and 2004, respectively.  Cash provided from operations in 2006decreased $14.4 million from 2005 attributable to net income of $108.2 million,offset by noncash income statement effects of approximately $34.7 millionrelated to depreciation and amortization and stock compensation charges.  The $6.8 million cash portion of a loss onthe early extinguishment of debt was recognized in 2006 (see Note E).  Cash flow was used in operations in largepart due to increases in inventory of $139.9 million, offset by an increase inaccounts payable and accrued liabilities of $105.9 million.  Changes in other balance sheet accounts of $18.0million provided the remaining cash flow from operations.

Interest paid in 2006 decreased by $2.0 million due to theextinguishment of debt, while interest paid in 2005 decreased by $0.7 milliondue to lower interest paid related to the litigation settlement in 2004.

Cash used in investing activities was $37.1 million, $112.9 million, and$39.2 million for 2006, 2005, and 2004, respectively.  During 2006, cash used in investing was forthe purchase of investments in debt securities totaling $368.6 million, $44.0million of investments in capital expenditures, and $26.2 million paid for aninvestment in joint ventures (see Note M) offset by proceeds from sale andmaturity of investments of $402.4 million. During 2005, cash used in investing was due to the purchase ofinvestments in debt securities totaling $324.1 million and $21.0 million ofinvestments in capital expenditures, offset by proceeds from sale of propertyof $2.5 million and proceeds from the sale of investments of $229.7 million.

Cash provided by (used in) financing activities was $(152.9) million,$36.6 million, and $6.4 million for 2006, 2005, and 2004, respectively.  During 2006, $156.8 million was used forearly extinguishment of senior subordinated notes, which included a premium (seeNote E).  Additionally, cash was used inthe purchase of $5.5 million of treasury stock, offset by proceeds of exercisestock options of $6.4 million, and tax benefits from share-based payments of$3.0 million.  During 2005 and 2004, cashwas provided from the exercising of stock options.

Lone Star has an aggregate of approximately $250.0 million of registeredsecurities, which include debt instruments, preferred stock, common stock,depository shares, and warrants, under previously filed universal shelfregistration statements.  Additionally,as a “well-known seasoned issuer,” Lone Star should be able, under new SECrules, to access the capital markets through an automatically effective shelfregistration statement.

In 2001, the Company issued $150.0 million of 9% senior subordinatednotes due June 1, 2011 (the “Senior Notes”).  On June 1, 2006, the Company exercised its option to redeem the SeniorNotes at 104.5% of their principal amount, plus accrued and unpaidinterest.  The Company paid cash of$163.5 million for the $150 million of principal on the Senior Notes, a premiumof $6.8 million for early redemption, and $6.7 million of accrued and unpaidinterest.  Related to this earlyextinguishment of the Senior Notes, the Company recognized a loss on earlyextinguishment of debt of $9.3 million comprised of the $6.8 million premiumand $2.5 million of unamortized debt issuance costs associated with the SeniorNotes.

Lone Star announced on August15, 2006 that it had entered into a definitive agreement to form a jointventure (“Joint Venture”) with Hunan Valin Steel Tube & Wire Co., Ltd. (“Valin”),one of China’s largest steelmakers. Under the agreement, Lone Star wouldacquire a 40% stake in one of Valin’s subsidiaries, Hengyang Valin MPM SteelTube Co. Ltd., for a consideration of $132 million in cash. Lone Star wouldalso provide significant technical and related operational support for theJoint Venture. Lone Star contemplates a series of future transactions relatedto the steel tube assets of Valin in Hengyang, Hunan Province with the expectationthat Lone Star would eventually contribute up to an aggregate of approximately$238 million for 47% of the Joint Venture. All transactions being contemplatedare subject to relevant regulatory approvals and consents and foreign currencyexchange rates.

On October 24, 2006, Lone Star announced that its Board of Directors hadauthorized the open-market purchase of Lone Star’s common stock from time totime for a total investment not to exceed $100 million, which expires at theend of 2007.  Shares purchased by LoneStar will be added to treasury shares and may be used in Lone Star’s long termincentive plan and for other corporate purposes.  As of December 31, 2006, Lone Star hadpurchased 111,900 shares of its common stock at a total cost of approximately$5.5 million.

On November 30, 2006, Lone Star announced that it completed the jointventure transaction with Grupo Peixoto de Castro to produce finished weldedoilfield tubular products.  Under theagreement, Lone Star acquired a 50% ownership stake in 

 

33

----

 

Apolo Mecanica e Estruturas LTDA, for approximately $42 million, ofwhich $24 million was paid at closing with the balance to be paid over the next18 months (see Joint Ventures — Note M).

On December 20, 2006, Lone Star announced that it had entered into adefinitive agreement to form a joint venture with the Welspun Group (“Welspun”),to design, engineer, and construct a manufacturing facility capable ofproducing large diameter spiral welded tubulars.  Lone Star will have 40 % ownership in the newlyformed company, Welspun-Lone Star Tubulars LLC (“Welspun-Lone Star Tubulars”).  The total investment in the joint venture isanticipated to be approximately $66 million, including third-partyfinancing.  As of December 31, 2006, LoneStar had contributed $1.6 million with additional contributions in the firstquarter of 2007 in the range of $0 to $14 million. (see Joint Ventures — NoteM).

In December 2006, Lone Star amended and restated its $125 million creditfacility to increase the total available borrowings to $225 million and extendthe expiration date to December 2010. Borrowings under the credit facility can be used for general corporatepurposes.  Borrowings under the creditfacility are collateralized by substantially all of Lone Star’s assets, otherthan real estate.  At Lone Star’s option,the interest rate is the prime lending rate or the LIBOR, plus the applicableadditional interest.  Under theagreement, Lone Star can borrow an amount based on a borrowing base of 85% ofour eligible accounts receivable, plus the lesser of 70% of eligible inventoryor $155.0 million, reduced by outstanding letters of credit, which totaled $0.7million at December 31, 2006.  The creditfacility remains undrawn and the total availability was $224.3 million at December31, 2006.  For 2006, we were incompliance with the facility’s covenants and we do not anticipate noncompliancein the foreseeable future.

We operate in capital intensive businesses. We have made, and we expectwe will be required to make, significant capital expenditures each year forrecurring maintenance necessary to keep manufacturing facilities operational,to comply with environmental and other legal requirements and to improve ourinformation systems. Additionally, we regularly make capital expenditures fortechnological improvements and for research and development projects. Iffunding is insufficient at any time in the future, we may be unable to developor enhance our products or services, take advantage of business opportunities,or respond to competitive pressures.  In2006, we invested $44.0 million to increase productivity, enhance productquality, and upgrade manufacturing capabilities.  We plan further investment of approximately$50 million in our facilities in 2007. Depending on business conditions and operating volumes, capitalexpenditures may be increased or decreased from the estimate throughout theyear.

Steel engages in slab consignment and sales agreements with thirdparties.  Under these agreements, Steelarranges for third parties to purchase slabs from vendors that manufacture theslabs and the third party consigns the slab inventory to Steel.  Steel is then required to repurchase the slabinventory based on usage within specified time periods.  These inventory financing transactions havebeen accounted for as product financing arrangements.  Inventory financed under these arrangementsis recorded as inventory by Steel.  AtDecember 31, 2006, there was $25.7 million included in accounts payable underthese financing arrangements.  There wereno amounts recorded in accounts payable for financed inventory at December 31,2005.

Our operations are subject to environmental compliance and permittingrequirements of various foreign, federal, and state governmental agencies. Webelieve that the cost of maintaining compliance with environmental requirementswill fall within our contemplated operating and capital expenditure plans,averaging $1.0 million to $2.0 million annually in the foreseeable future.

**OFF-BALANCE SHEET ARRANGEMENTS ANDAGGREGATE CONTRACTUAL OBLIGATIONS**

At December 31, 2006, we had contractual cash obligations to repay debt,to make payments under leases, purchase obligations, and commercial commitmentsin the form of unused lines of credit. Payments due under these long-term obligations are as follows ($ inmillions):
| ** **                       | ** ** | **Obligations Due By Period(1)** | ** ** |
|----------------------------------|------------|-------------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                       | ** ** | **2007** | ** ** | **2008  to  2009** | ** ** | **2010  to  2011** | ** ** | **Thereafter** | ** ** |
| Operating lease obligations      |       | 11.4                                            |       | 4.1 |   | 3.3 |   | 3.5 |   | 0.5 |   |
| Purchase obligations             |       | 28.6                                            |       | 19.2 |   | 9.4 |   | — |   | — |   |
| Joint venture obligations (2)    |       | 18.8                                            |       | 12.5 |   | 6.3 |   | — |   | — |   |
| Other long-term obligations (3)  |       | 9.2                                             |       | 9.2 |   | — |   | — |   | — |   |
| Total  Contractual Obligations   |       | $                                               | 68.0       |   | $ | 45.0 |   | $ | 19.0 |   | $ | 3.5 |   | $ | 0.5 |   |
|                                  |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

34

----

 

----

(1)          The table does not include an estimate forincome tax payments which we are required to make but not required to includeabove.

(2)          Obligation for Apolo Joint Venture.

(3)          Other long-term obligationsrepresent cash contributions to our pension plan.

Commercial commitment expirations are as follows ($ in millions):
| ** **              | ** ** | **Commitment Expiration by Period** | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | **Total**                                          | ** ** | **2007** | ** ** | **2008  to  2009** | ** ** | **2010  to  2011** | ** ** | **Thereafter** | ** ** |
| Unused credit  facility |       | $                                                  | 225.0      |   | $ | — |   | $ | — |   | $ | 225.0 |   | $ | — |   |
|                         |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

##### **RECENT ACCOUNTINGPRONOUNCEMENTS**

In June, 2006, the FASB issued Interpretation No. 48 — *Accounting for Uncertainty in Income Taxes* (“FIN 48”).  FIN 48 clarifies the accounting foruncertainty in income taxes by prescribing the minimum recognition threshold atax position is required to meet before being recognized in the financialstatements.  FIN 48 utilizes a two-stepapproach for evaluating tax positions. Recognition (Step 1) occurs when an enterprise concludes that a taxposition, based solely on its technical merits is more likely than not to besustained upon examination.  Measurement(Step 2) is only addressed if Step 1 has been satisfied.  Under Step 2, the tax benefit is measured atthe largest amount of benefit, determined on a cumulative probability basis,that is more likely than not to be realized upon final settlement.  FIN 48’s use of the term “more likely thannot” in Steps 1 and 2 is consistent with how the term is used in SFAS 109 (i.e.the likelihood of an occurrence greater than 50%).  FIN 48 applies to all tax positions relatedto income taxes subject to SFAS 109.  TheCompany will adopt FIN 48 as of January 1, 2007 as required.  The Company expects the cumulative adjustmentto beginning retained earnings related to the implementation of FIN 48 to beimmaterial.

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements* (“SFAS 157”). This standardclarifies the principle that fair value should be based on the assumptions thatmarket participants would use when pricing an asset or liability. Additionally,it establishes a fair value hierarchy that prioritizes the information used todevelop those assumptions.  SFAS 157 iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007.  The Company iscurrently evaluating the impact that the implementation of SFAS 157 will haveon its financial position, results of operations, and cash flows.

In September 2006, the FASB issued SFAS No. 158, *Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans***** ****(“SFAS 158”**** ****).This standard requires employers to recognize the underfunded or overfundedstatus of a defined benefit postretirement plan as an asset or liability in itsstatement of financial position and to recognize changes in the funded statusin the year in which the changes occur through accumulated other comprehensiveincome. Additionally, SFAS 158 requires employers to measure the funded statusof a plan as of the date of its year-end statement of financial position.  The new reporting requirements and relatednew footnote disclosure rules of SFAS 158 are effective for fiscal years endingafter December 15, 2006.  The new measurement date requirement applies forfiscal years ending after December 15, 2008. The impact that the implementation of SFAS 158 had on our results ofoperations or financial condition is detailed in Employee Benefit Plans — NoteJ.

**FORWARD-LOOKING INFORMATION**

The statements included in this Annual Report regarding future financialperformance and results and the other statements that are not historical factsare forward-looking statements.  Thewords “believes,” “intends,” “expects,” “anticipates,” “projects,” “estimates,”“predicts,” and similar expressions are also intended to identifyforward-looking statements.  Suchstatements are “forward-looking statements” within the meaning of the safeharbor provisions of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. These forward-looking statements are based on our analysis of currentlyavailable competitive, financial and economic data and our operating plans.  They are inherently uncertain, and events andactual results could turn out to be significantly different from ourexpectations.

The following are some of the factors that should be considered whenevaluating these forward-looking statements:

·                  fluctuations in domestic and worldwide pricesand demand for natural gas and oil;

·                  fluctuations in levels of natural gas andcrude oil exploration and development activities;

·                  fluctuations in the demand for our productsand services;

·                  the competition for raw materials used in ourbusiness and the volatility of our raw material costs;

 

35

----

 

·                  the effect of foreign competition on ourindustry, particularly oilfield products, which could be increased by an easingof U.S. government import trade restrictions;

·                  fluctuations in inventory levels of oilfieldproducts;

·                  the existence of inherent risk in oil and gasdrilling and transmission activities;

·                  fluctuations in levels of manufacturing andother general economic activity, particularly in the automotive and other industriesthat purchase our specialty tubulars; and

·                  general economic conditions.

A sustained increase or decrease in the price of natural gas or oil,which could have a material impact on exploration and production activities,could also materially affect our financial position, results of operations, andcash flows.  These and other importantfactors could cause actual results to differ materially from theforward-looking statements described in this Annual Report. Lone StarTechnologies, Inc. does not undertake any obligation to update or revise ourforward-looking statements, whether as a result of new information, futureevents or otherwise.  Should one or moreof these risks or uncertainties materialize, or should underlying assumptionsprove incorrect, actual outcomes may vary materially from those indicated.

**ITEM 7A.          QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

We are exposed to certain risks associated with the change in foreigncurrency rates, interest rates, and commodity prices.  We seek to minimize the potential adverseimpact of those market risks through the use of appropriate managementtechniques including the limited use of derivative financial instruments.  Our potential Valin Joint Venture investment,which is subject to Chinese government approval, is subject to risk of exchangerate fluctuations (see Joint Ventures — Note M).  Our operations in Mexico and Thailand and ourApolo Joint Venture are accounted for in the local currency, converted to theU.S. dollar equivalent based on published exchange rates for the periodreported and are therefore subject to risk of exchange rate fluctuations.

Our investments in cash equivalents, the maturity of which are threemonths or less, and our investments in debt securities, the weighted-averagematurity of which are less than one year, are subject to interest raterisk.  The value of these securitieswould decline in the event of increases in market interest rates.  We manage this risk by investing insecurities that have relatively short-term maturities and with varying maturitydates.  In addition, we intend to holdsome of these securities until maturity and, as a result, avoid the lossesresulting from sudden changes in interest rates.

To the extent that we borrow against our credit facility, we are exposedto interest rate risk arising from the variable-rate nature of the facility.There were no borrowings on this facility at December 31, 2006 and 2005.  In the past, we have used interest rate swapsto effectively fix a portion of the interest rates on our variable rate creditfacilities.  We did not have any interestrate swaps at December 31, 2006 and 2005.

We are subject to commodity price risk, primarily with respect topurchases of steel and natural gas. Purchased steel represents a significant portion of our cost of goodssold.  As a result, fluctuations in thecost of purchased steel, which can be volatile and cyclical in nature, have asignificant impact on our margins both positively and negatively.  Our steel costs have risen significantlysince the end of 2003 and are expected to remain volatile and high.  We have absorbed certain price increases insteel, and there can be no assurance that we will be successful in passingthese higher steel costs on to our customers.

We purchase natural gas for our operations and therefore have a limitedmarket risk in natural gas prices.  As aresult, our earnings could be affected by changes in the price of naturalgas.  As market conditions dictate, wemay enter into contracts to acquire a significant portion of our natural gasrequirements over periods ranging from 6 to 18 months.  Our remaining requirements are purchased onthe market at the current value.  Our naturalgas purchase commitments at December 31, 2006, totaled $28.6 million.

 

36

----

 

**ITEM 8.        CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

**INDEX TO CONSOLIDATEDFINANCIAL STATEMENTS**
|                                                                                                             | **Page** | ** ** |
|-------------------------------------------------------------------------------------------------------------|----------|------------|
| Management’s Report on Internal Control Over Financial  Reporting                                      | 38       |       |
| Reports of Independent Registered Public Accounting  Firm                                                   | 39       |       |
| Consolidated Results of Operations for the Years Ended  December 31, 2006, 2005, and 2004                   | 41       |       |
| Consolidated  Balance Sheets at December 31, 2006 and 2005                                                  | 42       |       |
| Consolidated Statements of Cash Flows, for the Years  Ended December 31, 2006, 2005, and 2004               | 43       |       |
| Consolidated Statements of Shareholders’ Equity for  the Years Ended December 31, 2006, 2005, and 2004 | 44       |       |
| Notes to Consolidated Financial Statements                                                                  | 45       |       |
| Schedule II—Valuation and Qualifying Accounts                                                          | 66       |       |

 

37

----

**MANAGEMENT’SREPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**

To the Board of Directors and Shareholders of Lone Star Technologies,Inc.:

The management of Lone Star Technologies, Inc. and subsidiaries (“LoneStar”) is responsible for establishing and maintaining adequate internalcontrol over financial reporting, as such term is defined in SecuritiesExchange Act Rule 13a-15(f).

All internal control systems, no matter how well designed, have inherentlimitations.  Therefore, even thosesystems determined to be effective can provide only reasonable assurance withrespect to financial statement preparation and presentation.

Lone Star’s management, including its principal executive officer andprincipal financial officer, assessed the effectiveness of the Lone Star’sinternal control over financial reporting as of December 31, 2006.  In making this assessment, it used thecriteria set forth by the Committee of Sponsoring Organizations of the TreadwayCommission (“COSO”) in *Internal Control —Integrated Framework*.  Basedon our assessment we believe that, as of December 31, 2006, Lone Star’sinternal control over financial reporting is effective based on those criteria.

Lone Star’s independent registered public accounting firm, Deloitte& Touche LLP, has issued an audit report on our assessment of Lone Star’sinternal control over financial reporting, which is included herein.
| Lone Star Technologies, Inc. |
|------------------------------|
| Dallas, Texas                |
| February 27, 2007            |

 
| **/s/**Rhys J. Best     | ** ** | **/s/**Charles J.  Keszler |
|-------------------------|------------|----------------------------|
| ** **              | ** ** | ** **                 |
| **Rhys  J. Best**       | ** ** | **Charles  J. Keszler**    |
| Chief Executive Officer |       | Chief Financial Officer    |

 

38

----

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

Tothe Board of Directors and Shareholders of Lone Star Technologies, Inc.:

We have audited management’sassessment, included in the accompanying “Management’s Report on InternalControl Over Financial Reporting,” that Lone Star Technologies, Inc. andsubsidiaries (the “Company”) maintained effective internal control overfinancial reporting as of December 31, 2006, based on criteria established in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.The Company’s management is responsible for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of theCompany’s internal control over financial reporting based on our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design andoperating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinions.

A company’s internal controlover financial reporting is a process designed by, or under the supervision of,the company’s principal executive and principal financial officers, or personsperforming similar functions, and effected by the company’s board of directors,management, and other personnel to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples. A company’s internal control over financial reporting includesthose policies and procedures that (1) pertain to the maintenance of recordsthat, in reasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonable assurancethat transactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat receipts and expenditures of the company are being made only in accordancewith authorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of the inherentlimitations of internal control over financial reporting, including thepossibility of collusion or improper management override of controls, materialmisstatements due to error or fraud may not be prevented or detected on atimely basis. Also, projections of any evaluation of the effectiveness of theinternal control over financial reporting to future periods are subject to therisk that the controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’sassessment that the Company maintained effective internal control overfinancial reporting as of December 31, 2006, is fairly stated, in all materialrespects, based on the criteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission. Also in our opinion, the Companymaintained, in all material respects, effective internal control over financialreporting as of December 31, 2006, based on the criteria established in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheet as of December 31, 2006 and therelated consolidated results of operations, statements of shareholders’ equityand cash flows for the year ended December 31, 2006 of the Company and ourreport dated February 27, 2007 expressed an unqualified opinion on thosefinancial statements and included an explanatory paragraph regarding theCompany’s adoption of two new accounting standards.

DELOITTE& TOUCHE LLP

Dallas,Texas

February 27, 2007

39

----

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors andShareholders of

Lone Star Technologies, Inc.:

We have audited theaccompanying consolidated balance sheets of Lone Star Technologies, Inc. andsubsidiaries (the “Company”) as of December 31, 2006 and 2005, and the relatedconsolidated results of operations, statements of shareholders’ equity and cashflows for each of the three years in the period ended December 31, 2006.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financial statementsbased on our audits.

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In our opinion, suchconsolidated financial statements present fairly, in all material respects, thefinancial position of Lone Star Technologies, Inc. and subsidiaries as ofDecember 31, 2006 and 2005, and the results of their operations and their cashflows for each of the three years in the period ended December 31, 2006, in conformitywith accounting principles generally accepted in the United States of America.

As discussed in notes A and Jto the consolidated financial statements, effective January 1, 2006, theCompany adopted the provisions of Statement of Financial Accounting Standards(SFAS) No. 123R, *Share-Based Payment*and effectiveDecember 31, 2006 the Company adopted the provisions of SFAS No. 158, *Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans.*

We have also audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the effectiveness of theCompany’s internal control over financial reporting as of December 31, 2006,based on the criteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated February 27, 2007expressed an unqualified opinion on management’s assessment of theeffectiveness of the Company’s internal control over financial reporting and anunqualified opinion on the effectiveness of the Company’s internal control overfinancial reporting.

DELOITTE& TOUCHE LLP

Dallas, Texas

February27, 2007

 

40

----

 

**LONE STAR TECHNOLOGIES, INC.****CONSOLIDATEDRESULTS OF OPERATIONS*****($and shares in millions, except per share data)***

 
| ** **                                     | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                           |       |                                                          |       |   |   |   |   |
| Net revenues                                   |       | $                                                             | 1,377.6    |   | $ | 1,285.1 |   | $ | 966.8 |   |
| Cost of goods sold                             |       | 1,142.6                                                       |       | 1,012.8 |   | 804.8 |   |
| Gross profit                                   |       | 235.0                                                         |       | 272.3 |   | 162.0 |   |
| Selling, general, and  administrative expenses |       | 62.2                                                          |       | 50.5 |   | 44.6 |   |
| Operating income                               |       | 172.8                                                         |       | 221.8 |   | 117.4 |   |
| Interest income                                |       | 10.4                                                          |       | 5.8 |   | 1.8 |   |
| Interest expense                               |       | (7.4                                                          | )          | (16.1 | ) | (16.8 | ) |
| Loss on early extinguishment  of debt          |       | (9.3                                                          | )          | — |   | — |   |
| Other income, net                              |       | 1.0                                                           |       | 8.7 |   | 2.0 |   |
| Income before  income tax                      |       | 167.5                                                         |       | 220.2 |   | 104.4 |   |
| Income tax (benefit)  expense                  |       | 59.3                                                          |       | (3.4 | ) | 3.4 |   |
| Net income                                     |       | $                                                             | 108.2      |   | $ | 223.6 |   | $ | 101.0 |   |
|                                           |       |                                                          |       |   |   |   |   |
| **Per common share – basic:**             | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  available to common shareholders   |       | $                                                             | 3.54       |   | $ | 7.44 |   | $ | 3.51 |   |
|                                           |       |                                                          |       |   |   |   |   |
| **Per common share – diluted:**           | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  available to common shareholders   |       | $                                                             | 3.47       |   | $ | 7.34 |   | $ | 3.46 |   |
|                                           |       |                                                          |       |   |   |   |   |
| **Weighted–average shares  outstanding**  | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                          |       | 30.6                                                          |       | 30.0 |   | 28.7 |   |
| Diluted                                        |       | 31.2                                                          |       | 30.5 |   | 29.2 |   |
|                                           |       |                                                          |       |   |   |   |   |

 

See Notes toConsolidated Financial Statements

 

41

----

**LONE STARTECHNOLOGIES, INC.**

**CONSOLIDATED BALANCE SHEETS**

***($ in millions, except share data)***

 
| ** **                                                                                                       | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                       | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **                                                                                                       | ** ** | ** **            | ** ** | ** ** | ** ** |
| **ASSETS**                                                                                                       |       |                  |       |   |   |
| Current Assets:                                                                                                  |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                       |       | $                     | 46.0       |   | $ | 102.2 |   |
| Short-term  investments                                                                                          |       | 120.4                 |       | 153.5 |   |
| Accounts  receivable, less allowances of $1.5 and

$1.4,  respectively                                           |       | 135.9                 |       | 141.3 |   |
| Inventories                                                                                                      |       | 384.9                 |       | 245.0 |   |
| Deferred tax  asset                                                                                              |       | 20.4                  |       | 65.3 |   |
| Other current  assets                                                                                            |       | 8.3                   |       | 13.6 |   |
| Total current  assets                                                                                            |       | 715.9                 |       | 720.9 |   |
|                                                                                                             |       |                  |       |   |   |
| Property, plant, and  equipment, net                                                                             |       | 213.3                 |       | 197.5 |   |
| Investments in joint  ventures                                                                                   |       | 45.0                  |       | — |   |
| Goodwill                                                                                                         |       | 40.9                  |       | 40.9 |   |
| Other noncurrent assets                                                                                          |       | 17.2                  |       | 20.0 |   |
| Total assets                                                                                                     |       | $                     | 1,032.3    |   | $ | 979.3 |   |
|                                                                                                             |       |                  |       |   |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                   | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                                                                                             |       |                  |       |   |   |
| Current Liabilities:                                                                                             |       |                  |       |   |   |
| Accounts payable                                                                                                 |       | $                     | 152.6      |   | $ | 54.7 |   |
| Accrued  liabilities                                                                                             |       | 55.3                  |       | 53.7 |   |
| Total current  liabilities                                                                                       |       | 207.9                 |       | 108.4 |   |
|                                                                                                             |       |                  |       |   |   |
| Senior subordinated  debt                                                                                        |       | —                |       | 150.0 |   |
| Postretirement benefit  obligations                                                                              |       | 39.8                  |       | 39.0 |   |
| Deferred tax liability                                                                                           |       | 11.6                  |       | 28.5 |   |
| Other noncurrent  liabilities                                                                                    |       | 20.6                  |       | 13.2 |   |
| Total  liabilities                                                                                               |       | 279.9                 |       | 339.1 |   |
|                                                                                                             |       |                  |       |   |   |
| Commitments and  Contingencies (See Note K)                                                                      |       |                  |       |   |   |
|                                                                                                             |       |                  |       |   |   |
| Shareholders’ Equity:                                                                                       |       |                  |       |   |   |
| Preferred stock,  $1 par value  (authorized: 10,000,000 shares, issued: none)                                    |       | —                |       | — |   |
| Common stock, $1  par value

(authorized:  80,000,000 shares, issued: 31,040,874 and

30,600,205,  respectively) |       | 31.0                  |       | 30.6 |   |
| Capital surplus                                                                                                  |       | 438.5                 |       | 422.1 |   |
| Accumulated  other comprehensive loss                                                                            |       | (37.4                 | )          | (33.3 | ) |
| Retained  earnings                                                                                               |       | 329.4                 |       | 221.2 |   |
| Treasury stock,  at cost (181,249 and 10,862 shares, respectively)                                               |       | (9.1                  | )          | (0.4 | ) |
| Total  shareholders’ equity                                                                                 |       | 752.4                 |       | 640.2 |   |
| Total  liabilities and shareholders’ equity                                                                 |       | $                     | 1,032.3    |   | $ | 979.3 |   |

See Notes to Consolidated Financial Statements

 

42

----

**LONE STARTECHNOLOGIES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

***($ in millions)***
| ** **                                                                                                     | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                     | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cash flows from operating  activities:**                                                                     |       |                                                          |       |   |   |   |   |
| Net income                                                                                                     |       | $                                                             | 108.2      |   | $ | 223.6 |   | $ | 101.0 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities, net of acquired  companies: |       |                                                          |       |   |   |   |   |
| Depreciation and  amortization                                                                                 |       | 28.8                                                          |       | 27.9 |   | 27.8 |   |
| Noncash charge  for stock compensation                                                                         |       | 5.9                                                           |       | 3.5 |   | 1.6 |   |
| Net loss (gain)  on property disposals and impairments                                                         |       | 0.1                                                           |       | (0.1 | ) | 0.1 |   |
| Gain on early  termination of alliance agreement                                                               |       | —                                                        |       | (7.8 | ) | — |   |
| Cash portion of  loss on early extinguishment of debt                                                          |       | 6.8                                                           |       | — |   | — |   |
| Deferred taxes                                                                                                 |       | 7.2                                                           |       | (13.3 | ) | — |   |
| Changes in  operating assets and liabilities:                                                                  |       |                                                          |       |   |   |   |   |
| Accounts  receivable                                                                                           |       | 5.4                                                           |       | (18.7 | ) | (52.8 | ) |
| Inventories                                                                                                    |       | (139.9                                                        | )          | (116.7 | ) | 24.5 |   |
| Other current  assets                                                                                          |       | 5.3                                                           |       | 48.8 |   | (33.5 | ) |
| Accounts payable  and accrued liabilities                                                                      |       | 105.9                                                         |       | 17.4 |   | 1.9 |   |
| Litigation  reserves                                                                                           |       | —                                                        |       | (1.0 | ) | (33.0 | ) |
| Other                                                                                                          |       | 0.1                                                           |       | (15.4 | ) | (8.1 | ) |
| Net cash  provided by operating activities                                                                     |       | 133.8                                                         |       | 148.2 |   | 29.5 |   |
| ** **                                                                                                     |       |                                                          |       |   |   |   |   |
| **Cash flows from investing  activities:**                                                                     |       |                                                          |       |   |   |   |   |
| Capital  expenditures                                                                                          |       | (44.0                                                         | )          | (21.0 | ) | (13.0 | ) |
| Purchase of  investments                                                                                       |       | (369.3                                                        | )          | (324.1 | ) | (88.6 | ) |
| Restricted cash                                                                                                |       | —                                                        |       | — |   | 32.2 |   |
| Proceeds from  sale of property, plant, and equipment                                                          |       | —                                                        |       | 2.5 |   | 0.7 |   |
| Proceeds from  sales of investments                                                                            |       | 371.4                                                         |       | 227.3 |   | 29.5 |   |
| Maturities of  investments                                                                                     |       | 31.0                                                          |       | 2.4 |   | — |   |
| Cash paid for  joint ventures                                                                                  |       | (26.2                                                         | )          | — |   | — |   |
| Net cash used in  investing activities                                                                         |       | (37.1                                                         | )          | (112.9 | ) | (39.2 | ) |
| ** **                                                                                                     |       |                                                          |       |   |   |   |   |
| **Cash flows from financing  activities:**                                                                     |       |                                                          |       |   |   |   |   |
| Redemption of  senior subordinated notes, including premium                                                    |       | (156.8                                                        | )          | — |   | — |   |
| Proceeds from  exercise of options                                                                             |       | 6.4                                                           |       | 36.6 |   | 6.4 |   |
| Excess tax  benefit from share-based compensation                                                              |       | 3.0                                                           |       | — |   | — |   |
| Purchase of  treasury stock                                                                                    |       | (5.5                                                          | )          | — |   | — |   |
| Net cash (used  in) provided by financing activities                                                           |       | (152.9                                                        | )          | 36.6 |   | 6.4 |   |
| Effect of  foreign exchange rate changes on cash                                                               |       | —                                                        |       | 0.1 |   | 0.2 |   |
| Net change in  cash and cash equivalents                                                                       |       | (56.2                                                         | )          | 72.0 |   | (3.1 | ) |
| Cash and cash  equivalents, beginning of year                                                                  |       | 102.2                                                         |       | 30.2 |   | 33.3 |   |
| Cash and cash  equivalents, end of year                                                                        |       | $                                                             | 46.0       |   | $ | 102.2 |   | $ | 30.2 |   |
|                                                                                                           |       |                                                          |       |   |   |   |   |
| **Supplemental  cash flow disclosures:**                                                                       |       |                                                          |       |   |   |   |   |
| Interest paid                                                                                                  |       | $                                                             | 14.3       |   | $ | 16.3 |   | $ | 17.0 |   |
| Income taxes  paid, net                                                                                        |       | $                                                             | 31.9       |   | $ | 4.9 |   | $ | 1.8 |   |
| Non-cash joint venture investment                                                                              |       | 18.8                                                          |       | — |   | — |   |

 

SeeNotes to Consolidated Financial Statements

43

----

**LONE STARTECHNOLOGIES, INC.**

**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY**

*($ in millions)*
| ** **                                 | ** ** | ** ** | ** ** | ** **  | ** ** | **Accumulated**   | ** ** | **Retained**     | ** ** | ** **   | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|------------|------------|-------------|------------|-------------------|------------|------------------|------------|--------------|------------|------------|------------|
| ** **                                 | ** ** | ** ** | ** ** | ** **  | ** ** | **Other**         | ** ** | **Earnings**     | ** ** | ** **   | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **Common** | ** ** | **Capital** | ** ** | **Comprehensive** | ** ** | **(Accumulated** | ** ** | **Treasury** | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **Stock**  | ** ** | **Surplus** | ** ** | **Loss**          | ** ** | **Deficit)**     | ** ** | **Stock**    | ** ** | **Total**  | ** ** |
|                                       |       |       |       |        |       |              |       |             |       |         |       |       |       |
| **Balance, January 1, 2004**               |       | $          | 28.7       |        | $          | 355.1             |       | $                | (32.2      | )            | $          | (103.4     | )          | $ | (2.3 | ) | $ | 245.9 |   |
| Net income                                 |       | —     |       | —      |       | —            |       | 101.0            |       | —       |       | 101.0      |       |
| Other comprehensive  income (loss):        |       |       |       |        |       |              |       |             |       |         |       |       |       |
| Minimum  pension liability adjustment      |       | —     |       | —      |       | (0.6              | )          | —           |       | —       |       | (0.6       | )          |
| Foreign  currency translation adjustment   |       | —     |       | —      |       | 0.2               |       | —           |       | —       |       | 0.2        |       |
| Comprehensive  income                      |       |       |       |        |       |              |       |             |       |         |       | 100.6      |       |
| Employee benefit plan  stock issuance      |       | 0.5        |       | 7.9         |       | —            |       | —           |       | (0.4         | )          | 8.0        |       |
|                                       |       |       |       |        |       |              |       |             |       |         |       |       |       |
| **Balance, December 31, 2004**             |       | 29.2       |       | 363.0       |       | (32.6             | )          | (2.4             | )          | (2.7         | )          | 354.5      |       |
| Net income                                 |       | —     |       | —      |       | —            |       | 223.6            |       | —       |       | 223.6      |       |
| Other comprehensive  income (loss):        |       |       |       |        |       |              |       |             |       |         |       |       |       |
| Minimum  pension liability adjustment      |       | —     |       | —      |       | (0.8              | )          | —           |       | —       |       | (0.8       | )          |
| Foreign  currency translation adjustment   |       | —     |       | —      |       | 0.1               |       | —           |       | —       |       | 0.1        |       |
| Comprehensive  income                      |       |       |       |        |       |              |       |             |       |         |       | 222.9      |       |
| Tax benefit from  stock-based compensation |       | —     |       | 23.7        |       | —            |       | —           |       | —       |       | 23.7       |       |
| Employee benefit plan  stock issuance      |       | 1.4        |       | 35.4        |       | —            |       | —           |       | 2.3          |       | 39.1       |       |
|                                       |       |       |       |        |       |              |       |             |       |         |       |       |       |
| **Balance, December 31, 2005**             |       | 30.6       |       | 422.1       |       | (33.3             | )          | 221.2            |       | (0.4         | )          | 640.2      |       |
| Net income                                 |       | —     |       | —      |       | —            |       | 108.2            |       | —       |       | 108.2      |       |
| Other comprehensive  income:               |       |       |       |        |       |              |       |             |       |         |       |       |       |
| Minimum  pension liability adjustment      |       | —     |       | —      |       | 2.9               |       | —           |       | —       |       | 2.9        |       |
| Comprehensive  income                      |       |       |       |        |       |              |       |             |       |         |       | 111.1      |       |
| Adoption of SFAS 158                       |       |       |       |        |       | (7.0              | )          |             |       |         |       | (7.0       | )          |
| Tax benefit from  stock-based compensation |       | —     |       | 2.8         |       | —            |       | —           |       | —       |       | 2.8        |       |
| Employee benefit plan  stock issuance      |       | 0.4        |       | 13.6        |       | —            |       | —           |       | (3.2         | )          | 10.8       |       |
| Acquisition of treasury  stock             |       | —     |       | —      |       | —            |       | —           |       | (5.5         | )          | (5.5       | )          |
|                                       |       |       |       |        |       |              |       |             |       |         |       |       |       |
| **Balance, December 31, 2006**             |       | $          | 31.0       |        | $          | 438.5             |       | $                | (37.4      | )            | $          | 329.4      |       | $ | (9.1 | ) | $ | 752.4 |   |

 

See Notes to ConsolidatedFinancial Statements

44

----

**Lone Star Technologies, Inc.**

**Notes to Consolidated Financial Statements**

Lone Star Technologies, Inc.(“Lone Star” or the “Company”), a Delaware corporation, is a management andholding company with six principal operating subsidiaries, Lone Star Steel Company(“Steel”), Fintube Technologies, Inc. (“Fintube”), Bellville Tube Company, L.P.(“Bellville”), Wheeling Machine Products, Inc. (“Wheeling”), Delta Tubular Processing, Inc. (“DTP”), acquired May 1,2003, and, Delta Tubular International, Inc. (“DTI”), acquired June 2,2003.  Steel manufactures and globallymarkets oilfield tubular products to the oil and gas drilling industry,mechanical tubing products to automotive, fluid power, and other markets forvarious mechanical applications, and flat rolled steel and other tubularproducts to domestic industrial markets. Fintube manufactures specialty finned tubular products used in a varietyof heat recovery applications including combined-cycle electrical power generation.  Bellville manufactures oilfield tubularproducts.  Wheeling manufacturescouplings used to connect individual sections of oilfield casing andtubing.  DTP and DTI provide oil countrytubular processing services including threading and inspection services.  During 2006, Lone Star announced three jointventures for the production of oilfield and other tubular products (See JointVentures - Note M).

Lone Star’s consolidated revenues are not seasonal.  However, demand for oilfield products issubject to significant fluctuations due to the volatility of oil and gas pricesand domestic drilling activity, as well as other factors including competitionfrom imports.  Demand for mechanicaltubing and finned tubular products is primarily subject to fluctuations ingeneral economic conditions.

**ACCOUNTING POLICIES -NOTE A**

***Principles of consolidation*****.**  Theconsolidated financial statements include the accounts of Lone Star and itswholly owned subsidiaries.  Allsignificant intercompany accounts and transactions have been eliminated inconsolidation.  In the Notes toConsolidated Financial Statements, all dollar and share amounts in tabulationare in millions of dollars and shares, respectively, except per share data andunless otherwise noted.  Certain prioryear amounts have been reclassified to conform to the current year’spresentation.

***Cash and cash equivalents*****.**  LoneStar’s cash and cash equivalents include commercial bank accounts and highlyliquid investments in a fund consisting of U. S. government and relatedagencies obligations with original maturities of less than three months.

***Investments.***Lone Star accounts for its investments in debtsecurities under “SFAS” No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*. Under SFAS115, investments for which Lone Star has the positive intent and the ability tohold to maturity are classified as held-to-maturity securities and are reportedat amortized cost, which approximates fair market value at December 31, 2006and 2005.  Those classified asavailable-for-sale are reported at fair value with unrealized gains and lossesrecorded in comprehensive income.

***Inventories.*** Inventories are stated at the lower of costor market value.  Cost is determinedusing the last-in, first-out (“LIFO”) method for approximately 82% of theCompany’s total current inventories after LIFO reserve for the years endedDecember 31, 2006 and 2005.  The cost ofremaining inventories is determined using the average cost method.  Inventories include raw materials and certainsupplies.

***Property, plant, and equipment. ***Property, plant and equipment are stated at cost.  Significant betterments and improvements arecapitalized if they extend the useful life of the asset, while maintenance andrepairs are expensed when incurred. Depreciation is provided on the straight-line method over theestimated useful lives of depreciable assets as follows:
| Land improvements                        |   | 3 - 39 Years |
|------------------------------------------|--------|--------------|
| Buildings,  structures, and improvements |   | 4 - 30 Years |
| Machinery and  equipment                 |   | 3 - 30 Years |

45

----

***Impairment of long-lived assets.***** **In accordance with SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*, Lone Starperiodically evaluates the recoverability of long-lived assets whenever eventsand changes in circumstances indicate that the carrying amount of an asset maynot be fully recoverable.  At December31, 2006, the Company believes that its long-lived assets have not beenimpaired.

***Investments in Joint Ventures. ***The Company utilized the equity method of accounting for its investmentsin Apolo Mecanica e Estruturas LTDA (“Apolo”) and Welspun-Lone Star TubularsLLC (“Welspun Joint Ventures”), since the Company exercised significantinfluence over the operations and financial policies of these entities.

***Income taxes***.  Lone Star applies the provisions of SFAS No.109, *Accounting for Income Taxes*,which utilizes an asset and liability approach for financial accounting andincome tax reporting.  Deferred taxliabilities or assets are recognized for the estimated future tax effectsattributable to temporary differences and carryforwards and are adjustedwhenever tax rates or other provisions of income tax statutes change.  Deferred tax assets are reduced, if deemednecessary, by a valuation allowance for any tax benefits that are not expectedto be realized.

***Revenue recognition***. Product revenues are recognized as sales when revenue is earned and isrealized or realizable.  This includessatisfying the following criteria:  thearrangement with the customer is evident, usually through the receipt of apurchase order; the sales price is fixed or determinable; delivery hasoccurred, which may include delivery to the customer storage warehouse locationat one of the Company’s subsidiaries, in which instance, the risk of loss hasbeen passed to the customer; and collectibility is reasonably assured.  Freight and shipping billed to customers isincluded in net sales, and the cost of freight and shipping is included in costof sales.  The Company has marketingagreements to sell steel oilfield tubular products manufactured by othercompanies.  Revenue is recorded on agross basis for certain transactions with alliance mills when the Company isthe primary obligor and has general inventory and credit risk, and certainother transactions are recorded net.

***Foreign currency translation.***** **In accordance with SFAS No. 52, *ForeignCurrency Translation*, operations in Mexico, Thailand and theBrazilian joint venture use the local currency as the functional currency whilethe Canadian operation uses the U.S. dollar as its functional currency. Revenueand expenses from the Company’s international operations are translated usingthe average exchange rates in effect for the period in which the items occur.The Company’s Canadian operation that has the U.S. dollar as its functionalcurrency translates monetary assets and liabilities using current rates ofexchange at the balance sheet date and translates nonmonetary assets andliabilities using historical rates of exchange. Gains and losses fromremeasurement for such operations are included in other income, on a net basisand have historically not been significant. The Company’s operations in Mexico,Thailand, and its Brazilian joint venture that do not have the U.S. dollar asits functional currency translate assets and liabilities at current rates ofexchange in effect at the balance sheet date. The resulting gains and lossesfrom translation for each are included as a component of shareholders’ equity.

***Business and Credit Risk.***  LoneStar sells products to numerous customers primarily in the oil and gas drillingindustry.  Although this concentrationcould affect the Company’s overall exposure to credit risk, management believesthat the Company is exposed to minimal risk since the majority of its businessis conducted with major companies within the industry.  The Company performs ongoing creditevaluations of its customers and generally does not require collateral whenextending credit. The Company maintains a reserve for potential credit losses.Such losses have historically been within management’s expectations.  The Company does not have financialinstruments with off-balance sheet risk.

Lone Star maintains cash and cash equivalents and investments in debtsecurities with various financial institutions. As part of its cash and riskmanagement processes, the Company performs periodic evaluations of the relativecredit standing of the financial institutions. Lone Star has not sustained credit losses from instruments held atfinancial institutions.

***Stock-Based Employee Compensation. ***Lone Star adopted SFAS123 (revised 2004), *Share-Based Payment*(“SFAS 123R”), on January 1,2006.  SFAS 123R requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair values. UnderSFAS 123R, Lone Star is required to measure the cost of employee servicesreceived in exchange for stock options and similar awards based on thegrant-date fair value of the award and recognize this cost in the incomestatement over the period during which an employee is required to provideservice in exchange for the award.  Thepro forma disclosures previously permitted under SFAS 123 are no longer analternative to financial statement recognition. Lone Star adopted SFAS 123R on January 1, 2006 using themodified prospective method.  Under thismethod, Lone Star recognized compensation cost, on a prospective basis, for theportion of outstanding awards for which the requisite service had not yet beenrendered as of January 1, 2006 and any new grants, based upon the grant-datefair value of those awards calculated under SFAS 123R for pro forma disclosurepurposes.  Accordingly, prior periodamounts have 

46

----

not been restated. Through December 31, 2005, the Company accounted for stock-basedcompensation utilizing the intrinsic value method in accordance with theprovisions of APB Opinion No. 25, *Accountingfor Stock Issued to Employees* and related Interpretations.Accordingly, the Company recognized compensation expense on the Company’srestricted stock grants, but no compensation expense was recognized for optionplans because the exercise prices of employee stock options equal or exceed themarket prices of the underlying stock on the dates of grant.  As permitted, the Company elected to adoptthe disclosure only provisions of SFAS 123 prior to the adoption of SFAS123R.

***Fair Value of Financial Instruments.*********The carrying amount of cash and cashequivalents, trade receivables, and payables approximates fair value because ofthe short maturity of those instruments. The estimated fair value of Lone Star’s investments in debt securitiesbased on quoted market prices was $120.4 million and $153.4 million at December31, 2006 and 2005, respectively.  Theseestimated fair values may not be representative of actual values of thefinancial instruments that could have been realized as of December 31, 2006 orthat will be realized in the future.

As of December 31, 2006 and 2005, the Company had outstanding letters ofcredit of $0.7 million and $0.3 million, respectively, which approximates fairvalue.

***Accumulated Other ComprehensiveLoss.***  Asof December 31, 2006, accumulated other comprehensive loss consisted of $37.4million, related to minimum pension liability adjustments and the additionalpension liability of  $7.0 millionrelated to adoption of SFAS 158 (see New Accounting Pronouncements below).  As of December 31, 2005, accumulated othercomprehensive loss consists of $33.3 million and related to minimum pensionliability adjustments.

***Use of Estimates.***  Preparation of the consolidated financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, disclosures of contingent assets and liabilities,and the reported amounts of revenues and expenses. The Company’s estimates areprimarily based on historical experience and business knowledge and are revisedas circumstances change.  However, actualresults could differ from those estimates.

Lone Star’s products are used in applications, which are subject toinherent risks including, but not limited to well failures, performancedeficiencies, line pipe leaks, personal injury, property damage, environmentalcontamination or loss of oil and gas production.  The Company warrants its products to meetcertain specifications.  Actual orclaimed deficiencies from these specifications may give rise to claims and theCompany maintains a reserve for asserted and unasserted warranty claims.  The warranty claim exposure is evaluatedusing historical claim trends and information available on specifically knownclaims. The Company also maintains product and excess liability insurancesubject to certain deductibles that limit the exposure to these claims.  The Company considers the extent of insurancecoverage in its estimate of the reserve. Typically, this reserve is not subject to significant fluctuations fromperiod-to-period.  However, theincurrence of an unusual amount of claims could alter the Company’s exposureand the related reserve.  The followingtable identifies changes in warranty reserves from January 1, 2004 to December31, 2006:

 
| ** **                                              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Beginning  balance                                      |       | $        | 3.0        |     | $          | 2.4      |       | $ | 2.4 |   |
| Warranty expense accruals                               |       | 10.1     |       | 8.0      |       | 3.1      |       |
| Changes in estimates to pre-existing warranty  accruals |       | —   |       | (0.2     | )          | —   |       |
| Warranty settlements                                    |       | (9.7     | )          | (7.2     | )          | (3.1     | )          |
| Ending balance                                          |       | $        | 3.4        |     | $          | 3.0      |       | $ | 2.4 |   |

 

Lone Star is subject to numerous environmental regulations and isactively remediating known exposures and conducting post-closure monitoringactivities.  The Company maintains anenvironmental reserve to cover the costs of expected remediation andpost-closure monitoring and estimates the cost for the remediation andpost-closure monitoring based on historical experience, results of monitoring,and the known extent of exposure.  TheCompany evaluates the range of exposure and records the reserve at the mostprobable amount within that range. Typically, this reserve is not subject to significant fluctuations fromperiod-to-period.  However, given thenature of environmental exposures, significant changes in the reserve arepossible.

47

----

***New Accounting Pronouncements.***

In June, 2006, the FASB issued Interpretation No. 48 — *Accounting for Uncertainty in Income Taxes* (“FIN 48”).  FIN 48 clarifies the accounting foruncertainty in income taxes by prescribing the minimum recognition threshold atax position is required to meet before being recognized in the financialstatements.  FIN 48 utilizes a two-stepapproach for evaluating tax positions. Recognition (Step 1) occurs when an enterprise concludes that a taxposition, based solely on its technical merits is more likely than not to besustained upon examination.  Measurement(Step 2) is only addressed if Step 1 has been satisfied.  Under Step 2, the tax benefit is measured atthe largest amount of benefit, determined on a cumulative probability basis,that is more likely than not to be realized upon final settlement.  FIN 48’s use of the term “more likely thannot” in Steps 1 and 2 is consistent with how the term is used in SFAS 109 (i.e.the likelihood of an occurrence greater than 50%).  FIN 48 applies to all tax positions relatedto income taxes subject to SFAS 109.  TheCompany will adopt FIN 48 as of January 1, 2007 as required.  The Company expects the cumulative adjustmentto beginning retained earnings related to the implementation of FIN 48 to beimmaterial.

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements* (“SFAS 157”). This standardclarifies the principle that fair value should be based on the assumptions thatmarket participants would use when pricing an asset or liability. Additionally,it establishes a fair value hierarchy that prioritizes the information used todevelop those assumptions.  SFAS 157 iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007.  The Company iscurrently evaluating the impact that the implementation of SFAS 157 will haveon its financial position, results of operations, and cash flows.

In September 2006, the FASB issued SFAS No. 158, *Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans*( “SFAS 158”**** ****). This standardrequires employers to recognize the underfunded or overfunded status of adefined benefit postretirement plan as an asset or liability in its statementof financial position and to recognize changes in the funded status in the yearin which the changes occur through accumulated other comprehensive income.Additionally, SFAS 158 requires employers to measure the funded status of aplan as of the date of its year-end statement of financial position.  The new reporting requirements and relatednew footnote disclosure rules of SFAS 158 are effective for fiscal years endingafter December 15, 2006.  The new measurement date requirement applies forfiscal years ending after December 15, 2008. The impact that the implementation of SFAS 158 had on our resultsof operations or financial condition is detailed in Employee Benefit Plans —Note J.

**BUSINESS SEGMENTS  — NOTE B**

Lone Star currently has six operating subsidiaries that have separatemanagement teams and infrastructures that offer different products andservices.  The subsidiaries have been aggregatedunder three reportable segments: oilfield, specialty tubing, and flat-rolled steel and other tubulargoods.  During 2006, Lone Star announcedthree joint ventures for the production of oilfield and other tubular products(see Joint Ventures - Note M). Management evaluates segment performance based primarily on revenue andearnings from operations and segments are organized around the products andservices provided to the customers each segment serves.  One oilfield products distributor, Sooner PipeL.P., comprised 13% of total net revenues in 2006.  No single customer in 2005 and 2004 comprisedmore than 10% of total net revenues. Direct foreign revenues as a percentage of total revenues were 2%, 3%,and 2% in 2006, 2005, and 2004, respectively.  Foreign assets as a percentage of total assetswere less than 1% at December 31, 2006, 2005, and 2004, respectively.

The accounting policies of each segment are the same as those describedin Note A of the Notes to Consolidated Financial Statements.  Intersegment sales and transfers are notsignificant.  Interest expense, interestincome, other income and expense, and income taxes have not been allocated tothe segments.

***Oilfield.*** Oilfield products are comprised of casing, tubing, line pipe andcouplings that are manufactured and marketed globally to the oil and gasdrilling industry.  The oilfield segmentincludes high-quality alloy and carbon welded oil country tubular goods,including casing, which acts as a structural retainer wall in oil and natural gaswellbores, and production tubing, which transmits hydrocarbons to thesurface.  Line pipe is used to gather andtransmit oil and natural gas.  Couplingsare used to connect individual sections of oilfield casing and tubing.  The oilfield segment also includesend-finishing, heat treating, inspection, and storage services.

***Specialty tubing.***  LoneStar’s specialty tubing business includes the manufacture, marketing and saleof a variety of custom-engineered tubular products used in exactingapplications, such as the manufacture of hydraulic cylinders for constructionand farm equipment; automotive applications, such as stabilizers and intrusiontubes; and other uses, including machine parts, bearing races, down-hole pumpbarrels, heavy lift crane boom chords, drill rods, and liner hangers.  Heat 

48

----

recovery tubular products are used in fuel economizers, industrialprocessing, petrochemical plants, refineries, and combined cycle electricalpower generation.

***Flat-rolled steel and other tubulargoods.***  Flat-rolled steel is manufactured principallyfor use by the Company in the manufacture of tubular products.  The majority of the Company’s flat-rolledsteel sales are to an alliance mill for conversion into OCTG.  The Company also sells flat-rolled steel tofabricators of large diameter pipe, storage tanks, rail cars, and a variety ofother construction and industrial products. Lone Star also provides transportation, storage, and other services to avariety of industries.

The following tables present information on the segments.  The “Corporate/Other” column includescorporate-related items and other insignificant nonsegments.

 
| ** **                      | ** ** | ** **   | ** ** | ** **    | ** ** | **Flat**           | ** ** | ** **       | ** ** | ** ** | ** ** |
|---------------------------------|------------|--------------|------------|---------------|------------|--------------------|------------|------------------|------------|------------|------------|
| ** **                      | ** ** | ** **   | ** ** | ** **    | ** ** | **Rolled**         | ** ** | ** **       | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **   | ** ** | ** **    | ** ** | **Steel and** | ** ** | ** **       | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **   | ** ** | **Specialty** | ** ** | **Other**          | ** ** | **Corporate**    | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Oilfield** | ** ** | **Tubing**    | ** ** | **Products**       | ** ** | **/ Other** | ** ** | **Total**  | ** ** |
| **2006**                        | ** ** | ** **   | ** ** | ** **    | ** ** | ** **         | ** ** | ** **       | ** ** | ** ** | ** ** |
| Revenues                        |       | $            | 1,103.6    |          | $          | 176.5              |       | $                | 97.5       |       | $          | — |   | $ | 1,377.6 |   |
| Segment operating income (loss) |       | 192.8        |       | (4.9          | )          | (3.1               | )          | (12.0            | )          | 172.8      |       |
| Depreciation and amortization   |       | 19.9         |       | 8.0           |       | 0.7                |       | 0.2              |       | 28.8       |       |
| Total assets                    |       | 664.3        |       | 153.2         |       | 22.7               |       | 192.1            |       | 1,032.3    |       |
| Capital expenditures            |       | 37.2         |       | 6.3           |       | —             |       | 0.5              |       | 44.0       |       |
|                            |       |         |       |          |       |               |       |             |       |       |       |
| **2005**                        | ** ** | ** **   | ** ** | ** **    | ** ** | ** **         | ** ** | ** **       | ** ** | ** ** | ** ** |
| Revenues                        |       | $            | 1,009.8    |          | $          | 181.5              |       | $                | 93.8       |       | $          | — |   | $ | 1,285.1 |   |
| Segment operating income (loss) |       | 229.5        |       | (4.1          | )          | 3.3                |       | (6.9             | )          | 221.8      |       |
| Depreciation and amortization   |       | 18.6         |       | 8.5           |       | 0.7                |       | 0.1              |       | 27.9       |       |
| Total assets                    |       | 485.7        |       | 143.2         |       | 20.3               |       | 330.1            |       | 979.3      |       |
| Capital expenditures            |       | 17.7         |       | 3.1           |       | —             |       | 0.2              |       | 21.0       |       |
|                            |       |         |       |          |       |               |       |             |       |       |       |
| **2004**                        | ** ** | ** **   | ** ** | ** **    | ** ** | ** **         | ** ** | ** **       | ** ** | ** ** | ** ** |
| Revenues                        |       | $            | 695.4      |          | $          | 175.1              |       | $                | 96.3       |       | $          | — |   | $ | 966.8 |   |
| Segment operating income (loss) |       | 105.8        |       | (1.5          | )          | 19.5               |       | (6.4             | )          | 117.4      |       |
| Depreciation and amortization   |       | 16.9         |       | 9.9           |       | 0.9                |       | 0.1              |       | 27.8       |       |
| Total assets                    |       | 359.1        |       | 164.5         |       | 25.0               |       | 98.1             |       | 646.7      |       |
| Capital expenditures            |       | 11.0         |       | 1.9           |       | —             |       | 0.1              |       | 13.0       |       |

 

**GOODWILL — NOTE C**

All acquisitions  have beenaccounted for under the purchase method of accounting, and accordingly, thepurchase price has been allocated to the assets acquired and the liabilitiesassumed based upon fair values at the date of the acquisition.  The excess purchase price over the fair valueof the tangible and intangible net assets acquired has been recorded asgoodwill.

The Company completes the annual goodwill impairment test during thefourth quarter of each subsequent year. The Company estimates the fair value of each reporting unit using apresent value method that discounts estimated future cash flows. The cash flowestimates incorporate assumptions on future cash flow growth, terminal values,and discount rates.  Lone Star’s annualgoodwill impairment measurement date is December 1.

49

----

As of both December 31, 2006 and 2005, Lone Star’s oilfield andspecialty tubing segments included $14.9 million and $26.0 million of goodwill,respectively.  There were no changes inthe carrying amount of goodwill for the years ended December 31, 2006 and 2005.

**INVESTMENTS — NOTE D**

Investmentsin available-for-sale debt securities were as follows at December 31, 2006:
| ** **                                                                      | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** |
|---------------------------------------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------------|------------|
| ** **                                                                      | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Estimated**       | ** ** |
| ** **                                                                      | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| **Available-for-Sale Securities  (carried at fair value):** | ** ** | ** **    | ** ** | ** **     | ** ** | ** **     | ** ** | ** **          | ** ** |
| Municipal securities                                                            |       | 65.9          |       | —         |       | —         |       | 65.9                |       |
| Debt securities                                                                 |       | 54.5          |       | —         |       | —         |       | 54.5                |       |
|                                                                            |       | 120.4         |       | —         |       | —         |       | 120.4               |       |
| Total investment in  debt securities                                            |       | $             | 120.4      |           | $          | —         |       | $                   | —     |   | $ | 120.4 |   |
|                                                                                 |            |               |            |                |            |                |            |                     |            |  |  |  |  |

 

Investments inheld-to-maturity and available-for-sale debt securities were as follows atDecember 31, 2005:
| ** **                                                                        | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------------|------------|
| ** **                                                                        | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Estimated**       | ** ** |
| ** **                                                                        | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| **Held-to-Maturity Securities  (carried at amortized cost):** | ** ** | ** **    | ** ** | ** **     | ** ** | ** **     | ** ** | ** **          | ** ** |
| U.S. government and agencies                                                      |       | $             | 6.0        |           | $          | —         |       | $                   | —     |   | $ | 6.0 |   |
| Debt securities of public companies                                               |       | 17.0          |       | —         |       | 0.1            |       | 16.9                |       |
|                                                                              |       | 23.0          |       | —         |       | 0.1            |       | 22.9                |       |
| **Available-for-Sale  Securities**                                                |       |          |       |           |       |           |       |                |       |
| **(carried  at fair value):**                                                     |       |          |       |           |       |           |       |                |       |
| Municipal securities                                                              |       | 33.2          |       | —         |       | —         |       | 33.2                |       |
| Debt securities                                                                   |       | 97.3          |       | —         |       | —         |       | 97.3                |       |
|                                                                              |       | 130.5         |       | —         |       | —         |       | 130.5               |       |
| Total investment in debt  securities                                              |       | $             | 153.5      |           | $          | —         |       | $                   | 0.1        |   | $ | 153.4 |   |

 

TheCompany did not have any held-to-maturity securities at December 31, 2006.  The amortized cost of investments inavailable-for-sale debt securities equaled fair value at December 31, 2006.  The weighted-average maturities of theCompany’s available-for-sale securities were approximately 19 days at December31, 2006.  The weighted averagematurities of the Company’s held-to-maturity and available-for-sale securitieswere approximately 153 days and 15 days, respectively, at December 31,2005.  The contractual maturities ofheld-to-maturity and available-for-sale securities at December 31, 2006, wereall due in less than one year.

Proceedsfrom sales of available-for-sale securities were $371.4 million and $227.3million in fiscal 2006 and 2005, respectively. No realized gain or loss was recognized upon the sale of thesesecurities in 2006 and 2005.  Thespecific identification method is used to account for gains and losses onavailable-for-sale securities.

**DEBT — NOTE E**

In December 2006, Lone Star amended and restated its $125 million creditfacility to increase the total available borrowings to $225 million andextended the expiration date to December 2010. Borrowings under the credit facility can be used for 

50

----

general corporate purposes and are collateralized by substantially allof Lone Star’s assets, other than real estate. At Lone Star’s option, the interest rate is the prime lending rate orthe LIBOR, plus the applicable additional interest.  Under the agreement, Lone Star can borrow anamount based on a borrowing base of 85% of eligible accounts receivable plusthe lesser of 70% of eligible inventory or $155.0 million, reduced byoutstanding letters of credit, which totaled $0.7 million at December 31,2006.  The credit facility remainsundrawn and the total availability was $224.3 million at December 31,2006.  At December 31, 2006, the Companywas in compliance with the facility’s covenants, and does not anticipatenoncompliance in the foreseeable future.

Steel engages in slab consignment and sales agreements with thirdparties.  Under these agreements, Steelarranges for third parties to purchase slabs from vendors that manufacture theslabs and the third party consigns the slab inventory to Steel.  Steel is then required to repurchase the slabinventory based on usage within specified time periods.  These inventory financing transactions havebeen accounted for as product financing arrangements.  Inventory financed under these arrangementsis recorded as inventory by Steel.  AtDecember 31, 2006, there was $25.7 million included in accounts payable underthese financing arrangements.  There wereno amounts recorded in accounts payable for financed inventory at December 31,2005.

In 2001, the Company issued$150.0 million of 9% senior subordinated notes due June 1, 2011 (the “SeniorNotes”).   On June 1, 2006, the Companyexercised its option to redeem the Senior Notes at 104.5% of their principalamount, plus accrued and unpaid interest. The Company paid cash of $163.5 million for the $150 million ofprincipal on the Senior Notes, a premium of $6.8 million for early redemption,and $6.7 million of accrued and unpaid interest.  Related to this early extinguishment of theSenior Notes, the Company recognized a loss on early extinguishment of debt of$9.3 million comprised of the $6.8 million premium and $2.5 million ofunamortized debt issuance costs associated with the Senior Notes.

Total interest incurred including amortization of deferred financingcosts was $9.9 million, $16.1 million, and $16.8 million for the years endedDecember 31, 2006, 2005, and 2004, respectively.

**SHAREHOLDERS’EQUITY — NOTE F**

In October, 2006, the Company’s Board of Directors authorized a $100million stock buy-back program, which will expire December 31, 2007.  Under the program, a total of 111,900 sharesat a cost of $5.5 million or a weighted-average price of $48.70 wererepurchased as treasury shares.  Theadditional shares held in treasury at December 31, 2006 and 2005, result fromthe Company’s withholding of an equivalent number of shares for federal andstate taxes related to the Company’s long-term incentive employee benefitplan.  For the year ended December 31,2005, 217,000 shares were utilized for the satisfaction of stock issuancesunder the Company’s long-term incentive plan and the Company withheld 31,904shares for federal and state taxes.  The181,249 and 10,862 treasury shares held as of December 31, 2006, and 2005,respectively, are reported at their acquired cost.

The following table (in whole shares) identifies changes in common stockissued and treasury stock from January 1, 2004 to December 31, 2006 (not inmillions):

 
| ** **                  | ** ** | ** ** | ** ** | **Treasury** | ** ** | ** **      | ** ** |
|-----------------------------|------------|------------|------------|--------------|------------|-----------------|------------|
| ** **                  | ** ** | **Issued** | ** ** | **Stock**    | ** ** | **Outstanding** | ** ** |
| Balance, January  1, 2004   |       | 28,660,903 |       | (174,107     | )          | 28,486,796      |       |
| Employee benefit plans      |       | 579,963    |       | (21,851      | )          | 558,112         |       |
| Balance,  December 31, 2004 |       | 29,240,866 |       | (195,958     | )          | 29,044,908      |       |
| Employee benefit plans      |       | 1,359,339  |       | 185,096      |       | 1,544,435       |       |
| Balance,  December 31, 2005 |       | 30,600,205 |       | (10,862      | )          | 30,589,343      |       |
| Employee benefit plans      |       | 440,669    |       | (58,487      | )          | 382,182         |       |
| Treasury stock purchase     |       | —     |       | (111,900     | )          | (111,900        | )          |
| Balance, December 31,  2006 |       | 31,040,874 |       | (181,249     | )          | 30,859,625      |       |

 

51

----

**EARNINGS PER SHARE — NOTE G**

Basic earnings per share is computed by dividing net income by theweighted-average number of shares of common stock outstanding.   Diluted earnings per share is computed bydividing net income by the weighted-average number of shares of common stockoutstanding and other dilutive securities.

 
| ** **                                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Numerator:                                           |       |     |       |     |       |     |       |
| Net income                                           |       | $        | 108.2      |     | $          | 223.6    |       | $ | 101.0 |   |
|                                                 |       |     |       |     |       |     |       |
| Denominator:                                         |       |     |       |     |       |     |       |
| Weighted-average shares used to compute basic EPS    |       | 30.6     |       | 30.0     |       | 28.7     |       |
| Effect of dilutive securities:                       |       |     |       |     |       |     |       |
| Stock options and restricted stock                   |       | 0.6      |       | 0.5      |       | 0.5      |       |
| Weighted-average  shares used to compute diluted EPS |       | 31.2     |       | 30.5     |       | 29.2     |       |
|                                                      |            |          |            |          |            |          |            |  |  |  |

 

In 2004, optionsto purchase 1.1 million shares of Lone Star stock were excluded from thecalculation of diluted earnings per share as inclusion of such options wouldhave been anti-dilutive.

 

52

----

**Additional Balance Sheet Information — Note  H**
|                                                | ** ** | **At December 31,** | ** ** |
|------------------------------------------------|------------|-------------------------------|------------|
| ** **                                     | ** ** | **2006**                      | ** ** | **2005** | ** ** |
| ***Inventories***                              |       |                          |       |   |   |
| Finished goods                                 |       | $                             | 217.0      |   | $ | 121.7 |   |
| Work in process                                |       | 158.9                         |       | 129.0 |   |
| Raw materials                                  |       | 147.1                         |       | 105.6 |   |
| Materials, supplies, and other                 |       | 36.6                          |       | 29.5 |   |
| ***Total inventories at FIFO***                |       | 559.6                         |       | 385.8 |   |
| Reserve to reduce inventories to LIFO value    |       | (169.6                        | )          | (135.1 | ) |
| ***Total inventories***                        |       | 390.0                         |       | 250.7 |   |
| Amount included in other noncurrent assets     |       | (5.1                          | )          | (5.7 | ) |
| ***Inventories, current***                     |       | $                             | 384.9      |   | $ | 245.0 |   |
| *** ***                                   |       |                          |       |   |   |
| ***Other  current assets***                    |       |                          |       |   |   |
| Insurance and other deposits                   |       | $                             | 1.0        |   | $ | 3.6 |   |
| Inventory deposit                              |       | 2.0                           |       | 3.0 |   |
| Deferred compensation                          |       | 0.3                           |       | 0.2 |   |
| Other                                          |       | 5.0                           |       | 6.8 |   |
| ***Total other current assets***               |       | $                             | 8.3        |   | $ | 13.6 |   |
| *** ***                                   |       |                          |       |   |   |
| ***Property,  plant, and equipment***          |       |                          |       |   |   |
| Land and land improvements                     |       | $                             | 19.0       |   | $ | 18.0 |   |
| Buildings, structures, and improvements        |       | 34.6                          |       | 33.0 |   |
| Machinery and equipment                        |       | 473.1                         |       | 447.5 |   |
| Construction in progress                       |       | 22.7                          |       | 9.3 |   |
| ***Total property, plant, and  equipment***    |       | 549.4                         |       | 507.8 |   |
| Less accumulated depreciation and amortization |       | (336.1                        | )          | (310.3 | ) |
| ***Property, plant, and equipment,  net***     |       | $                             | 213.3      |   | $ | 197.5 |   |
| *** ***                                   |       |                          |       |   |   |
| ***Other  noncurrent assets***                 |       |                          |       |   |   |
| Inventory (supplies and spare parts)           |       | $                             | 5.1        |   | $ | 5.7 |   |
| Insurance and other deposits                   |       | —                        |       | 4.3 |   |
| Deferred compensation                          |       | 5.6                           |       | 3.1 |   |
| Deferred financing costs                       |       | —                        |       | 3.0 |   |
| Other                                          |       | 6.5                           |       | 3.9 |   |
| ***Total other noncurrent assets***            |       | $                             | 17.2       |   | $ | 20.0 |   |
| *** ***                                   |       |                          |       |   |   |
| ***Accrued  liabilities***                     |       |                          |       |   |   |
| Accrued compensation                           |       | $                             | 14.1       |   | $ | 20.0 |   |
| Warranty reserves                              |       | 3.4                           |       | 3.0 |   |
| Environmental reserves                         |       | 1.7                           |       | 1.3 |   |
| Pension obligations                            |       | 2.2                           |       | 4.1 |   |
| Taxes payable                                  |       | 2.2                           |       | 7.8 |   |
| Note payable to joint venture                  |       | 12.5                          |       | — |   |
| Other                                          |       | 19.2                          |       | 17.5 |   |
| ***Total accrued liabilities***                |       | $                             | 55.3       |   | $ | 53.7 |   |
| *** ***                                   |       |                          |       |   |   |
| ***Other  noncurrent liabilities***            |       |                          |       |   |   |
| Environmental reserves                         |       | $                             | 7.2        |   | $ | 7.9 |   |
| Note payable to joint venture                  |       | 6.3                           |       | — |   |
| Other                                          |       | 7.1                           |       | 5.3 |   |
| ***Total  other noncurrent liabilities***      |       | $                             | 20.6       |   | $ | 13.2 |   |

 

53

----

During 2004, inventory quantities were reduced. This reduction resultedin a liquidation of LIFO inventory layers, the effect of which increased netincome by approximately $17.9 million or $0.61 per diluted share.  There were no reductions of LIFO inventorylayers in 2006 and 2005.

**INCOME TAXES - NOTEI**

Income tax expense (benefit) was $59.3 million, ($3.4) million, and $3.4million for 2006, 2005, and 2004, respectively. For 2006, 2005, and 2004, substantially all of the income fromcontinuing operations was earned domestically.

The income tax provision from continuing operations consisted of thefollowing:
| ** **                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                           |       |     |       |     |       |     |       |
| Federal and  Payments in lieu      |       | $        | 48.3       |     | $          | 2.9      |       | $ | 1.2 |   |
| State                              |       | 3.8      |       | 7.0      |       | 2.2      |       |
| Total current                      |       | $        | 52.1       |     | $          | 9.9      |       | $ | 3.4 |   |
|                               |       |     |       |     |       |     |       |
|                               |       |     |       |     |       |     |       |
| Deferred:                          |       |     |       |     |       |     |       |
| Federal and  Payments in lieu      |       | $        | 6.0        |     | $          | (12.9    | )          | — |   |
| State                              |       | 1.2      |       | (0.4     | )          | —   |       |
| Total deferred                     |       | $        | 7.2        |     | $          | (13.3    | )          | $ | — |   |
|                               |       |     |       |     |       |     |       |
| Total income tax expense (benefit) |       | $        | 59.3       |     | $          | (3.4     | )          | $ | 3.4 |   |

 

A reconciliation of the U.S. federal statutory rate to actual income tax(benefit) expense is as follows:
| ** **                                            | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expense at U.S.  statutory rate                       |       | $        | 58.6       |     | $          | 77.1     |       | $ | 36.5 |   |
| State and other income  taxes, net of federal benefit |       | 3.3      |       | 4.6      |       | 3.4      |       |
| Manufacturing  incentives, including benefits in lieu |       | (1.0     | )          | —   |       | —   |       |
| Tax-exempt interest                                   |       | (1.8     | )          | —   |       | —   |       |
| Change in valuation  allowance                        |       | 0.4      |       | (83.2    | )          | (36.6    | )          |
| Other                                                 |       | (0.2     | )          | (1.9     | )          | 0.1      |       |
| Total income tax  expense (benefit)                   |       | $        | 59.3       |     | $          | (3.4     | )          | $ | 3.4 |   |

 

In connection with its 1988 acquisition of American Federal Bank, F.S.B.(“AFB”), the Company entered into an agreement (the “Assistance Agreement”)with the Federal Savings and Loan Insurance Corporation (“FSLIC”), which provides,in part, that the federal and state tax savings attributable to the Company’sutilization of AFB’s tax loss carryovers and certain other tax benefit itemsattributable to the period of the Company’s ownership of AFB are to be paid bythe Company to the FSLIC.  The successor in interest to the FSLIC is theFSLIC Resolution Fund (the “Resolution Fund”), which is administered by theFederal Deposit Insurance Corporation.  Under the Assistance Agreement,the benefit due to the Resolution Fund is generally computed by comparing ahypothetical calculation of what the Company’s tax liability would have beenwithout any of the AFB-related tax benefit items to its actual tax liabilityfor a particular year.  Income tax expense represents obligations that maybe payable to the FDIC in lieu of payment to the IRS, in addition to federaland state income taxes.  The Company hassignificant NOLs for purposes of its reporting to the IRS, but considers onlythose NOLs that reduce payments to both the IRS and FDIC as tax assets.  The Company has an AMT credit carryforwardtotaling $10.2 million that may be carried forward indefinitely under U.S. law.

54

----

The following table discloses the components of the deferred tax amountsat December 31, 2006 and 2005:
|                                             | ** ** | **2006**                                                       | ** ** | **2005**                                                             | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| **Deferred  tax assets:**                   |       |                                                           |       |                                                                 |       |
| Postretirement benefit accruals             |       | **$         5.5** | ** ** | **$          5.5** |       |
| Environmental reserves                      |       | 3.2                                                            |       | 3.5                                                                  |       |
| Other expense accruals and reserves         |       | 11.9                                                           |       | 10.2                                                                 |       |
| Inventories                                 |       | 1.7                                                            |       | 11.8                                                                 |       |
| Other                                       |       | 2.3                                                            |       | 1.2                                                                  |       |
| Pension Liability                           |       | 9.6                                                            |       | 10.0                                                                 |       |
| Net operating loss carryforwards            |       | 3.4                                                            |       | 30.4                                                                 |       |
| Alternative minimum tax credit carryforward |       | 10.2                                                           |       | 6.8                                                                  |       |
| Total deferred tax assets                   |       | 47.8                                                           |       | 79.4                                                                 |       |
|                                        |       |                                                           |       |                                                                 |       |
| **Deferred  tax liabilities:**              |       |                                                           |       |                                                                 |       |
| ** **                                  |       |                                                           |       |                                                                 |       |
| Property, plant and equipment               |       | (35.8                                                          | )          | (39.8                                                                | )          |
|                                        |       |                                                           |       |                                                                 |       |
| Net deferred tax  assets                    |       | 12.0                                                           |       | 39.6                                                                 |       |
| Less valuation  allowance                   |       | (3.2                                                           | )          | (2.8                                                                 | )          |
| Net deferred tax  amount                    |       | $                                                              | 8.8        |                                                                 | $          | 36.8 |   |
|                                             |            |                                                                |            |                                                                      |            |  |  |

 

In assessing the realization of deferred tax assets, managementconsiders whether it is more likely than not that some portion or all of thedeferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon thegeneration of future taxable income during the periods in which those temporarydifferences become deductible. Management considers the scheduled reversal of deferred tax items,projected future taxable income, and tax planning strategies in making thisassessment.  As of December 31, 2006,management believes it is more likely than not that all of the net deferred taxassets will be realized with the exception of loss carryforwards in foreign andcertain state jurisdictions for which a valuation allowance has been provided.

On May 18, 2006, the Texas Governor signed into law a Texas margin tax(H.B. No. 3), which restructures the state business tax by replacing thetaxable capital and earned surplus components of the current franchise tax witha new “taxable margin” component.  Because the tax base on the Texasmargin tax is derived from an income-based measure, we believe the margin taxis an income tax and, therefore, the provisions of SFAS 109 regarding therecognition of deferred taxes apply to the new margin tax.  In accordancewith SFAS 109, the effect on deferred tax assets of a change in tax law shouldbe included in tax expense attributable to continuing operations in the periodthat includes the enactment date.   Therefore, the Company hasrecalculated its deferred tax assets and liabilities for Texas based on the newmargin tax and the change was recorded in 2006.  The impact of the changein deferred tax was not a material impact.

Included in income tax expense for the year ended December 31, 2006, areinterest and penalties related to income tax uncertainties.  Management believes recording interest andpenalties related to income tax uncertainties as income tax expense betterreflects income tax expense and provides better information reporting.

No provision has been made for income taxes, which may become payableupon distribution of the foreign subsidiaries’ earnings since cumulative basislosses have been generated.

**Employee Benefit Plans - Note J**

***Defined contribution plans*****.** Defined contribution plans are available to substantially all full-timeemployees under which participants can make voluntary pretaxcontributions.  For nonbargaining unitemployees, matching contributions are provided within specified limits.  Through December 2006, Steel madecontributions at rates specified under collective bargaining agreements for itsbargaining unit employees.  Contributionstotaled $2.2 million, $3.4 million, and $3.4 million for the years endedDecember 31, 2006, 2005, and 2004, respectively.

***Nonqualified deferred compensationplan*****.**  The Company has a nonqualified deferredcompensation plan for certain management personnel and highly compensated employeesof Lone Star and its subsidiaries that provides eligible employees theopportunity to defer a specified percentage of their cash compensation.  Participants may elect to defer up to 

55

----

50% of total compensation and Lone Star will match 60% of the amountdeferred by each employee with the matching not to exceed $40,000.  The obligation included in other noncurrentliabilities was $5.4 million and $3.4 million at December 31, 2006 and 2005,respectively.

***Employee stock purchase plan***.  TheCompany has an employee stock purchase plan for all eligible employees.  Eligible employees include all regularfull-time employees of Lone Star and its subsidiaries who have been employedfor at least 12 months.  Eligibleemployees may defer up to 5% of their compensation for each quarter for thepurchase of Lone Star common stock. Shares are purchased at the end of each quarter at a price equal to thelower of: (a) 90% of the market price of Lone Star’s common stock on the firstday of the quarter, or (b) 90% of the market price of Lone Star’s common stockon the last day of the quarter.  Themaximum number of Lone Star shares that may be purchased for all participantsunder the plan is 200,000 shares, of which 146,219 shares were available to beissued at December 31, 2006.

***Long-term incentive plan***.  LoneStar has a long-term incentive plan which provides for the issuance of upto 6,700,000 shares of common stock to key employees and outside directorsthrough the granting of incentive and nonqualified stock options, stockappreciation rights, restricted stock grants, and performance unit grants.  The option price is the average of the highand low market price on the date of the grant. Options are generally exercisable for 10 years with one-fourth ofthe shares becoming exercisable on the one-year anniversary of the grant dateand an additional one-fourth becoming exercisable on the same anniversarydate over the next three years.  No stockoptions were granted in 2006 and 2005. In 2004, 293,500 options were granted to certain key employees andoutside directors that become fully exercisable on the one-year anniversary ofthe grant date and are exercisable for five years.  For all options granted, if the optionee’semployment is terminated under certain circumstances after a change of controlof Lone Star occurs before an option’s fourth anniversary, the option may beexercised in full earlier.  Also,accelerated vesting of options can occur upon death or retirement fromemployment of an option holder.

During the year endedDecember 31, 2006, Lone Star recorded $5.9 million of non-cash charges forstock compensation related to amortization of the fair value of restrictedstock and unvested stock options to operating income and income before incometax.  This represents a $1.6 millionincrease from the stock compensation that would have been recorded under APB 25for the year ended December 31, 2006. The adoption of SFAS 123R reduced net income by $1.0 million for theyear ended December 31, 2006 and reduced both basic EPS and diluted EPS by$0.03.  Net cash proceeds from theexercise of stock options during the years ended December 31, 2006, 2005 and2004 were $6.4 million, $36.6 million and $6.4 million.  The associated income tax benefit from stockoptions exercised during the years ended December 31, 2006, 2005 and 2004 were$2.4 million, $10.4 million and $0 million.

The following table reflectsthe compensation expense recognized and associated income tax benefit fromstock options exercised for the years ended December 31, 2006, 2005 and 2004:

|                      | ** ** | **Actual** 2006 | ** ** | **Proforma** 2005 | ** ** | **Proforma** 2004 | ** ** |
|----------------------|------------|----------------------|------------|------------------------|------------|------------------------|------------|
| Compensation expense |       | $                    | 5.9        |                   | $          | 7.3                    |       | $ | 7.5 |   |
| Income tax benefits  |       | 2.1                  |       | —                 |       | —                 |       |
|                      |            |                      |            |                        |            |                        |            |  |  |  |

 

The weighted-average fair value per option granted in 2004 was $8.58. Nooptions were granted in 2005 and 2006. The fair value of each option grant is estimated on the date of grantusing the Black-Scholes option-pricing model with the followingweighted-average assumptions for grants in 2004: risk-free interest rate of2.61%; volatility of 63.19%; expected life of 3.5 years; and, all option grantswithout payment of dividends.  Toestimate options expected to vest, Lone Star used a forfeiture rate of 4% and arisk-free interest rate based on the U.S Treasury constant maturity interestrate whose term is consistent with the expected life of the stock options.  The volatility is estimated based onhistorical stock date for Lone Star.  Theexpected life of stock options is estimated based on historicalexperience.  Beginning on the date ofadoption of SFAS 123R, forfeitures of options are estimated based on historicalexperience.  Prior to the date ofadoption, forfeitures were recorded as they occurred.

56

----

TheCompany previously applied the intrinsic value method provisions of AccountingPrinciples Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB25”), and related interpretations for stock-based compensation.  Accordingly, the Company recognizedcompensation expense on the Company’s restricted stock awards, but no compensationexpense was recognized for stock option plans as all option grants under theplan had an exercise price equal to the market value of the underlying commonstock on the date of grant.   Aspermitted, the Company had previously elected to adopt the disclosure-onlyprovisions of SFAS 123.  Had compensationcost for stock options awards been recorded for the year ended December 31,2005 and 2004 consistent with SFAS 123R, net income and earnings per sharewould have been reduced to the following amounts:

|                                                                                                                                               | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net income as reported                                                                                                                        |       | $        | 223.6      |     | $          | 101.0 |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects                                  |       | 3.5      |       | 1.6      |       |
| Deduct: Total  stock-based employee compensation expense determined under fair-value-based method  for all awards, net of related tax effects |       | (7.3     | )          | (7.5     | )          |
| Pro forma net  income                                                                                                                         |       | $        | 219.8      |     | $          | 95.1 |   |
|                                                                                                                                          |       |     |       |     |       |
| Basic earnings per  share                                                                                                                     |       |     |       |     |       |
| as reported                                                                                                                                   |       | $        | 7.44       |     | $          | 3.51 |   |
| pro forma                                                                                                                                     |       | $        | 7.33       |     | $          | 3.31 |   |
| Diluted earnings per  share                                                                                                                   |       |     |       |     |       |
| as reported                                                                                                                                   |       | $        | 7.34       |     | $          | 3.46 |   |
| pro forma                                                                                                                                     |       | $        | 7.21       |     | $          | 3.26 |   |

 

57

----

The followingsummarizes the stock option activity for the years shown (not in millions):

|                                         | ** ** | ** **         | ** ** | ** **              | ** ** | **Weighted-**           | ** ** | ** **                    | ** ** |
|-----------------------------------------|------------|--------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **                              | ** ** | ** **         | ** ** | **Weighted-**           | ** ** | **Average**             | ** ** | **Aggregate**                 | ** ** |
| ** **                              | ** ** | **Number of** | ** ** | **Average**             | ** ** | **Remaining Life** | ** ** | **Intrinsic Value**      | ** ** |
| **Stock Options Outstanding** | ** ** | **Options**        | ** ** | **Exercise Price** | ** ** | **(in years)**     | ** ** | **($ in millions)** | ** ** |
| Outstanding, December  31, 2003         |       | 2,613,225          |       | $                       | 24.95      |                    |       |                          |       |   |
| Granted                                 |       | 394,000            |       | 18.19                   |       |                    |       |                          |       |
| Exercised                               |       | (449,025           | )          | 14.35                   |       |                    |       |                          |       |
| Cancelled/forfeited                     |       | (75,150            | )          | 34.71                   |       |                    |       |                          |       |
| Outstanding, December  31, 2004         |       | 2,483,050          |       | $                       | 25.49      |                    | 5.7        |                          | $          | 23.7 |   |
| Granted                                 |       | —             |       | —                  |       |                    |       |                          |       |
| Exercised                               |       | (1,450,351         | )          | 25.23                   |       |                    |       |                          |       |
| Cancelled/forfeited                     |       | (35,125            | )          | 16.15                   |       |                    |       |                          |       |
| Outstanding, December  31, 2005         |       | 997,574            |       | $                       | 26.20      |                    | 5.5        |                          | $          | 25.4 |   |
| Granted                                 |       | —             |       | —                  |       |                    |       |                          |       |
| Exercised                               |       | (246,763           | )          | 25.75                   |       |                    |       |                          |       |
| Cancelled/forfeited                     |       | (15,500            | )          | 18.94                   |       |                    |       |                          |       |
| Outstanding, December 31, 2006          |       | 735,311            |       | $                       | 26.51      |                    | 4.6        |                          | $          | 16.2 |   |

 

|                                      | ** ** | ** **         | ** ** | ** **              | ** ** | **Weighted-**           | ** ** | ** **                    | ** ** |
|--------------------------------------|------------|--------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | ** **         | ** ** | **Weighted-**           | ** ** | **Average**             | ** ** | **Aggregate**                 | ** ** |
| ** **                           | ** ** | **Number of** | ** ** | **Average**             | ** ** | **Remaining Life** | ** ** | **Intrinsic Value**      | ** ** |
| **Unvested Stock Options** | ** ** | **Options**        | ** ** | **Exercise Price** | ** ** | **(in years)**     | ** ** | **($ in millions)** | ** ** |
| Outstanding, December  31, 2005      |       | 349,750            |       | $                       | 17.51      |                    | 7.1        |                          | $          | 11.9 |   |
| Granted                              |       | —             |       | —                  |       |                    |       |                          |       |
| Vested                               |       | (210,250           | )          | 17.51                   |       |                    |       |                          |       |
| Forfeited                            |       | (11,750            | )          | 16.31                   |       |                    |       |                          |       |
| Outstanding, December 31, 2006       |       | 127,750            |       | $                       | 17.62      |                    | 6.6        |                          | $          | 3.9 |   |

 

At December 31, 2006, 1,516,563 shares were available for futuregrant.  At December 31, 2006, 2005, and2004, 607,563, 647,825, and 1,442,706 options, respectively, wereexercisable.  The following tablesummarizes information with respect to options outstanding and exercisable atDecember 31, 2006 (not in millions):
| ** **                                                                                                               | ** ** | ** **         | ** ** | ** **   | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |          |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|--------------|------------|------------------------------|------------|------------------------------|------------|---------------|
| ** **                                                                                                               | ** ** | ** **         | ** ** | ** **   | ** ** | ** **                   | ** ** | ** **                   | ** ** | **Weighted-** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                               | ** ** | ** **         | ** ** | ** **   | ** ** | ** **                   | ** ** | **Weighted-**                | ** ** | **Average**   | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                                                                                               | ** ** | ** **         | ** ** | ** **   | ** ** | ** **                   | ** ** | **Average**                  | ** ** | **Remaining** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**                                                                                                        | ** ** | **Number of** | ** ** | **Exercise** | ** ** | **Contractual**              | ** ** | **Number of**           | ** ** | **Exercise**  | ** ** |
| **Exercise Prices**                                                                                                 | ** ** | **Shares**         | ** ** | **Price**    | ** ** | **Life (Yrs.)**         | ** ** | **Shares**                   | ** ** | **Price**     | ** ** |
|                                                                                                                     |       |               |       |         |       |                         |       |                         |       |          |   |   |   |   |   |
| $                   14.31 |       | —             |       | $            | 16.52      |                         | 204,250    |                         | $          | 16.01         |   | 5.7 |   | 136,750 |   | $ | 15.87 |   |
| 16.75                                                                                                                    |       | —             |       | 20.94        |       | 112,936                      |       | 18.57                        |       | 4.1           |   | 71,436 |   | 19.37 |   |
| 21.82                                                                                                                    |       | —             |       | 27.53        |       | 156,250                      |       | 24.56                        |       | 5.0           |   | 137,500 |   | 24.72 |   |
| 34.06                                                                                                                    |       | —             |       | 50.06        |       | 261,875                      |       | 39.28                        |       | 3.7           |   | 261,875 |   | 39.28 |   |
| $                   14.31 |       | —             |       | $            | 50.06      |                         | 735,311    |                         | $          | 26.51         |   | 4.6 |   | 607,561 |   | $ | 28.38 |   |
|                                                                                                                          |            |                    |            |              |            |                              |            |                              |            |               |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

58

----

Summarized beloware outstanding options that are fully exercisable.

|                                       | ** ** | ** **         | ** ** | **Weighted-**                 | ** ** | **Weighted-**           | ** ** | ** **                    | ** ** |
|---------------------------------------|------------|--------------------|------------|-------------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **                            | ** ** | ** **         | ** ** | **Average**                   | ** ** | **Average**             | ** ** | **Aggregate**                 | ** ** |
| ** **                            | ** ** | **Number of** | ** ** | **Exercise Price**       | ** ** | **Remaining Life** | ** ** | **Intrinsic Value**      | ** ** |
| **Options Exercisable at:** | ** ** | **Options**        | ** ** | **($ in millions)** | ** ** | **(in years)**     | ** ** | **($ in millions)** | ** ** |
| December 31, 2004                     |       | 1,442,706          |       | $                             | 29.50      |                    | 5.2        |                          | $          | 8.7 |   |
| December 31, 2005                     |       | 647,825            |       | $                             | 30.89      |                    | 4.6        |                          | $          | 13.5 |   |
| December 31, 2006                     |       | 607,561            |       | $                             | 28.38      |                    | 4.1        |                          | $          | 12.2 |   |

 

Lone Star also issued 156,700, 152,950, and 137,500 shares of restrictedstock grants to certain employees and outside directors, with a value at grantdate of $7.9 million, $7.1 million, and $2.5 million during 2006, 2005, and2004, respectively.

|                                       | ** ** | ** **         | ** ** | ** **            | ** ** | **Weighted-**           | ** ** |
|---------------------------------------|------------|--------------------|------------|-----------------------|------------|-------------------------|------------|
| ** **                            | ** ** | ** **         | ** ** | **Weighted-**         | ** ** | **Average**             | ** ** |
| ** **                            | ** ** | **Number of** | ** ** | **Average Fair** | ** ** | **Remaining Life** | ** ** |
| **Restricted Stock Grants** | ** ** | **Shares**         | ** ** | **Value**             | ** ** | **(in years)**     | ** ** |
| Outstanding, December  31, 2005       |       | 356,044            |       | $                     | 35.76      |                    | 3.0        |   |
| Granted                               |       | 156,700            |       | 50.28                 |       | 4.6                     |       |
| Vested                                |       | (163,889           | )          | 28.90                 |       | —                  |       |
| Forfeited                             |       | (17,850            | )          | 26.69                 |       | 3.9                     |       |
| Outstanding, December 31, 2006        |       | 331,005            |       | 46.36                 |       | 4.2                     |       |
|                                       |            |                    |            |                       |            |                         |            |  |

 

The shares generally vest ratably over a four-, five-, or six-yearperiod beginning on the second anniversary of date of grant.  The fair value of restricted stock is chargedto Shareholders’ Equity and amortized to expense over the requisite vestingperiods.  In 2006, shares were granted tocertain key employees and outside directors with accelerated vesting provisionsbased on the achievement of certain performance objectives.  If performance objectives are met, one thirdof the shares become vested on the first, second, and third anniversaries, andto certain key employees with 4-year split cliff vesting provisions.  In 2005, shares were granted to certain keyemployees and outside directors with accelerated vesting provisions based onthe achievement of certain performance objectives.  The performance objective was met in2005.  One third of the shares vested in2006.  In 2004, shares were granted tocertain key employees and outside directors with accelerated vesting provisionsbased on the achievement of certain performance objectives.  The performance objectives were met andone-third of the shares were vested in 2005 and the remaining two-thirds werevested in 2006.  The Company recognizedcompensation expense in 2006, 2005, and 2004 related to all awards of $4.3million, $3.5 million, and $1.6 million, respectively, which includedrecognition of expense in 2005 and 2004 related to the acceleration of vestingfor achievement of certain 2004 performance objectives.  As of December 31, 2006, there was $15.3million of total unrecognized compensation cost related to non-vestedrestricted stock.  That cost is expectedto be recognized over a weighted-average period of 4.2 years.

The Company has elected to apply the short-cutmethod to determine the hypothetical additional paid-in capital (“APIC”) poolprovided by FSP SFAS 123(R) — 3, (*TransitionElection Related to Accounting for the Tax Effects of Share-Based PaymentAwards*).  The Company haddetermined that a hypothetical pool of excess tax benefits existed in APIC asof January 1, 2006, the date of adoption of SFAS 123R, related to historicalstock option exercises.  In futureperiods, excess tax benefits resulting from stock option exercises will berecognized as additions to APIC in the period the benefit is realized.  In the event of a shortfall (i.e., the taxbenefit realized is less than the amount previously recognized through periodicstock compensation expense recognition and related deferred tax accounting),the shortfall would be charged against APIC to the extent of previous excessbenefits, if any, including the hypothetical APIC pool, and then to taxexpense.

***Defined Benefit Pension and Postretirement Benefit Plans*****.**  Steelhas three defined benefit pension plans covering substantially all of itsbargaining unit employees.  Retirement benefits are based on flat-rateamounts for years of service.  A special initial lump-sum pension paymentequal to 13 weeks of vacation pay is also paid following retirement.

During 1996 and 1998, thethree pension plans were amended so that new employees hired after the dates ofsuch amendments did not participate in the defined benefit plans. However, existing employees continued to accrue pension 

59

----

benefits under theplans.  New employees were only eligibleto participate in one of the defined contribution retirement plans.  In September 2005, two of the three largestpension plans were again amended so that substantially all of such employeeswere eligible to begin accruing defined pension benefits under the plans.  Concurrent with the implementation of thedefined benefit plan amendments, the Company discontinued making employercontributions to the defined contribution retirement plans for these employees.

Steel also sponsors an unfunded defined benefit postretirement healthcare plan for eligible bargaining unit employees and a limited number of otherretirees eligible under special early retirement programs.  These healthcare plan benefits are limited to eligible retirees until age 65, at which timecoverage terminates.  The employeespouses’ coverage benefit term is limited to the earlier of five years from thedate of employee retirement or the spouse attaining age 65.  The Companyalso provides a postretirement benefit for life insurance to its bargainingunit employees.  The anticipated costs of these postretirement benefitsare accrued over the employees’ years of service.

At December 31, 2006, the Company adopted the recognition and disclosureprovisions of SFAS 158, which requires, among other things, the recognition ofthe funded status of its defined benefit plans on the balance sheet and thatchanges in that funded status be recognized in the year in which the changesoccur through comprehensive income.  Theinitial impact of the standard due to unrecognized prior service costs and netactuarial losses is recognized as a component of accumulated comprehensive lossin shareholders’ equity, net of tax. This new standard also requires the measurement of plan assets andbenefit obligations to be as of the same date as a company’s fiscal year end,with such requirement effective for fiscal years ending after December 15,2008.

The incremental effects of adopting the provisions of SFAS 158 on theCompany’s balance sheets at December 31, 2006, are presented in thefollowing table.  The adoption of SFAS158 had no effect on the Company’s consolidated results of operations for theyear ended December 31, 2006, or for any prior period presented, and it willnot affect the Company’s operating results in future periods.  Had the Company not been required to adoptSFAS 158 at December 31, 2006, it would have recognized only an additionalminimum liability adjustment for its pension obligations pursuant to Statementof Financial Accounting Standards No. 87. For the year ended December 31, 2006, the effect of recognizing theadditional minimum liability is included in the table below in the columnlabeled “Before Application of SFAS 158.”

|                                      | ** ** | **Before**                | ** ** | ** **      | ** ** | **After**                 | ** ** |
|--------------------------------------|------------|---------------------------|------------|-----------------|------------|---------------------------|------------|
| ** **                           | ** ** | **Application**           | ** ** | ** **      | ** ** | **Application**           | ** ** |
| ** **                           | ** ** | **of SFAS 158** | ** ** | **Adjustments** | ** ** | **of SFAS 158** | ** ** |
| Postretirement benefit  obligations  |       | $                         | 32.9       |            | $          | 9.1                       |       | $ | 42.0 |   |
| Other noncurrent assets              |       | 19.0                      |       | (1.8            | )          | 17.2                      |       |
| Deferred tax liability               |       | 15.5                      |       | (3.9            | )          | 11.6                      |       |
| Accumulated other comprehensive loss |       | (30.4                     | )          | (7.0            | )          | (37.4                     | )          |
|                                      |            |                           |            |                 |            |                           |            |  |  |  |

 

The Company utilized anannual measurement date of November 30th for its plans.  The following table sets forth the changes inthe plans’ benefit obligations, assets, and funded status, as well as the amountsrecognized in the consolidated balance sheets and accumulated othercomprehensive loss as of December 31, 2006 and 2005.

60

----

| ** **                                                      | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                                      | ** ** | **2006**                  | ** ** | **2005**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Change in Benefit Obligation**                                | ** ** | ** **                | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Benefit  obligation at beginning of year                        |       | $                         | 101.7      |                    | $          | 97.0 |   | $ | 24.8 |   | $ | 20.3 |   |
| Service cost                                                    |       | 2.9                       |       | 1.5                     |       | 0.9 |   | 0.6 |   |
| Interest cost                                                   |       | 5.7                       |       | 5.6                     |       | 1.4 |   | 1.2 |   |
| Plan participants’  contributions                          |       | —                    |       | —                  |       | 0.1 |   | 0.1 |   |
| Amendments                                                      |       | —                    |       | —                  |       | — |   | 1.6 |   |
| Special  termination benefits                                   |       | 0.2                       |       | 0.1                     |       | — |   | — |   |
| Actuarial loss  (gain)                                          |       | (0.2                      | )          | 4.1                     |       | 0.1 |   | 3.3 |   |
| Benefits paid                                                   |       | (7.0                      | )          | (6.6                    | )          | (2.2 | ) | (2.3 | ) |
| Projected  Benefit Obligation at end of year                    |       | $                         | 103.3      |                    | $          | 101.7 |   | $ | 25.1 |   | $ | 24.8 |   |
|                                                            |       |                      |       |                    |       |   |   |   |   |
| **Change in Plan Assets**                                       |       |                      |       |                    |       |   |   |   |   |
| Fair value of  plan assets at beginning of year                 |       | $                         | 74.1       |                    | $          | 67.7 |   | $ | — |   | $ | — |   |
| Actual return on  plan assets                                   |       | 8.8                       |       | 5.1                     |       | — |   | — |   |
| Employer  contributions                                         |       | 10.5                      |       | 7.9                     |       | 2.1 |   | 2.2 |   |
| Plan participants’  contributions                          |       | —                    |       | —                  |       | 0.1 |   | 0.1 |   |
| Benefits paid                                                   |       | (7.0                      | )          | (6.6                    | )          | (2.2 | ) | (2.3 | ) |
| Fair value of  plan assets at end of year                       |       | $                         | 86.4       |                    | $          | 74.1 |   | $ | — |   | $ | — |   |
|                                                            |       |                      |       |                    |       |   |   |   |   |
| **Funded Status**                                               |       |                      |       |                    |       |   |   |   |   |
| Unfunded status  at end of year                                 |       | $                         | 16.9       |                    | $          | 27.6 |   | $ | 25.1 |   | $ | 24.8 |   |
| Unrecognized  actuarial gain (loss)                             |       |                      |       | (34.5                   | )          |   |   | (8.6 | ) |
| Unrecognized  prior service cost                                |       |                      |       | (0.6                    | )          |   |   | (1.5 | ) |
| Net amount  recognized                                          |       |                      |       | $                       | (7.5       | ) |   |   | $ | 14.7 |   |
|                                                            |       |                      |       |                    |       |   |   |   |   |
| **Amounts Recognized in  Consolidated Balance Sheets**          |       |                      |       |                    |       |   |   |   |   |
| Postretirement  benefit obligations - current                   |       | $                         | —     |                    | $          | 2.0 |   | $ | 2.2 |   | $ | 2.1 |   |
| Postretirement  benefit obligations - noncurrent                |       | 16.9                      |       | 24.9                    |       | 22.9 |   | 14.2 |   |
| Other noncurrent  assets - intangible asset                     |       | —                    |       | (0.6                    | )          | — |   | (1.6 | ) |
| Accumulated  other comprehensive loss                           |       | —                    |       | (33.8                   | )          | — |   | — |   |
| Net amount  recognized                                          |       | $                         | 16.9       |                    | $          | (7.5 | ) | $ | 25.1 |   | $ | 14.7 |   |
|                                                            |       |                      |       |                    |       |   |   |   |   |
| **Amounts Recognized in  Accumulated Other Comprehensive Loss** |       |                      |       |                    |       |   |   |   |   |
| Net actuarial  loss                                             |       | $                         | (29.7      | )                       |       |   | $ | (8.3 | ) |   |   |
| Prior service  cost                                             |       | (0.4                      | )          |                    |       | (1.4 | ) |   |   |
| Total amount  recognized, before tax effects                    |       | $                         | (30.1      | )                       |       |   | $ | (9.7 | ) |   |   |

 

AtDecember 31, 2006, deferred tax assets (included in net deferred taxliabilities) of $2.7 million were recorded for the tax effects of the amountsrecognized in accumulated other comprehensive loss.  The accumulated benefit obligation for alldefined benefit pension plans was $102.5 million and $101.0 million at December31, 2006 and 2005, respectively.  Allplans had an accumulated benefit obligation in excess of plan assets for both2006 and 2005.

Thefollowing table shows the components of net periodic benefit expense for 2006,2005, and 2004, and the other changes in plan assets and benefit obligationsrecognized in other comprehensive income for 2006.

61

----

 
| ** **                                                                                         | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                                                                         | ** ** | **2006**                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net Periodic Benefit Expense**                                                                   |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| Service cost                                                                                       |       | $                         | 2.9        |                    | $          | 1.5 |   | $ | 1.0 |   | $ | 0.9 |   | $ | 0.7 |   | $ | 0.5 |   |
| Interest cost                                                                                      |       | 5.7                       |       | 5.6                     |       | 5.7 |   | 1.4 |   | 1.2 |   | 0.9 |   |
| Expected return  on plan assets                                                                    |       | (6.1                      | )          | (5.4                    | )          | (4.8 | ) | — |   | — |   | — |   |
| Amortization of  prior service cost                                                                |       | 0.2                       |       | 0.2                     |       | 0.2 |   | 0.1 |   | — |   | — |   |
| Special  termination benefits                                                                      |       | 0.2                       |       | 0.1                     |       | — |   | — |   | — |   | — |   |
| Recognized net  actuarial loss (gain)                                                              |       | 1.9                       |       | 2.7                     |       | 2.7 |   | 0.4 |   | 0.2 |   | — |   |
| Net periodic  benefit expense                                                                      |       | $                         | 4.8        |                    | $          | 4.7 |   | $ | 4.8 |   | $ | 2.8 |   | $ | 2.1 |   | $ | 1.4 |   |
|                                                                                               |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| **Other Changes in Plan Assets  and Benefit Obligations Recognized in Other Comprehensive Income** |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| Net actuarial loss  (gain)                                                                         |       | $                         | (2.9       | )                       |       |   |   |   | $ | 0.1 |   |   |   |   |   |
| Recognized  actuarial loss                                                                         |       | (1.9                      | )          |                    |       |   |   | (0.4 | ) |   |   |   |   |
| Recognized prior  service cost                                                                     |       | (0.2                      | )          |                    |       |   |   | (0.1 | ) |   |   |   |   |
| Total recognized  in other comprehensive income                                                    |       | $                    | (5.0       | )                       |       |   |   |   | $ | (0.4 | ) |   |   |   |   |
|                                                                                               |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| Total recognized in net  benefit cost and other comprehensive income                               |       | $                    | (0.2       | )                       |       |   |   |   | $ | 2.4 |   |   |   |   |   |

 

The amount in accumulated other comprehensive loss expected to berecognized as components of net periodic benefit cost in the year endedDecember 31, 2007 include $1.9 million for net actuarial loss recognition and$0.3 million for prior service cost recognition.  No plan assets are expected to be returned tothe Company during the year ended December 31, 2007.

The followingweighted average assumptions were used in determining net periodic benefitexpense and benefit obligations:
|                                                     | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|-----------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                          | ** ** | **2006**                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net  Periodic Benefit Expense**                   |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| Discount rate                                       |       | 5.75                      | %          | 6.00                    | %          | 6.25 | % | 5.75 | % | 6.00 | % | 6.25 | % |
| Expected long-term investment return on plan assets |       | 8.00                      | %          | 8.00                    | %          | 8.00 | % | — |   | — |   | — |   |
| Rate of compensation increase                       |       | 3.50                      | %          | 3.00                    | %          | 3.00 | % | — |   | — |   | — |   |
|                                                |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| **Benefit  Obligations**                            |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| Discount rate                                       |       | 5.75                      | %          | 5.75                    | %          | 6.00 | % | 5.75 | % | 5.75 | % | 6.00 | % |
| Rate of  compensation increase                      |       | 3.50                      | %          | 3.50                    | %          | 3.00 | % | — |   | — |   | — |   |

 

The discount rate reflects the rate of return on high-qualityfixed-income investments whose maturity dates and amounts approximate thetiming and amounts of the expected future benefit payments.

The return on plan assets reflects the weighted-average of the expectedlong-term rates of return for the broad categories of investments held in theplans.  The expected long-term rate ofreturn is adjusted when there are fundamental changes in expected returns onthe plan assets.

The Company plans to contribute $9.2 million to its pension plans during2007.  Funding requirements forsubsequent years are uncertain and will significantly depend on whether theplans’ actuary changes any significant assumptions used to calculate planfunding levels, the actual return on plan assets, changes in the employeegroups covered by the plans, and any legislative or regulatory changesaffecting plan funding requirements.  Fortax planning, financial planning, cash flow 

62

----

management, or cost reduction purposes, the Company may increase,accelerate, decrease, or delay contributions to the plans to the extentpermitted by law.

The Company’sexpected future benefit payments for each of the next five years and in theaggregate for the following five years thereafter are as follows:

|                   | ** ** | **Pension**  | ** ** | **Other**    | ** ** |
|-------------------|------------|--------------|------------|--------------|------------|
| ** **        | ** ** | **Benefits** | ** ** | **Benefits** | ** ** |
| 2007              |       | $            | 7.1        |         | $          | 2.2 |   |
| 2008              |       | 7.2          |       | 2.0          |       |
| 2009              |       | 7.4          |       | 2.1          |       |
| 2010              |       | 7.5          |       | 2.3          |       |
| 2011              |       | 7.7          |       | 2.4          |       |
| 2012 through 2016 |       | 40.9         |       | 12.8         |       |
|                   |            |              |            |              |            |  |  |

 

Assumed health care cost trend rates have a significant effect on theamounts reported for the health care plans. The annual rate of increase in the per capita costs of covered healthcare benefits is assumed to decrease from 9% to an ultimate trend rate of 5% bythe year 2012.  Increasing the assumedmedical cost trend rates by one percentage point in each year would haveresulted in a $2.1 million increase in the benefit obligation as of December31, 2006, and a $0.3 million increase in the aggregate of the service cost andinterest cost components of net periodic benefit expense for 2006.  A 1% decrease in the assumed trend rateswould have resulted in a $1.8 million decrease in the benefit obligation and a$0.2 million decrease in expense.

Lone Star’s investment strategy for its pension plansis to preserve the capital of the pension plans’ assets and maximize investmentearnings in excess of inflation with acceptable levels of volatility whilemeeting the pension plans’ goal of providing, protecting, and enhancing theeconomic well-being of Lone Star employees, retirees, and their beneficiaries.  This investment strategy will be achievedthrough target allocation for each asset class with a maximum and minimum rangearound each target.  No investments willbe made in securities that fall outside of the categories listed below.  Without limiting the general scope of theforegoing, private placements and the securities of Lone Star Technologies,Inc. are specifically excluded and not deemed appropriate investments.

Target investment allocations for 2006 were asfollows:

|                                  | ** ** | ** ** | ** ** | **Range** | ** ** |
|----------------------------------|------------|------------|------------|-----------|------------|
| **Asset Category**          | ** ** | **Target** | ** ** | **Min%**  | ** ** | **Max%** | ** ** |
| Domestic equity  securities      |       | 40         | %          | 30        | %          | 50 | % |
| International  equity securities |       | 10         | %          | 0         | %          | 20 | % |
| Fixed income  securities         |       | 48         | %          | 35        | %          | 65 | % |
| Cash investments                 |       | 2          | %          | 0         | %          | 5 | % |

 

The allocations are rebalanced as considered necessaryby the Company’s pension plan committee to correspond with anticipated changein investing conditions.   The followingtable sets forth the percentage of fair value of total assets by asset categoryas of the Company’s measurement date:

|                                  | ** ** | **Fiscal Year** | ** ** |
|----------------------------------|------------|----------------------|------------|
| **Asset Category**          | ** ** | **2006**             | ** ** | **2005** | ** ** |
| Domestic equity  securities      |       | 47                   | %          | 47 | % |
| International  equity securities |       | 8                    | %          | 8 | % |
| Fixed income  securities         |       | 44                   | %          | 40 | % |
| Cash investments                 |       | 1                    | %          | 5 | % |
| Total                            |       | 100                  | %          | 100 | % |

 

***Profit-sharing plans*.**  CertainLone Star subsidiaries have profit-sharing plans for their employees thatprovide for payment of a specified percentage of quarterly operatingearnings.  Total payments under the planwere $9.0 million, $8.6 million, and $0.8 million for 2006, 2005, and 2004,respectively.

63

----

**Commitments And Contingencies — Note K**

As of December 31, 2006, the Company had long-term purchase commitmentstotaling $28.6 million to acquire natural gas at specified minimum volumes andat fixed prices through January 2008.

Equipment is leased under various operating leases.  Rental expense totaled $5.5 million, $5.8million, and $4.5 million in 2006, 2005, and 2004, respectively.  Future minimum lease payments undernoncancelable operating leases with initial or remaining terms in excess of oneyear are as follows: 2007, $4.1 million; 2008, $3.3 million; 2009, $2.3million; 2010, $1.2 million; and 2011, $0.5 million.

Lone Star’s operations are subject to numerous environmental laws.  The three major areas of regulation are airquality, water quality, and solid and hazardous waste management.  The primary governmental oversight agenciesinclude the Texas Commission on Environmental Quality and the EnvironmentalProtection Agency.  The Company isengaged in various ongoing environmental monitoring and compliance programs,voluntary remediation activities, and capital improvement projects.  Estimated future expenditures for certainremediation programs are included in accrued liabilities and other noncurrentliabilities as shown in Note H and are computed on a nondiscounted basis.  Included in other noncurrent liabilities areenvironmental reserves of $7.2 million and $7.9 million at December 31, 2006and 2005, respectively.  Current reservesof $1.7 million and $1.3 million are included in accrued liabilities atDecember 31, 2006 and 2005, respectively. The Company believes that adequate accruals have been made related toall known environmental matters.

During the last eight years, Steel has been named as one of a number ofdefendants in 47 lawsuits alleging that certain individuals were exposed toasbestos on the defendants’ premises. The plaintiffs are seeking unspecified damages.  Of the 47 lawsuits, 23 have been settled orare pending settlement for approximately $0.4 million in the aggregate and 15have been dismissed or are pending dismissal. Steel did not manufacture or distribute any products containingasbestos.  Some or all of these claimsmay not be covered by the Company’s insurance. The Company has accrued for the estimated exposure to known claims, butdoes not know the extent to which future claims may be filed.  Therefore, the Company cannot estimate itsexposure, if any, to unasserted claims.

Beginning in 2003, Lone Star’s subsidiary Zinklahoma, Inc., inactivesince 1989, has been named as one of a number of defendants in seven lawsuitsalleging that the plaintiffs had contracted mesothelioma as the result ofexposure to asbestos in products manufactured by the defendants and John ZinkCompany (“Zink”).  Five of these lawsuitshave been dismissed and one was settled for less than $0.1 million.  Lone Star acquired the stock of Zink in 1987and, in 1989, sold the assets of the former Zink to Koch Industries, Inc. (“Koch”)and renamed the now inactive subsidiary “Zinklahoma, Inc.”  Lone Star retained, and agreed to indemnifyKoch against, certain preclosing liabilities of Zink.  It is Lone Star’s understanding that Zinknever manufactured asbestos and primarily used it only in certain purchasedgaskets that were encapsulated in copper and contained in burners and flaresmade by Zink prior to 1984, when Zink ceased using asbestos-containing productsentirely.  Koch continues to operate thebusiness as John Zink Company, LLC (“Zink LLC”).

In addition, Zink LLC has been named in twelve lawsuits in which theplaintiffs, six of whom have mesothelioma, allege exposure to asbestos in Zink’sproducts (six of these have been dismissed). Koch is seeking indemnification from Lone Star with respect to these sixpending lawsuits alleging exposure to asbestos. The costs of defending and settling the lawsuits alleging exposure toasbestos in Zink’s products have been borne by Zink’s insurance carrier.

Lone Star and its subsidiaries are parties to a number of other lawsuitsand controversies in the normal course of business, which are not discussedherein.  Management of Lone Star and itsoperating companies, based upon their analysis of known facts and circumstancesand reports from legal counsel, does not believe that any such matter or mattersin the aggregate will have a material adverse effect on the results ofoperations, financial condition, or cash flows of Lone Star and itssubsidiaries, taken as a whole.

On November 30, 2006, Lone Star announced that it completed the jointventure transaction (“Apolo Joint Venture”) with Grupo Peixoto de Castro (“GPC”),a Brazilian-based holding company with businesses in the steel, oil,petrochemical, chemical, real estate, and financial industries.  Under the agreement, Lone Star acquired a 50%ownership stake in Apolo Mecanica e Estruturas LTDA, an oilfield tubularproducts facility in southeastern Brazil that is operated by Apolo (“Apolo”),for approximately $42 million.  Theremaining 50% ownership stake is held by GPC, and profits from the Apolo JointVenture will be shared equally between the two partners.  Lone Star paid $24 million at closing withthe balance in the form of notes payable over the next 18 months.

On December 20, 2006, Lone Star announced that it had entered into adefinitive agreement to form a joint venture (“Joint Venture”) with the WelspunGroup (“Welspun”), one of India’s leading manufacturers of tubular products andtextiles, to design, engineer, and construct a manufacturing facility capableof producing 300,000 net tons annually of Spiral Welded 

64

----

Tubulars in the 24” and 60” outside diameter range with best in classcoating capabilities.  Under theagreement, Lone Star will acquire 40% ownership in the newly formed company,Welspun-Lone Star Tubulars LLC with the remaining 60% ownership stake beingheld by Welspun Pipe Inc., a 100% subsidiary of Welspun Gujarat Stahl RohrenLimited, Welspun’s steel pipe manufacturing arm.  The total joint venture investment isanticipated to be approximately $66 million including third-partyfinancing.  Profits by the Joint Venturewill be shared between the partners based upon their respective ownershipstakes.  As of December 31, 2006, LoneStar had contributed $1.6 million to the Welspun Joint Venture with additionalcontributions in the first quarter of 2007 in the range of $0 to $14 million.

**Early Termination of Alliance Agreement — Note L**

During the second quarter of 2005, the Company announced that Steel andTubos del Caribe, S.A. (“Tubocaribe”), a Columbian manufacturer of OCTG and linepipe, had terminated their strategic alliance, following a change in ownershipof Tubocaribe.  The agreement was due toexpire in October 2006.

As consideration for the early termination of the agreement, in thefourth quarter of 2005, Tubocaribe delivered, without charge to Steel, anagreed quantity of OCTG with an estimated value of $7.8 million.  A gain was recognized in the second quarterof 2005 for the $7.8 million and is included in “Other income” in Lone Star’sconsolidated results of operation for the year ended December 31, 2005.

**Joint Ventures — Note M**

Lone Star announced on August 15, 2006, that it had entered into adefinitive agreement to form a joint venture (“Joint Venture”) with Hunan ValinSteel Tube & Wire Co., Ltd. (“Valin”), one of China’s largest steelmakers.Under the agreement, Lone Star would acquire a 40% stake in one of Valin’ssubsidiaries, Hengyang Valin MPM Steel Tube Co. Ltd., for a consideration of$132 million in cash. Lone Star would also provide significant technical andrelated operational support for the Joint Venture. Lone Star contemplates aseries of future transactions related to the steel tube assets of Valin inHengyang, Hunan Province with the expectation that Lone Star would eventuallycontribute up to an aggregate of $238 million for 47% of the Joint Venture. Alltransactions being contemplated are subject to relevant regulatory approvalsand consents and subject to foreign currency exchange rates.

Upon injection of the $132 million into theJoint Venture, Lone Star and Valin will also jointly establish a sales companywith an initial equity investment of $15 million each to manage the NorthAmerican sales and marketing of tubular products produced by the Joint Venture.Lone Star will have exclusive marketing and sales rights in North America to aminimum of 200,000 tons annually of oilfield tubular products produced by theJoint Venture.

On November 30, 2006, Lone Star announced that it completed Apolo JointVenture.  Under the agreement, Lone Staracquired a 50% ownership stake in Apolo, an oilfield tubular products facilityin southeastern Brazil that is operated by Apolo, for approximately $42million.  The remaining 50% ownershipstake is held by GPC, and profits from the Apolo Joint Venture will be shared equallybetween the two partners.  Lone Star paid$24 million at closing with $18.8 million, denominated in U.S. dollars,  payable over the next 18 months, of which$12.5 million is included in accrued liabilities and $6.3 million is includedin other noncurrent liabilities.

Through its investment in the Apolo Joint Venture, Lone Star acquiredthe ability to participate in meeting the growing demand for oil countrytubular goods and line pipe in Brazil and other rapidly expanding SouthAmerican markets.  This transaction is anatural extension of the strategic alliance that Lone Star’s primary operatingcompany, Steel, has with Apolo, which will remain in force and will continue togive Lone Star exclusive marketing rights in North America for Apolo’s tubularproducts.

On December 20, 2006, Lone Star announced that it had entered into theWelspun Joint Venture.  Under theagreement, Lone Star will acquire 40% ownership in the newly formed company,Welspun-Lone Star Tubulars LLC with the remaining 60% ownership stake beingheld by Welspun Pipe Inc., a 100% subsidiary of Welspun Gujarat Stahl RohrenLimited, Welspun’s steel pipe manufacturing arm.  The total joint venture investment isanticipated to be approximately $66 million, including third-party financing.  Profits by the Welspun Joint Venture will beshared between the partners based upon their respective ownership stakes.  As of December 31, 2006, Lone Star hadcontributed $1.6 million to the Welspun Joint Venture with additionalcontributions in the first quarter of 2007 in the range of $0 to $14 million.

The Company has related party transactions that involve its Apolo JointVenture and Welspun Joint Venture.  TheCompany purchases casing, tubing, and line pipe produced by its Apolo JointVenture for resale to the Company’s customers. The 

65

----

Company sells line pipe produced by Welspun Pipe, Inc. at theirfacilities in India on a commission basis and in the future will sell productsproduced by the Welspun Joint Venture at its facilities in the United States.  The purchase and resale of Apolo products arereflected in the Company’s cost of goods sold and revenues and during 2006,revenues from these transactions totaled $21.1 million.  The commissions from sales of Welspunproduced line pipe are reflected in the Company’s revenues and totaled $6.5million in 2006.

**Quarterly Financial Summary(Unaudited)  — Note N**
| ** **                                  | ** ** | **2006 - Quarter Ended** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                  | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Total** | ** ** |
| ** **                                  | ** ** | **First**                               | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Year** | ** ** |
| Net revenues                                |       | $                                       | 350.9      |   | $ | 355.8 |   | $ | 336.1 |   | $ | 334.8 |   | $ | 1,377.6 |   |
| Gross profit                                |       | 80.8                                    |       | 71.8 |   | 40.3 |   | 42.1 |   | 235.0 |   |
| Net income                                  |       | 41.3                                    |       | 32.2 |   | 16.6 |   | 18.1 |   | 108.2 |   |
|                                        |       |                                    |       |   |   |   |   |   |   |   |   |
| **Per  common share — basic**          |       |                                    |       |   |   |   |   |   |   |   |   |
| Net income available to common shareholders |       | $                                       | 1.36       |   | $ | 1.05 |   | $ | 0.54 |   | $ | 0.59 |   | $ | 3.54 |   |
| **Per  common share — diluted**        |       |                                    |       |   |   |   |   |   |   |   |   |
| Net income available to common shareholders |       | $                                       | 1.33       |   | $ | 1.04 |   | $ | 0.53 |   | $ | 0.58 |   | $ | 3.47 |   |

 
| ** **                                   | ** ** | **2005 - Quarter Ended** | ** ** |       |
|----------------------------------------------|------------|--------------------------|------------|------------|
| ** **                                   | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Total** | ** ** |
| ** **                                   | ** ** | **First**                | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Year** | ** ** |
| Net revenues                                 |       | $                        | 297.8      |       | $ | 325.7 |   | $ | 324.1 |   | $ | 337.5 |   | $ | 1,285.1 |   |
| Gross profit                                 |       | 55.3                     |       | 70.8       |   | 69.8 |   | 76.4 |   | 272.3 |   |
| Net income                                   |       | 38.9                     |       | 63.5       |   | 50.3 |   | 70.9 |   | 223.6 |   |
|                                         |       |                     |       |       |   |   |   |   |   |   |   |
| **Per  common share — basic**           |       |                     |       |       |   |   |   |   |   |   |   |
| Net income available to common shareholders  |       | $                        | 1.32       |       | $ | 2.14 |   | $ | 1.66 |   | $ | 2.32 |   | $ | 7.44 |   |
| **Per  common share — diluted**         |       |                     |       |       |   |   |   |   |   |   |   |
| Net income  available to common shareholders |       | $                        | 1.30       |       | $ | 2.09 |   | $ | 1.63 |   | $ | 2.28 |   | $ | 7.34 |   |
|                                              |            |                          |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**LONE STARTECHNOLOGIES, INC.**

**Schedule II - Valuation and Qualifying Accounts**

**December 31,2004, 2005, and 2006**

***($ in millions)***
| ** **                                      | ** ** | **Balance at** | ** ** | **Charged to** | ** ** | **Charged**       | ** ** | ** **     | ** ** | **Balance**        | ** ** |
|-------------------------------------------------|------------|---------------------|------------|---------------------|------------|-------------------|------------|----------------|------------|--------------------|------------|
| ** **                                      | ** ** | **Beginning**       | ** ** | **Costs and**  | ** ** | **to Other** | ** ** | ** **     | ** ** | **at End**    | ** ** |
| ** **                                      | ** ** | **of Period**  | ** ** | **Expenses**        | ** ** | **Accounts**      | ** ** | **Deductions** | ** ** | **of Period** | ** ** |
| *Year  ended December 31, 2004*                 |       |                |       |                |       |              |       |           |       |               |       |
| Allowance for doubtful accounts                 |       | $                   | 1.7        |                | $          | 0.1               |       | —         |       | $                  | (0.5       | ) | $ | 1.3 |   |
| Valuation allowance on net deferred tax assets  |       | $                   | 112.1      |                | $          | —            |       | —         |       | $                  | (26.1      | ) | $ | 86.0 |   |
|                                            |       |                |       |                |       |              |       |           |       |               |       |
| *Year  ended December 31, 2005*                 |       |                |       |                |       |              |       |           |       |               |       |
| Allowance for doubtful accounts                 |       | $                   | 1.3        |                | $          | 0.2               |       | —         |       | $                  | (0.1       | ) | $ | 1.4 |   |
| Valuation allowance on net deferred tax assets  |       | $                   | 86.0       |                | $          | —            |       | —         |       | $                  | (83.2      | ) | $ | 2.8 |   |
|                                            |       |                |       |                |       |              |       |           |       |               |       |
| *Year ended  December 31, 2006*                 |       |                |       |                |       |              |       |           |       |               |       |
| Allowance for doubtful accounts                 |       | $                   | 1.4        |                | $          | 0.2               |       | —         |       | $                  | (0.1       | ) | $ | 1.5 |   |
| Valuation  allowance on net deferred tax assets |       | $                   | 2.8        |                | $          | 0.4               |       | —         |       | $                  | —     |   | $ | 3.2 |   |

 

**Item 9.  Changes In andDisagreements With Accountants On Accounting and Financial Disclosure**

None.

66

----

 

**ITEM 9A.          CONTROLS AND PROCEDURES**

(a)          Evaluation of disclosure controls andprocedures.

Under supervision and with the participation of our management,including our principal executive officer and principal financial officer, weconducted an evaluation of the effectiveness of the design and operation of ourdisclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e)under the Securities Exchange Act of 1934, as of the end of the period coveredby this Annual Report on Form 10-K (the “Evaluation Date”); and whether anychange has occurred in the Company’s internal control over financial reportingpursuant to Exchange Act Rules 13a-15(d) and 15d-15(d).  Based on this evaluation, our principalexecutive officer and principal financial officer concluded as of theEvaluation Date that our disclosure controls and procedures were effective.

(b)         Management’s report on internal control overfinancial reporting.

Management’s report on internal control over financial reporting, whichappears on page 38 of this Annual Report, is incorporated herein by reference.

Management’s assessment of the effectiveness of internal control overfinancial reporting as of December 31, 2006, was audited by Deloitte &Touche LLP, an independent registered public accounting firm, as stated in itsreport which appears on page 39 of this Annual Report, which is incorporatedherein by reference.

(c)          Changes in internal control over financialreporting.

There was no change in our internal control over financial reporting thatoccurred in the fourth quarter of 2006 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

**ITEM 9B.          OTHER INFORMATION**

None.

**PART III**

**ITEM 10.****                               ****DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

Information required under this item is contained in Lone Star’s proxystatement for the 2007 Annual Meeting of Shareholders, and is incorporatedherein by reference.

**ITEM 11.****                               ****EXECUTIVECOMPENSATION**

Information required under this item is contained in Lone Star’s proxystatement for the 2007 Annual Meeting of Shareholders, and is incorporatedherein by reference.

**ITEM 12.****                               ****SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDERSMATTERS**

Information required under this item with respect to beneficial ownersof more than 5% of outstanding common stock, directors and executive officers,and securities authorized for issuance under equity compensation plans iscontained in Lone Star’s proxy statement for the 2007 Annual Meeting ofShareholders, and is incorporated herein by reference.

**ITEM 13.****                               ****CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

Information required under this item with respect to directors andexecutive officers is contained in Lone Star’s proxy statement for the 2007Annual Meeting of Shareholders, and is incorporated herein by reference.

**ITEM 14.****                               ****PRINCIPALACCOUNTING FEES AND SERVICES**

Information with respect to fees and services related to the Company’sindependent auditors, Deloitte & Touche LLP, and the disclosure of theAudit Committee’s preapproval policies and procedures are contained in LoneStar’s proxy statement for the 2007 Annual Meeting of Shareholders, and areincorporated herein by reference.

67

----

**PartIV**

**ITEM 15.****                               ****EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**

1.                 Financial Statements - the followingConsolidated Financial Statements are filed as part of this report:

·                  Reports ofIndependent Registered Public Accounting Firm

·              Management’s Report on Internal Control OverFinancial Reporting

·              Consolidated Results of Operations—for the years ended December 31, 2006, 2005, and 2004

·              Consolidated Balance Sheets - at December 31,2006 and 2005

·                  Consolidated Statementsof Cash Flows—for the years ended December 31, 2006, 2005, and 2004

·                  Consolidated Statementsof Shareholders’ Equity -at December 31, 2006, 2005, and 2004

·              Notes to Consolidated Financial Statements

2.                 Schedule II - Valuation and QualifyingAccounts

Note:         All schedules not filed herein for whichprovision is made under Rules of Regulation S-X have been omitted as notapplicable or not required or the information required has been included in thenotes to the Consolidated Financial Statements.

3.                 Index to Exhibits

***Description***
| 2.1 |   | Purchase and Sale Agreement among North Star Steel  Company, Universal Tubular Services, Inc., Cargill, Incorporated, Lone Star  Technologies, Inc., and Star Seamless, Inc., dated as of August 16, 2001  (incorporated by reference to Exhibit 2.1 to Form 8-K/A of Lone Star as filed  on August 17, 2001).                                                                                                                                                                                                                                                                                                                     |
|-----|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1 |   | Certificate of  Incorporation of Registrant (incorporated by reference to Exhibit 3(a) to  Form S-4 Registration Statement of Lone Star as filed on April 4, 1986,  File No. 33-4581).                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 3.2 |   | Certificate of  Amendment to Certificate of Incorporation dated September 30, 1986  (incorporated by reference to Exhibit 3.2 to Form S-3 Registration Statement  of Lone Star as filed on February 4, 2000, File No. 333-96207).                                                                                                                                                                                                                                                                                                                                                                                                  |
| 3.3 |   | Agreement and Plan of  Merger dated March 6, 1986, among Steel, a Texas corporation, Lone Star, a  Delaware corporation, and Lone Star Steel Company Merging Corporation, a  Delaware corporation (incorporated by reference to Exhibit II to Form S-4  Registration Statement of Lone Star as filed on April 4, 1986, File No. 33-4581).                                                                                                                                                                                                                                                                                          |
| 3.4 |   | Amended and Restated  Bylaws, as amended and restated on September 21, 2004 (incorporated by  reference to Exhibit 3.1 to Form 8-K of Lone Star as filed on September 24,  2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 3.5 |   | Certificate of  Amendment to Certificate of Incorporation dated May 20, 1998 (incorporated by  reference to Exhibit 3.4 to Form 10-Q for the quarter ended June 30, 1998).                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.1 |   | Statement of Resolution  establishing Cumulative Preferred Stock, Series A (par value $1 per share),  dated September 9, 1988 (incorporated by reference to Exhibit 3(c) of Form 10-K  of Lone Star filed April 7, 1989).                                                                                                                                                                                                                                                                                                                                                                                                          |
| 4.2 |   | Indenture dated as of  May 29, 2001, among Lone Star, Environmental Holdings, Inc., Zinklahoma,  Inc., Lone Star Steel Company, Lone Star Logistics, Inc., Lone Star Steel  International, Inc., Lone Star Steel Sales Company, Rotac, Inc., T&N Lone  Star Warehouse Co., Texas & Northern Railway Company, Lone Star ST  Holdings, Inc., Fintube Technologies, Inc., Fintube Canada, Inc., Bellville  Tube Corporation, and Wells Fargo Bank Minnesota, National Association (incorporated  by reference to Exhibit 4.4 to Form S-4 Registration Statement of Lone Star  as filed on June 27, 2001, File No. 333-63944). |
| 4.3 |   | Exchange and  Registration Rights Agreement dated May 29, 2001, among Lone Star, Goldman,  Sachs & Co., Salomon Smith Barney Inc., Banc of America Securities LLC,  CIBC World Markets Corp., Dresdner Kleinwort Wasserstein Securities LLC, RBC  Dominion Securities Corporation, and The Robinson-Humphrey Company,                                                                                                                                                                                                                                                                                                          |

 

68

----

 
|         |   | LLC (incorporated by reference to Exhibit 4.5 to  Form S-4 Registration Statement of Lone Star as filed on June 27, 2001, File  No. 333-63944).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1    |   | Amended 1985 Long-Term  Incentive Plan (incorporated by reference to Exhibit A of Proxy Statement of  Lone Star as filed on October 22, 1993).*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.1(a) |   | Amendments to the  Amended 1985 Long-Term Incentive Plan adopted on May 8, 1997 (incorporated by  reference to Exhibit 10.1(a) to Form 10-Q of Lone Star for the quarter ended  June 30, 1997). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 10.1(b) |   | Amendments to the  Amended 1985 Long-Term Incentive Plan adopted on May 14, 1998 (incorporated  by reference to same numbered Exhibit to Form 10-Q for the quarter ended June  30, 1998). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.1(c) |   | Amendments to the  Amended 1985 Long-Term Incentive Plan adopted on May 11, 1999 (incorporated  by reference to same numbered Exhibit to Form 10-Q for the quarter ended June  30, 1999). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.1(d) |   | Amendment to the  Amended 1985 Long-Term Incentive Plan adopted on May 9, 2000 (incorporated by  reference to same numbered Exhibit to Form 10-Q for the quarter ended June  30, 2000.) *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.1(e) |   | Amendments to the  Amended 1985 Long-Term Incentive Plan adopted on May 8, 2001 (incorporated by  reference to same numbered Exhibit to Form 10-Q for the quarter ended June  30, 2001). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.1(f) |   | Amendment to the 1985  Long-Term Incentive Plan adopted on May 9, 2002 (incorporated by reference to  same numbered Exhibit to Form 10-Q for the quarter ended June 30, 2002). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.1(g) |   | Amendments to the 1985  Long-Term Incentive Plan adopted on May 13, 2003 (incorporated by reference  to same numbered Exhibit to Form 10-K for the year ended December 31, 2003).  *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.2    |   | 2004 Long-Term  Incentive Plan (incorporated by reference to Appendix A to the Proxy  Statement of Lone Star filed on March 19, 2004). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.3    |   | Employment Retention  Policy adopted May 8, 1997, letter agreements dated May 22, 1997, between  Lone Star, Charles J. Keszler and Robert F. Spears and between Steel and W.  Byron Dunn and letter agreement dated September 25, 1997, between Lone Star  and Rhys J. Best (incorporated by reference to same numbered Exhibit to Form  10-K for the year ended December 31, 1997).*                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.4    |   | 2006 Employment  Retention Policy (incorporated by reference to Exhibit 10.1 to  Form 8-K of Lone Star as filed on November 1, 2006). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 10.5    |   | Form of Letter  Agreement regarding 2006 Employment Retention Policy (incorporated by  reference to Exhibit 10.2 to Form 8-K of Lone Star as filed on  November 1, 2006). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.6    |   | Contract for Electric  Service dated September 30, 1996, between Southwestern Electric Power Company  and Steel (incorporated by reference to Exhibit 10.21 to Form 10-K for the  year ended December 31, 1996).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.7    |   | Compromise and  Settlement Agreement and Release dated July 31, 1997, between Lone Star and  Guaranty Federal Bank, F.S.B. (incorporated by reference to Exhibit 10.26 to  Form 10-K for the year ended December 31, 1997).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.8    |   | Phantom Stock Deferred  Compensation Plan adopted on September 22, 1998 (incorporated by reference to  Exhibit 10.28 to Form 10-Q for the quarter ended September 30, 1998).*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.9    |   | Employee Stock Purchase  Plan adopted on May 9, 2000 (incorporated by reference to Exhibit 10.36 to  Form 10-Q for the quarter ended June 30, 2000).*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.10   |   | Second Amended and  Restated Deferred Compensation Plan adopted by Lone Star’s Board of Directors  on September 21, 2004 (incorporated by reference to Exhibit 10.36 to Form 8-K  of Lone Star as filed on December 16, 2004). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.11   |   | First Amendment, dated  December 15, 2005, to Second Amended and Restated Deferred Compensation Plan  (incorporated by reference to Exhibit 10.1 to Form 8-K of Lone Star as filed  on December 21, 2005). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.12   |   | Second Amendment, dated  December 14, 2006, to the Second Amended and Restated Deferred Compensation  Plan (incorporated by reference to Exhibit 10.1 to Form 8-K of Lone  Star as filed on December 15, 2006). *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.13   |   | Employment Agreement  dated May 7, 2001, between Lone Star and Rhys J. Best (incorporated by  reference to Exhibit 99.1 to Form 8-K of Lone Star as filed on May 9, 2001).  *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.14   |   | Amended and Restated  Financing Agreement dated October 8, 2001, among The CIT Group/Business  Credit, Inc. (as “Agent” and “Lender”), the Lenders party thereto, and Lone  Star, Lone Star Steel Company, Fintube Technologies, Inc., Lone Star  Logistics, Inc., T&N Lone Star Warehouse Co., Texas & Northern  Railway Company, Fintube Canada, Inc. and Bellville Tube Corporation (as  Borrowers), and Environmental Holdings, Inc., Zinklahoma, Inc., Lone Star  Steel International, Inc., Lone Star Steel Sales Company, Rotac, Inc., and  Lone Star ST Holdings, Inc. (as Guarantors) (incorporated by reference to  Exhibit 10.13 to Amendment No. 2 to Form S-4 of Lone Star as filed on October  9, 2001, File No. 333-63944). |
| 10.15   |   | First Amendment, dated  as of December 31, 2001, to Amended and Restated Financing Agreement dated  October 8, 2001 (incorporated by reference to Exhibit 10.31 to Form 10-Q for  the quarter ended March 31, 2002).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |

 

69

----

 
| 10.13 |   | Second Amendment, dated March 13, 2002, to Amended  and Restated Financing Agreement dated October 8, 2001 (incorporated by  reference to Exhibit 10.32 to Form 10-Q for the quarter ended March 31,  2002).                                                                                                                             |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.14 |   | Third Amendment, dated  as of September 30, 2002, to Amended and Restated Financing Agreement dated  October 8, 2001 (incorporated by reference to Exhibit 10.33 to Form 10-Q for  the quarter ended September 30, 2002).                                                                                                                |
| 10.15 |   | Fourth Amendment, dated  as of September 30, 2002, to Amended and Restated Financing Agreement dated  October 8, 2001 (incorporated by reference to Exhibit 10.34 to Form 10-Q for  the quarter ended September 30, 2002).                                                                                                               |
| 10.16 |   | Fifth Amendment, dated  as of May 5, 2003, to Amended and Restated Financing Agreement dated October  8, 2001 (incorporated by reference to Exhibit 10.1 to Form 10-Q for the  quarter ended June 30, 2003).                                                                                                                             |
| 10.17 |   | Sixth Amendment, dated  as of August 29, 2003, to Amended and Restated Financing Agreement dated  October 8, 2001 (incorporated by reference to same numbered Exhibit to Form  10-K for year ended December 31, 2003).                                                                                                                   |
| 10.18 |   | Seventh Amendment,  dated as of December 16, 2003, to Amended and Restated Financing Agreement  dated October 8, 2001 (incorporated by reference to same numbered Exhibit to  Form 10-K for year ended December 31, 2003).                                                                                                               |
| 10.19 |   | Eighth Amendment, dated  as of September 21, 2004, to Amended and Restated Financing Agreement dated  October 8, 2001 (incorporated by reference to Exhibit 10.35 to Form 10-Q for  quarter ended September 30, 2004).                                                                                                                   |
| 10.20 |   | Ninth Amendment, dated  as of December 31, 2005, to Amended and Restated Financing Agreement dated  October 8, 2001 (incorporated by reference to Exhibit 10.21 to Form 10-K for  the year ended December 31, 2005).                                                                                                                     |
| 10.21 |   | Tenth Amendment, dated  as of June 30, 2006, to Amended and Restated Financing Agreement dated  October 8, 2001 (incorporated by reference to Exhibit 10.1 to  Form 10-Q of Lone Star as filed on October 25, 2006).                                                                                                           |
| 10.22 |   | Second Amended and  Restated Financing Agreement (incorporated by reference to Exhibit  10.2 to Form 8-K of Lone Star as filed on December 15, 2006).                                                                                                                                                                          |
| 10.23 |   | Form of Director and  Officer Restricted Stock Agreement (incorporated by reference to Exhibit 10.2  to Form 8-K of Lone Star as filed on March 7, 2005). *                                                                                                                                                                              |
| 10.24 |   | Compensation and  benefits outline for Joe Alvarado dated May 7, 2004, and related letter  agreement dated October 8, 2004, between Lone Star and Joe Alvarado  (incorporated by reference to Exhibit 10.22 to Form 10-K of Lone Star as  filed on March 2, 2005). *                                                                     |
| 10.25 |   | Form of Director Stock  Option Agreement (incorporated by reference to Exhibit 10.1 to Form 8-K of  Lone Star as filed on September 24, 2004). *                                                                                                                                                                                         |
| 10.26 |   | Form of Director  Restricted Stock Unit Award (incorporated by reference to Exhibit 10.2 to  Form 8-K of Lone Star as filed on September 24, 2004). *                                                                                                                                                                                    |
| 10.27 |   | Form of Employee Stock  Option Agreement with One-Year Vesting (incorporated by reference to Exhibit  10.3 to Form 8-K of Lone Star as filed on September 24, 2004). *                                                                                                                                                                   |
| 10.28 |   | Form of Employee Stock  Option Agreement with Four-Year Vesting (incorporated by reference to Exhibit  10.4 to Form 8-K of Lone Star as filed on September 24, 2004). *                                                                                                                                                                  |
| 10.29 |   | Form of Employee  Restricted Stock Agreement (incorporated by reference to Exhibit 10.5 to Form  8-K of Lone Star as filed on September 24, 2004). *                                                                                                                                                                                     |
| 10.33 |   | Lone Star Phantom Stock  Deferred Compensation Plan (incorporated by reference to Exhibit 10.1 to  Form 8-K of Lone Star as filed on January 3, 2006). *                                                                                                                                                                       |
| 10.34 |   | Form of Officer and  Manager Restricted Stock Agreement (incorporated by reference to Exhibit  10.1 to Form 8-K of Lone Star as filed on March 6, 2006). *                                                                                                                                                                     |
| 10.35 |   | Form of Strategic  Incentive Plan Participant Restricted Stock Agreement (incorporated by  reference to Exhibit 10.2 to Form 8-K of Lone Star as filed on  March 6, 2006). *                                                                                                                                                   |
| 10.36 |   | Form of Director  Restricted Stock Unit Award (incorporated by reference to Exhibit 10.3 to  Form 8-K of Lone Star as filed on March 6, 2006). *                                                                                                                                                                               |
| 10.37 |   | Joint Venture Contract  dated August 15, 2006, of Hengyang Valin MPM Steel Tube Co. Ltd.  (incorporated by reference to Exhibit 10.1 to Form 8-K of Lone Star  as filed on August 15, 2006).                                                                                                                                   |
| 10.38 |   | Articles of Association  dated August 15, 2006, of Hengyang Valin MPM Steel Tube Co. Ltd.  (incorporated by reference to Exhibit 10.2 to Form 8-K of Lone Star  as filed on August 15, 2006).                                                                                                                                  |
| 10.39 |   | Capital Increase  Agreement dated August 15, 2006, for Hengyang Valin MPM Steel Tube Co. Ltd.  (incorporated by reference to Exhibit 10.3 to Form 8-K of Lone Star  as filed on August 15, 2006).                                                                                                                              |
| 10.40 |   | Guaranty dated August  15, 2006, from Lone Star in favor of Hengyang Valin Steel Tube Co. Ltd. and  Hunan Valin Steel Tube & Wire Co., Ltd. (incorporated by reference to  Exhibit 10.4 to Form 8-K of Lone Star as filed on August 15, 2006).                                                                             |
| 10.41 |   | Form of Shareholders  Agreement between Star China Ltd. and Hunan Valin Steel Tube & Wire Co.,  Ltd. (incorporated by reference to Exhibit 10.5 to Form 8-K of Lone  Star as filed on August 15, 2006).                                                                                                                    |
| 10.42 |   | Cover Page Agreement  dated August 15, 2006, including Forms of Hengyang Valin MPM Steel Tube Co.  Ltd. Sale, Marketing, and Supply Agreement and Hengyang Valin Steel Tube Co.  Ltd. Sale, Marketing, and Supply Agreement (incorporated by reference to  Exhibit 10.6 to Form 8-K of Lone Star as filed on August 15, 2006). |

 

70

----

 
| 10.43 |   | Technology Cross License Agreement dated August 15,  2006, between Lone Star and Hengyang Valin MPM Steel Tube Co., Ltd.  (incorporated by reference to Exhibit 10.7 to Form 8-K of Lone Star  as filed on August 15, 2006).                                                                                                                                               |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.44 |   | Trademark License  Agreement dated August 15, 2006, between Lone Star Steel Company, L.P. and  Hengyang Valin MPM Steel Tube Co., Ltd. (incorporated by reference to Exhibit  10.8 to Form 8-K of Lone Star as filed on August 15, 2006).                                                                                                                                  |
| 10.45 |   | Contribution Agreement  dated as of October 24, 2006, among Apolo Tubos e Equipamentos S.A., Apolo  Mecânica e Estruturas Ltda., Lone Star and Cirrus Participacoes Ltda.  (incorporated by reference to Exhibit 10.1 to Form 8-K of Lone Star  as filed on October 25, 2006).                                                                                        |
| 10.46 |   | Form of Amended and  Restated By-Laws of Apolo Mecânica e Estruturas Ltda. (incorporated by  reference to Exhibit 10.2 to Form 8-K of Lone Star as filed on  October 25, 2006).                                                                                                                                                                                       |
| 10.47 |   | Form of Trademark  Cross-License Agreement between Lone Star Steel Company, L.P. and Apolo  Mecânica e Estruturas S.A. (incorporated by reference to Exhibit 10.3 to  Form 8-K of Lone Star as filed on October 25, 2006).                                                                                                                                            |
| 10.48 |   | Form of Promissory Note  from Star Capital Funding, Inc. payable to Star Brazil Cayman Ltd.  (incorporated by reference to Exhibit 10.4 to Form 8-K of Lone Star  as filed on October 25, 2006).                                                                                                                                                                           |
| 10.49 |   | Form of Sale, Marketing,  and Supply Agreement between Lone Star Steel Company, L.P. and Apolo Mecânica  e Estruturas S.A. (incorporated by reference to Exhibit 10.5 to  Form 8-K of Lone Star as filed on October 25, 2006).                                                                                                                                        |
| 10.50 |   | Form of Shareholders  Agreement of Apolo Mecânica e Estruturas S.A. (incorporated by reference to  Exhibit 10.6 to Form 8-K of Lone Star as filed on October 25,  2006).                                                                                                                                                                                         |
| 10.51 |   | Form of Transition  Services Agreement between Apolo Mecânica e Estruturas S.A.and Apolo Tubos e  Equipamentos S.A. (incorporated by reference to Exhibit 10.7 to  Form 8-K of Lone Star as filed on October 25, 2006).                                                                                                                                               |
| 10.52 |   | Form of Trademark  License Agreement between Apolo Tubos e Equipamentos S.A. and Apolo Mecânica  e Estruturas S.A. (incorporated by reference to Exhibit 10.8 to Form 8-K  of Lone Star as filed on October 25, 2006).                                                                                                                                                |
| 10.53 |   | Form of Transition  Services Agreement between Apolo Mecânica e Estruturas S.A.and Apolo Tubos e  Equipamentos S.A. (incorporated by reference to Exhibit 10.9 to  Form 8-K of Lone Star as filed on October 25, 2006).                                                                                                                                               |
| 10.54 |   | Memorandum and Articles  of Association of Star Brazil Cayman Ltd. (incorporated by reference to  Exhibit 10.10 to Form 8-K of Lone Star as filed on October 25,  2006).                                                                                                                                                                                                   |
| 10.55 |   | Form of Stock Purchase  Agreement among Antônio Joaquim Peixoto de Castro Palhares and Paulo Cesar  Peixoto de Castro Palhares, Apolo Mecânica e Estruturas S.A., Apolo Tubos e  Equipamentos S.A., GPC Participacoes S.A., and Cirrus Participacoes Ltda.  (incorporated by reference to Exhibit 10.11 to Form 8-K of Lone Star  as filed on October 25, 2006). |
| 10.56 |   | Limited Liability  Company Agreement of Welspun-Lonestar Tubulars LLC dated December 20, 2006  (incorporated by reference to Exhibit 10.1 to Form 8-K of Lone Star  as filed on December 20, 2006).                                                                                                                                                                        |
| 10.57 |   | Contribution Agreement  among Lone Star, Welspun Pipes, Inc., and Welspun-Lone Star Tubulars LLC  dated December 20, 2006 (incorporated by reference to Exhibit 10.2 to  Form 8-K of Lone Star as filed on December 20, 2006).                                                                                                                                             |
| 10.58 |   | Mutual Services  Agreement among Lone Star, Welspun Pipes, Inc., and Welspun-Lone Star  Tubulars LLC dated December 20, 2006 (incorporated by reference to Exhibit  10.3 to Form 8-K of Lone Star as filed on December 20, 2006).                                                                                                                                          |
| 10.59 |   | Trademark License  Agreement between Lone Star Steel Company, L.P. and Welspun-Lone Star  Tubulars LLC dated December 20, 2006 (incorporated by reference to Exhibit  10.4 to Form 8-K of Lone Star as filed on December 20, 2006).                                                                                                                                        |
| 10.60 |   | Trademark License  Agreement between Welspun Pipes, Inc. and Welspun-Lone Star Tubulars LLC  dated December 20, 2006 (incorporated by reference to Exhibit 10.5 to  Form 8-K of Lone Star as filed on December 20, 2006).                                                                                                                                                  |
| 14.1  |   | Code of Ethics for  Senior Financial Officers adopted by Lone Star’s Board of Directors on March  20, 2003 (incorporated by reference to Exhibit 99.1 to Form 10-K for the year  ended December 31, 2002).                                                                                                                                                                      |
| 14.2  |   | Code of Ethics for  Senior Officers (incorporated by reference to Exhibit 14.1 to  Form 8-K of Lone Star as filed on December 15, 2006).                                                                                                                                                                                                                                   |
| 21.1  |   | List of Subsidiaries  (filed herewith).                                                                                                                                                                                                                                                                                                                                              |
| 23.1  |   | Consent of Deloitte  & Touche LLP (filed herewith).                                                                                                                                                                                                                                                                                                                              |
| 24.1  |   | Power of Attorney: Dan  O. Dinges (filed herewith).                                                                                                                                                                                                                                                                                                                                  |
| 24.2  |   | Power of Attorney:  Frederick B. Hegi, Jr. (filed herewith).                                                                                                                                                                                                                                                                                                                         |
| 24.3  |   | Power of Attorney:  Robert L. Keiser (filed herewith).                                                                                                                                                                                                                                                                                                                               |

 

71

----

 
| 24.4 |   | Power of Attorney: Robert Kelley (filed herewith).                                                                                                                                           |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 24.5 |   | Power of Attorney: M.  Joseph McHugh (filed herewith).                                                                                                                                       |
| 24.6 |   | Power of Attorney:  Alfred M. Micallef (filed herewith).                                                                                                                                     |
| 24.7 |   | Power of Attorney:  David A. Reed (filed herewith).                                                                                                                                          |
| 24.8 |   | Power of Attorney:  Jerry E. Ryan (filed herewith).                                                                                                                                          |
| 31.1 |   | Certification of Rhys  J. Best pursuant to Rule 13a-14 of the Securities Exchange Act of 1934 as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).       |
| 31.2 |   | Certification of  Charles J. Keszler pursuant to Rule 13a-14 of the Securities Exchange Act of  1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  (filed herewith). |
| 32.1 |   | Certification pursuant  to 18 U.S.C. §1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002 (filed herewith).                                                      |

----

*       Managementcontract or compensatory plan or arrangement.

 

72

----

 

**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.
|                         | ** ** | **                       ****LONE STAR TECHNOLOGIES, INC.** |
|-------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **              | ** ** | ** **                                                                                                                                                                     |   |   |
| Date: February 27, 2007 |       |                                                                                                                                                                           | By: | /s/ Charles J. Keszler |
|                    |       |                                                                                                                                                                           |   | (Charles J. Keszler) |
|                    |       |                                                                                                                                                                           | Vice President and Chief |
|                    |       |                                                                                                                                                                           |   | Financial Officer |

 

Pursuant to the requirements of the Securities Exchange Act of 1934, thisreport has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.
| Signature                      | ** ** | **Title**                              | ** ** | **Date**          |
|--------------------------------|------------|----------------------------------------|------------|-------------------|
|                           |       |                                   |       |              |
|                           |       |                                   |       |              |
| /s/ Rhys J. Best               |       | Chairman, Director,and Chief           |       | February 27, 2007 |
| (Rhys J. Best)                 |       | Executive Officer                      |       |              |
|                           |       | (Principal Executive Officer)          |       |              |
|                           |       |                                   |       |              |
| /s/ Charles J.  Keszler        |       | Vice President and Chief               |       | February 27, 2007 |
| (Charles J.  Keszler)          |       | Financial Officer (Principal Financial |       |              |
|                           |       | and Accounting Officer)                |       |              |
|                           |       |                                   |       |              |
| /s/ Dan O.  Dinges *           |       | Director                               |       | February 27, 2007 |
|  (Dan O. Dinges)          |       |                                   |       |              |
|                           |       |                                   |       |              |
| /s/ Frederick B.  Hegi, Jr. *  |       | Director                               |       | February 27, 2007 |
|  (Frederick B. Hegi, Jr.) |       |                                   |       |              |
|                           |       |                                   |       |              |
| /s/ Robert L.  Keiser *        |       | Director                               |       | February 27, 2007 |
|  (Robert L. Keiser)       |       |                                   |       |              |
|                           |       |                                   |       |              |
| /s/ Robert  Kelley *           |       | Director                               |       | February 27, 2007 |
|  (Robert Kelley)          |       |                                   |       |              |
|                           |       |                                   |       |              |
| /s/ M. Joseph  McHugh *        |       | Director                               |       | February 27, 2007 |
| (M. Joseph  McHugh)            |       |                                   |       |              |
|                           |       |                                   |       |              |
| /s/ Alfred M.  Micallef *      |       | Director                               |       | February 27, 2007 |
| (Alfred M.  Micallef)          |       |                                   |       |              |
|                           |       |                                   |       |              |
| /s/ David A.  Reed *           |       | Director                               |       | February 27, 2007 |
| (David A. Reed)                |       |                                   |       |              |
|                           |       |                                   |       |              |
| /s/ Jerry E.  Ryan *           |       | Director                               |       | February 27, 2007 |
| (Jerry E. Ryan)                |       |                                   |       |              |
|                           |       |                                   |       |              |

 
|        |                                    |   |   |   |
|--------|-----------------------------------------|--------|--------|--------|
| *By:   | /s/ Charles J. Keszler                  |   |   |   |
|   | (Charles J.  Keszler, Attorney-in-Fact) |   |   |   |

 

73

----