**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, DC 20549**

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**FORM 10-K**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the year ended December 31, 2006**

**or**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACTOF 1934

**CommissionFile Number 001-13711**

**WALTER INDUSTRIES, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                             |   | **13-3429953**      |
|------------------------------------------|--------|---------------------|
| (State or other jurisdiction of          |   | (IRS Employer       |
| incorporation or organization)           |   | Identification No.) |
| **4211 W. Boy Scout Boulevard**          |   | ** **          |
| **Tampa, Florida**                       |   | **33607**           |
| (Address of principal executive offices) |   | (Zip Code)          |

 

**(813) 871-4811**

Registrant’s telephonenumber, including area code: 

Securities registeredpursuant to Section 12(b) of the Act:

| **Title of each class**      |   | **Name of exchange on which registered** |
|------------------------------|--------|------------------------------------------|
| Common Stock, par value $.01 |   | New York Stock Exchange                  |

 

Securities registered pursuant to Section 12(g) ofthe Act:**  NONE**

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes x No o

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes x No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes x No o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o No x

The aggregate market valueof voting stock held by non-affiliates of the registrant, based on the closingprice of the Common Stock on June 30, 2006, the registrant’s most recentlycompleted second fiscal quarter, as reported by the New York Stock Exchange,was approximately $2.51 billion.

Number of shares of commonstock outstanding as of January 31, 2007: 51,959,977

**Documents Incorporated byReference**

Applicableportions of the Proxy Statement for the Annual Meeting of Stockholders of theCompany to be held April 25, 2007 are incorporated by reference in Part IIIof this Form 10-K.

 

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**PART I**

**Item1. Description of Business andItem 1A. Risk Factors**

**(a)  Narrative Description of Business**

**General**

Walter Industries, Inc.(“the Company”), organized in 1987, is a diversified company that operates infive reportable segments: Natural Resources, Sloss, Financing, Homebuilding andOther. Through these operating segments, the Company offers a diversified lineof products and services including coal and natural gas, furnace and foundrycoke and slag fiber, mortgage financing, and home construction.

During the year ended December 31,2006, the Company began reporting Sloss Industries Corporation (“Sloss”) as aseparate segment due to its significance in relation to the Company’scontinuing operations. Sloss was previously included in “Other.”  Sloss primarily manufactures and marketsfoundry and furnace coke, which are used by foundries and blast furnaces in theproduction of iron and steel products.

Our businesses may be grouped in the following broadcategories:

***Natural Resources and Sloss.***   OurNatural Resources segment consists primarily of Jim Walter Resources, Inc.(‘‘JWR’’) and Kodiak Mining Company, LLC (“Kodiak”). In 2006 JWR produced 5.7million tons of high quality coal, primarily for the metallurgical market. Inaddition, JWR owns 50% of Black Warrior Methane Corp., which extracts coalbedmethane gas. JWR generated 7.7 billion cubic feet of natural gas in 2006. TheCompany owns a 51% interest in Kodiak, which operates an underground mine inShelby County, Alabama designed primarily to produce steam coal. Sloss is amanufacturer of furnace and foundry coke and slag fiber.

***Financing and Homebuilding.******  ***Our Financing segment, whichconsists primarily of Mid-State Homes, Inc. (“MSH”) and Walter MortgageCompany (“WMC”), originates, purchases, services and securitizes non-conforminginstalment notes and loans that are secured by mortgages and liens. The mortgageportfolio at December 31, 2006 was approximately $1.8 billion. OurHomebuilding segment includes Jim Walter Homes, Inc. (‘‘JWH’’), a leadingon-your-lot homebuilder. JWH, which has a significant presence in thesoutheastern United States, provides mortgage financing for approximately 90%of the homes we build and sells these originated notes to MSH.

***Other.******  ***The Other segment includesthe Company’s land subsidiaries and corporate expenses.

**Recent Developments**

**Acquisition, Initial Public Offering and Spin-off ofMueller Water Products, Inc.**

*Acquisition*

In October 2005, theCompany acquired all of the outstanding common stock of Mueller Water Products, Inc.(“Mueller Water”) for $943.4 million and assumed approximately $1.1 billion ofindebtedness at Mueller Water. In conjunction with the acquisition, the Company’swholly owned subsidiary, United States Pipe and Foundry Company, LLC, (“U.S.Pipe”) was contributed to Mueller Water.

Also in October 2005,the Company announced its plan to undertake an initial public offering and aspin-off of Mueller Water to unlock shareholder value by creating a “pure play”water infrastructure company and a predominantly “pure play” coal company.

*Initial public offering*

In June 2006, MuellerWater completed its initial public offering (“IPO”) of 28.8 million shares of Series Acommon stock, at $16 per share (NYSE: MWA). The net proceeds of $428.9 millionwere used to 

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repay aportion of Mueller Water’s existing debt. The Company did not receive any cashproceeds from the offering. In connection with the issuance of the Series Acommon stock, Mueller Water issued 85.8 million shares of Series B commonstock to the Company in exchange for the Company’s one share held prior to theIPO.

*Spin-off*

On December 14, 2006,the Company distributed all of its 85.8 millionshares of Mueller Water Series B common stock to itsshareholders. The distribution took place in the form of a pro rata commonstock dividend whereby each shareholder received 1.6524432  shares ofMueller Water Series B common stock for each share of Company common stockheld on the record date (“the spin-off”). The spin-off was intended to betax-free to the Company and to the shareholders of the Company for U.S. incometax purposes, except for any cash received in lieu of fractional shares.

The Company and MuellerWater are now independent and have separate public ownership, boards ofdirectors and management. To facilitate Mueller Water’s separation from theCompany, the Company and Mueller Water are providing certain services to eachother during a transition period not to exceed one year from the spin-off date.Amounts previously reported in the Mueller Co., Anvil and U.S. Pipe segments,collectively “Mueller Water,” are presented in discontinued operations for allperiods presented.

**Debt and Equity Transactions**

In addition to the stockdividend issued to shareholders in December 2006 relating to the spin-offof Mueller Water, significant changes to the Company’s debt and equitystructure during 2006 include:

*Common Stock Offering*

In February 2006, theCompany raised $168.7 million in net proceeds from a 2.645 million share commonstock offering. Of these proceeds, $102.9 million was used to repay the termloan under the 2005 Walter Credit Agreement.

*Conversion of Convertible Senior Subordinated Notes*

During 2006, holders ofapproximately $174.2 million of the Company’s Convertible Senior SubordinatedNotes surrendered these notes in exchange for 9.761 million shares of theCompany’s common stock and $19.4 million of conversion inducement fees. At December 31,2006, $0.8 million of these notes remain outstanding.

*Issuance of Asset-Backed Notes*

In November 2006,Mid-State Capital Corporation, an indirect subsidiary of the Company, completedits 2006-1 Trust private offering of $256.9 million in asset-backed notes.The notes mature in October 2040 and bear interest at a weighted average,fixed coupon rate of 6.28%. The net proceeds were used to repay borrowingsunder the Mid-State Trust IX and Mid-State Trust XIV mortgage warehousefacilities and provided $39.2 million of liquidity for the Company’s generalcorporate purposes.

*Prepayment of Term Loan*

In 2006, the Companyrepaid $200.2 million of its term loan under the 2005 Walter Credit Agreementusing proceeds from the February 2006 common stock issuance and availablecash flow.

**Other Strategic Initiatives**

As previously announced, theCompany continues to evaluate strategic alternatives for its Financing andHomebuilding businesses.

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The Company makes itsAnnual Report on Form 10-K, Quarterly Reports on Form 10-Qand Current Reports on Form 8-K and amendments thereto available onits website at *www.walterind.com* without chargeas soon as reasonably practical after filing or furnishing these reports to theSecurities and Exchange Commission (“SEC”). Additionally, the Company will alsoprovide, without charge, a copy of its Form 10-K to any shareholderby mail. Requests should be sent to Walter Industries Inc., Attention:Shareholder Relations, 4211 W. Boy Scout Boulevard, Tampa, Florida 33607. Youmay read and copy any document the Company files at the SEC’s public referenceroom at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330for further information on the public reference room. The Company’s SEC filingsare also available to the public from the SEC’s website at http://www.sec.gov.

**(b)  Industry Segments**

The Company’s industrysegment information is included in Note 20 of “Notes to Consolidated FinancialStatements” included herein.

**(c)  Description of Business**

**Natural Resources**

*Jim Walter Resources, Inc.*

The operations of JimWalter Resources, Inc. (“JWR”) are conducted through its Mining Division,which mines and sells high quality metallurgical coal from two undergroundmines in Alabama, and its De-Gas Division, which extracts and sellsnatural gas from the coal seams owned or leased by JWR. In December 2006,mining operations ceased at Mine No. 5. The preparation plant at Mine No. 5will remain operational and serve as the washer and shipping point forproduction associated with the Mine No. 7 East expansion project.

In 2004, the Companyannounced a project to expand production in an area called Mine No. 7 East.The new mine area will consist of one additional longwall unit and threecontinuous miner sections, providing incremental annual production capacity ofapproximately 2.7 million tons. The investment of approximately $175 millionwill result in longwall production beginning in early 2009. Capitalexpenditures through December 31, 2006 related to this expansion projectamounted to $49.3 million and are expected to be approximately $74.0 million in2007.

The Mining Division hadnet sales and revenues of $611.7 million, $493.5 million and $347.8 million inthe years ended December 31, 2006, 2005 and 2004, respectively.

The Mining Division,headquartered in Brookwood, Alabama, currently has approximately 7.0 milliontons of rated annual coal production capacity from its mines located in westcentral Alabama between the cities of Birmingham and Tuscaloosa. The MiningDivision extracts coal primarily from Alabama’s Blue Creek seam, which containhigh-quality bituminous coal. Blue Creek coal offers high coking strength withlow coking pressure, low sulfur and low-to-medium ash content with high BTUvalues that can be sold either as metallurgical coal (used to produce coke) oras compliance steam coal (used by electric utilities because it meets currentenvironmental compliance specifications).

The majority of coal ismined using longwall extraction technology with development support fromcontinuous miners. Underground mining with longwall technology drives greaterproduction efficiency, improved safety, higher coal recovery and lowerproduction costs. The Mining Division currently operates one longwall miningsystem in each mine for primary production and four to six continuous miner sectionsin each mine for the development of mains and longwall panel entries. As notedabove, the Company is investing in Mine No. 7 East such that the mine willoperate two longwall mining systems. The Mining Division’s normal operatingplan is a longwall/continuous miner production ratio of approximately 80% / 20%.This ratio is expected to remain consistent after the closure of Mine No. 5and following the start of longwall operations for the Mine No. 7 Eastexpansion in 2009.

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Environmental expendituresimposed by laws relating to mining have been insignificant to date and nosubstantial expenditures are expected in the future.

The Mining Division’s coalis principally sold to a diversified base of offshore metallurgical coalcustomers. The division’s metallurgical coal is sold to customers in numerousmarkets throughout Europe, South America, Turkey and Africa. Most metallurgicalcoal sales are made under fixed price supply contracts, usually with a durationof one year, running principally from July through June. However, somesales of metallurgical coal can occur in the spot market as dictated byavailable JWR supply and market demand. During 2006, JWR’s two largestcustomers represented approximately 11.7% and 11.2% of the Mining Division’ssales, respectively. The Company believes that the loss of those customerswould not have a material adverse effect on the results of operations of theCompany as the loss of volume from these customers would be replaced with salesto other existing or new customers due to strong worldwide demand formetallurgical coal. Foreign sales accounted for approximately 95% of the MiningDivision’s net sales during the year. Domestic sales include coal sold toSloss.

The De-Gas Division,headquartered in Brookwood, Alabama, extracts and sells natural gas from thecoal seams owned or leased by JWR, primarily through Black Warrior MethaneCorp., an equal ownership joint venture with El Paso Production Co., asubsidiary of El Paso Corporation.  JWRalso operates a wholly owned low quality gas (“LQG”) facility.

The original motivationfor the joint venture was to increase safety in JWR’s Blue Creek mines byreducing natural gas concentrations with wells drilled in conjunction with themining operations. There were 415 wells producing approximately 13.8 billioncubic feet of natural gas in 2006. JWR generated 7.7 billion cubic feet in2006, including 1.4 billion cubic feet from its LQG operations. Thedegasification operation has improved mining operations and safety by reducingmethane gas levels in the mines, and has been a highly profitable operation. Withthe shutdown of Mine No. 5, gas production is expected to decline toapproximately 6.8 to 7.1 billion cubic feet in 2007.

*Kodiak Mining Company, LLC*

Kodiak Mining Company, LLC(“Kodiak”) was established in 2005 to develop and operate an underground coalmine in Shelby County, Alabama. The mine has high BTU, low sulfur coal that canbe sold into either the metallurgical or steam coal market. Total production isexpected to reach approximately 0.7 million tons per year until the coal isexhausted or a new mining area is developed. Production began in 2006 and isexpected to reach 0.4 million tons in 2007.

**Sloss**

Sloss is a manufacturingoperation, founded in 1920 and headquartered in Birmingham, Alabama, which hasthree major product lines:  foundry coke,furnace coke and slag fiber. Foundry coke (approximately 130,000 tons per year)is marketed to ductile iron pipeplants and foundries producing castings, such as for the automotive andagricultural equipment industries. Furnace coke is sold primarily to thedomestic steel industry for producing steel in blast furnaces. Slag fiber is aninsulating fiber utilized principally as a raw material by acoustical ceilingtile manufacturers.

**Financing**

Within the Financingsegment, MSH purchases and services instalment notes and mortgages originatedby its affiliated homebuilder, JWH. WMC an indirect subsidiary of the Company,offers financing to JWH homebuyers that is secured by first lien mortgages andalso purchases mortgage loans from third parties. WMC’s mortgage loans are alsosold to MSH, but are serviced by WMC through a sub-servicing agreement with MSH.References to instalment notes include mortgage loans originated or purchasedby WMC. Mortgage loans in the portfolio, before allowances, were approximately$213.9 million and $148.0 million at December 31, 2006 and 2005,respectively. At December 31, 2006, the Company held fixed (96%) and variable-rate (4%) instalment notesranging from 5.3% to 13.7% annual 

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percentage rate, without points or closing costs. Seealso Note 3 of “Notes to Consolidated Financial Statements” included herein fora description of the revenue recognition policies of Financing.

*Mid-State Homes, Inc.*

MSH, headquartered inTampa, Florida, was established in 1958 to purchase and service mortgageinstalment notes originated by JWH. Currently, MSH funds its purchase of thesemortgage instalment notes as well as the mortgage loans it acquires from WMCusing various warehouse lines of credit. Historically, once a critical mass ofassets have been accumulated, MSH securitizes the assets using a grantor trust,structured as a financing, which requires that the assets and liabilities berecorded on the balance sheet with no gain for tax purposes. These businesstrusts acquire the mortgage instalment notes and loans using the proceeds fromborrowings secured by the notes. MSH owns, directly or indirectly, all of thebeneficial interests in these trusts. Only the notes in the trusts secure theborrowings of these trusts, and therefore these borrowings are non-recourse tothe Company. For additional information on the notes, the trusts and theirrelated borrowings, see Notes 8 and 14 of “Notes to Consolidated FinancialStatements.”

At December 31, 2006,MSH’s portfolio was geographically distributed as follows:  Texas (32%), Mississippi (15%), Alabama (8%)and Florida and Louisiana, (each 6%). The remaining portfolio was spread primarilyin other southeastern states.

*Walter Mortgage Company*

WMC was established in2001 to provide home financing to customers of JWH. Through WMC, homebuyershave the option of financing land along with their home purchase, including atraditional cash down payment in lieu of land equity. Existing MSH customersalso have the option of refinancing their mortgage with WMC. WMC initiated aprogram to acquire mortgage loans in 2003 that meet the Company’s underwritingcriteria. Loans are purchased from other mortgage companies, banks, thrifts,builders and other various sellers of first lien mortgages. During 2006, $103.8million of mortgage loans were purchased by WMC from third parties. Activity atWMC since inception through December 31, 2006, includes 3,401 mortgagestotaling approximately $321.6 million.

*Other*

Best Insurors, Inc. (“Best”),located in Tampa, Florida, is an agency that primarily places fire and extendedinsurance coverage for homeowners who finance through WMC or JWH. Cardem InsuranceCompany Ltd. (“Cardem”), located in Bermuda, primarily provides reinsurance ofsuch insurance placed through Best and provides captive coverage for variousother company risks, including workers’ compensation for Homebuilding.

**Homebuilding**

*Jim Walter Homes, Inc.*

Jim Walter Homes, Inc.and its subsidiaries (“JWH”), headquartered in Tampa, Florida, markets andsupervises the construction of detached, single-family residential homes, onland owned by its customers, primarily in the southeastern United States wherethe weather generally permits year-round construction. JWH also providesfinancing on a significant portion of the homes sold. JWH, through its whollyowned subsidiary Crestline Homes, Inc., also manufactures and distributesmodular (factory-built) homes. In 2007, JWH made the decision to exit themodular manufacturing business.

JWH historically hasconcentrated on the low- to moderately-priced segment of the housing market. JWH’sproducts consist of over 60 models ranging in size from approximately 800 toover 3,000 square feet. At December 31, 2006, JWH operated 81 branchoffices located in 16 states. During 2006 JWH’s net sales, excluding modularunit shipments, are represented in the following states: Texas (21%); Florida(14%); Mississippi (12%); Louisiana (11%); Alabama (8%); South Carolina, NorthCarolina and Georgia, (each 

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6%). Approximately69% of the branch offices are located on land that is owned by JWH, with thebalance located on leased land. Branch offices serve as “sales centers” thatare designed to allow customers to view various model homes.

Historically, JWH has not owned or acquired land forhome construction purposes and was not a land developer, which significantlylimits the amount of required capital to operate the business. The actualconstruction of conventionally-built homes sold by JWH is generally performedon customer-owned land by local building sub-contractors with their own crews,pursuant to subcontracts executed in connection with each home.

JWH builds homes which are constructed to varyingdegrees of interior completion. JWH’s product line includes “shell” homes,which are completely finished on the outside, with the inside containing onlyrough floors, ceiling joists, partition studding and closet framing. Themajority of JWH’s customers select all interior options, thereby purchasing ahome considered to be “90+% complete,” which generally excludes only driveway,landscaping and utility connections. Remaining units are sold at varying stagesof interior finishing.

Thefollowing chart shows the unit sales volume of JWH and the percent of homessold by category  for the years ended December 31,2006, 2005 and 2004:

| ** **                                  | ** ** | ** ** | ** ** | **Percent of Unit Sales** | ** ** |
|---------------------------------------------|------------|------------|------------|------------------------------------------|------------|
| **Year Ending December 31,** | ** ** | ** ** | ** ** | **Units Built**                     | ** ** | **Shell** | ** ** | **Various Stages** | ** ** | **90+% Complete** | ** ** | **Modular** | ** ** |
| 2006                                        |       |       | 3,047      |                                     |       |   | 4 | % |   |   | 9 | % |   |   | 75 | % |   |   | 12 | % |   |
| 2005                                        |       |       | 3,022      |                                     |       |   | 4 | % |   |   | 6 | % |   |   | 68 | % |   |   | 22 | % |   |
| 2004                                        |       |       | 3,251      |                                     |       |   | 6 | % |   |   | 7 | % |   |   | 71 | % |   |   | 16 | % |   |
|                                             |            |            |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

During the years ended December 31, 2006, 2005and 2004, the average net sales price of all homes sold was $90,000, $74,700and $71,700, respectively.

The estimated backlog of stick-built homes to beconstructed by JWH as of December 31, 2006 was 1,513, as compared to 2,053at December 31, 2005. After the land is cleared and appropriate buildingpermits are obtained, the time to construct a home averages between thirteenand twenty-one weeks.

Most homes sold by JWH are purchased with financingprovided by JWH. Qualified customers may obtain financing on an instalment salecontract offered on a fixed-rate mortgage basis generally requiring no downpayment and secured by the home and the land on which it is situated. JWH doesnot charge closing costs, points, credit service fees or similar add-on chargesand does not require private mortgage insurance. When a home is financed byJWH, the Company does not obtain third party appraisals or title insurance. JWHoffers credit terms for up to a maximum of 30 years, up to 100% of the purchaseprice of the home. During 2006, the stated annual percentage rates offered fornew mortgage instalment notes ranged between 7.0% and 10.5%.

If JWH finances the newhome purchase, upon completion of construction to the agreed-upon percentage,in the ordinary course of business, JWH sells the building and instalment salecontract, the note and the related mortgage, deed of trust or other securityinstrument to MSH, pursuant to an agreement between JWH and MSH.

**Other**

**The Other segment includes theCompany’s land subsidiaries and corporate expenses. The land subsidiariesengage in maximizing the value of vacant land, primarily through outright propertysales and realizing royalty income on coal, timber and other minerals. Corporateexpenses consist primarily of salaries, overhead and other costs associatedwith executive management, finance, accounting, tax, treasury, legal,information technology, risk management, human resources, payroll and othermanagement services.**

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**Seasonality**

Certain of the businessesof the Company are subject to seasonal fluctuations to varying degrees. Salesat JWH are usually lowest in the winter months due to weather and the lowerlevel of construction activity. The businesses of the Company may also besignificantly influenced by the general economy, interest rates, levels ofconstruction activity and commodity prices.

**Competition**

See “Risks Related to theBusiness—*We face significant competition in the industriesin which we operate and foreign competition is intense and could harm oursales, profitability and cash flows.”*

**Trade Names,Trademarks and Patents**

The names of each of theCompany’s subsidiaries are well established in the respective markets theyserve. Management believes that customer recognition of such trade names is ofsignificant importance. The Company’s subsidiaries have numerous patents andtrademarks. Management does not believe, however, that any one such patent ortrademark is material to the Company’s individual segments or to the businessas a whole.

**Research andDevelopment**

Research activitiesconducted by each business are directed toward new products, improvement ofexisting products, development of new uses for existing products, process andsystems development and cost reduction efforts. Total research and developmentexpenditures for all of the businesses in the years ended December 31,2006, 2005 and 2004, were less than 1% of the Company’s consolidated net salesand revenues.

**Raw Materials andLabor**

Substantially all of theraw materials needed for the operations of the Company and its subsidiaries areeither purchased from domestic sources or produced by the Company and itssubsidiaries. All materials used by the various businesses of the Company areavailable in quantities required to support their respective operations. Availabilityand the cost of raw materials may have a significant influence over therevenues and costs of the Company. Costs potentially having a significantinfluence on the Company include coal, electricity, lumber, other buildingmaterials and labor. See further discussion in “Risks Related to the Business*—**Shortages or price fluctuations inraw materials and labor could delay, or increase the cost of construction orproduction and adversely affect our results of operations.”*

**Environmental**

The Company and its subsidiaries are subject to a widevariety of laws and regulations concerning the protection of the environment,both with respect to the construction and operation of many of its plants,mines and other facilities, and with respect to remediating environmentalconditions that may exist at its own and other properties. The Company believesthat it and its subsidiaries are in substantial compliance with federal, stateand local environmental laws and regulations. Expenses charged to continuingoperations for compliance of ongoing operations and for remediation ofenvironmental conditions arising from past operations in the years ended December 31,2006, 2005 and 2004 were approximately $4.9 million, $5.9 million and $5.2million, respectively. Because environmental laws and regulations continue toevolve, and because conditions giving rise to obligations and liabilities underenvironmental laws are in some circumstances not readily identifiable, it isdifficult to forecast the amount of such future environmental expenditures orthe effects of changing standards on future business operations or results.Consequently, the Company can give no assurance that such expenditures will notbe material in the future.

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Environmental matters aremore fully described in Note 18 of “Notes to Consolidated Financial Statements.”

**Employees**

As of December 31,2006, the Company and its subsidiaries employed approximately 2,800 people, ofwhom approximately 1,400 were hourly workers and 1,400 were salaried employees.Unions represented approximately 1,200 employees under collective bargainingagreements, of which approximately 970 were covered by one contract with theUnited Mine Workers of America that expires on December 31, 2011.

**Risk Related to theBusiness**

***Our business may suffer as a result of changes ingeneral and local economic conditions and other factors beyond our control,which could depress demand for our products.***

Certain of the industries in which we operate arecyclical and have experienced significant difficulties in the past. Ourfinancial performance depends, in large part, on varying conditions in themarkets we serve, which fluctuate in response to various factors beyond ourcontrol.

The prices at which JWR sells coal and natural gas arelargely dependent on prevailing market prices for those products. We haveexperienced significant price fluctuations in our coal and natural gasbusinesses, and we expect that such fluctuations will continue. Demand for and,therefore, the price of, coal and natural gas are driven by a variety offactors such as availability, price, location and quality of competing sourcesof coal or natural gas, availability of alternative fuels or energy sources,government regulation and economic conditions. In addition, reductions in thedemand for metallurgical coal are caused by reduced steel production by ourcustomers, increases in the use of substitutes for steel (such as aluminum,composites or plastics) and the use of steel-making technologies that use lessor no metallurgical coal. Demand for steam coal is primarily driven by theconsumption patterns of the domestic electric power generation industry, which,in turn, is influenced by demand for electricity and technological developments.We estimate that a 10% decrease in the price of coal in 2006 would haveresulted in a reduction in pre-tax income of $54 million. Demand for naturalgas is also affected by storage levels of natural gas in North America andconsumption patterns, which can be affected by weather conditions. We estimatethat a 10% decrease in the price in natural gas in 2006 would have resulted ina reduction in pre-tax income of approximately $1.4 million in that year,which includes the benefit of hedges. Occasionally we utilize derivativecommodity instruments to manage fluctuations in natural gas prices. Currently,we have hedged approximately 28% of our anticipated 2007 natural gas productionat an average price of $8.85 per mmbtu.

Demand in the financingand homebuilding businesses is affected by changes in general and localeconomic conditions, such as interest rates, housing costs, migration patterns,employment levels, job growth and consumer confidence. An oversupply ofalternatives to new homes, such as rental properties and used homes, coulddepress prices and reduce margins for the sale of new homes. Higher interestrates generally increase the cost of mortgage loans to customers and thereforereduce demand for new homes and mortgage loans. Almost all purchasers of ourhomes require mortgage financing for a substantial portion of the purchaseprice. In times of low interest rates and increased availability of mortgagefunds, the volume of home sales by JWH may be expected to decrease as additionalcompetition is able to enter the market. Recently, interest rates have beenincreasing from historically low levels. Lastly, weather conditions and naturaldisasters, such as the recent hurricanes in the southeastern United States,tornadoes, floods and fires, can harm the local homebuilding business. Thisrisk is exacerbated by our concentration in a limited number of states.

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***Our business is subject to risk of price increases andfluctuations and delay in the delivery of raw materials and purchased components.***

Most of the industries in which we operate requiresignificant amounts of raw materials and labor and, therefore, shortages orincreased costs of raw materials and labor could adversely affect our businessor results of operations.

Our homebuilding operationsrely on the availability of lumber, drywall, cement and other buildingmaterials. The availability and market prices of these materials are influencedby various factors that are beyond our control. Shortages of, and priceincreases for, such materials have occurred in the past and may occur in thefuture. Further, if we are unable to secure a proper level of skilled labor forour homebuilding operations, we may be unable to build as many houses or buildthem as cost effectively, and our levels of revenue and net income may bereduced.

***We face significant competition in the industries inwhich we operate and foreign competition is intense and could harm our sales,profitability and cash flows.***

Our coal business faces competition from foreignproducers that sell their coal in the export market and, therefore,fluctuations in exchange rates will affect the price for coal we produce. Ifour competitors’ currencies decline against the U.S. dollar or against ourcustomers’ currencies, those competitors may be able to offer lower prices toour customers. Furthermore, if the currencies of our overseas customers were tosignificantly decline in value in comparison to the U.S. dollar, thosecustomers may seek decreased prices for the coal we sell to them. Both of thesefactors could reduce our profitability or result in lower coal sales.

The homebuilding industryis highly competitive and fragmented. We compete in each of our markets withnumerous national, regional and local builders. Some of these builders havegreater financial resources, more established market positions and lower costsof capital, labor and material than we do. We compete for customers, rawmaterials and skilled subcontractors. We also compete with resales of existinghomes and available rental housing. Our financing operations are subject tocompetition from third-party providers, many of which are substantially larger,may have a lower cost of funds or overhead than we do and may focus exclusivelyon providing such services.

***Our revenues are seasonal due to weather conditionsand the level of construction activity at different times of the year; we maynot be able to generate revenues that are sufficient to cover our expensesduring certain periods of the year.***

The homebuilding industryis moderately seasonal, with lower production and lower revenues during thewinter months. This seasonality in demand has resulted in fluctuations in ourrevenues and operating results. Because much of our overhead and expenses arefixed payments, seasonal trends can cause reductions in our overall profitmargin and financial condition, especially during our slower periods.

***We are exposed to increased risks of delinquencies,defaults and losses on mortgages and loans associated with our strategy ofproviding credit or loans to lower credit grade borrowers.***

We specialize in originating, securitizing andservicing mortgage notes and loans (which we refer to as “mortgage assets”) tocredit-impaired borrowers who are generally unable to qualify for loans fromconventional mortgage sources due to loan size, credit characteristics ordocumentation standards. We are subject to various risks associated with thelower credit homeowners to whom we finance, including, but not limited to, therisk that these borrowers will not pay interest and principal when due, andthat the value received from the sale of the borrower’s home in a repossessionwill not be sufficient to repay the borrower’s obligation to us. Delinquenciesand defaults cause reductions in our interest income and our net income.

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If delinquencyrates and losses are greater than we expect:

·       thefair market value of the mortgage assets pledged as collateral for warehouseborrowings, and the value of our ownership interest in the securitizations, maydecline;

·       wemay be unable to obtain financing or continue to securitize loans on attractiveterms, or at all; or

·       theallowances that we establish for losses on mortgage assets may be insufficient,which could depress our business, financial condition, liquidity and netincome.

During economic slowdowns or recessions, mortgage andloan delinquencies and defaults generally increase. In addition, significantdeclines in market values of residences securing mortgages and loans reducehomeowners’ equity in their homes. The limited borrowing power of our customersincreases the likelihood of delinquencies, defaults and credit losses onforeclosure. Many of our borrowers have limited access to consumer financingfor a variety of reasons, including a relatively high level of debt service,lower credit scores, higher loan-to-value ratios of the mortgage assets, pastcredit write-offs, outstanding judgments or prior bankruptcies. As a result,the actual rate of delinquencies, repossessions and credit losses on our loansare often higher under adverse economic conditions than those experienced inthe mortgage loan industry in general.

In addition, the rate of delinquencies may be higherafter natural disasters or adverse weather conditions. For example, during thethird quarter of 2005, Hurricane Katrina impacted several states where ourmortgage asset portfolio had high concentrations of customers. As a result, ourdelinquency rate in those states increased substantially and we incurred aspecial $1.3 million provision for estimated losses on instalment notesthat was anticipated as a result of Hurricane Katrina.

After a default by aborrower, we evaluate the cost effectiveness of repossessing the property. Suchdefault may cause us to charge our allowances for credit losses on our loanportfolio. Any material decline in real estate values increases theloan-to-value ratios of our loans and the loans backing our mortgage relatedsecurities. This weakens collateral values and the amount, if any, obtainedupon repossessions. If we must take losses on a mortgage or loan backing ourmortgage related securities or loans that exceed our allowances, our financialcondition, net income and cash flows could suffer.

***We depend on short-term borrowings to fund ourmortgage origination business which exposes us to liquidity risks.***

We depend on short-term borrowings to warehouseinstalment notes and mortgages that are originated by our homebuildingsubsidiaries and WMC and purchased by MSH. Therefore, we rely on our ability torenew or replace our maturing short-term borrowings on a continuous basis. Wecurrently have two committed warehouse facilities providing up to an aggregateof $350.0 million of liquidity by three lenders and one surety provider.If our lenders do not allow us to renew our borrowings or we cannot replacematuring borrowings on favorable terms or at all, we might have to sell ourmortgage-related assets under adverse market conditions, or we might not beable to continue to originate mortgage assets, which would significantly harmour net income and may result in material losses.

We pay interest on our borrowings under our variablefunding warehouse loan facilities at a floating rate based on short-term rates,and, therefore, increases in short-term interest rates will increase the costof our facilities. In addition, if the regulatory capital requirements imposedon our lenders change, it may significantly increase the cost of the variablefunding loan facilities. Increases in the cost of our facilities would reduceour profitability and may prevent us from continuing to originate instalmentnotes and mortgages.

The amount of financing wereceive under our variable funding loan facilities is directly related to thelenders’ valuation of the mortgage assets that secure the outstandingborrowings. Our lenders have the ability to re-evaluate the market value of themortgage assets that secure our outstanding borrowings under certaincircumstances. In the event the lenders determine that the value of themortgage assets has 

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decreased,they have the right to initiate a margin call. A margin call would require usto transfer additional instalment notes and mortgage loans to the lenders(without any advance of funds from the lenders for such transfer of mortgages)or to repay a portion of the outstanding borrowings. Any such margin call couldcause our mortgage origination business, net income and liquidity to declinesignificantly.

***Our strategy of securitizing our mortgage assets makesus dependent on the capital markets for liquidity and cash flow and exposes usto substantial risks.***

We rely on our securitizations to generate cash forrepayment of borrowings under our variable funding loan facilities, originationof new mortgage assets and general working capital purposes. We may not succeedin securitizing mortgage assets that we currently have outstanding under, andpledged to, our warehouse credit facilities or that we originate in the future.Our inability to continue to successfully securitize our mortgage assets onfavorable terms would significantly impair our mortgage origination businessand reduce our profitability.

Our ability tocomplete securitizations of our mortgage assets at favorable prices, or at all,depends on a number of factors, including:

·       thehistorical performance of the portfolio of mortgage assets we originate;

·       theratings of our securities;

·       theavailability of credit enhancement on acceptable economic terms or at all;

·       conditionsin the capital markets generally and conditions in the mortgage asset-backed securitiesmarket specifically; and

·       generaleconomic conditions.

Significant increases ininterest rates may reduce our ability to securitize our mortgage assetsand could negatively impact our profitability and cash flow. The interestrates that we receive on our mortgage assets are fixed between 12 and18 months before we complete a securitization. If interest rates increasesignificantly during this time, the net interest margin we realize would beimpaired and reduce profitability and cash flow. In addition, we may berequired to pledge additional collateral to meet over-collateralizationrequirements, which could decrease the value of our ownership interests andhave a negative impact on our cash flow.

***Our mortgage-backed and asset-backed securitizationsrequire over-collateralization and credit enhancement, which may decrease ourcash flow and net income.***

Our securitizations typically haveover-collateralization requirements that may decrease the value of ourownership interests in our securitizations and have a negative impact on ourcash flow. Generally, if the mortgage assets of a securitization trust performpoorly, the over-collateralization feature of the securitization directs excesscash flow from the securitized pool of mortgage assets to the senior debtsecurities of the trust. During any period in which this happens we may notreceive any cash distributions from such mortgage trust. In addition, the poolof mortgage assets of a securitization must meet certain performance testsbased on delinquency levels, losses and other criteria in order for us toreceive excess cash flow. If these performance tests, or significant termsregarding the calculation of such tests, are not satisfied, we would not bepermitted to receive excess cash flow from the securitizations. Materialvariations in the rate or timing of our receipt of cash distributions fromthese mortgage assets may adversely affect our mortgage origination businessand net income and may affect our overall financial condition.

Furthermore, all of ourcompleted securitizations have used credit enhancement to improve the prices atwhich we issued our mortgage-backed and asset-backed notes. We currently expectthat the credit enhancement for the senior tranches we issue in the future willbe primarily in the form of subordination of certain tranches, financialguaranty insurance policies for the assets or both. The market for any 

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subordinatesecurities we issue could become temporarily illiquid or trade at steepdiscounts, thereby reducing the proceeds we receive from a securitization ofmortgage assets. If we use financial guaranty insurance policies and the costof these insurance policies increases, our net interest margin will be reduced.Such credit enhancement features may not be available at costs that would allowus to achieve profitable levels of net interest margin from the securitizationsof our mortgage assets.

***We may be subject to product liability or warrantyclaims that could require us to make significant payments.***

We would be exposed to product liability claims in theevent that the use of our products results, or is alleged to result, in bodilyinjury and/or property damage. There is a risk that we will experience productliability or warranty losses in the future or that we will incur significantcosts to defend such claims. Such losses and costs may be material. While wecurrently have product liability insurance, our product liability insurancecoverage may not be adequate for any liabilities that may ultimately beincurred or the coverage may not continue to be available on terms acceptableto us. A successful claim brought against us in excess of our availableinsurance coverage could require us to make significant payments or cause arequirement to participate in a product recall that may harm our reputation orprofitability.

We warrant ourhomebuilding products to be free of certain defects. As a homebuilder, we aresubject in the ordinary course of our business to product liability and homewarranty claims. Because of the long useful life of our products, it ispossible that latent defects might not appear for several years. Any lossesthat result or are alleged to result from defects in our products, couldsubject us to claims for damages, including consequential damages. In addition,we could elect to replace our defective products and/or compensate ourcustomers for damages caused by our defective products even in the absence of aformal claim for damages. The insurance that we maintain may not be availableon terms acceptable to us in the future and such coverage may not be adequatefor liabilities actually incurred. Any claims or expenses relating to defectiveproducts that result in liability exceeding our insurance coverage could raisecosts and expenses or require us to accrue expenses or record accountingcharges and reduce our net income. Further, claims of defects could result inadverse publicity against us, which could lower our sales and harm ourbusiness.

***Environmental, health and safety laws and regulationscould subject us to liability for fines, clean-ups and other damages, requireus to incur significant costs to modify our operations and increase ourmanufacturing costs.***

We are subject to a wide variety of laws andregulations concerning the protection of the environment and human health andsafety, both with respect to the construction and operation of our mines andother facilities and with respect to remediating environmental conditions thatmay exist at our own and other properties. Certain of our facilities have beenin operation for many years and, over time, we and predecessor operators ofthese facilities may have generated, used, handled and disposed of hazardousand other regulated wastes. Environmental liabilities could exist, includingcleanup obligations at these or at other locations where materials from ouroperations were disposed of, which could result in future expenditures thatcannot be currently quantified and which could reduce our profits. Failure tocomply with any environmental, health or safety requirements could result inthe assessment of damages, or imposition of penalties, suspension ofproduction, a required upgrade or change to equipment, or processes or acessation of operations at one or more of our facilities. Because these laws arecomplex, constantly changing and may be applied retroactively, there is a riskthat these requirements, in particular as they change in the future, may impairour business, profitability and results of operations.

We may be required toconduct investigations and perform remedial activities that could require us toincur material costs in the future. Our operations involve the use of hazardoussubstances and the disposal of hazardous wastes. We may incur costs to managethese substances and wastes and may be subject to claims for damage forpersonal injury, property damages or damage to natural resources.

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***Our homebuilding operations expose us to a variety ofrisks including liability for action of third parties.***

We are exposed to avariety of risks associated with construction activities, including shortagesof raw materials or labor, cost overruns, unforeseen environmental orengineering problems and natural disasters, any of which could delayconstruction and result in a substantial increase in our expenses. In addition,we contract with unaffiliated subcontractors to construct our homes. Althoughthe timing and quality of our construction depends on the availability, skilland cost of these subcontractors, we are responsible for the performance of theentire contract, including work assigned to these subcontractors. Anyconstruction delays or cost increases could harm our operating results, theimpact of which may be further affected by our inability to raise sales prices.

***Economic conditions in Texas, North Carolina,Mississippi, Alabama and Florida have a material impact on our profitabilitybecause we conduct a significant portion of our business in these markets.***

We currently conduct asignificant portion of our financing and homebuilding businesses in the Texas,North Carolina, Mississippi, Alabama and Florida markets. In the past, homeprices and sales activities have declined from time to time and rates of lossand delinquency on mortgage assets have increased from time to time, drivenprimarily by weaker economic conditions in these markets. Furthermore,precarious economic and budget situations at the state government level maydepress the market for our homes or hinder the ability of our customers torepay their obligations in areas in which we conduct the majority of ourfinancing or homebuilding operations. Our concentration of homebuilding or mortgageassets in such markets may have a negative impact on our operating results.

***Our failure to retain our current customers and renewour existing customer contracts could adversely affect our business.***

A significant portion ofthe sales of our coal and methane gas are to long-term customers. The successof these businesses depends on our ability to retain our current clients, renewour existing customer contracts when required and solicit new customers. Ourability to do so generally depends on a variety of factors, including thequality and price of our products, our ability to market these productseffectively and the level of competition we face.

***If transportation for our coal becomes unavailable oruneconomic for our customers, our ability to sell coal could suffer.***

Transportation costs represent a significant portionof the total cost of coal and, as a result, the cost of transportation is acritical factor in a customer’s purchasing decision. Increases in ourtransportation costs could make our coal less competitive with the same oralternative products from competitors with lower transportation costs.

We typically depend uponrail or barge to deliver coal to the port of Mobile, Alabama. While our coalcustomers typically arrange and pay for transportation from the port of Mobileto the point of use, disruption of any of these transportation services becauseof weather-related problems, strikes, lock-outs or other events couldtemporarily impair our ability to supply our products to our customers, therebyresulting in lost sales and reduced profitability. All of our mines are servedby only one rail carrier, which increases our vulnerability to these risks,although our access to barge transportation partially mitigates that risk.

***The government extensively regulates our miningoperations, which imposes significant costs on us, and future regulations couldincrease those costs or limit our ability to produce coal.***

Federal, state and local authorities regulate the coalmining industry with respect to matters such as employee health and safety,permitting and licensing requirements, air quality standards, water pollution,plant and wildlife protection, reclamation and restoration of mining propertiesafter mining is completed, the discharge of materials into the environment,surface subsidence from underground mining, and the 

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effects that mining has ongroundwater quality and availability. In addition, we are subject tosignificant legislation mandating specified benefits for retired coal miners.Numerous governmental permits and approvals are required for mining operations.We are required to prepare and present to federal, state or local authoritiesdata pertaining to the effect or impact that any proposed exploration for orproduction of coal may have upon the environment. Compliance with theseregulations may be costly and time-consuming and may delay commencement orcontinuation of exploration or production operations. The possibility existsthat new legislation and/or regulations and orders may be adopted that may havea material adverse effect on our mining operations, our cost structure and/orour customers’ ability to use coal. New legislation or administrativeregulations (or judicial interpretations of existing laws and regulations),including proposals related to the protection of the environment that wouldfurther regulate and tax the coal industry, may also require us or ourcustomers to change operations significantly or incur increased costs.

In addition, the United States and over 160 othernations are signatories to the 1992 Framework Convention on Climate Change,which is intended to limit emissions of greenhouse gases, such as carbondioxide. In December 1997, in Kyoto, Japan, the signatories to theconvention established a binding set of emission targets for developed nations.Although the specific emission targets vary from country to country, the UnitedStates would be required to reduce emissions to 93% of 1990 levels over afive-year budget period from 2008 through 2012. Although the United States hasnot ratified the emission targets and no comprehensive regulations focusing onU.S. greenhouse gas emissions are in place, these restrictions, whether throughratification of the emission targets or other efforts to stabilize or reducegreenhouse gas emissions, could adversely impact the price of and demand forcoal.

Recent mining accidentsinvolving fatalities in West Virginia, Kentucky and Mexico have receivednational attention and prompted responses at the state and federal level thathave resulted in increased scrutiny of current safety practices and proceduresin the mining industry. For example, on January 26, 2006, West Virginiapassed a new law imposing stringent new mine safety and accident reportingrequirements and increased civil and criminal penalties for violations of minesafety laws. Other states have proposed or passed similar bills and resolutionsaddressing mine safety practices. On January 25, 2006, an Alabama circuitjudge ordered the Alabama governor and legislature to take action to ensure thesafety of Alabama’s mine workers. In addition, several mine safety bills havebeen introduced in Congress that would mandate improvements in mine safetypractices, increase or add civil and criminal penalties for non-compliance withsuch laws or regulations, and expand the scope of federal oversight, inspectionand enforcement activities. On February 7, 2006, the federal Mine Safetyand Health Administration (“MSHA”) announced the promulgation of new emergency rules onmine safety. These rules address mine safety, equipment, training andemergency reporting requirements. Unlike most MSHA rules, these emergency rules willbecome effective immediately upon their publication in the Federal Register.Implementing new procedures in order to ensure we comply with these new lawsand regulations could adversely affect our results of operation and financialcondition.

***Coal mining is subject to inherent risks and isdependent upon many factors and conditions beyond our control, which may causeour profitability and our financial position to decline.***

Coal mining issubject to inherent risks and is dependent upon a number of conditions beyondour control that can affect our costs and production schedules at particularmines. These risks and conditions include:

·       unexpectedequipment or maintenance problems;

·       variationsin geological conditions;

·       naturaldisasters;

·       undergroundmine floodings;

·       excesswater ingress;

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·       environmentalhazards;

·       industrialaccidents;

·       explosionscaused by the ignition of coal dust or other explosive materials at our minessites; and

·       firescaused by the spontaneous combustion of coal.

These risks and conditionscould result in damage to or the destruction of mineral properties orproduction facilities, personal injury or death, environmental damage, delaysin mining, monetary losses and legal liability. For example, an explosion andfire occurred in Mine No. 5 in September 2001. The accident causedextensive damage to the mine and resulted in the deaths of thirteen employees.Insurance coverage may not be available or sufficient to fully cover claimswhich may arise from these risks and conditions. We have also experiencedadverse geological conditions in our mines, such as variations in coal seamthickness, variations in the competency and make-up of the roof strata,fault-related discontinuities in the coal seam and the potential for ingress ofexcessive amounts of methane gas or water. Such adverse conditions may increaseour cost of sales and reduce our profitability, and may cause us to decide toclose a mine. Any of these risks or conditions could have a negative impact onour profitability, the cash available from our operations and our financialposition.

***Our business may be harmed by work stoppages andother labor relations matters.***

The majority of ouremployees within the Jim Walter Resources and Sloss businesses are unionizedand we have a risk of work stoppages as the result of strike or lockout.The majority of employees of JWR are members of United Mine Workers of America(“UMWA”). Normally, our negotiations with the UMWA follow the national contractnegotiated with the UMWA by the Bituminous Coal Operators Association. Thecollective bargaining agreement expires December 31, 2011. At our SlossIndustries subsidiary, our contract with the United Steelworkers of Americaexpires December 6, 2010. We experienced an economic strike at Sloss atthe end of 2001 that lasted eight months. Future work stoppages, labor unionissues or labor disruptions at our key customers or service providers couldimpede our ability to produce and deliver our products, to receive criticalequipment and supplies or to collect payment. This may increase our costs orimpede our ability to operate one or more of our operations.

***Our expenditures for postretirement benefit andpension obligations are significant and could be materially higher than we havepredicted if our underlying assumptions prove to be incorrect.***

We provide a range of benefits to our employees andretired employees, including pensions and postretirement healthcare. We recordannual amounts relating to these plans based on calculations specified bygenerally accepted accounting principles, which include various actuarialassumptions. As of December 31, 2006, we estimate that our pension plans’aggregate accumulated benefit obligation had a present value of approximately$175.2 million, and our fair value of plan assets was approximately$141.5 million. As of December 31, 2006, we estimate that ourpostretirement health care and life insurance plans’ aggregate accumulatedbenefit obligation would have had a present value of approximately$330.2 million, and such benefits are not required to be funded. Inrespect of the funding obligations for our plans, we must make minimum cashcontributions on a quarterly basis. Our estimated minimum funding obligationrelating to these plans in 2007 is $22.0 million. We have estimated theseobligations based on assumptions described under the heading “CriticalAccounting Policies and Estimates—Employee Benefits” in “Management’sDiscussion and Analysis of Results of Operations and Financial Condition” andin the notes to our consolidated financial statements incorporated herein byreference. Assumed health care cost trend rates, discount rates, expectedreturn on plan assets and salary increases have a significant effect on theamounts reported for the pension and health care plans. If our assumptions donot materialize as expected, cash expenditures and costs that we incur could bematerially higher. Moreover, regulatory changes could increase our obligationsto provide these or additional benefits.

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In addition, certain ofour subsidiaries participate in multiemployer pension plan trusts establishedfor union employees. Contributions to these funds could increase as a result offuture collective bargaining with the UMWA, a shrinking contribution base as aresult of the insolvency of other coal companies who currently contribute tothese funds, lower than expected returns on pension fund assets, or otherfunding deficiencies. We have no current intention to withdraw from anymultiemployer pension plan, but if we were to do so, under the EmployeeRetirement Income Security Act of 1974, as amended (“ERISA”), we would beliable for a proportionate share of the plan’s unfunded vested benefitliabilities upon our withdrawal. Through June 30, 2007, our withdrawalliability for the multiemployer pension plans amounts to $102.1 million.

***We self-insure workers’ compensation and certainmedical and disability benefits, and greater than expected claims could reduceour profitability.***

We are self-insured for workers’ compensation benefitsfor work-related injuries. Workers’ compensation liabilities, including thoserelated to claims incurred but not reported, are recorded principally usingannual valuations based on discounted future expected payments using historicaldata of the division or combined insurance industry data when historical datais limited. In addition, JWR is responsible for medical and disability benefitsfor black lung disease under the Federal Coal Mine Health and Safety Act of1969, as amended, and is self-insured against black lung related claims. Weperform an annual evaluation of the overall black lung liabilities at thebalance sheet date, using assumptions regarding rates of successful claims,discount factors, benefit increases and mortality rates, among others.

Based on the actuarially determined present value ofworkers’ compensation liabilities using a discount factor of 4.64% and 4.5% for2006 and 2005, respectively, we have recorded liabilities of $33.5 millionand $33.7 million as of December 31, 2006 and 2005, respectively. Aone-percentage-point increase in the discount rate on the discounted claimsliability at December 31, 2006 would decrease our liability by$0.2 million, while a one-percentage-point decrease in the discount ratewould increase our liability by $0.2 million.

If the number or severityof claims for which we are self insured increases, or we are required to accrueor pay additional amounts because the claims prove to be more severe than ouroriginal assessment, our operating results could be reduced.

***Restrictive covenants in our debt instruments maylimit our ability to engage in certain transactions and may diminish ourability to make payments on our indebtedness.***

Our debt instrumentscontain various covenants that limit our ability to engage in certaintransactions. Our 2005 Credit Agreement requires the maintenance of specifiedfinancial ratios and the satisfaction of other financial condition tests. Inaddition, our debt instruments require us to provide regular financialinformation to our lenders. Such requirements generally may be satisfied by ourtimely filing with the SEC of annual and quarterly reports under the ExchangeAct. Our ability to satisfy those financial ratios, tests or covenants can beaffected by events beyond our control, and there is a risk that we will notmeet those tests. A breach of any of these covenants could result in a defaultunder our debt instruments. If an event of default were not remedied after thedelivery of notice of default and lapse of any relevant grace period, theholders of our debt would be able to declare it immediately due and payable.Upon the occurrence of an event of default under our 2005 Credit Agreement, therespective lenders could also terminate all commitments to extend furthercredit. If we were unable to repay those amounts, such lenders could proceedagainst the collateral granted to them to secure the indebtedness under oursenior credit facilities. We have pledged substantially all of our assets(including our intellectual property) as security under our 2005 CreditAgreement. If under our credit agreement the lenders accelerate the repaymentof borrowings, we may not have sufficient assets to repay our senior creditfacilities and our other indebtedness, which could negatively impact the valueof our stock and our ability to continue as a going concern.

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***We may be unsuccessful in identifying or integrating suitableacquisitions, which could impair our growth.***

Our growth strategy isbuilt upon organic growth and on taking advantage of opportunities to acquirecomplementary businesses. This strategy depends on the availability ofacquisition candidates with businesses that can be successfully integrated intoour existing business and that will provide us with complementary capabilities,products or services. However, we may be unable to identify targets that willbe suitable for acquisition. In addition, if we identify a suitable acquisitioncandidate, our ability to successfully implement the acquisition will depend ona variety of factors, including our ability to finance the acquisition. Ourability to finance our acquisitions is subject to a number of factors,including the availability of adequate cash from operations or of acceptablefinancing terms and the terms of our debt instruments. In addition, there aremany challenges to integrating acquired companies and businesses in ourcompany, including eliminating redundant operations, facilities and systems,coordinating management and personnel, retaining key employees, managingdifferent corporate cultures and achieving cost reductions and cross-sellingopportunities. We may not be able to meet these challenges in the future.

***We may have substantial additional federal taxliability for accounting adjustments related to our method of recognizingrevenue on the sale of homes and interest on related instalment notereceivables, as well as to federal income taxes allegedly owed.***

The Internal RevenueService has issued a Notice of Proposed Deficiency assessing additional tax of$82.2 million for the fiscal years ended May 31, 2000, December 31,2000 and December 31, 2001. The proposed adjustments relate primarily toour method of recognizing revenue on the sale of homes and related interest onthe instalment note receivables. In addition, a controversy exists with regardto federal income taxes allegedly owed by our consolidated group of companiesfor fiscal years 1980 through 1994. It is estimated that the amount of taxpresently claimed by the Internal Revenue Service is approximately$34 million for issues currently in dispute in bankruptcy court. Thisamount is subject to interest and penalties. While we believe that our taxfiling positions have substantial merit and intend to defend any tax claimsasserted, we cannot offer any assurance that the Internal Revenue Service or afederal court will uphold our tax filing positions. Moreover, although webelieve that we have sufficient accruals to address any such tax claims,including related interest and penalties, an adverse ruling, judgment or courtorder could impose significant financial liabilities in excess of our accruals,which could have an adverse effect on our financial condition and results ofoperations and could require a significant cash payment to settle the claims.

***We may be required to satisfy certain indemnificationobligations to Mueller Water or may not be able to collect on indemnificationrights from Mueller Water.***

In connection with the spin-off of Mueller Water on December 14,2006, we entered into certain agreements with Mueller Water, including anincome tax allocation agreement and a joint litigation agreement. Under theterms of those agreements, we and Mueller Water agreed to indemnify each otherwith respect to the indebtedness, liabilities and obligations that will beretained by our respective companies, including certain tax and litigationliabilities. These indemnification obligations could be significant. Forexample, to the extent that we or Mueller Water take any action that would beinconsistent with the treatment of the spin-off of Mueller Water as a tax-freetransaction under Section 355 of the Internal Revenue Code, then any taxresulting from such actions is attributable to the acting company. The abilityto satisfy these indemnities if called upon to do so will depend upon thefuture financial strength of each of our companies. We cannot determine whetherwe will have to indemnify Mueller Water for any substantial obligations afterthe distribution. We also cannot assure you that, if Mueller Water has toindemnify us for any substantial obligations, Mueller Water will have theability to satisfy those obligations to us. If Mueller Water is unable tosatisfy its obligations under its indemnity to us, we may have to satisfy thoseobligations.

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***Natural disastersand adverse weather conditions could disrupt our businesses and adverselyaffect our results of operations.***

The climates of many ofthe states in which we operate, including Mississippi, Alabama, Florida andTexas, where we have some of our larger operations, present increased risks ofnatural disaster and adverse weather. Natural disasters or adverse weather inthe areas in which we build, finance or insure homes or have mining ormanufacturing operations, or in nearby areas, have in the past, and may in thefuture, delay new home deliveries, increase costs by damaging inventories ofhomes and construction materials, reduce the availability of raw materials andskilled labor, lead to significant insurance claims, cause increases in delinquenciesand defaults in our mortgage portfolio, limit access to our mines andfactories, destroy or damage our inventory, reduce or eliminate certain modesof transporting our coal, increase volatility in the cost of raw materials andweaken the demand for new homes in affected areas, which could adversely affectour earnings. In addition, the rate of delinquencies may be higher afternatural disasters or adverse weather conditions. For example, during the thirdquarter of 2005, Hurricane Katrina impacted several states where our mortgageasset portfolio had high concentrations of customers. As a result, ourdelinquency rate in those states increased substantially and we incurred aspecial $1.3 million provision for estimated losses on instalment notesthat was anticipated as a result of Hurricane Katrina. The occurrence of largeloss events due to natural disasters or adverse weather could reduce theinsurance coverage available to us, increase the cost of our insurance premiumsand weaken the financial condition of our insurers, thereby limiting ourability to mitigate any future losses we may incur from such events. Moreover,severe flooding, wind and water damage, forced evacuations, contamination, gasleaks, fire and environmental and other damage caused by natural disasters oradverse weather could lead to a general economic downturn, including increasedprices for oil, gas and energy, loss of jobs, regional disruptions in travel,transportation and tourism and a decline in real-estate related investments,especially in the areas most directly damaged by the disaster or storm.

**Item 1B. UnresolvedStaff Comments**

None

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**Item 2. Descriptionof Property**

The administrative headquarters and manufacturingfacilities of the Company and its subsidiaries are summarized as follows:

| ** **            | ** **            | **Principal**                            | ** ** | **Land**                | ** ** | **Square Footage** | ** ** |
|-----------------------|-----------------------|------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **            | **Facility/Location** | ** **                               | ** ** | **Products/Operations** | ** ** | **Acreage**             | ** ** | **Leased** | ** ** | **Owned** | ** ** |
| **Natural Resources** |                  |                                     |       |                    |       |                    |       |   |   |
| Jim Walter Resources  |                  |                                     |       |                    |       |                    |       |   |   |
| Brookwood, AL         |                  | Administrative  headquarters             |       |                    |       |                    |       | 42,000 |   |
| Brookwood, AL         |                  | Central  shop, supply center             |       |                    |       |                    |       | 131,100 |   |
|                  |                  | and training center                      |       |                    |       |                    |       |   |   |
| Brookwood, AL         |                  | Real  estate                             |       | 7,000                   |       |                    |       |   |   |
| Brookwood, AL         |                  | Coal  mines                              |       | 30,400                  |       |                    |       | 460,600 |   |
| Kodiak                |                  |                                     |       |                    |       |                    |       |   |   |
| Shelby County, AL     |                  | Mine  support facilities                 |       |                    |       |                    |       | 13,100 |   |
| Shelby County, AL     |                  | Administrative  headquarters             |       |                    |       |                    |       | 1,000 |   |
| Shelby County, AL     |                  | Supply  shop                             |       |                    |       |                    |       | 98 |   |
| **Sloss**             |                  |                                     |       |                    |       |                    |       |   |   |
| Birmingham, AL        |                  | Administrative  headquarters             |       |                    |       |                    |       | 12,000 |   |
| Birmingham, AL        |                  | Furnace &  foundry coke battery |       | 511                     |       |                    |       | 148,000 |   |
| Birmingham, AL        |                  | Slag  fiber                              |       | 5                       |       |                    |       | 63,000 |   |
| Birmingham, AL        |                  | Closed  facility                         |       | 3                       |       |                    |       | 53,000 |   |
| Birmingham, AL        |                  | Closed  facility                         |       | 2                       |       |                    |       | 10,000 |   |
| Alexandria, IN        |                  | Closed  facility                         |       | 33                      |       |                    |       | 112,000 |   |
| **Homebuilding**      |                  |                                     |       |                    |       |                    |       |   |   |
| Tampa, FL             |                  | Administrative  headquarters             |       |                    |       | 24,200                  |       |   |   |
| Laurinburg, NC        |                  | Modular  homes                           |       | 26                      |       |                    |       | 245,000 |   |
| **Financing**         |                  |                                     |       |                    |       |                    |       |   |   |
| Tampa, FL             |                  | Administrative  headquarters             |       |                    |       | 22,300                  |       |   |   |
| Richland Hills, TX    |                  | Administrative  headquarters for         |       |                    |       |                    |       |   |   |
|                  |                  | Walter Mortgage Company                  |       |                    |       | 8,600                   |       |   |   |
| **Other**             |                  |                                     |       |                    |       |                    |       |   |   |
| Tampa, FL             |                  | Corporate headquarters                   |       |                    |       | 33,000                  |       |   |   |
|                       |                       |                                          |            |                         |            |                         |            |  |  |  |  |

 

20

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Recoverable coal reserves assigned to currentlyoperating mines were estimated to be approximately 136.3 million tons as of December 31,2006.

A summary of mineral reserves, as calculated byNatural Resources’ Mine Planning and Engineering department, is as follows:

**ESTIMATEDRECOVERABLE**(1) COAL RESERVES AS OFDECEMBER 31, 2006(In Thousands of Tons)

|                | ** ** | ** **       | ** ** | ** **              | ** ** | ** **     | ** ** | ** **   | ** ** | ** **    | ** ** | ** **        | JWR’s | ** ** | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |       |
|---------------------|------------|------------------|------------|-------------------------|------------|----------------|------------|--------------|------------|---------------|------------|-------------------|------------|------------|------------|--------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
|                |       | **Reserves (2)** | ** ** | **Classifications (3)** | ** ** | **Type (4)**   | ** ** | **Interest** | ** ** | **Quality**   | ** ** | **Production(6)** |       |
|                |       | ** **       | ** ** | ** **              | ** ** | ** **     | ** ** | ** **   | ** ** | ** **    | ** ** | **Steam (S)**     | ** ** | ** ** | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
|                |       | ** **       | ** ** | ** **              | ** ** | ** **     | ** ** | ** **   | ** ** | ** **    | ** ** | **or**            | ** ** | ** ** | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
|                |       | ** **       | ** ** | ** **              | ** ** | ** **     | ** ** | ** **   | ** ** | ** **    | ** ** | **Metallur-**     | ** ** | ** ** | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Mining Property     |       | **Total (9)**    | ** ** | **Assigned**            | ** ** | **Unassigned** | ** ** | **Measured** | ** ** | **Indicated** | ** ** | **gical (M)**     | ** ** | **Owned**  | ** ** | **Leased (5)**     | ** ** | **Ash**    | ** ** | **Sulf.**  | ** ** | **BTU/lb** | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004** |   |
| No. 4 Mine     |       | 60,569           |       | 60,569                  |       | —         |       | 57,058       |       | 3,510         |       | S/M               |       | —     |       | 60,569             |       | 9          |       | .80        |       | 14,150     |       | 2,187      |       | 3,039      |   | 3,053 |   |
| No. 5 Mine (8) |       | —           |       | —                  |       | —         |       | —       |       | —        |       | —            |       | —     |       | —   |       |       |       |       |       |       |       | 821        |       | 657        |   | 1,484 |   |
| No. 7 Mine     |       | 75,726           |       | 75,726                  |       | —         |       | 62,950       |       | 12,776        |       | S/M               |       | 2,473      |       | 73,253             |       | 9          |       | .65        |       | 14,150     |       | 2,646      |       | 2,091      |   | 2,387 |   |
| TOTAL (7)           |       | 136,295          |       | 136,295                 |       | —         |       | 120,008      |       | 16,286        |       |              |       | 2,473      |       | 133,822            |       |       |       |       |       |       |       | 5,654      |       | 5,787      |   | 6,924 |   |

----

(1)             “Recoverable” reserves are defined as tons of mineablecoal in the Blue Creek seam, which can be extracted and marketed after adeduction for coal to be left in pillars, etc. and adjusted for reasonablepreparation and handling losses. The Company’s coal reserves have not beenreviewed by an independent third party in the last three years.

(2)             “Assigned” reserves represent coal which has beencommitted by JWR to its operating mines and plant facilities. “Unassigned”reserves represent coal which is not committed to an operating mine and wouldrequire additional expenditures to recover. The division of reserves into thesetwo categories is based upon current mining plans, projections and techniques.

(3)             The recoverable reserves (demonstrated resources) arethe sum of “Measured” and “Indicated” resources. Measured coal extends 1/4 milefrom any point of observation or measurement. Indicated coal is projected toextend from 1/4 mile to 3/4 mile from any point of observation or measurement. Inferredcoal extends from 3/4 mile to 3 miles from any point of observation ormeasurement. Inferred reserves are not included in recoverable reserves.

(4)             All of the coal in the Blue Creek seam is suitable formetallurgical purposes and as compliance steam coal.

(5)             Leases are renewable until the reserves are mined toexhaustion or are of sufficient duration to permit mining of all of thereserves before the expiration of the term.

(6)             The production year ends on December 31. Productionincludes “middling” coal.

(7)             Additional properties that are currently not underlease are under review for possible leasing options.

(8)             No. 5 Mine ceased operations December 2006.

(9)    Quality factors are on a “received basis,” which includes anestimate for moisture, which averaged 1.6% to 1.7% during 2006.

**Item 3.  Legal Proceedings**

See the section entitled “Environmental”in Description of Business and Notes 3 and 18 of “Notes to ConsolidatedFinancial Statements” included herein.

**Item 4. Submissionof Matters to a Vote of Security Holders**

None.

21

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**PART II**

**Item 5.  Market for the Registrant’s Common Stock,Related Stockholder Matters and Issuer Purchases of Equity Securities**

TheCompany’s common stock (the “Common Stock”) has been listed on the New YorkStock Exchange under the trading symbol “WLT” since December 18, 1997. Thetable below sets forth, for the fiscal periods indicated, the range of high andlow closing sales prices of the Common Stock. Sales prices for the years endingDecember 31, 2006 and 2005 were adjusted for the Mueller Water spin-offusing a conversion factor that was calculated as the per share sales priceimmediately preceding the spin-off divided by the per share sales priceimmediately following the spin-off. The historical sales prices were divided bythis conversion factor to arrive at the adjusted sales prices. See Note 2 of “Notesto Consolidated Financial Statements” for further discussion of the spin-off.

|                         | ** ** | **Year ended  December 31, 2006** | ** ** |
|-------------------------|------------|--------------------------------------------------|------------|
| ** **              | ** ** | **High**                                         | ** ** | **Low** | ** ** |
| 1st Fiscal quarter |       | $                                                | 35.21      |   | $ | 25.66 |   |
| 2nd Fiscal quarter |       | 36.40                                            |       | 23.37 |   |
| 3rd Fiscal quarter |       | 28.78                                            |       | 21.97 |   |
| 4th Fiscal quarter |       | 28.00                                            |       | 20.66 |   |
|                         |            |                                                  |            |  |  |  |  |

 

|                         | ** ** | **Year ended   December 31, 2005** | ** ** |
|-------------------------|------------|--------------------------------------------------------|------------|
| ** **              | ** ** | **High**                                               | ** ** | **Low** | ** ** |
| 1st Fiscal quarter |       | $                                                      | 23.54      |   | $ | 15.66 |   |
| 2nd Fiscal quarter |       | 24.73                                                  |       | 17.21 |   |
| 3rd Fiscal quarter |       | 25.18                                                  |       | 20.55 |   |
| 4th Fiscal quarter |       | 27.05                                                  |       | 20.85 |   |
|                         |            |                                                        |            |  |  |  |  |

 

During the year ended December 31, 2006, theCompany declared and paid to shareholders of record on March 17, June 9,September 15 and November 20 a dividend of $0.04 per share as of eachof these dates. During the year ended December 31, 2005, the Companydeclared and paid to shareholders of record on February 18, May 12, August 12and on November 11 a dividend of $0.04 per share. Covenants contained incertain of the debt instruments referred to in Note 14 of “Notes toConsolidated Financial Statements” may restrict the amount the Company can payin cash dividends. Future dividends will be declared at the discretion of theboard of directors and will depend on the Company’s future earnings, financialcondition and other factors affecting dividend policy. Any declaration andpayment of cash dividends on the Company’s Common Stock in excess of specifiedamounts will result in an adjustment of the conversion rate for the convertiblenotes. In the first quarter of 2007, the board of directors announced a 25%increase in the quarterly dividend to $0.05 per share.

In connection with the Company’s spin-off of MuellerWater, the Company declared and issued a stock dividend of its 85.8 million Series Bshares held in Mueller Water to shareholders of record on December 6, 2006.Shareholders received 1.6524432 shares of Series B common stock of MuellerWater for each share of the Company’s Common Stock held.

As of February 15, 2007, there were 131 shareholdersof record of the Common Stock.

22

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Thefollowing table sets forth certain information relating to the Company’s equitycompensation plans as of December 31, 2006:
|                                        | ** ** | **Number of  Securities to be  Issued upon  Exercise of  Outstanding  Options, Warrants  and Rights** | ** ** | **Weighted  Average Exercise  Price of  Outstanding  Options  Warrants and  Rights** | ** ** | **Number of  Securities  Remaining  Available for  Future Issuance** | ** ** |
|----------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| Equity compensation  plans approved by |       |                                                                                                                                     |       |                                                                                                |       |                                                                                |       |   |   |   |   |   |   |
| Security holders:                      |       |                                                                                                                                     |       |                                                                                                |       |                                                                                |       |   |   |   |   |   |   |
| 2002 Long-term Incentive Award Plan    |       |                                                                                                                                     | 1,563,178  |                                                                                                |       |                                                                                | $          | 20.81 |   |   |   | 2,587,253 |   |   |
| 1995 Long-term Incentive Stock Plan    |       |                                                                                                                                     | 526,960    |                                                                                                |       |                                                                                | $          | 7.67 |   |   |   | — |   |   |
| 1996 Employee  Stock Purchase Plan     |       |                                                                                                                                     | —     |                                                                                                |       |                                                                                | —     |   |   |   | 1,588,450 |   |   |

 

*Recent Sales ofUnregistered Securities*

On April 20, 2004, the Company issued and sold ina private placement, $175 million principal amount of 3.75% Convertible SeniorSubordinated Notes, due 2024, to qualified institutional buyers pursuant to Rule 144Aunder the Securities Act of 1933, as amended. Proceeds to the Company wereapproximately $168.9 million, net of approximately $6.1 million of underwritingfees and expenses.

During 2006, holders of$174.2 million of the Company’s Convertible Senior Subordinated Notessurrendered convertible notes in exchange for 9.761 million shares of theCompany’s common stock and $19.4 million of conversion inducement fees.

*Purchase of EquitySecurities by the Company and Affiliated Purchasers*

On July 21, 2003, theCompany’s Board of Directors authorized an increase in the Common Stock OpenMarket share buyback program to $25.0 million. During 2004 and 2003 the Companyacquired 6,959,000 and 2,529,000 shares, respectively, pursuant to the openmarket share repurchase program. No purchases were made in 2006. At December 31,2006, $7.5 million remains available under this authorization.

23

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**Item 6.  Selected Financial Data**

Thefollowing data, insofar as it relates to each of the years ended December 31,2006, 2005, 2004, 2003 and 2002 has been derived from annual consolidatedfinancial statements, including the consolidated balance sheets and the relatedconsolidated statements of operations, changes in stockholders’ equity andcomprehensive income (loss) and statements of cash flows and the notes theretoas they relate to the Company’s continuing operations as of December 31,2006. The information presented below is for continuing operations and shouldbe read in conjunction with the Company’s consolidated financial statements andthe notes thereto including Note 2 related to discontinued operations, Note 3related to significant accounting policies, and the other information containedelsewhere in this report.

| ** **                                                                                   | ** ** | **Years ended December 31,2002**                    | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                   | ** ** | **(in thousands, except per share data)** | ** ** |
| Net sales and  revenues                                                                      |       | $                                                                  | 1,309,856  |   | $ | 1,138,042 |   | $ | 984,801 |   | $ | 951,384 |   | $ | 938,786 |   |
| Income from continuing operations                                                            |       | $                                                                  | 145,584    |   | $ | 34,351 |   | $ | 50,534 |   | $ | 11,278 |   | $ | 38,316 |   |
| Basic income per share from continuing operations                                            |       | $                                                                  | 3.31       |   | $ | 0.89 |   | $ | 1.31 |   | $ | 0.26 |   | $ | 0.86 |   |
| Number of shares used in calculation of basic income  per share from continuing operations   |       | 44,030                                                             |       | 38,485 |   | 38,582 |   | 43,026 |   | 44,318 |   |
| Diluted income per share from continuing operations                                          |       | $                                                                  | 2.86       |   | $ | 0.78 |   | $ | 1.16 |   | $ | 0.26 |   | $ | 0.86 |   |
| Number of shares used in calculation of diluted  income per share from continuing operations |       | 52,078                                                             |       | 49,209 |   | 46,255 |   | 43,364 |   | 44,726 |   |
| Capital expenditures                                                                         |       | $                                                                  | 101,055    |   | $ | 114,518 |   | $ | 29,979 |   | $ | 37,890 |   | $ | 39,440 |   |
| Net property,  plant and equipment                                                           |       | $                                                                  | 311,189    |   | $ | 258,502 |   | $ | 179,015 |   | $ | 192,396 |   | $ | 188,292 |   |
| Total assets(1)                                                                              |       | $                                                                  | 2,684,115  |   | $ | 2,492,535 |   | $ | 2,452,906 |   | $ | 2,496,958 |   | $ | 2,360,783 |   |
| Debt:                                                                                        |       |                                                               |       |   |   |   |   |   |   |   |   |
| Mortgage-backed/asset-backed notes                                                           |       | $                                                                  | 1,736,706  |   | $ | 1,727,329 |   | $ | 1,763,827 |   | $ | 1,829,898 |   | $ | 1,776,020 |   |
| Corporate debt                                                                               |       | $                                                                  | 248,706    |   | $ | 448,875 |   | $ | — |   | $ | 113,754 |   | $ | 308,900 | ** ** |
| Convertible senior subordinated notes                                                        |       | $                                                                  | 785        |   | $ | 175,000 |   | $ | 175,000 |   | $ | — |   | $ | — |   |
| Quarterly cash dividend  per common share                                                    |       | $                                                                  | 0.04       |   | $ | 0.04 |   | $ | 0.03 | (2) | $ | 0.03 |   | $ | 0.03 |   |

 

----

(1)   Excludesassets of discontinued operations.

(2)   Raised to$0.04 per common share in the fourth quarter of 2004.

24

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**Item 7.  Management’s Discussion and Analysis ofResults of Operations and Financial Condition and**

**Item 7A.Quantitative and Qualitative Disclosures About Market Risk**

**CRITICAL ACCOUNTINGESTIMATES**

Management’s discussion and analysis is based on, andshould be read in conjunction with, the consolidated financial statements andnotes thereto, particularly Note 20 of “Notes to Consolidated FinancialStatements” which presents net sales and revenues and operating income byreportable segment. The preparation of financial statements in accordance withaccounting principles generally accepted in the United States of America (“U.S.GAAP”) requires management to make estimates and assumptions that affect theamounts reported in these financial statements or disclosed in the relatednotes thereto. Management evaluates these estimates and assumptions on anongoing basis, utilizing historical experience, consultation with experts andother methods considered reasonable in the particular circumstances. Nevertheless,actual results may differ significantly from management’s estimates.

Management believes thefollowing discussion addresses the Company’s most critical accountingestimates, which are those that are most important to the portrayal of theCompany’s financial condition and results and require management’s mostdifficult, subjective and complex judgments, often as a result of the need tomake estimates about the effect of matters that are inherently uncertain. Theseestimates are based upon management’s historical experience and on variousother assumptions that the Company believes reasonable under the circumstances.Changes in estimates used in these and other items could have a material impacton our financial statements.

*Revenue recognition*

Revenue transactionsinvolving the sale of homes, real estate, products and commodities are recordedwhen title to the goods is transferred. Interest income on instalment notes isrecognized using the interest method. Instalment notes receivable are initiallyrecorded at the discounted value of the future instalment note payments usingan imputed interest rate which represents the estimated prevailing market rateof interest for credit of similar terms issued to customers with similar creditratings to Homebuilding’s customers. The Company estimates this rate by addinga credit spread and a margin to a benchmark funding rate in order to covercosts and expected losses. This rate is periodically compared to rates chargedby competitors and other lenders to customers of similar credit quality tovalidate that the methodology results in a market rate of interest. Theseestimates affect revenue recognition by determining the allocation of incomebetween the amount recognized by the Homebuilding segment from the constructionof the home and the amount recognized by the Financing segment over the life ofthe instalment note as interest income. Variations in the estimated market rateof interest used to initially record the instalment notes receivable couldaffect the amount and timing of income recognition in each of these segments.

*Allowances forLosses*

Allowances for losses on trade and other accountsreceivable are based, in large part, upon judgments and estimates of expectedlosses and specific identification of problem trade accounts and otherreceivables. Significantly weaker than anticipated industry or economicconditions could impact customers’ ability to pay or could impact the value ofunderlying collateral such that actual losses are greater than the amountsprovided for in these allowances.

Management’s periodic evaluation of the adequacy ofthe allowance for losses on instalment notes is based on the Company’s pastloss experience, known and inherent risks in the portfolio, delinquencies, theestimated value of the underlying real estate collateral, and current economicand market conditions within the applicable geographic areas surrounding theunderlying real estate. The allowance for losses on instalment notes andmortgage loans is increased by provisions for losses charged to income and isreduced by charge-offs net of recoveries.

25

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Theallowance for losses on instalment notes receivable was $13.0 million at December 31,2006 compared to $12.5 million at December 31, 2005. See Note 8 of “Notesto the Consolidated Financial Statements.” The following table showsinformation about the allowance for losses for the periods presented.
| ($ in thousands) | ** ** | **Allowance for  Losses** | ** ** | **As a % of  Net  Instalment  Notes  Receivable** | ** ** | **Net Losses and  Charge Offs  Deducted from  the Allowance** | ** ** | **As a % of  Net  Instalment  Notes  Receivable** | ** ** |
|----------------------------|------------|--------------------------------|------------|------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| December 31,  2006    |       |                           | $          | 13,011                                                           |       |                                                                                   |       | 0.73                                                             | %          |   |   | $ | 8,540 |   |   |   | 0.48 | % |   |
| December 31,  2005    |       |                           | 12,489     |                                                             |       |                                                                                   | 0.74       |                                                             |       |   | 9,435 |   |   |   | 0.56 |   |   |
| December 31, 2004     |       |                           | 11,200     |                                                             |       |                                                                                   | 0.65       |                                                             |       |   | 12,109 |   |   |   | 0.71 |   |   |

 

The following table presents information aboutdelinquencies in the instalment notes receivable portfolio.
|                                                           | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Total Number of  Accounts Outstanding                     |       | 40,991                |       | 43,178 |   | 46,785 |   |
| Delinquencies as  a Percent of                            |       |                  |       |   |   |   |   |
| Number of  Accounts Outstanding                           |       |                  |       |   |   |   |   |
| 31-60 Days                                                |       | 1.43                  | %          | 1.31 | % | 1.32 | % |
| 61-90 Days                                                |       | 0.55                  | %          | 0.62 | % | 0.59 | % |
| 91-Days or more                                           |       | 1.95                  | %          | 2.42 | % | 2.23 | % |
|                                                      |       | 3.93                  | %          | 4.35 | % | 4.14 | % |
| Instalment Notes Receivable Outstanding(1)($in  millions) |       | $                     | 1,793      |   | $ | 1,706 |   | $ | 1,728 |   |
| Delinquencies as  a Percent of Amounts Outstanding(1)     |       |                  |       |   |   |   |   |
| 31-60 Days                                                |       | 1.59                  | %          | 1.56 | % | 1.84 | % |
| 61-90 Days                                                |       | 0.65                  | %          | 0.69 | % | 0.62 | % |
| 91-Days or more                                           |       | 2.19                  | %          | 2.90 | % | 2.46 | % |
|                                                      |       | 4.43                  | %          | 5.15 | % | 4.92 | % |
|                                                           |            |                       |            |  |  |  |  |  |  |  |

 

----

(1)          Based on grossinstalment balances outstanding.

The calculation ofdelinquencies excludes from delinquent amounts those accounts that are inbankruptcy proceedings that are paying their mortgage payments in contractualcompliance with bankruptcy court approved mortgage payment obligations.

*Inventory valuation*

Inventories areperiodically evaluated for indications of excess and obsolete exposure basedupon anticipated usage, inventory turnover, inventory levels and ultimateproduct sales value. If necessary, an adjustment for losses related toinventory values is recognized. This evaluation of inventory values is based onmanagement’s estimation of market conditions relating to both pricing andanticipated sales volumes for the Company’s products.

*Employee Benefits*

The Companyprovides a range of benefits to its employees and retired employees, includingpensions and postretirement healthcare. The Company records annual amountsrelating to these plans based on calculations specified by U.S. GAAP, whichinclude various actuarial assumptions used in developing the required estimatesincluding the following key factors:

·       Discountrate

26

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·       Salarygrowth

·       Retirementrates

·       Mortalityrates

·       Healthcarecost trends

·       Expected return on planassets

| ** **                                                           | ** ** | **Pension Benefits**   | ** ** | **Other Benefits**     | ** ** |
|----------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                           | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
| Weighted average  assumptions used to determine benefit obligations: |       |                        |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Discount rate                                                        |       |                        | 5.90       | %                           |       |   | 5.40 | % |   | 5.90 | % |   | 5.40 | % |   |
| Rate of compensation increase                                        |       |                        | 3.50       | %                           |       |   | 3.50 | % |   | — |   |   | — |   |   |
| Weighted average assumptions used to determine net periodic  cost:   |       |                        |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Discount rate                                                        |       |                        | 5.40       | %                           |       |   | 6.00 | % |   | 5.40 | % |   | 6.00 | % |   |
| Expected return on plan assets                                       |       |                        | 8.90       | %                           |       |   | 8.90 | % |   | — |   |   | — |   |   |
| Rate of  compensation increase                                       |       |                        | 3.50       | %                           |       |   | 3.50 | % |   | — |   |   | — |   |   |

 

| Assumed  healthcare cost trend rates:                                              |   |   |   |   |   |   |   |   |   | Pre-65 |   | Post-65 |   |   |   |   |   |
|------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---------|--------|--------|--------|--------|--------|
| Healthcare cost  trend rate assumed for the next year                              |   |   | — |   |   |   | — |   |   | 8.60   | %      | 9.40    | %      |   | 9.00   | %      |   |
| Rate to which the  cost trend rate is assumed to decline (the ultimate trend rate) |   |   | — |   |   |   | — |   |   | 5.00   | %      | 5.00    | %      |   | 5.00   | %      |   |
| Year that the rate  reaches the ultimate trend rate                                |   |   | — |   |   |   | — |   |   | 2012   |   | 2012    |   |   | 2010   |   |   |

 

The discount rate used to determine pension and otherpost-retirement expense was increased to 5.90% for 2006 from 5.40% used in 2005.The rate of return on plan assets used to determine pension expense is 8.90%for both 2006 and 2005. The discount rate is based on a yield-curve approachwhich discounts each projected benefit obligation based cash flow of theliability stream at an interest rate specifically applicable to the timing ofeach respective liability stream cash flow. The model sums the present valuesof all of the cash flows and then calculates the equivalent weighted-averagediscount rate by imputing the single interest rate that equates the totalpresent value with the stream of future cash flows. The Company reviews itsactuarial assumptions on an annual basis and makes modifications to theassumptions based on current rates and trends when appropriate. As required byU.S. GAAP, the effects of the modifications are amortized over future periods.

Assumed healthcare cost trend rates, discount rates,expected return on plan assets and salary increases have a significant effecton the amounts reported for the pension and healthcare plans. Aone-percentage-point change in the rate for each of these assumptions wouldhave the following effects as of and for the year ended December 31, 2006(in thousands):

27

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|                                                                | ** ** | **1-Percentage  Point Increase** | ** ** | **1-Percentage  Point Decrease** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Healthcare cost trend:                                         |       |                                  |       |                                  |       |   |   |   |   |
| Effect on total of service and interest cost  components       |       |                                  | $          | 3,425                                 |       |   |   | $ | (2,725 | ) |   |
| Effect on postretirement benefit obligation                    |       |                                  | 42,335     |                                  |       |   | (34,959 | ) |   |
| Discount rate:                                                 |       |                                  |       |                                  |       |   |   |   |   |
| Effect on postretirement service and interest cost  components |       |                                  | 114        |                                  |       |   | (393 | ) |   |
| Effect on postretirement benefit obligation                    |       |                                  | (39,507    | )                                     |       |   | 45,778 |   |   |
| Effect on current year postretirement expense                  |       |                                  | (2,248     | )                                     |       |   | 2,290 |   |   |
| Effect on pension service and interest cost  components        |       |                                  | 23         |                                  |       |   | (92 | ) |   |
| Effect on pension benefit obligation                           |       |                                  | (19,670    | )                                     |       |   | 23,768 |   |   |
| Effect on current year pension expense                         |       |                                  | (1,556     | )                                     |       |   | 1,829 |   |   |
| Expected return on plan  assets:                               |       |                                  |       |                                  |       |   |   |   |   |
| Effect on current year pension expense                         |       |                                  | (1,375     | )                                     |       |   | 1,375 |   |   |
| Rate of compensation  increase:                                |       |                                  |       |                                  |       |   |   |   |   |
| Effect on pension service and interest cost  components        |       |                                  | 451        |                                  |       |   | (386 | ) |   |
| Effect on pension benefit obligation                           |       |                                  | 3,419      |                                  |       |   | (3,144 | ) |   |
| Effect on current  year pension expense                        |       |                                  | 861        |                                  |       |   | (743 | ) |   |
|                                                                |            |                                       |            |                                       |            |  |  |  |  |  |  |

 

The Company also has significant liabilities foruninsured or partially insured employee-related liabilities, including workers’compensation liabilities, miners’ Black Lung benefit liabilities, andliabilities for various life and health benefits. The recorded amounts of theseliabilities are based on estimates of loss from individual claims and onestimates determined on an actuarial basis from historical experience usingassumptions regarding rates of successful claims, discount factors, benefitincreases and mortality rates.

Workers’ compensation and Black Lung benefitliabilities are also affected by discount rates used. Changes in the frequencyor severity of losses from historical experience, changes in discount rates oractual losses on individual claims that differ materially from estimatedamounts could affect the recorded amount of these liabilities. At December 31,2006, a one-percentage-point increase in the discount rate on the discountedBlack Lung liability would decrease the liability by $1.1 million, while a one-percentage-point decrease in thediscount rate would increase the liability by $1.4 million.

For the workers’compensation liability, the Company applies a discount rate at a risk-freeinterest rate, generally a U.S. Treasury bill rate, for each policy year. Therate used is one with a duration that corresponds to the weighted averageexpected payout period for each policy year. Once a discount rate is applied toa policy year, it remains the discount rate for the year until all claims arepaid. The use of this method decreases the volatility of the liability asimpacted by changes in the discount rate. At December 31, 2006, aone-percentage-point increase in the discount rate on the discounted workers’compensation liability would decrease the liability by $0.2 million, while aone-percentage-point decrease in the discount rate would increase the liabilityby $0.2 million.

*Litigation,Investigations and Claims*

The Company is involved in litigation, investigationsand claims arising out of the normal conduct of its business, including thoserelating to commercial transactions, as well as environmental, health andsafety matters. The Company estimates and accrues its liabilities resultingfrom such matters based on a variety of factors, including outstanding legalclaims and proposed settlements; assessments by internal counsel of pending orthreatened litigation; and assessments of potential environmental liabilitiesand remediation costs. The Company believes it has adequately accrued for thesepotential liabilities; however, facts and circumstances may change that couldcause the actual liabilities to exceed the estimates, or that may requireadjustments to the recorded liability balances in the future.

As discussed in Note 13 of “Notes to ConsolidatedFinancial Statements,” the Company is in dispute with the Internal Revenue Service(the “IRS”) on a number of Federal income tax issues. The Company 

28

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believes that its taxfiling positions have substantial merit and it intends to vigorously defendthese positions. The Company has established accruals that it feels aresufficient to address claims, including related interest and penalties, whereits defense may be unsuccessful or where a settlement of issues may bewarranted. The amount of the accrual is based on an assessment by management ofboth the probability and extent of loss for each of the disputed issuesinvolved. Since the issues involved are highly complex, are subject to theuncertainties of extensive litigation and/or administrative processes and mayrequire an extended period of time to reach ultimate resolution, it is possiblethat management’s estimate of this liability could change.

Accruals for property-liability claims and claimsexpense are the estimated amounts necessary to settle both reported andunreported claims of insured property-liability losses, based upon the facts ineach case and the Company’s experience with similar cases. The establishment ofappropriate accruals, including accruals for catastrophes such as hurricanes,is an inherently uncertain process. Accrual estimates are regularly reviewedand updated using the most current information available. Accruals forcatastrophic uninsured losses at plant or mine facilities would be made on anad hoc basis based on relevant facts and circumstances.

Environmental laws andregulations continue to evolve and because conditions giving rise toobligations and liabilities under environmental laws are in some circumstancesnot readily identifiable, it is difficult to forecast the amount of such futureenvironmental expenditures or the effects of changing standards on futurebusiness operations or results.

*Accounting for theImpairment of Long-Lived Assets Including Goodwill and Intangibles*

Long-lived assets,including goodwill and intangibles, are reviewed for impairment whenever eventsor changes in circumstances indicate that the book value of the asset may notbe recoverable.  The Company periodicallyevaluates whether events and circumstances have occurred that indicate possibleimpairment. Goodwill is also reviewed for possible impairment at least annually.The Company uses estimates of future cash flows of the related asset, assetgrouping or reporting unit in measuring whether the assets are recoverable. Changesin actual or estimated future cash flows could have an impact on therecoverability of such assets, resulting in future impairment charges.

*RestructuringCharges*

The Company occasionallyrecords restructuring costs associated with manufacturing plant and mineclosings and other exit activities. These costs are estimated by managementbased on factors such as projected timing and duration of transitions, theamount and timing of termination benefits and the amount and timing of relatedcontract exit costs. During the restructuring process, management reviews theestimates of restructuring costs and adjusts them if necessary given currenteconomic conditions.

**DISCONTINUEDOPERATIONS**

As more fully discussed in Note 2 of “Notes toConsolidated Financial Statements,” the Company completed the spin-off ofMueller Water, which included the Mueller, U.S. Pipe and Anvil operatingsegments, on December 14, 2006. As such, the operating results, assets andliabilities, and cash flows of Mueller Water have been reported separately fromthe Company’s continuing operations as “discontinued operations” for allperiods presented. Income (loss) from discontinued operations includes the netoperating results of the Mueller Water business. There was no gain or lossrecognized in the statement of operations relating to this transaction, andtransaction costs were not significant.

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**RESULTS OF CONTINUING OPERATIONS**

**2006 Summary Operating Results**

| ** **                                             | ** ** | **For the Year Ended December 31, 2006** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **Natural**                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Cons** | ** ** | ** ** | ** ** |
| **(in thousands)**                                | ** ** | **Resources**                                                          | ** ** | **Sloss** | ** ** | **Financing** | ** ** | **Homebuilding** | ** ** | **Other** | ** ** | **Elims** | ** ** | **Total** | ** ** |
| Net sales                                              |       | $                                                                      | 634,152    |   | $ | 132,714 |   | $ | 14,597 |   |   | $ | 273,542 |   |   | $ | 3,652 |   | $ | (11,946 | ) | $ | 1,046,711 |   |
| Interest income  on instalment notes                   |       |  

—                                                         |       | — |   |  

199,659 |   |   | — |   |   | — |   | — |   | 199,659 |   |
| Miscellaneous  income                                  |       | 45,428                                                                 |       | 319 |   | 5,295 |   |   | 2,299 |   |   | 11,435 |   | (1,290 | ) | 63,486 |   |
| Net sales and  revenues                                |       | 679,580                                                                |       | 133,033 |   | 219,551 |   |   | 275,841 |   |   | 15,087 |   | (13,236 | ) | 1,309,856 |   |
| Cost of sales                                          |       | 370,002                                                                |       | 112,454 |   | 6,738 |   |   | 223,630 |   |   | 3,304 |   | (12,589 | ) | 703,539 |   |
| Interest  expense(1)                                   |       | —                                                                 |       | — |   | 118,743 |   |   | — |   |   | — |   | — |   | 118,743 |   |
| Depreciation                                           |       | 27,004                                                                 |       | 3,623 |   | 1,387 |   |   | 5,385 |   |   | 1,618 |   | — |   | 39,017 |   |
| Selling,  general, & administrative           |       | 16,457                                                                 |       | 7,926 |   | 29,819 |   |   | 68,756 |   |   | 26,804 |   | — |   | 149,762 |   |
| Provision for  losses on instalment notes              |       |  

—                                                         |       | — |   |  

9,062 |   |   | — |   |   | — |   | — |   | 9,062 |   |
| Postretirement  benefits                               |       | 19,772                                                                 |       | (680 | ) | (1,544 | ) |   | (3,224 | ) |   | (787 | ) | — |   | 13,537 |   |
| Amortization of  intangibles                           |       | —                                                                 |       | — |   | 2,405 |   |   |   |   |   | — |   | — |   | 2,405 |   |
| Credit for  estimated hurricane insurance losses       |       |  

—                                                         |       | — |   |  

(1,046 | ) |   | — |   |   | — |   | — |   | (1,046 | ) |
| Restructuring &  impairment charges           |       | —                                                                 |       | 1,639 |   | — |   |   | 3,409 |   |   | — |   | — |   | 5,048 |   |
| Operating income  (loss)                               |       | $                                                                      | 246,345    |   | $ | 8,071 |   | $ | 53,987 |   |   | $ | (22,115 | ) |   | $ | (15,852 | ) | $ | (647 | ) | $ | 269,789 |   |
| Corporate debt interest  and debt conversion expense   |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   | (57,384 | ) |
| Income from continuing operations before income  taxes |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   | $ | 212,405 |   |

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(1)          Excludescorporate debt interest and conversion expense.

**Year Ended December 31,2006 as Compared to the Year Ended December 31, 2005**

*Overview*

The Company’s income fromcontinuing operations for the year ended December 31, 2006 was $145.6million, or $2.86 per diluted share, which compares to $34.4 million, or $0.78per diluted share in the prior year period.

Principalfactors impacting income from continuing operations in the current year resultscompared to the prior year period include:

·       NaturalResources’ average selling prices for coal increased 25.8% and natural gasprices increased 9.1%, reflecting the benefit of hedging. These increases werepartially offset by lower sales volumes and higher mining costs, primarily atMine No. 4, which resulted from unfavorable geological conditions. Additionally,the prior year included $21.9 million of idle mine costs due to a water ingressproblem at Mine No. 5 and adverse geologic conditions in Mine No. 7,while 2006 results include miscellaneous income of $23.4 million relating to aninsurance settlement for the 2005 Mine No. 5 water ingress problem.

·       Financingresults in the current period reflect an $11.1 million reduction inhurricane-related claims expense compared to the prior year period. Additionally,the provision for losses on the mortgage portfolio improved $1.7 million versusthe prior year period.

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·       Homebuildinghad 20.5% higher average net selling prices, increased on-your-lot deliveriesand improved gross margins, reflecting price increases and tighter costcontrols. Reductions in selling, general and administrative expenses alsocontributed to improved results. Homebuilding recognized a $3.4 millionproperty impairment charge in 2006 related to the modular homes division, while2005 results include the complete impairment of Homebuilding’s goodwill of$63.2 million.

·       Resultsin 2006 include $19.4 million of debt conversion expense to induce theconversion of $174.2 million of the Company’s Convertible Senior SubordinatedNotes into 9.761 million shares of common stock.

·       The Company’s 2006effective tax rate was 31.9%, which reflects the benefit of Natural Resources’depletion deductions, partially offset by the effect of non-deductible debtconversion expense.

*Outlook andStrategic Initiatives*

**Natural Resources and Sloss**

·       TheCompany expects coal production to total between 6.5 million and 6.9 milliontons in 2007, including approximately 400,000 tons from Kodiak.

·       Productioncosts per ton are expected to be in the low-to-mid-$40-per-ton range, animprovement in performance that reflects higher planned volumes at Mines No. 4and 7 and the elimination of higher cost coal from Mine No. 5. Theperformance improvement will be tempered by higher labor and employee benefitsdue to the recently renegotiated UMWA contract, which will increase expense by$15.0 million in 2007.

·       TheCompany has approximately 2.3 million tons of metallurgical coal committed forsale in the first half of 2007 at a price of $115 per metric ton, FOB port ofMobile.

·       TheCompany expects its natural gas business to sell between 6.8 to 7.1 billioncubic feet in 2007, which is a reduction from 2006 primarily due to the closureof Mine No. 5. Approximately 28% of anticipated 2007 natural gas sales hasbeen hedged at an average price of $8.85 per mmbtu.

·       Thedevelopment and resulting longwall operation of the “Southwest A” panel in MineNo. 7 is expected to produce approximately 1.5 million tons of coalbetween 2007 and 2008. The Mine No. 7 East expansion remains on scheduleto begin longwall production in early 2009 and is expected to produce anadditional 2.7 million tons of coal annually.

·       Withrespect to demand for metallurgical coal, the Company continues to see strengthin steel pricing and demand among the majority of its core customers. Inaddition, many of the Company’s customers have significant expansion plansunderway. Additionally, due to high ocean transportation rates out of Australiaand Western Canada into Europe, the Company’s Blue Creek coal is becoming morecost competitive.

·       At Kodiak, the Company iscurrently operating one continuous miner section and expects to add anadditional continuous miner section after completion of the preparation plantat the end of the first quarter of 2007. The Company expects sales to begin inthe second quarter of 2007 and expects Kodiak to contribute to earnings andcash flow during the second half of 2007.

**Homebuilding and Financing**

·       Financinghas delivered record low delinquencies and stable earnings and cash flows. Theportfolio is considered to be insulated from re-adjusting ARM loans, risingdefaults and slowing home appreciation. Over 96% of the portfolio is comprisedof fixed rate mortgages, and the rural nature of the collateral and adherenceto strict underwriting guidelines serves to limit losses. However, the Companyexpects a slight contraction in margins in 2007 due to rising interest rates onmortgage-backed debt securities.

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·       Significantprogress has been made to reduce the Homebuilding aged backlog, improve grossmargins and reduce selling, general and administrative costs. On-your-lot unitcompletions of 2,700 to 3,000 are expected in 2007, with improving gross marginwhich will help drive Homebuilding to its goal of achieving profitability in2007.

·       Homebuildingcontinues to work toward reducing cycle times by expanding the use ofalternative construction methodologies. In 2006, the Company announced plans touse its modular home division to achieve this objective. However, in 2007 theCompany decided to exit the manufacture and distribution of modular homes dueto the poor performance of this division. The modular homes business incurredan operating loss of approximately $8.0 million in 2006, excluding the $3.4million impairment charge for certain of its long-lived assets.

·       As previously announced,the Company continues to evaluate strategic alternatives for its Financing andHomebuilding businesses.

*Consolidated Results of Continuing Operations*

Net sales and revenues forthe year ended December 31, 2006 were $1.3 billion. Revenues grew by$171.8 million, or 15.1% from $1.1 billion in the prior year. Increasedrevenues at Natural Resources, Homebuilding and Sloss were partially offset bydecreased revenues at Financing. Natural Resources revenues increased primarilydue to price increases for coal and natural gas and higher gas volumes,partially offset by decreased coal sales volumes. Homebuilding revenuesincreased due to higher average selling prices. Financing revenues declinedprimarily due to a declining yield in the portfolio and lower prepaymentincome, partially offset by an increase in the balance of the note portfolio.

Cost of sales, exclusiveof depreciation, increased $70.7 million to $703.5 million and represented67.2% of net sales in 2006 versus $632.8 million and 69.6% of net sales in theprior year. The margin percentage improvement in 2006 was primarily the resultof improved margins at Homebuilding and Natural Resources.

Depreciation for the yearended December 31, 2006 was $39.0 million, an increase of $7.0 millioncompared to 2005. The increase is primarily due to higher capital expendituresat Natural Resources during the last two years.

Selling, general andadministrative expenses of $149.8 million were 11.4% of net sales and revenuesin 2006, compared to $154.5 million and 13.6% in 2005. The improvement is dueto lower costs at Homebuilding resulting from focused efforts to reduceoverhead expenses and due to lower corporate employee-related expenses.

Provision for losses oninstalment notes was $9.1 million in 2006, compared to $10.7 million in 2005.Prior year included a $1.3 million charge for expected portfolio lossesresulting from Hurricanes Katrina and Rita offset slightly by higher volume ofresales in the current period in the Financing segment.

Postretirement benefitsexpense decreased to $13.5 million in 2006, compared to $14.4 million in 2005,primarily due to a $4.1 million curtailment gain resulting from the terminationof benefits for certain current employees and those retirees who are eligiblefor Medicare of the Financing and Homebuilding segments. In 2007, the Companyexpects its postretirement benefits expense to be $25.4 million.

Interest expense formortgage-backed and asset-backed notes decreased to $118.7 million in 2006,compared to $122.0 million in 2005 primarily due to lower average monthly debtbalances and delayed warehouse borrowings resulting from a favorable cashposition.

Interest expense on corporate debt increased $14.6million to $38.0 million due to a higher average debt balance outstanding in2006 resulting from the borrowings under the 2005 Walter Credit Agreement tofinance the acquisition of Mueller Water in October 2005. Debt conversionexpense of $19.4 million in 2006 was related to the conversion of approximately$174.2 million of the Company’s Convertible Senior Subordinated notes duringthe year. There were no conversions recognized in 2005.

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Restructuring and impairment charges were $5.0 millionin 2006, a decrease of $58.4 million from 2005. The prior year included a $63.2million goodwill impairment charge at Homebuilding. The current year expenseincludes a $3.4 million property impairment charge at Homebuilding and a $1.6million impairment charge relating to Sloss’ chemical division, which was sold in November 2006.

The Company’s effective tax rate of 31.9% in 2006differed from the Federal statutory rate primarily due to the favorable effectof Natural Resources’ percentage depletion deductions, partially offset by non-deductibledebt conversion expenses. The Company’s effective tax rate of 51.7% in 2005differed from the Federal statutory rate primarily due to the effect of thelargely non-deductible $63.2 million goodwill impairment charge. See also Note13 to “Notes to Consolidated Financial Statements.”

The current and prior yearresults also include the impact of the factors discussed in the followingsegment analysis.

*Segment Analysis*

***Natural Resources***

Netsales and revenues were $679.6 million for the year ended December 31,2006, an increase of $131.0 million from $548.6 million in 2005. The increasewas primarily due to higher metallurgical coal and natural gas prices andincreased natural gas volumes partially offset by decreased coal volumes. Inaddition, miscellaneous income in 2006 includes $23.4 million for thesettlement of an insurance claim for the 2005 Mine No. 5 water ingressproblem.

| ** **                                   | ** ** | **For the year ended** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **December 31,**                 | ** ** |
| ** **                                   | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Average Coal  Selling Price (per ton)        |       | $                                     | 103.58     |   | $ | 82.33 |   |
| Tons of Coal Sold  (in millions)             |       | 5.6                                   |       | 5.9 |   |
| Average Natural  Gas Selling Price (per MCF) |       | $                                     | 8.67       |   | $ | 7.95 |   |
| Billion Cubic  Feet of Natural Gas Sold      |       | 7.7                                   |       | 6.9 |   |
| Number of Natural Gas  Wells                 |       | 415                                   |       | 405 |   |

 

For the year ended 2006, Natural Resources’ operatingincome was $246.3 million, compared to operating income of $164.1 million in2005. The increase in operating income in 2006 primarily resulted from theshift to higher margin metallurgical coal sales and increased margins fromhigher natural gas pricing, partially offset by higher freight costs and higherMine No. 4 production costs per ton. Cost per ton increased at MineNo. 4 predominantly due to lower production volume relative to 2005 as aresult of thin seam conditions and weak roof conditions encountered at thebeginning of the current longwall panel, which began in April 2006. Theseconditions contributed to reduced longwall advance rates and difficulties withroof control. The longwall at Mine No. 4 has since experienced improvedadvance rates and is now achieving normal longwall advance rates. The increasein operating income in 2006 was also due to $23.4 million of income recognizedfor the settlement of an insurance claim for the 2005 Mine No. 5 wateringress problem, whereas 2005 included $21.9 million of idle mine costsprimarily resulting from the water ingress.

As previously announced,the Company completed production at Mine No. 5 in December 2006. Asof December 31, 2006 mining equipment has been recovered and the mineshafts are in the process of being sealed. Total expected costs to close themine are $8.5 million. Approximately $6.6 million of the closure costs qualifyas restructuring costs and were recorded prior to December 31, 2005. Othercosts, primarily representing estimated workers’ compensation and otherincremental costs related to the closure of the mine, will be charged toexpense when incurred.

33

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**Sloss**

Net sales and revenueswere $133.0 million for 2006, an increase of $4.0 million compared to 2005.Revenues increased in 2006 due to higher furnace coke volume and pricing, whichincreased 6.4% and 1.3%, respectively, over the prior year, partially offset bya 13.9% decline in shipments of foundry coke. Sloss’ operating income was $3.4million lower than the previous year primarily due to an impairment charge of$1.6 million relating to the chemical division, which was sold inNovember 2006.

**Financing**

Net sales and revenues were $219.6 million in 2006, adecrease of $9.6 million from 2005. This decrease is attributable to adeclining yield on the portfolio and lower prepayment-related interest income*.*Operating income was $54.0 million in2006, compared to $46.0 million in 2005. Operating income increased primarilyas a result of a $1.7 million decrease in the provision for losses oninstalment notes. In addition, 2005 included a provision for estimatedhurricane insurance losses of $10.0 million. Due to a relatively inactivehurricane season in 2006, there were no significant charges for excesscatastrophic losses in Financing’s insurance business.

Delinquencies (the percentage of amounts outstandingover 30 days past due) were 4.4% at December 31, 2006, down from 5.2% atDecember 31, 2005. The improvement is primarily due to customer paymentdisruptions caused by the 2005 hurricanes which temporarily increased paymentdefaults in the prior year period. The calculation of delinquencies excludesfrom delinquent amounts those accounts that are in bankruptcy proceedings thatare paying their mortgage payments in contractual compliance with bankruptcycourt approved mortgage payment obligations.

**Homebuilding**

Netsales and revenues were $275.8 million in 2006, an increase of $49.0 millionfrom 2005 as a result of higher average net selling prices and slightly higheroverall deliveries as shown in the table below.

| ** **                  | ** ** | **For the year ended  December 31,** | ** ** |
|-----------------------------|------------|----------------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| Homes Completed:            |       |                                                     |       |   |   |
| Stick-Built                 |       | 2,663                                                    |       | 2,361 |   |
| Modular                     |       | 384                                                      |       | 661 |   |
|                        |       | 3,047                                                    |       | 3,022 |   |
| Average Net  Selling Price: |       |                                                     |       |   |   |
| Stick-Built                 |       | $                                                        | 90,300     |   | $ | 78,800 |   |
| Modular                     |       | $                                                        | 87,600     |   | $ | 60,100 |   |

 

The operating loss was$22.1 million for 2006 compared to an operating loss of $103.9 million in 2005.Prior year results included a $63.2 million goodwill impairment charge. Theimproved performance in 2006 was due to higher average net selling prices andcost reduction activities, partially offset by a $3.4 million impairment chargefor certain long-lived assets in the modular homes division.

**Other**

Net sales and revenueswere $15.1 million for 2006 compared to $12.4 million in 2005. Land sales were$0.9 million better than 2005. Net general corporate expenses, principallyincluded in selling, general and administrative expense, were $26.8 million forthe year ended 2006 compared to $30.9 million for 2005 reflecting lowerpersonnel related expenses and professional fees partially offset by anincrease in bonus expense and stock-based compensation expense resulting fromthe January 1, 2006 adoption of Statement of Financial AccountingStandards (“SFAS”) No. 123(R), “Share-Based Payment.”

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**2005 Summary Operating Results**

| ** **                                             | ** ** | **For the Year Ended December 31, 2005** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **Natural**                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Cons** | ** ** | ** ** | ** ** |
| **(in  thousands)**                                    | ** ** | **Resources**                                                          | ** ** | **Sloss** | ** ** | **Financing** | ** ** | **Homebuilding** | ** ** | **Other** | ** ** | **Elims** | ** ** | **Total** | ** ** |
| Net sales                                              |       | $                                                                      | 543,202    |   | $ | 128,486 |   | $ | 15,539 |   |   | $ | 225,675 |   |   | $ | 957 |   | $ | (5,162 | ) | $ | 908,697 |   |
| Interest income  on instalment notes                   |       | —                                                                 |       | — |   | 206,582 |   |   | — |   |   | — |   | — |   | 206,582 |   |
| Miscellaneous  income                                  |       | 5,375                                                                  |       | 549 |   | 7,035 |   |   | 1,121 |   |   | 11,397 |   | (2,714 | ) | 22,763 |   |
| Net sales and  revenues                                |       | 548,577                                                                |       | 129,035 |   | 229,156 |   |   | 226,796 |   |   | 12,354 |   | (7,876 | ) | 1,138,042 |   |
| Cost of sales                                          |       | 332,883                                                                |       | 105,314 |   | 7,122 |   |   | 190,859 |   |   | 1,795 |   | (5,162 | ) | 632,811 |   |
| Interest expense(1)                                    |       | —                                                                 |       | — |   | 122,005 |   |   | — |   |   | — |   | — |   | 122,005 |   |
| Depreciation                                           |       | 20,855                                                                 |       | 3,859 |   | 1,403 |   |   | 4,966 |   |   | 893 |   | — |   | 31,976 |   |
| Selling,  general, & administrative           |       | 14,053                                                                 |       | 8,983 |   | 28,438 |   |   | 72,110 |   |   | 30,942 |   | — |   | 154,526 |   |
| Provision for  losses on instalment notes              |       | —                                                                 |       | — |   | 10,724 |   |   | — |   |   | — |   | — |   | 10,724 |   |
| Postretirement  benefits                               |       | 16,448                                                                 |       | (563 | ) | (240 | ) |   | (468 | ) |   | (776 | ) | — |   | 14,401 |   |
| Amortization of  intangibles                           |       | —                                                                 |       | — |   | 3,641 |   |   | — |   |   | — |   | — |   | 3,641 |   |
| Provision for  estimated hurricane insurance losses    |       | —                                                                 |       | — |   | 10,044 |   |   | — |   |   | — |   | — |   | 10,044 |   |
| Restructuring &  impairment charges           |       | 235                                                                    |       | — |   | — |   |   | 63,210 |   |   | — |   | — |   | 63,445 |   |
| Operating income (loss)                                |       | $                                                                      | 164,103    |   | $ | 11,442 |   | $ | 46,019 |   |   | $ | (103,881 | ) |   | $ | (20,500 | ) | $ | (2,714 | ) | $ | 94,469 |   |
| Corporate debt interest expense                        |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   | (23,400 | ) |
| Income from continuing  operations before income taxes |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   | $ | 71,069 |   |

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(1)          Excludescorporate debt interest expense.

**Year Ended December 31,2005 as Compared to the Year Ended December 31, 2004**

*Overview*

The Company’s income from continuing operations for theyear ended December 31, 2005 was $34.4 million or $0.78 per diluted share,which compares to $50.5 million, or $1.16 per diluted share in 2004.

Principal factorsimpacting income from continuing operations in the prior year results include:

·       NaturalResources incurred $21.9 million of idle mine costs in 2005 due to a wateringress problem at Mine No. 5 and adverse geological conditions in Mine No. 7.

·       Agoodwill impairment charge of $63.2 million was recognized at Homebuildingduring 2005.

·       Financingresults included a $10.0 million provision for estimated hurricane insurancelosses in 2005, compared to $4.0 million in 2004.

·       In 2005, the Company’seffective tax rate was 51.7%. The $63.2 million goodwill impairment charge waslargely non-deductible for tax purposes. This compares with a 3.9% effectivetax rate for 2004 when the Company recognized a favorable benefit of $11.4million from the reversal of certain valuation allowances in addition to thefavorable benefit from Natural Resources’ depletion deductions.

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*ConsolidatedResults of Continuing Operations*

Net sales and revenues for the year ended December 31,2005 were $1.138 billion versus $0.985 billion for the year ended December 31,2004, a 15.6% increase. Increased revenues at Natural Resources and Sloss werepartially offset by decreased revenues at Homebuilding and Financing. NaturalResources revenues increased primarily due to price increases for coal andnatural gas, partially offset by decreased coal and natural gas sales volumes.Homebuilding revenues decreased due to lower unit completions, partially offsetby higher average selling prices. Financing revenues declined primarily due toa declining portfolio as a result of fewer note originations from theHomebuilding segment and lower prepayment-related interest income*.*

Cost of sales, exclusive of depreciation, of $632.8million was 69.6% of net sales in 2005 versus $553.4 million, or 73.8% of netsales in 2004. The margin percentage improved as compared to 2004 because ofincreases in sales prices in Natural Resources and at Sloss, partially offsetby higher lumber costs and job cost overruns in the Homebuilding segment. NaturalResources incurred $21.9 million of idle mine costs in 2005 due to a wateringress problem at Mine No. 5 and adverse geological conditions in Mine No. 7,both of which were resolved in the fourth quarter of 2005.

Selling, general and administrative expenses of $154.5million were 13.6% of net sales and revenues in 2005 compared to $168.3million, or 17.1% in 2004. Decreased selling, general and administrativeexpense were due to: (i) a decrease of $5.3 million at Homebuildingrelated primarily to lower advertising, construction overhead and legal fees; (ii) adecrease at Financing of $2.3 million, primarily due to lower property taxesand legal fees; and (iii) a decrease at Natural Resources of $3.2 million,primarily due to lower legal expenses incurred in 2005, since 2004 includedlegal expenses related to an accident at Mine No. 5.

Provision for losses on instalment notes decreased to$10.7 million in 2005, compared to $12.4 million in 2004 due to lower volumeand improved recovery rates on sales of repossessed homes, partially offset by$1.3 million provided in 2005 due to estimated losses resulting from the effectsof Hurricanes Katrina and Rita.

Postretirement benefits expense increased to $14.4million in 2005, compared to $9.5 million in 2004, primarily due to a lowerdiscount rate used to measure the liability and related actuarially-determinedexpenses recognized in 2005.

Interest expense for mortgage-backed and asset-backednotes decreased to $122.0 million in 2005, compared to $127.3 million in 2004primarily due to a decline in the instalment note portfolio balance as a resultof fewer note originations from the Homebuilding segment.

Interest expense on corporate debt increased $5.2million to $23.4 million in 2005 due to indebtedness incurred to finance theMueller Water acquisition.

The provision for estimated hurricane insurance losseswas $10.0 million in 2005, compared to $4.0 million in 2004. The increase inestimated losses was due to both the severity of Hurricane Katrina and theresulting impact on Mississippi, which is a large market for insurance policiesunderwritten by the Financing segment.

Restructuring and impairment charges were $63.4million in 2005 and included a $63.2 million goodwill impairment charge atHomebuilding and $0.2 million at Natural Resources due to a small impairmentfor a Mine No. 7 longwall shield, partially offset by slightly reducedMine No. 5 shutdown costs.

The Company’s effective tax rate of 51.7% in 2005differed from the Federal statutory rate primarily due to non-deductiblegoodwill charges, partially offset by the favorable effect of depletiondeductions related to the Company’s mining operations. The Company’s effectivetax rate of 3.9% in 2004 differed from the Federal statutory rate primarily dueto a reversal of a valuation allowance provided for in 

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previous years and due tothe favorable effect of depletion deductions. See also Note 13 to “Notes toConsolidated Financial Statements.”

The current and prior yearresults also include the impact of the factors discussed in the followingsegment analysis.

*Segment Analysis*

**Natural Resources**

Netsales and revenues were $548.6 million for the year ended December 31,2005, an increase of $153.1 million from $395.5 million in 2004. The increasewas primarily due to higher metallurgical coal and natural gas prices,partially offset by decreased coal and natural gas volumes.

| ** **                                   | ** ** | **For the year ended** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **December 31,**                 | ** ** |
| ** **                                   | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Average Coal  Selling Price (per ton)        |       | $                                     | 82.33      |   | $ | 53.00 |   |
| Tons of Coal Sold  (in millions)             |       | 5.9                                   |       | 6.5 |   |
| Average Natural  Gas Selling Price (per MCF) |       | $                                     | 7.95       |   | $ | 6.08 |   |
| Billion Cubic  Feet of Natural Gas Sold      |       | 6.9                                   |       | 7.9 |   |
| Number of Natural Gas  Wells                 |       | 405                                   |       | 399 |   |

 

The average natural gas selling prices as indicated inthe table above for 2005 and 2004 include the effects of approximately $3.0million of losses and $1.5million of gains, respectively, on hedges of anticipated natural gas productionand sales.

Strong performance at Natural Resources continued in2005. Increased worldwide demand, particularly from China, for metallurgicalcoal as well as reduced supply, contributed to price increases in the world’s metallurgicalcoal markets. In 2005, Natural Resources produced 5.7 million tons of coal,which is 1.2 million tons lower than 2004 primarily due to a water ingressproblem at Mine No. 5 that occurred during the second half of 2005 andadverse geological conditions in Mine No. 7. The water ingress problem atMine No. 5 was rectified in the fourth quarter of 2005 and operationsresumed to full capacity in December 2005, while new and much strongerlongwall equipment was deployed at Mine No. 7 in the fourth quarter of2005, which was specifically designed to alleviate continued unfavorablegeological conditions at Mine No. 7.

For 2005, Natural Resources’ operating income was$164.1 million, compared to $69.7 million in 2004*.*The increase was due to higher metallurgical coal andnatural gas sales prices and reduced legal expenses incurred versus the prioryear, partially offset by lower metallurgical coal volumes and lower gasvolumes and $21.9 million of idle mine costs in 2005 due to a water ingressproblem at Mine No. 5 and adverse geological conditions in Mine No. 7,both of which were resolved in the fourth quarter of 2005.

In December 2004, the Company announced that ithad approved a four-year capital investment program to increase coal productioncapacity at Mine No. 7. Capital expenditures through December 31,2005 related to this expansion project amounted to $20.8 million.

In 2003, the Companyannounced that it expected to close Mine No. 5 in 2004. Due to animprovement in the metallurgical coal market, the Company extended its coalproduction plans for Mine No. 5 with a revised scheduled shutdown of late2006 or early 2007. As a result of thetemporary idling of Mine No. 5 and the increased manpower requirementsrelated to an expansion program at Mine No. 7, the Company anticipatedterminating fewer Mine No. 5 employees than previously estimated. As aresult, the Company re-measured the restructuring liability, which resulted ina $0.6 million net reversal in 2005 of amounts previously charged to restructuringexpense within the Natural Resources segment.

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**Sloss**

Net sales and revenueswere $129.0 million for 2005, an increase of $26.0 million compared to 2004.Revenue increased in 2005 due to higher prices for furnace and foundry coke,which increased 45% and 49%, respectively, over the prior year, partiallyoffset by a 16% decline in shipments of foundry coke. Sloss operating incomewas $4.6 million higher than the previous year due to the favorable effect ofincreased sales prices, partially offset by increased coal and other costs.

**Financing**

Net sales and revenues were $229.2 million in 2005, adecrease of $13.6 million from 2004. This decrease is attributable to adeclining portfolio as a result of fewer note originations from theHomebuilding segment and lower prepayment-related interest income*.*Operating income was $46.0 million in2005, compared to $54.8 million in 2004. The segment results declined primarilyas a result of lower instalment note revenues on a declining portfolio, a $6.0million incremental provision for estimated hurricane-related losses and a $1.3million impact from incremental loan losses expected to result from customersin hurricane impacted areas.

Delinquencies (thepercentage of amounts outstanding over 30 days past due) were 5.2% at December 31,2005, up from 4.9% at December 31, 2004 primarily due to customer paymentdisruptions caused by the 2005 hurricanes. The calculation of delinquenciesexcludes from delinquent amounts those accounts that are in bankruptcyproceedings that are paying their mortgage payments in contractual compliancewith bankruptcy court approved mortgage payment obligations.

**Homebuilding**

Netsales and revenues were $226.8 million during 2005, a decrease of $7.0 million,as a result of 7% fewer unit completions, partially offset by a 4% increase inaverage net selling prices. The higher average net selling prices reflect theincreasing popularity of larger homes with more amenities as well as priceincreases to offset higher material costs. Partially offsetting theseincreases, the average selling prices of the Homebuilding segment’s modularproduct declined by an average of $3,900 per unit, reflecting the introductionof a new, lower-priced product line in the first half of 2005. This productline was discontinued in the fourth quarter of 2005 when it was determined thatit would not achieve profitability objectives. The decline in unit completionsfrom the prior year reflects weaker market conditions in the Company’saffordable-housing market segment compared to the broader homebuilding industry*.*The decline in unit completions wascomprised of a 13.5% decline in stick-built units, partially offset by anincrease of 140 modular unit completions.

| ** **                  | ** ** | **For the year ended** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|
| ** **                  | ** ** | **December 31,**                 | ** ** |
| ** **                  | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Homes Completed:            |       |                                  |       |   |   |
| Stick-Built                 |       | 2,361                                 |       | 2,730 |   |
| Modular                     |       | 661                                   |       | 521 |   |
|                        |       | 3,022                                 |       | 3,251 |   |
| Average Net  Selling Price: |       |                                  |       |   |   |
| Stick-Built                 |       | $                                     | 78,800     |   | $ | 73,000 |   |
| Modular                     |       | $                                     | 60,100     |   | $ | 64,000 |   |

 

The segment reported anoperating loss of $103.9 million for the year ended December 31, 2005,compared to an operating loss of $33.3 million in the prior year. This declinewas primarily due to a non-cash charge of $63.2 million in the fourth quarterof 2005 to write-off goodwill, as a result of the Company’s annual impairmenttesting. This write-off eliminated all of the Homebuilding segment’s goodwillfrom the Company’s consolidated balance sheet. This adjustment was necessary toproperly 

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reflectthe fair value of Homebuilding, which has been generating losses during thelast few years. Excluding the goodwill write-off, Homebuilding segmentoperating results declined by $7.4 million in 2005. This decline reflects lowerunit completions and lower margins, partially offset by higher average sellingprices and lower selling, general and administrative expenses compared to 2004.The decline in margins reflects costs in 2005 related to repairs and rework onaged units under construction. The decline in selling, general andadministrative expenses in 2005 reflects lower overhead costs resulting fromthe closure of unprofitable model home parks between the third quarter of 2004and second quarter of 2005 and lower advertising expenses.

**Other**

Net sales and revenueswere $12.4 million for 2005 compared to $18.4 million in 2004. Land sales were$3.4 million better than 2004. Net general corporate expenses, principallyincluded in selling, general and administrative expenses were $26.6 million in2005 compared to $28.6 million in 2004. Corporate expenses declined due tolower medical costs ($3.9 million) and reduced internal and external auditservices related to compliance with Sarbanes-Oxley 404 Act requirements ($2.9million) partially offset by higher employee-related costs ($4.0 million).

**FINANCIAL CONDITION**

Cash and cash equivalents of continuing operationsincreased to $127.4 million at December 31, 2006 from $64.4 million at December 31,2005, reflecting $181.2 million in cash flows provided by continuing operatingactivities, $98.5 million of cash flows used in investing activities of continuingoperations and $90.0 million of cash flows used in financing activities ofcontinuing operations. See additional discussion in the Statement of Cash Flowssection that follows.

Restricted short-term investments of $90.0 million at December 31,2006 decreased $34.5 million from December 31, 2005 due to the loweramount of pre-funding generated from the issuance of the 2006-1 TrustAsset Backed Notes as compared with the issuance of the 2005-1 TrustAsset Backed Notes and due to a decrease in prepayment speeds between the lastquarter of 2006 compared to the same period in 2005.

Net receivables were $88.6 million at December 31,2006, an increase of $14.0 million from December 31, 2005 primarily due to$18.4 million due from the Company’s insurance carrier for the settlement ofclaims associated with the 2005 water ingress problem at Mine No. 5.

Inventories were $108.9 million at December 31,2006, a decrease of $13.3 million from December 31, 2005, primarily due toa reduction in the backlog of homes under construction at Homebuilding*.*

Prepaid expenses of $30.1 million at December 31,2006 increased $8.7 million from December 31, 2005 primarily due toincreased prepaid expenses at Natural Resources resulting from an increase inprepaid property insurance and due to the timing of and an increase in theamount of longwall move costs.

Property, plant and equipment was $311.2 million at December 31,2006, an increase of $52.7 million over 2005 due in large part to capitalexpenditures at Natural Resources for the Mine No. 7 East expansionproject.

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Corporate debt decreased $374.4 million reflecting theconversion of $174.2 million of convertible notes and $200.2 million repaymentof the term loan facility.

Accumulated postretirementbenefits obligation of $330.2 million increased $105.0 million from 2005primarily as a result of the effect of the adoption of SFAS No. 158, “Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans.”

**LIQUIDITY ANDCAPITAL RESOURCES**

*Overview*

The Company’s principal sources of short-term fundingare existing cash balances, operating cash flows and borrowings under itsrevolving credit facility and warehouse lines of credit. The Company’sprincipal sources of long-term funding are its bank term loan and itsfinancings under mortgage-backed/asset-backed notes. As of December 31,2006, total debt has decreased by $365.0 million compared to December 31,2005. See discussion below and Note 14 of “Notes to Consolidated FinancialStatements.”

Cash inflows from the sales of goods at the Company’sNatural Resources and Sloss segments are generated in the normal course,generally within 90 days or less from the date of title transfer of the goodssold. At our Financing and Homebuilding segments, the majority of homesconstructed and sold by Homebuilding are internally financed. JWH incursconstruction costs to build the home, which are financed via internal Companyresources, including existing cash balances, cash flows generated fromoperations or borrowings under credit facilities. When the home is completed,JWH tenders it to the customer. At this time, JWH recognizes the sale of thehome and sells the instalment note contract to MSH which recognizes an increasein instalment notes receivable. No cash is generated from this intercompanytransaction. MSH then borrows periodically under its warehouse facilities,typically at 80% of the face of the instalment note contract, using theinstalment note contract as collateral. On a monthly basis, MSH pays interestand other funding costs under the warehouse facilities using collections frominstalment notes receivable. Historically, once there is approximately $200-300million of accumulated borrowings under the warehouse facilities, MSH willpackage the instalment notes and pledge them as collateral to complete amortgage-backed/asset-backed securitized debt offering. MSH historically hasreceived 95% of the face value of the instalment notes receivable. MSH usesproceeds from the securitization to pay off the warehouse facilities and anyexcess cash flow generated would be available for general corporate purposes.

The Company believes that,based on current forecasts and anticipated market conditions, sufficientoperating cash flow will be generated to meet substantially all operatingneeds, to make planned capital expenditures and to make all required interestpayments on indebtedness for the next twelve to eighteen months. However, theCompany’s operating cash flows and liquidity are significantly influenced bynumerous factors, including the general economy and, in particular, prices ofcoal and natural gas, levels of construction activity, costs of raw materialsand interest rates.

*Mortgage-backed/Asset-backedNotes*

At December 31, 2006, non-recoursemortgage-backed/asset-backed notes outstanding totaled $1.7 billion andconsisted of eight issues of public debt and one issue of private debtproviding financing for instalment notes receivable purchased by Mid-StateHomes (“MSH”). Mortgage debt also includes outstanding borrowings, if any,under a $200.0 million and a $150.0 million Variable Funding Loan Agreement (“warehousefacilities”) providing temporary financing to MSH for its current purchases ofinstalment notes and mortgage loans from JWH and WMC. At December 31, 2006,there were no borrowings outstanding under these warehouse facilities, leavinga total of $350.0 million available for future borrowings.

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In November 2006,Mid-State Capital Corporation, a wholly owned subsidiary of the Companycompleted its 2006-1 Trust private offering of $256.9 million inasset-backed bonds with a single maturity date of October 2040 and with aweighted average, fixed interest coupon of 6.28%.

*2005 Walter CreditAgreement*

The 2005 Walter Credit Agreement is a securedobligation of the Company and substantially all of the wholly owned domesticsubsidiaries of the Company. The 2005 Walter Term Loan requires quarterlyprincipal payments of $0.6 million through October 3, 2012, at which timethe remaining principal outstanding is due. The 2005 Walter Term Loan carries afloating interest rate of 175 basis points over LIBOR. At December 31,2006, the balance outstanding on the term loan was $248.7 million and theweighted-average interest rate was 7.12%. The commitment fee on the unused portionof the 2005 Walter Revolving Credit Facility is 0.35% and the interest rate isa floating rate of 150 basis points over LIBOR. At December 31, 2006,there were no borrowings outstanding under the revolving credit facility, butthe Company issued $62.5 million in letters of credit, reducing availabilityfor borrowings to $162.5 million.

In February 2006, theCompany sold 2.65 million shares of common stock for $168.7 million of net cashproceeds. Of these proceeds, $102.9 million was used to repay the term loanfacility. In addition, during the year ended December 31, 2006, theCompany repaid $22.3 million on the term loan facility on a mandatory basis andmade $75.0 million of optional prepayments using available cash flow.

*Convertible SeniorSubordinated Notes*

On April 20, 2004, the Company issued$175.0 million aggregate principal amount of 3.75% Convertible SeniorSubordinated Notes due May 1, 2024 (the “convertible notes”). During 2006,holders of $174.2 million of the Company’s convertible notes surrendered theirconvertible notes in exchange for 9.761 million shares of the Company’s commonstock and $19.4 million of conversion inducement fees.

At December 31, 2006,the $0.8 million remaining convertible notes outstanding are currentlyconvertible into 84,000 shares of the Company’s common stock, as conversionconditions specified in the Indenture regarding market price have beensatisfied.   Each $1,000 principal note may convert into 107.0241shares of the Company’s common stock, which represents a conversion price ofapproximately $9.34 per share.

*Statement of CashFlows*

Cash from continuing operations was approximately$127.4 million and $64.4 million at December 31, 2006 and December 31,2005, respectively. Cash increased primarily due to cash flows generated fromoperations, partially reduced by cash flows used in investing and financingactivities.

Cash flows provided by operating activities ofcontinuing operations were $181.2 million in 2006 as compared to $251.3 millionin 2005. The decrease year-over-year is primarily due to the increase ininstalment note receivables. The 2005 cash flow benefited from higherprepayments as compared to 2006, primarily due to a more favorable interestrate market in 2005 which contributed to increased customer refinancingactivity and thus, prepayments.

Cash flows used in investing activities of continuingoperations in 2006 were $98.5 million as compared to $1.0 billion in 2005. Themajor cause of this change is the 2005 acquisition of Mueller Water for $867.0million, net of cash acquired. Cash flows used in investing activities ofcontinuing operations in 2006 included cash flows used to purchase property,plant and equipment ($101.1 million) and to purchase mortgage loans ($103.8million). These cash outflows were partially offset by principal paymentsreceived on purchased loans totaling $46.0 million and cash inflows fromrestricted short term investments totaling $34.5 million.

Cash flows used in financing activities of continuingoperations in 2006 were $90.0 million compared to cash flows provided byfinancing activities of $410.5 million in 2005. Financing activities in 2005included 

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$460.0 million ofborrowings, primarily related to the acquisition of Mueller Water. Cash flowsused in financing activities of continuing operations in 2006 includedretirements of corporate debt ($200.2 million) and retirements ofmortgage-back/asset-backed notes ($392.6 million), substantially offset by cashproceeds from the sale of the Company’s common stock ($168.7 million) and theissuance of mortgage-backed/asset-backed notes ($401.9 million). Cash used infinancing activities in 2006 also includes $82.1 million of cash remaining onMueller Water’s balance sheet at the time of the spin-off.

Capital expenditurestotaled $101.1 million in the year ended December 31, 2006 relatedprincipally to the Mine No. 7 East expansion project and other minedevelopment activities at Natural Resources. We estimate that capitalexpenditures for the year ending December 31, 2007 will approximate $125million to $150 million. Of this amount, approximately $70 million to $80million relates to the Mine No. 7 East expansion project. Actualexpenditures in 2007 may be more or less than this amount, depending upon thelevel of earnings and cash flow, or expansion opportunities in certain markets.

*ContractualObligations and Commercial Commitments*

The Company has certain contractual obligations andcommercial commitments. Contractual obligations are those that will requirecash payments in accordance with the terms of a contract, such as a borrowingor lease agreement. Commercial commitments represent potential obligations forperformance in the event of demands by third parties or other contingentevents, such as lines of credit or guarantees of debt.

The following tables summarize the Company’scontractual obligations and commercial commitments as of December 31, 2006.The unconditional purchase obligations primarily represent commitments topurchase raw materials. This table does not include interest owed on theseobligations. For the year ended December 31, 2006, the Company paidapproximately $32.6 million of interest on corporate debt. For the year ending December 31,2007, the Company estimates total cash interest payments related to corporatedebt will be approximately $18.7 million.

Contractualobligations and commercial commitments:

| ** **                            | ** ** | ** ** | ** ** | **Payments Due by Period (in Thousands)** | ** ** |
|---------------------------------------|------------|------------|------------|--------------------------------------------------------------------|------------|
| ** **                            | ** ** | **Total**  | ** ** | **2007**                                                           | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** |
| Mortgage-backed/asset-backed debt(1)  |       | $          | 1,736,706  |                                                               | $          | 250,751 |   | $ | 210,726 |   | $ | 181,097 |   | $ | 164,897 |   | $ | 147,042 |   | $ | 782,193 |   |
| Corporate debt(2)                     |       | 248,706    |       | 2,519                                                              |       | 2,519 |   | 2,519 |   | 2,519 |   | 2,519 |   | 236,111 |   |
| Convertible senior subordinated notes |       | 785        |       | —                                                             |       | — |   | — |   | — |   | — |   | 785 |   |
| Operating leases                      |       | 29,166     |       | 9,755                                                              |       | 7,922 |   | 5,142 |   | 3,075 |   | 2,466 |   | 806 |   |
| Unconditional purchase obligations    |       | 30,402     |       | 30,402                                                             |       | — |   | — |   | — |   | — |   | — |   |
| Total contractual cash obligations    |       | $          | 2,045,765  |                                                               | 293,427    |   | 221,167 |   | 188,758 |   | 170,491 |   | 152,027 |   | $ | 1,019,895 |   |
| Other long-term liabilities(3)        |       |       |       | 21,970                                                             |       | 18,734 |   | 20,228 |   | 21,589 |   | 22,598 |   |   |   |
| Total cash  obligations               |       |       |       | $                                                                  | 315,397    |   | $ | 239,901 |   | $ | 208,986 |   | $ | 192,080 |   | $ | 174,625 |   |   |   |

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(1)          The asset-backed notepayments are based on scheduled maturities, adjusted for estimated prepaymentsand delinquencies. Prepayments are estimated based on historical experience andexpectations about future economic conditions, particularly interest rates.

(2)          In January 2007,the Company used $28.0 million of available cash to repay a portion of the termloan outstanding under the 2005 Walter Credit Agreement.

(3)          Other long-termliabilities include pension and other post-retirement benefit liabilities. Whilethe estimated total liability is actuarially determined, there are nodefinitive payments by period as pension contributions depend ongovernment-mandated minimum funding requirements and other post-retirementbenefits are paid as incurred. Accordingly, amounts by period included in thisschedule are estimates and primarily include estimated post-retirementbenefits.

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Availablecommitments under existing borrowing arrangements:

| ** **                                | ** ** | ** **    | ** ** | **Amounts of Commitment Expiration per Year** | ** ** |
|-------------------------------------------|------------|---------------|------------|------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **Total**     | ** ** | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **Amounts**   | ** ** | **Less than**                                                     | ** ** | **1 - 3** | ** ** | **4-5** | ** ** | **Over 5** | ** ** |
| **(in thousands)**                   | ** ** | **Committed** | ** ** | **1 Year**                                                        | ** ** | **Years** | ** ** | **Years** | ** ** | **Years** | ** ** |
| Trust IX Variable  Funding Loan Facility  |       |          | $          | 150,000                                                                |       |   | $ | 150,000 |   |   | $ | — |   |   | $ | — |   |   | $ | — |   |   |
| Trust XIV  Variable Funding Loan Facility |       |          | 200,000    |                                                                   |       | 200,000 |   |   | — |   |   | — |   |   | — |   |   |
| Revolving Credit  Facilities(1)           |       |          | 162,500    |                                                                   |       | — |   |   | — |   |   | 162,500 |   |   | — |   |   |
| Total available  commitments              |       |          | $          | 512,500                                                                |       |   | $ | 350,000 |   |   | $ |   |   |   | $ | 162,500 |   |   | $ | — |   |   |

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(1)          Includes a sub-facilityfor standby and commercial letters of credit of which $62.5 million wasutilized at December 31, 2006.

Environmental, miscellaneous litigation and othercommitments and contingencies:

See Note 18 of “Notes toConsolidated Financial Statements” for discussion of these matters not includedin the tables above due to their contingent nature.

**MARKET RISK**

The Company is exposed tocertain market risks inherent in the Company’s operations. These risksgenerally arise from transactions entered into in the normal course of business.The Company’s primary market risk exposures relate to interest rate risk andcommodity risks. The Company does not enter into derivatives or other financialinstruments for trading or speculative purposes.

*Interest rate risk*

The Company’s primary interest rate risk exposuresrelate to the interest rates on its third-party indebtedness and the instalmentnotes receivable portfolio during the warehousing period and prepaymentsthereof.

On October 3, 2005, the Company entered into acredit agreement as more fully described in Note 14 of “Notes to ConsolidatedFinancial Statements” with total credit facilities of $675.0 million andfloating rate interest rates based on LIBOR plus a spread.

On November 1, 2005, the Company entered into aninterest rate hedge agreement (“hedge”) with a notional value of $75 million,as more fully described in Note 14 of “Notes to Consolidated FinancialStatements.”  The objective of the hedgeis to protect the Company against rising LIBOR interest rates that would have anegative effect on the Company’s cash flows due to changes in interest paymentson its 2005 Walter Credit Agreement. The structure of the hedge is a three-yearcollar contract with a floor of 4.25% and a cap of 5.69%. The collar agreementcalls for the Company to make fixed rate payments over the term of the hedgewhen stated three-month LIBOR rates are below the floor and to receive paymentsfrom the counter-party when the three-month LIBOR rates are above the cap. Itis anticipated that the hedge will be settled upon maturity, and will beaccounted for as a cash flow hedge. The changes in the fair value of theseswaps that take place through the date of maturity are recorded in accumulatedother comprehensive income (loss).

On November 28, 2006, the Company entered intotwo interest rate hedge agreements each with a notional value of $25.0 million.On January 30, 2007 and February 14, 2007, the Company entered intotwo additional hedge agreements with notional values of $50.0 million and $35.0million, respectively. The objective of these hedges is to protect againstchanges in the benchmark interest rate on the forecasted issuance ofmortgage-backed bonds anticipated to be priced on or around April 1, 2008.The hedges will be settled on or before maturity and are being accounted for asa cash flow hedges. As such, changes in the fair value of the hedges that takeplace through the date of maturity are recorded in accumulated othercomprehensive income (loss).

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A ten percent decrease in interest rates from theDecember 31, 2006 and 2005 rates would result in an increase to annualpre-tax income from these financial instruments of approximately $1.8 millionand $3.2 million, respectively, while a ten percent increase in rates woulddecrease annual pre-tax income approximately $1.4 million and $2.8 million,respectively.

The Company’s fixed-rate gross instalment notesreceivables were $1.793 billion and fixed-rate mortgage-backed/asset-backednotes were $1.737 billion as of December 31, 2006. The fixed rate natureof these instruments and their offsetting positions effectively mitigatesignificant interest rate risk exposure from these instruments. If interestrates decrease, the Company may be exposed to higher prepayment speeds. Thiscould result in a modest increase in short-term profitability. However, itcould adversely impact long-term profitability as a result of a shrinkingportfolio. Changes in interest rates may impact the fair value of thesefinancial instruments.

*Commodity risks*

The Company is exposed to commodity price risk onsales of natural gas. On an annual basis, the Company’s sales of natural gasapproximates 6.8 million mmbtu (equivalent of 7.0 billion cubicfeet).

The Company occasionally utilizes derivative commodityinstruments to manage the exposure to changing natural gas prices. Suchderivative instruments are structured as cash flow hedges and not for trading. During2006 and 2005, the Company hedged approximately 42% and 32%, respectively, ofits natural gas sales with swap contracts. These swap contracts effectivelyconverted a portion of forecasted sales at floating-rate natural gas prices toa fixed-rate basis. These swap contracts resulted in cash inflows of $12.3 millionin 2006 and cash outflows of $3.0 million in 2005, impacting net sales andrevenues.

At December 31, 2006,swap contracts to hedge approximately 0.6 million mmbtu of anticipatednatural gas sales in 2007 and at December 31, 2005, swap contracts tohedge approximately 4.5 million mmbtu of anticipated natural gas sales in2006, were outstanding as more fully described in Note 19 of “Notes toConsolidated Financial Statements.” At December 31, 2006, a ten percentincrease in the natural gas prices would result in a $0.4 million decrease inthe fair value of the swap contracts outstanding. On February 8, 2007, theCompany entered into an additional swap contract to hedge approximately 1.35 millionmmbtu of anticipated natural gas sales in 2007. 

**NEW ACCOUNTINGPRONOUNCEMENTS**

In July 2006, the FASB issued Interpretation (“FIN”)No. 48, “Accounting for Uncertainty in Income Taxes,” which provides theminimum recognition threshold that a tax provision must meet before beingrecognized in the financial statements. This interpretation also providesguidance on derecognition of income tax assets and liabilities, classificationof current and deferred income tax assets and liabilities, accounting forinterest and penalties associated with tax positions, accounting for incometaxes in interim periods and income tax disclosures. FIN No. 48 applies toall tax positions related to income taxes subject to SFAS No. 109, “Accountingfor Income Taxes.”  The Company estimatesthe adoption of this interpretation, which becomes effective January 1,2007, will result in an adjustment to decrease the beginning retained earningsby approximately $5.0 million to $10.0 million.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements,” which provides a definition of fair value,establishes a framework for measuring fair value and expands financialstatement disclosure requirements. SFAS No. 157 requires companies to basefair values on what they would receive from a sale to a third party in the openmarket. The Company has not yet determined what impact, if any, the adoption ofthis statement, which becomes effective January 1, 2008, will have on itsconsolidated financial statements.

In September 2006, the FASB issued SFAS No. 158,“Employers’ Accounting for Defined Benefit Pension and Other PostretirementPlans,” which requires the Company to recognize the overfunded or underfundedstatus of a defined benefit postretirement plan (other than a multiemployerplan) as an asset or liability in the balance sheet and to recognize changes inthat funded status as a component of other 

44

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comprehensive income. SeeNote 15 for the impact of this guidance, which was effective December 31,2006. In addition, SFAS No. 158 requires companies to measure plan assetsand liabilities as of the fiscal year-end reporting date. The Company uses a September 30measurement date and will be required to adopt this provision December 31,2008. The Company has not yet determined what impact the adoption of thisrequirement of this statement will have on its consolidated financialstatements.

In September 2006, the FASB issued FASB StaffPosition No. AUG AIR-1, “Accounting for Planned MajorMaintenance Activities” (“AUG AIR-1”), which provides guidance onwhich methods are allowed to properly account for planned major maintenanceactivities. The three accepted methods under AUG AIR-1 are directexpense, built-in overhaul, and deferral methods. The Company has not yetdetermined what impact the adoption of this statement, which becomes effective January 1,2007, will have on its consolidated financial statements.

In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities,” which allows reporting entities to choose to measuremany financial instruments and certain other items at fair value. The objectiveis to improve financial reporting by providing entities with the opportunity toreduce volatility in reported earnings that result from measuring relatedassets and liabilities differently without having to apply complex hedgeaccounting provisions, using the guidance in SFAS No. 133 (as amended), “Accountingfor Derivative Instruments and Hedging Activities.”  The Company has not yet determined whatimpact the adoption of this requirement, which becomes effective January 1,2008, will have on its consolidated financial statements.

**PRIVATE SECURITIESLITIGATION REFORM ACT SAFE HARBOR STATEMENT**

Except for historicalinformation contained herein, the statements in this release areforward-looking and made pursuant to the safe harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. Forward-looking statements involveknown and unknown risks and uncertainties that may cause the Company’s actualresults in future periods to differ materially from forecasted results. Thoserisks include, among others, changes in customers’ demand for the Company’sproducts, changes in raw material, labor, equipment and transportation costsand availability, geologic and weather conditions, changes in extraction costsand pricing in the Company’s mining operations, changes in customer orders,pricing actions by the Company’s competitors, potential changes in themortgage-backed capital market, and general changes in economic conditions.Risks associated with forward-looking statements are more fully described inthe Company’s filings with the Securities and Exchange Commission. Those risksalso include the timing of and ability to execute other strategic actions thatmay be pursued. The Company has no duty to update its outlook statements as ofany future date.

**UNAUDITED INTERIM FINANCIAL INFORMATION:(in thousands, except per share amounts)**

| ** **                                  | ** ** | **Quarter ended** | ** ** |
|---------------------------------------------|------------|------------------------|------------|
| **Fiscal Year 2006(4)**           | ** ** | ** **             | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31(1)** | ** ** |
| Net sales and  revenues                     |       | $                      | 322,175    |   | $ | 329,159 |   |   | $ | 341,695 |   |   |   | $ | 316,827 |   |   |
| Income from continuing operations           |       | 36,049                 |       | 37,475 |   |   | 35,661 |   |   |   | 28,435 |   |   |
| Income (loss) from  discontinued operations |       | (750                   | )          | 26,486 |   |   | 27,584 |   |   |   | 7,429 |   |   |
| Net income                                  |       | $                      | 35,299     |   | $ | 63,961 |   |   | $ | 63,245 |   |   |   | $ | 35,864 |   |   |
| Diluted income  (loss) per share:(2)(3)     |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Income from  continuing operations          |       | $                      | 0.73       |   | $ | 0.74 |   |   | $ | 0.70 |   |   |   | $ | 0.55 |   |   |
| Income from  discontinued operations        |       | (0.02                  | )          | 0.50 |   |   | 0.53 |   |   |   | 0.14 |   |   |
| Net income                                  |       | $                      | 0.71       |   | $ | 1.24 |   |   | $ | 1.23 |   |   |   | $ | 0.69 |   |   |
|                                             |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

45

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| ** **                                  | ** ** | **Quarter ended** | ** ** |
|---------------------------------------------|------------|------------------------|------------|
| **Fiscal Year 2005(4)**           | ** ** | ** **             | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31(1)** | ** ** |
| Net sales and  revenues                     |       | $                      | 247,803    |   | $ | 312,105 |   |   | $ | 253,187 |   |   |   | $ | 324,947 |   |   |
| Income (loss) from continuing operations    |       | 16,551                 |       | 33,739 |   |   | 14,269 |   |   |   | (29,398 | ) |   |
| Income (loss) from  discontinued operations |       | 2,214                  |       | 7,742 |   |   | 5,928 |   |   |   | (43,999 | ) |   |
| Net income (loss)                           |       | $                      | 18,765     |   | $ | 41,481 |   |   | $ | 20,197 |   |   |   | $ | (73,397 | ) |   |
| Diluted income  (loss) per share: (2)(3)    |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from  continuing operations   |       | $                      | 0.36       |   | $ | 0.71 |   |   | $ | 0.31 |   |   |   | $ | (0.75 | ) |   |
| Income (loss) from  discontinued operations |       | 0.05                   |       | 0.16 |   |   | 0.12 |   |   |   | (1.13 | ) |   |
| Net income (loss)                           |       | $                      | 0.41       |   | $ | 0.87 |   |   | $ | 0.43 |   |   |   | $ | (1.88 | ) |   |
|                                             |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Results for the fourthquarter 2006 include $23.4 million of income related to the settlement ofan insurance claim associated with a 2005 water ingress problem at Mine No. 5.The fourth quarter 2005 results include a $63.2 million goodwillimpairment charge at Homebuilding.

(2)          The sum of quarterly earningsper share amounts may be different than annual amounts as a result of theimpact of variations in shares outstanding due to rounding differences.

(3)          Dilutive earnings pershare includes the dilutive effect of the Company’s convertible seniorsubordinated notes, issued April 2004.

(4)          Amountsvary from previous Form 10-Q disclosures as a result of classifyingMueller Water as discontinued operations in connection with the December 14,2006 spin-off.

**Item 8.  Financial Statements and Supplementary Data**

Financial Statements andSupplementary Data consist of the financial statements as indexed on page F-1and unaudited financial information presented in Part II, Item 7, “Management’sDiscussion and Analysis of Results of Operations and Financial Condition”.

**Item 9.  Changes in and Disagreements with Accountantson Accounting and Financial Disclosure**

Incorporated by referenceto the 2007 Proxy Statement.

**Item 9A.  Controls and Procedures**

**Evaluation ofDisclosure Controls and Procedures**

As of December 31,2006, the Company’s management, including the Company’s vice chairman(principal executive officer) and chief financial officer (principal financialofficer), evaluated the effectiveness of the design and operation of theCompany’s disclosure controls and procedures (as defined in Rules 13a-15(e)and 15(d)-15(e) under the Securities Exchange Act of 1934, as amended (“ExchangeAct”). These disclosure controls and procedures have been designed to ensurethat information required to be disclosed by the Company in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported within the time periods specified by the SEC’s rules and regulationsand that such information is accumulated and communicated to  the Company’s management, including itsprincipal executive officer and chief financial officer, as appropriate, toallow timely decisions regarding required financial disclosure. Based on thisevaluation, the principal executive officer and chief financial officer haveconcluded that the Company’s disclosure controls and procedures were effectiveas of December 31, 2006.

**Management’s Reporton Internal Control over Financial Reporting**

Management is responsible for establishing andmaintaining adequate internal control over financial reporting (as defined inExchange Act Rule 13a-15(f)). Internal control over financialreporting is a 

46

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process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles in the United States of America. Acompany’s internal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

Management assessed the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2006. Inmaking this assessment, management used the criteria set forth by the Committeeof Sponsoring Organizations of the Treadway Commission (“COSO”) in *Internal Control-Integrated Framework*. Management hasconcluded that, as of December 31, 2006, the Company’s internal controlover financial reporting was effective.

Management’s assessment ofthe effectiveness of the Company’s internal control over financial reporting asof December 31, 2006, has been audited by PricewaterhouseCoopers LLP,an independent registered certified public accounting firm, as stated in theirreport which appears herein.

**Evaluation ofChanges in Internal Control over Financial Reporting**

There were no changes inthe Company’s internal control over financial reporting (as defined in Rule 13a-15(f) underthe Securities Exchange Act of 1934) during the quarter ended December 31,2006 that have materially affected, or are reasonably likely to materiallyaffect the Company’s internal control over financial reporting.

**Item 9B. OtherInformation**

None

47

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**Part III**

**Item10.**                 Directors,Executive Officers and Corporate Governance

**Executive Officers of the Registrant**

Setforth below is a list showing the names, ages and positions of the executiveofficers of the Company.

| **Name**             | ** ** | **Age** | ** ** | **Position**                                                                                |
|----------------------|------------|---------|------------|---------------------------------------------------------------------------------------------|
| Victor P. Patrick    |       | 49      |       | Vice Chairman, General  Counsel and Secretary                                               |
| Joseph J. Troy       |       | 43      |       | Executive Vice  President, Chief Financial Officer                                          |
| Mark J. O’Brien |       | 64      |       | Chairman and Chief  Executive Officer, JWH Holding Company, LLC                             |
| George R. Richmond   |       | 56      |       | Chief Executive Officer  of Jim Walter Resources, Inc.                                      |
| Ronald E. McCaslin   |       | 59      |       | President of Jim Walter  Homes, Inc.                                                   |
| Charles E. Cauthen   |       | 48      |       | Chief Financial Officer  of JWH Holding Company, LLC and President of Mid-State Homes, Inc. |
| Miles C. Dearden     |       | 47      |       | Senior Vice President,  Treasurer                                                           |
| Lisa A. Honnold      |       | 39      |       | Senior Vice President,  Controller                                                          |
| Larry E. Williams    |       | 59      |       | Senior Vice President, Human Resources                                                      |

 

Our executive officers asof March 1, 2007 are listed below.

**Victor P. Patrick**was appointedVice Chairman in August 2006 and has continued to serve as GeneralCounseland Secretary since joining the Company in August 2002. Mr. Patrickwas appointed as a Director of the Company in December 2006. Prior tojoining the Company, he worked for Honeywell International from 1994 toJuly 2002, most recently as Vice President, Secretary and Deputy GeneralCounsel.

**Joseph J. Troy**was appointedExecutive Vice President, Chief Financial Officer in August 2006.Mr. Troy has also served as Senior Vice President—Financial Services,President of Mid-State Homes and Senior Vice President and Treasurer of theCompany since November 2000. He was Executive Vice President and ChiefFinancial Officer of Gold Standard Multimedia from February 2000 to November 2000.From 1998 through February 2000, he was Vice President and Treasurer ofthe Company.

**Mark J.O’Brien**was appointed Chairman and Chief Executive Officer ofthe Company’s JWH Holding Company, LLC (consisting of its Financing andHomebuilding businesses) in February 2006. Mr. O’Brien has alsoserved as a member of the Company’s board of directors since June 2005. Previously,he was the Chief Executive Officer of Pulte Homes, Inc., where he servedin various capacities for 21 years until his retirement in 2003.

**George R.Richmond**was appointed Chief Executive Officer of Jim WalterResources in February 2006 and President and Chief Operating Officer ofJim Walter Resources in 1997. Mr. Richmond has held various positions atJWR since 1978. Mr. Richmond was appointed as a Director of the Company inDecember 2006.

**Ronald E. McCaslin**wasappointed President of Jim Walter Homes, Inc. in October 2006.Mr. McCaslin previously served as president of Stratford Homes. Priorthereto, he was President and Chief Operating Officer for the manufacturingdivision of American Homestar. Additionally, he has held executive positionswith Fleetwood Homes as well as with companies in the commercial appliance andequipment industry.

**Charles E. Cauthen**wasappointed Chief Financial Officer of JWH Holding Company, LLC and President ofMid-State Homes, Inc. in November 2006. Prior thereto, he served asPresident of Jim Walter Homes since August 2005. Previously, he served theCompany as Chief Operating Officer of Jim Walter Homes since February 2005and Senior Vice President and Controller since November 2000. Priorthereto, he was Senior Vice President and Chief Financial Officer—ConsumerProducts Group, Bank of America, from 1999 to November 2000.

48

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**Miles C.Dearden**was appointed Senior Vice President in February 2005and Vice President, Treasurer in April 2002. Previously, he was AssistantTreasurer beginning in March 2001. Prior to joining the Company, he workedfor Bank of America from 1987 until 2001, most recently as a managing directorfor the bank’s Global Corporate and Investment Bank.

**Lisa A. Honnold**wasappointed Senior Vice President, Controller of the Company in March 2006.Ms. Honnold has served as Vice President of Corporate Accounting for theCompany since December 2005. Prior to joining the Company, Ms. Honnoldwas Vice President, Corporate Controller of Catalina Marketing Corporation fromDecember 2004 to November 2005, holding the previous title ofAssistant Controller since November 2003. From 1996 to November 2003,Ms. Honnold held various positions with NACCO Industries, Inc., lastserving as Manager of Financial Reporting and Analysis.

**Larry E. Williams**wasappointed Senior Vice President, Human Resources in November 2001. Previously,he was Senior Vice President/Human Resources for CoBank from 1989 to 2001.

**Code of Conduct**

The Board has adopted aCode of Conduct Policy and Compliance Program (“Code of Conduct”) which isapplicable to all employees, directors and officers of the Company. The code ofConduct is posted on the Company’s website at *www.walterind.com*and is available in print to stockholders who request a copy. The Company hasmade available an Ethics Hotline, where employees can anonymously report aviolation of the Code of Conduct.

**Additional Information**

Additional information, asrequired in Item 10. “Directors and Executive Officers of the Registrant” areincorporated by reference to the Proxy Statement (the “2007 Proxy Statement”)included in the Schedule 14A to be filed by the Company with the Securities andExchange Commission (the “Commission”) under the Securities Exchange Act of1934, as amended.

**Item11.**                 ExecutiveCompensation

Incorporated by referenceto the 2007 Proxy Statement.

**Item12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

The equity compensationplan information as required by Item 201(d) of Regulation S-K isillustrated in Part II, Item 5 of this document. All other information asrequired by Item 12 is incorporated by reference to the 2007 Proxy Statement.

**Item13.**                 CertainRelationships and Related Transactions, and Director Independence

Incorporated by referenceto the 2007 Proxy Statement.

**Item14.**                 PrincipalAccounting Fees and Services

Incorporated by referenceto the 2007 Proxy Statement.

**Part IV**

**Item15.**                 Exhibits,Financial Statement Schedules

(a)(1)                     FinancialStatements - See Index to Financial Statements on page F-1.

(2)                   Exhibits—SeeItem 15(b).

(b)          Exhibits—SeeIndex to Exhibits on pages E1—E-4.

49

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

|               |       | WALTER INDUSTRIES, INC.                                                    |
|---------------|------------|----------------------------------------------------------------------------|
| March 1, 2007 | ** ** | /s/ JOSEPH J. TROY                                                         |
| ** **    | ** ** | Joseph J. Troy,  Executive Vice President  and Principal Financial Officer |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the datesindicated.

| March 1, 2007 |   | /S/ VICTOR P. PATRICK                                                                                      |
|---------------|--------|------------------------------------------------------------------------------------------------------------|
|          |   | Victor P. Patrick, Vice Chairman and Director, General  Counsel and Secretary, Principal Executive Officer |
| March 1, 2007 |   | /S/ HOWARD L. CLARK  JR.                                                                                   |
|          |   | Howard L. Clark, Jr., Director*                                                                       |
| March 1, 2007 |   | /S/ JERRY W. KOLB                                                                                          |
|          |   | Jerry W. Kolb, Director*                                                                                   |
| March 1, 2007 |   | /S/  PATRICK A. KRIEGSHAUSER                                                                               |
|          |   | Patrick A. Kriegshauser, Director*                                                                         |
| March 1, 2007 |   | /S/  JOSEPH B. LEONARD                                                                                     |
|          |   | Joseph B. Leonard, Director*                                                                               |
| March 1, 2007 |   | /S/ MARK J. O’BRIEN                                                                                   |
|          |   | Mark J. O’Brien, Director, Chairman and  Chief Executive Officer, JWH Holding Company, LLC*           |
| March 1, 2007 |   | /S/  BERNARD G. RETHORE                                                                                    |
|          |   | Bernard G. Rethore, Director*                                                                              |
| March 1, 2007 |   | /S/  GEORGE R. RICHMOND                                                                                    |
|          |   | George R. Richmond, Director, President and Chief  Executive Officer, Jim Walter Resources*                |
| March 1, 2007 |   | /S/ MICHAEL T. TOKARZ                                                                                      |
|          |   | Michael T. Tokarz, Chairman*                                                                               |
| March 1, 2007 |   | /S/  LISA A. HONNOLD                                                                                       |
|          |   | Lisa A. Honnold, Senior Vice President, Controller  and Principal Accounting Officer                       |
| By:           |   | S/  JOSEPH J. TROY                                                                                         |   |   |
|          |   | Joseph J. Troy                                                                                             |   |   |
|          |   | Attorney-in-Fact                                                                                           |   |   |
|               |        |                                                                                                            |  |  |  |  |

 

50

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**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

| Walter Industries, Inc.  and Subsidiaries                                                                                                                           |   |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| ** **                                                                                                                                                               |   |   |
| Report of Independent  Registered Certified Public Accounting Firm                                                                                                       |   | F-2    |
|                                                                                                                                                                     |   |   |
| Consolidated Balance  Sheets—December 31, 2006 and 2005                                                                                                        |   | F-4    |
|                                                                                                                                                                     |   |   |
| Consolidated Statements  of Operations for Each of the Three Years in the Period Ended December 31,  2006                                                           |   | F-5    |
|                                                                                                                                                                     |   |   |
| Consolidated Statements  of Changes in Stockholders’ Equity and Comprehensive Income (Loss) for Each  of the Three Years in the Period Ended December 31, 2006 |   | F-6    |
|                                                                                                                                                                     |   |   |
| Consolidated Statements  of Cash Flows for Each of the Three Years in the Period Ended December 31,  2006                                                           |   | F-7    |
|                                                                                                                                                                     |   |   |
| Notes to Consolidated Financial Statements                                                                                                                               |   | F-9    |

 

F-1

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**Reportof Independent Registered Certified Public Accounting Firm**

To Board of Directors and Stockholders of WalterIndustries, Inc.:

We have completedintegrated audits of Walter Industries, Inc.’s consolidated financialstatements and of its internal control over financial reporting as of December 31,2006 in accordance with the standards of the Public Company AccountingOversight Board (United States). Our opinions, based on our audits, arepresented below.

**Consolidatedfinancial statements**

In our opinion, the consolidated financial statementslisted in the index appearing under Item 15(a)(1) present fairly, in allmaterial respects, the financial position of Walter Industries, Inc. andits subsidiaries (the “Company”) at December 31, 2006 and 2005, and theresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2006 in conformity with accountingprinciples generally accepted in the United States of America. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit of financial statements includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 6 andNote 15 to the consolidated financial statements, the Company has changed themanner in which it accounts for share-based compensation and for definedbenefit pension and other postretirement plans, respectively.

**Internal controlover financial reporting**

Also, in our opinion, management’s assessment,included in Management’s Report on Internal Control over Financial Reportingappearing under Item 9A, that the Company maintained effective internal controlover financial reporting as of December 31, 2006 based on criteriaestablished in *Internal Control - Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO), is fairly stated, in all material respects, based on those criteria.Furthermore, in our opinion, the Company maintained, in all material respects,effective internal control over financial reporting as of December 31,2006, based on criteria established in *Internal Control -Integrated Framework* issued by the COSO. The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express opinions on management’s assessmentand on the effectiveness of the Company’s internal control over financialreporting based on our audit. We conducted our audit of internal control overfinancial reporting in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances. We believe thatour audit provides a reasonable basis for our opinions.

F-2

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A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

/s/PricewaterhouseCoopers LLP

Tampa, Florida

February 28, 2007

F-3

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**WALTER INDUSTRIES,INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(in thousands, except share amounts)**
|                                                                                                             | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                  | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                  |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                  |       | $                     | 127,370    |   | $ | 64,436 |   |
| Short-term  investments, restricted                                                                         |       | 90,042                |       | 124,573 |   |
| Instalment notes  receivable, net of allowance of $13,011 and $12,489, respectively     |       | 1,779,697             |       | 1,693,922 |   |
| Receivables, net                                                                                            |       | 88,643                |       | 74,610 |   |
| Inventories                                                                                                 |       | 108,871               |       | 122,146 |   |
| Prepaid expenses                                                                                            |       | 30,146                |       | 21,460 |   |
| Property, plant  and equipment, net                                                                         |       | 311,189               |       | 258,502 |   |
| Other long-term  assets                                                                                     |       | 137,262               |       | 121,991 |   |
| Goodwill                                                                                                    |       | 10,895                |       | 10,895 |   |
| Assets of  discontinued operations                                                                          |       | —                |       | 2,911,369 |   |
|                                                                                                        |       | $                     | 2,684,115  |   | $ | 5,403,904 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                              |       |                  |       |   |   |
| Accounts payable                                                                                            |       | $                     | 62,706     |   | $ | 53,355 |   |
| Accrued expenses                                                                                            |       | 96,552                |       | 95,221 |   |
| Debt:                                                                                                       |       |                  |       |   |   |
| Mortgage-backed/asset-backed notes                                                                          |       | 1,736,706             |       | 1,727,329 |   |
| Corporate debt                                                                                              |       | 249,491               |       | 623,875 |   |
| Accrued interest                                                                                            |       | 17,053                |       | 20,397 |   |
| Accumulated  postretirement benefits obligation                                                             |       | 330,241               |       | 225,241 |   |
| Other long-term  liabilities                                                                                |       | 189,458               |       | 182,664 |   |
| Liabilities of  discontinued operations                                                                     |       | —                |       | 2,187,206 |   |
| Total liabilities                                                                                           |       | $                     | 2,682,207  |   | $ | 5,115,288 |   |
| Commitments and  Contingencies (Note 18)                                                                    |       |                  |       |   |   |
| Stockholders’  equity:                                                                                 |       |                  |       |   |   |
| Common stock,  $.01 par value per share:                                                                    |       |                  |       |   |   |
| Authorized—200,000,000 shares  Issued—72,730,770 and 59,818,401 shares                            |       | 728                   |       | 598 |   |
| Capital in excess of par value                                                                              |       | 757,699               |       | 1,210,751 |   |
| Accumulated deficit                                                                                         |       | (398,564              | )          | (602,002 | ) |
| Treasury stock—20,771,902 shares, at cost                                                              |       | (259,317              | )          | (259,317 | ) |
| Accumulated other comprehensive loss                                                                        |       | (98,638               | )          | (61,414 | ) |
| Total stockholders’ equity                                                                             |       | 1,908                 |       | 288,616 |   |
|                                                                                                        |       | $                     | 2,684,115  |   | $ | 5,403,904 |   |

 

The accompanying notes are an integral part of the consolidated financial statements.

F-4

----

**WALTER INDUSTRIES,INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share amounts)**
|                                                                                    | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales and revenues:                                                            |       |                                                          |       |   |   |   |   |
| Net sales                                                                          |       | $                                                             | 1,046,711  |   | $ | 908,697 |   | $ | 749,878 |   |
| Interest income on instalment notes                                                |       | 199,659                                                       |       | 206,582 |   | 220,041 |   |
| Miscellaneous                                                                      |       | 63,486                                                        |       | 22,763 |   | 14,882 |   |
|                                                                               |       | 1,309,856                                                     |       | 1,138,042 |   | 984,801 |   |
| Cost and expenses:                                                                 |       |                                                          |       |   |   |   |   |
| Cost of sales (exclusive of depreciation)                                          |       | 703,539                                                       |       | 632,811 |   | 553,413 |   |
| Depreciation                                                                       |       | 39,017                                                        |       | 31,976 |   | 33,697 |   |
| Selling, general and administrative                                                |       | 149,762                                                       |       | 154,526 |   | 168,339 |   |
| Provision for losses on instalment notes                                           |       | 9,062                                                         |       | 10,724 |   | 12,402 |   |
| Postretirement benefits                                                            |       | 13,537                                                        |       | 14,401 |   | 9,487 |   |
| Interest expense—mortgage-backed/asset-backed notes                           |       | 118,743                                                       |       | 122,005 |   | 127,273 |   |
| Interest expense—corporate debt                                               |       | 38,014                                                        |       | 23,400 |   | 18,182 |   |
| Amortization of intangibles                                                        |       | 2,405                                                         |       | 3,641 |   | 4,976 |   |
| Restructuring and impairment charges                                               |       | 5,048                                                         |       | 63,445 |   | 470 |   |
| Provision (credit) for estimated hurricane insurance  losses                       |       | (1,046                                                        | )          | 10,044 |   | 3,983 |   |
| Debt conversion expense                                                            |       | 19,370                                                        |       | — |   | — |   |
|                                                                               |       | 1,097,451                                                     |       | 1,066,973 |   | 932,222 |   |
| Income from  continuing operations before income tax expense and minority interest |       | 212,405                                                       |       | 71,069 |   | 52,579 |   |
| Income tax  expense                                                                |       | 67,821                                                        |       | 36,718 |   | 2,045 |   |
| Income from  continuing operations before minority interest                        |       | 144,584                                                       |       | 34,351 |   | 50,534 |   |
| Minority interest  in net loss of affiliate                                        |       | 1,000                                                         |       | — |   | — |   |
| Income from  continuing operations                                                 |       | 145,584                                                       |       | 34,351 |   | 50,534 |   |
| Income (loss)  from discontinued operations                                        |       | 52,785                                                        |       | (27,305 | ) | (617 | ) |
| Net income                                                                         |       | $                                                             | 198,369    |   | $ | 7,046 |   | $ | 49,917 |   |
| Basic income per  share:                                                           |       |                                                          |       |   |   |   |   |
| Income from continuing operations                                                  |       | $                                                             | 3.31       |   | $ | 0.89 |   | $ | 1.31 |   |
| Income (loss) from discontinued operations                                         |       | 1.20                                                          |       | (0.71 | ) | (0.02 | ) |
| Net income                                                                         |       | $                                                             | 4.51       |   | $ | 0.18 |   | $ | 1.29 |   |
| Diluted income  per share:                                                         |       |                                                          |       |   |   |   |   |
| Income from continuing operations                                                  |       | $                                                             | 2.86       |   | $ | 0.78 |   | $ | 1.16 |   |
| Income (loss) from discontinued operations                                         |       | 1.01                                                          |       | (0.55 | ) | (0.02 | ) |
| Net income                                                                         |       | $                                                             | 3.87       |   | $ | 0.23 |   | $ | 1.14 |   |

 

The accompanying notes are an integral part of the consolidated financial statements.

F-5

----

**WALTER INDUSTRIES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYAND COMPREHENSIVE INCOME (LOSS)FOR THE THREE YEARS ENDED DECEMBER 31, 2006(in thousands)**

| ** **                                                                                       | ** ** | **Total** | ** ** | **Common  Stock** | ** ** | **Capital in  Excess of  Par Value** | ** ** | **Comprehensive  Income (Loss)** | ** ** | **Accumulated  Deficit** | ** ** | **Treasury  Stock** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------|------------|-------------------|------------|-----------------------------------------------------|------------|---------------------------------------|------------|--------------------------|------------|---------------------|------------|-----------------------------------------------------------|------------|
| Balance at December 31, 2003                                                                |       | $         | 276,610    |              |       | $                                                   | 557        |                                  |       | $                        | 1,150,442  |                |       |                                                      |       |   |   | $ | (658,965 | ) |   | $ | (164,018 | ) |   | $ | (51,406 | ) |   |
| Comprehensive  income:                                                                           |       |      |       |              |       |                                                |       |                                  |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Net income                                                                                       |       | 49,917    |       |              |       |                                                |       |                                  |       |                     | $          | 49,917              |       |                                                      |       | 49,917 |   |   |   |   |   |   |   |   |
| Other  comprehensive income (loss), net of tax:                                                  |       |      |       |              |       |                                                |       |                                  |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Increase in additional pension liability                                                         |       | (405      | )          |              |       |                                                |       |                                  |       |                     | (405       | )                   |       |                                                      |       |   |   |   |   |   | (405 | ) |   |
| Net unrealized gain on hedges                                                                    |       | 702       |       |              |       |                                                |       |                                  |       |                     | 702        |                |       |                                                      |       |   |   |   |   |   | 702 |   |   |
| Comprehensive income                                                                             |       |      |       |              |       |                                                |       |                                  |       |                     | $          | 50,214              |       |                                                      |       |   |   |   |   |   |   |   |   |   |
| Stock issued upon exercise of stock options                                                      |       | 26,580    |       |              | 23         |                                                |       | 26,557                                |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Tax benefit from the exercise of stock options                                                   |       | 5,363     |       |              |       |                                                |       | 5,363                                 |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Purchases of treasury stock                                                                      |       | (95,299   | )          |              |       |                                                |       |                                  |       |                     |       |                |       |                                                      |       |   |   | (95,299 | ) |   |   |   |   |
| Dividends paid, $.13 per share                                                                   |       | (4,939    | )          |              |       |                                                |       | (4,939                                | )          |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Stock-based compensation                                                                         |       | 698       |       |              |       |                                                |       | 698                                   |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Balance at December 31, 2004                                                                |       | 259,227   |       |              | 580        |                                                |       | 1,178,121                             |       |                     |       |                |       |                                                      | (609,048   | ) |   | (259,317 | ) |   | (51,109 | ) |   |
| Comprehensive  loss:                                                                             |       |      |       |              |       |                                                |       |                                  |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Net income                                                                                       |       | 7,046     |       |              |       |                                                |       |                                  |       |                     | $          | 7,046               |       |                                                      |       | 7,046 |   |   |   |   |   |   |   |   |
| Other  comprehensive loss, net of tax:                                                           |       |      |       |              |       |                                                |       |                                  |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Cumulative foreign currency translation adjustment                                               |       | (113      | )          |              |       |                                                |       |                                  |       |                     | (113       | )                   |       |                                                      |       |   |   |   |   |   | (113 | ) |   |
| Increase in additional pension liability                                                         |       | (9,573    | )          |              |       |                                                |       |                                  |       |                     | (9,573     | )                   |       |                                                      |       |   |   |   |   |   | (9,573 | ) |   |
| Net unrealized loss on hedges                                                                    |       | (619      | )          |              |       |                                                |       |                                  |       |                     | (619       | )                   |       |                                                      |       |   |   |   |   |   | (619 | ) |   |
| Comprehensive loss                                                                               |       |      |       |              |       |                                                |       |                                  |       |                     | $          | (3,259              | )          |                                                      |       |   |   |   |   |   |   |   |   |   |
| Stock issued upon exercise of stock options                                                      |       | 19,872    |       |              | 18         |                                                |       | 19,854                                |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Tax benefit from the exercise of stock options                                                   |       | 17,469    |       |              |       |                                                |       | 17,469                                |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Dividends paid, $.16 per share                                                                   |       | (6,145    | )          |              |       |                                                |       | (6,145                                | )          |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Stock-based compensation                                                                         |       | 1,452     |       |              |       |                                                |       | 1,452                                 |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Balance at December 31, 2005                                                                |       | 288,616   |       |              | 598        |                                                |       | 1,210,751                             |       |                     |       |                |       |                                                      | (602,002   | ) |   | (259,317 | ) |   | (61,414 | ) |   |
| Adjustment to initially apply SEC SAB No. 108                                               |       | 5,069     |       |              |       |                                                |       |                                  |       |                     |       |                |       |                                                      | 5,069      |   |   |   |   |   |   |   |   |
| Adjusted balance at December 31, 2005                                                       |       | 293,685   |       |              | 598        |                                                |       | 1,210,751                             |       |                     |       |                |       |                                                      | (596,933   | ) |   | (259,317 | ) |   | (61,414 | ) |   |
| Comprehensive  income:                                                                           |       |      |       |              |       |                                                |       |                                  |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Net income                                                                                       |       | 198,369   |       |              |       |                                                |       |                                  |       |                     | $198,369   |                |       |                                                      | 198,369    |   |   |   |   |   |   |   |   |
| Other  comprehensive income, net of tax:                                                         |       |      |       |              |       |                                                |       |                                  |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Cumulative foreign currency translation adjustment                                               |       | 1,053     |       |              |       |                                                |       |                                  |       |                     | 1,053      |                |       |                                                      |       |   |   |   |   |   | 1,053 |   |   |
| Decrease in additional pension liability                                                         |       | 703       |       |              |       |                                                |       |                                  |       |                     | 703        |                |       |                                                      |       |   |   |   |   |   | 703 |   |   |
| Net unrealized gain on hedges                                                                    |       | 4,113     |       |              |       |                                                |       |                                  |       |                     | 4,113      |                |       |                                                      |       |   |   |   |   |   | 4,113 |   |   |
| Comprehensive income                                                                             |       |      |       |              |       |                                                |       |                                  |       |                     | $          | 204,238             |       |                                                      |       |   |   |   |   |   |   |   |   |   |
| Adjustment to initially apply FASB Statement  No. 158                                       |       | (74,513   | )          |              |       |                                                |       |                                  |       |                     |       |                |       |                                                      |       |   |   |   |   |   | (74,513 | ) |   |
| Sale of common stock                                                                             |       | 168,680   |       |              | 26         |                                                |       | 168,654                               |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Stock issued upon conversion of convertible notes                                                |       | 176,108   |       |              | 98         |                                                |       | 176,010                               |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Gain on sale of investment in Mueller Water  Products, Inc. through initial public offering |       | 132,048   |       |              |       |                                                |       | 125,088                               |       |                     |       |                |       |                                                      |       |   |   |   |   |   | 6,960 |   |   |
| Stock dividend for spin-off of Mueller Water  Products, Inc.                                |       | (919,933  | )          |              |       |                                                |       | (944,393                              | )          |                     |       |                |       |                                                      |       |   |   |   |   |   | 24,460 |   |   |
| Stock issued upon exercise of stock options                                                      |       | 4,735     |       |              | 6          |                                                |       | 4,729                                 |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Tax benefit on the exercise of stock options                                                     |       | 8,310     |       |              |       |                                                |       | 8,310                                 |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Dividends paid, $.16 per share                                                                   |       | (6,825    | )          |              |       |                                                |       | (6,825                                | )          |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Stock-based compensation                                                                         |       | 15,375    |       |              |       |                                                |       | 15,375                                |       |                     |       |                |       |                                                      |       |   |   |   |   |   |   |   |   |
| Balance at  December 31, 2006                                                               |       | $         | 1,908      |              |       | $                                                   | 728        |                                  |       | $                        | 757,699    |                |       |                                                      |       |   |   | $ | (398,564 | ) |   | $ | (259,317 | ) |   | $ | (98,638 | ) |   |

 

The accompanying notes are an integral part of the consolidated financial statements.

F-6

----

**WALTER INDUSTRIES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)**

| ** **                                                                                      | ** ** | **For the years ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| OPERATING ACTIVITIES                                                                            |       |                                                          |       |   |   |   |   |
| Net income                                                                                      |       | $                                                             | 198,369    |   | $ | 7,046 |   | $ | 49,917 |   |
| Income (loss) from  discontinued operations                                                     |       | (52,785                                                       | )          | 27,305 |   | 617 |   |
| Income from  continuing operations                                                              |       | 145,584                                                       |       | 34,351 |   | 50,534 |   |
| Adjustments to reconcile income from continuing operations to net cash  provided by operations: |       |                                                          |       |   |   |   |   |
| Provision for  losses on instalment notes receivable                                            |       | 9,062                                                         |       | 10,724 |   | 12,402 |   |
| Depreciation                                                                                    |       | 39,017                                                        |       | 31,975 |   | 33,697 |   |
| Restructuring and  impairment charges                                                           |       | 5,048                                                         |       | 64,062 |   | — |   |
| Provision for  (benefit from) deferred income taxes                                             |       | 13,639                                                        |       | 19,357 |   | (8,468 | ) |
| Other                                                                                           |       | 14,341                                                        |       | 30,302 |   | 17,905 |   |
| Decrease (increase) in assets, net of effect of acquisition:                                    |       |                                                          |       |   |   |   |   |
| Receivables                                                                                     |       | (30,222                                                       | )          | 5,351 |   | 6,200 |   |
| Inventories                                                                                     |       | 13,275                                                        |       | (15,761 | ) | (8,402 | ) |
| Prepaid expenses                                                                                |       | (4,784                                                        | )          | (2,845 | ) | (13,276 | ) |
| Instalment notes  receivable, net                                                               |       | (33,755                                                       | )          | 52,585 |   | 50,628 |   |
| Increase (decrease) in liabilities, net of effect of acquisition:                               |       |                                                          |       |   |   |   |   |
| Accounts payable                                                                                |       | (1,040                                                        | )          | 16,488 |   | (25,434 | ) |
| Accrued expenses                                                                                |       | 14,329                                                        |       | 1,096 |   | 15,576 |   |
| Accrued interest                                                                                |       | (3,344                                                        | )          | 3,584 |   | (306 | ) |
| Cash flows  provided by operating activities                                                    |       | 181,150                                                       |       | 251,269 |   | 131,056 |   |
| INVESTING ACTIVITIES                                                                            |       |                                                          |       |   |   |   |   |
| Acquisitions, net  of cash acquired                                                             |       | 10,500                                                        |       | (867,085 | ) | — |   |
| Purchases of loans                                                                              |       | (103,823                                                      | )          | (61,098 | ) | (40,229 | ) |
| Principal payments  received on purchased loans                                                 |       | 45,954                                                        |       | 21,072 |   | 9,156 |   |
| Additions to  property, plant and equipment                                                     |       | (101,055                                                      | )          | (114,518 | ) | (29,979 | ) |
| Cash proceeds from  sale of property, plant and equipment                                       |       | 4,273                                                         |       | 4,495 |   | 6,508 |   |
| Decrease  (increase) in short-term investments, restricted                                      |       | 34,531                                                        |       | (24,668 | ) | 410 |   |
| Other                                                                                           |       | 11,159                                                        |       | 109 |   | 2,124 |   |
| Cash flows used in  investing activities                                                        |       | (98,461                                                       | )          | (1,041,693 | ) | (52,010 | ) |
| FINANCING ACTIVITIES                                                                            |       |                                                          |       |   |   |   |   |
| Issuance of  mortgage-backed/asset-backed notes                                                 |       | 401,876                                                       |       | 393,463 |   | 409,517 |   |
| Payments on  mortgage-backed/asset-backed notes                                                 |       | (392,647                                                      | )          | (429,004 | ) | (475,588 | ) |
| Proceeds from  issuance of corporate debt                                                       |       | —                                                        |       | 460,000 |   | 310,701 |   |
| Retirement of  corporate debt                                                                   |       | (200,169                                                      | )          | (11,125 | ) | (250,895 | ) |
| Sale of common  stock                                                                           |       | 168,680                                                       |       | — |   | — |   |
| Cash spun-off with  Mueller Water Products, Inc.                                           |       | (82,145                                                       | )          | — |   | — |   |
| Purchases of  treasury stock                                                                    |       | —                                                        |       | — |   | (95,299 | ) |
| Tax benefit on the  exercise of employee stock options                                          |       | 8,310                                                         |       | — |   | — |   |
| Exercise of  employee stock options                                                             |       | 4,735                                                         |       | 19,872 |   | 26,580 |   |
| Other                                                                                           |       | 1,372                                                         |       | (22,740 | ) | (12,969 | ) |
| Cash flows  provided by (used in) financing activities                                          |       | (89,988                                                       | )          | 410,466 |   | (87,953 | ) |
| Cash flows used in  continuing operations                                                       |       | (7,299                                                        | )          | (379,958 | ) | (8,907 | ) |
| CASH FLOWS FROM DISCONTINUED OPERATIONS                                                         |       |                                                          |       |   |   |   |   |
| Cash flows  provided by operating activities                                                    |       | 64,131                                                        |       | 87,753 |   | 22,959 |   |
| Cash flows used in  investing activities                                                        |       | (80,249                                                       | )          | (31,106 | ) | (27,110 | ) |
| Cash flows  provided by financing activities                                                    |       | 13,391                                                        |       | 413,783 |   | — |   |
| Cash flows  provided by (used in) discontinued operations                                       |       | (2,727                                                        | )          | 470,430 |   | (4,151 | ) |
| Net increase  (decrease) in cash and cash equivalents                                           |       | $                                                             | (10,026    | ) | $ | 90,472 |   | $ | (13,058 | ) |
| Cash and cash  equivalents at beginning of period                                               |       | $                                                             | 64,436     |   | $ | 46,924 |   | $ | 59,809 |   |
| Add: Cash and cash  equivalents of discontinued operations at beginning of period               |       | 72,960                                                        |       | — |   | 173 |   |
| Net increase  (decrease) in cash and cash equivalents                                           |       | (10,026                                                       | )          | 90,472 |   | (13,058 | ) |
| Less: Cash and  cash equivalents of discontinued operations at end of period                    |       | —                                                        |       | (72,960 | ) | — |   |
| Cash and cash  equivalents at end of period                                                     |       | $                                                             | 127,370    |   | $ | 64,436 |   | $ | 46,924 |   |

F-7

----

**WALTER INDUSTRIES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (in thousands)**

 

| SUPPLEMENTAL DISCLOSURES:                                        |   |   |    |       |   |      |   |
|------------------------------------------------------------------|--------|--------|---------|------------|--------|-----------|--------|
| Interest paid                                                    |   | $      | 148,703 |       | $      | 135,408   |   | $ | 137,646 |   |
| Income taxes paid  (refunded), net                               |   | $      | 32,495  |       | $      | 18,483    |   | $ | (466 | ) |
| Non-cash conversion of  Senior Subordinated Convertible          |   |   |    |       |   |      |   |
| Notes into common  stock                                         |   | $      | 174,215 |       | $      | —    |   | $ | — |   |
| Non-cash dividend  to spin-off Mueller Water Products, Inc. |   | $      | 944,393 |       | $      | —    |   | $ | — |   |
| Investing Activities:                                            |   |   |    |       |   |      |   |
| Acquisition of Mueller  Water:                                   |   |   |    |       |   |      |   |
| Fair value of  assets acquired                                   |   | $      | —  |       | $      | 2,539,833 |   | $ | — |   |
| Liabilities  assumed                                             |   | — |    | (1,596,448 | )      | —    |   |
| Less: Cash  acquired                                             |   | — |    | (76,300    | )      | —    |   |
| Net cash paid                                                    |   | $      | —  |       | $      | 867,085   |   | $ | — |   |

 

The accompanying notes are an integral part of the consolidated financial statements

F-8

----

**WALTER INDUSTRIES,INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1—Organization**

Walter Industries, Inc.(“Walter”), together with its consolidated subsidiaries (“the Company”), is adiversified company which operates in five reportable segments:  Natural Resources, Sloss, Financing,Homebuilding and Other, see Note 20. Through these operating segments, theCompany offers a diversified line of products and services including coal andnatural gas, furnace and foundry coke, slag fiber, mortgage financing and homeconstruction. In the fourth quarter of 2006, the Company began reporting Slossas a separate segment due to its significance in relation to all continuingoperating segments. Prior to the fourth quarter Sloss was included in the Othersegment. All prior year disclosures reflect this change.

**NOTE 2—DiscontinuedOperations**

**Acquisition,Initial Public Offering and Spin-off of Mueller Water Products, Inc.**

*Acquisition*

In October 2005, the Company acquired all of theoutstanding common stock of Mueller Water Products, Inc. (“Mueller Water”)for $943.4 million and assumed approximately $1.1 billion of indebtedness atMueller Water. In conjunction with the acquisition, the Company’s wholly ownedsubsidiary, United States Pipe and Foundry Company, LLC, (“U.S. Pipe”) wascontributed to Mueller Water.

Also in October 2005,the Company announced its plan to undertake an initial public offering andspin-off of Mueller Water to unlock shareholder value by creating a “pure play”water infrastructure company and a predominantly “pure play” coal company.

*Initial publicoffering*

In June 2006, MuellerWater completed its initial public offering (“IPO”) of 28.8 million shares of Series Acommon stock, at $16 per share (NYSE: MWA). The net proceeds of $428.9 millionwere used to repay a portion of Mueller Water’s existing debt and the Companyrecognized a gain of $132.0 million on the sale of the 25.1% ownership interestwhich has been included in stockholders’ equity. In connection with the IPO,Mueller Water issued approximately 85.8 million shares of Series B commonstock to the Company in exchange for the Company’s one share held prior to theIPO.

*Spin-off*

On December 14, 2006, theCompany distributed all of its 85.8 million shares of MuellerWater Series B common stock to its shareholders. The distributiontook place in the form of a pro rata common stock dividend whereby eachshareholder received 1.6524432  shares of Mueller Water Series Bcommon stock for each share of Company common stock held on the record date (“thespin-off”). The spin-off was intended to be tax-free to the Company and tothe shareholders of the Company for U.S. income tax purposes, except for anycash received in lieu of fractional shares.

As a result of the distribution, the Company nolonger has any ownership interest in Mueller Water. The Company andMueller Water have entered into several agreements to facilitate the spin-off,including a Transition Services Agreement to provide certain services to eachother, including tax, accounting, human resources and communication. The termof the services to be provided varies, but the Agreement is 

F-9

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expected to terminate oneyear from the spin-off date. The Company and Mueller Water entered into anIncome Tax Allocation Agreement that sets forth the rights and obligations ofthe Company and Mueller Water with respect to taxes and other liabilities thatcould be imposed in the event of a determination by the Internal RevenueService, upon audit, that the transaction is inconsistent with the tax-freestatus of the spin-off. Additionally, the Company and Mueller also entered intoa Joint Litigation Agreement that allocates responsibilities for pendingand future litigation and claims, allocates insurance coverages and third-partyindemnification rights, where appropriate, and provides that each party shouldcooperate with each other regarding such litigation claims and rights on a goingforward basis.

As a result of the spin-off, amounts previouslyreported in the Mueller Co., Anvil and U.S. Pipe segments (collectively, “MuellerWater”) are presented as discontinued operations for all periods presented.

The Company allocatedcertain corporate expenses, limited to specifically identified costs and othercorporate shared services which supported segment operations to discontinuedoperations, in accordance with EITF 87-24, “Allocation of Interest toDiscontinued Operations.”  These costsrepresent expenses that have historically been allocated to and recorded by theCompany’s operating segments as selling, general and administrative expenses.The Company did not elect to allocate additional interest expense todiscontinued operations in accordance with EITF 87-24.

**Other DiscontinuedOperations Activity**

In December 2003, the Company sold AppliedIndustrial Materials Corporation (“AIMCOR”), previously a wholly ownedsubsidiary of the Company, to Oxbow Carbon and Minerals LLC (“Oxbow”) for$127.7 million. Per the sales agreement for the divestiture of AIMCOR, thefinal sales price was subject to certain post-closing cash and net workingcapital adjustments. These adjustments are defined in the sales agreement andwere subject to resolution and arbitration processes provided for in the agreement.As a result of this transaction, the Company recognized in 2003 a receivablefor estimated net cash and working capital adjustments due to the Company.During 2006, the Company recognized a charge of $1.7 million, net of a taxbenefit of $0.9 million, to reflect the net realizable value of the receivableof $11.3 million, which was collected in December  2006. This charge, aswell as other legal and consulting costs resulting from the transaction, isincluded as a loss from discontinued operations in the consolidated statementof operations.

Thetable below presents the significant components of operating results includedin income (loss) from discontinued operations for the years ended December 31,2006, 2005 and 2004 (in thousands).

| ** **                                                                                  | ** ** | **For the years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales and  revenues                                                                     |       | $                                                             | 1,792,364  |   | $ | 916,098 |   | $ | 564,478 |   |
| Income (loss)  from discontinued operations before income tax expense and minority interest |       | $                                                        | 111,145    |   | $  | (44,257 | ) | $  | 4,573 |   |
| Income tax  (expense) benefit                                                               |       | (46,216                                                       | )          | 16,952 |   | (5,190 | ) |
| Minority interest  in net income                                                            |       | (12,144                                                       | )          | — |   | — |   |
| Income (loss) from  discontinued operations                                                 |       | $                                                             | 52,785     |   | $ | (27,305 | ) | $ | (617 | ) |

 

F-10

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The assets and liabilitiesreflected as discontinued operations in the consolidated balance sheet as of December 31,2005 are shown below (in thousands).

| Cash and cash  equivalents          |   | $         | 72,960    |   |
|-------------------------------------|--------|-----------|-----------|--------|
| Receivables, net                    |   | 276,505   |      |
| Inventory                           |   | 429,147   |      |
| Prepaid expenses                    |   | 9,859     |      |
| Property, plant  and equipment, net |   | 344,848   |      |
| Other long-term  assets             |   | 72,095    |      |
| Identifiable  intangibles, net      |   | 849,294   |      |
| Goodwill                            |   | 856,661   |      |
| Total assets                        |   | $         | 2,911,369 |   |
| Accounts payable                    |   | $         | 107,861   |   |
| Accrued expenses                    |   | 118,375   |      |
| Accrued interest                    |   | 12,222    |      |
| Debt                                |   | 1,548,578 |      |
| Other long-term  liabilities        |   | 400,170   |      |
| Total liabilities                   |   | $         | 2,187,206 |   |

 

Accumulated othercomprehensive loss associated with discontinued operations at December 31,2005 was $34.0 million, including $32.9 million of minimum pension liability, $1.0million of net unrealized loss on hedges and a $0.1 million of foreign currencytranslation loss.

**NOTE 3—Summary ofSignificant Accounting Policies**

**Basis ofPresentation**

The consolidated financialstatements include the accounts of all wholly and majority owned subsidiaries.Preparation of financial statements in accordance with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the amounts reported in the consolidated financial statements. Actualresults could differ from those estimates. All significant intercompanybalances and transactions have been eliminated. The notes to consolidatedfinancial statements, except where otherwise indicated, relate to continuingoperations only.

**Concentrations ofCredit Risk**

Financial instruments, which potentially subject theCompany to significant concentrations of credit risk, consist principally ofcash and cash equivalents, investments, instalment notes receivable, and tradeand other receivables.

The Company maintains cash and cash equivalents inhigh quality securities with various financial institutions. Concentrations ofcredit risk with respect to instalment notes receivable and trade and otherreceivables are limited due to the large number of customers and theirdispersion across many geographic areas. However, of the gross amount ofinstalment notes receivable at December 31, 2006, 32%, 15%, 8%, and 6%, (December 31,2005, 31%, 15%, 9%, and 6%) are secured by homes located in the states ofTexas, Mississippi, Alabama, and Florida and Louisiana (each 6%), respectively.The Company believes the potential for incurring material losses related to theconcentration of these credit risks is remote.

The Company providesinsurance to homeowners primarily in the southeastern United States and, due tothe concentration in this area, is subject to risk of loss due to the threat ofhurricanes and other natural disasters.

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**Revenue Recognition**

The Company recognizes revenue based on therecognition criteria set forth in the Securities and Exchange Commission’sStaff Accounting Bulletin 104, “Revenue Recognition in Financial Statements.”

*NaturalResources—**For*coal shipments via rail,revenue is recognized when title and risk of loss transfer to the customer whenthe railcar is loaded. For coal shipments via ocean vessel, revenue isrecognized under international shipping standards as defined by Incoterms 2000when title and risk of loss transfer to the customer. For the Company’s methanegas operations, revenues are recognized when the gas has been transferred tothe customer’s pipeline, at which time transfer of title occurs.

Miscellaneous income in 2006 includes $23.4 millionrelated to the settlement of an insurance claim associated with a 2005 wateringress problem at Mine No. 5.

*Sloss—**For*products shippedvia rail or truck, revenue is recognized when the risk of loss and titletransfers to the customer, generally at the point of shipment.

*Financing—**Within*the Financingsegment, Mid-State Homes, Inc. (“MSH”) purchases, securitizes and servicesinstalment notes and mortgages originated by Jim Walter Homes (“JWH”) andWalter Mortgage Company (“WMC”). JWH offers financing to homebuyers and WMCoriginates and purchases loans that are secured by mortgages and liens.References to instalment notes or mortgage instalment notes include mortgageloans offered by WMC.

Instalment notes receivable are initially recorded byJWH at the discounted value of the future instalment note payments using animputed interest rate. The imputed interest rate used represents the estimatedprevailing market rate of interest for credit of similar terms issued tocustomers with credit ratings similar to JWH’s customers. The Company estimatesthis rate by adding a credit spread and a margin to a benchmark funding rate inorder to cover costs and expected losses. This rate is periodically compared torates charged by competitors and other lenders to customers of similar creditquality to validate that the methodology results in a market rate of interest.These estimates affect revenue recognition by determining the allocation ofincome between the amount recognized by the Homebuilding segment from theconstruction of the home and the amount recognized by the Financing segmentover the life of the instalment note as interest income. Variations in theestimated market rate of interest used to initially record instalment notesreceivable could affect the amount and timing of income recognition in each ofthese segments. Instalment note payoffs received in advance of scheduledmaturity (prepayments) effect the amount of interest income due to therecognition of any remaining unamortized discounts or premiums arising from thenote’s inception.

The interest income generated by both MSH and WMC isrecognized using the interest method. The legal instruments used in eachcompany allow for different fee structures to be charged to the customer, forexample late fees and prepayment fees, and ultimately recognized as revenue.JWH offers instalment notes, which state the maximum amount to be charged tothe customer, and ultimately recognized as revenue, based on the contractualnumber of payments and dollar amount of monthly payments. WMC purchases fixedand variable rate mortgage loans and offers mortgage loans that have fixedmonthly payments and repayment terms similar to instalment notes. Both MSH andWMC have the ability to levy costs to protect their collateral position upondefault, such as attorney fees and late charges, as allowed by state law.

Instalment notes are placed on non-accrual status whenany portion of the principal or interest is ninety days past due. When placedon non-accrual status, the related interest receivable is reversed againstinterest income of the current period. Instalment notes are removed fromnon-accrual status when the amount financed and the associated interest incomebecome current. Recoveries of advanced taxes and insurance related toinstalment notes are recognized as income when collected.

F-12

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The Financing segment sells homes and related realestate repossessed or foreclosed on from customers in default of their loans ornotes (“Repo Sales”). Repo Sales involve the sale and, in most circumstances,the financing of both a home and related real estate. Revenues from Repo Salesare recognized by the full accrual method where appropriate. However, therequirement for a minimum 5% initial cash investment frequently is not met.When this is the case, losses are immediately recognized, and gains aredeferred and recognized by the instalment method until the buyer’s investmentreaches the minimum 5%. At that time, revenue is recognized by the full accrualmethod.

*Homebuilding—**The*Company’soperations involve three principal types of homebuilding transactions:

a.                 Selling a homeconstructed for consumers on real estate owned by the consumer (“On Your LotSales”);

b.                Selling modularhomes constructed in a factory principally to distributors for resale toconsumers (“Modular Sales”);

c.                 Selling a homeconstructed for consumers on real estate owned by the consumer but encumberedby a previous borrowing (“Real Estate Sales”).

Sales for cash at closing occasionally occur for eachof the above categories. However, except for Modular Sales, most involve someform of seller financing.

On Your Lot Sales constitute the majority of the salesin the homebuilding business. Since the real estate (land) is already owned bythe customer and is not financed by the Company, these transactions representsales of personal property financed by instalment sales contracts (“Notes”).Revenue from the construction and sale of a home is recognized upon completionof construction and legal transfer of ownership to the customer.

Modular Sales are generally made to distributors forresale to consumers and do not involve sales of real estate. Sales are madeunder various customary industrial credit terms, with receivables due within 10to 90 days following delivery. Revenue is recognized when legal ownership hastransferred and upon delivery to the distributor or to a customer site.

For Real Estate Sales, the Company finances both ahome and the related real estate. Revenues on Real Estate Sales are recognizedby the full accrual method when all of the following criteria are met:

a.                 The sale is consummated at a closing with thecustomer after construction is completed and legal transfer of ownership hasoccurred;

b.                The buyer’s initial cash investment is noless than 5% of the sales value. The buyer’s continuing investment is requiredto be a level monthly payment sufficient to amortize the borrowing over a termnot to exceed 30 years;

c.                 The Company’s receivable is secured by afirst mortgage and is not subject to future subordination; and

d.                The Company transfers to the buyer the risksand rewards of ownership and does not have any continuing involvement with theproperty.

*Other—**Land*sales arerecognized as revenue when legal transfer of ownership to the buyer occurs,which is at closing.

Given the diversity of theCompany’s businesses, many transactions have unique characteristics, which haveto be analyzed on a case-by-case basis. This diversity of products andcontracts can lead to variations in the timing of income recognition. However,most transactions are not individually significant, nor could they materiallyimpact earnings.

F-13

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**Shipping andHandling**

Costs to ship products to customers are included incost of sales and amounts billed to customers, if any, to cover shipping andhandling are included in net sales.

**Cash and CashEquivalents**

Cash and cash equivalents include short-term depositsand highly liquid investments that have original maturities of three months orless, when purchased, and are stated at cost which approximates market. TheCompany’s cash management system provides for the reimbursement of all majorbank disbursement accounts on a daily basis. Checks issued but not yetpresented to the banks for payment (i.e. book cash overdrafts) are included inaccounts payable.

**Allowances forLosses**

Allowances for losses on trade and other accountsreceivables are based, in large part, upon judgments and estimates of expectedlosses and specific identification of problem trade accounts and otherreceivables. Significantly weaker than anticipated industry or economicconditions could impact customers’ ability to pay such that actual losses maybe greater than the amounts provided for in these allowances.

Management’s periodic evaluation of the adequacy ofthe allowance for losses on instalment notes is based on the Company’s pastloss experience, known and inherent risks in the portfolio, delinquencies, theestimated value of the underlying real estate collateral and current economicand market conditions within the applicable geographic areas surrounding theunderlying real estate. The allowance for losses on instalment notes isincreased by provisions for losses charged to income and is reduced bycharge-offs net of recoveries.

**Inventories**

Inventories are valued at the lower of cost or marketusing either the first-in, first-out (“FIFO”) or average cost method ofaccounting. Additionally, the Company evaluates its inventory in terms ofexcess and obsolete exposures. This evaluation includes such factors asanticipated usage, inventory turnover, inventory levels and ultimate productsales value. Inventory cost includes an overhead component that can be affectedby levels of production and actual costs incurred. Management periodicallyevaluates the effects of production levels and actual costs incurred on thecosts capitalized as part of inventory cost.

**Property, Plant andEquipment**

Property, plant and equipment are recorded at cost.Depreciation is recorded principally on the straight-line method over theestimated useful lives of the assets. Leasehold improvements are amortized onthe straight-line method over the lesser of the useful life of the improvementor the remaining lease term. Estimated useful lives used in computingdepreciation expense are 3 to 20 years for machinery and equipment, 3 to 50 yearsfor land improvements and buildings, and mine life for mine development costs.Gains and losses upon disposition are reflected in the statement of operationsin the period of disposition.

Direct internal and external costs to implementcomputer systems and software are capitalized and are amortized over theestimated useful life of the system or software, which generally is 3 to 5years beginning when site installations or module development is complete andready for its intended use.

The Company applies Statement of Financial AccountingStandards (“SFAS”) No. 143, “Accounting for Asset Retirement Obligations,”related to reclamation efforts for its Natural Resources segment. Under SFASNo. 143, liabilities are recognized at fair value for an asset retirementobligation in the period in which it is incurred and the carrying amount of therelated long-lived asset is correspondingly increased. Over time, the liabilityis accreted to its future value. The corresponding asset capitalized atinception is depreciated over the useful life of the asset.

F-14

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The Company appliesFinancial Accounting Standards Board Interpretation (“FIN”) No. 47, “Accountingfor Conditional Asset Retirement Obligations.” The Company has certain legal obligations for asset retirements relatedto disposing of materials in the event of closure, abandonment or sale ofcertain of its facilities, primarily in the Sloss segment. A liability has notbeen recognized as of December 31, 2006 because the fair value of theobligation cannot be reasonably estimated. The Company cannot estimate thetiming of recognition because it plans to operate the facilities that aresubject to the asset retirement obligations for the foreseeable future. TheCompany would recognize a liability in the period in which sufficientinformation became available to reasonably estimate the liability’s fair value.

**Accounting for theImpairment of Long-Lived Assets**

Long-lived assets arereviewed for impairment whenever events or changes in circumstances indicatethat the book value of the asset may not be recoverable. The Companyperiodically evaluates whether events and circumstances have occurred thatindicate possible impairment. The Company uses an estimate of the futureundiscounted net cash flows of the related asset or asset group over theremaining life in measuring whether or not the assets are recoverable, see Note5.

**Workers’Compensation and Pneumoconiosis (“Black Lung”)**

TheCompany is self-insured for workers’ compensation benefits for work relatedinjuries. Liabilities, including those related to claims incurred but notreported, are recorded principally using annual valuations based on discountedfuture expected payments and using historical data of the division or combinedinsurance industry data when historical data is limited. Workers’ compensationliabilities were as follows (in thousands):

| ** **                                                     | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Undiscounted  aggregated estimated claims to be paid           |       | $                     | 39,952     |   | $ | 40,359 |   |
| Workers compensation  liability recorded on a discounted basis |       | 33,513                |       | 33,666 |   |
|                                                                |            |                       |            |  |  |  |  |

 

The Company applies a discount rate at a risk-freeinterest rate, generally a U.S. Treasury bill rate, for each policy year. Therate used is one with a duration that corresponds to the weighted averageexpected payout period for each policy year. Once a discount rate is applied toa policy year, it remains the discount rate for the year until all claims arepaid. The use of this method decreases the volatility of the liability asimpacted by changes in the discount rate. The weighted average rate used fordiscounting the liability at December 31, 2006 was 4.64%. Aone-percentage-point increase in the discount rate on the discounted claimsliability would decrease the liability by $0.2 million, while aone-percentage-point decrease in the discount rate would increase the liabilityby $0.2 million.

The Company is responsiblefor medical and disability benefits for black lung disease under the FederalCoal Mine Health and Safety Act of 1969, as amended, and is self-insuredagainst black lung related claims. The Company performs an annual evaluation ofthe overall black lung liabilities at the balance sheet date. The calculationis performed using assumptions regarding rates of successful claims, discountfactors, benefit increases and mortality rates, among others. The actuariallydetermined present value of the obligation using a discount factor of 5.7% and5.4% for 2006 and 2005, respectively, recorded by the Company was $7.4 millionand $7.2 million as of December 31, 2006 and 2005, respectively, and wasrecorded in other long-term liabilities. A one-percentage-point increase in thediscount rate on the discounted claims liability would decrease the liabilityby $1.1 million, while a one-percentage-point decrease in the discount ratewould increase the liability by $1.4 million.

F-15

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**Insurance Claims(Hurricane Losses)**

Accruals for property-liability claims and claimsexpense are recognized when probable and reasonably estimable at amountsnecessary to settle both reported and unreported claims of insuredproperty-liability losses, based upon the facts in each case and the Company’sexperience with similar cases. The establishment of appropriate accruals,including accruals for catastrophes such as hurricanes, is an inherentlyuncertain process. Accrual estimates are regularly reviewed and updated, usingthe most current information available.

The Company recorded acredit in 2006 and a provision in 2005 and 2004 for estimated hurricaneinsurance losses of $(1.0) million, $10.0 million and $4.0 million, net ofexpected reinsurance proceeds from unrelated insurance carriers, respectively. Theseestimates, recorded in the Financing segment, were for estimated claim lossesas a result of damage from Hurricanes Katrina and Rita in 2005 and fourhurricanes in 2004 that impacted the Company’s market area.

**RepossessedProperty**

Repossessed property isrecorded at its estimated fair value less estimated costs to sell. Gains onsales of repossessed land and homes are recorded into income based on the buyer’sequity in the property. On sales to buyers with at least 5% equity in theproperty, gains are recorded into income at time of sale when title passes. Forthose sales to buyers with less than 5% equity in the property, the gain onsale is deferred and recorded to income on a pro-rata basis in relation topayments received until buyer’s equity equals 5%, at which time the remainingdeferred gain is recorded into income.

**DerivativeInstruments and Hedging Activities**

The Company enters into interest rate hedge agreementsin accordance with the Company’s internal debt and interest rate riskmanagement policy which is designed to mitigate risks related to floating ratefinancing agreements which are subject to changes in the market rate ofinterest. Also, the Company enters into interest rate hedge agreements designedto protect against the risk of rising interest rates on the forecasted amountof securitization debt to be issued to finance instalment notes and mortgageloans receivable of the Financing segment. Changes in the fair value ofinterest rate hedge agreements that are designated and effective as hedges arerecorded in accumulated other comprehensive income (loss) (“OCI”). Deferredgains or losses are reclassified from OCI to the statement of operations in thesame period as the underlying transactions are recorded and are recognized inthe caption, interest expense. In addition, the settled amount of an interestrate hedge agreement that has been terminated prior to its original termcontinues to be deferred in OCI and is recognized in the statement ofoperations over the term of the underlying debt agreement designated as thehedged item. Changes in the fair value of interest rate hedge agreements thatare not effective as hedges are recorded immediately in the statement ofoperations as interest expense.

To protect against the reduction in the value offorecasted cash flows resulting from sales of natural gas, the Companyperiodically engages in a natural gas hedging program. The Company hedgesportions of its forecasted revenues from sales of natural gas with natural gasderivative contracts, generally either “swaps” or “collars”. The Company entersinto natural gas derivatives that effectively convert a portion of itsforecasted sales at floating-rate natural gas prices to a fixed-rate basis,thus reducing the impact of natural gas price changes on net sales and revenues.When natural gas prices fall, the decline in value of future natural gas salesis offset by gains in the value of swap contracts designated as hedges. Conversely,when natural gas prices rise, the increase in the value of future cash flowsfrom natural gas sales is offset by losses in the value of the swap contracts.Changes in the fair value of natural gas derivative agreements that aredesignated and effective as hedges are recorded in OCI. Deferred gains orlosses are reclassified from 

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OCI to the statement ofoperations in the same period as the underlying transactions are recorded andare recognized as miscellaneous income.

Interest rate hedge agreement and natural gasderivative contracts held by the Company have been designated as hedges offorecasted cash flows. The Company does not currently hold any non-derivativeinstruments designated as hedges or any derivatives designated as fair valuehedges. In addition, the Company does not enter into derivative financialinstruments for speculative or trading purposes. Derivative contracts areentered into only with counterparties that management considers credit-worthy.

Cash flows from hedgingactivities are reported in the statement of cash flows in the sameclassification as the hedged item, generally as a component of cash flows fromoperations.

**EnvironmentalExpenditures**

The Company capitalizesenvironmental expenditures that increase the life or efficiency of property orthat reduces or prevents environmental contamination. The Company accrues forenvironmental expenses resulting from existing conditions that relate to pastoperations when the costs are probable and reasonably estimable. See Note 18for additional discussion of environmental matters.

**Income (Loss) perShare**

The Company calculatesbasic income (loss) per share based on the weighted average common sharesoutstanding during each period and diluted income (loss) per share based onweighted average and dilutive common equivalent shares outstanding during eachperiod. Dilutive common equivalent shares include the dilutive effect of stockoptions, as well as the Company’s convertible senior subordinated notes, seeNote 17.

**Reclassifications**

Certain reclassificationshave been made to prior years’ amounts to conform to the current periodpresentation.

**Adoption of SEC**StaffAccounting Bulletin (“SAB”) No. 108

In September 2006, the SEC staff issued SAB No. 108,“Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements.”  SAB No. 108 was issued in order toeliminate the diversity of practice surrounding how public companies quantifyfinancial statement misstatements.

In SAB No. 108, the SEC staff established anapproach that requires quantification of financial statement misstatementsbased on the effects of the misstatements on each of the company’s financialstatements and the related financial statement disclosures. This approach iscommonly referred to as a “dual approach” because it requires quantification oferrors under two methods—one method which focuses primarily on the impact of amisstatement on the income statement and another method which focuses primarilyon the effect of correcting the period-end balance sheet.

SAB No. 108 permits existing public companies toinitially apply its provisions either by (i) restating prior financialstatements as if the “dual approach” had always been used or (ii) recordingthe cumulative effect of initially applying the “dual approach” as adjustmentsto the carrying values of assets and liabilities as of January 1, 2006with an offsetting adjustment recorded to the opening balance of retainedearnings (accumulated deficit). The Company has applied the provisions of SAB No. 108using the cumulative effect transition method as of January 1, 2006 tocorrect errors in previous financial statements which had been consideredimmaterial, both individually and in the aggregate.

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Thefollowing table summarizes the effects, up to January 1, 2006, of applyingthe guidance in SAB No. 108 (in thousands):

| ** **                                    | ** ** | ** **                    | ** ** | **Period in which the**                                                                          | ** ** |
|-----------------------------------------------|------------|-------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                    | ** ** | ** **                    | ** ** | **Misstatement Originated**                                                                                | ** ** |
| ** **                                    | ** ** | **Adjustment**                | ** ** | **For the years ended**                                                                          | ** ** | **Cumulative** | ** ** |
| ** **                                    | ** ** | **Recorded as of**  | ** ** | **      December 31,         ** | ** ** | **Prior to** | ** ** |
| ** **                                    | ** ** | **January 1, 2006** | ** ** | **    2005    **                                                        | ** ** | **    2004    ** | ** ** | **January 1, 2004** | ** ** |
| (1) Black  lung net asset                |       |                          | $          | 1,868                                                                                                           |       |   |   | $ | (303 | ) |   |   | $ | 125 |   |   |   | $ | 2,046 |   |   |
| (2) Survivor  benefits accrual           |       |                          | 1,055      |                                                                                                            |       |   | — |   |   |   | — |   |   |   | 1,055 |   |   |
| (3) Accrued  interest income methodology |       |                          | 3,213      |                                                                                                            |       |   | (531 | ) |   |   | (574 | ) |   |   | 4,318 |   |   |
| (4) Escrow  balance                      |       |                          | 875        |                                                                                                            |       |   | 19 |   |   |   | 97 |   |   |   | 759 |   |   |
| (5) OPEB  asset                          |       |                          | (316       | )                                                                                                               |       |   | 30 |   |   |   | 30 |   |   |   | (376 | ) |   |
| Net tax effects  of above items               |       |                          | (1,626     | )                                                                                                               |       |   | 188 |   |   |   | 175 |   |   |   | (1,989 | ) |   |
| Increase to beginning accumulated  deficit    |       |                          | $          | 5,069                                                                                                           |       |   |   | $ | (597 | ) |   |   | $ | (147 | ) |   |   | $ | 5,813 |   |   |

 

(1)     BlackLung Net Asset

In previous years, assets were set aside in a trustfund to satisfy potential Black Lung obligations of JWR’s Mine No. 4.  Since prior to 2003, it has been the Company’spractice to exclude both the trust fund assets and the related Black Lungobligation of Mine No. 4 from recognition on the Company’s financialstatements. Changes to the net overfunded position were not material to theincome statement.

(2) Survivor Benefits Accrual

Prior to 2003, the Company recorded a separate accrualfor certain survivor medical benefits at JWR and the balance in this accrualhas not changed. The Company determined that these obligations areappropriately captured in the measurement of the liability for otherpostretirement benefits (“OPEB”), which is recognized separately from thisaccrual. As such it was determined that this additional accrual was notrequired.

(3)  Accrued Interest Income Methodology

In 2003, the Company determined that for those instalmentnotes Financing acquired prior to January 1, 2003, interest incomeapplicable to delinquent instalments was not accrued until the account becamedelinquent for more than 30 days. Interest income was recognized when theinstalment note became delinquent for 31 days and continued to be accrued afterthat until such delinquency was cured or until 90 days, at which time theaccrued interest income was reversed in full. In 2003, a decision was made tocontinue this methodology for instalment notes acquired prior to January 1,2003 because the effect on the statement of operations in any particular yearhad been and would continue to be immaterial. Since 2003, the Company has beencalculating interest income as soon as the instrument becomes delinquent forthose instalment notes acquired subsequent to January 1, 2003. The Companybelieves that this is the appropriate income recognition methodology since ithas a history of collecting interest on delinquent accounts that are curedprior to becoming 90-days delinquent. As such, the Company has correctedthe interest income recognition methodology for pre-January 1, 2003instalment note accounts as of January 1, 2006.

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(4) Escrow Balance

In previous years, the Company’s formerly ownedsubsidiary, U.S. Pipe, contributed funds which are held in escrow for theeventual funding of U.S. Pipe’s landfill clean-up. Although this asset retirementobligation had been appropriately recognized by U.S. Pipe, this restrictedasset and its related interest income had not previously been recognized in thefinancial statements. Both the asset and related retirement obligation areincluded on the balance sheet of U.S. Pipe, which was spun-off on December 14,2006.

(5) OPEB Asset

Prior to 2003, Slossrecognized an asset, netted against restructuring liabilities, relating to theeffect of the curtailment of post-retirement medical obligations resulting fromthe termination of certain employees. At that time, Sloss began, and hascontinued, amortizing the asset. Since the actuary appropriately incorporatesthe obligations of these former employees in its assumptions, and the Companyhas historically recognized an expense and obligation in accordance with theactuary’s report, it is not necessary for Sloss to have this additional OPEBasset and expense recorded.

**NOTE 4—ConsolidatedStatements of Cash Flows**

The Company has revised its consolidated statement ofcash flows for the years ended December 31, 2005 and 2004 to reflect thenet increase or decrease in Financing’s instalment note receivable balancerelating to the portfolio of assets originated by Homebuilding as an element indetermining cash flows from operating activities. Previously, this item wasreported in investing activities. The previous cash flow treatment followed theCompany’s principal lines of business reporting; however, on a consolidatedbasis, there is no cash flow resulting from Financing’s purchase of instalmentnotes from Homebuilding. Financing’s purchases of loans from third parties, aswell as the principal portion of cash collections on those loans, remain ininvesting activities.

Prioramounts reported have been revised as follows (in thousands):
|                                                 | ** ** | **For the years ended December 31,** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                      | ** ** | **Previous Presentation**                           | ** ** | **Change** | ** ** | **As Revised** | ** ** |
| ** **                                      | ** ** | **2005**                                                 | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Instalment notes  receivable, net               |       | $                                                        | —     |   | $ | — |   | $ | 52,585 |   | $ | 50,628 |   | $ | 52,585 |   | $ | 50,628 |   |
| Net cash provided  by operating activities      |       | 198,684                                                  |       | 80,428 |   | 52,585 |   | 50,628 |   | 251,269 |   | 131,056 |   |
| Purchases of  loans                             |       | (422,861                                                 | )          | (455,242 | ) | 361,763 |   | 415,013 |   | (61,098 | ) | (40,229 | ) |
| Principal  payments received on purchased loans |       | 455,420                                                  |       | 474,797 |   | (434,348 | ) | (465,641 | ) | 21,072 |   | 9,156 |   |
| Net cash provided by  investing activities      |       | (989,108                                                 | )          | (1,382 | ) | (52,585 | ) | (50,628 | ) | (1,041,693 | ) | (52,010 | ) |
|                                                 |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-19

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**NOTE 5—Restructuring,Impairment and Other Charges**

A summary of restructuringand impairment charges included the following (in thousands):

| ** **                                      | ** ** | **For the years ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                      | ** ** | **   2006   **                  | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| JWR Mine No. 5  shutdown                   |       |                                                          | $          | — |   |   | $ | (618 | ) |   | $ | 470 |   |   |
| JWR Mine No. 7  longwall shield impairment |       |                                                          | —     |   |   | 853 |   |   | — |   |   |
| Homebuilding goodwill  impairment               |       |                                                          | —     |   |   | 63,210 |   |   | — |   |   |
| Homebuilding property  impairment               |       |                                                          | 3,409      |   |   | — |   |   | — |   |   |
| Sloss chemical division  impairment             |       |                                                          | 1,639      |   |   | — |   |   | — |   |   |
| Total restructuring and  impairment charges     |       |                                                          | $          | 5,048 |   |   | $ | 63,445 |   |   | $ | 470 |   |   |

 

In the fourth quarter of 2006, the Company recorded aproperty impairment charge of $3.4 million related to Homebuilding’s modularhome division. There was an indication of impairment due to lower than expectedoperating performance in the fourth quarter of 2006 that is not expected tochange significantly in the near future. The Company determined the fair valueof the long-lived assets using a probability-weighted discounted cash flow. Subsequentto December 31, 2006, primarily as a result of the poor fourth quarter2006 performance, the Company has decided to exit the modular homemanufacturing and distribution business.

During 2006, the Company recorded impairment chargestotaling $1.6 million relating to Sloss’ chemical division. These assets weresold in November 2006.

The Company recorded a $63.2 million goodwill impairmentin 2005 to eliminate the goodwill of the Homebuilding segment, see Note 12.

In 2005, the Company recognized an impairment chargeof $0.9 million at its Natural Resources segment as a result of adversegeologic conditions in Mine No. 7, which caused damage to certainunderground longwall mining equipment that was not economically viable torepair. The equipment was abandoned in January 2006.

In 2003, the Company announced that it expected toclose Mine No. 5 in 2004. Due to an improvement in the metallurgical coalmarket, the Company extended its coal production plans for Mine No. 5 witha revised scheduled shutdown of late 2006 or early 2007. Mine No. 5 shutdown in 2006; mining equipment has been recovered and the mine shafts are inthe process of being sealed. Total expected costs to close the mine are $8.5million. Approximately $6.6 million of the closure costs qualify asrestructuring costs and have been recorded by the Company. Other costs,primarily representing estimated worker’s compensation and other incrementalcosts related to the closure of the mine, will be charged to expense whenincurred.

Activityin accrued restructuring was as follows (in thousands):

| ** **                      | ** ** | **For the years ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Beginning balance               |       | $                                                             | 621        |   | $ | 1,588 |   | $ | 1,145 |   |
| Restructuring  expenses accrued |       | 590                                                           |       | 1,478 |   | 2,136 |   |
| Restructuring  payments         |       | (209                                                          | )          | (997 | ) | (27 | ) |
| Other                           |       | 316                                                           |       | — |   | — |   |
| Reversal of prior  accruals     |       | —                                                        |       | (1,448 | ) | (1,666 | ) |
| Ending balance                  |       | $                                                             | 1,318      |   | $ | 621 |   | $ | 1,588 |   |

 

F-20

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**NOTE 6—Stock-BasedCompensation Plans**

As of January 1, 2006, the Company adopted SFAS No. 123(revised 2004), “Share-Based Payment” (“SFAS 123(R)”) which requires theCompany to value and record, as compensation expense, stock awards granted toemployees under a fair value based method. Prior to January 1, 2006, theCompany accounted for stock awards granted to employees under the recognitionand measurement principles of Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations. As a result, nocompensation expense was previously recognized for stock options granted toemployees because all stock options granted had exercise prices equal to themarket value of the Company’s stock at the date of the grant, whilecompensation expense associated with restricted stock unit grants was beingrecognized over the vesting period of the grant.

SFAS 123(R) applies to new awards and to awardsmodified, repurchased or canceled after January 1, 2006. The Companyutilizes the modified prospective application method for stock options andrestricted stock units granted prior to January 1, 2006, which requiresthe Company to record compensation expense beginning January 1, 2006 forthe unvested portion of those stock awards. This compensation expense ischarged to the statement of operations with a corresponding credit to capitalin excess of par value. In addition, the Company is required, uponadoption, to calculate the pool of income tax benefits that were previouslyrecorded in capital in excess of par value and are available to absorb futureincome tax benefit deficiencies that can result from the exercise or maturityof stock awards. The Company has elected to calculate this pool under thealternative transition method provided for in FASB Staff Position No. 123(R)-3, “Transition Election Related to Accounting for the Tax Effects ofShare-Based Payment Awards.” Additionally, the Company is required to reflectthe benefits of tax deductions in excess of recognized compensation cost as anoperating cash outflow and a financing cash inflow. The Company uses theBlack-Scholes option pricing model to value its stock option grants andestimates forfeitures in calculating the expense related to stock-basedcompensation.

Theeffect of accounting for stock options in accordance with SFAS 123(R) onthe financial performance of the Company for the year ended December 31,2006 was as follows (in thousands, except per share data):

| Decrease in  income from continuing operations before income taxes |   |   | $     | 5,055  |   |   |   |
|--------------------------------------------------------------------|--------|--------|-------|--------|--------|--------|--------|
| Decrease in  income from continuing operations                     |   |   | 3,276 |   |   |   |
| Decrease in net  income                                            |   |   | 2,829 |   |   |   |
| Cash outflow from  operating activities                            |   |   | 8,310 |   |   |   |
| Cash inflow from  financing activities                             |   |   | 8,310 |   |   |   |
| Decrease in basic  income per share                                |   |   | 0.06  |   |   |   |
| Decrease in diluted  income per share                              |   |   | 0.05  |   |   |   |

 

F-21

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In accordance with themodified prospective transition method, the Company’s consolidated financialstatements for periods ended prior to January 1, 2006 have not beenrestated to reflect, and do not include, the impact of SFAS 123(R). Hadcompensation cost for the Company’s option plans for the years ended December 31,2005 and 2004 been determined based on the fair value at the grant dates asprescribed by SFAS 123(R), the Company’s net income and net income per share ona pro forma basis would have been (in thousands, except per share data):

| ** **                                                                                                                                        | ** ** | **For the years ended  December 31,** | ** ** | ** **   |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|--------------|
| ** **                                                                                                                                        | ** ** | **2005**(1)                                               | ** ** | **2004**(1)  | ** ** | ** ** |
| Net income, as reported                                                                                                                           |       | $                                                         | 7,046      |         | $ | 49,917 |   |   |
| Add: Stock-based  compensation expense included in reported net income, net of related tax  effects                                               |       | 944                                                       |       | 456          |   |   |
| Deduct: Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of related tax effects |       | (2,449                                                    | )          | (3,041  | ) |   |
| Pro forma net income                                                                                                                              |       | $                                                         | 5,541      |         | $ | 47,322 |   |   |
| Net income per share:                                                                                                                             |       |                                                      |       |         |   |   |
| Basic—as reported                                                                                                                            |       | $                                                         | 0.18       |         | $ | 1.29 |   |   |
| Basic—pro forma                                                                                                                              |       | 0.14                                                      |       | 1.23         |   |   |
| Diluted—as reported                                                                                                                          |       | 0.23                                                      |       | 1.14         |   |   |
| Diluted—pro forma                                                                                                                            |       | 0.11                                                      |       | 1.09         |   |   |

----

(1)          Includes amounts relatedto discontinued operations.

Thepreceding pro forma results were calculated using the Black Scholesoption-pricing model. Weighted average assumptions used for stock compensationawards granted in the following prior year periods were:

| ** **               | ** ** | **For the years ended  December 31,** | ** ** |
|--------------------------|------------|-----------------------------------------------------------|------------|
| ** **               | ** ** | **   2005   **              | ** ** | **   2004   ** | ** ** |
| Risk free  interest rate |       |                                                      | 4.10       | % |   |   | 4.99 | % |   |
| Dividend yield           |       |                                                      | 0.40       | % |   |   | 1.00 | % |   |
| Expected life  (years)   |       |                                                      | 5.8        |   |   |   | 6.9 |   |   |
| Volatility               |       |                                                      | 40.36      | % |   |   | 39.83 | % |   |

 

**Equity Award Plans**

The stockholders of the Company approved the 2002Long-Term Incentive Award Plan (the “2002 Plan”),  under which an aggregate of 3.9 million,as restated to reflect the modification for the Mueller Water spin-off, sharesof the Company’s common stock have been reserved for grant and issuance ofincentive and non-qualified stock options, stock appreciation rights and stockawards.

Under the Long-Term Incentive Stock Plan approved bystockholders in October 1995 (the “1995 Plan”) and amended in September 1997,an aggregate of 6.0 million shares of the Company’s common stock have beenreserved for the grant and issuance of incentive and non-qualified stockoptions, stock appreciation rights and stock awards.  However, the 1995 Plan expired in 2005 and,therefore, no further grants will be issued under this plan.

Under both plans (collectively, the “Equity AwardPlans”), an option becomes exercisable at such times and in such installmentsas set by the Compensation Committee of the Board of Directors (generally, 

F-22

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vesting occurs over threeor five years in equal annual increments), but no option will be exercisableafter the tenth anniversary of the date on which it is granted.

Under both plans, the Company may issue restrictedstock units. The Company has issued restricted stock units which fully vestafter seven years of continuous employment. Generally, these units are subjectto accelerated vesting if the stock price of the Company reaches certainpre-established targets within certain time periods after issuance.

In connection with the spin-off of Mueller Water, andin accordance with the anti-dilution provisions contained within the EquityAward Plans, the Company modified the equity awards outstanding at December 14,2006, the spin-off date. The modifications were structured to maintain theintrinsic value for the employee. All equity awards in the Company’s stock heldby employees of or employees transferring to Mueller Water were cancelled andreplaced by equity awards in Mueller Water stock. Similarly, all equity awardsheld by employees remaining with the Company were cancelled and replaced by newequity awards with similar terms such that the intrinsic value immediatelyafter the spin-off was the same as the intrinsic value immediately prior to thespin-off. There were no modifications to any other terms of the awards. Thesemodifications did not yield any incremental compensation cost under FAS 123(R).

For the years ended December 31, 2006, 2005 and2004, the Company recorded stock-based compensation expense related to equity awardsof Walter Industries, Inc. in its continuing operations of approximately$8.1 million, $1.3 million and 0.7 million, respectively, These amounts areincluded in selling, general and administrative expenses and have beenallocated to the reportable segments. The total income tax benefits in theCompany’s continuing operations recognized in the statements of operations forshare-based compensation arrangements were $2.9 million, $0.5 million and $0.3million for such years, respectively.

Asummary of activity related to stock options under the Equity Award Plansduring the year ended December 31, 2006, including awards applicable todiscontinued operations, is presented below:
|                                           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in years)** | ** ** | **Aggregate  Intrinsic Value  ($000)** | ** ** |
|-------------------------------------------|------------|------------|------------|--------------------------------------------|------------|--------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Outstanding at  December 31, 2005(1) |       | 1,708,649  |       |                                       | $          | 8.13                                                                     |       |                                        |       |   |   |   |   |   |   |   |
| Granted(1)                                |       | 1,184,513  |       |                                       | 28.74      |                                                                     |       |                                        |       |   |   |   |   |   |   |
| Exercised(1)                              |       | (862,665   | )          |                                       | 5.76       |                                                                     |       |                                        |       |   |   |   |   |   |   |
| Cancelled(2)                              |       | (290,660   | )          |                                       | 21.99      |                                                                     |       |                                        |       |   |   |   |   |   |   |
| Outstanding at  December 31, 2006(3) |       | 1,739,837  |       |                                       | $          | 21.02                                                                    |       |                                        |       | 8.30 |   |   |   | $ | 10,488 |   |   |
| Exercisable at  December 31, 2006(3) |       | 416,639    |       |                                       | $          | 7.12                                                                     |       |                                        |       | 5.62 |   |   |   | $ | 8,305 |   |   |

----

(1)          Restated to reflect theimpact of modification made in connection with the Mueller Water spin-off andincludes options outstanding that were subsequently cancelled and converted toMueller Water equity, see (2).

(2)          Includes awardscancelled and converted to Mueller Water equity awards.

(3)          Reflects the impact ofmodification made in connection with the Mueller Water spin-off and isapplicable only to continuing operations.

F-23

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Weightedaverage assumptions used to determine the grant-date fair value of optionsgranted under the Equity Award Plans during the year ended December 31,2006 were:

| ** **               | ** ** | **For the year ended** | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **December 31, 2006**       | ** ** |
| Risk free  interest rate |       |                                  | 4.67       | % |   |
| Dividend yield           |       |                                  | 0.30       | % |   |
| Expected life  (years)   |       |                                  | 5.20       |   |   |
| Volatility               |       |                                  | 36.76      | % |   |
| Forfeiture rate          |       |                                  | 4.50       | % |   |

 

The risk-free interest rate is based on the U.S.Treasury yield in effect at the time of grant with a term equal to the expectedlife. The expected dividend yield is based on the Company’s estimated annualdividend payout at grant date. The expected term of the options represents theperiod of time the options are expected to be outstanding. Expected volatilityis based on historical volatility of the Company’s share price for the expectedterm of the options.

Asummary of activity related to restricted stock units under the Equity AwardPlans during the year ended December 31, 2006, including awards applicableto discontinued operations, is as follows:
|                                           | ** ** | **Shares** | ** ** | **Weighted  Average Remaining  Contractual Term  (in Years)** | ** ** | **Aggregate  Intrinsic Value  ($000)** | ** ** |
|-------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Outstanding at  December 31, 2005(1) |       | 493,360    |       |                                                                         |       |                                        |       |   |   |   |   |
| Granted(1)                                |       | 224,848    |       |                                                                         |       |                                        |       |   |   |   |   |
| Vested(1)                                 |       | (113,214   | )          |                                                                         |       |                                        |       |   |   |   |   |
| Cancelled(2)                              |       | (254,693   | )          |                                                                         |       |                                        |       |   |   |   |   |
| Outstanding at  December 31, 2006(3) |       | 350,301    |       |                                                                         | 2.47       |                                        |       |   | $ | 9,476 |   |   |
|                                           |            |            |            |                                                                              |            |                                             |            |  |  |  |  |  |

----

(1)          Restated to reflect theimpact of modification made in connection with the Mueller Water spin-off and includesrestricted stock units outstanding that were subsequently cancelled andconverted to Mueller Water equity, see (2).

(2)          Includes awardscancelled and converted to Mueller Water equity awards.

(3)          Reflects the impact ofmodification made in connection with the Mueller Water spin-off and isapplicable only to continuing operations.

The weighted-averagegrant-date fair value of stock options and restricted stock units grantedduring the year ended December 31, 2006 was $11.48 and $32.85,respectively. The total amount of cash received from exercise of stock optionswas $4.7 million for the year ended December 31, 2006. The total intrinsicvalue of stock awards exercised or converted during the year ended 2006 wasapproximately $26.4 million. As of December 31, 2006, there was approximately$10.9 million of unrecognized compensation cost related to non-vestedshare-based compensation arrangements granted under the Equity Award Plans;that cost is to be recognized over a weighted average period of 2.3 years.

**Subsidiary EquityAward**

In 2006, the Board of Directors granted a specialequity award to certain executives of the Financing and Homebuilding businesseswhereby the employees received non-qualified options in JWH Holding Company,LLC to acquire the equivalent of 11.25% of the total combined designated equityof the Financing and Homebuilding businesses. The exercise price of theseoptions was fair value at date of grant. 

F-24

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These options will vestover a three-year period and expire in ten years. None of the options wereforfeited or exercisable as of December 31, 2006.

TheCompany calculated the fair value of these options awards using theBlack-Scholes model and recognized $2.9 million of compensation expense in 2006.Assumptions used to determine the grant-date fair value of these options were:

| Risk free  interest rate |   | 4.62  | %      |
|--------------------------|--------|-------|--------|
| Dividend yield           |   | 0.00  | %      |
| Expected life  (years)   |   | 3.0   |   |
| Volatility               |   | 41.85 | %      |
| Forfeiture rate          |   | 0.00  | %      |

 

As of December 31,2006, there was $3.7 million of unrecognized compensation cost that is expectedto be recognized over 2.25 years.

**Employee StockPurchase Plan**

The Walter Industries, Inc.Employee Stock Purchase Plan was adopted in January 1996 and amended in April 2004.All full-time employees of the Company who have attained the age of majority inthe state in which they reside are eligible to participate. The Companycontributes a sum equal to 15% (20% after five years of continuousparticipation) of each participant’s actual payroll deduction as authorized,and remits such funds to a designated brokerage firm which purchases in theopen market shares of the Company’s common stock for the accounts of theparticipants. The total number of shares that may be purchased under the planis 3.5 million. Total shares purchased under the plan during the years ended December 31,2006, 2005 and 2004 were approximately 35,000, 43,000 and 122,000,respectively, and the Company’s contributions recognized as expense wereapproximately $0.3 million, $0.4 million and $0.3 million, respectively, duringsuch years.

**NOTE 7—RestrictedShort-Term Investments**

Restricted short-terminvestments at December 31, 2006 and 2005 include (i) temporaryinvestments primarily in commercial paper or money market accounts withmaturities less than 90 days from collections on instalment notes receivableowned by various Mid-State Trusts (the “Trusts”) ($84.0 million and $118.2million, respectively) which are available only to pay expenses of the Trustsand principal and interest on indebtedness of the Trusts and (ii) miscellaneousother segregated accounts restricted to specific uses ($6.0 million and $6.4million, respectively).

**NOTE 8—InstalmentNotes Receivable and Mortgage Loans**

Instalment notes receivable arise from sales ofdetached, single-family homes to JWH customers. Mortgage loans are originatedby WMC by providing land and home financing for JWH customers and byre-financing MSH customers. WMC also purchases loans from third parties,including mortgage companies and other homebuilders. These receivables requireperiodic payments, over periods of 10 to 30 years, and are secured by firstmortgages or similar security instruments. The credit terms offered by JWH andits affiliates are usually for 100% of the purchase price of the home. Thebuyer’s ownership of the land and improvements necessary to complete the homeconstitute an equity investment to which the Company has access should thebuyer default on payment of the instalment note obligation. The Companycurrently holds fixed (96%) and variable-rate (4%) instalment notes rangingfrom 5.3% to 13.7% annual percentage rate, without points or closing costs. Originationcosts are deferred and amortized over the average life of the note portfolio.

F-25

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Instalment notesreceivable are summarized as follows (in thousands):

| ** **                        | ** ** | **December 31,** | ** ** | ** ** |
|-----------------------------------|------------|-----------------------|------------|------------|
| ** **                        | ** ** | **2006**              | ** ** | **2005**   | ** ** | ** ** |
| Instalment notes  receivable      |       | $                     | 1,578,760  |       | $ | 1,558,383 |   |   |
| Mortgage loans                    |       | 213,948               |       | 148,028    |   |   |
| Less: Allowance for  losses       |       | (13,011               | )          | (12,489    | ) |   |
| Instalment notes receivable,  net |       | $                     | 1,779,697  |       | $ | 1,693,922 |   |   |

 

Activityin the allowance for losses is summarized as follows (in thousands):
|                                 | ** ** | **For the years ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Balance at  beginning of year   |       | $                                                             | 12,489     |   | $ | 11,200 |   | $ | 10,907 |   |
| Provisions  charged to income   |       | 9,062                                                         |       | 10,724 |   | 12,402 |   |
| Charge-offs, net  of recoveries |       | (8,540                                                        | )          | (9,435 | ) | (12,109 | ) |
| Balance at end of year          |       | $                                                             | 13,011     |   | $ | 12,489 |   | $ | 11,200 |   |

 

Charge-offs on instalment notes and mortgage loansoccur when management believes it will be unable to collect all amountscontractually due and begins the foreclosure process. The charge-off ismeasured based upon the excess of the recorded investment in the receivableover the estimated fair value of the collateral as reduced by estimated sellingcosts. Recoveries on charge-offs are immaterial to aggregate charge-offs.

MSH and Mid-State Capital Corporation have created anumber of business trusts for the purpose of purchasing instalment notes fromJWH and mortgage loans from WMC with the net proceeds from the issuance ofmortgage backed notes or asset-backed notes. MSH and Mid-State CapitalCorporation directly or indirectly own all of the beneficial interests in thesetrusts. The assets of the trusts are not available to satisfy claims of generalcreditors of the Company and the liabilities for notes issued by the trusts areto be satisfied solely from the proceeds of the instalment notes owned by thetrusts and are non-recourse to the Company.

**NOTE 9—Receivables**

Receivablesare summarized as follows (in thousands):

| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Trade receivables          |       | $                     | 48,973     |   | $ | 41,191 |   |
| Other receivables          |       | 42,374                |       | 34,403 |   |
| Less: Allowance for losses |       | (2,704                | )          | (984 | ) |
| Receivables, net           |       | $                     | 88,643     |   | $ | 74,610 |   |

 

Other receivables at December 31,2006 includes $18.4 million due from the Company’s insurance carrier for thesettlement of claims associated with a 2005 water ingress problem at Mine No. 5.Other receivables at December 31, 2005 include $13.8 million of estimatedcash and net working capital adjustment claims related to the sale of AIMCOR,see Note 2,  $8.9 million of coal excisetax refund claims and $1.1 million due from the agent handling the proceedsfrom the exercise of stock options.

F-26

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**NOTE 10—Inventories**

Inventories are summarizedas follows (in thousands):

| ** **                          | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Finished goods                      |       | $                     | 35,623     |   | $ | 35,468 |   |
| Goods in process                    |       | 26,136                |       | 33,527 |   |
| Raw materials and  supplies         |       | 17,698                |       | 22,541 |   |
| Repossessed houses held  for resale |       | 29,414                |       | 30,610 |   |
| Total inventories                   |       | $                     | 108,871    |   | $ | 122,146 |   |

 

**NOTE 11—Property,Plant and Equipment**

Property,plant and equipment are summarized as follows (in thousands):

| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Land and minerals                     |       | $                     | 72,950     |   | $ | 73,705 |   |
| Land improvements                     |       | 19,790                |       | 19,539 |   |
| Buildings and  leasehold improvements |       | 71,331                |       | 69,786 |   |
| Mine development  costs               |       | 15,677                |       | 13,657 |   |
| Machinery and  equipment              |       | 300,875               |       | 230,728 |   |
| Construction in  progress             |       | 75,613                |       | 73,708 |   |
| Total                                 |       | 556,236               |       | 481,123 |   |
| Less: Accumulated  depreciation       |       | (245,047              | )          | (222,621 | ) |
| Net                                   |       | $                     | 311,189    |   | $ | 258,502 |   |

 

**NOTE12—Goodwill**

Goodwill is notamortized, but instead is reviewed for impairment on an annual basis on January 1,or more frequently if significant events occur that indicate that impairmentcould exist. The fair value of each of the Company’s reporting units isdetermined using valuation models and expected future cash flow projectionsrelated to each reporting unit, which is then discounted using a risk-adjusteddiscount rate and adjusted for comparable industry earnings multiples. TheCompany’s reporting units are similar, although not identical, to its reportingsegments.

Thechanges in the carrying amount of goodwill by reportable segment for 2006, 2005and 2004 are as follows (in thousands):

| ** **                            | ** ** | **Homebuilding** | ** ** | **Financing** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|------------------|------------|---------------|------------|-----------|------------|
| Balance as of  January 1, 2004   |       |             | $          | 63,210        |       |      |       | $ | 10,895 |   |   | $ | 74,105 |   |
| Activity                              |       |             | —     |          |       |      | —     |   |   | — |   |
| Balance as of  December 31, 2004 |       |             | 63,210     |          |       |      | 10,895     |   |   | 74,105 |   |
| Impairment charge                     |       |             | (63,210    | )             |       |      | —     |   |   | (63,210 | ) |
| Balance as of  December 31, 2005 |       |             | —     |          |       |      | 10,895     |   |   | 10,895 |   |
| Activity                              |       |             | —     |          |       |      | —     |   |   | — |   |
| Balance as of  December 31, 2006 |       |             | $          | —        |       |      |       | $ | 10,895 |   |   | $ | 10,895 |   |

 

In 2006, 2005 and 2004,the Company used a discounted cash flow approach in performing its annualimpairment testing. As a result of this annual testing, the Company recorded animpairment charge of $63.2 million to reduce the goodwill of the Homebuildingsegment to zero in 2005. This impairment charge 

F-27

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wasdriven by significantly lower than expected operating results of theHomebuilding segment during the fourth quarter of 2005 which in turn led toreduced future cash flow expectations versus those forecasted in the prioryear.

**NOTE 13—IncomeTaxes**

*Income tax expense (benefit)applicable to continuing operations consists of the following components (inthousands):*

| ** **      | ** ** | **For the years ended December 31,** | ** ** |
|-----------------|------------|--------------------------------------|------------|
| ** **      | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **      | ** ** | **Current**                          | ** ** | **Deferred** | ** ** | **Total** | ** ** | **Current** | ** ** | **Deferred** | ** ** | **Total** | ** ** | **Current** | ** ** | **Deferred** | ** ** | **Total** | ** ** |
| Federal         |       |                                 | $          | 46,571 |   |   |   | $ | 7,938 |   |   | $ | 54,509 |   |   | $ | 11,433 |   |   |   | $ | 15,187 |   |   | $ | 26,620 |   |   | $ | 10,026 |   |   |   | $ | 8,906 |   |   | $ | 18,932 |   |
| State and local |       |                                 | 7,611      |   |   |   | 5,701 |   |   | 13,312 |   |   | 5,928 |   |   |   | 4,170 |   |   | 10,098 |   |   | 487 |   |   |   | (17,374 | ) |   | (16,887 | ) |
| Total           |       |                                 | $          | 54,182 |   |   |   | $ | 13,639 |   |   | $ | 67,821 |   |   | $ | 17,361 |   |   |   | $ | 19,357 |   |   | $ | 36,718 |   |   | $ | 10,513 |   |   |   | $ | (8,468 | ) |   | $ | 2,045 |   |

 

Theincome tax expense (benefit) at the Company’s effective tax rate differed fromthe statutory rate as follows:

| ** **                             | ** ** | **For the years ended December 31,** | ** ** |
|----------------------------------------|------------|-------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Statutory tax  rate                    |       | 35.0                                      | %          | 35.0 | % | 35.0 | % |
| Effect of:                             |       |                                      |       |   |   |   |   |
| State and local income tax             |       | 4.0                                       |       | 4.6 |   | 0.7 |   |
| Non-deductible goodwill impairment     |       | —                                    |       | 30.4 |   | — |   |
| Foreign sales benefit                  |       | (2.2                                      | )          | (6.0 | ) | (0.7 | ) |
| Excess depletion benefit               |       | (6.8                                      | )          | (17.9 | ) | (13.4 | ) |
| Non-deductible debt conversion expense |       | 3.1                                       |       | — |   | — |   |
| Change in valuation allowances         |       | 0.1                                       |       | 4.7 |   | (21.7 | ) |
| Other                                  |       | (1.3)                                     |       | 0.9 |   | 4.0 |   |
| Effective tax rate                     |       | 31.9                                      | %          | 51.7 | % | 3.9 | % |

 

Deferredtax assets (liabilities) related to the following (in thousands):

| ** **                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax  assets:                                |       |                  |       |   |   |
| Allowance for losses                                 |       | $                     | 5,854      |   | $ | 4,942 |   |
| Inventories                                          |       | 1,881                 |       | 1,270 |   |
| Net operating loss/capital loss/credit carryforwards |       | 8,191                 |       | 25,612 |   |
| Accrued expenses                                     |       | 30,413                |       | 39,650 |   |
| Postretirement benefits other than pensions          |       | 95,570                |       | 86,868 |   |
| Pensions                                             |       | 52,086                |       | 11,650 |   |
|                                                 |       | 193,995               |       | 169,992 |   |
| Less: valuation  allowance                           |       | (6,708                | )          | (7,128 | ) |
| Total deferred tax assets                            |       | 187,287               |       | 162,864 |   |
| Deferred tax  liabilities:                           |       |                  |       |   |   |
| Interest income on instalment notes                  |       | (86,258               | )          | (107,163 | ) |
| Depreciation and amortization                        |       | (37,275               | )          | (33,453 | ) |
| Total deferred tax liabilities                       |       | (123,533              | )          | (140,616 | ) |
| Net deferred tax assets of  continuing operations    |       | $                     | 63,754     |   | $ | 22,248 |   |

 

F-28

----

Asummary of activity in the valuation allowance for deferred tax assets is shownbelow (in thousands):

| ** **                          | ** ** | **For the years ended December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Balance at  beginning of period     |       | $                                                             | 7,128      |   | $ | 3,780 |   | $ | 15,200 |   |
| Additions charged  to tax provision |       | —                                                        |       | 3,348 |   | — |   |
| Reductions                          |       | (420                                                          | )          | — |   | (11,420 | ) |
| Balance at end of period            |       | $                                                             | 6,708      |   | $ | 7,128 |   | $ | 3,780 |   |

 

The change in valuationallowances recorded as a component of income tax expense at December 31,2006, consists primarily of $0.4 million of state tax benefits true-up atHomebuilding for which the Company believes it is more likely than not that thedeferred tax asset will be realized.

The Company has netoperating loss carryforwards for Alabama state income taxes at NaturalResources and Sloss of approximately $40.5 million that expire beginning in2009. The annual utilization of the loss carryforward is limited due to a 2004change in ownership, but the Company believes that the losses will be utilizedwithin the carryforward period due to expected profitability of operations andtax planning strategies. Homebuilding has net operating loss carryforwards forstate income tax purposes for which a valuation allowance previously has beenestablished that are significantly limited and may expire before utilization. Ifcertain changes in ownership of the Company occur in the future, utilization ofthe net carryforwards and credits may be further limited.

On February 20, 2006,the IRS completed its audit of the Company’s Federal income tax returns andissued a 30-day letter proposing tax deficiencies in the amount of $82.2million for the years ended May 31, 2000, December 31, 2000 and December 31,2001. The issues in the 30-day letter relate primarily to the Company’smethod of recognizing revenue on the sale of homes and related interest on theinstalment notes receivable. The items at issue relate primarily to the timingof revenue recognition and consequently, should the IRS prevail on itspositions, the Company’s financial exposure is limited to interest andpenalties.

On December 27, 1989,the Company and most of its subsidiaries each filed a voluntary petition forreorganization under Chapter 11 of Title 11 of the United States Code (the “BankruptcyProceedings”) in the United States Bankruptcy Court for the Middle District ofFlorida, Tampa Division (the “Bankruptcy Court”). The Company emerged frombankruptcy on March 17, 1995 (the “Effective Date”) pursuant to theAmended Joint Plan of Reorganization Dated as of December 9, 1994, asmodified on March 1, 1995 (as so modified the “Consensual Plan”). Despitethe confirmation and effectiveness of the Consensual Plan, the Bankruptcy Courtcontinues to have jurisdiction over, among other things, the resolution ofdisputed prepetition claims against the Company and other matters that mayarise in connection with or related to the Consensual Plan, including claimsrelated to Federal income taxes.

A controversy exists withregard to Federal income taxes allegedly owed by the Company for fiscal years1980 through 1994. In connection with the bankruptcy proceedings, the IRS fileda proof of claim in the Bankruptcy Court (the “Proof of Claim”) for a substantialamount of taxes, interest and penalties with respect to fiscal years ended August 31,1980 and August 31, 1983 through May 31, 1994. The Company filed anadversary proceeding in the Bankruptcy Court disputing the Proof of Claim (the “AdversaryProceeding”) and the various issues have been and are being litigated in theBankruptcy Court.

The amounts initiallyasserted by the Proof of Claim do not reflect the subsequent resolution ofvarious issues through settlements or concessions by the parties. Afteradjustment for these items, the Company estimates that the amount of taxpresently claimed by the IRS is approximately $34 million for issues currentlyin dispute in the Adversary Proceeding. This amount is subject to interest andpenalties. Of the $34 million in claimed tax, $21 million represents issues inwhich the IRS is not challenging the deductibility of the particular expensebut only whether such expense is deductible in a particular year. 

F-29

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Consequently,the Company believes that, should the IRS prevail on any such issues, theCompany’s financial exposure is limited to interest and possible penalties andthe amount of tax claimed will be offset by deductions in other years. Substantiallyall of the issues in the Proof of Claim, which have not been settled orconceded, have been litigated before the Bankruptcy Court and are subject toappeal but only at the conclusion of the entire Adversary Proceeding.

The Company believes that those portions of the Proofof Claim which remain in dispute or are subject to appeal substantiallyoverstate the amount of taxes allegedly owing. However, because of thecomplexity of the issues presented and the uncertainties associated withlitigation, the Company is unable to predict the ultimate outcome of theAdversary Proceeding.

The Company believes thatall of its current and prior tax filing positions have substantial merit andintends to defend vigorously any tax claims asserted. The Company believes thatit has sufficient accruals to address any claims, including interest andpenalties.

**NOTE 14—Debt**

Debtconsisted of the following (in thousands):

| ** **                                  | ** ** | ** **            | ** ** | **Weighted Average Stated** | ** ** | **Estimated**                      | ** ** |
|---------------------------------------------|------------|-----------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                  | ** ** | **December 31,** | ** ** | **Interest Rate**                | ** ** | **Final**                          | ** ** |
| ** **                                  | ** ** | **2006**              | ** ** | **2005**                              | ** ** | **At December 31, 2006** | ** ** | **Maturity** | ** ** |
| Mortgage-Backed/Asset  Backed Notes:        |       |                  |       |                                  |       |                               |       |   |   |   |   |   |   |
| Trust IV Asset Backed Notes                 |       | $                     | 207,812    |                                  | $          | 256,100                            |       |   | 8.33 | % |   |   | 2030 |   |   |
| Trust VI Asset Backed Notes                 |       | 153,233               |       | 171,937                               |       |                               | 7.42       | % |   |   | 2035 |   |   |
| Trust VII Asset Backed Notes                |       | 127,847               |       | 142,968                               |       |                               | 6.34       | % |   |   | 2036 |   |   |
| Trust VIII Asset Backed Notes               |       | 152,352               |       | 180,919                               |       |                               | 7.79       | % |   |   | 2038 |   |   |
| Trust IX Variable Funding Loan              |       | —                |       | —                                |       |                               | Various    |   |   |   | 2007 |   |   |
| Trust X Asset Backed Notes                  |       | 228,449               |       | 258,076                               |       |                               | 6.30       | % |   |   | 2036 |   |   |
| Trust XI Asset Backed Notes                 |       | 198,499               |       | 224,736                               |       |                               | 5.51       | % |   |   | 2038 |   |   |
| Trust XIV Variable Funding Loan             |       | —                |       | —                                |       |                               | Various    |   |   |   | 2007 |   |   |
| 2004-1 Trust Asset Backed Notes             |       | 200,890               |       | 228,797                               |       |                               | 6.64       | % |   |   | 2037 |   |   |
| 2005-1 Trust Asset Backed Notes             |       | 218,486               |       | 263,796                               |       |                               | 6.15       | % |   |   | 2040 |   |   |
| 2006-1 Trust Asset Backed Notes             |       | 249,138               |       | —                                |       |                               | 6.28       | % |   |   | 2040 |   |   |
|                                        |       | 1,736,706             |       | 1,727,329                             |       |                               |       |   |   |   |   |   |   |
| Corporate debt:                             |       |                  |       |                                  |       |                               |       |   |   |   |   |   |   |
| 2005 Walter Credit Agreement–Term Loan |       | 248,706               |       | 448,875                               |       |                               | 7.12       | % |   |   | 2012 |   |   |
| Convertible Senior Subordinated Notes       |       | 785                   |       | 175,000                               |       |                               | 3.75       | % |   |   | 2024 |   |   |
|                                        |       | 249,491               |       | 623,875                               |       |                               |       |   |   |   |   |   |   |
| Total                                       |       | $                     | 1,986,197  |                                  | $          | 2,351,204                          |       |   |   |   |   |   |   |   |   |

 

TheCompany’s debt repayment schedule, excluding interest, as of December 31,2006 is as follows (in thousands):

| ** **                            | ** ** | **Payments Due** |       |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2007**              | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** |   |
| Mortgage-backed/asset-backed notes    |       | $                     | 250,751    |   | $ | 210,726 |   | $ | 181,097 |   | $ | 164,897 |   | $ | 147,042 |   | $ | 782,193 |   |
| Term loan(1)                          |       | 2,519                 |       | 2,519 |   | 2,519 |   | 2,519 |   | 2,519 |   | 236,111 |   |
| Convertible Senior Subordinated Notes |       | —                |       | — |   | — |   | — |   | — |   | 785 |   |
|                                  |       | $                     | 253,270    |   | $ | 213,245 |   | $ | 183,616 |   | $ | 167,416 |   | $ | 149,561 |   | $ | 1,019,089 |   |

----

(1)             In January 2007, the Company used $28.0 million ofavailable cash to repay a portion of the term loan outstanding under the 2005Walter Credit Agreement.

F-30

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**Mortgage-Backed andAsset-Backed Notes and Variable Funding Loan Facilities**

The Trusts, beneficially owned by Mid-State andMid-State Capital Corporation, indirect subsidiaries of the Company, are thedepositors under the Company’s outstanding mortgage-backed and asset-backednotes (the “trust notes”), which consist of eight series of public offerings,one private offering, a $200.0 million and a $150.0 million Variable FundingLoan Agreement (the “variable funding loan facilities”). These borrowingsprovide financing for instalment notes receivable and mortgage assets purchasedby Mid-State. These instalment notes receivable and mortgage assets aredeposited into the Trusts. Upon deposit, these instalment notes and mortgageassets become assets of the Trusts and are not available to satisfy claims ofgeneral creditors of the Company. The trust notes and the variable funding loanfacilities are to be satisfied solely from the proceeds of the underlyinginstalment notes receivable and mortgages and are non-recourse to the Company.

In November 2006, Mid-State Capital Corporationcompleted its 2006-1 Trust private offering of $256.9 million inasset-backed notes. The notes mature October 2040 and bear interest at aweighted average, fixed interest coupon of 6.28%. The net proceeds were used torepay borrowings under the Mid-State Trust IX and Mid-State Trust XIV mortgage variablefunding loan facilities and provided $39.2 million of liquidity for the Company’sgeneral corporate purposes.

The variable funding loanfacilities contain covenants that, among other things, restrict the ability ofthe borrower Trust to dispose of assets, engage in other businesses, createliens, engage in mergers or consolidations and otherwise restrict corporateactivities. In addition, under certain circumstances, if the value of themortgage assets securing the facilities has decreased, the lenders under thevariable funding loan facilities have the right to require the Trust totransfer additional mortgages to the lender or to repay a portion of theoutstanding borrowings. Events of default under the variable funding loanfacilities include customary events of default as well as asset quality tests.The borrower Trust’s failure to comply with the covenants in the variablefunding loan facilities could result in an event of default, which, if notcured, amended or waived, could result in the entire principal balance andaccrued interest becoming immediately due and payable.

**2005 Walter CreditAgreement**

On October 3, 2005, Walter Industries enteredinto a $675.0 million credit agreement (“2005 Walter Credit Agreement”) whichincludes (1) an amortizing term loan facility in an initial aggregateprincipal amount of $450.0 million, $248.7 million of which wasoutstanding as of December 31, 2006, and (2) a $225.0 millionrevolving credit facility, which provides for loans and letters of credit. Asof December 31, 2006, the Company had issued $62.5 million in lettersof credit, which reduced availability for borrowings under the revolving creditfacility to $162.5 million. As of December 31, 2006, there were noborrowings outstanding under the revolving credit facility. The revolvingcredit facility will terminate in 2010, and the term loan will mature in 2012.

Loans as of December 31, 2006 bear interest atthe Company’s option, at LIBOR plus 150 basis points or the alternate base rateplus 50 basis points for borrowings under the revolving credit facility; andLIBOR plus 175 basis points or the alternate base rate plus 75 basis points forthe term loan. In addition, the Company pays quarterly commitment fees at arate equal to 0.35% per year on the unused portion of the revolving creditfacility and pays a letter of credit fee.

The term loan is subject to mandatory prepayment withthe net cash proceeds from the sale of property, incurrence of debt,issuances of equity securities and excess cash flow, subject to specifiedexceptions and limitations. All of the Company’s direct and indirect domesticrestricted subsidiaries, as defined, are guarantors of the 2005 Walter CreditAgreement. The Company’s obligations are secured by substantially all of theCompany’s and guarantors’ real, personal and intellectual property, and theCompany’s ownership interest in the guarantors.

F-31

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The 2005 Walter Credit Agreement contains customarynegative covenants and restrictions on the Company’s ability to engage inspecified activities, including, but not limited to, as defined, limitations onother indebtedness, liens, investments and guarantees; restrictions ondividends and redemptions of capital stock and prepayments and redemptions ofdebt; limitations on capital expenditures; and restrictions on mergers andacquisitions, sales of assets, sale and leaseback transactions and transactionswith affiliates. The 2005 Walter Credit Agreement also contains financialcovenants requiring the Company to maintain a maximum consolidated leverageratio, a maximum consolidated senior secured leverage ratio and a minimum fixedcharge coverage ratio.

In February 2006, theCompany sold 2.65 million shares of common stock for $168.7 million of net cashproceeds. Of these proceeds, $102.9 million was used to repay the term loanfacility. In addition, during 2006, the Company repaid $22.3 million on theterm loan facility on a mandatory basis and made $75.0 million of optionalprepayments using available cash flow. As a result of these term loanprepayments, $1.1 million of unamortized debt expense was charged to interestexpense during 2006.

**Convertible Notes**

In 2004, the Companyissued $175.0 million aggregate principal amount of 3.75% ConvertibleSenior Subordinated Notes due May 1, 2024 (the “convertible notes”). During2006, holders of approximately $174.2 million of the Company’s convertiblenotes surrendered their convertible notes in exchange for 9.761 million sharesof the Company’s common stock and $19.4 million of conversion inducement fees.

At December 31, 2006, the $0.8 million remainingconvertible notes outstanding are currently convertible into 84,000 shares ofthe Company’s common stock, as conversion conditions specified in the Indentureregarding market price have been satisfied.   Each $1,000 principalnote may convert into 107.0241 shares of the Company’s common stock, whichrepresents a conversion price of approximately $9.34 per share.

In 2006, a tax benefit of$6.4 million was recognized as a direct increase to stockholders’ equityrelated to the convertible notes.

**Interest Rate HedgeAgreements**

On November 28, 2006, the Company entered intotwo interest rate hedge agreements each with a notional value of $25.0 million.On January 30, 2007 and February 14, 2007, the Company entered intotwo additional hedge agreements with notional values of $50.0 million and $35.0million, respectively. The objective of these hedges is to protect againstchanges in the benchmark interest rate on the forecasted issuance ofmortgage-backed bonds anticipated to be priced on or around April 1, 2008.The hedges will be settled on or before maturity and are being accounted for asa cash flow hedges. As such, changes in the fair value of the hedges that takeplace through the date of maturity are recorded in accumulated othercomprehensive income (loss).

F-32

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On November 1, 2005, the Company entered into aninterest rate hedge agreement with a notional value of $75.0 million. Theobjective of the hedge is to protect the Company against rising LIBOR interestrates that would have a negative effect on the Company’s cash flows due tochanges in interest payments on its 2005 Walter Credit Agreement. The structureof the hedge is a three-year collar contract with a floor of 4.25% and a cap of5.69%. The collar agreement calls for the Company to make fixed rate paymentsover the term of the hedge when stated three-month LIBOR rates are below thefloor and to receive payments from the counter-party when the three-month LIBORis above the cap. It is anticipated that the hedge will be settled uponmaturity and is being accounted for as a cash flow hedge. As such, changes inthe fair value of the hedge that take place through the date of maturity arerecorded in accumulated other comprehensive income (loss).

The fair value of interest rate hedges outstanding at December 31,2006 and 2005 was an asset of $0.4 million and a liability of$0.1 million, respectively. During 2006 and 2005, the Company recorded anunrealized gain of $0.2 million and an unrealized loss of$0.1 million, respectively, net of tax, from its interest rate hedgeagreements, in accumulated other comprehensive income (loss).

**NOTE 15—Pension and OtherEmployee Benefits**

The Company has various pension and profit sharingplans covering substantially all employees. In addition to its own pensionplans, the Company contributes to certain multi-employer plans. Combined totalpension expense for the years ended December 31, 2006, 2005 and 2004 was$8.1 million, $6.8 million and $8.6 million, respectively. The Company fundsits retirement and employee benefit plans in accordance with the requirementsof the plans and, where applicable, in amounts sufficient to satisfy the “MinimumFunding Standards” of the Employee Retirement Income Security Act of 1974 (“ERISA”).The plans provide benefits based on years of service and compensation or atstated amounts for each year of service.

In 2006, the Company also provides certainpostretirement benefits other than pensions, primarily healthcare, to eligibleretirees. The Company’s postretirement benefit plans are not funded. Newsalaried employees have been ineligible to participate in postretirementhealthcare benefits since May 2000. Effective January 1, 2003, theCompany placed a monthly cap on Company contributions for postretirement healthcarecoverage. In 2006, the Company terminated benefits for certain employees ofFinancing and Homebuilding that had not reached a certain number of years ofcontinuous service and/or age. Those employees will no longer be eligible toearn postretirement healthcare benefits. In addition, retiree medical coveragewas terminated for those retirees who are eligible for Medicare. As a result, theFinancing and Homebuilding segments recognized a net curtailment gain of $4.1million in 2006.

F-33

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In 2006, the Company adopted SFAS No. 158, “Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans,” whichrequires the Company to recognize the overfunded or underfunded status of adefined benefit postretirement plan (other than a multiemployer plan) as anasset or liability in the balance sheet and to recognize changes in that fundedstatus as a component of other comprehensive income. The Company uses a September 30measurement date for all of its pension and postretirement benefit plans. Theamounts recognized for such plans are as follows:

| ** **                                                     | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|----------------------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                                     | ** ** | **December 31,**     | ** ** | **December 31,**   | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                     | ** ** | **2006**                  | ** ** | **2005**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | **(in thousands)**   | ** ** |
| Accumulated benefit obligation                                 |       |                      | $          | 175,218                 |       |   |   | $ | 173,237 |   |   |   | $ | 334,513 |   |   |   | $ | 284,584 |   |   |
| Change in  projected benefit obligation:                       |       |                      |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Benefit obligation at beginning of year                        |       |                      | $          | 180,073                 |       |   |   | $ | 163,509 |   |   |   | $ | 284,584 |   |   |   | $ | 250,999 |   |   |
| Service cost                                                   |       |                      | 3,745      |                    |       |   | 2,862 |   |   |   | 2,122 |   |   |   | 1,241 |   |   |
| Interest cost                                                  |       |                      | 9,465      |                    |       |   | 9,564 |   |   |   | 14,925 |   |   |   | 14,644 |   |   |
| Amendments                                                     |       |                      | —     |                    |       |   | 438 |   |   |   | — |   |   |   | 99 |   |   |
| Actuarial loss                                                 |       |                      | 7,501      |                    |       |   | 13,447 |   |   |   | 54,048 |   |   |   | 31,483 |   |   |
| Net curtailment gain                                           |       |                      | —     |                    |       |   | — |   |   |   | (4,793 | ) |   |   | — |   |   |
| Benefits paid                                                  |       |                      | (11,341    | )                       |       |   | (9,747 | ) |   |   | (16,373 | ) |   |   | (13,882 | ) |   |
| Benefit obligation at end of year                              |       |                      | $          | 189,443                 |       |   |   | $ | 180,073 |   |   |   | $ | 334,513 |   |   |   | $ | 284,584 |   |   |
| Change in plan  assets:                                        |       |                      |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Fair value of plan assets at beginning of year                 |       |                      | $          | 132,850                 |       |   |   | $ | 127,107 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Actual gain on plan assets                                     |       |                      | 13,301     |                    |       |   | 13,996 |   |   |   | — |   |   |   | — |   |   |
| Employer contributions                                         |       |                      | 6,668      |                    |       |   | 1,494 |   |   |   | 16,373 |   |   |   | 13,882 |   |   |
| Benefits paid                                                  |       |                      | (11,341    | )                       |       |   | (9,747 | ) |   |   | (16,373 | ) |   |   | (13,882 | ) |   |
| Fair value of plan assets at  end of year                      |       |                      | $          | 141,478                 |       |   |   | $ | 132,850 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Funded (unfunded) status of the plan                           |       |                      | $          | (47,965                 | )          |   |   | $ | (47,223 | ) |   |   | $ | (334,513 | ) |   |   | $ | (284,584 | ) |   |
| Unrecognized net actuarial loss                                |       |                      | *          |                    |       |   | 56,343 |   |   |   | * |   |   |   | 78,348 |   |   |
| Unrecognized prior service cost                                |       |                      | *          |                    |       |   | 2,991 |   |   |   | * |   |   |   | (23,966 | ) |   |
| Unrecognized net transition obligation                         |       |                      | *          |                    |       |   | — |   |   |   | * |   |   |   | — |   |   |
| Post-measurement date contributions                            |       |                      | —     |                    |       |   | — |   |   |   | 4,272 |   |   |   | 4,961 |   |   |
| Net amount recognized                                          |       |                      | $          | (47,965                 | )          |   |   | $ | 12,111 |   |   |   | $ | (330,241 | ) |   |   | $ | (225,241 | ) |   |
| Amounts  recognized in the consolidated balance sheet:         |       |                      |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Other long-term liabilities                                    |       |                      | $          | (47,965                 | )          |   |   | $ | (48,811 | ) |   |   | $ | — |   |   |   | $ | — |   |   |
| Accumulated postretirement benefits obligation                 |       |                      | —     |                    |       |   | — |   |   |   | (330,241 | ) |   |   | (225,241 | ) |   |
| Prepaid benefit cost                                           |       |                      | *          |                    |       |   | 13,245 |   |   |   | — |   |   |   | — |   |   |
| Intangible assets                                              |       |                      | *          |                    |       |   | 3,018 |   |   |   | — |   |   |   | — |   |   |
| Accumulated other comprehensive income, continuing  operations |       |                      | *          |                    |       |   | 44,659 |   |   |   | — |   |   |   | — |   |   |
| Net amount recognized                                          |       |                      | $          | (47,965                 | )          |   |   | $ | 12,111 |   |   |   | $ | (330,241 | ) |   |   | $ | (225,241 | ) |   |
| Amounts  recognized in accumulated other comprehensive income: |       |                      |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Prior service cost (credit)                                    |       |                      | $          | 2,576                   |       |   |   | $ | * |   |   |   | $ | (19,964 | ) |   |   | $ | * |   |   |
| Net actuarial loss                                             |       |                      | 57,702     |                    |       |   | * |   |   |   | 129,450 |   |   |   | * |   |   |
| Net amount recognized, pre-tax                                 |       |                      | $          | 60,278                  |       |   |   | $ | * |   |   |   | $ | 109,486 |   |   |   | $ | * |   |   |

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*                    Notapplicable due to change in accounting standard.

F-34

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Theincremental effect of applying SFAS No. 158 on individual line items in thebalance sheet as of December 31, 2006 is as follows (in thousands):

| ** **                                                                                | ** ** | **Before  Application of  SFAS 158** | ** ** | **Total SFAS  158 Effect** | ** ** | **After  Application of  SFAS 158** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|--------------------------------------|------------|-----------------------------------------------|------------|
| Other long-term  assets                                                                   |       |                                           | $          | 139,853                              |       |                                          |       | $ | (2,591 | ) |   |   | $ | 137,262 |   |   |
| Total Assets                                                                              |       |                                           | 2,686,706  |                                 |       |                                          | (2,591     | ) |   |   | 2,684,115 |   |   |
| Net deferred  income tax asset (see Note 13)                                              |       |                                           | 11,937     |                                 |       |                                          | 51,817     |   |   |   | 63,754 |   |   |
| Other long-term  liabilities                                                              |       |                                           | 175,205    |                                 |       |                                          | 14,253     |   |   |   | 189,458 |   |   |
| Accumulated  postretirement benefits obligation                                           |       |                                           | 220,755    |                                 |       |                                          | 109,486    |   |   |   | 330,241 |   |   |
| Total Liabilities                                                                         |       |                                           | 2,754,129  |                                 |       |                                          | 71,922     |   |   |   | 2,682,207 |   |   |
| Stockholder’s  equity—accumulated other comprehensive income (loss), net of tax |       |                                           | (24,125    | )                                    |       |                                          | (74,513    | ) |   |   | (98,638 | ) |   |
| Total stockholders’  equity                                                          |       |                                           | 76,421     |                                 |       |                                          | (74,513    | ) |   |   | 1,908 |   |   |

 

The components of net periodic benefit cost are asfollows (in thousands):

| ** **                                              | ** ** | **Pension Benefits**                                     | ** ** | **Other Benefits**                                       | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                              | ** ** | **For the years ended December 31,** | ** ** | **For the years ended December 31,** | ** ** |
| ** **                                              | ** ** | **2006**                                                      | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Components of net  periodic benefit cost:               |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |
| Service cost                                            |       | $                                                             | 3,745      |                                                          | $          | 2,862 |   | $ | 3,245 |   | $ | 2,122 |   | $ | 1,241 |   | $ | 1,387 |   |
| Interest cost                                           |       | 9,465                                                         |       | 9,564                                                         |       | 9,517 |   | 14,925 |   | 14,644 |   | 13,329 |   |
| Expected return on plan assets                          |       | (11,385                                                       | )          | (10,905                                                       | )          | (10,420 | ) | — |   | — |   | — |   |
| Amortization of transition amount                       |       | —                                                        |       | —                                                        |       | — |   | — |   | — |   | — |   |
| Amortization of prior service cost                      |       | 415                                                           |       | 384                                                           |       | 435 |   | (4,402 | ) | (4,359 | ) | (4,072 | ) |
| Amortization of net loss (gain)                         |       | 4,226                                                         |       | 3,312                                                         |       | 3,228 |   | 4,953 |   | 2,875 |   | (1,307 | ) |
| Curtailment settlement (gain) loss                      |       | —                                                        |       | —                                                        |       | 1,133 |   | (4,061 | ) | — |   | 150 |   |
| Net periodic  benefit cost for continuing operations    |       | 6,466                                                         |       | 5,217                                                         |       | 7,138 |   | 13,537 |   | 14,401 |   | 9,487 |   |
| Discontinued  operations periodic benefit cost (income) |       | —                                                        |       | 8,651                                                         |       | 8,392 |   | — |   | (1,456 | ) | (1,347 | ) |
| Net periodic benefit  cost                              |       | $                                                             | 6,466      |                                                          | $          | 13,868 |   | $ | 15,530 |   | $ | 13,537 |   | $ | 12,945 |   | $ | 8,140 |   |

 

The estimated portion ofnet prior service cost and net actuarial loss remaining in accumulated othercomprehensive income that is expected to be recognized as a component of net periodicbenefit cost in 2007 are as follows (in thousands):

| ** **                   | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|------------------------------|------------|---------------------------|------------|-------------------------|------------|
| Prior service  cost          |       |                      | $          | 415                     |       |   |   | $ | (4,257 | ) |   |
| Net actuarial  loss          |       |                      | 4,572      |                    |       |   | 7,372 |   |   |
| Net amount to be  recognized |       |                      | $          | 4,987                   |       |   |   | $ | 3,115 |   |   |

 

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A summary key ofassumptions used is as follows:

| ** **                                                           | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                                           | ** ** | **December 31,**     | ** ** | **December 31,**   | ** ** |
| ** **                                                           | ** ** | **2006**                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average  assumptions used to determine benefit obligations: |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| Discount rate                                                        |       | 5.90                      | %          | 5.40                    | %          | 6.00 | % | 5.90 | % | 5.40 | % | 6.00 | % |
| Rate of compensation increase                                        |       | 3.50                      | %          | 3.50                    | %          | 3.50 | % | — |   | — |   | — |   |
| Weighted average assumptions used to determine net  periodic cost:   |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| Discount rate                                                        |       | 5.40                      | %          | 6.00                    | %          | 6.35 | % | 5.40 | % | 6.00 | % | 6.35 | % |
| Expected return on plan assets                                       |       | 8.90                      | %          | 8.90                    | %          | 8.90 | % | — |   | — |   | — |   |
| Rate of compensation increase                                        |       | 3.50                      | %          | 3.50                    | %          | 3.50 | % | — |   | — |   | — |   |

 

| Assumed health  care cost trend rates at December 31:                         |   |   |   |   |   |   |   | Pre-65 |   | Post-65 |   |   |   |   |   |
|------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---------|--------|--------|--------|--------|--------|
| Health care cost  trend rate assumed for next year                                 |   | — |   | — |   |   |   | 8.60   | %      | 9.40    | %      | 9.00   | %      | 10.00  | %      |
| Rate to which the  cost trend rate is assumed to decline (the ultimate trend rate) |   | — |   | — |   |   |   | 5.00   | %      | 5.00    | %      | 5.00   | %      | 5.00   | %      |
| Year that the rate  reaches the ultimate trend rate                                |   | — |   | — |   | — |   | 2012   |   | 2012    |   | 2010   |   | 2009   |   |

 

The discount rate is based on a yield-curve approachwhich discounts each projected benefit obligation based cash flow of theliability stream at an interest rate specifically applicable to the timing ofeach respective liability stream cash flow. The model sums the present valuesof all of the cash flows and then calculates the equivalent weighted-averagediscount rate by imputing the single interest rate that equates the totalpresent value with the stream of future cash flows.

The yield curve used is a hypothetical Aa spotyield-curve represented by a series of 60 individual semi-annual discount ratesfrom one-half to thirty years. Each discount rate in the curve was determinedby creating a hypothetical zero coupon bond derived by bootstrapping. Bootstrappingis a technique used by bond analysts to derive the yield of hypothetical zerocoupon bonds from coupon bonds. It assumes that the value of any individual Aacoupon security should equal the value of a package of zero coupon Aasecurities that duplicates the coupon bond’s cash flow. It is an iterativecalculation that determines the discount rate which equates the cash flows ofeach semi-annual coupon bond with a hypothetical zero coupon bond based on theactual coupon bond price quotations for each semi-annual maturity cell andequal weighting of the highest yielding (yield to maturity) quartile of bondsin five distinct maturity groups. Each bond was a Aa rated, non-callable bondwith at least $150 million par outstanding.

The expected return on pension assets is based on thelong-term actual average rate of return on the Plans’ pension assets andprojected returns using asset mix forecasts and historical return data.

TheCompany’s pension plans’ weighted-average asset allocations at September 30,2006 and 2005, by asset category, are as follows:

| ** **        | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
| Asset Category:   |       |     |       |     |       |   |   |   |   |
| Equity securities |       |     | 69         | %        |       |   | 69 | % |   |
| Debt securities   |       |     | 30         | %        |       |   | 30 | % |   |
| Other             |       |     | 1          | %        |       |   | 1 | % |   |
| Total             |       |     | 100        | %        |       |   | 100 | % |   |

 

The plan assets of the pension plans are held andinvested by the Walter Industries, Inc. Subsidiaries Master Pension Trust(“Pension Trust”). The Pension Trust employs a total return investment approachwhereby a mix of equity and fixed income investments are used to meet thelong-term funding requirements of the Pension Trust. The asset mix strives togenerate rates of return sufficient to fund plan liabilities and exceed thelong-term rate of inflation, while maintaining an appropriate level ofportfolio 

F-36

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risk. Risk tolerance isestablished through consideration of plan liabilities, plan funded status andcorporate financial condition. The investment portfolio is diversified acrossdomestic and foreign equity holdings, and by investment styles and marketcapitalizations. Fixed income holdings are diversified by issuer, security typeand principal and interest payment characteristics. Derivatives may be used togain market exposure in an efficient and timely manner; however, derivativesmay not be used to leverage the portfolio beyond the market value of theunderlying investments. Investment risk is measured and monitored on an ongoingbasis through quarterly investment portfolio reviews, annual benefits liabilitymeasurements, and periodic asset/liability studies.

As of September 30,2006 the Trust’s strategic asset allocation was as follows:

| ** **                  | ** ** | **Strategic** | ** ** | **Tactical**   | ** ** |
|-----------------------------|------------|---------------|------------|----------------|------------|
| **Asset Class**        | ** ** | ** **    | ** ** | **Allocation** | ** ** | **Range** | ** ** |
| Total Equity                |       |          | 70         | %              |       | 65-70% |   |
| Large Capitalization Stocks |       |          | 45         | %              |       | 40-50% |   |
| Mid Capitalization Stocks   |       |          | 10         | %              |       | 8-12% |   |
| International Stocks        |       |          | 15         | %              |       | 12-18% |   |
| Total Fixed Income          |       |          | 30         | %              |       | 25-35% |   |
| Total Cash                  |       |          | 0          | %              |       | 0-2% |   |
|                             |            |               |            |                |            |  |  |  |  |

 

These ranges are targets and deviations may occur fromtime-to-time due to market fluctuations. Portfolio assets are typicallyrebalanced to the allocation targets at least annually.

The Pension Trust employs a building block approach indetermining the long-term rate of return for plan assets. Historical marketreturns are studied and long-term risk/return relationships between equity andfixed income asset classes are analyzed. This analysis supports the widelyaccepted fundamental investment principle that assets with greater riskgenerate higher returns over long periods of time. The historical impact ofreturns in one asset class on returns of another asset class is reviewed toevaluate portfolio diversification benefits. Current market factors includinginflation rates and interest rate levels are considered before assumptions aredeveloped. The long-term portfolio return is established via the building blockapproach by adding interest rate risk and equity risk premiums to theanticipated long-term rate of inflation. Proper consideration is given to theimportance of portfolio diversification and periodic rebalancing. Peer data andhistorical return assumptions are reviewed to check for reasonableness.

Assumedhealthcare cost trend rates, discount rates, expected return on plan assets andsalary increases have a significant effect on the amounts reported for thepension and healthcare plans. A one-percentage-point change in the trend ratefor these assumptions would have the following effects (in thousands):

| ** **                                                     | ** ** | **1-Percentage**        | ** ** | **1-Percentage**        | ** ** |
|----------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                     | ** ** | **Point Increase** | ** ** | **Point Decrease** | ** ** |
| Health care cost  trend:                                       |       |                    |       |                    |       |   |   |   |   |
| Effect on total of service and interest cost  components       |       |                    | $          | 3,425                   |       |   |   | $ | (2,725 | ) |   |
| Effect on postretirement benefit obligation                    |       |                    | 42,335     |                    |       |   | (34,959 | ) |   |
| Discount rate:                                                 |       |                    |       |                    |       |   |   |   |   |
| Effect on postretirement service and interest cost  components |       |                    | 114        |                    |       |   | (393 | ) |   |
| Effect on postretirement benefit obligation                    |       |                    | (39,507    | )                       |       |   | 45,778 |   |   |
| Effect on current year postretirement benefits  expense        |       |                    | (2,248     | )                       |       |   | 2,290 |   |   |
| Effect on pension service and interest cost  components        |       |                    | 23         |                    |       |   | (92 | ) |   |
| Effect on pension benefit obligation                           |       |                    | (19,670    | )                       |       |   | 23,768 |   |   |
| Effect on current year pension expense                         |       |                    | (1,556     | )                       |       |   | 1,829 |   |   |
| Expected return  on plan assets:                               |       |                    |       |                    |       |   |   |   |   |
| Effect on current year pension expense                         |       |                    | (1,375     | )                       |       |   | 1,375 |   |   |
| Rate of  compensation increase:                                |       |                    |       |                    |       |   |   |   |   |
| Effect on pension service and interest cost  components        |       |                    | 451        |                    |       |   | (386 | ) |   |
| Effect on pension benefit obligation                           |       |                    | 3,419      |                    |       |   | (3,144 | ) |   |
| Effect on current year pension expense                         |       |                    | 861        |                    |       |   | (743 | ) |   |
|                                                                |            |                         |            |                         |            |  |  |  |  |  |  |

 

F-37

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The Company has determined that it sponsors healthcare benefit plans that provide a benefit that is at least actuariallyequivalent to Medicare Part D. The Company received a $0.6 millionreimbursement benefit for the Medicare Part D subsidy in 2006. The effectof the subsidy on the measurement of net periodic postretirement benefit costfor 2005 and 2004 was zero.

TheCompany’s minimum pension plan funding requirement for 2007 is $4.7 million. InJanuary 2007, the Company contributed $7.0 million, fulfilling its funding requirement.The Company also expects to pay $17.3 million in benefits related to its otherpost-retirement healthcare plan in 2007 for benefit payments. The followingestimated benefit payments from the plans, which reflect expected futureservice, as appropriate, are expected to be paid (in thousands):

| ** **      | ** ** | **Pension  Benefits** | ** ** | **Other  Postretirement  Benefits  Before  Medicare  Subsidy** | ** ** | **Medicare  Part D  Subsidy** | ** ** |
|-----------------|------------|-----------------------|------------|----------------------------------------------------------------|------------|------------------------------------|------------|
| 2007            |       | $                     | 10,270     |                                                           |       | $                                  | 18,018     |   |   |   | $ | 748 |   |   |
| 2008            |       | 10,970                |       |                                                           | 19,523     |                               |       |   | 789 |   |   |
| 2009            |       | 12,798                |       |                                                           | 21,050     |                               |       |   | 822 |   |   |
| 2010            |       | 11,444                |       |                                                           | 22,440     |                               |       |   | 851 |   |   |
| 2011            |       | 12,054                |       |                                                           | 23,453     |                               |       |   | 855 |   |   |
| Years 2012-2016 |       | 70,560                |       |                                                           | 129,256    |                               |       |   | 4,298 |   |   |
|                 |            |                       |            |                                                                |            |                                    |            |  |  |  |  |  |  |  |

 

Under the labor contract with the United Mine Workersof America, Jim Walter Resources makes payments into multi-employer pensionplan trusts established for union employees. Under ERISA, an employer is liablefor a proportionate part of the plans’ unfunded vested benefits liabilitiesupon its withdrawal from the plan. ERISA imposes certain liabilities oncontributors to multi-employer pension plans in the event of a contributor’swithdrawal from the plan. The Company does not have any intention to withdrawfrom the plan. Through June 30, 2007, the calculation of the Company’swithdrawal liability amounts to $102.1 million.

The Company and certain of its subsidiaries maintainprofit sharing and 401(k) plans. The total cost of these plans in 2006,2005 and 2004 was $2.4 million, $2.2 million and $2.0 million, respectively.

**NOTE 16—Stockholders’Equity**

In 2003, the Company’s Board of Directors authorizedan increase in the Common Stock Open Market share buyback program to $25.0million. During 2004, the Company acquired 6.959 million shares pursuant to theopen market share repurchase program. At December 31, 2006, $7.5 millionremains available under this authorization.

In April 2004, the Company purchased 4.961million shares of its common stock for approximately $63.0 million, of which3.961 million shares costing $50.0 million were purchased from certainaffiliates of Kohlberg, Kravis, Roberts and Co. (“KKR”). In October 2004,the Company purchased 2.0 million shares of its common stock from certain KKRaffiliates for approximately $32.3 million in a private transaction thatoccurred concurrently with an offering by KKR of its 8.0 million remainingshares of the Company’s common stock. Following the offering, KKR did not ownany shares of the Company’s common stock.

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**NOTE 17—Net Income (Loss)Per Share**

A reconciliation ofthe basic and diluted net income (loss) per share computations for the yearsended December 31, 2006, 2005 and 2004 are as follows (in thousands,except per share data):

| ** **                                                                       | ** ** | **For the years ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                       | ** ** | **Basic**                                                     | ** ** | **Diluted** | ** ** | **Basic** | ** ** | **Diluted** | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
| Numerator:                                                                       |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Income from continuing operations                                                |       | $                                                             | 145,584    |   | $ | 145,584 |   | $ | 34,351 |   | $ | 34,351 |   | $ | 50,534 |   | $ | 50,534 |   |
| Effect of dilutive securities:                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Interest related to 3.75% convertible senior  subordinated notes, net of tax (a) |       | —                                                        |       | 3,385 |   | — |   | 4,266 |   | — |   | 3,021 |   |
|                                                                             |       | $                                                             | 145,584    |   | $ | 148,969 |   | $ | 34,351 |   | $ | 38,617 |   | $ | 50,534 |   | $ | 53,555 |   |
| Income (loss) from discontinued operations                                       |       | $                                                        | 52,785     |   | $  | 52,785 |   | $  | (27,305 | ) | $  | (27,305 | ) | $  | (617 | ) | $  | (617 | ) |
| Denominator:                                                                     |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Average number of common shares outstanding                                      |       | 44,030                                                        |       | 44,030 |   | 38,485 |   | 38,485 |   | 38,582 |   | 38,582 |   |
| Effect of dilutive securities:                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Stock options (b)                                                                |       | —                                                        |       | 642 |   | — |   | 919 |   | — |   | 885 |   |
| 3.75% convertible senior subordinated notes (a)                                  |       | —                                                        |       | 7,406 |   | — |   | 9,805 |   | — |   | 6,788 |   |
|                                                                             |       | 44,030                                                        |       | 52,078 |   | 38,485 |   | 49,209 |   | 38,582 |   | 46,255 |   |
| Income from continuing operations                                                |       | $                                                             | 3.31       |   | $ | 2.86 |   | $ | 0.89 |   | $ | 0.78 |   | $ | 1.31 |   | $ | 1.16 |   |
| Income (loss)  from discontinued operations                                      |       | 1.20                                                          |       | 1.01 |   | (0.71 | ) | (0.55 | ) | (0.02 | ) | (0.02 | ) |
| Net income (loss) per  share                                                     |       | $                                                             | 4.51       |   | $ | 3.87 |   | $ | 0.18 |   | $ | 0.23 |   | $ | 1.29 |   | $ | 1.14 |   |

----

(a)           Represents theinterest, net of tax, and shares issuable upon conversion related to theCompany’s contingent convertible senior subordinated notes.

(b)          Represents the number ofshares of common stock issuable on the exercise of dilutive employee stockoptions less the number of shares of common stock which could have beenpurchased with the proceeds from the exercise of such options. These purchaseswere assumed to have been made at the higher of either the market price of thecommon stock at the end of the period or the average market price for theperiod. Stock options outstanding of 408,238, 14,468 and 180,250 for the yearsended December 31, 2006, 2005 and 2004, respectively, were excluded fromthe calculation above because their effect would have been anti-dilutive.

**NOTE 18—Commitments andContingencies**

*Income TaxLitigation*

The Company is currently engaged in litigation withregard to Federal income tax disputes; see Note 13 for a more completeexplanation.

*EnvironmentalMatters*

The Company is subject to a wide variety of laws andregulations concerning the protection of the environment, both with respect tothe construction and operation of its plants, mines and other facilities andwith respect to remediating environmental conditions that may exist at its ownand other properties. 

F-39

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The Company believes thatit is in substantial compliance with federal, state and local environmentallaws and regulations. The Company accrues for environmental expenses resultingfrom existing conditions that relate to past operations when the costs areprobable and reasonably estimable.

Sloss and Walter Industries Inc. have received aletter from attorneys purporting to represent a group of residents of the NorthBirmingham area of Jefferson County, Alabama alleging personal injury, propertydamage, nuisance and trespass. The allegations against Sloss relate to airemissions from its coking facility. Walter is named in this litigation becauseof its ownership interest in Sloss. Management believes that if suit is filedon these allegations, Sloss and Walter will have substantial defenses.

Sloss was named in a suit (Adkins v. Sloss, et al. inCircuit Court, Wayne County, West Virginia; Civil Action No. 04-C261)that was the lead case of 13 suits filed in Wayne County, WV, over the spill of“light oil” from a railcar loaded at the Sloss facility. In 2006, the Companyrecognized a liability of $1.0 million for the estimated settlement of thismatter. Sloss has settled with the plaintiffs in this case for an amount thatwas not material to the Company’s financial statements.

Sloss Industries entered into a decree order in 1989relative to a Resource Conservation Recovery Act (“RCRA”) compliance programmandated by the EPA. A RCRA Facility Investigation (“RFI”) Work Plan wasprepared which proposed investigative tasks to assess the presence ofcontamination at the Sloss facility. The Work Plan was approved in 1994 and thePhase I investigations were conducted and completed between 1995 and 1999.Phase II investigations for the Chemical Plant/Coke Plant and BiologicalTreatment Facility and Sewers/Land Disposal Areas were performed in 2000 and2001 and are substantially complete. At the end of 2004, EPA re-directed Sloss’RFI efforts toward completion of the Environmental Indicator (“EI”)determinations for the Current Human Exposures. This EI effort was completed toassist EPA in meeting goals set by the Government Performance Results Act(“GPRA”) for RCRA by 2005. Sloss implemented the approved EI Sampling Plan inApril 2005. EPA approved/finalized the EI determinations for Sloss’Birmingham facility in September 2005. In an effort to refocus the RFI,EPA has now provided technical comments on the Phase II RFI report and thereport recently submitted as part of the EI effort. A Phase III work plan has beensubmitted to the EPA during the first quarter of 2007.

Although no assurances can be given that the Companywill not be required in the future to make material expenditures relating tothe Sloss site or other sites, management does not believe at this time thatthe cleanup costs, if any, associated with these sites will have a materialadverse effect on the financial condition of the Company, but such cleanupcosts could be material to results of operations in a future reporting period.

*Miscellaneous Litigation*

Drummond Company, Inc. filed suit in state courtin Tuscaloosa County, Alabama on October 29, 2001, against the Company andseveral of its subsidiaries (Drummond Company, Inc. v. WalterIndustries, Inc., et al., Case No. CV 2002-0673). Drummond claimedthat it was entitled to exclusive surface mining rights on certain lands ownedby United Land Corporation, a wholly owned subsidiary of the Company. TheCompany filed a counterclaim seeking injunctive relief, substantial actualdamages and punitive damages against Drummond based on fraud. The Company andits subsidiaries were granted summary judgment on all of Drummond’s claims onMarch 29, 2005. A jury trial denied United Land Corporation’scounter-claim on April 8, 2005. Drummond and the Company appealed thetrial court’s decision and in December 2006 the Alabama Supreme Courtruled in favor of the Company and the case has been sent back to the trialcourt for further proceedings to determine the Company’s damages. Drummond’sclaims do not affect the underground mining operations of Jim Walter Resources.

F-40

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On November 29, 2006, the Company reached asettlement with Oxbow Carbon and Minerals LLC resolving all outstandingdisputes in respect of the sale by the Company to Oxbow of the Corporation’sformer AIMCOR subsidiary, see Note 2.

The Company and its subsidiariesare parties to a number of other lawsuits arising in the ordinary course oftheir businesses. The Company provides for costs relating to these matters whena loss is probable and the amount is reasonably estimable. The effect of theoutcome of these matters on the Company’s future results of operations cannotbe predicted with certainty as any such effect depends on future results ofoperations and the amount and timing of the resolution of such matters. Whilethe results of litigation cannot be predicted with certainty, the Companybelieves that the final outcome of such other litigation will not have amaterially adverse effect on the Company’s consolidated financial statements.

*Commitments andContingencies—Other*

In the opinion ofmanagement, accruals associated with contingencies incurred in the normalcourse of business are sufficient. Resolution of existing known contingenciesis not expected to significantly affect the Company’s financial position andresult of operations.

**Operating Leasesand Purchase Obligations**

The Company accounts for operating leases inaccordance with SFAS 13, “Accounting for Leases,” which includes guidance forevaluating free rent periods, amortization period of leasehold improvements andincentives related to leasehold improvements. The Company’s operating leasesare primarily for mining equipment, automobiles and office space.

Rentexpense was $11.8 million, $11.9 million and $15.8 million for the years ended December 31,2006, 2005 and 2004, respectively. Future minimum payments under non-cancelableoperating leases and purchase obligations as of December 31, 2006 are (inthousands):

| ** ** | ** ** | **Operating** | ** ** | **Purchase**    | ** ** |
|------------|------------|---------------|------------|-----------------|------------|
| ** ** | ** ** | **Leases**    | ** ** | **Obligations** | ** ** |
| 2007       |       |          | $          | 9,755           |       |   |   | $ | 30,402 |   |   |
| 2008       |       |          | 7,922      |            |       |   | — |   |   |
| 2009       |       |          | 5,142      |            |       |   | — |   |   |
| 2010       |       |          | 3,075      |            |       |   | — |   |   |
| 2011       |       |          | 2,466      |            |       |   | — |   |   |
| Thereafter |       |          | 806        |            |       |   | — |   |   |

 

**NOTE 19—FinancialInstruments**

**Fair Value ofFinancial Instruments**

The following methods and assumptions were used toestimate fair value disclosures:

*Cash and cash equivalents, restricted short-terminvestments, trade receivables, other receivables and accounts payable*—Thecarrying amounts reported in the balance sheet approximate fair value.

*Instalment notes receivable*—*The*estimated fair value of instalment notes was $2.0billion for each period ended at December 31, 2006 and 2005, based uponvaluations prepared as of those dates and were determined by a comparison withthe quoted market price of financial instruments believed to be comparable toand have similar characteristics as the Company’s instalment notes receivable. Thevalue of mortgage-backed assets such as instalment notes receivable is verysensitive to changes in interest rates.

*Debt*—The estimated fair value ofmortgage-backed/asset-backed notes approximated $1.8 billion for each periodended at December 31, 2006 and 2005, based on current yields forcomparable debt issues or 

F-41

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prices for actualtransactions. The value of mortgage-backed debt obligations is very sensitiveto changes in interest rates.

The estimated fair value of the Company’s 3.75%convertible senior subordinated notes due May 1, 2024 was estimated basedon several standard market variables including the Company’s common stockprice, its volatility and yields on comparable debt. The estimated fair valueof the Company’s convertible notes approximates book value at December 31,2006 and was estimated to be $496.3 million at December 31, 2005. Theestimated fair value of the Company’s term loan approximates book value at December 31,2006 and 2005.

*Interest rate hedges*—*Interest*rate hedges are discussed in more detail in Note14.

*Commodity hedges*—*At*December 31, 2006, the Company had one contractoutstanding to hedge 0.6 million mmbtus or 35% of anticipated sales in thefirst quarter of 2007 at a price of $10.54, scheduled to expire in the firstquarter 2007. The fair value of this contract at December 31, 2006 was anasset of $2.6 million. At December 31, 2005, the Company had threecontracts outstanding to hedge 1.6 million mmbtus or 92% of anticipatedproduction in the first quarter of 2006 at a weighted average price of $9.64,scheduled to expire in the first quarter of 2006. The fair value of thesecontracts at December 31, 2005 was a liability of $0.8 million. As of December 31,2006, the Company recorded a net unrealized gain from these natural gas hedginginstruments of $1.7 million, net of tax, as a component of other comprehensiveincome compared to a net unrealized loss of $0.5 million, net of tax, at December 31,2005.

On February 8, 2007,the Company entered into a swap contract to hedge 1.35 mmbtus million orapproximately 26% of anticipated sales for the last three quarters of 2007 at aprice of $8.10. These hedges are scheduled to expire December 31, 2007.

**NOTE 20—Segment Analysis**

The Company’s reportable segments are strategicbusiness units that offer different products and services and have separatemanagement teams. The business units have been aggregated into five reportablesegments since the long-term financial performance of these reportable segmentsis affected by similar economic conditions. The five reportable segmentsare:  Natural Resources, Sloss,Homebuilding, Financing and Other. The Natural Resources segment is comprisedof coal mining and methane gas operations. Sloss manufactures foundry andfurnace coke and slag fiber.   TheFinancing segment provides mortgage financing on homes constructed by theHomebuilding segment and purchases mortgages originated by others. Homebuildingmarkets and supervises the construction of detached, single-family residentialhomes, primarily in the southeastern United States. The Other segment includesthe land division and corporate expenses.

The accounting policies of the segments are the sameas those described in the summary of significant accounting policies. TheCompany evaluates performance based on operating earnings of the respectivebusiness segments.

F-42

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Summarized financialinformation concerning the Company’s reportable segments is shown in thefollowing tables (in thousands):

| ** **                                                                                          | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Sales and  revenues:                                                                                |       |                                                          |       |   |   |   |   |
| Natural Resources                                                                                   |       | $                                                             | 679,580    |   | $ | 548,577 |   | $ | 395,532 |   |
| Sloss                                                                                               |       | 133,033                                                       |       | 129,035 |   | 102,974 |   |
| Natural Resources and Sloss                                                                         |       | 812,613                                                       |       | 677,612 |   | 498,506 |   |
| Financing                                                                                           |       | 219,551                                                       |       | 229,156 |   | 242,777 |   |
| Homebuilding                                                                                        |       | 275,841                                                       |       | 226,796 |   | 233,755 |   |
| Financing and Homebuilding Group                                                                    |       | 495,392                                                       |       | 455,952 |   | 476,532 |   |
| Other                                                                                               |       | 15,087                                                        |       | 12,354 |   | 18,427 |   |
| Consolidating eliminations                                                                          |       | (13,236)                                                      |       | (7,876) |   | (8,664) |   |
| Sales and revenues (a)(b)                                                                           |       | $                                                             | 1,309,856  |   | $ | 1,138,042 |   | $ | 984,801 |   |
| Segment operating income (loss) (c)(d):                                                             |       |                                                          |       |   |   |   |   |
| Natural Resources                                                                                   |       | $                                                             | 246,345    |   | $ | 164,103 |   | $ | 69,702 |   |
| Sloss                                                                                               |       | 8,071                                                         |       | 11,442 |   | 6,845 |   |
| Natural Resources and Sloss                                                                         |       | 254,416                                                       |       | 175,545 |   | 76,547 |   |
| Financing (e)                                                                                       |       | 53,987                                                        |       | 46,019 |   | 54,838 |   |
| Homebuilding                                                                                        |       | (22,115)                                                      |       | (103,881) |   | (33,347) |   |
| Financing and Homebuilding Group                                                                    |       | 31,872                                                        |       | (57,862) |   | 21,491 |   |
| Other                                                                                               |       | (15,852)                                                      |       | (20,500) |   | (28,045) |   |
| Consolidating eliminations                                                                          |       | (647)                                                         |       | (2,714) |   | 768 |   |
| Segment operating income (loss)                                                                     |       | 269,789                                                       |       | 94,469 |   | 70,761 |   |
| Less corporate debt interest and debt conversion  costs                                             |       | (57,384)                                                      |       | (23,400) |   | (18,182) |   |
| Income (loss) from continuing operations before  income tax (expense) benefit and minority interest |       | 212,405                                                       |       | 71,069 |   | 52,579 |   |
| Income tax (expense) benefit                                                                        |       | (67,821)                                                      |       | (36,718) |   | (2,045) |   |
| Income from  continuing operations before minority interest                                         |       | $                                                        | 144,584    |   | $  | 34,351 |   | $  | 50,534 |   |
| Depreciation:                                                                                       |       |                                                          |       |   |   |   |   |
| Natural Resources                                                                                   |       | $                                                             | 27,004     |   | $ | 20,855 |   | $ | 22,464 |   |
| Sloss                                                                                               |       | 3,623                                                         |       | 3,859 |   | 3,794 |   |
| Natural Resources and Sloss                                                                         |       | 30,627                                                        |       | 24,714 |   | 26,258 |   |
| Financing                                                                                           |       | 1,387                                                         |       | 1,403 |   | 1,471 |   |
| Homebuilding                                                                                        |       | 5,385                                                         |       | 4,966 |   | 4,792 |   |
| Financing and Homebuilding Group                                                                    |       | 6,772                                                         |       | 6,369 |   | 6,263 |   |
| Other                                                                                               |       | 1,618                                                         |       | 893 |   | 1,176 |   |
| Total                                                                                               |       | $                                                             | 39,017     |   | $ | 31,976 |   | $ | 33,697 |   |
| Gross capital  expenditures:                                                                        |       |                                                          |       |   |   |   |   |
| Natural Resources                                                                                   |       | $                                                             | 86,305     |   | $ | 94,301 |   | $ | 21,733 |   |
| Sloss                                                                                               |       | 7,761                                                         |       | 7,314 |   | 4,329 |   |
| Natural Resources  and Sloss                                                                        |       | 94,066                                                        |       | 101,615 |   | 26,062 |   |
| Financing                                                                                           |       | 295                                                           |       | 206 |   | 924 |   |
| Homebuilding                                                                                        |       | 5,669                                                         |       | 8,921 |   | 2,647 |   |
| Financing and  Homebuilding Group                                                                   |       | 5,964                                                         |       | 9,127 |   | 3,571 |   |
| Other                                                                                               |       | 1,025                                                         |       | 3,776 |   | 346 |   |

F-43

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| Total                             |   | $         | 101,055   |      | $      | 114,518   |   | $ | 29,979    |   |
|-----------------------------------|--------|-----------|-----------|-----------|--------|-----------|--------|---|-----------|--------|
| Identifiable  assets:             |   |      |      |      |   |      |   |
| Natural Resources                 |   | $         | 480,065   |      | $      | 317,297   |   | $ | 235,726   |   |
| Sloss                             |   | 57,686    |      | 69,981    |   | 60,410    |   |
| Natural Resources  and Sloss      |   | 537,751   |      | 387,278   |   | 296,136   |   |
| Financing                         |   | 1,940,103 |      | 1,796,377 |   | 1,790,663 |   |
| Homebuilding                      |   | 81,715    |      | 85,680    |   | 148,212   |   |
| Financing and Homebuilding Group  |   | 2,021,818 |      | 1,882,057 |   | 1,938,875 |   |
| Other                             |   | 124,546   |      | 223,200   |   | 217,895   |   |
| Assets of discontinued operations |   | —    |      | 2,911,369 |   | 463,580   |   |
| Total                             |   | $         | 2,684,115 |      | $      | 5,403,904 |   | $ | 2,916,486 |   |

----

(a)           Intra-segment sales(made primarily at prevailing market prices) are deducted from sales of theselling segment and are eliminated using consolidating eliminations.

(b)          Export sales were $551.9million, $371.7 million and $212.2 million in the years ended December 31,2006, 2005 and 2004, respectively. Export sales to Brazil were 14.2%, 9.3% and5.9% of consolidated net sales and revenues for 2006, 2005 and 2004,respectively.

(c)           Operating incomeamounts include amortization of intangibles. The Company recorded approximately$2.4 million, $3.6 million and $5.0 million of amortization expense related tothe Financing segment for the years ended December 31, 2006, 2005 and2004, respectively.

(d)          Operatingincome amounts include expenses for postretirement benefits. A breakdown bysegment of postretirement benefits (income) expense is as follows (inthousands):

| ** **        | ** ** | **For the years ended December 31,** | ** ** |
|-------------------|------------|---------------------------------------------------------------|------------|
| ** **        | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Natural Resources |       | $                                                             | 19,772     |   | $ | 16,448 |   | $ | 10,896 |   |
| Sloss             |       | (680                                                          | )          | (563 | ) | (401 | ) |
| Financing         |       | (1,544                                                        | )          | (240 | ) | (207 | ) |
| Homebuilding      |       | (3,224                                                        | )          | (468 | ) | (465 | ) |
| Other             |       | (787                                                          | )          | (776 | ) | (336 | ) |
|              |       | $                                                             | 13,537     |   | $ | 14,401 |   | $ | 9,487 |   |

 

(e)           Operatingincome amounts for the Financing segment include interest expense on themortgage-backed/asset-backed notes of $118.7 million, $122.0 million and $127.3million for the years ended December 31, 2006, 2005 and 2004,respectively.

**NOTE 21—Related PartyTransactions**

The Company owns a 50% interest in the joint ventureBlack Warrior Methane (“BWM”), which is accounted for under the proportionateconsolidation method. The Company has granted the rights to produce and sellmethane gas from its coal mines to BWM. The Company also supplies labor andequipment to BWM and charges the joint venture for such costs on a monthlybasis. The total of these charges for 2006, 2005 and 2004 were $2.1 million,$2.6 million and $2.2 million, respectively.

In 2004, the Company completed the sale of the assetsof Vestal Manufacturing Company, a wholly owned subsidiary, for $6.0 million,subject to certain post-closing adjustments. The Company recorded an after taxloss of approximately $0.8 million on the sale. Michael T. Tokarz, Chairman ofthe Company’s Board of Directors, is the chairman and investment manager of MVCCapital, an investment fund that 

F-44

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participated in theacquisition of Vestal’s assets. Mr. Tokarz owns less than five percent ofthe equity of MVC Capital. There were no fees paid to Mr. Tokarz inconnection with the sale. Mr. Tokarz did not vote on the transaction orparticipate in the Board’s decision to approve the sale of Vestal.

See Note 16 for adiscussion of transactions with KKR.

**NOTE 22—AccountingPronouncements Not Yet Adopted**

In July 2006 the FASB issued FIN No. 48, “Accountingfor Uncertainty in Income Taxes,” which provides the minimum recognitionthreshold that a tax provision must meet before being recognized in thefinancial statements. This interpretation also provides guidance onderecognition of income tax assets and liabilities, classification of currentand deferred income tax assets and liabilities, accounting for interest andpenalties associated with tax positions, accounting for income taxes in interimperiods and income tax disclosures. FIN No. 48 applies to all taxpositions related to income taxes subject to SFAS No. 109, “Accounting forIncome Taxes.”  The Company estimates theadoption of this interpretation, which becomes effective January 1, 2007,will result in an adjustment to decrease the beginning retained earnings byapproximately $5.0 million to $10.0 million.

In September 2006 the FASB issued SFAS No. 157,“Fair Value Measurements,” which provides a definition of fair value,establishes a framework for measuring fair value and expands financialstatement disclosure requirements. SFAS No. 157 requires companies to basefair values on what they would receive from a sale to a third party in the openmarket. The Company has not yet determined what impact, if any, the adoption ofthis statement, which becomes effective January 1, 2008, will have on itsconsolidated financial statements.

In September 2006 the FASB issued SFAS No. 158,“Employers’ Accounting for Defined Benefit Pension and Other PostretirementPlans,” which requires the Company to recognize the overfunded or underfundedstatus of a defined benefit postretirement plan (other than a multiemployerplan) as an asset or liability in the balance sheet and to recognize changes inthat funded status as a component of other comprehensive income. See Note 15for the impact of this guidance, which was effective December 31, 2006. Inaddition, SFAS No. 158 requires companies to measure plan assets andliabilities as of the fiscal year-end reporting date. The Company uses a September 30measurement date and will be required to adopt this provision December 31,2008. The Company has not yet determined what impact the adoption of thisrequirement of this statement will have on its consolidated financialstatements.

In September 2006 the FASB issued FASB StaffPosition No. AUG AIR-1, “Accounting for Planned Major MaintenanceActivities (“AUG AIR-1”), which provides guidance on which methods areallowed to properly account for planned major maintenance activities. The threeaccepted methods under AUG AIR-1 are direct expense, built-in overhaul,and deferral methods. The Company has not yet determined what impact theadoption of this statement, which becomes effective January 1, 2007, willhave on its consolidated financial statements.

In February 2007 the FASB issued SFAS No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities,” which allowsreporting entities to choose to measure many financial instruments and certainother items at fair value. The objective is to improve financial reporting byproviding entities with the opportunity to reduce volatility in reportedearnings that result from measuring related assets and liabilities differentlywithout having to apply complex hedge accounting provisions, using the guidancein SFAS No. 133 (as amended), “Accounting for Derivative Instruments andHedging Activities.”  The Company has notyet determined what impact the adoption of this requirement, which becomes effectiveJanuary 1, 2008, will have on its consolidated financial statements.

F-45

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**EXHIBITINDEX**

| Exhibit Number | ** ** | ** ** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                             | ** ** | ** ** |
|----------------|------------|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| 2(a)(i)        |       | —     |       | Amended Joint Plan of  Reorganization of Walter Industries, Inc. and certain of its subsidiaries,  dated as of December 9, 1994 (1)                                                                                                                                                                                                         |
| 2(a)(ii)       |       | —     |       | Modification to  the Amended Joint Plan of Reorganization of Walter Industries, Inc. and  certain of its subsidiaries, as filed in the Bankruptcy Court on March 1,  1995 (2)                                                                                                                                                               |
| 2(a)(iii)      |       | —     |       | Findings of Fact,  Conclusions of Law and Order Confirming Amended Joint Plan of Reorganization  of Walter Industries, Inc. and certain of its subsidiaries, as modified (3)                                                                                                                                                                |
| 3(i)           |       | —     |       | Amended and  Restated Certificate of Incorporation of the Company (4)                                                                                                                                                                                                                                                                       |
| 3(ii)          |       | —     |       | Amended and  Restated By-Laws (5)                                                                                                                                                                                                                                                                                                           |
| 4.1            |       | —     |       | Indenture dated  as of April 20, 2004 between Walter Industries, Inc. and the Bank of New York  Trust Company, N.A., as Trustee (6)                                                                                                                                                                                                         |
| 4.2            |       | —     |       | Form of 3.75%  Convertible Senior Subordinated Notes due 2024 (included as Exhibit A to  Exhibit 4.1) (6)                                                                                                                                                                                                                                   |
| 4.3            |       | —     |       | Resale  Registration Rights Agreement dated April 20, 2004 between Walter Industries,  Inc. and Banc of America Securities, LLC and Morgan Stanley & Co.  Incorporated, as representatives of the Initial Purchasers (6)                                                                                                                |
| 4.4            |       | —     |       | Form of Specimen  Certificate for Registrant's Common Stock (incorporated by reference to  Exhibit 4(b) to Registration Statement on Form S-1 filed by the Registrant  (No. 033-59013) (7)                                                                                                                                                  |
| 10.1*          |       | —     |       | Director and  Officer Indemnification Agreement, dated as of March 3, 1995, among the  Company and the Indemnitee parties thereto (8)                                                                                                                                                                                                       |
| 10.2*          |       | —     |       | Walter  Industries, Inc. Executive Change-in-Control Severance Agreement (9)                                                                                                                                                                                                                                                                |
| 10.3*          |       | —     |       | Walter Industries  Executive Deferred Compensation and Supplemental Retirement Plan (9)                                                                                                                                                                                                                                                     |
| 10.4*          |       | —     |       | Walter  Industries, Inc. Directors’ Deferred Fee Plan (10)                                                                                                                                                                                                                                                                             |
| 10.5*          |       | —     |       | Walter Industries,  Inc. Supplemental Pension Plan (9)                                                                                                                                                                                                                                                                                      |
| 10.6*          |       | —     |       | Walter  Industries, Inc. Executive Incentive Plan (11)                                                                                                                                                                                                                                                                                      |
| 10.7*          |       | —     |       | 1995 Long-Term  Incentive Stock Plan of Walter Industries, Inc. (12)                                                                                                                                                                                                                                                                        |
| 10.8*          |       | —     |       | 2002 Long-Term  Incentive Award Plan of Walter Industries, Inc. (13)                                                                                                                                                                                                                                                                        |
| 10.9*          |       | —     |       | Restricted Stock  Unit Award Agreement (9)                                                                                                                                                                                                                                                                                                  |
| 10.10*         |       | —     |       | Non-Statutory  Stock Option Agreement (9)                                                                                                                                                                                                                                                                                                   |
| 10.11          |       | —     |       | Walter Credit  Agreement dated as of October 3, 2005 among Walter Industries, Inc. as  borrower, Bank of America, N.A., as Administrative Agent, Morgan Stanley  Senior Funding, Inc, as Syndication Agent and SunTrust Bank, BNP Paribas and  Calyon New York Branch, as co-documentation agents and the other lenders  named therein (14) |

E-1

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| 10.11.1  |   | — |   | Amendment No. 1 to  Credit Agreement dated as of January 24, 2006 (15)                                                                                                                                                                                                                              |
|----------|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.11.2  |   | — |   | Amendment No. 2  to Credit Agreement dated as of February 14, 2006 (16)                                                                                                                                                                                                                             |
| 10.11.3  |   | — |   | Amendment No. 3  to Credit Agreement dated as of September 14, 2006                                                                                                                                                                                                                                 |
| 10.12    |   | — |   | Second Amended  and Restated Variable Funding Loan Agreement, dated as of June 15, 2006,  among YC SUSI Trust, Atlantic Asset Securitization LLC, Mid-State Trust IX,  Treasury Bank, a Division of Countrywide Bank, N.A., The Bank of New York,  Bank of America, N.A. and Calyon New York Branch |
| 10.13    |   | — |   | Amended and  Restated Variable Funding Loan Agreement dated as of June 15, 2006, among  Three Pillars Funding, LLC, Mid-State Trust XIV, Treasury Bank, a Division of  Countrywide Bank, N.A., The Bank of New York, SunTrust Capital Markets, Inc. and  SunTrust Bank.                             |
| 10.13.1  |   | — |   | Amendment No. 1  to Amended and Restated Variable Funding Loan Agreement dated as of November  27, 2006, among Three Pillars Funding, LLC, Mid-State Trust XIV, Treasury  Bank, a Division of Countrywide Bank, N.A., The Bank of New York and SunTrust  Capital Markets, Inc. and SunTrust Bank    |
| 10.14*   |   | — |   | Agreement dated  as of July 24, 2002, between the Company and Victor Patrick (10)                                                                                                                                                                                                                   |
| 10.15*   |   | — |   | Agreement dated  as of October 31, 2000, between the Company and Joseph J. Troy (17)                                                                                                                                                                                                                |
| 10.16*   |   | — |   | Agreement dated  as of September 9, 2005, between the Company and Gregory Hyland (18)                                                                                                                                                                                                               |
| 10.16.1* |   | — |   | Agreement dated  as of March 2, 2006, between the Company and Gregory Hyland (19)                                                                                                                                                                                                                   |
| 10.16.2* |   | — |   | Agreement dated  December 14, 2006, between the Company and Gregory Hyland (20)                                                                                                                                                                                                                     |
| 10.17*   |   | — |   | Agreement dated  as of March 2, 2006, between the Homes Group and Mark O’Brien (19)                                                                                                                                                                                                            |
| 10.18*   |   | — |   | Agreement, dated  as of December 28, 2000, between the Company and William F. Ohrt (21)                                                                                                                                                                                                             |
| 10.19*   |   | — |   | Agreement dated  March 13, 2006, between the Company and George R. Richmond (22)                                                                                                                                                                                                                    |
| 10.20*   |   | — |   | Agreement dated  as of January 23, 2006, between Mueller Water Products, Inc. and Dale Smith  (15)                                                                                                                                                                                                  |
| 10.21*   |   | — |   | Agreement dated  as of June 17, 2005, between Mueller Group, LLC and Thomas Fish (23)                                                                                                                                                                                                               |
| 10.22*   |   | — |   | Agreement dated  as of November 2, 2006, between the Homes Group and Charles E. Cauthen                                                                                                                                                                                                             |
| 10.23*   |   | — |   | JWH Holding  Company, LLC Economic Profit Plan                                                                                                                                                                                                                                                      |
| 12.1     |   | — |   | Ratio of Earnings  to Fixed Charges                                                                                                                                                                                                                                                                 |
| 16.1     |   | — |   | Letter of  PricewaterhouseCoopers LLP (24)                                                                                                                                                                                                                                                          |

E-2

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| 21   |   | — |   | Subsidiaries of  the Company                                                                                                   |
|------|--------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------|
| 23   |   | — |   | Consent of  PricewaterhouseCoopers LLP                                                                                         |
| 24   |   | — |   | Power of Attorney                                                                                                              |
| 31.1 |   | — |   | Certification  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002—Chief Executive  Officer                         |
| 31.2 |   | — |   | Certification  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002—Chief Financial  Officer                         |
| 32.1 |   | — |   | Certification  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section  1350—Chief Executive Officer |
| 32.2 |   | — |   | Certification Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350—Chief  Financial Officer |

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The Exhibitsidentified above with an asterisk (*) are management contracts or compensatoryplans or arrangements.

       (1) This Exhibit is incorporated by reference to the Application forQualification of Indenture of Form T-3 filed by the Company with the Commissionon February 6, 1995.

       (2) This Exhibit is incorporated by reference to Amendment No. 2 to theApplication for Qualification of Indenture on Form T-3 filed by the Companywith the Commission on March 7, 1995.

       (3) This Exhibit is incorporated by reference to the RegistrationStatement of Form S-1 (File No. 33-59013) filed by the Company with theCommission on May 2, 1995.

       (4) This Exhibit is incorporated by reference to the Form 10-Q filed bythe Company with the Commission on August 9, 2004.

       (5) This Exhibit is incorporated by reference to Form 10-Q filed by theCompany with the Commission on November 7, 2005.

       (6) This Exhibit is incorporated by reference to Form S-3 filed by theCompany with the Commission on July 15, 2004.

       (7) This Exhibit is incorporated by reference to Exhibit 4(b) toRegistration Statement on Form S-1 filed by the Company.

       (8) This Exhibit is incorporated by reference to Amendment No. 1 to theRegistration Statement on Form S-1 (File No. 33-59013) filed by the Companywith the Commission on May 2, 1995.

       (9) This Exhibit is incorporated by reference to Form 10-K filed by theCompany with the Commission on March 16, 2005.

(10) This Exhibit is incorporated by reference to Form 10-K filed by theCompany with the Commission on March 15, 2004.

(11) This Exhibit is incorporated by reference to Appendix A to theCompany's Proxy Statement, dated March 31, 2006, filed by the Company withthe Commission on March 31, 2006.

(12) This Exhibit is incorporated by reference to the RegistrationStatement on Form S-8 filed by the Company with the Commission on April 1,1996.

(13) This Exhibit is incorporated by reference to Exhibit A of theCompany's Proxy Statement, dated March 25, 2002, filed by the Company with theCommission on March 25, 2002.

E-3

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(14) This Exhibit is incorporated by reference to Form 8-K filed by theCompany with the Commission on October 5, 2005.

(15) This Exhibit is incorporated by reference to Form 8-K filed by theCompany with the Commission on January 27, 2006.

(16) This Exhibit is incorporated by reference to Form 8-K filed by theCompany with the Commission on February 21, 2006.

(17) This Exhibit is incorporated by reference to Form 10-K filed by theCompany with the Commission on March 21, 2003.

(18) This Exhibit is incorporated by reference to Form 8-K filed by theCompany with the Commission on September 12, 2005.

(19) This Exhibit is incorporated by reference to Form 8-K filed by theCompany with the Commission on March 3, 2006.

(20) This Exhibit is incorporated by reference to Form 8-K filed by theCompany with the Commission on December 20, 2006.

(21) This Exhibit is incorporated by reference to Form 10-K filed by theCompany with the Commission on March 20, 2002.

(22) This Exhibit is incorporated by reference to Form 10-K filed by theCompany with the Commission on March 16, 2006.

(23) This Exhibit is incorporated by reference to Form 10-K filed byMueller Water Products, Inc. with the Commission on December 19, 2005.

(24) This Exhibit is incorporated by reference to Form 8-K filed by theCompany with the Commission on January 3, 2007.

E-4

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