This Management's Discussion and Analysis of Financial Condition and Result of Operations ("MD&A") describes the matters that we consider to be important to understanding the results of our operations for each of the three years in the period ended December 31, 2008, and our capital resources and liquidity as of December 31, 2008 and 2007. Use of the terms "Rocky," the "Company," "we," "us" and "our" in this discussion refer to Rocky Brands, Inc. and its subsidiaries. Our fiscal year begins on January 1 and ends on December 31. We analyze the results of our operations for the last three years, including the trends in the overall business followed by a discussion of our cash flows and liquidity, our credit facility, and contractual commitments. We then provide a review of the critical accounting judgments and estimates that we have made that we believe are most important to an understanding of our MD&A and our consolidated financial statements. We conclude our MD&A with information on recent accounting pronouncements which we adopted during the year, as well as those not yet adopted that are expected to have an impact on our financial accounting practices.

The following discussion should be read in conjunction with the "Selected Consolidated Financial Data" and our consolidated financial statements and the notes thereto, all included elsewhere herein. The forward-looking statements in this section and other parts of this document involve risks and uncertainties including statements regarding our plans, objectives, goals, strategies, and financial performance. Our actual results could differ materially from the results anticipated in these forward-looking statements as a result of factors set forth under the

ROCKY BRANDS, INC. 19

caption "Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995" below. The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements made by or on behalf of the Company.

Our products are distributed through three distinct business segments:
wholesale, retail and military. In our wholesale business, we distribute our products through a wide range of distribution channels representing over ten-thousand retail store locations in the U.S. and Canada. Our wholesale channels vary by product line and include sporting goods stores, outdoor retailers, independent shoe retailers, hardware stores, catalogs, mass merchants, uniform stores, farm store chains, specialty safety stores and other specialty retailers. Our retail business includes direct sales of our products to consumers through our Lehigh Safety Shoes mobile and retail stores (including a fleet of trucks, supported by small warehouses that include retail stores, which we refer to as mini-stores), our Rocky outlet store and our websites. We also sell footwear under the Rocky label to the U.S. military.

2008 OVERVIEW

Highlights of our 2008 financial performance include the following:

• Net sales, led by a decrease of approximately $15.3 million in wholesale sales, decreased to $259.5 million from $275.3 million in 2007.

• Our gross margin decreased to $102.2 million from $108.0 million the prior year. Gross margin was 39.4% versus 39.2% in 2007, primarily due to the 180 basis point increase in gross margin on wholesale sales, which was partially offset by a 70 basis point decrease in gross margin on retail sales and a decrease in gross margin on military sales.

• Our operating expenses decreased $28.9 million to $92.4 million from $121.3 million compared to the prior year. Included in operating expenses are additional non-cash intangible impairment charges of $4.9 million and $24.9 million for 2008 and 2007, respectively, relating to carrying value of trademarks and goodwill, respectively. SG&A expenses decreased $8.9 million to $87.5 million, or 33.7% of net sales in 2008 compared to $96.4 million, or 35.0% of net sales for 2007.

• Net income increased to $1.2 million including a $3.0 million non-cash intangible impairment charge, net of tax benefits, compared to a loss of $23.1 million, including a $23.5 million non-cash intangible impairment charge, net of tax benefits, for the prior year. Diluted earnings per common share increased to $0.21 versus a loss of $4.22 per diluted share, including a $0.54 and $4.30 per diluted share non-cash intangible impairment charge in 2008 and 2007, respectively.

• Total debt minus cash, cash equivalents was $83.4 million or 49.5% of total capitalization at December 31, 2008 compared to $97.0 million or 52.3% of total capitalization at year-end 2007. Total debt decreased $15.8 million to $87.7 million or 52.0% of total capitalization at December 31, 2008 compared to $103.5 million or 55.9% of total capitalization at December 31, 2007.

Net sales. Net sales and related cost of goods sold are recognized at the time products are shipped to the customer and title transfers. Net sales are recorded net of estimated sales discounts and returns based upon specific customer agreements and historical trends.

Cost of goods sold. Our cost of goods sold represents our costs to manufacture products in our own facilities, including raw materials costs and all overhead expenses related to production, as well as the cost to purchase finished products from our third party manufacturers. Cost of goods sold also includes the cost to transport these products to our distribution centers.

SG&A expenses. Our SG&A expenses consist primarily of selling, marketing, wages and related payroll and employee benefit costs, travel and insurance expenses, depreciation, amortization, professional fees, facility expenses, bank charges, and warehouse and outbound freight expenses.

20 ROCKY BRANDS, INC.

PERCENTAGE OF NET SALES

The following table sets forth consolidated statements of operations data as
percentages of total net sales:


                                                     Years Ended December 31,
                                                   2008        2007         2006

        Net sales                                   100.0 %     100.0 %      100.0 %
        Cost of goods sold                           60.6 %      60.8 %       58.5 %

        Gross margin                                 39.4 %      39.2 %       41.5 %
        SG&A expense                                 33.7 %      35.0 %       34.0 %
        Non-cash intangible impairment charges        1.9 %       9.0 %        0.3 %

        Income (loss) from operations                 3.8 %      (4.8 )%       7.2 %

Results of Operations

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Net sales. Net sales decreased 5.7% to $259.5 million for 2008 compared to $275.3 million the prior year. Wholesale sales decreased $15.3 million to $187.3 million for 2008 compared to $202.6 million for 2007. The $15.3 million decrease in wholesale sales is primarily attributable to a supply chain disruption for our western footwear category combined with sales decreases in our outdoor footwear categories resulting from current economic conditions. Retail sales were $65.8 million in 2008 compared to $70.7 million for 2007. The $4.9 million decrease in retail sales results from customer decisions to close plants, reduce headcount and defer safety shoe purchases as a result of current economic conditions. Military segment sales, which occur from time to time, were $6.4 million for 2008 compared to $2.0 million in 2007. Shipments in 2008 were under the $6.4 million contract issued in July 2007 and the $5.0 million contract issued in January 2008. Average list prices for our footwear, apparel and accessories were similar in 2008 compared to 2007.

Gross margin. Gross margin decreased to $102.2 million or 39.4% of net sales for 2008 compared to $108.0 million or 39.2% of net sales for the prior year. Wholesale gross margin for 2008 was $68.5 million, or 36.6% of net sales, compared to $70.4 million, or 34.8% of net sales in 2007. The 180 basis point increase reflects an increase in sales price per unit, as well as a decrease in manufacturing costs resulting from increased operating efficiencies at our manufacturing facilities. Retail gross margin for 2008 was $33.2 million, or 50.4% of net sales, compared to $36.1 million, or 51.1% of net sales, in 2007. The 70 basis point decrease is primarily the result of increased costs to purchase products. Military gross margin in 2008 was $0.6 million, or 9.1% of net sales, compared to $1.4 million, or 72.9% of net sales in 2007. The decrease in basis points reflects the $1.2 million settlement in 2007 of a previously cancelled military contract.

SG&A expenses. SG&A expenses were $87.5 million, or 33.7% of net sales in 2008 compared to $96.4 million, or 35.0% of net sales for 2007. The net change primarily reflects decreases in salaries and commissions of $5.7 million, professional fees of $1.6 million and freight and handling of $1.5.

Non-cash intangible impairment charges. As a result of our annual evaluation of intangible assets, in 2008 we recognized impairment losses on the carrying values of the Lehigh and Gates trademarks of $4.0 million and $0.9 million, respectively. We recognized tax benefits relating to the Lehigh and Gates trademark impairments of $1.6 million and $0.3 million, respectively. We estimated fair value based on projections of the future cash flows for each of the trademarks. We then compared the carrying value for each trademark to its estimated fair value. Since the fair value of the trademark was less than its carrying value, we recognized the reductions in fair value as non-cash intangible impairment charges in our 2008 operating expenses. In 2007, we recognized an impairment loss on the carrying value of goodwill in the amount of $24.9 million. Because the trading value of our shares indicated a level of equity market capitalization below our book value at the time of the annual impairment test, there was indication that our goodwill could be impaired. In performing the first step of the impairment test, we valued the wholesale segment, for which all the goodwill applied, based on the guideline company method. The companies we selected are publicly traded wholesale competitors who manufacture shoes and apparel. While the selected companies may differ from the wholesale division in terms of the specific products they provide, they have similar

ROCKY BRANDS, INC. 21

financial risks and operating performance and reflect current economic conditions for the footwear and apparel industry in general. As a result of this analysis, it was determined that an indication of impairment did exist and the results of the second step of the impairment test resulted in an impairment of $24.9 million or $23.5 million, net of tax benefit to our goodwill.

Interest expense. Interest expense was $9.3 million in 2008, compared to $11.6 million for the prior year. A reduction in our average borrowings combined with reductions in Prime and LIBOR interest rates during 2008 resulted in a decrease of $2.3 million in interest expense for 2008. Interest expense for 2007 includes $0.8 million of deferred financing costs.

Income taxes. Income tax benefit was $0.6 million in 2008, compared to $1.4 million for the same period a year ago. We recognized a $1.9 million and $1.3 million benefit relating to the non-cash intangible impairment charge of $4.9 million and $24.9 million in 2008 and 2007, respectively. In 2008, we recognized a $0.6 million reduction in income tax expense related to the filing of the 2007 Federal income tax return and a $0.1 million reduction in income tax expense related to an adjustment of state deferred tax liabilities. In 2007, we recognized a $0.3 million benefit relating to a prior year state income tax refund.

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

Net sales. Net sales increased 4.5% to $275.3 million for 2007 compared to $263.5 million the prior year. Wholesale sales decreased $0.6 million to $202.6 million for 2007 compared to $203.2 million for 2006. The $7.6 million decreases in sales in our outdoor and western footwear categories were offset by an increase in sales in our work footwear category. Retail sales were $70.7 million in 2007 compared to $59.2 million for 2006. The $11.5 million increase in retail sales results from the growth in market share experienced as a result of the bankruptcy of a leading competitor. Military segment sales, which occur from time to time, were $2.0 million for 2007 compared to $1.1 million in 2006. Average list prices for our footwear, apparel and accessories were similar in 2007 compared to 2006.

Gross margin. Gross margin decreased to $108.0 million or 39.2% of net sales for 2007 compared to $109.3 million or 41.5% of net sales for the prior year. The decrease in basis points is primarily attributable to a reduction in margin for wholesale sales offset by an increase in margin relating to the $1.2 million settlement of a previously cancelled military contract. Wholesale gross margin for 2007 was $70.4 million, or 34.8% of net sales, compared to $79.0 million, or 38.9% of net sales in 2006. The 410 basis point decrease reflects a decrease in sales price per unit for competitive reasons, as well as an increase in manufacturing costs from both our company operated facilities and third party manufacturers and an increase in sales of discontinued products at lower margins. Retail gross margin for 2007 was $36.1 million, or 51.1% of net sales, compared to $30.2 million, or 51.0% of net sales, in 2006. Military gross margin in 2007 was $1.4 million, or 72.9% of net sales, compared to $0.1 million, or 9.5% of net sales in 2006. The increase in basis points reflects the $1.2 million settlement of a previously cancelled military contract.

SG&A expenses. SG&A expenses were $96.4 million, or 35.0% of net sales in 2007 compared to $89.6 million, or 34.0% of net sales for 2006. The net change primarily reflects increases in salaries and commissions of $3.1 million, bad debt and collection expense of $1.1 million, professional fees of $0.9 million, telecommunication expense of $0.7 million, vehicle expenses of $0.6 million, rents of $0.5 million, repairs and maintenance of $0.6 million, show expenses of $0.4 million and freight and handling of $0.3 million, offset by a decrease in benefits of $0.6 million and advertising expense of $1.5 million. SG&A expenses for 2006 include a gain on the sale of a company-owned property of $0.7 million and pension expense of $0.4 million relating to the pension curtailment relating to the freezing of the non-union pension plan in 2006.

Non-cash intangible impairment charges. As a result of our annual evaluation of intangible assets, under the terms and provisions of Statement of Financial Accounting Standard ("SFAS") No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), we recognized an impairment loss on the carrying value of goodwill in the amount of $24.9 million in 2007. Because the trading value of our shares indicated a level of equity market capitalization below our book value at the time of the annual impairment test, there was indication that our goodwill could be impaired. In performing the first step of the impairment test, the company valued the wholesale segment, for which all the goodwill applied, based on the guideline company method. The companies we selected are

22 ROCKY BRANDS, INC.

publicly traded wholesale competitors who manufacture shoes and apparel. While the selected companies may differ from the wholesale division in terms of the specific products they provide, they have similar financial risks and operating performance and reflect current economic conditions for the footwear and apparel industry in general. As a result of this analysis, it was determined that an indication of impairment did exist and the results of the second step of the impairment test resulted in an impairment of $24.9 million; or $23.5 million, net of tax benefit; to our goodwill. In 2006, we recognized an impairment loss on the carrying value of the Gates trademark in the amount of $0.8 million.

Interest expense. Interest expense was $11.6 million in 2007, compared to $11.6 million for the prior year. Interest expense includes $0.8 million and $0.4 million of deferred financing costs for 2007 and 2006 respectively. A reduction in average borrowings resulted in a decrease of $0.4 million in interest expense for 2007.

Income taxes. Income tax benefit for the year ended December 31, 2007 was $1.4 million, compared to an expense of $2.8 million for the same period a year ago. In 2007, we recognized a $1.3 million benefit relating to the non-cash intangible impairment charge and a $0.3 million benefit relating to a prior year state income tax refund.

LIQUIDITY AND CAPITAL RESOURCES

Overview

Our principal sources of liquidity have been our income from operations and borrowings under our credit facility and other indebtedness. In January 2005, we incurred additional indebtedness to fund our acquisition of EJ Footwear as described below.

Over the last several years our principal uses of cash have been for our acquisition of EJ Footwear as well as for working capital and capital expenditures to support our growth. Our working capital consists primarily of trade receivables and inventory, offset by accounts payable and accrued expenses. Our working capital fluctuates throughout the year as a result of our seasonal business cycle and business expansion and is generally lowest in the months of January through March of each year and highest during the months of May through October of each year. We typically utilize our revolving credit facility to fund our seasonal working capital requirements. As a result, balances on our revolving credit facility will fluctuate significantly throughout the year. Our working capital decreased to $124.6 million at December 31, 2008, compared to $135.3 million at the end of the prior year.

Our capital expenditures relate primarily to projects relating to our corporate offices, property, merchandising fixtures, molds and equipment associated with our manufacturing operations and for information technology. Capital expenditures were $4.8 million for 2008 and $5.8 million in 2007. Capital expenditures for 2009 are anticipated to be approximately $5.0 million.

In conjunction with the completion of our 2005 acquisition of EJ Footwear, we entered into agreements with GMAC Commercial Finance ("GMAC"), and with American Capital Financial Services, Inc., as agent, and American Capital Strategies, Ltd., as lender (collectively, "ACAS"), for credit facilities totaling $148 million. The credit facilities were used to fund the acquisition of EJ Footwear. Under the terms of the agreements, the interest rates and repayment terms were: (1) a five-year $100 million revolving credit facility with GMAC with an interest rate of LIBOR plus 2.5% or prime plus 1.0% at our option (weighted average of 8.31% at December 31, 2006); (2) an $18 million term loan with GMAC with an interest rate of LIBOR plus 3.25% or prime plus 1.75% at our option (weighted average of 9% at December 31, 2006), payable in equal quarterly installments over three years beginning in 2005; and (3) a $30 million term loan with ACAS with an interest rate of LIBOR plus 8.0%, payable in equal installments from 2008 through 2011. The total amount available on our revolving credit facility was subject to a borrowing base calculation based on various percentages of accounts receivable and inventory.

In June 2006, we amended our debt agreement with GMAC to include a new three-year, $15 million term loan with an interest rate of (1) LIBOR plus 3.25% or (2) prime plus 1.75%, payable over three years beginning in September 2006. The proceeds from the new term loan were used to pay down the $30 million ACAS term loan. In conjunction with this repayment, we amended the terms of the ACAS term loan, including lowering the interest rate to LIBOR plus 6.5%, adjusting the repayment schedule to reflect the lower loan balance payable in equal installments from August 2009 to January 2011, and modifying certain restrictive loan covenants.

ROCKY BRANDS, INC. 23

In November 2006, we amended the terms of the restrictive covenants through December 2007 pertaining to minimum EBITDA, senior and total leverage, and fixed charges. This amendment increased the interest rate on borrowings under the ACAS agreement to LIBOR plus 8.5%.

In May 2007, we entered into a Note Purchase Agreement, totaling $40 million, with Laminar Direct Capital L.P., Whitebox Hedged High Yield Partners, L.P. and GPC LIX L.L.C., and issued notes to them for $20 million, $17.5 million and $2.5 million, respectively, at an interest rate of 11.5% payable semi-annually over the five year term of the notes. Principal repayment is due at maturity in May 2012. The proceeds from these notes were used to pay down the GMAC Commercial Finance ("GMAC") term loans which totaled approximately $17.5 million and the $15 million American Capital Strategies, LTD ("ACAS") term loan. The balance of the proceeds, net of debt acquisition costs of approximately $1.5 million, was used to reduce the outstanding balance on the revolving credit facility. The Note Purchase Agreement is secured by a security interest in our assets and is subordinate to the security interest under the GMAC line of credit.

The total amount available on our revolving credit facility is subject to a borrowing base calculation based on various percentages of accounts receivable and inventory. As of December 31, 2008, we had $44.7 million in borrowings under this facility and total capacity of $64.4 million. Our credit facilities contain certain restrictive covenants, which among other things, require us to maintain certain minimum EBITDA and certain leverage and fixed charge coverage ratios. At December 31, 2008, we had no retained earnings available for dividends. As of December 31, 2008, we were in compliance with these restrictive covenants.

We believe that our existing credit facilities coupled with cash generated from operations will provide sufficient liquidity to fund our operations for at least the next twelve months. Our continued liquidity, however, is contingent upon future operating performance, cash flows and our ability to meet financial covenants under our credit facilities. Based on our expected borrowings for 2009, a hypothetical 100 basis point increase in short term interest rates would result, over the subsequent twelve-month period, in a reduction of approximately $0.7 million in income before income taxes and cash flows. The estimated reductions are based upon the current level of variable debt and assume no changes in the composition of that debt.

Cash Flows


         Cash Flow Summary                          2008        2007       2006
                                                          ($ in millions)

         Cash provided by (used in):
         Operating activities                      $  18.3     $ 16.5     $  0.7
         Investing activities                         (4.8 )     (5.7 )     (3.9 )
         Financing activities                        (15.7 )     (8.0 )      5.3

         Net change in cash and cash equivalents   $  (2.2 )   $  2.8     $  2.1

Operating Activities. Net cash provided by operating activities totaled $18.3 million for Fiscal 2008, compared to $16.5 million for Fiscal 2007, and $0.7 million for Fiscal 2006. The principal sources of net cash in 2008 included decreases of $5.1 million in accounts receivable, $5.1 million in inventory and $0.6 million in income taxes receivable offset by decreases of $2.1 million in accounts payable and $1.0 million in accrued and other liabilities. The principal sources of net cash in 2007 included decreases of $2.5 million in inventory and $2.9 million in income taxes receivable combined with increases of $2.1 million in accounts payable and $1.7 million in accrued and other liabilities. The principal uses of net cash in 2006 included a $2.2 million increase in accounts receivable-trade related to wholesale sales growth in the fourth quarter, a $2.6 million increase in inventories to support anticipated sales growth in the first quarter of 2007, a $2.3 million increase in income tax receivable and a $2.9 million decrease in accounts payable during 2006.

Investing Activities. Net cash used in investing activities was $4.8 million in Fiscal 2008 compared to $5.7 million in Fiscal 2007 and $3.9 million in Fiscal 2006. The principal use of cash in 2008 and 2007 was for the purchase of molds and equipment associated with our manufacturing operations and for information technology software and system upgrades. The principal use of cash in 2006 was capital expenditures relating to our corporate

24 ROCKY BRANDS, INC.

offices, property, merchandising fixtures, molds and equipment associated with our manufacturing operations and for information technology.

Financing Activities. Cash used by financing activities during 2008 was $15.7 million compared to $8.0 million in 2007 and cash provided by financing activities of $5.3 million in 2006. Proceeds and repayments of the revolving credit facility reflect daily cash disbursement and deposit activity. The Company's financing activities during 2008 included cash proceeds from the issuance of debt of $0.4 million and repayments on long term debt of $0.4 million. The Company's financing activities during 2007 included cash proceeds from the issuance of debt of $40 million and proceeds from the exercise of stock options and related tax benefits of $0.4 million and repayments on long term debt of $32.8 million. The Company's financing activities during 2006 included cash proceeds from the issuance of debt of $30.1 million and proceeds from the exercise of stock options and related tax benefits of $0.8 million, offset by debt repayments of $25.0 million and debt financing costs of $0.6 million.

Borrowings and External Sources of Funds

Our borrowings and external sources of funds were as follows at December 31,
2008 and 2007:


                                                   December 31
                                                 2008        2007
                                                 ($ in millions)

                   Revolving credit facility   $   44.8     $  60.5
                   Term loans                      40.0        40.0
                   Real estate obligations          2.7         3.0
                   Other                            0.3           -

                   Total debt                      87.8       103.5
                   Less current maturities          0.5         0.3

                   Net long-term debt          $   87.3     $ 103.2

Our real estate obligations were $2.7 million at December 31, 2008. The mortgage financing, completed in 2000, includes two of our facilities, with monthly payments of approximately $0.1 million through 2014.

We lease certain machinery, trucks, shoe centers, and manufacturing facilities under operating leases that generally provide for renewal options. Future . . .