Introduction

Deltic Timber Corporation ("Deltic" or the "Company") is a natural resources company engaged primarily in the growing and harvesting of timber and the manufacture and marketing of lumber. Deltic owns approximately 438,600 acres of timberland, primarily in Arkansas and north Louisiana. The Company's sawmill operations are located at Ola in central Arkansas (the "Ola Mill") and at Waldo in south Arkansas (the "Waldo Mill"). In addition to its timber and lumber operations, the Company is engaged in real estate development in central Arkansas. The Company also holds a 50 percent interest in Del-Tin Fiber L.L.C. ("Del-Tin Fiber"), a joint venture to manufacture and market medium density fiberboard ("MDF"). Deltic is a calendar-year company for both financial and income tax reporting.

The Company is organized into four segments: (1) Woodlands, which manages all aspects of the timberlands including harvesting and sale of timber, timberland sales and acquisitions, oil and gas mineral revenues, and hunting land leases;
(2) Mills, which consists of Deltic's two sawmills that manufacture a variety of softwood lumber products; (3) Real Estate, which includes the Company's real estate developments and a related country club operation; and (4) Corporate, which consists of executive management, accounting, information systems, human resources, purchasing, treasury, income tax, and legal staff functions that provide support services to the operating business units. (The Company currently does not allocate the cost of maintaining these support functions to its operating units.)

The Company's timberlands consist primarily of Southern Pine, known in the industry as a type of "softwood". Deltic considers its timberlands to be the Company's most valuable asset and the harvest of stumpage to be its most significant and consistent source of income; accordingly, Deltic actively manages its timberlands to increase productivity and maximize the long-term value of these timber assets. The Company harvests timber from the timberlands in accordance with its harvest plans and sells such timber in the domestic market or converts it to lumber in its sawmills. Stumpage supplied to the Company's sawmills is transferred at prices that approximate market in its operating regions. Deltic derives additional revenues from its timberlands in the form of hunting leases, mineral lease bonuses, mineral royalties, and land easements. In late 1996, the Company implemented a timberland acquisition program to enable it, when desired, to increase harvest levels, while expanding its timber inventory. The Company continues to focus its acquisition program on timberland within its current operating area. Additionally, as market conditions allow, Deltic will sell tracts of land where market values exceed that of the tracts' worth as a timber growing platform. During 2008, and especially in the fourth quarter, Deltic was able to significantly increase its sales of non-strategic recreational-use hardwood bottomland. The Company looks to continue these sales in coming years as it seeks to replace the non-strategic acres with strategic southern yellow pine sawtimber producing acres.

The Company's two sawmills employ modern technology in order to improve efficiency, reduce labor costs, maximize utilization of the timber resource, and maintain high standards for production quality, with safety being one of its highest priorities. In addition, each mill is strategically located near significant portions of the Company's timberlands. The mills produce a variety of lumber products, including dimension lumber, timbers, and boards. These lumber products are sold primarily to wholesale distributors, lumber treaters, and truss manufacturers in the Southern and mid-western United States and are used mainly in residential construction, roof trusses, and laminated beams.

The Company's real estate operations were started in 1985 to maximize the value of former timberland strategically located in the growth corridor of west Little Rock, Arkansas. Since that time, the Company has been developing Chenal Valley, a premier planned community consisting of 4,700 acres of residential and commercial properties. The property is being developed in stages, and real estate sales to date have consisted primarily of residential lots, which are sold to builders or individuals, and commercial sites. In addition to Chenal Valley, Deltic has developed Chenal Downs, a 400-acre development located just outside Chenal Valley, and is developing Red Oak Ridge, an 800-acre development in Hot Springs, Arkansas.

The Del-Tin Fiber plant is located near El Dorado, Arkansas. Construction of the plant was completed, and initial production began in 1998. The plant is designed to have a rated annual production capacity of 150 million square feet ("MMSF") of 3/4 inch MDF, making it one of the largest plants of its type in North America. MDF, which is used primarily in the furniture, store fixture, laminate flooring, and molding industries, is manufactured from sawmill residuals such as chips, shavings, and sawdust, pressed and held together by an adhesive bond.

Executive Overview

Deltic is primarily a wood products producer operating in a commodity-based business environment, with a major diversification in real estate development. This environment is affected by a number of factors, including general economic conditions, interest rates, availability and costs of credit, imports, foreign exchange rates, housing starts, new and existing home inventories, home foreclosures, residential repair and remodeling, commercial construction, industry capacity and production levels, the availability of raw materials, cost of fuel, and weather conditions. Given its relative size and the nature of most commodity markets, the Company has little or no influence over the market's pricing levels for its wood products. Accordingly, the Company will continually seek to reduce controllable costs and expenses from its manufacturing processes. Sales of real estate are affected by general economic conditions, interest rates, home foreclosures, new and existing home inventories, and the availability and cost of credit; specifically as such factors are manifested in the Company's operating area of central Arkansas.

Significant accomplishments for the Company's operating segments during the year of 2008 include: (1) the Woodlands segment capitalized on the strong demand for pulpwood and achieved a 15 percent higher average sales price per ton for pine pulpwood and a 22 percent higher average sales price per ton for hardwood pulpwood; (2) the sale of approximately 5,100 acres of non-strategic, recreational-use, hardwood bottomland and the utilization of the proceeds to enhance Deltic's core timberland holdings; (3) the Mills segment achieved positive cash flow in the current year due to continued improvements in operating efficiencies and the benefits from reduced unit manufacturing cost, primarily through lower log supply cost; and (4) the Real Estate segment's Red Oak Ridge development reported its second best level of annual residential sales activity.

The Woodlands segment maintained its position as the Company's established core operation. The 2008 pine sawtimber harvest volume increased slightly to 580,000 tons when compared to 2007's volume of 576,000 tons, but the average sales price decreased 18 percent to $33 per ton. Despite the decline in the average pine sawtimber sales price, the segment's 2008 overall operating income increased by $3 million, or 12 percent. The improvement was due to increased sales of non-strategic hardwood bottomland; higher revenues from hunting and oil and gas lease rentals and royalties, and easements and rights-of-way; and increased other revenues resulting from the natural gas drilling activity occurring on the Company's fee lands, including damages for acreage taken out of timber production for wellsite locations, and fees for allowing seismic testing. Since Deltic expects the markets for residential housing and lumber to remain depressed through 2009, prices received for pine sawtimber harvested for this period are not expected to improve from current levels.

While lumber production levels within a region can influence pine sawtimber prices, lumber prices typically do not. Over the long-term, there is a fundamental correlation between the level of lumber prices and pine sawtimber prices. However, in the short-term, the geographical size differential between the lumber and pine sawtimber markets results in the two acting somewhat independently of each other. Pine sawtimber markets operate primarily within local or regional areas with sales being mainly to sawmills. These mills are subject to a relatively fixed level of demand for raw materials that is driven by the facilities' required production levels. Changes in pricing levels within the lumber market typically do not have an immediate effect on the existing demand for raw materials in the short-term; therefore, the resulting impact on pine sawtimber prices will usually lag in timing and be less volatile than the market for lumber. This trend would typically also be true in the short-term during times of a depressed lumber market. Ultimately, the Company's ability to sell pine sawtimber at acceptable prices in the future will be dependent upon the size or existence of markets for manufactured lumber and other wood products. The Company continues to manage the harvest level of its forests on a sustainable-yield basis.

Timberland designated as higher and better use consists of tracts with market values that exceed the land's worth as a timber growing platform. Deltic's approximately 57,000-acre timberland holdings in the expanding westward growth corridor of Little Rock, Arkansas, is an example of such land. Non-strategic timberland is composed primarily of hardwood bottomland acreage not suitable for the growing of pine timber for which the demand by recreational users for hunting, etc. has increased in recent years, tracts too small to allow efficient timber management, those geographically isolated from other Company fee lands, or any other acreage not deemed strategic to Deltic's operations or growth. Approximately 5,100 acres of non-strategic hardwood bottomland was sold during 2008. Additional sales of these acres will continue in 2009 and beyond as market conditions allow. The sales of the non-strategic hardwood bottomland were accomplished in conjunction with acquiring 5,000 acres of pine timberland. By utilizing the tax-deferring, like-kind exchange method, Deltic was able to minimize the tax consequences and invested or will invest timberland sale proceeds into pine timberland.

In addition to pine and hardwood timber sales, the Company receives additional values of land ownership, such as revenues from hunting leases, mineral lease rentals and royalties, and land easements, that have historically provided additional income to Deltic's Woodlands segment. Recent advances in technology and increased pricing levels have resulted in the economic viability of expanded natural gas exploration within the state of Arkansas. One current area of activity, known as the "Fayetteville Shale Play", is an unconventional natural gas reservoir, ranging in depth from 1,300 feet to 6,500 feet, and is spread across multiple Arkansas counties. Deltic has leased approximately 32,100 acres in this area to various exploration enterprises and received applicable lease rental payments, with the possibility of future royalty income should production be established. The Company continues to evaluate additional leasing requests within the currently defined boundary of the Fayetteville Shale Play, although future leasing will probably not be significant within this boundary. Production has begun in a few areas and Deltic received over $1.3 million in royalty payments from this area in 2008. The ultimate benefit to Deltic from these mineral leases remains speculative and unknown to the Company and is contingent on the level of natural gas prices and the successful extraction and sale of natural gas from the area.

For the Mills segment, the status of the lumber market and the resulting pricing for the Company's commodity softwood lumber products will continue to impact operating strategies and financial results. By the end of 2008, the seasonally adjusted annual rate of housing starts had reached its lowest level in 50 years. Factors affecting this decline were the U.S. economic recession, falling home prices, stricter mortgage lending practices brought about by sub-prime loan failures, construction loan delinquencies that are causing lenders to tighten credit for new developments, increased home foreclosure rates, and increased new and existing home inventory levels. The segment's 2008 average lumber sales price declined six percent when compared to 2007. Lumber sales volume increased 17 percent compared to 2007 due mainly to the three-month suspension of production at the Waldo Mill while undergoing fire related repairs in 2007 combined with improved hourly production rates throughout 2008. As with any commodity market, the Company expects the historical volatility of lumber prices to continue in the future. Other factors impacting future lumber prices include the level of production capacity utilized, inventory levels, and the level of repair and remodeling activity. Many industry analysts are projecting that the market for new housing will not improve during 2009. That, along with excess production capacity and high inventory levels, could have a negative impact on lumber sales prices. As in the past, Deltic will make timely management decisions to take advantage of supply and demand situations.

Since commodity-based markets rarely benefit from real price growth, after inflation, Deltic has concentrated management's attention, in regard to its manufacturing operations, on improving sales realizations through product and customer mix enhancements and improving production efficiencies and the cost structure at its lumber mills. The Company has achieved improved production efficiencies at both of its sawmills, largely as a result of an intensive capital upgrade program over the past four years. This improvement has been more significant at the Ola Mill, as the upgrade program there has focused on maximizing hourly productivity rates with the smaller log size available as raw material for the mill. In 2008, Deltic installed a new log bucking system at this sawmill, improving the log-to-lumber yield ratio there. Deltic will continue to seek opportunities that will enable it to increase operating efficiencies, while reducing controllable cost.

Sales activity levels for the Company's real estate developments have been affected by economic conditions that influence the level of housing starts in the central Arkansas region, including general economic conditions, new and existing housing inventories, home foreclosure rates, and stricter lending requirements for homebuyers and builders. These conditions contributed to a decrease in the overall demand for residential lots in Chenal Valley, the largest of the Company's three active developments, as evidenced by Chenal Valley's 25 residential lot closings. This was a reduction of 48 lots from 2007's level of 73 residential lot closings. As of December 31, 2008, there were 174 developed lots in Chenal Valley uncommitted. The Company opened 32 new lots during 2008 to maintain a specific mix of lot offerings. Ultimately, the impact to Deltic's overall real estate business model from fluctuations, both positive and negative, in the annual volumes of residential lot sales is deemed minimal in light of the Company's continued focus on the long-term financial returns from the ultimate build-out of the Chenal Valley development. In Deltic's other two active developments, Red Oak Ridge had sales of 12 lots and Chenal Downs had two lot sales. Deltic has 61 developed lots in Red Oak Ridge and 13 in Chenal Downs uncommitted as of year-end 2008. While Chenal Downs is fully developed, Deltic plans to develop additional lots within Red Oak Ridge as demanded by market conditions. Actual future annual lot development levels will be dependent upon the demand for the Company's residential lots.

The Real Estate segment's average sales price for residential lots sold in 2008 was $78,000, which was a decrease of 13 percent when compared to 2007, due to the current-year sales mix. The Company has not nor does it plan to reduce the sales price of its residential lots. Deltic's lot development plans provide for a mix of lot offerings that represent all real estate market segments for a planned community. Neighborhoods adjoining Chenal Country Club's second 18-hole, championship golf course designed by Robert Trent Jones, Jr. represent the highest priced market segment in the Chenal Valley development. Average prices for non-golf course lots are lower and vary between neighborhoods depending on other factors such as lot size and location. The mix of lot offerings for any given year will be driven by lot inventory and expected demand.

Commercial real estate sales activity is by nature less predictable than residential activity. With the number of residents and past growth in West Little Rock, specifically Chenal Valley, the Company continues to receive interest in multi-family housing sites and commercial real estate in and around the vicinity of "The Promenade at Chenal," an upscale shopping center within Chenal Valley that opened in 2008, though economic uncertainties and stricter lending requirements has had an impact on commercial acreage closings. There were no sales of commercial real estate acreage in 2008 compared to 26 acres in 2007. Future pricing trends for commercial real estate sales are difficult to predict and are influenced by multiple factors, which include intended use of the site, and property location and access. No commercial acreage is included in the Chenal Downs development. Red Oak Ridge includes a small amount of commercial property, depending on actual final land usages. The Company will begin to develop and offer commercial sites as this development's population density increases. There were no sales of undeveloped acreage during 2008, while the Company sold approximately 680 acres in 2007.

Operating results for Del-Tin Fiber are affected primarily by the overall MDF market and plant operating performance. Del-Tin was able to operate at a profitable level during 2008 by passing through the higher raw material costs, in the form of price increases, and improved production efficiencies. The demand for thin board, used in store fixtures and laminate flooring, remained strong through the first nine months of 2008, but with the reduction in housing starts along with the current recession, the market began weakening in the fourth quarter. Del-Tin has continued to maximize earnings potential of the thin board production by developing a strategy to grow market share for this product.

Operationally, Del-Tin Fiber maintained its uptime percentage and premium grade production levels. The facility was able to push through increased raw material costs to its customers; however, Del-Tin will continue to be affected by decreased supply and increased costs for wood fiber used in the manufacturing process. The wood fiber supply and cost issues are due largely to a shortage of softwood residual wood chips as area lumber mills curtailed production in reaction to lumber market conditions. With reduced mill production levels, the volume of residual by-product chips produced decreases proportionally. During 2007 and 2008, the resin glue utilized to bond MDF in the manufacturing process increased significantly in price due to substantial price increases in methanol, which is a raw material used in the manufacture of the resin glue. Due to decreases in the cost of methanol in late 2008 and curtailments by wood product manufacturing facilities that use the resin glue, there is currently an increased supply of resin glue. With this reduction in cost to manufacture resin glue and increased supply, Del-Tin's cost for resin is starting to decrease.

For 2009, wood fiber cost is expected to remain near current levels, while resin glue prices are projected to decrease. Manufacturers have been able to recover a portion of their raw materials cost through price increases, though it may slip some with the decreased cost for resin glue. Del-Tin Fiber's efforts will be concentrated on further improvements in its hourly productivity level and other plant operating efficiencies, while making additional reductions in the plant's manufacturing cost structure where possible.

On May 22, 2008, the Food, Conservation, and Energy Act of 2008 was enacted. Within this Act was the TREE Act, which included a provision for a reduced federal tax rate on qualified timber gains for one year. Gains on qualified timber sales beginning May 23, 2008, through May 22, 2009, will be taxed at a 15 percent alternate tax rate for corporations. Efforts are ongoing to extend this provision for another year or to make this legislation permanent, but law changes are not certain until passed by both houses of Congress and signed into law by the President. Due to the lack of taxable income for Deltic in 2008, the effects of this act were inconsequential for the year, but could provide a lower effective tax rate in 2009. Deltic has benefited from various discrete tax items in 2008 that combined to provide a lower effective tax rate.

Significant Events

On October 29, 2008, Deltic delivered a notice of voluntary prepayment to all participants in the $30 million Note Purchase Agreement dated December 20, 2002, as amended. In the agreement, the Company requested that the Note Purchasers waive any prepayment penalty or other requirement to pay any "make whole" fees. All participants except Modern Woodmen of America accepted the terms on October 30, 2008. As a result, $25 million of the $30 million notes were paid in full on November 4, 2008, and cancelled.

On June 30, 2008, the Company entered into an agreement with Metropolitan Life and a group of other domestic insurance companies to amend the existing note agreement of the $30,000,000 private placement senior notes. The amendment changed the minimum fixed charge coverage and other ratios applicable to the Company's business to be the same as those contained in the Company's Series A Senior Notes placed with the American AgCredit PCA.

On August 7, 2007, Deltic amended its revolving credit agreement with SunTrust Bank and other banks whereby the unsecured and committed revolving credit facility was increased from $260 million to $300 million. An option to request an increase in the amount of aggregate revolving commitments from $300 million to $350 million was reinstated. The agreement, which was set to expire on September 9, 2010, was extended to September 9, 2012. The funds available through this agreement will enable the Company to take full advantage of value-added growth opportunities as they present themselves.

On March 30, 2007, the Company entered into an agreement with American AgCredit PCA to amend and restate the terms of the Company's series A Senior Notes ("Notes") in the principal amount of $40 million. Under the new agreement, the Notes are due and payable December 18, 2016. Prior to the agreement, the Notes would have become due on December 18, 2008, pursuant to a Note Purchase Agreement effective December 19, 1998. The interest rate for the Notes remains the same as under the 1998 agreement (6.66 percent) through December 18, 2008, and after that date, the rate was reduced to 6.10 percent for the balance of the term of the Notes.

On April 6, 2004, RED Development LLC announced that it planned to purchase from Deltic a site within Chenal Valley for "The Promenade at Chenal," an upscale lifestyle shopping center. After extensive efforts by both parties, the sale of 38 acres of commercial property was closed on September 27, 2006. Construction began on the shopping center in 2007 and was completed in May 2008. The development of "The Promenade at Chenal" is strategic to Chenal Valley in that it is expected to further increase interest in the Company's additional 135 acres of commercially-zoned property adjacent to the site.

From the time production began at Del-Tin Fiber in 1998 until the fourth quarter of 2003, both operating and financial performance was below the expectations established at the time that the decision to construct the plant was made. As a result, on April 25, 2002, Deltic announced that Banc One Capital Markets, Inc. had been retained as financial advisor to assist in the evaluation of strategic alternatives for the Company's investment in Del-Tin Fiber. Subsequently, Deltic's management and Board of Directors completed its review of these strategic alternatives and announced the Company intended to exit the MDF business upon the earliest, reasonable opportunity provided by the market. As a result of this decision, the Company's evaluation of possible impairment of the carrying value of its investment in the joint-venture was based primarily upon the estimated cash flows from a possible sale of the Company's interest during 2003 and resulted in a determination that the Company's investment was impaired as of December 31, 2002. The investment was written off, to zero, and the write-off amounted to $18.7 million before income taxes.

Due to the Company's commitment to fund its share of any of the facility's operating working capital needs until the facility was able to consistently generate sufficient funds to meet its cash requirements or Deltic's ownership was sold, the Company recognized equity in Del-Tin Fiber equal to the extent of these advances during 2003. For the year of 2003, such advances approximated the Company's equity share of losses for the plant. Accordingly, the investment in Del-Tin Fiber at December 31, 2003 was zero. The Company also continued to utilize its management resources to work with Del-Tin's management and the joint-venture partner to improve operating performance at the plant. As a result of these improvements, on December 11, 2003, Deltic's Board of Directors revised its intent regarding the Company's investment in Del-Tin Fiber and ceased efforts to sell the Company's interest in the joint venture, while continuing to focus on improving operating and financial results of the plant. Due to this decision, the 2003 evaluation of fair value for the investment was based primarily upon the future net cash flows from Del-Tin Fiber's operations over the remaining life of the plant. In 2004, the Company began recording its equity share of the operating results of the joint venture.

Results of Operations

In the following tables, Deltic's net sales and results of operations are presented for the three years ended December 31, 2008. Explanations of significant variances and additional analyses for the Company's consolidated and segmental operations follow the tables.

                                                        Years Ended December 31,
   (Millions of dollars, except per share amounts)     2008          2007      2006
   Net sales
   Woodlands                                         $    46.0        39.6      37.6
   Mills                                                  91.4        79.3     101.9
   Real Estate                                            11.4        30.3      35.5
   Eliminations                                          (19.3 )     (20.9 )   (21.9 )

   Net sales                                         $   129.5       128.3     153.1


   Operating income
. . .