RESULTS OF OPERATIONS

Universal Stainless & Alloy Products, Inc., headquartered in Bridgeville, Pa., manufactures and markets a broad line of semi-finished and finished specialty steels, including stainless steel, tool steel and certain other alloyed steels. The Company's products are sold to rerollers, forgers, service centers, OEMs and wire redrawers.

An analysis of the Company's operations is as follows:

                                                 2008                  2007                  2006
For the years ended December 31,            Amount       %        Amount       %        Amount       %
(dollars in thousands)
NET SALES
Stainless steel                            $ 172,222    73.2 %   $ 164,228    71.4 %   $ 151,633    74.4 %
Tool steel                                    39,046    16.6        28,119    12.2        23,389    11.5
High-strength low alloy steel                 11,936     5.1        25,892    11.3        16,467     8.1
High-temperature alloy steel                   7,931     3.4         9,317     4.0         9,837     4.8
Conversion services                            1,941     0.8         2,011     0.9         2,137     1.0
Other                                          2,030     0.9           369     0.2           410     0.2


Total net sales                              235,106   100.0       229,936   100.0       203,873   100.0
Total cost of products sold                  204,929    87.2       184,491    80.3       160,722    78.8
Selling and administrative expenses           11,085     4.7        12,038     5.2        10,792     5.3


Operating income                           $  19,092     8.1 %   $  33,407    14.5 %   $  32,359    15.9 %

Net sales by market segment are as follows:

                                         2008                  2007                  2006
For the years ended December 31,    Amount       %        Amount       %        Amount       %
(dollars in thousands)
Service centers                    $ 110,889    47.2 %   $ 119,736    52.1 %   $ 101,510    49.8 %
Forgers                               52,551    22.4        47,711    20.7        38,539    18.9
Rerollers                             41,660    17.7        35,006    15.2        33,273    16.3
Original equipment manufacturers      18,955     8.1        18,287     8.0        18,368     9.0
Wire redrawers                         7,129     3.0         6,843     3.0         9,660     4.8
Conversion services                    1,941     0.8         2,011     0.9         2,137     1.0
Miscellaneous                          1,981     0.8           342     0.1           386     0.2


Net sales                          $ 235,106   100.0 %   $ 229,936   100.0 %   $ 203,873   100.0 %


Tons shipped                          45,679                43,644                50,485

2008 Results as Compared to 2007: The increase in net sales in 2008 is primarily due to a 5% increase in tonnage shipped, partially offset by product mix changes and lower raw material surcharges. Shipments of tool steel plate products, petrochemical products and power generation products increased 22%, 15% and 16%, respectively, over 2007. These increases were mostly offset by a 17% decrease in aerospace product shipments. The reduced demand for aerospace products was partially due to the Boeing work stoppage during 2008 and by conservative service center purchasing practices in anticipation of lower surcharges due to falling commodity prices. The assessment of lower surcharges is primarily due to a decline in the average cost of nickel from $16.89 in 2007 to $9.58 in 2008 partially offset by increase costs of chrome and carbon scrap. In addition, miscellaneous sales benefitted from the $1.1 million sale of excess scrap in June 2008.

Cost of products sold, as a percentage of net sales, increased in 2008 as compared to 2007. This increase is primarily due to the shift in sales from service centers to forgers and rerollers, timing of raw material purchases and the assessment of the related surcharges, and operation cost increases. A significant portion of the raw material timing issue occurred during the 2008 fourth quarter. From September 2008 to December 2008, the average cost of nickel and chrome declined 46%, while molybdenum declined 70% and carbon scrap declined 56%. These declines resulted in the Company increasing its inventory reserves by $1.0 million in 2008. The significant decline in material costs will continue to negatively impact the Company's financial results during the first half of 2009. Operation costs were negatively impacted by a $1.6 million increase in natural gas costs, resulting from rate increases of approximately 25% at the Bridgeville facility, and a $2.8 million increase in labor costs. In addition, the Company expensed $834,000 related to the relocation of the Company's round bar finishing line from Bridgeville to Dunkirk in 2008.

Selling and administrative expenses decreased from $12.0 million, or 5.2% of net sales to $11.1 million, or 4.7% of net sales, primarily due to the 2007 settlement of a lawsuit between the Company and Teledyne Technologies Incorporated ("Teledyne"). Management continuously monitors its selling and administrative expenses in relation to net sales.

Interest expense and other financing costs decreased from $731,000 in 2007 to $105,000 in 2008. The decrease is primarily due to the December 2007 retirement of the $7.5 million outstanding balance on the Company's term loan with PNC Bank.

Other income, net increased to $911,000 in 2008 from $776,000 in 2007. This increase is primarily attributed to additional interest income of $91,000 earned from excess cash invested during 2008. In addition, the Company received funds under the CDSOA of $599,000 and $586,000 in 2008 and 2007, respectively.

The effective income tax rates for the years ended December 31, 2008 and 2007 were 29.9% and 32.7%, respectively. The change in the effective income tax rate is primarily due to the impact of the lower income level on the Company's permanent tax deductions and favorable adjustments to state income provisions.

2007 Results as Compared to 2006: The increase in net sales in 2007 reflects increased selling prices, primarily a result from the impact of higher raw material surcharges assessed and an increase in higher value-added products, partially offset by lower shipments overall. In 2007, shipments of petrochemical products, power generation products and aerospace products decreased 34%, 25% and 10%, respectively, compared with 2006. Raw material surcharges continued to escalate during 2007, led by an increase in the monthly average nickel prices from $15.68 in December 2006 to a high of $23.67 in May 2007. After May 2007, the monthly average nickel prices declined to $11.79 in December 2007. This decrease will reduce raw material surcharges assessed on future shipments if the average nickel price remains at lower levels.

Cost of products sold, as a percentage of net sales, increased in 2007 as compared to 2006. This increase is primarily due to higher raw material costs, which are generally reimbursed by the customer through raw material surcharges, and operation cost increases.

Selling and administrative expenses increased to $12.0 million, or 5.2% of net sales from $10.8 million, or 5.3% of net sales, primarily due to higher employment costs and the settlement of a lawsuit between the Company and Teledyne. The higher employments costs were primarily due to the addition of a corporate officer in 2007 and an increase in stock compensation expense from $273,000 in 2006 to $427,000 in 2007. This increase was partially offset by a $367,000 expense related to a software project the Company terminated, the establishment of a $193,000 reserve for an EPA violation which was settled in 2007 and $200,000 for certain commercial product-claim issues during 2006.

Interest expense and other financing costs decreased from $1.1 million in 2006 to $731,000 in 2007. The decrease is primarily due to a decline in the average balance of the revolving line of credit over the prior year, as well as recognizing lower interest expense associated with the funding of scheduled payments on the existing term debt of the Company. In December 2007, the Company retired the $7.5 million outstanding balance on its PNC Term Loan which was not scheduled to mature until June 30, 2011.

Other income, net increased from $522,000 in 2006 to $776,000 in 2007. This increase is primarily attributed to the receipt of funds under the CDSOA of $586,000 in 2007 in comparison to $463,000 in 2006. In addition, the Company recognized $178,000 of interest income from excess cash invested during the second half of 2007.

The effective income tax rates for the years ended December 31, 2007 and 2006 were 32.7% and 35.2%, respectively. The reduction in the effective income tax rate in 2007 reflects an increase in the Company's permanent tax deductions, related to an increase in the manufacturer's production activities deduction and the recognition of additional permanent tax deductions as a result of reconciling its 2006 federal and state tax returns filed during the period to the tax provision recognized for the year ended December 31, 2006. The 2007 rate also reflects a favorable shift in the apportionment of taxable income for state income tax purposes.

Business Segment Results

The Company is comprised of three operating locations and one corporate headquarters. For segment reporting, the Bridgeville and Titusville facilities have been aggregated into one reportable segment, Universal Stainless & Alloy Products, because of the management reporting structure in place. The Universal Stainless & Alloy Products manufacturing process involves melting, remelting, treating and hot and cold rolling of semi-finished and finished specialty steels. Dunkirk Specialty Steel's manufacturing process involves hot rolling and finishing specialty steel bar, rod and wire products.

UNIVERSAL STAINLESS & ALLOY PRODUCTS SEGMENT

An analysis of the segment's operations is as follows:



                                                 2008                  2007                  2006
For the years ended December 31,            Amount       %        Amount       %        Amount       %
(dollars in thousands)
NET SALES
Stainless steel                            $ 121,612    58.9 %   $ 108,535    53.6 %   $ 102,372    57.1 %
Tool steel                                    37,631    18.2        25,638    12.7        21,747    12.1
High-strength low alloy steel                  3,881     1.9        12,764     6.3         8,177     4.6
High-temperature alloy steel                   2,977     1.4         4,067     2.0         3,787     2.1
Conversion service                             1,278     0.6         1,405     0.7         1,530     0.9
Other                                          1,875     0.9           295     0.1           325     0.2


                                             169,254    81.9       152,704    75.4       137,938    77.0
Intersegment                                  37,384    18.1        49,858    24.6        41,232    23.0


Total net sales                              206,638   100.0       202,562   100.0       179,170   100.0
Material cost of sales                       114,930    55.6       106,456    52.6        85,298    47.6
Operation cost of sales                       68,415    33.1        67,286    33.2        66,806    37.3
Selling and administrative expenses            7,613     3.7         8,345     4.1         7,392     4.1


Operating income                           $  15,680     7.6 %   $  20,475    10.1 %   $  19,674    11.0 %

Net sales for the year ended December 31, 2008 increased $4.1 million, or 2%, in comparison to the year ended December 31, 2007 primarily due to a 2% increase in tonnage shipped and by product mix changes, partially offset by lower raw material surcharges discussed above. Shipments of tool steel plate products, petrochemical products and power generation products increased 20%, 17% and 15%, respectively, over 2007. These increases were mostly offset by a 20% decrease in aerospace product shipments. In addition, other sales benefitted from the $1.1 million sale of excess scrap in 2008. Operating income for the year ended December 31, 2008 decreased $4.8 million, primarily due the decline in aerospace sales, and the timing of raw material purchases that resulted in the material cost of sales increasing from 52.6% to 55.6%.

Net sales for the year ended December 31, 2007 increased by $23.4 million, or 13.1%, in comparison to the year ended December 31, 2006 primarily due to raw material surcharge increases, which offset increased material cost of sales of $21.2 million for the period. Shipments of petrochemical products, power generation products and aerospace products decreased 38%, 24% and 8%, respectively, compared with 2006. Operating income for the year ended December 31, 2007 increased by $801,000 primarily due to improved mix of products shipped and higher selling prices, partially offset by an increase in the material cost of sales from 47.6% to 52.6%

DUNKIRK SPECIALTY STEEL SEGMENT

An analysis of the segment's operations is as follows:



                                           2008                 2007                 2006
For the years ended December 31,      Amount      %        Amount      %        Amount      %
(dollars in thousands)
NET SALES
Stainless steel                      $ 50,610    72.8 %   $ 55,693    68.2 %   $ 49,261    70.1 %
High-strength low alloy steel           8,055    11.6       13,128    16.1        8,290    11.8
High-temperature alloy steel            4,954     7.1        5,250     6.4        6,050     8.6
Tool steel                              1,415     2.0        2,481     3.0        1,642     2.3
Conversion services                       663     1.0          606     0.7          607     0.9
Other                                     155     0.2           74     0.1           85     0.1


                                       65,852    94.7       77,232    94.5       65,935    93.8
Intersegment                            3,712     5.3        4,493     5.5        4,320     6.2


Total net sales                        69,564   100.0       81,725   100.0       70,255   100.0
Material cost of sales                 44,215    63.6       47,905    58.6       38,705    55.1
Operation cost of sales                18,465    26.5       17,404    21.3       16,678    23.8
Selling and administrative expense      3,472     5.0        3,693     4.5        3,400     4.8


Operating income                     $  3,412     4.9 %   $ 12,723    15.6 %   $ 11,472    16.3 %

Net sales for the year ended December 31, 2008 decreased $12.2 million, or 15%, in comparison to the year ended December 31, 2007 primarily due to a 10% decrease in shipments as well as the impact of lower raw material surcharges. Shipments of aerospace products and commodity grade products decreased 23% and 24%, respectively, which were partially offset by a 33% increase in petrochemical products. Operating income for the year ended December 31, 2008 decreased $9.3 million primarily due to the decline in aerospace sales and the timing of raw material purchases that resulted in the material cost of sales increasing from 58.6% to 63.6% and higher operation costs due to $834,000 of costs related to relocation of the round bar finishing line from Bridgeville to Dunkirk.

Net sales for the year ended December 31, 2007 for this segment increased by $11.5 million, or 16.3%, in comparison to the year ended December 31, 2006 primarily due to raw material surcharge increases, which more than offset increased material cost of sales of $9.2 and lower shipments for the period. Shipments of petrochemical products decreased 31%, which were mostly offset by a 49% increase in commodity grade products. Operating income increased by $1.3 million primarily due to the impact from rising nickel prices, partially offset by higher operating costs resulting from the favorable shift in product mix. For this segment, raw material surcharges are primarily assessed at the time of shipment while the material cost of those shipments is determined at the time of order entry. Based upon the timing of surcharges, the Company estimates Dunkirk generated an operating income benefit of $3.9 million and $1.5 million for the years ended December 31, 2007 and 2006, respectively.

Liquidity and Capital Resources

The Company generated cash from operations of $17.7 million, $33.6 million and $6.3 million in the years ended December 31, 2008, 2007 and 2006, respectively. Cash received from sales of $228.7 million, $235.9 million and $198.7 million for the years ended December 31, 2008, 2007 and 2006, respectively, represent the primary source of cash from operations. An analysis of the primary uses of cash is as follows:

                                         2008                  2007                  2006
For the years ended December 31,    Amount       %        Amount       %        Amount       %
(dollars in thousands)
Raw material purchases             $ 111,212    52.7 %   $ 100,504    49.7 %   $  92,117    47.9 %
Employment costs                      38,380    18.2        36,103    17.8        36,094    18.8
Utilities                             19,915     9.4        18,657     9.2        18,528     9.6
Other                                 41,547    19.7        47,057    23.3        45,700    23.7


Total uses of cash                 $ 211,054   100.0 %   $ 202,321   100.0 %   $ 192,439   100.0 %

Cash used for raw material purchases increased in 2008 in comparison to 2007 and 2006 primarily due to increased production and higher transaction prices. The Company continuously monitors market price fluctuations of its key raw materials. The following table reflects the average market values per pound for key raw materials for selected months during the last three-year period.

                        December     June      December     June      December     June
                          2008       2008        2007       2007        2006       2006
        Nickel         $     4.39   $ 10.23   $    11.79   $ 18.92   $    15.68   $  9.41
        Chrome         $     0.96   $  2.19   $     1.66   $  1.27   $     0.64   $  0.64
        Molybdenum     $     9.85   $ 33.22   $    32.54   $ 32.65   $    24.87   $ 25.28
        Carbon Scrap   $     0.11   $  0.34   $     0.14   $  0.13   $     0.10   $  0.15

The monthly average price of nickel increased from $9.41 in June 2006 to $15.68 in December 2006 to a high of $23.67 in May 2007. The significant rise was believed to be due to increased demand from foreign (primarily Chinese) and domestic sources coupled with supply volatility which caused raw material market values to rise significantly between June 2006 and May 2007. The sharp increase had a material negative impact on the operating margins of the Universal Stainless & Alloy Product Segment and a material positive impact on the operating margins of the Dunkirk Specialty Steel Segment. The monthly average nickel prices declined from its record level in May 2007 to $12.54 in August 2007 and to $11.79 in December 2007. The sharp decline resulted from decreased demand for nickel while supplies continued to increase during the second half of 2007. The sharp decline also had a material negative impact on the operating margins of both business segments through the recognition of increased inventory reserves. The reserve increased from 2.3% of the consolidated inventory balance at December 31, 2006 to 3.3% at December 31, 2007.

During the first nine months of 2008, the monthly average prices of nickel and molybdenum remained stable while chrome and carbon scrap experienced significant increases. From September 2008 to December 2008, the average cost of nickel and chrome declined 46%, while molybdenum declined 70% and carbon scrap declined 56%. The sharp decline also had a material negative impact on the operating margins of both business segments through the recognition of increased inventory reserves. The reserve increased from 3.3% of the consolidated inventory balance at December 31, 2007 to 5.1% at December 31, 2008. While the material surcharge mechanism is designed to offset modest fluctuations in raw material prices, it cannot immediately absorb significant spikes in raw material prices. There can be no assurance that the raw material surcharge mechanism will completely offset immediate changes in the Company's raw material costs. A material decline in raw material prices within a short period of time could have a material adverse effect on the financial results of the Company.

Increases in both employment and utility costs are primarily due to higher rates at comparable production volumes. The increased employment costs primarily relate to higher wages partially offset by decreased payouts under the Company's profit-sharing plans. Increased utility costs are related to a 27% increase in average natural gas rates, principally at the Bridgeville facility.

Other uses of cash decreased between 2008 and 2007 and increased between 2006 and 2007. 2007 included payments made to settle the Teledyne lawsuit and EPA violation as well as incurring increased maintenance expenses. In addition, payments for federal and state income taxes, net of refunds received, decreased from $11.8 million in 2006 to $11.3 million and $6.4 million in 2007 and 2008, respectively.

At December 31, 2008, working capital approximated $94.8 million, as compared to $85.9 million at December 31, 2007. The increase is attributable to a $4.2 million increase in cash, a $2.3 million increase in prepaid and current deferred taxes and a $2.6 million decrease in accrued employment and other accrued liabilities. The increased cash balance is primarily resulting from the net income generated during the year and a $637,000 decrease in managed working capital, which is defined as accounts receivable and inventory less accounts payable and outstanding checks in excess of bank balances. The managed working capital days sales outstanding decreased from 121 days at December 31, 2007 to 117 days at December 31, 2008.

Capital Expenditures and Investments. The Company's capital expenditures were approximately $12.9 million and $8.8 million in 2008 and 2007, respectively. The 2008 expenditures were primarily made to complete the installation of the high-temperature annealing facility in Dunkirk, the addition of annealing and finishing equipment in Bridgeville and upgrades to the round bar finishing line relocated from Bridgeville to Dunkirk during the year.

On January 29, 2009, the Company announced that it will invest $13 million in its Bridgeville melt shop. The investment will include major upgrades in equipment, automation and plant layout designed to: cut production cycle times and customer lead times; improve on-time delivery performance; increase material yields; reduce operating costs and enhance working capital management. The equipment and infrastructure spending will be completed by the end of 2009, and the automation investment will be completed by the middle of 2010. The project is expected to begin producing cost savings in the 2009 fourth quarter. Once fully implemented, the investment is expected to yield cost savings of more than $7.5 million per year. The Company expects to fund substantially all of the investment with a bank term loan. Capital expenditures are expected to approximate $16.0 million in 2009, of which $11.0 million is specifically for the Bridgeville melt shop.

Capital Resources Including Off-Balance Sheet Arrangements. The Company does not maintain off-balance sheet arrangements nor does it participate in non-exchange traded contracts requiring fair value accounting treatment or material related-party transaction arrangements.

PNC Credit Agreement. The Company is party to a credit agreement with PNC Bank (the "PNC Credit Agreement"), which establishes a $15.0 million revolving credit facility ("PNC Line") with a term expiring on June 30, 2009. The PNC Line is collateralized by substantially all of the Company's assets. At December 31, 2008, the Company had its $15.0 million revolving line of credit with PNC Bank available for borrowings.

The Company pays a commitment fee on the unused portion of the PNC Line of 0.25%, provided it maintains certain financial ratios. Interest on borrowings under the PNC Line is based on short-term market rates, which may be further adjusted, based upon the Company maintaining certain financial ratios. The Company is required to be in compliance with three financial covenants: a minimum leverage ratio of 3.0:1.0 or less; a minimum debt service ratio of 2.0:1.0 or greater; and a minimum tangible net worth of $87.3 million as of December 31, 2008. The Company was in compliance with all financial ratios and restrictive covenants it is required to maintain under the credit agreement at December 31, 2008.

On February 27, 2009, the Company entered into a new unsecured credit agreement providing for a $12.0 million term loan scheduled to mature on February 28, 2014 and a $15.0 million revolving credit facility with a term expiring on June 30, 2012. The Company also executed an interest rate swap to convert the LIBOR floating rate term loan to a fixed interest rate for the life of the loan. The Company believes it will maintain compliance with the financial covenants in effect throughout 2009.

Government Financing Programs. The Company maintains two loan agreements with the Commonwealth of Pennsylvania's Department of Commerce, originally aggregating $600,000. A $200,000 15-year loan bears interest at 5% per annum with the term ending in 2011, and a $400,000 20-year loan bears interest at 6% per annum with the term ending in 2016. In 2002, Dunkirk Specialty Steel issued two ten-year, 5% interest-bearing notes payable to the New York Job Development Authority for the combined amount of $3.0 million. As of December 31, 2008, the total principal balance of all government-financed debt instruments is $1.4 million.

Stock-Based Financing Activity. The Company issued 72,785 and 90,751 shares of its Common Stock for the years ended December 31, 2008 and 2007, respectively, through its two stock-based compensation plans. In 2008, certain employees, officers and members of the Company's Board of Directors exercised 64,850 stock options issued under the Stock Incentive Plan for $625,000 plus related tax benefits of $529,000. In 2007, certain employees, officers and members of the Company's Board of Directors exercised 84,750 stock options issued under the Stock Incentive Plan for $897,000 plus related tax benefits of $958,000. The remaining shares were issued to employees participating in the Employee Stock Purchase Plan.

In October 1998, the Company initiated a stock repurchase program to repurchase up to 315,000 shares of its outstanding Common Stock in open market transactions at market prices. The Company repurchased no shares in 2008 and 326 shares in 2007. The Company is authorized to repurchase 44,205 remaining shares of Common Stock under this program as of December 31, 2008.

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