UNIVERSAL STAINLESS & ALLOY PRODUCTS INC - Annual Report: 2006 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

For the Fiscal Year Ended December 31, 2006

OR

Commission File Number 000-25032

UNIVERSAL STAINLESS & ALLOY PRODUCTS, INC.

(Exact name of Registrant as specified in its charter)

Securities registered pursuant to Section 12(b) of the Act: [None]

Securities registered pursuant to Section 12(g) of the Act:

Title of Class

Common Stock, par value $.001 per share

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definitions of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One)

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

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

The aggregate market value of the voting stock held by non-affiliates of the registrant on June 30, 2006, based on the closing price of $29.27 per share on that date, was $36,310,079. For the purposes of this disclosure only, the registrant has assumed that its directors, executive officers, and beneficial owners of 5% or more of the registrant’s Common Stock are the affiliates of the registrant. The registrant has made no determination that such persons are “affiliates” within the meaning of Rule 405 under the Securities Act of 1933.

As of February 28, 2007, there were 6,636,074 shares of the Registrant’s Common Stock issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Part III of this Form 10-K incorporates by reference portions of the Company’s definitive Proxy Statement for the Annual Meeting of Stockholders scheduled to be held May 15, 2007.

FINANCIAL REVIEW

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PART I

GENERAL

Universal Stainless & Alloy Products, Inc. and its wholly-owned subsidiaries (the “Company”), which was incorporated in 1994, manufactures and markets semi-finished and finished specialty steel products, including stainless steel, tool steel and certain other alloyed steels. The Company’s manufacturing process involves melting, remelting, heat treating, hot and cold rolling, machining and cold drawing of semi-finished and finished specialty steels. The Company’s products are sold to rerollers, forgers, service centers, original equipment manufacturers and wire redrawers. The Company’s customers further process its products for use in a variety of industries, including the aerospace, power generation, petrochemical and heavy equipment manufacturing industries. The Company also performs conversion services on materials supplied by customers that lack certain of the Company’s production facilities or that are subject to their own capacity constraints.

The Company comprises 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. Dunkirk Specialty Steel represents the second reportable segment.

The Company’s products are manufactured in a wide variety of grades, widths and gauges in response to customer specifications. At its Bridgeville facility, the Company produces specialty steel products in the form of long products (ingots, blooms, billets and bars) and flat rolled products (slabs and plates). Certain grades requiring vacuum-arc remelting (“VAR”) may be transported to the Titusville facility to complete that process and then be transported back to the Bridgeville facility for further processing. The semi-finished long products are primarily used by the Company’s Dunkirk facility and certain customers to produce finished bar, rod and wire products, and the semi-finished flat rolled products are used by customers to produce fine-gauge plate, sheet and strip products. The finished bar products manufactured by the Company are primarily used by original equipment manufacturers and by service center customers for distribution to a variety of end users. The Company also produces customized shapes primarily for original equipment manufacturers that are cold rolled from purchased coiled strip, flat bar or extruded bar at its Precision Rolled Products department (“PRP”), located at its Titusville facility.

INDUSTRY OVERVIEW

The specialty steel industry is a relatively small but distinct segment of the overall steel industry. Specialty steels include stainless steels, high-speed and tool steels, electrical steels, high-temperature alloys, magnetic alloys and electronic alloys. Specialty steels are made with a high alloy content, which enables their use in environments that demand exceptional hardness, toughness, strength and resistance to heat, corrosion or abrasion, or combinations thereof. Specialty steels generally must conform to more demanding customer specifications for consistency, straightness and surface finish than carbon steels. Annual domestic consumption of specialty steels approximated 2.8 million tons in 2005 according to the Specialty Steel Industry of North America (“SSINA”). Of this amount, approximately 2.0 million tons of specialty steels consumed domestically represented stainless steel sheet and strip and electrical alloy products that the Company does not produce. According to SSINA data through September 30, 2006, consumption in 2006 has increased 11% from 2005 levels.

The Company primarily manufactures its products within the following product lines and, generally, in response to customer orders:

Stainless Steel. Stainless steel, which represents the largest part of the specialty steel market, contains elements such as nickel, chrome and molybdenum that give it the unique qualities of high strength, good wear characteristics, natural attractiveness, ease of maintenance and resistance to rust, corrosion and heat. Stainless steel is used, among other applications, in the automotive, aerospace and power generation industries, as well as in the manufacture of food handling, health and medical, chemical processing and pollution control equipment. The increased number of applications for stainless steel has resulted in the development of a greater variety of stainless steel metallurgical grades than carbon steel.

Tool Steel. Tool steels contain elements of manganese, silicon, chrome and molybdenum to produce specific hardness characteristics that enable them to form, cut, shape and shear other materials in the manufacturing process. Heating and cooling at precise rates in the heat-treating process bring out these hardness characteristics. Tool steels are utilized in the manufacturing of metals, plastics, paper and aluminum extrusions, pharmaceuticals, electronics and optics.

High-Temperature Alloy Steel. These steels are designed to meet critical requirements of heat resistance and structural integrity. They generally have very high nickel content relative to other types of specialty steels. High-temperature alloy steels are manufactured for use generally in the aerospace industry.

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High-Strength Low Alloy Steel. High-strength low alloy steel is a relative term that refers to those steels that maintain alloying elements that range in versatility. The alloy element of nickel, chrome and molybdenum in such steels typically exceeds the alloy element of carbon steels but not that of high-temperature alloy steel. High-strength low alloy steels are manufactured for use generally in the aerospace industry.

Net sales by principal product line were as follows:

RAW MATERIALS

The Company’s Bridgeville facility depends on the delivery of key raw materials for its day-to-day operations. These key raw materials are ferrous and non-ferrous scrap metal and alloys, primarily consisting of nickel, chrome, molybdenum and copper. Scrap metal is primarily generated by industrial sources and is purchased through a number of scrap brokers and dealers. Alloys are generally purchased from domestic agents and originate in Australia, Canada, China, Russia and South Africa. Political disruptions in countries such as these could cause supply interruptions and affect the availability and price of the raw materials purchased by the Company.

The Bridgeville facility supplies semi-finished specialty steel products as starting materials to the Company’s Titusville and Dunkirk facilities. Semi-finished specialty steel starting materials, not capable of being produced by the Company at a competitive cost, are purchased from other suppliers. The Company generally purchases these starting materials from steel strip coil suppliers, extruders, flat rolled producers and service centers. The Company believes that adequate supplies of starting material will continue to be available.

The cost of raw materials represents more than 50% of the Company’s total cost of products sold in 2006 and 2005 due to significant increases in transaction prices for raw materials purchased. Raw material prices vary based on numerous factors, including quality, and are subject to frequent market fluctuations. Future raw material prices cannot be predicted with any degree of certainty. Therefore, the Company does not maintain any long-term written agreements with any of its raw material suppliers.

The Company has implemented a sales price surcharge mechanism on its products to help offset the impact of raw material price fluctuations. For substantially all semi-finished products, the surcharge is calculated at the time of order entry, based on average raw material prices reported for the previous 20-day period. For substantially all finished products, the surcharge is calculated based on average raw material prices reported for the previous 20-day period from the promised ship date. While the material surcharge mechanism is designed to offset modest fluctuations in raw material prices, it can not immediately absorb significant spikes in raw material prices. A material change in raw material prices within a short period of time could have a material adverse effect on the financial results of the Company, and there can be no assurance that the raw material surcharge mechanism will completely offset immediate changes in the Company’s raw material costs.

ENERGY AGREEMENTS

The production of specialty steel requires the ready availability of substantial amounts of electricity and natural gas for which the Company negotiates competitive agreements for the supply of energy and natural gas. While the Company believes that its energy agreements allow it to compete effectively within the specialty steel industry, the potential of curtailments exists as a result of decreased supplies during periods of increased demand for electricity and natural gas. These interruptions not only can adversely affect the operating performance of the Company, but also can lead to increased costs. In 2005, the Company implemented a sales price surcharge mechanism on its products to help offset the impact of natural gas price fluctuations.

CUSTOMERS

The Company’s customer base increased from 501 customers at December 31, 2005 to 504 customers at December 31, 2006. The Company’s five largest customers in the aggregate accounted for approximately 43% and 46% of net sales for the years

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ended December 31, 2006 and 2005, respectively. Sales to Carpenter Technology Corporation (“CRS”), Reliance Steel & Aluminum and Fry Steel accounted for 12.5%, 10.5% and 10.4% of the Company’s net sales for the year ended December 31, 2006, respectively, and accounted for 17.2%, 7.6% and 9.5% of the Company’s net sales for the year ended December 31, 2005, respectively. The accounts receivable balances from these customers comprised approximately 23% of total accounts receivable at December 31, 2006 and 2005. No other customer accounted for more than 10% of the Company’s net sales for the years ended December 31, 2006 and 2005.

The Company maintains a supply contract agreement with Talley Metals, a subsidiary of CRS, that continues to automatically renew with the placement of new orders each month and requires a 90-day written notice to terminate by either party. Talley Metals is required under the agreement to purchase a minimum of 1,000 tons of stainless reroll billet products each calendar month and average at least 1,250 tons per month during the last twelve-month period. The value of the contract on a monthly basis will depend on product mix and key raw material prices.

BACKLOG

The Company primarily manufactures products to meet specific customer orders. The Company’s backlog of orders on hand as of December 31, 2006, was approximately $120 million as compared to approximately $116 million at the same time in 2005. The increase in the backlog is primarily due to strong product demand and base price increases implemented during 2006. Customer orders are generally subject to cancellation with the payment of a penalty charge prior to delivery. The Company’s backlog may not be indicative of actual sales and therefore should not be used as a measure of future revenue.

COMPETITION

Competition in the Company’s markets is based upon product quality, delivery capability, customer service and price. Maintaining high standards of product quality, while responding quickly to customer needs and keeping production costs at competitive levels, is essential to the Company’s ability to compete in its markets.

Annual domestic U.S. consumption of specialty steel products of the type manufactured by the Company approximates one million tons. The Company restricts its participation in this market by limiting the volume of commodity stainless steel products it markets because of the highly competitive nature of the commodity business.

The Company believes that nine domestic companies that manufacture one or more similar specialty steel products are significant competitors, including Allegheny Technologies Incorporated (“ATI”) and CRS. There are many smaller producing companies and material converters in the United States who are also considered to be competitors of the Company.

High import penetration of specialty steel products, especially stainless and tool steels, also impacts the competitive nature within the United States. Unfair pricing practices by foreign producers have resulted in high import penetration into the U.S. markets in which the Company participates. According to SSINA, import penetration for the years ended December 31, 2005 and 2004 was 53% and 41%, respectively, for stainless bar, and 63% and 65%, respectively, for stainless rod. Import penetration was lower than these levels during the first nine months of 2006, with stainless bar at 50% and stainless rod 44% import penetration.

The Continued Dumping and Subsidy Offset Act of 2000 (the “CDSOA”) provides for payment of import duties collected by the U.S. Treasury to domestic companies injured by unfair foreign trade practices. The assets purchased for the operations of Dunkirk Specialty Steel were previously owned and operated by AL Tech Specialty Steel, Inc. and Empire Specialty Steel, Inc. During their ownership, both organizations participated in several anti-dumping lawsuits with other domestic specialty steel producers. The Company has joined other domestic producers in the filing of trade actions against foreign producers.

In 2003 and in accordance with the CDSOA, the Company filed claims to receive its appropriate share of the import duties collected and was notified that it was awarded $604,000, of which $10,000 was received in 2003. The remaining payment was not received until 2004, when a favorable ruling was issued by the U.S. Court of Appeals for the Federal Circuit in connection with a lawsuit challenging the distribution method of the import duties. In 2004, the Company received $507,000, net of expenses incurred, as part of its 2004 award. In January 2005, the Company received an additional $59,000 from the U.S. Treasury, representing an increase in the total allocation of available funds awarded to the Company for 2004. In December 2005, the Company received a net payment of $358,000 as its 2005 award, and, in November 2006, the Company received a net payment of $463,000 as its 2006 award.

The Company expects to benefit from the CDSOA until its scheduled expiration on September 30, 2007. The amount of future benefits is dependent on the amount of import duties collected and the relationship of Dunkirk Specialty Steel’s claim in relation to claims filed by other domestic specialty steel producers.

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The Company also faces competition from producers of certain alternative materials, particularly aluminum, composites and plastics. Any competitive factors that adversely affect the market for finished products manufactured by the Company or its customers could indirectly adversely affect the demand for the Company’s specialty steel products. See the information under the heading “Competition” in Item 1A, Risk Factors, of this Annual Report on Form 10-K.

EMPLOYEE RELATIONS

The Company considers the maintenance of good relations with its employees to be important to the successful conduct of its business. The Company has profit-sharing plans for certain salaried employees and all of its United Steelworkers (the “USW”) represented employees and has equity ownership programs for all of its eligible employees, in an effort to forge an alliance between its employees’ interests and those of the Company’s stockholders. At December 31, 2006, the Company had 316 employees at its Bridgeville facility, 47 employees at its Titusville facility and 164 employees at its Dunkirk facility, of whom 258, 40 and 140 were USW members, respectively.

Collective Bargaining Agreements

The Company recognizes the USW as the exclusive representative for the Company’s hourly employees with respect to the terms and conditions of their employment. The Company has entered into the following collective bargaining agreements:

The Company believes a critical component of its collective bargaining agreements is the inclusion of a profit sharing plan. Under the plans, the hourly employees are entitled to receive 8.5% of their respective facilities’ annual pretax profits in excess of $1.0 million at Bridgeville and Dunkirk, and in excess of $500,000 at Titusville.

Employee Benefit Plans

The Company provides group life and health insurance plans for its hourly and salary employees. The Company also maintains separate 401(k) retirement plans for its hourly and salary employees. Pursuant to each plan, participants may elect to make pre-tax and after-tax contributions to the plan, subject to certain limitations imposed under the Internal Revenue Code of 1986, as amended. In addition, the Company is required to make periodic contributions to the plans based on service, except as described below.

The Company also participates in the Steelworkers Pension Trust (the “Trust”), a multi-employer defined-benefit pension plan that is open to all hourly and salaried employees associated with the Bridgeville facility. The Company makes periodic contributions to the Trust based on hours worked at a fixed rate for each hourly employee and a fixed monthly contribution on behalf of each salaried employee. The hourly employees may continue their contributions to the 401(k) retirement plan even though the Company contributions ceased. The Company also makes a monthly contribution to the 401(k) retirement plan on behalf of each salaried employee participating in the Trust. The amount of the contribution will be dependent upon each salaried employee’s contribution to the 401(k) retirement plan.

Employee Stock Purchase Plan

Under the 1996 Employee Stock Purchase Plan, as amended (the “Plan”), the Company is authorized to issue up to 150,000 shares of Common Stock to its full-time employees, nearly all of whom are eligible to participate. Under the terms of the Plan, employees can choose as of January 1 and July 1 of each year to have up to 10% of their total earnings withheld to purchase up to 100 shares of the Company’s Common Stock each six-month period. The purchase price of the stock is 85% of the lower of its beginning-of-the-period or end-of-the-period market prices. At December 31, 2006, the Company had issued 90,311 shares of Common Stock since the plan’s inception.

Safety

The Company has established and seeks to maintain appropriate safety standards and policies for its employees. To encourage plant safety, the USW agreements provide that employees will be entitled to receive 50% of the savings, if any, of reduced workers’ compensation insurance premiums obtained due to reductions in the state experience modifier issued to the Company.

On February 28, 2006, the U.S. Department of Labor Occupational Safety and Health Organization (“OSHA”) promulgated a revised workplace occupational exposure limit standard for hexavalent chromium. Companies that produce or work with

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stainless steel may be required to construct and install engineering controls necessary to meet the new exposure limits. The Company believes that it is compliant with the revised standard and continues to evaluate its ability to comply with the revised standard. There can be no assurance that the Company, or its customers, operate in compliance with the revised standard and may be obligated to install engineering controls necessary to meet the new exposure limits or that the Company, or its customers, would have the financial resources to do so.

ENVIRONMENTAL

The Company is subject to federal, state and local environmental laws and regulations (collectively, “Environmental Laws”), including those governing discharges of pollutants into the air and water, and the generation, handling and disposal of hazardous and non-hazardous substances. The Company monitors its compliance with Environmental Laws applicable to it and, accordingly, believes that it is currently in compliance with all laws and regulations in all material respects. In December 2005, the Company received a Notice of Violation from the Environmental Protection Agency (the “EPA”) alleging violations of certain permitting issues at the Bridgeville facility. The Company is cooperating with the EPA to resolve these issues. The Company is subject periodically to environmental compliance reviews by various regulatory offices. The Company may be liable for the remediation of contamination associated with generation, handling and disposal activities. Environmental costs could be incurred, which may be significant, related to environmental compliance, at any time or from time to time in the future.

EXECUTIVE OFFICERS

The following table sets forth, as of December 31, 2006, certain information with respect to the executive officers of the Company:

Clarence M. McAninch has been President and Chief Executive Officer and a Director of the Company since July 1994. Mr. McAninch served as Vice President, Sales and Marketing, of the Stainless and Alloy Products Division of Armco from 1992 to 1994.

Paul A. McGrath has been Vice President of Operations of the Company since March 2001, General Counsel since January 1995 and was appointed Secretary in May 1996. Prior thereto, he was employed by Westinghouse Electric Corporation for approximately 24 years in various management positions.

Richard M. Ubinger has been Vice President of Finance of the Company since March 2001, Chief Financial Officer and Principal Accounting Officer since August 1994 and was appointed Assistant Secretary in November 1995 and Treasurer in May 1996. From 1981 to 1994, Mr. Ubinger was employed by Price Waterhouse LLP. Mr. Ubinger is a Certified Public Accountant.

On January 16, 2007, the Company announced that Kenneth W. Matz has been named President of the Company and that Mr. McAninch assumed the new title of Chairman of the Board and Chief Executive Officer. Mr. Matz, 55, had been employed by Gibraltar Industries since 1988 and served as President of its Processed Metals Group from 2002 to 2007. In addition, Mr. McGrath assumed the new title of Vice President of Administration, General Counsel and Secretary.

PATENTS AND TRADEMARKS

The Company does not consider its business to be materially dependent on patent or trademark protection, and believes it owns or maintains effective licenses covering all the intellectual property used in its business. The Company seeks to protect its proprietary information by use of confidentiality and non-competition agreements with certain employees.

ACCOUNTING MATTER

In the future, the Company will be required to establish and maintain an effective control environment in order to comply with Section 404 of the Sarbanes-Oxley Act relating to internal controls over financial reporting. Section 404 of the

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Sarbanes-Oxley Act will require our independent registered public accounting firm to attest as to the effectiveness of our internal controls over financial reporting beginning in the year the Company is required to comply, which currently would be the fiscal year ending December 31, 2007. The Company is currently reviewing its internal control program for any significant deficiencies or material weaknesses and opportunities to improve the effectiveness of its control environment.

AVAILABLE INFORMATION

Copies of the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as well as proxy and information statements that we file with the Securities and Exchange Commission (the “SEC”), are available free of charge on the Company’s website at www.univstainless.com as soon as reasonably practicable after such reports are filed with the SEC. The contents of our website are not part of this Form 10-K. You also may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site at www.sec.gov that contains reports, proxy and information statements and other information regarding issuers, like the Company, that file electronically with the SEC.

The Company’s business and results of operations are subject to a wide range of substantial business and economic factors including, but not limited to, the factors discussed below, many of which are not within the Company’s control. See the information under the heading “Forward-Looking Information Safe Harbor” in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of this Annual Report on Form 10-K.

SIGNIFICANT CUSTOMERS AND CONCENTRATED CUSTOMER BASE

Net sales to the Company’s three largest customers and their affiliates approximated 34%, 34% and 40% of total 2006, 2005 and 2004 sales, respectively. The accounts receivable balances from these three customers comprised approximately 23% of total accounts receivable at December 31, 2006 and 2005. The Company’s five largest customers in the aggregate accounted for approximately 43% of 2006 net sales and 33% of receivables. An adverse change in, or termination of, the Company’s relationship with one or more of its major customers or one or more of its market segments could have a material adverse effect upon the Company. See the information under the heading “Customers” in Item 1, Business, of this Annual Report on Form 10-K.

COMPETITION

The Company competes with domestic and foreign sources of specialty steel products. In addition, many of the finished products sold by the Company’s customers are in direct competition with finished products manufactured by foreign sources, which may affect the demand for those customers’ products. Any competitive factors that adversely affect the market for finished products manufactured by the Company or its customers could indirectly adversely affect the demand for the Company’s semi-finished products. Additionally, the Company’s products compete with products fashioned from alternative materials such as aluminum, composites and plastics, the production of which includes domestic and foreign enterprises. Competition in the Company’s field is intense and is expected to continue to be so in the foreseeable future. There can be no assurance that the Company will be able to compete successfully in the future. See the information under the heading “Competition” in Item 1, Business, of this Annual Report on Form 10-K.

AEROSPACE MARKET

A large portion of the Company’s sales represent products sold to customers in the aerospace market. The aerospace market is historically cyclical due to both external and internal market factors. These factors include general economic conditions, airline profitability, demand for air travel, age of fleets, varying fuel and labor costs, price competition, and international and domestic political conditions such as military conflict and the threat of terrorism. The length and degree of cyclical fluctuation can be influenced by any one or a combination of these factors and therefore are difficult to predict with certainty. A downturn in the aerospace industry would adversely affect the demand for products and/or the prices at which the Company is able to sell its products, and its results of operations, business and financial condition could be materially adversely affected.

SUPPLY OF RAW MATERIALS AND COST OF RAW MATERIALS

The Company relies on a limited number of suppliers, some of which are foreign owned, for its raw material needs. Raw material prices are affected by cyclical, seasonal and other market factors. Alloys consumed by the Company are primarily available from foreign sources, some of which are located in countries that may be subject to unstable political and economic

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conditions. Those conditions might disrupt supplies or affect the prices of the raw materials used by the Company. The Company does not maintain long-term supply agreements with any of its independent suppliers. If its supply of raw materials were interrupted, the Company might not be able to obtain sufficient quantities of raw materials, or obtain sufficient quantities of such materials at satisfactory prices, which, in either case, could adversely affect the Company’s results of operations. In addition, significant volatility in the price of the Company’s principal raw materials could adversely affect the Company’s financial results. See the information under the headings “Raw Materials” in Item 1, Business, and “Liquidity and Capital Resources” in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of this Annual Report on Form 10-K.

RELIANCE ON ENERGY AGREEMENTS

The manufacturing of specialty steels is an energy-intensive industry. While the Company believes that its energy agreements allow it to compete effectively within the specialty steel industry, the Company is subjected to curtailments as a result of decreased supplies and increased demand for electricity and natural gas. These interruptions not only can adversely affect the operating performance of the Company, but also can lead to increased costs for energy. See the information under the heading “Energy Agreements” in Item 1, Business, of this Annual Report on Form 10-K.

LABOR MATTERS

The Company has 438 employees out of a total of 527 who are covered under collective bargaining agreements. The collective bargaining agreement for the Dunkirk facility employees will expire in October 2007. There can be no assurance that the Company will succeed in concluding a collective bargaining agreement with the union to replace the one that expires.

RELIANCE ON CRITICAL MANUFACTURING EQUIPMENT

The Company’s manufacturing processes are dependent upon certain critical pieces of specialty steel making equipment, such as the Company’s electric-arc furnace, its ESR and VAR furnaces, and its universal rolling mill. In the event a critical piece of equipment should become inoperative as a result of unexpected equipment failure, there can be no assurance that the Company’s operations would not be substantially curtailed, which may have a negative effect on the Company’s financial results. See Item 2, Properties.

SAFETY MATTERS

On February 28, 2006, the U.S. Department of Labor Occupational Safety and Health Organization (“OSHA”) promulgated a revised workplace occupational exposure limit standard for hexavalent chromium. Companies that produce or work with stainless steel may be required to construct and install engineering controls necessary to meet the new exposure limits. The Company believes that it is compliant with the revised standard and continues to evaluate its ability to comply with the revised standard. There can be no assurance that the Company, or its customers, operate in compliance with the revised standard and may be obligated to install engineering controls necessary to meet the new exposure limits or that the Company, or its customers, would have the financial resources to do so.

ENVIRONMENTAL ISSUES

In December 2005, the Company received a Notice of Violation from the EPA alleging violations of certain permitting issues at the Bridgeville facility. The Company is cooperating with the EPA to resolve these issues. See the information under the heading “Environmental” in this Annual Report on Form 10-K.

COMPLIANCE WITH SECTION 404 OF THE SARBANES-OXLEY ACT OF 2002

In the future, the Company may be required to file a report on internal accounting controls, in accordance with Section 404 of the Sarbanes-Oxley Act of 2002, with the filing of future Form 10-Ks. In order to comply, the Company will be required to increase the amount of documentation surrounding its internal control system and provide evidence that the system has been properly tested to support management’s conclusions. While the Company believes its internal control system is adequate in all material respects, there is no assurance that the Company will not identify a material weakness requiring disclosure in the future. See information under the heading “Accounting Matter” in Item 1, Business, and in Item 9A, Controls and Procedures, in this Annual Report on Form 10-K.

LEGAL MATTER

The Company is currently defending itself in a suit that alleges it manufactured steel product, utilized in the manufacturing of crankshafts, that was defective. After in-depth investigation, it is the Company’s position that the suit is without merit. While the Company believes that insurance coverage is available for the defense and damages, if any, relating to the claim, an unfavorable ruling in the suit could have a material adverse effect on the Company’s financial condition. See Item 3, Legal Proceedings, of this Annual Report on Form 10-K.

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None.

The Company owns its Bridgeville facility, which consists of approximately 600,000 square feet of floor space on approximately 51 acres. The Bridgeville facility contains melting, remelting, conditioning, rolling, annealing and various other processing equipment. Substantially all products shipped from the Bridgeville facility are processed through its melt shop and universal rolling mill operations. In January 2007 the Company completed renovations to one of the buildings acquired from AK Steel (“AKS”) in 2005 and moved the Company’s executive offices into the building.

The Company owns its Titusville facility, which consists of seven buildings on approximately 10 acres, including two principal buildings of approximately 265,000 square feet in total area. The Titusville facility contains five VAR furnaces and various rolling and finishing equipment.

The Company owns its Dunkirk facility, which consists of approximately 800,000 square feet of floor space on approximately 82 acres. The Dunkirk facility processes semi-finished billet and bar stock through one or more of its four rolling mills. The products are then finished and shipped as finished bar, rod and wire products.

Specialty steel production is a capital-intensive industry. The Company believes that its facilities and equipment are suitable for its present needs. The Company believes, however, that it will continue to require capital from time to time to add new equipment and to repair or replace existing equipment to remain competitive and to enable it to manufacture quality products and provide delivery and other support service assurances to its customers.

On June 29, 2001, suit was filed against the Company in the Court of Common Pleas of Allegheny County, Pennsylvania by Teledyne Technologies Incorporated (“Teledyne”). The suit alleges that steel product manufactured by the Company was defective and that the Company was or should have been aware of the defects. Teledyne has alleged that the steel supplied by the Company caused certain crankshafts sold by Teledyne to be defective. As a result, Teledyne is claiming damages relating to the recall, replacement and repair of aircraft engines.

After in-depth investigation, it is the Company’s position that the suit is without merit and it intends to vigorously defend that position. The Company is currently engaged in the pre-trial phase of the proceedings and believes that the final disposition of this suit will not have a material adverse effect on the financial condition and the results of operations of the Company. The trial is now listed on the May 2007 trial docket for the Court of Common Pleas of Allegheny County, Pennsylvania.

No matters were submitted to a vote of security holders during the fourth quarter of 2006.

PART II

At December 31, 2006, a total of 6,839,543 shares of the Company’s Common Stock, par value $.001 per share, were issued and held by approximately 145 holders of record. There were 270,469 shares of the issued Common Stock of the Company held in treasury at December 31, 2006.

Certain holders of Common Stock and the Company are party to a stockholder agreement. That agreement maintains in effect certain registration rights granted to non-management stockholders, which provides to them two demand registration rights exercisable at any time upon written request for the registration of Restricted Shares of Common Stock having an aggregate net offering price of at least $5,000,000.

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PRICE RANGE OF COMMON STOCK

The Common Stock is listed on the NASDAQ Global Market under the symbol “USAP.” The following table sets forth the range of high and low sale prices per share of Common Stock, for the periods indicated below:

EQUITY COMPENSATION PLAN INFORMATION

Securities authorized for issuance under equity compensation plans at December 31, 2006 are as follows:

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PERFORMANCE GRAPH

The performance graph below compares the cumulative total shareholder return on the Company’s stock with the cumulative total return on the equity securities of NASDAQ Market Index and a peer group selected by the Company, including the following companies: ATI, CRS and the Timken Company. The graph assumes an investment of $100 on December 31, 2001 and reinvestment of dividends, if any, on the date of dividend payment. The performance graph represents past performance and should not be considered to be an indication of future performance.

COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN

AMONG UNIVERSAL STAINLESS

NASDAQ MARKET INDEX AND PEER GROUP INDEX

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PREFERRED STOCK

The Company’s Certificate of Incorporation provides that the Company may, by vote of its Board of Directors, issue up to 1,980,000 shares of Preferred Stock. The Preferred Stock may have rights, preferences, privileges and restrictions thereon, including dividend rights, dividend rates, conversion rights, voting rights, terms of redemption, redemption prices, liquidation preferences and the number of shares constituting any series or designation of such series, without further vote or action by the stockholders. The issuance of Preferred Stock may have the effect of delaying, deferring or preventing a change in control of the Company without further action by the stockholders and may adversely affect the voting and other rights of the holders of Common Stock. The issuance of Preferred Stock with voting and conversion rights may adversely affect the voting power of the holders of Common Stock, including the loss of voting control to others.

The Company has no outstanding Preferred Stock and has no plans to issue any of the authorized Preferred Stock.

DIVIDENDS

The Company has never paid a cash dividend on its Common Stock. The Company’s Credit Agreement with PNC Bank, National Association (“PNC Bank”) currently limits the payment of cash dividends payable on its Common Stock to 50% of the Company’s excess cash flow per fiscal year. Excess cash flow represents the amount of the Company’s earnings before interest, taxes, depreciation and amortization that is greater than the sum of the Company’s payments for interest, income taxes, the principal portion of long-term debt and capital lease obligations, and capital expenditures.

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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, original equipment manufacturers and wire redrawers.

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

Net sales by market segment are as follows:

2006 Results as Compared to 2005: The increase in net sales in 2006 reflects increased shipments of higher value-added products, primarily those that require vacuum-arc or electro-slag remelted steels, as well as higher surcharges assessed due to increased raw material costs. A substantial percentage of the net sales increase was derived from shipments of product to serve the increased demands of the aerospace market. Raw material costs, especially nickel, increased significantly during 2006 as a result of an increase in the global demand for stainless steel and supply volatility.

Cost of products sold, as a percent of net sales, decreased in 2006 as compared to 2005. This decrease is primarily due to the Company’s shift in product mix as well as the impact of rising raw material costs throughout 2006. The duration of the production cycle permitted the Company’s Dunkirk Specialty Steel facility to assess surcharges based on raw material costs that were higher than those costs incurred at the time the raw materials were purchased.

Selling and administrative expenses increased primarily due to higher employment costs resulting from continued growth of the business, and included $273,000 related to the January 1, 2006 adoption of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the modified prospective method. Compensation related to stock-based compensation plans was not previously recognized as expense under the former accounting guidance, APB Opinion 25, “Accounting for Stock Issued to Employees.” Unrecognized stock-based compensation expense related to non-vested stock awards totaled $570,000 at December 31, 2006. At such date, the weighted-average period over which this unrecognized expense was expected to be recognized was 25 months.

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The Company also expensed $367,000 related to a software project the Company terminated during the year and $413,000 related to fees paid for outside consultants to assist the Company in evaluating its current system of internal accounting controls for purposes of future compliance with Section 404 of the Sarbanes-Oxley Act of 2002. In addition, the Company established a reserve of $193,000 for the probable settlement of an EPA violation and $200,000 for certain commercial product-claim issues that were more than offset by a $104,000 write-off of software development costs, the $184,000 write-off of an office building at the Dunkirk Specialty Steel facility and the receipt of an additional property tax invoice from AK Steel related to the Bridgeville Facility that required the Company to record an additional expense of $174,000 in 2005.

Interest expense and other financing costs increased from $851,000 in 2005 to $1.1 million in 2006. The increase was primarily due to the Company funding the increase in working capital to support higher raw material costs with a revolving line of credit and higher interest rates. This increase was partially offset by lower interest expense associated with existing term debt as the Company continued to fund its scheduled payments.

Other income, net increased from $437,000 in 2005 to $522,000 in 2006. The increase was primarily due to the receipt of $463,000, net of expenses, under the Continued Dumping and Subsidy Offset Act of 2000 (“CDSOA”) in 2006 in comparison to $414,000 received in 2005.

The 2006 effective income tax rate was 35.2% compared to a 35.4% tax rate in 2005. The change in the effective income tax rate is primarily attributable to a favorable shift of apportioned income for state income tax purposes as well as the impact of recognizing a $180,000 tax credit in Pennsylvania as a result of participating in the state’s Educational Improvement Tax in 2006.

2005 Results as Compared to 2004: The increase in net sales in 2005 reflects increased shipments of higher value-added niche products, primarily for the aerospace, power generation, petrochemical and tool steel markets, as well as the adoption of surcharge mechanisms for additional raw material components and price increases implemented during the past two-year period.

Cost of products sold, as a percentage of net sales, decreased in 2005 as compared to 2004. This decrease is primarily due to an improved mix of higher-margin products shipped, in conjunction with the impact of raw material surcharges and base price increases, implemented over the past two years, which more than offset higher raw material, labor, energy and other manufacturing supply costs.

Selling and administrative expenses increased primarily due to higher employment costs related to the continued growth of the business in 2005, higher property taxes and the write-off of a building held for sale, which were partially offset by a reduction in the bad debt provision. Under a previous lease agreement, the Company was responsible to reimburse AKS for a portion of the property taxes assessed against the Bridgeville facility. In June 2005, the Company received an invoice for prior year property taxes that required the Company to record an additional expense of $174,000. Attempts to sell the Dunkirk office building since February 2002 have not been successful, and the Company had no prospective buyers. The change in circumstances caused the Company’s management to write off the $184,000 carrying value of the Dunkirk office building. A substantial portion of the 2004 bad debt expense was related to one customer who filed for Chapter 11 bankruptcy protection and to a second financially distressed customer’s inability to pay its outstanding receivable balance at December 31, 2004. In 2005, the Company received a partial payment of $110,000 from this customer.

Interest expense and other financing costs increased from $422,000 in 2004 to $851,000 in 2005. The increase is primarily due to a $5.0 million increase in the average balance of the revolving line of credit over the prior year, coupled with increasing the term loan by $8.1 million in June 2005.

Other income, net is primarily attributed to the receipt of funds under the CDSOA. In 2003, the Company received notice that it was awarded $604,000, of which $10,000 was received. The remaining payment was not received until 2004 when a favorable ruling was issued by the U.S. Court of Appeals for the Federal Circuit in connection with a lawsuit challenging the distribution method of the import duties. In addition, the Company received $507,000, net of expenses incurred, in 2004 as part of its 2004 award. In 2005, the Company received an additional $59,000 from the U.S. Treasury, representing an increase in the total allocation of available funds awarded to the Company for 2004, as well as a net payment of $358,000 related to its 2005 award.

The effective income tax rates for the years ended December 31, 2005 and 2004 were 35.4% and 35.0%, respectively. The rate increase is primarily attributable to an increase in the federal statutory rate from 34% to 35% due to the level of income the Company achieved in 2005, partially offset by the manufacturer’s tax exemption, initially permitted in 2005.

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BUSINESS SEGMENT RESULTS

The Company comprises 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:

Net sales for the year ended December 31, 2006 increased $25.9 million, or 17%, in comparison to the year ended December 31, 2005 primarily due to increased shipments of higher value-added products to the forger, service center and OEM markets, offset by decreased shipments to the reroller market and a reduction in conversion services rendered, as well as the impact of price increases implemented since January 1, 2005 and higher surcharges assessed due to increased raw material costs. Operating income for the year ended December 31, 2006 increased $4.7 million primarily due to the impact of the favorable product mix, higher surcharges assessed and base price increases implemented, more than offsetting higher raw material, labor, energy and other manufacturing costs.

Net sales for the year ended December 31, 2005 increased by $45.0 million, or 41.6%, in comparison to the year ended December 31, 2004 primarily due to the adoption of raw material surcharge mechanisms, which offset increased material cost of sales of $25.6 million for the period. The remaining increase is primarily due to increased shipments of higher value-added niche products and several price increases implemented during the past two-year period. Operating income for the year ended December 31, 2005 increased by $7.5 million primarily due to increased production volumes, improved mix of products shipped and higher selling prices, partially offset by higher raw material, labor, utilities and other manufacturing supply costs.

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DUNKIRK SPECIALTY STEEL SEGMENT

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

Net sales for the year ended December 31, 2006 increased $17.2 million, or 33%, in comparison to the year ended December 31, 2005 primarily due to increased shipments of higher value-added products requiring vacuum-arc remelting, as well as the impact of price increases implemented since January 1, 2005 and higher surcharges assessed due to increased raw material costs. Operating income for the year ended December 31, 2006 increased $4.8 million primarily due to the impact of the favorable product mix, higher surcharges assessed and base price increases implemented, more than offsetting higher raw material, labor, energy and other manufacturing costs.

Net sales for the year ended December 31, 2005 for this segment increased by $18.3 million, or 52.7%, in comparison to the year ended December 31, 2004 primarily due to the adoption of raw material surcharge mechanisms, which offset increased material cost of sales of $11.7 million for the period. The remaining increase is primarily due to increased shipments of higher value-added niche products and several price increases implemented during the past two-year period. Operating income increased by $3.6 million primarily due to increased production volumes, improved mix of products shipped and higher selling prices, partially offset by higher raw material, labor, utilities and other manufacturing supply costs.

LIQUIDITY AND CAPITAL RESOURCES

The Company generated cash from operations of $6.3 million and $3.3 million in the years ended December 31, 2006 and 2005, respectively, and used cash for operations of $9.7 million in the year ended December 31, 2004. Cash received from sales of $198.7 million, $167.2 million and $108.4 million for the years ended December 31, 2006, 2005 and 2004, respectively, represent the primary source of cash from operations. An analysis of the primary uses of cash is as follows:

Cash used for raw material purchases increased in 2006 in comparison to 2005 and 2004 primarily due to 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 selected months during the last three-year period.

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The average price of nickel in December 2006 increased 67% since June 2006, and 157% since December 2005. Increased demand from foreign (primarily China) and domestic sources and supply volatility caused raw material market values to rise significantly throughout 2006. A significant portion of the increase between June 2006 and December 2006 occurred during a two-week period in July 2006. This event 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. While the material surcharge mechanism is designed to offset modest fluctuations in raw material prices, it can not immediately absorb significant spikes in raw material prices. 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, and there can be no assurance that the raw material surcharge mechanism will completely offset immediate changes in the Company’s raw material costs.

Increased employment costs are primarily due to higher production volumes and increased payouts under the Company’s profit-sharing and other incentive compensation plans, and higher employee-related insurance costs. Increased utility costs are primarily due to higher consumption and rates charged for electricity and natural gas. In October 2004, the Company’s electricity costs at the Bridgeville facility increased by approximately $200,000 per month due, in part, to a Public Utility Commission ruling that reduced the number of off-peak power hours available to conduct its melting operations, and increased energy market prices. The Company expects that electrical distribution costs at the Bridgeville facility will increase by $1.6 million in 2007 due to a rate increase effective January 6, 2007, assuming the same rate of consumption as 2006.

The increase in other uses of cash is primarily attributable to making payments for federal and state income taxes, net of refunds received of $11.8 million, $6.7 million and $1.5 million in 2006, 2005 and 2004, respectively, as well as purchases of operating supplies and services to support higher production volumes.

At December 31, 2006, working capital approximated $80.3 million, as compared to $61.7 million at December 31, 2005. Accounts receivable represents $5.3 million and $3.4 million of the 2006 and 2005 increases in comparison to the prior year, which relates to the growth in net sales. Inventory, net of non-debt current liabilities, increased $11.6 million and $10.1 million in 2006 and 2005, respectively, in comparison to the prior year, primarily due to increased production volumes of higher margin products requiring longer production cycles and increased raw material costs incurred during the year. The cost of raw materials contained within work-in-process inventory is approximately $8.0 million higher at December 31, 2006, as compared to December 31, 2005, and $5.0 million higher at December 31, 2005, as compared to December 31, 2004, as a result of increased raw material transaction prices.

Capital Expenditures and Investments. The Company’s capital expenditures were approximately $7.7 million and $8.8 million in 2006 and 2005, respectively. Most of the 2006 expenditures were used to purchase additional equipment in response to increased demand, including a plate flattener, milling machines and a seventh VAR furnace installed at the Bridgeville facility. The 2005 expenditures also included purchases of additional equipment as well as a sixth VAR furnace, and the remainder was primarily for replacements of older fixed assets.

Capital expenditures are expected to approximate $10.0 million in 2007, based on current market conditions. The expenditures will be used principally for the purchase of new equipment and building improvements, and will be funded from operating cash flows. Commitments of additional capital expenditures may occur if market conditions continue to improve.

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. This credit agreement also provides for a $10.0 million term loan (“PNC Term Loan”) scheduled to mature on June 30, 2011. The outstanding principal balance under the PNC Term Loan is payable in twenty consecutive quarterly installments of $500,000, beginning on September 30, 2006. The PNC Line and PNC Term Loan are collateralized by substantially all of the Company’s assets.

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Interest on borrowings under the PNC Line and PNC Term Loan is based on short-term market rates, which may be further adjusted, based upon the Company maintaining certain financial ratios. The Company pays a commitment fee on the unused portion of the PNC Line of 0.25%, provided it maintains certain financial ratios.

At December 31, 2006, the Company had $6.6 million of its $15.0 million revolving line of credit with PNC Bank available for borrowings. The Company is in compliance with all financial ratios and restrictive covenants it is required to maintain under the credit agreement as of December 31, 2006. The Company believes it will maintain compliance with the financial covenants in effect throughout 2007.

Government Financing Programs. The Company maintains two loan agreements with the Commonwealth of Pennsylvania’s Department of Commerce, 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 1996, the Company entered into a ten-year, 6% interest-bearing loan with the Redevelopment Authority of Allegheny County Economic Development Fund in the amount of $1,514,000, and was fully amortized in 2006. 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, 2006, the total principal balance of these government-financed debt instruments is $2.2 million.

Stock-Based Financing Activity. The Company issued 152,760 and 85,671 shares of its Common Stock for the years ended December 31, 2006 and 2005, respectively, through its two stock-based compensation plans. In 2006, certain employees, officers and members of the Company’s Board of Directors exercised 144,125 stock options issued under the Stock Incentive Plan for $1,444,000 plus related tax benefits of $1,073,000. In 2005, certain employees and a member of the Company’s Board of Directors exercised 75,725 stock options issued under the Stock Incentive Plan for $703,000 plus related tax benefits of $207,000. The remaining shares were issued to employees participating in the Employee Stock Purchase Plan.

On October 19, 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 412 shares in 2006, 157 shares in 2005 and no shares of Common Stock during 2004. The Company is authorized to repurchase 44,531 remaining shares of Common Stock under this program as of December 31, 2006.

Short- and Long-Term Liquidity. The Company expects to meet substantially all of its short-term liquidity requirements resulting from operations and current capital investment plans with internally generated funds and borrowings under the PNC Credit Agreement. At December 31, 2006, the Company had $2.9 million in cash and $6.6 million available under the PNC Line. In addition, the ratio of current assets to current liabilities at December 31, 2005 was 4.2:1 compared with 3.9:1 at December 31, 2005, and the debt to total capitalization ratio was 15.8% compared with 18.9%, respectively.

The Company’s long-term liquidity depends upon its ability to obtain additional orders from its existing customers, attract new customers and control costs. Additional sources of financing may be required to fund growth initiatives identified by the Company.

Contractual Obligations. At December 31, 2006, the Company had the following contractual obligations:

Long-term debt includes the PNC Term Loan. The Company has a rate of interest of 6.65% at December 31, 2006. The table assumes the Company will maintain that interest rate until maturity. Long-term debt also includes an $8.4 million outstanding balance on the PNC Line, currently due to expire on June 30, 2009. The table assumes the PNC Line will not be extended and would mature at the current outstanding amount. Purchase obligations include the value of all open purchase orders with established quantities and purchase prices as well as minimum purchase commitments.

Supply Contract. The Company maintains a supply contract agreement with Talley Metals that continues to automatically renew with the placement of new orders each month and requires a 90-day written notice to terminate by either party. In addition, Talley Metals is required under the agreement to purchase a minimum of 1,000 tons of stainless reroll billet products each calendar month and average at least 1,250 tons per month during the last 12-month period. The value of the contract on a monthly basis will depend on product mix and key raw material prices.

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Import Protections. The CDSOA provides for payment of import duties collected by the U.S. Treasury Department to domestic companies injured by unfair foreign trade practices. The assets purchased by Dunkirk Specialty Steel were previously owned and operated by AL Tech Specialty Steel, Inc. and Empire Specialty Steel, Inc. During their ownership, both organizations participated in several anti-dumping lawsuits with other domestic specialty steel producers. In accordance with the CDSOA, the Company filed claims to receive their appropriate share of the import duties collected and received a net payment of $463,000 in 2006. The Company expects to benefit from the CDSOA until its scheduled expiration on September 30, 2007. The amount of future benefit is dependent on the amount of import duties collected and the relationship of Dunkirk Specialty Steel’s claim in relation to claims filed by other domestic specialty steel producers

EFFECTS OF INFLATION

Despite modest inflation in recent years, rising costs, in particular the cost of certain raw materials and energy, continue to affect operations. The Company strives to mitigate the effects of inflation through cost containment, productivity improvements, sales price increases and surcharges.

CONTINGENT ITEMS

Product Claims. The Company is subject to various claims and legal actions that arise in the normal course of conducting business. At December 31, 2006, the Company established a reserve of $200,000 for commercial product-claims related to three sales by Dunkirk Specialty Steel.

Environmental Matters. The Company, as well as other steel companies, is subject to demanding environmental standards imposed by federal, state and local environmental laws and regulations. In December 2005, the Company received a Notice of Violation from the EPA alleging violations of certain permitting issues. The Company is cooperating with the EPA to resolve these issues, and believes it will not have a material adverse effect on financial condition. The Company is not aware of any other environmental condition that currently exists at any of its facilities that would cause a material adverse effect on the financial condition of the Company.

Legal Matters. On June 29, 2001, suit was filed against the Company in the Court of Common Pleas of Allegheny County, Pennsylvania by Teledyne. The suit alleges that steel product manufactured by the Company was defective and that the Company was or should have been aware of the defects. Teledyne has alleged that the steel supplied by the Company caused certain crankshafts sold by Teledyne to be defective. As a result, Teledyne is claiming damages relating to the recall, replacement and repair of aircraft engines.

After in-depth investigation, it is the Company’s position that the suit is without merit and it intends to vigorously defend that position, is currently engaged in the pre-trial phase of the proceedings, and believes that the final disposition of this suit will not have a material adverse effect on the financial condition and the results of operations of the Company. The trial is now listed on the May 2007 trial docket for the Court of Common Pleas of Allegheny County, Pennsylvania.

CRITICAL ACCOUNTING POLICIES AND NEW ACCOUNTING PRONOUNCEMENTS

Critical Accounting Policies. Revenue recognition is the most critical accounting policy of the Company. Revenue from the sale of products is recognized when both risk of loss and title have transferred to the customer, which in most cases coincides with shipment of the related products, and collection is reasonably assured. The Company manufactures specialty steel product to customer purchase order specifications and in recognition of requirements for product acceptance. Material certification forms are executed, indicating compliance with the customer purchase orders, before the specialty steel products are packed and shipped to the customer. Occasionally customers request that the packed products be held at the Company’s facility beyond the stated shipment date. In these situations, the Company receives written confirmation of the request, and acknowledgement that title has passed to the customer and that normal payment terms apply. Such amounts included in revenue for the years ended December 31, 2006, 2005 and 2004 were less than 1% of net sales.

Revenue from conversion services is recognized when the performance of the service is complete. Invoiced shipping and handling costs are also accounted for as revenue. Customer claims are accounted for primarily as a reduction to gross sales after the matter has been researched and an acceptable resolution has been reached.

In addition, management constantly monitors the ability to collect its unpaid sales invoices and the valuation of its inventory. The allowance for doubtful accounts includes specific reserves for the value of outstanding invoices issued to customers currently operating under the protection of the federal bankruptcy law and other amounts that are deemed potentially not collectible with a reserve equal to 15% of 90-day or older balances. However, the total reserve will not be less than 1% of total accounts receivable.

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The cost of inventory is principally determined by the first in, first-out (FIFO) method for material costs as well as the average cost method for operation costs. An inventory reserve is provided for material on hand for which management believes cost exceeds fair market value and for material on hand for more than one year not assigned to a specific customer order.

Long-lived assets are reviewed for impairment annually by each operating facility. An impairment write-down will be recognized whenever events or changes in circumstances indicate that the carrying value may not be recoverable through estimated future undiscounted cash flows. Based on management’s assessment of the carrying values of such long-lived assets, no impairment reserve had been deemed necessary as of December 31, 2006 and 2005. Attempts to sell the Dunkirk office building since February 2002 have not been successful, and the Company had no prospective buyers. The change in circumstances caused the Company’s management to write off the $184,000 carrying value of the Dunkirk office building during first quarter 2005. Retirements and disposals are removed from cost and accumulated depreciation accounts, with the gain or loss reflected in operating income.

In addition, management assesses the need to record a valuation allowance to reduce deferred tax assets to the amount that is more likely than not to be realized. The Company believes it will generate sufficient income in addition to taxable income generated from the reversal of its temporary differences to utilize the deferred tax assets recorded at December 31, 2006.

New Accounting Pronouncements. See information under the heading “Note 1: Significant Accounting Policies” within “Notes to Consolidated Financial Statements” in Item 8, Financial Statements and Supplementary Data, in this Annual Report on Form 10-K for details of recently issued accounting pronouncements and their expected impact on the Company’s financial statements.

FUTURE OUTLOOK

The Company enters 2007 with a total backlog of approximately $120 million and expects demand for aerospace, power generation, petrochemical and tool steel products to remain strong throughout the year. The Company also expects that its results will improve in 2007 in conjunction with the third quarter 2006 installation of a seventh VAR furnace at the Bridgeville facility that should increase the production output for certain higher-value-added products, and the installation of additional equipment in 2007.

FORWARD-LOOKING INFORMATION SAFE HARBOR

The Management’s Discussion and Analysis and other sections of this Annual Report on Form 10-K contain forward-looking statements that reflect the Company’s current views with respect to future events and financial performance. Statements looking forward in time, including statements regarding future growth, cost savings, expanded production capacity, broader product lines, greater capacity to meet customer quality reliability, price and delivery needs, enhanced competitive posture, effect of new accounting pronouncements and no material financial impact from litigation or contingencies are included in this Annual Report on Form 10-K pursuant to the “safe harbor” provision of the Private Securities Litigation Reform Act of 1995.

The Company’s actual results will be affected by a wide range of factors, including those items described in Item 1A, Risk Factors. Many of these factors are not within the Company’s control and involve known and unknown risks and uncertainties that may cause the Company’s actual results in future periods to be materially different from any future performance suggested herein. Any unfavorable change in the foregoing or other factors could have a material adverse effect on the Company’s business, financial condition and results of operations. Further, the Company operates in an industry sector where securities values may be volatile and may be influenced by economic and other factors beyond the Company’s control.

The Company does not use derivative financial instruments to reduce its financial risk. The Company’s customers and suppliers absorb fluctuations in foreign currency exchange rates. In addition, the Company maintains some long-term, fixed cost supply agreements for its major purchase requirements. Prices for the Company’s raw materials and natural gas requirements are subject to frequent market fluctuations, and profit margins may decline in the event market values increase. Selling price increases and surcharges are implemented to offset raw material and natural gas market price increases.

The cost of raw materials represents more than 50% of the Company’s total cost of products sold in 2006 and 2005 due to significant increases in transaction prices for raw materials purchased. Raw material prices vary based on numerous factors, including quality, and are subject to frequent market fluctuations. Future raw material prices cannot be predicted with any degree of certainty. Therefore, the Company does not maintain any long-term written agreements with any of its raw material suppliers.

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The Company has implemented a sales price surcharge mechanism on its products to help offset the impact of raw material price fluctuations. For substantially all semi-finished products, the surcharge is calculated at the time of order entry, based on average raw material prices reported for the previous 20-day period. For substantially all finished products, the surcharge is calculated based on average raw material prices reported for the previous 20-day period from the promised ship date. While the material surcharge mechanism is designed to offset modest fluctuations in raw material prices, it can not immediately absorb significant spikes in raw material prices. A material change in raw material prices within a short period of time could have a material adverse effect on the financial results of the Company and there can be no assurance that the raw material surcharge mechanism will completely offset immediate changes in the Company’s raw material costs.

The Company is exposed to market risk from changes in interest rates related to its long-term debt. At December 31, 2006, $2.2 million of the Company’s total long-term debt has fixed interest rates. The remaining $17.4 million represents the outstanding balance on the PNC Line and PNC Term Loan that bear variable interest rates. Since the interest rate on this debt floats with the short-term market rate of interest, the Company is exposed to the risk that these interest rates may increase. For example, a hypothetical 1% increase in the rate of interest on $17.4 million of outstanding floating-rate loans would result in increased annual interest costs of $174,000.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Universal Stainless & Alloy Products, Inc.

We have audited the accompanying consolidated balance sheets of Universal Stainless & Alloy Products, Inc. and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of operations, and cash flows for each of the three years in the period ended December 31, 2006. In addition, our audits included the financial statement schedule as of December 31, 2006, 2005 and 2004 included in the index at Item 15 (2) (Schedule II). These consolidated financial statements and financial statement schedule are the responsibility of Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Universal Stainless & Alloy Products, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements as a whole, presents fairly, in all material respects, the information set forth therein.

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CONSOLIDATED STATEMENTS OF OPERATIONS

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

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CONSOLIDATED BALANCE SHEETS

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

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CONSOLIDATED STATEMENTS OF CASH FLOWS