UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______ to ______
Commission file number 1-32459
HEADWATERS INCORPORATED
(Exact name of registrant as specified in its charter)
Delaware 87-0547337
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
10653 South River Front Parkway, Suite 300
South Jordan, Utah 84095
(Address of principal executive offices) (Zip Code)
(801) 984-9400
(Registrant's telephone number, including area code)
Not applicable
(Former name, former address and former fiscal year,
if changed since last report)
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 whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer (as defined in Rule
12b-2 of the Exchange Act).
Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ]
The number of shares outstanding of the Registrant's common stock as of
July 20, 2006 was 42,304,951.
HEADWATERS INCORPORATED
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Page No.
ITEM 1. FINANCIAL STATEMENTS (Unaudited):
Condensed Consolidated Balance Sheets - As of September 30, 2005 and
June 30, 2006.............................................................. 3
Condensed Consolidated Statements of Income - For the three and nine
months ended June 30, 2005 and 2006........................................ 4
Condensed Consolidated Statement of Changes in Stockholders' Equity -
For the nine months ended June 30, 2006.................................... 5
Condensed Consolidated Statements of Cash Flows - For the nine months
ended June 30, 2005 and 2006.............................................. 6
Notes to Condensed Consolidated Financial Statements......................... 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.................................................................20
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...................30
ITEM 4. CONTROLS AND PROCEDURES......................................................30
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS............................................................31
ITEM 1A. RISK FACTORS.................................................................31
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS..................32
ITEM 3. DEFAULTS UPON SENIOR SECURITIES..............................................32
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..........................32
ITEM 5. OTHER INFORMATION............................................................32
ITEM 6. EXHIBITS.....................................................................32
SIGNATURES..............................................................................33
Forward-looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995 regarding
future events and our future results that are based on current expectations,
estimates, forecasts, and projections about the industries in which we operate
and the beliefs and assumptions of our management. Actual results may vary
materially from such expectations. Words such as "expects," "anticipates,"
"targets," "goals," "projects," "believes," "seeks," "estimates," or variations
of such words and similar expressions, are intended to identify such
forward-looking statements. In addition, any statements that refer to
projections of our future financial performance, our anticipated growth and
trends in our businesses, and other characterizations of future events or
circumstances, are forward-looking. For a discussion of the factors that could
cause actual results to differ from expectations, please see the risk factors
described in Item 7 of our Annual Report on Form 10-K for the year ended
September 30, 2005 and in Item 1A of this report. There can be no assurance that
our results of operations will not be adversely affected by such factors. Unless
legally required, we undertake no obligation to revise or update any
forward-looking statements for any reason. Readers are cautioned not to place
undue reliance on these forward-looking statements, which speak only as of the
date of this report.
Our internet address is www.headwaters.com. There we make available, free of
charge, our 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 soon as reasonably
practicable after we electronically file such material with, or furnish it to,
the Securities and Exchange Commission ("SEC"). Our reports can be accessed
through the investor relations section of our web site. The information found on
our web site is not part of this or any report we file with or furnish to the
SEC.
2
ITEM 1. FINANCIAL STATEMENTS
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, June 30,
(in thousands, except per-share data) 2005 2006
- -------------------------------------------------------------- ---------------- -----------------
ASSETS
Current assets:
Cash and cash equivalents $ 13,666 $ 59,663
Trade receivables, net 174,127 144,086
Other receivable 70,000 --
Inventories 60,519 72,879
Current and deferred income taxes 28,577 19,759
Other 8,185 13,761
---------------- -----------------
Total current assets 355,074 310,148
---------------- -----------------
Property, plant and equipment, net 190,450 204,883
---------------- -----------------
Other assets:
Intangible assets, net 276,248 262,881
Goodwill 811,545 826,679
Debt issue costs and other assets 38,339 47,818
---------------- -----------------
Total other assets 1,126,132 1,137,378
---------------- -----------------
Total assets $1,671,656 $1,652,409
================ =================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 43,957 $ 32,964
Accrued personnel costs 33,584 33,751
Accrued income taxes 14,941 1,359
Other accrued liabilities 66,191 71,289
Deferred license fee revenue 26,858 22,328
Current portion of long-term debt 52,207 7,475
---------------- -----------------
Total current liabilities 237,738 169,166
---------------- -----------------
Long-term liabilities:
Long-term debt 601,811 587,826
Deferred income taxes 108,449 105,952
Other 37,345 17,171
---------------- -----------------
Total long-term liabilities 747,605 710,949
---------------- -----------------
Total liabilities 985,343 880,115
---------------- -----------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.001 par value; authorized 100,000
shares; issued and outstanding: 41,842 shares at
September 30, 2005 (including 347 shares held in
treasury) and 42,305 shares at June 30, 2006
(including 278 shares held in treasury) 42 42
Capital in excess of par value 489,602 500,679
Retained earnings 197,808 271,912
Treasury stock and other (1,139) (339)
---------------- -----------------
Total stockholders' equity 686,313 772,294
---------------- -----------------
Total liabilities and stockholders' equity $1,671,656 $1,652,409
================ =================
See accompanying notes.
3
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended June 30, Nine Months Ended June 30,
------------------------------------ --------------------------------
(in thousands, except per-share data) 2005 2006 2005 2006
- ----------------------------------------------- ----------------- ------------------ --------------- ----------------
Revenue:
Construction materials $147,582 $162,067 $370,467 $423,744
Coal combustion products 69,453 74,068 170,973 197,724
Alternative energy 91,694 59,794 208,097 224,692
----------------- ------------------ --------------- ----------------
Total revenue 308,729 295,929 749,537 846,160
Cost of revenue:
Construction materials 97,720 107,264 248,140 288,200
Coal combustion products 51,436 53,714 130,882 149,022
Alternative energy 37,874 40,147 91,119 140,395
----------------- ------------------ --------------- ----------------
Total cost of revenue 187,030 201,125 470,141 577,617
----------------- ------------------ --------------- ----------------
Gross profit 121,699 94,804 279,396 268,543
Operating expenses:
Amortization 6,126 6,278 18,322 18,419
Research and development 4,758 3,363 10,109 9,682
Contract litigation settlement (38,252) -- (38,252) --
Selling, general and administrative 53,598 35,921 122,585 103,192
----------------- ------------------ --------------- ----------------
Total operating expenses 26,230 45,562 112,764 131,293
----------------- ------------------ --------------- ----------------
Operating income 95,469 49,242 166,632 137,250
Other income (expense):
Net interest expense (11,364) (8,156) (45,967) (25,816)
Other, net (6,375) 541 (11,514) (4,960)
----------------- ------------------ --------------- ----------------
Total other income (expense), net (17,739) (7,615) (57,481) (30,776)
----------------- ------------------ --------------- ----------------
Income before income taxes 77,730 41,627 109,151 106,474
Income tax provision (22,440) (14,220) (32,750) (32,370)
----------------- ------------------ --------------- ----------------
Net income $ 55,290 $ 27,407 $ 76,401 $ 74,104
================= ================== =============== ================
Basic earnings per share $ 1.35 $ 0.65 $ 2.07 $ 1.77
================= ================== =============== ================
Diluted earnings per share $ 1.17 $ 0.58 $ 1.81 $ 1.58
================= ================== =============== ================
See accompanying notes.
4
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
For the Nine Months Ended June 30, 2006
Common stock Capital in Total
------------------- excess Retained Treasury stock, stockholders'
(in thousands) Shares Amount of par value earnings at cost Other equity
- ------------------------------------------- -------- ---------- ------------ ---------- --------------- ------- -------------
Balances as of September 30, 2005 41,842 $42 $489,602 $197,808 $(2,419) $1,280 $686,313
Exercise of stock options and
stock appreciation rights 461 -- 6,365 6,365
Tax benefit from exercise of stock
options and stock appreciation rights,
net of reversals pertaining to prior
periods (2,291) (2,291)
69 shares of treasury stock transferred
to employee stock purchase plan, at cost 1,764 190 1,954
Stock-based compensation 2 -- 5,239 5,239
Other comprehensive income - unrealized
gain on cash flow hedges, net of taxes 610 610
Net income for the nine months
ended June 30, 2006 74,104 74,104
-------- ---------- ------------ ---------- --------------- ------- -------------
Balances as of June 30, 2006 42,305 $42 $500,679 $271,912 $(2,229) $1,890 $772,294
======== ========== ============ ========== ============== ======= =============
See accompanying notes.
5
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended June 30,
--------------------------------
(in thousands) 2005 2006
- --------------------------------------------------------------------------------- --------------- ----------------
Cash flows from operating activities:
Net income $ 76,401 $ 74,104
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 41,318 46,955
Non-cash stock-based compensation expense 32,444 5,239
Non-cash interest expense related to amortization of debt issue costs 8,744 2,231
Amortization of non-refundable license fees (11,327) (16,551)
Deferred income taxes (18,355) 5,931
Net loss on disposition of property, plant and equipment 125 2
Decrease (increase) in trade receivables (32,397) 30,122
Increase in inventories (17,937) (11,606)
Increase (decrease) in accounts payable and accrued liabilities 53,898 (25,713)
Other changes in operating assets and liabilities, net (9,265) 61,972
--------------- ----------------
Net cash provided by operating activities 123,649 172,686
--------------- ----------------
Cash flows from investing activities:
Purchase of property, plant and equipment (43,047) (39,049)
Payments for acquisitions, net of cash acquired -- (24,297)
Investments in joint ventures and net increase in other assets (3,894) (11,735)
Proceeds from disposition of property, plant and equipment 265 1,081
--------------- ----------------
Net cash used in investing activities (46,676) (74,000)
--------------- ----------------
Cash flows from financing activities:
Net proceeds from issuance of long-term debt 29,332 --
Payments on long-term debt (329,176) (58,717)
Net proceeds from issuance of common stock 198,817 --
Proceeds from exercise of stock options 6,378 6,365
Income tax benefit from exercise of stock options and
stock appreciation rights (net of reversals pertaining
to prior periods) 6,309 (2,291)
Employee stock purchases 1,394 1,954
--------------- ----------------
Net cash used in financing activities (86,946) (52,689)
--------------- ----------------
Net increase (decrease) in cash and cash equivalents (9,973) 45,997
Cash and cash equivalents, beginning of period 20,851 13,666
--------------- ----------------
Cash and cash equivalents, end of period $ 10,878 $ 59,663
=============== ================
Supplemental schedule of non-cash investing and financing activities:
Purchase of variable interest in solid alternative fuel facility in
exchange for commitment to make future payments $ 7,500 $ --
Increase in accrued liabilities for earn-out and other acquisition-related
commitments -- 1,500
See accompanying notes.
6
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2006
(Unaudited)
1. Nature of Operations and Basis of Presentation
Organization and Description of Business - Headwaters Incorporated is
incorporated in Delaware. Headwaters owns 100% of the following
subsidiaries: Headwaters Resources, Inc. and Headwaters Construction
Materials, Inc. (the two of which combined were formerly Industrial
Services Group, Inc., a Utah-based company acquired by Headwaters in
September 2002) ("ISG"); Headwaters Technology Innovation Group, Inc.
(formerly Hydrocarbon Technologies, Inc., a New Jersey company acquired in
August 2001) ("HTI"); VFL Technology Corporation, a Pennsylvania company
acquired in April 2004 ("VFL"); Eldorado Stone, LLC, a Delaware company
acquired in June 2004 ("Eldorado"); Southwest Concrete Products, L.P., a
Texas company acquired in July 2004 ("SCP"); and Tapco Holdings, Inc., a
Michigan company acquired in September 2004 ("Tapco").
Headwaters is a diversified company providing products, technologies and
services to the construction materials and energy industries. Headwaters
generates revenue from the sale of construction materials, marketing coal
combustion products ("CCPs") and reclaiming waste coal, and through
commercial application of its energy, chemical and catalyst technologies.
Headwaters intends to continue to expand its business through growth of
existing operations, commercialization of technologies currently being
developed and strategic acquisitions of products or entities that expand
Headwaters' current operating platform.
Headwaters' construction materials segment is an industry leader nationwide
in two product categories, manufactured stone and siding accessories.
Headwaters also develops, manufactures and distributes bagged concrete,
stucco, mortar and an array of concrete block products. Revenue from
construction materials is diversified geographically and also by market,
including the new construction and the remodeling and home improvement
markets.
ISG's CCP operations and VFL (together referred to as Headwaters'
Resources, Inc., or "Resources") comprise the largest manager and marketer
of CCPs in the United States, purchasing CCPs from utilities and supplying
them to Headwaters' customers as a replacement for portland cement in a
variety of concrete infrastructure and building projects.
Headwaters' alternative energy segment is now operating two coal
reclamation facilities at which high volumes of ash (rocks, dirt, and other
impurities) are removed from waste coal, resulting in a high value
marketable coal. In addition, Headwaters is constructing its first ethanol
plant and proceeding with the commercialization of catalyst technologies,
including catalysts that help improve the yield and quality of
petroleum-based fuel. Historically, Headwaters has been a market leader in
providing technologies used to produce coal-based solid alternative fuels.
As the solid coal-based alternative fuels business diminishes, Headwaters
believes that it will be replaced by existing and future growth
opportunities.
Basis of Presentation - The accompanying unaudited condensed consolidated
financial statements have been prepared in accordance with the rules and
regulations of the Securities and Exchange Commission ("SEC") for quarterly
reports on Form 10-Q. In the opinion of management, all adjustments
considered necessary for a fair presentation have been included, and
consist of normal recurring adjustments.
Certain information and footnote disclosures normally included in annual
financial statements prepared in accordance with U.S. generally accepted
accounting principles have been condensed or omitted. These financial
statements should be read in conjunction with the consolidated financial
statements and notes thereto included in Headwaters' Annual Report on Form
10-K for the year ended September 30, 2005 ("Form 10-K") and in Headwaters'
Quarterly Reports on Form 10-Q for the quarters ended December 31, 2005 and
March 31, 2006.
Headwaters' fiscal year ends on September 30. Unless otherwise noted,
future references to 2005 refer to Headwaters' fiscal quarter and/or
nine-month period ended June 30, 2005, and references to 2006 refer to
Headwaters' fiscal quarter and/or nine-month period ended June 30, 2006.
The consolidated financial statements include the accounts of Headwaters,
all of its subsidiaries and other entities in which Headwaters has a
controlling interest. All significant intercompany transactions and
accounts are eliminated in consolidation. Due to the seasonality of the
operations of the construction materials and CCP segments and other
7
factors, Headwaters' consolidated results of operations for 2006 are not
indicative of the results to be expected for the full fiscal 2006 year.
Reclassifications - Certain prior period amounts have been reclassified to
conform to the current period's presentation. The reclassifications had no
effect on net income or total assets.
2. Segment Reporting
The following segment information has been prepared in accordance with SFAS
No. 131, "Disclosure about Segments of an Enterprise and Related
Information." The accounting policies of the segments are the same as those
described in the notes to the financial statements in Headwaters' Form
10-K. Segment performance is evaluated primarily on revenue growth and
operating income, although other factors are also used, such as income tax
credits generated by activities of the alternative energy segment.
Intersegment sales are immaterial.
Segment costs and expenses considered in deriving segment operating income
include cost of revenue, amortization, research and development, and
segment-specific selling, general and administrative expenses. Amounts
included in the "Corporate" column represent expenses not specifically
attributable to any segment and include administrative departmental costs
and general corporate overhead. Segment assets reflect those specifically
attributable to individual segments and primarily include accounts
receivable, inventories, property, plant and equipment, intangible assets
and goodwill. Other assets are included in the "Corporate" column.
Three Months Ended June 30, 2005
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
------------------------------------------ -------------- ------------ ------------- ------------- -------------
Segment revenue $147,582 $69,453 $91,694 $ -- $308,729
============== ============ ============= ============= =============
Depreciation and amortization $ (8,700) $(3,192) $(1,662) (81) $(13,635)
============== ------------ ------------- ------------- -------------
Operating income (loss) $ 16,919 $ 9,297 $86,261 $(17,008) $ 95,469
============== ============ ============= =============
Net interest expense (11,364)
Other income (expense), net (6,375)
Income tax provision (22,440)
-------------
Net income $ 55,290
=============
Capital expenditures $ 14,393 $ 2,265 $ 2,839 $ 41 $ 19,538
============== ============ ============= ============= =============
Three Months Ended June 30, 2006
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
------------------------------------------ -------------- ------------ ------------- ------------- -------------
Segment revenue $162,067 $74,068 $59,794 $ -- $295,929
============== ============ ============= ============= =============
Depreciation and amortization $(10,919) $(3,146) $(2,014) $ (96) $(16,175)
============== ============ ============= ============= =============
Operating income (loss) $ 29,063 $14,184 $14,175 $(8,180) $ 49,242
============== ============ ============= =============
Net interest expense (8,156)
Other income (expense), net 541
Income tax provision (14,220)
-------------
Net income $ 27,407
=============
Capital expenditures $ 9,270 $ 2,342 $ 2,782 $ 51 $ 14,445
============== ============ ============= ============= =============
8
Nine Months Ended June 30, 2005
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
------------------------------------------ -------------- ------------ ------------- ------------- -------------
Segment revenue $ 370,467 $170,973 $208,097 $ -- $ 749,537
============== ============ ============= ============= =============
Depreciation and amortization $ (27,445) $ (9,487) $ (4,154) $ (232) $ (41,318)
============== ============ ============= ============= =============
Operating income (loss) $ 43,593 $ 18,089 $137,175 $(32,225) $ 166,632
============== ============ ============= =============
Net interest expense (45,967)
Other income (expense), net (11,514)
Income tax provision (32,750)
-------------
Net income $ 76,401
=============
Capital expenditures $ 33,382 $ 5,664 $ 3,770 $ 231 $ 43,047
============== ============ ============= ============= =============
Segment Assets as of June 30, 2005 $1,135,629 $314,013 $146,285 $ 48,649 $1,644,576
============== ============ ============= ============= =============
Nine Months Ended June 30, 2006
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
------------------------------------------ -------------- ------------ ------------- ------------- -------------
Segment revenue $ 423,744 $197,724 $224,692 $ -- $ 846,160
============== ============ ============= ============= =============
Depreciation and amortization $ (31,648) $ (9,472) $ (5,551) $ (284) $ (46,955)
============== ============ ============= ============= =============
Operating income (loss) $ 57,321 $ 28,925 $ 67,271 $(16,267) $ 137,250
============== ============ ============= =============
Net interest expense (25,816)
Other income (expense), net (4,960)
Income tax provision (32,370)
-------------
Net income $ 74,104
=============
Capital expenditures $ 24,847 $ 7,099 $ 6,607 $ 496 $ 39,049
============== ============ ============= ============= =============
Segment Assets as of June 30, 2006 $1,160,267 $310,789 $ 79,915 $101,438 $1,652,409
============== ============ ============= ============= =============
3. Securities and Stock-Based Compensation
Shelf Registration Statement - Headwaters has an effective universal shelf
registration statement on file with the SEC that can be used for the sale
of common stock, preferred stock, convertible debt and other securities.
Approximately $18.0 million remains available for future offerings of
securities under this registration statement. A prospectus supplement
describing the terms of any additional securities to be issued is required
to be filed before any future offering would commence under the
registration statement.
Stock Incentive Grants - During the quarter ended June 30, 2006,
Headwaters' Board of Directors granted 197,000 stock appreciation rights
("SARs") to employees. The SARs were granted under the terms of an approved
plan, have an exercise price of $32.51 per share and vest over a five-year
period.
Stock-Based Compensation - Total stock-based compensation expense, none of
which involved the expenditure of cash, was approximately $27.2 million and
$1.6 million for the three months ended June 30, 2005 and 2006,
respectively, and $32.4 million and $5.2 million for the nine months ended
June 30, 2005 and 2006, respectively. As of June 30, 2006, there was
approximately $13.2 million of total compensation cost related to nonvested
awards not yet recognized, which will be recognized in future periods over
applicable vesting terms.
9
4. Inventories
Inventories consisted of the following at:
(in thousands) September 30, 2005 June 30, 2006
--------------------------------- -------------------- -------------------
Raw materials $12,604 $14,238
Finished goods 47,915 58,641
-------------------- -------------------
$60,519 $72,879
==================== ===================
5. Intangible Assets
Intangible Assets - Headwaters has no identified intangible assets that are
not being amortized. The following table summarizes the gross carrying
amounts and the related accumulated amortization of all amortizable
intangible assets as of:
September 30, 2005 June 30, 2006
-------------------------------- --------------------------------
Gross Gross
Estimated Carrying Accumulated Carrying Accumulated
(in thousands) useful lives Amount Amortization Amount Amortization
------------------------------ -------------- --------------- ---------------- --------------- ----------------
Contracts 7 - 20 years $117,690 $18,256 $124,531 $23,467
Customer relationships 7 1/2 - 15 years 68,331 5,395 68,331 9,112
Trade names 5 - 20 years 63,657 3,642 63,657 6,174
Patents and patented
technologies 7 1/2 - 16 years 55,359 8,060 52,989 11,771
Non-competition agreements 2 - 3 1/2 years 10,422 4,939 9,552 7,122
Other 9 - 15 years 2,336 1,255 2,916 1,449
--------------- ---------------- --------------- ----------------
$317,795 $41,547 $321,976 $59,095
=============== ================ =============== ================
Total amortization expense related to intangible assets was approximately
$6.2 million and $6.3 million for the three months ended June 30, 2005 and
2006, respectively, and $18.4 million for both the nine months ended June
30, 2005 and 2006. Total estimated annual amortization expense is as
follows for the fiscal years presented.
Year ending September 30, (in thousands)
------------------------- -------------
2006 $24,577
2007 22,887
2008 21,339
2009 21,127
2010 20,793
2011 20,613
6. Long-term Debt
Long-term debt consisted of the following at:
September 30, June 30,
(in thousands) 2005 2006
--------------------------------------------- ---------------- ---------------
Senior secured debt $472,673 $415,319
Convertible senior subordinated notes 172,500 172,500
Notes payable to a bank 8,705 7,413
Other 140 69
---------------- ---------------
654,018 595,301
Less: current portion (52,207) (7,475)
---------------- ---------------
Total long-term debt $601,811 $587,826
================ ===============
10
Senior Secured Credit Agreements - In September 2004, Headwaters entered
into two credit agreements with a syndication of lenders. The credit
agreements have since been amended, most recently in June 2006. A total of
$790.0 million was originally borrowed under the credit facility, which
also provides for up to $60.0 million of borrowings under a revolving
credit arrangement. The original proceeds were used to acquire Tapco and
repay in full the remaining balance due under Headwaters' former senior
secured credit agreement executed in March 2004. The $790.0 million of
borrowings consisted of a first lien term loan in the amount of $640.0
million and a second lien term loan in the amount of $150.0 million. The
second lien term loan was repaid in its entirety prior to September 30,
2005. With certain limited exceptions, the first lien term loan is secured
by all assets of Headwaters and is senior in priority to all other debt
except for specific SCP assets that collateralize the notes payable to a
bank discussed below. The terms of the credit facility, as amended, are
described in more detail in the following paragraphs. Headwaters is in
compliance with all debt covenants as of June 30, 2006.
The first lien term loan bears interest, at Headwaters' option, at either
i) the London Interbank Offered Rate ("LIBOR") plus 2.0%, 2.25%, or 2.5%,
depending on the credit ratings that have been most recently announced for
the loans by Standard & Poors Ratings Services ("S&P") and Moody's
Investors Service, Inc. ("Moody's"); or ii) the "base rate" plus 1.0%,
1.25%, or 1.5%, again depending on the credit ratings announced by S&P and
Moody's. Base rate is defined as the higher of the rate announced by Morgan
Stanley Senior Funding and the overnight rate charged by the Federal
Reserve Bank of New York plus 0.5%. Headwaters' current rate is LIBOR plus
2.0%. The weighted-average interest rate on the first lien debt was
approximately 6.6% at June 30, 2006, after giving consideration to the
effect of the interest rate hedge on $150.0 million of this debt, as
described below. Headwaters can lock in new LIBOR rates for the first lien
loan for one, two, three or six months. The most recent rate change
occurred in July 2006.
The first lien term loan ($415.3 million outstanding at June 30, 2006) is
repayable in quarterly installments of principal and interest, with minimum
required quarterly principal repayments of approximately $3.4 million
through August 2010, plus three repayments of approximately $125.2 million
each in November 2010, February 2011 and April 2011, the termination date.
Interest is generally due on a quarterly basis. During 2006, Headwaters
made one required principal repayment of $3.4 million and one optional
repayment of $24.0 million, which satisfied the required principal
repayments on the senior debt until November 2007.
There are mandatory prepayments of the first lien term loan in the event of
certain asset sales and debt and equity issuances and from "excess cash
flow," as defined in the agreement. Optional prepayments of the first lien
term loan are generally permitted without penalty or premium, except where
the proceeds for repayment are obtained from a "financing," as defined,
consummated for the purpose of lowering the interest rate on the first lien
debt, in which case there is a 1% prepayment penalty. Once repaid in full
or in part, no further reborrowings under either the first or second lien
loan arrangements can be made.
Borrowings under the revolving credit arrangement are generally subject to
the terms of the first lien loan agreement and bear interest at either
LIBOR plus 1.75% to 2.5% (depending on Headwaters' "total leverage ratio,"
as defined), or the base rate plus 0.75% to 1.5%. Borrowings and
reborrowings of any available portion of the $60.0 million revolver can be
made at any time through September 2009, when all loans must be repaid and
the revolving credit arrangement terminates. The fees for the unused
portion of the revolving credit arrangement range from 0.5% to 0.75%
(depending on Headwaters' "total leverage ratio," as defined). There were
no borrowings outstanding under the revolving credit arrangement as of June
30, 2006, or subsequent thereto. The credit agreement also allows for the
issuance of letters of credit, provided there is capacity under the
revolving credit arrangement. As of June 30, 2006, eight letters of credit
totaling $6.9 million were outstanding, with expiration dates ranging from
September 2006 to December 2008.
The credit agreements contain restrictions and covenants common to such
agreements, including limitations on the incurrence of additional debt,
investments, merger and acquisition activity, asset sales and liens, annual
capital expenditures in excess of $72.0 million for fiscal 2006 and $75.0
million for fiscal years 2007 through 2011, and the payment of dividends,
among others. In addition, Headwaters must maintain certain leverage and
fixed charge coverage ratios, as those terms are defined in the agreements,
as follows: i) a total leverage ratio of 4.25:1.0 or less, declining
periodically to 3.5:1.0 in 2010; ii) a maximum ratio of consolidated senior
funded indebtedness minus subordinated indebtedness to EBITDA of 3.25:1.0,
declining periodically to 2.5:1.0 in 2010; and iii) a minimum ratio of
EBITDA plus rent payments for the four preceding fiscal quarters to
11
scheduled payments of principal and interest on all indebtedness for the
next four fiscal quarters of 1.10:1.0 through September 30, 2006, and
1.25:1.0 thereafter.
As required by the senior secured credit facility, Headwaters entered into
certain other agreements to limit its variable interest rate exposure. The
first set of agreements expired on their terms prior to September 30, 2005.
The second set of agreements effectively fixes the LIBOR rate at 3.71% for
$150.0 million of the first lien debt for the period September 8, 2005
through September 8, 2007. Headwaters accounts for the agreements which
limit its variable interest rate exposure as cash flow hedges, with their
fair market value reflected in the consolidated balance sheet as either
other assets or other liabilities. The market value of the hedges can
fluctuate significantly over a relatively short period of time. The hedges
had a market value at June 30, 2006 of approximately $3.1 million, which,
net of $1.2 million of income taxes, represents other comprehensive income.
Total comprehensive income was approximately $53.3 million and $27.4
million for the three months ended June 30, 2005 and 2006, respectively,
and $76.9 million and $74.7 million for the nine months ended June 30, 2005
and 2006, respectively.
Convertible Senior Subordinated Notes - In connection with the Eldorado
acquisition, Headwaters issued $172.5 million of 2.875% convertible senior
subordinated notes due 2016. These notes are subordinate to the senior
secured debt described above. Holders of the notes may convert the notes
into shares of Headwaters' common stock at a conversion rate of 33.3333
shares per $1,000 principal amount ($30 conversion price), or 5.75 million
aggregate shares of common stock, contingent upon certain events. The
conversion rate adjusts for events related to Headwaters' common stock,
including common stock issued as a dividend, rights or warrants to purchase
common stock issued to all holders of Headwaters' common stock, and other
similar rights or events that apply to all holders of common stock.
The notes are convertible if any of the following five criteria are met: 1)
satisfaction of a market price condition which becomes operative if, prior
to June 1, 2011 and at any time after that date, in any calendar quarter
the closing price of Headwaters' common stock exceeds $39 per share for at
least 20 trading days in the 30 consecutive trading days ending on the last
trading day of the preceding calendar quarter; 2) a credit rating, if any,
assigned to the notes is three or more rating subcategories below the
initial rating, if any; 3) the notes trade at less than 98% of the product
of the common stock trading price and the number of shares of common stock
issuable upon conversion of $1,000 principal amount of the notes, except
this provision is not available if the closing common stock price is
between 100% and 130% of the current conversion price of the notes; 4)
Headwaters calls the notes for redemption; and 5) certain corporate
transactions occur, including distribution of rights or warrants to all
common stockholders entitling them to purchase common stock at less than
the current market price or distribution of common stock, cash or other
assets, debt securities or certain rights to purchase securities where the
distribution has a per share value exceeding 5% of the closing common stock
price on the day immediately preceding the declaration date for such
distribution. In addition, the notes are convertible if Headwaters enters
into an agreement pursuant to which Headwaters' common stock would be
converted into cash, securities or other property.
Headwaters may call the notes for redemption at any time on or after June
1, 2007 and prior to June 4, 2011 if the closing common stock price exceeds
130% of the conversion price for 20 trading days in any consecutive 30-day
trading period (in which case Headwaters must provide a "make whole"
payment of the present value of all remaining interest payments on the
redeemed notes through June 1, 2011). In addition, the holder of the notes
has the right to require Headwaters to repurchase all or a portion of the
notes on June 1, 2011 or if a fundamental change in common stock has
occurred, including termination of trading. Subsequent to June 1, 2011, the
notes require an additional interest payment equal to 0.40% of the average
trading price of the notes if the trading price equals 120% or more of the
principal amount of the notes.
Headwaters includes the additional shares of common stock contingently
issuable under the notes in its diluted EPS calculations on an if-converted
basis (see Note 8).
Notes Payable to a Bank - In connection with the acquisition of SCP in July
2004, Headwaters assumed SCP's obligations under its notes payable to a
bank. The notes require monthly interest and quarterly principal payments
and bear interest at variable rates, which as of June 30, 2006, ranged from
5.6% to 7.8%. Because the notes are callable by the bank, Headwaters has
included the outstanding balance in current portion of long-term debt in
12
the consolidated balance sheet. The notes are collateralized by certain
assets of SCP and contain financial covenants specific to SCP, including a
minimum fixed charge coverage ratio, a leverage ratio requirement, and
limitations on capital expenditures. Headwaters is in compliance with all
debt covenants as of June 30, 2006.
Interest - During the three months ended June 30, 2005 and 2006, Headwaters
incurred total interest costs related to its long-term debt and other
obligations of approximately $12.0 million and $9.1 million, respectively,
including approximately $2.0 million and $0.6 million, respectively, of
non-cash interest expense and approximately $0.1 million and $0.3 million,
respectively, of interest costs that were capitalized. During the nine
months ended June 30, 2005 and 2006, Headwaters incurred total interest
costs of approximately $46.6 million and $28.5 million, respectively,
including approximately $8.7 million and $2.2 million, respectively, of
non-cash interest expense and approximately $0.4 million and $0.7 million,
respectively, of interest costs that were capitalized.
Interest income was approximately $0.6 million for both the three months
ended June 30, 2005 and 2006, and $0.7 million and $2.0 million for the
nine months ended June 30, 2005 and 2006, respectively. The
weighted-average interest rate on the face amount of outstanding long-term
debt, disregarding amortization of debt issue costs, was approximately 5.2%
at September 30, 2005 and 5.5% at June 30, 2006.
7. Income Taxes
Headwaters' estimated effective income tax rate for the fiscal year ending
September 30, 2006 is 32.0%, the rate applied to the nine month period
ended June 30, 2006. Additionally, Headwaters recognized a net $1.7 million
benefit during the nine months ended June 30, 2006 ($2.2 million during the
three months ended June 30, 2006) for discrete items that did not affect
the calculation of the estimated effective income tax rate. Using a 32.0%
rate for the nine month period resulted in an income tax rate of
approximately 39.4% for the three months ended June 30, 2006, exclusive of
the quarter's discrete items totaling $2.2 million. The rates for the 2006
periods compare to effective tax rates of approximately 30.0% for the nine
months ended June 30, 2005 and 28.9% for the three months ended June 30,
2005. The discrete items benefiting the tax rate in 2006 primarily related
to the reversal of accruals for tax liabilities associated with the fiscal
year ended September 30, 2002, for which the statute of limitations has
expired.
The increase in the effective tax rate for fiscal 2006 as compared to
fiscal 2005 is primarily due to reduced Section 45K [formerly Section 29]
tax credits related to Headwaters' 19% interest in an entity that owns and
operates a coal-based solid alternative fuel production facility (see Note
10), plus two other smaller alternative fuel facilities that Headwaters
owns and operates. The alternative fuel produced at these three facilities
through December 2007 qualifies for tax credits pursuant to Section 45K of
the Internal Revenue Code, subject to the uncertainties of phase-out, IRS
audit and other risks associated with Section 45K tax credits, all as more
fully described in Note 10.
For purposes of calculating an estimated effective tax rate for fiscal
2006, Headwaters assumed a phase-out percentage for Section 45K tax credits
for calendar 2006 of 69%. This estimated phase-out percentage was derived
by estimating the calendar 2006 reference price for oil using actual oil
prices for the months January through April 2006, and published NYMEX oil
prices for the months May through December 2006. The monthly NYMEX oil
prices were reduced by approximately 10%, which percentage reduction
represents Headwaters' estimate of the relationship between NYMEX prices
and the average U.S. wellhead oil prices actually used to calculate the
annual reference price. The estimated reference price for calendar 2006 was
calculated by averaging the 12 months' actual or estimated oil prices,
which average was compared to the estimated phase-out range for calendar
2006 ($54.27 to $68.12) to derive an estimated phase-out percentage.
While it is not possible to accurately estimate the entire calendar year
2006 phase-out percentage at the current time, and it is certain that
Headwaters' estimate of the phase-out percentage will change during the
year, as of June 30, 2006, an estimated phase-out percentage of 69% is
Headwaters' best estimate of what the phase-out percentage for calendar
2006 would be, using available information as of that date. As of March 31,
2006, the estimated phase-out percentage for calendar 2006 was 37%. The
13
effect of the change in estimate of the phase-out percentage from 37% to
69% was recorded to income tax expense in the quarter ended June 30, 2006.
8. Earnings per Share
The following table sets forth the computation of basic and diluted EPS
for the periods indicated.
Three Months Ended June 30, Nine Months Ended June 30,
-------------------------------- -------------------------------
(in thousands, except per-share data) 2005 2006 2005 2006
------------------------------------------- --------------- ---------------- --------------- ---------------
Numerator:
Numerator for basic earnings per share -
net income $55,290 $27,407 $76,401 $74,104
Interest expense related to convertible
senior subordinated notes, net of taxes 1,052 892 3,100 3,022
--------------- ---------------- --------------- ---------------
Numerator for diluted earnings per share -
net income plus interest expense related
to convertible notes, net of taxes $56,342 $28,299 $79,501 $77,126
=============== ================ =============== ===============
Denominator:
Denominator for basic earnings per share -
weighted-average shares outstanding 41,019 41,984 36,877 41,813
Effect of dilutive securities:
Shares issuable upon exercise of options
and SARs 1,227 809 1,245 1,145
Shares issuable upon conversion of
convertible notes 5,750 5,750 5,750 5,750
--------------- ---------------- --------------- ---------------
Total potential dilutive shares 6,977 6,559 6,995 6,895
--------------- ---------------- --------------- ---------------
Denominator for diluted earnings per
share - weighted-average shares
outstanding after assumed exercises
and conversions 47,996 48,543 43,872 48,708
=============== ================ =============== ===============
Basic earnings per share $ 1.35 $ 0.65 $ 2.07 $ 1.77
=============== ================ =============== ===============
Diluted earnings per share $ 1.17 $ 0.58 $ 1.81 $ 1.58
=============== ================ =============== ===============
Anti-dilutive securities not considered in
diluted EPS calculation:
Stock options 240,000 280,000 180,000 140,000
SARs 1,150,000 3,150,000 380,000 1,110,000
9. Acquisitions
As described in Note 3 to the consolidated financial statements in the Form
10-K, Headwaters agreed to pay an earn-out to the sellers of SCP if a
specified earnings target was exceeded during the 12 months ended December
31, 2005 (the earn-out period). The earn-out consideration totaled $9.5
million and was recorded as additional goodwill. It was paid to the former
owners of SCP, one of whom is a current officer of Headwaters, in April
2006.
During the nine months ended June 30, 2006, Headwaters acquired certain
assets and assumed certain liabilities of four privately-held companies.
Total consideration paid or accrued for these four acquisitions was
approximately $16.3 million. Subsequent to June 30, 2006, Headwaters
acquired certain assets and assumed certain liabilities of an additional
company, for consideration which was not material. Pursuant to contractual
terms for four of the acquisitions, additional amounts may be payable in
the future, based on certain net revenues or the achievement of stipulated
revenue or earnings targets in future periods. Four of the five
acquisitions are in the construction materials segment and one is in the
alternative energy segment. Operating results since acquisition dates for
all of the businesses combined are not material.
14
10. Commitments and Contingencies
Commitments and contingencies as of June 30, 2006 not disclosed elsewhere,
are as follows.
Compensation Arrangements - During the quarter ended June 30, 2006, the
Compensation Committee of Headwaters' Board of Directors (the "Committee")
authorized the grant of long-term incentive cash bonus awards to certain
officers and employees. The awards were granted subsequent to June 30, 2006
under Headwaters' Long Term Incentive Compensation Plan approved by
stockholders in March 2005. In accordance with terms of the awards, cash
payments will be based on several factors, including the achievement of
stipulated financial goals as measured by economic value added ("EVA") over
a three-year period by Headwaters and its operating units. Payments for
these awards may not exceed $30.0 million in the aggregate.
Also during the June 2006 quarter, the Committee approved "Executive Change
in Control Agreements" with 12 officers, which agreements will be executed
subsequent to June 30, 2006. Upon a change in control, as defined, the
agreements will provide for immediate vesting and exercisability of all
outstanding stock awards. In addition, if termination of employment occurs
within a specified period of a change in control, the agreements provide
for i) severance pay equal to two times the sum of an officer's current
annual salary plus the highest cash bonus paid or payable for any single
year in the three-year period commencing two years prior to the year in
which the change in control occurs; and ii) continuance of health and other
benefits and perquisites for a two-year period following the change in
control. If terminations associated with a change in control would have
occurred on June 30, 2006, the severance payments due to the 12 officers
would have aggregated approximately $19.3 million.
As described in more detail in Note 12 to the consolidated financial
statements in the Form 10-K, during fiscal 2005 the Committee authorized
the grant of several stock incentive awards. At that time, the Committee
also authorized the grant of performance unit awards, to be settled in
cash, based on performance criteria tied to the economic value created or
preserved by one of Headwaters' business units after December 2007. The
grants of these performance units were made in November 2005 and could
result in the payment to employees of a maximum amount of approximately
$3.6 million if all performance criteria are met.
Property, Plant and Equipment - As of June 30, 2006, Headwaters was
committed to spend approximately $5.2 million on capital projects that were
in various stages of completion.
Solid Alternative Fuel Facility - Headwaters owns a 19% variable interest
in an entity that owns and operates a coal-based solid alternative fuel
production facility, where Headwaters is not the primary beneficiary.
Headwaters' 19% minority interest was acquired in exchange for initial cash
payments totaling $0.5 million and an obligation to pay $15.0 million in
monthly installments from October 2004 through December 2007. This
obligation, recorded in other accrued liabilities and other long-term
liabilities in the consolidated balance sheet (totaling approximately $8.4
million at June 30, 2006), bears interest at an 8% rate. Headwaters also
agreed to make additional payments to the seller based on a pro-rata
allocation of the tax credits generated by the facility, also through
December 2007. These additional contractual payments are affected by
phase-out and, along with the amortization of the $15.5 million investment,
are recorded in other expense in the consolidated statements of income and
total approximately $4.8 million and $(0.3) million for the three months
ended June 30, 2005 and 2006, respectively, and $12.0 million and $5.3
million for the nine months ended June 30, 2005 and 2006, respectively.
The alternative fuel produced at the facility through December 2007
qualifies for tax credits pursuant to Section 45K of the Internal Revenue
Code, and Headwaters is entitled to receive its pro-rata share of such tax
credits generated based upon its percentage of ownership of the facility.
Due to the combined effect of the seasonality of Headwaters' operations and
the requirement to use an estimated effective tax rate for the year in
calculating income taxes, Headwaters is not able to recognize the benefit
of all of the tax credits earned in the December and March quarters in its
results of operations for those quarters. Tax credits earned but not
recognized in the December and March quarters are recognized in the June
and September quarters. Even though Headwaters did not fully recognize its
portion of the benefits of the tax credits generated in the December and
March quarters, Headwaters' pro-rata share of costs incurred to generate
15
those tax credits is recognized as other expense as those costs are
incurred. Headwaters has the ability, under certain conditions, to limit
its liability under the fixed payment obligations currently totaling
approximately $8.4 million; therefore, Headwaters' obligation to make all
of the above-described payments is effectively limited to the tax benefits
Headwaters receives.
Joint Venture Obligations - In 2004, Headwaters entered into an agreement
with Degussa AG, an international chemical company based in Germany, to
jointly develop and commercialize a process for the direct synthesis of
hydrogen peroxide. Under terms of the joint venture agreement, Headwaters
paid $1.2 million for its investment in the joint venture in 2004, an
additional $1.0 million in October 2005 and is further obligated to pay
$1.0 million in fiscal 2006. Headwaters has also committed to fund 50% of
the joint venture's research and development expenditures, currently
limited to (euro)3.0 million, through September 2007, of which
approximately (euro)0.9 million (approximately $1.2 million) remains to be
paid as of June 30, 2006. Although there is no legal obligation to do so,
the joint venture partners currently have long-range plans to eventually
invest in large-scale hydrogen peroxide plants using the process for direct
synthesis of hydrogen peroxide.
In April 2006, Degussa Headwaters Korea Co., Ltd. ("DHK"), a joint venture
in formation between Degussa AG and Headwaters, entered into a Sale and
Purchase Agreement ("Purchase Agreement") as purchaser with Kemira
Chemicals Korea Corporation as seller. The transaction calls for the
transfer by the seller of certain assets and liabilities comprising a
hydrogen peroxide production business located in Ulsan, South Korea. The
base purchase price is (euro)27.5 million payable at closing, which amount
will be adjusted by several factors. Headwaters is a principal obligor with
respect to all non-financial obligations of DHK and with respect to 50% of
all financial obligations of DHK under the Purchase Agreement. The
transaction closing is subject to the fulfillment of certain conditions,
including the execution of a joint venture agreement between Degussa and
Headwaters.
Headwaters also owns a 51% interest in a joint venture with Great River
Energy, a Minnesota-based power generation and supply cooperative ("GRE"),
which was formed to construct, own and operate an ethanol plant in North
Dakota ("Blue Flint"). The plant is currently expected to begin operating
in early calendar 2007 with estimated ethanol production of 50 million
gallons annually. Estimated costs to construct the ethanol plant are
approximately $84.5 million, with an additional $11.0 million to be used
for working capital and start-up costs. As of June 30, 2006, Blue Flint was
committed to spend approximately $43.3 million in construction costs. Blue
Flint expects to fund plant construction and start-up costs with
approximately $76.4 million of debt secured by all the assets of Blue
Flint, along with capital contributions of $9.7 million and $9.4 million
from Headwaters and GRE, respectively. Headwaters has made its full capital
contribution as of June 30, 2006. The Blue Flint joint venture, which is
not a variable interest entity, is being accounted for using the equity
method of accounting because both partners have equal voting rights and
control over the joint venture.
Legal or Contractual Matters - Headwaters has ongoing litigation and
asserted claims which have been incurred during the normal course of
business, including the specific matters discussed below. Headwaters
intends to vigorously defend or resolve these matters by settlement, as
appropriate. Management does not currently believe that the outcome of
these matters will have a material adverse effect on Headwaters'
operations, cash flows or financial position.
Costs paid to outside legal counsel for litigation have historically
comprised a majority of Headwaters' litigation-related costs. During the
nine months ended June 30, 2006, Headwaters recorded a net credit of
approximately $(0.5) million for legal matters, including costs for outside
legal counsel. The credit in costs for legal matters was due to positive
developments in certain legal matters Headwaters is defending, leading to
reduced likelihood of ultimate legal liability. Headwaters currently
believes the range of potential loss for all unresolved matters, excluding
costs for outside counsel, is from $1.0 million up to the amounts sought by
claimants and has recorded a total liability as of June 30, 2006 of $1.0
million. Claims and damages sought by claimants in excess of this amount
are not deemed to be probable. Our outside counsel currently believe that
unfavorable outcomes of outstanding litigation are neither probable nor
remote and declined to express opinions concerning the likely outcomes or
liability to Headwaters. It is not possible to estimate what
litigation-related costs will be in future periods.
16
The matters discussed below raise difficult and complex legal and factual
issues, and the resolution of these issues is subject to many
uncertainties, including the facts and circumstances of each case, the
jurisdiction in which each case is brought, and the future decisions of
juries, judges, and arbitrators. Therefore, although management believes
that the claims asserted against Headwaters in the named cases lack merit,
there is a possibility of material losses in excess of the amounts accrued
if one or more of the cases were to be determined adversely against
Headwaters for a substantial amount of the damages asserted. It is possible
that a change in the estimates of probable liability could occur, and the
changes could be material. Additionally, as with any litigation, these
proceedings require that Headwaters incur substantial costs, including
attorneys' fees, managerial time, and other personnel resources and costs
in pursuing resolution.
McEwan. In 1995, Headwaters granted stock options to a member of its board
of directors, Lloyd McEwan. The director resigned from the board in 1996.
Headwaters has declined McEwan's attempts to exercise most of the options
on grounds that the options terminated. In June 2004, McEwan filed a
complaint in the Fourth District Court for the State of Utah against
Headwaters alleging breach of contract, breach of implied covenant of good
faith and fair dealing, fraud, and misrepresentation. McEwan seeks
declaratory relief as well as compensatory damages in the approximate
amount of $2.8 million and punitive damages. Headwaters has filed an answer
denying McEwan's claims and has asserted counterclaims against McEwan.
Because resolution of the litigation is uncertain, legal counsel cannot
express an opinion as to the ultimate amount of liability or recovery.
Boynton. In October 1998, Headwaters entered into a technology purchase
agreement with James G. Davidson and Adtech, Inc. The transaction
transferred certain patent and royalty rights to Headwaters related to a
synthetic fuel technology invented by Davidson. (This technology is
distinct from the technology developed by Headwaters.) This action is
factually related to an earlier action brought by certain purported
officers and directors of Adtech, Inc. That action was dismissed by the
United States District Court for the Western District of Tennessee and the
District Court's order of dismissal was affirmed on appeal. In the current
action, the allegations arise from the same facts, but the claims are
asserted by certain purported stockholders of Adtech. In June 2002,
Headwaters received a summons and complaint from the United States District
Court for the Western District of Tennessee alleging, among other things,
fraud, conspiracy, constructive trust, conversion, patent infringement and
interference with contract arising out of the 1998 technology purchase
agreement entered into between Davidson and Adtech on the one hand, and
Headwaters on the other. The plaintiffs seek declaratory relief and
compensatory damages in the approximate amount of between $15.0 million and
$25.0 million and punitive damages. In February 2006, the District Court
dismissed all claims against Headwaters. Also in February 2006, plaintiffs
filed their notice of appeal to the United States Court of Appeals for the
Sixth Circuit. In June 2006, the appeal was transferred to the United
States Court of Appeals for the Federal Circuit. Because the resolution of
the litigation is uncertain, legal counsel cannot express an opinion as to
the ultimate amount, if any, of Headwaters' liability.
Headwaters Construction Materials Matters. There are litigation and pending
and threatened claims made against certain subsidiaries of Headwaters
Construction Materials ("HCM") with respect to several types of exterior
finish systems manufactured and sold by its subsidiaries for application by
contractors on residential and commercial buildings. Typically, litigation
and these claims are controlled by such subsidiaries' insurance carriers.
The plaintiffs or claimants in these matters have alleged that the
structures have suffered damage from latent or progressive water
penetration due to some alleged failure of the building product or wall
system. The most prevalent type of claim involves alleged defects
associated with components of an Exterior Insulating and Finish System
("EIFS") which was produced for a limited time (through 1997) by Best
Masonry & Tool Supply and Don's Building Supply. There is a 10-year
projected claim period following discontinuation of the product.
Typically, the claims cite damages for alleged personal injuries and
punitive damages for alleged unfair business practices in addition to
asserting more conventional damage claims for alleged economic loss and
damage to property. To date, claims made against such subsidiaries have
been paid by their insurers, with the exception of minor deductibles,
although such insurance carriers typically have issued "reservation of
rights" letters. None of the cases has gone to trial. While, to date, none
of these proceedings have required that HCM incur substantial costs, there
17
is no guarantee of insurance coverage or continuing coverage. These and
future proceedings may result in substantial costs to HCM, including
attorneys' fees, managerial time and other personnel resources and costs.
Adverse resolution of these proceedings could have a materially negative
effect on HCM's business, financial condition, and results of operation,
and its ability to meet its financial obligations. Although HCM carries
general and product liability insurance, HCM cannot assure that such
insurance coverage will remain available, that HCM's insurance carrier will
remain viable, or that the insured amounts will cover all future claims in
excess of HCM's uninsured retention. Future rate increases may also make
such insurance uneconomical for HCM to maintain. In addition, the insurance
policies maintained by HCM exclude claims for damages resulting from
exterior insulating finish systems, or EIFS, that have manifested after
March 2003. Because resolution of the litigation and claims is uncertain,
legal counsel cannot express an opinion as to the ultimate amount, if any,
of HCM's liability.
Other. Headwaters and its subsidiaries are also involved in other legal
proceedings that have arisen in the normal course of business.
Section 45K Matters - A material amount of Headwaters' consolidated
revenues and net income is derived from Headwaters Energy Services' license
fees and sales of chemical reagents, both of which depend on the ability of
licensees and other customers to manufacture and sell qualified synthetic
fuels that generate tax credits under Section 45K [formerly Section 29] of
the Internal Revenue Code. Headwaters also claims Section 45K tax credits
based upon synthetic fuel sales from facilities in which Headwaters owns an
interest. From time to time, issues arise as to the availability of tax
credits and the phase-out of credits with the rising price of oil,
including the items discussed below.
Phase-Out. Section 45K tax credits are subject to phase-out after the
average annual domestic wellhead oil price ("reference price") reaches a
beginning phase-out threshold price, and are eliminated entirely if the
reference price reaches the full phase-out price. Historically, the
reference price has trended somewhat lower than published market prices for
oil. For calendar 2005, the reference price was $50.26 per barrel and the
phase-out range began at $53.20 and would have fully phased out tax credits
at $66.78 per barrel. Therefore, there was no phase-out of tax credits for
calendar 2005.
For calendar 2006, Headwaters estimates that the phase-out range (computed
by increasing the 2005 inflation adjustment factor by 2%) begins at $54.27
and completes phase-out at $68.12 per barrel. Congress is considering
legislation to change Section 45K phase-out calculations to a prospective
rather than retrospective application of the reference price. As of the
date hereof, it is too early to accurately estimate a reference price for
calendar 2006. However, Headwaters estimates that if average oil prices for
the calendar 2006 period to date are maintained for all of calendar 2006,
and absent a legislative change to a prospective application of the
reference price, partial phase-out would occur. As described in more detail
in Note 7, an estimate of the calendar 2006 phase out calculated as of June
30, 2006, using available information as of that date, resulted in a 69%
phase out.
In an environment of high oil prices, the risk of phase-out increases.
Headwaters' customers and licensees will make their own assessments of
phase-out risk. Customers and licensees that perceive a potential negative
financial impact from phase-out have reduced or stopped synthetic fuel
production or required Headwaters to share in the costs associated with
phase-out. Headwaters must make similar assessments with respect to the
continued operation of its own synthetic fuel production facilities. As of
the date hereof, many of Headwaters' licensees have decided to stop
production of synthetic fuel, at least temporarily. These events are
materially adversely affecting both the amounts and timing of recognition
of Headwaters' revenue, net income and cash flow.
The amount of license fee revenue recognized by Headwaters for the March
and June 2006 quarters was materially negatively affected by no revenues
being recognized for several licensees whose license agreements call for
Headwaters to be paid a portion of the tax credits earned by the licensee.
Because of the current uncertainty related to phase-out of tax credits for
calendar 2006, certain accounting rules governing revenue recognition,
requiring that the seller's price to the buyer be "fixed or determinable,"
at this time preclude revenue recognition for these licensees. Accordingly,
revenues for these licensees, which could total approximately $30.0 million
(calculated based on licensee-reported data, which amount ultimately
depends on the phase-out percentage of Section 45K) for the March and June
2006 quarters, will not be recognized until such time as they become more
certain as to reasonable estimation.
18
Legislation. Under current law, Section 45K tax credits for synthetic fuel
produced from coal expire on December 31, 2007. In addition, there have
been initiatives from time to time to consider the early repeal or
modification of Section 45K. If Section 45K expires at the end of 2007 or
if it is repealed or adversely modified, additional synthetic fuel
facilities would probably either close or substantially curtail production.
At this time, given current prices of coal and costs of synthetic fuel
production, Headwaters does not believe that production of synthetic fuel
will be profitable absent the tax credits. In addition, if more Headwaters
licensees close their facilities or materially reduce production activities
(whether after 2007, or upon earlier repeal or adverse modification of
Section 45K, or for any other reason), it would have a further material
adverse effect on the revenue, net income and cash flow of Headwaters, in
addition to the current material adverse effect caused by phase-out
concerns.
IRS Audits. Licensees are subject to audit by the IRS. The IRS may
challenge whether Headwaters' licensees satisfy the requirements of Section
45K, or applicable Private Letter Rulings, including placed-in-service
requirements, or may attempt to disallow Section 45K tax credits for some
other reason. The IRS has initiated audits of certain licensee-taxpayers
who claimed Section 45K tax credits and will continue the audit process in
the future. The inability of a licensee to claim Section 45K tax credits
would reduce Headwaters' future income from the licensee. In addition, the
IRS may audit Headwaters concerning tax credits claimed for synthetic fuel
sold from the facilities in which it owns an interest.
Senate Permanent Subcommittee on Investigations. On October 29, 2003, the
Permanent Subcommittee on Investigations of the Government Affairs
Committee of the United States Senate issued a notification of pending
investigations. The notification listed the synthetic fuel tax credit as a
new item. In February 2006, the Subcommittee described its investigation as
follows: "The Subcommittee is continuing its investigation [of] tax credits
claimed under Section 29 [now Section 45K] of the Internal Revenue Code for
the sale of coal-based synthetic fuels. This investigation is examining the
utilization of these tax credits, the nature of the technologies and fuels
created, the use of these fuels, and others [sic] aspects of Section 29.
The investigation will also address the IRS' administration of Section 29
tax credits." The Subcommittee conducted numerous interviews and received
large volumes of data between December 2003 and March 2004. Since that
time, to Headwaters' knowledge, there has been little activity regarding
the investigation. Headwaters cannot make any assurances as to the timing
or ultimate outcome of the Subcommittee investigation, nor can Headwaters
predict whether Congress or others may conduct investigations of Section
45K tax credits in the future. Renewed activity in the Subcommittee
investigation, if it occurs, may have a material adverse effect on the
willingness of current owners to operate their facilities, and may
materially adversely affect Headwaters' revenue, net income and cash flow.
License Fees - Pursuant to the terms of an agreement with a certain
licensee, this licensee has set aside substantial amounts for working
capital and other operational contingencies as provided for in the
agreement. These amounts may eventually be paid out to various parties
having an interest in the cash flows from the licensee's operations,
including Headwaters, if they are not used for working capital and other
operational contingencies. As a result, Headwaters currently expects to
receive at some future date a portion of those reserves, the amount of
which is not currently determinable and which constitutes a gain
contingency not recognizable as revenue.
19
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with the accompanying unaudited consolidated financial statements and notes
thereto included elsewhere herein. Headwaters' fiscal year ends on September 30
and unless otherwise noted, future references to 2005 refer to Headwaters'
fiscal quarter and/or nine-month period ended June 30, 2005, and references to
2006 refer to Headwaters' fiscal quarter and/or nine-month period ended June 30,
2006.
Introduction
During the past several years, Headwaters has executed on its two-fold
plan of maximizing cash flow from its existing operating business units and
diversifying from over-reliance on the legacy alternative energy segment Section
45K [formerly Section 29] business. With the addition and expansion of the CCP
management and marketing business through the acquisitions of ISG in 2002 and
VFL in 2004, and the growth of the construction materials business, culminating
in the acquisitions of Eldorado, Tapco and SCP in 2004, Headwaters has achieved
revenue growth and diversification into three business segments. Because
Headwaters also incurred increased indebtedness to make strategic acquisitions,
one of management's ongoing financial objectives is to continue to focus on
increased cash flows for purposes of reducing indebtedness.
A material amount of Headwaters' consolidated revenues and net income
is derived from Headwaters Energy Services' license fees and sales of chemical
reagents, both of which depend on the ability of licensees and other customers
to manufacture and sell qualified synthetic fuels that generate tax credits
under Section 45K [formerly Section 29] of the Internal Revenue Code. Headwaters
also claims Section 45K tax credits based upon synthetic fuel sales from
facilities in which Headwaters owns an interest. From time to time, issues arise
as to the availability of tax credits and the phase-out of credits with the
rising price of oil, including the items discussed hereafter.
Under current law, Section 45K tax credits for synthetic fuel produced
from coal expire on December 31, 2007. In addition, Section 45K tax credits are
subject to phase-out after the average annual domestic wellhead oil price
("reference price") reaches a beginning phase-out threshold price, and are
eliminated entirely if the reference price reaches the full phase-out price.
There was no phase-out of Section 45K tax credits for calendar 2005; however,
during 2006, higher oil prices have increased the likelihood of a phase-out of
tax credits for calendar 2006. As a result, Headwaters' revenue, operating
income, income tax provision and cash flow have all been materially negatively
affected in 2006. Furthermore, Headwaters' entire fiscal 2006 and fiscal 2007
results could be negatively affected by phase-out.
Headwaters' acquisition strategy targets businesses that are leading
players in their respective industries, that enjoy healthy margins from products
and services and that are not overly capital intensive, thus providing
additional cash flow that complements the financial performance of Headwaters'
existing business segments. In addition, in 2006, Headwaters has begun to
acquire small companies with innovative products that can be marketed using
Headwaters' existing distribution channels. Headwaters is also committed to
continuing to invest in HTI's research and development activities which are
focused on energy-related technologies and nanotechnology. Headwaters has agreed
to a joint venture project to construct, own and operate an ethanol plant
located in North Dakota which is currently expected to begin operating in early
calendar 2007, and is also beginning to invest in other alternative energy
projects such as coal cleaning and the use of nanocatalysts to engineer coal for
emissions reduction.
As a result of its diversification into CCPs and construction
materials, Headwaters is affected by seasonality, with the highest revenues and
profitability produced in the June and September quarters. With CCPs,
Headwaters' strategy is to continue to negotiate long-term contracts so that it
may invest in transportation and storage infrastructure for the marketing and
sale of CCPs. Headwaters also intends to continue its efforts to expand usage of
high-value CCPs and develop uses for lower-value CCPs, including the expanded
usage of CCPs in its construction materials businesses and the industry in
general.
Headwaters' acquisitions of Eldorado and Tapco have created a
concentration in the residential housing market. In light of Headwaters' strong
market shares in Eldorado's and Tapco's markets, Headwaters has increased
production capacity for Eldorado and has initiated the development and marketing
of new products from Tapco in order to maintain the historical growth rates of
the construction materials segment.
In fiscal 2005 and continuing into 2006, Headwaters has focused on
integration of its recent acquisitions, including the marketing of diverse
construction materials products through its national distribution network, and
developing the corporate infrastructure necessary to provide the information and
services that the business segments need to operate at optimal levels.
Headwaters became highly leveraged as a result of the fiscal 2004 acquisitions,
but has reduced its outstanding debt since that time through cash generated from
operations, from an underwritten public offering of common stock and from
20
proceeds from settlement of litigation. Headwaters intends to continue to focus
on repaying long-term debt while continuing to look for diversification
opportunities within prescribed parameters.
Section 45K Matters
Phase-Out. Section 45K tax credits are subject to phase-out after the
average annual domestic wellhead oil price ("reference price") reaches a
beginning phase-out threshold price, and are eliminated entirely if the
reference price reaches the full phase-out price. Historically, the reference
price has trended somewhat lower than published market prices for oil. For
calendar 2005, the reference price was $50.26 per barrel and the phase-out range
began at $53.20 and would have fully phased out tax credits at $66.78 per
barrel. Therefore, there was no phase-out of tax credits for calendar 2005.
For calendar 2006, Headwaters estimates that the phase-out range
(computed by increasing the 2005 inflation adjustment factor by 2%) begins at
$54.27 and completes phase-out at $68.12 per barrel. Congress is considering
legislation to change Section 45K phase-out calculations to a prospective rather
than retrospective application of the reference price. As of the date hereof, it
is too early to accurately estimate a reference price for calendar 2006.
However, Headwaters estimates that if average oil prices for the calendar 2006
period to date are maintained for all of calendar 2006, and absent a legislative
change to a prospective application of the reference price, partial phase-out
would occur. As described in more detail in Note 7 to the consolidated financial
statements, an estimate of the calendar 2006 phase out calculated as of June 30,
2006, using available information as of that date, resulted in a 69% phase out.
In an environment of high oil prices, the risk of phase-out increases.
Headwaters' customers and licensees will make their own assessments of phase-out
risk. Customers and licensees that perceive a potential negative financial
impact from phase-out have reduced or stopped synthetic fuel production or
required Headwaters to share in the costs associated with phase-out. Headwaters
must make similar assessments with respect to the continued operation of its own
synthetic fuel production facilities. As of the date hereof, many of Headwaters'
licensees have decided to stop production of synthetic fuel, at least
temporarily. These events are materially adversely affecting both the amounts
and timing of recognition of Headwaters' revenue, net income and cash flow.
The amount of license fee revenue recognized by Headwaters for the
March and June 2006 quarters was materially negatively affected by no revenues
being recognized for several licensees whose license agreements call for
Headwaters to be paid a portion of the tax credits earned by the licensee.
Because of the current uncertainty related to phase-out of tax credits for
calendar 2006, certain accounting rules governing revenue recognition, requiring
that the seller's price to the buyer be "fixed or determinable," at this time
preclude revenue recognition for these licensees. Accordingly, revenues for
these licensees, which could total approximately $30.0 million (calculated based
on licensee-reported data, which amount ultimately depends on the phase-out
percentage of Section 45K) for the March and June 2006 quarters, will not be
recognized until such time as they become more certain as to reasonable
estimation.
Legislation. Under current law, Section 45K tax credits for synthetic
fuel produced from coal expire on December 31, 2007. In addition, there have
been initiatives from time to time to consider the early repeal or modification
of Section 45K. If Section 45K expires at the end of 2007 or if it is repealed
or adversely modified, additional synthetic fuel facilities would probably
either close or substantially curtail production. At this time, given current
prices of coal and costs of synthetic fuel production, Headwaters does not
believe that production of synthetic fuel will be profitable absent the tax
credits. In addition, if more Headwaters licensees close their facilities or
materially reduce production activities (whether after 2007, or upon earlier
repeal or adverse modification of Section 45K, or for any other reason), it
would have a further material adverse effect on the revenue, net income and cash
flow of Headwaters, in addition to the current material adverse effect caused by
phase-out concerns.
IRS Audits. Licensees are subject to audit by the IRS. The IRS may
challenge whether Headwaters Energy Services' licensees satisfy the requirements
of Section 45K, or applicable Private Letter Rulings, including
placed-in-service requirements, or may attempt to disallow Section 45K tax
credits for some other reason. The IRS has initiated audits of certain
licensee-taxpayers who claimed Section 45K tax credits and will continue the
audit process in the future. The inability of a licensee to claim Section 45K
tax credits would reduce Headwaters' future income from the licensee. In
addition, the IRS may audit Headwaters concerning tax credits claimed for
synthetic fuel sold from the facilities in which it owns an interest.
Senate Permanent Subcommittee on Investigations. On October 29, 2003,
the Permanent Subcommittee on Investigations of the Government Affairs Committee
of the United States Senate issued a notification of pending investigations. The
notification listed the synthetic fuel tax credit as a new item. In February
2006, the Subcommittee described its investigation as follows: "The Subcommittee
is continuing its investigation [of] tax credits claimed under Section 29 [now
Section 45K] of the Internal Revenue Code for the sale of coal-based synthetic
fuels. This investigation is examining the utilization of these tax credits, the
nature of the technologies and fuels created, the use of these fuels, and others
21
[sic] aspects of Section 29. The investigation will also address the IRS'
administration of Section 29 tax credits." The Subcommittee conducted numerous
interviews and received large volumes of data between December 2003 and March
2004. Since that time, to Headwaters' knowledge, there has been little activity
regarding the investigation. Headwaters cannot make any assurances as to the
timing or ultimate outcome of the Subcommittee investigation, nor can Headwaters
predict whether Congress or others may conduct investigations of Section 45K tax
credits in the future. Renewed activity in the Subcommittee investigation, if it
occurs, may have a material adverse effect on the willingness of current owners
to operate their facilities, and may materially adversely affect Headwaters'
revenues and net income.
Consolidation and Segments
Consolidation. The consolidated financial statements include the
accounts of Headwaters, all of its subsidiaries and other entities in which
Headwaters has a controlling interest. Headwaters is also required to
consolidate any variable interest entities for which it is the primary
beneficiary; however, as of June 30, 2006, there are none. For investments in
companies in which Headwaters has a significant influence over operating and
financial decisions (generally defined as owning a voting or economic interest
of 20% to 50%), Headwaters applies the equity method of accounting. In instances
where Headwaters' investment is less than 20% and significant influence does not
exist, investments are carried at cost. All significant intercompany
transactions and accounts are eliminated in consolidation.
Segments. Headwaters operates in three business segments, construction
materials, CCPs and alternative energy. These segments are managed and evaluated
separately by management based on fundamental differences in their operations,
products and services.
The construction materials segment includes the bagged concrete,
stucco, mortar and block products business, as well as Eldorado's manufactured
architectural stone products and Tapco's building products used in exterior
residential home improvement and construction. Revenues for the construction
materials segment consist of product sales to wholesale and retail distributors,
contractors and other users of building products and construction materials.
The CCP segment markets coal combustion products such as fly ash and
bottom ash, known as CCPs, to the building products and ready mix concrete
industries. Headwaters markets CCPs to replace manufactured or mined materials,
such as portland cement, lime, agricultural gypsum, fired lightweight aggregate,
granite aggregate and limestone. Headwaters has long-term contracts, primarily
with coal-fired electric power generation plants, pursuant to which it manages
the post-combustion operations for the utilities. CCP revenues consist primarily
of product sales with a smaller amount of service revenue. VFL has been included
in Headwaters' CCP segment since its acquisition.
The alternative energy segment includes Headwaters' legacy coal-based
solid alternative fuels (Section 45K) business and HTI's business of developing
catalyst technologies to convert coal and heavy oil into higher-value liquid
fuels, as well as nanocatalyst processes and applications. Revenues for this
segment consist almost exclusively of sales of chemical reagents and license
fees.
Due to the seasonality of the operations of the construction materials
and CCP segments and other factors, Headwaters' consolidated results of
operations for the 2006 periods are not indicative of the results to be expected
for the full fiscal 2006 year.
Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005
The information set forth below compares Headwaters' operating results
for the three months ended June 30, 2006 ("2006") with operating results for the
three months ended June 30, 2005 ("2005").
Revenue. Total revenue for 2006 decreased by $12.8 million or 4% to
$295.9 million as compared to $308.7 million for 2005. The major components of
revenue are discussed in the sections below.
Construction Materials Segment. Sales of construction materials during
2006 were $162.1 million with a corresponding direct cost of $107.3 million.
Sales of construction materials during 2005 were $147.6 million with a
corresponding direct cost of $97.7 million. The increase in sales of
construction materials during 2006 was due primarily to increases in volume,
which occurred across all major product lines, with a lesser impact from price
increases related to passing on to customers raw material cost increases. Gross
margin percentage did not change from 2005 to 2006.
CCP Segment. CCP revenues for 2006 were $74.1 million with a
corresponding direct cost of $53.7 million. CCP revenues for 2005 were $69.5
million with a corresponding direct cost of $51.4 million. The gross margin
percentage increased 150 basis points from 2005 to 2006. The increase in CCP
revenues and gross margin percentage during 2006 was due primarily to upward
pricing trends in most concrete markets. CCPs are a substitute for portland
cement, and cement shortages have resulted in increased prices for CCPs in
several markets.
22
Alternative Energy Segment. Headwaters' alternative energy segment
revenue consists primarily of chemical reagent sales, license fee revenue
related to its solid alternative fuel technologies, and to a lesser extent,
sales of synthetic fuel from two solid alternative fuel production facilities
that Headwaters owns that began operating in 2005. The major components of
revenue for the alternative energy segment are discussed in the sections below.
A material amount of Headwaters' consolidated revenues and net income
is derived from Headwaters' license fees and sales of chemical reagents, both of
which depend on the ability of licensees and other customers to manufacture and
sell qualified synthetic fuels that generate tax credits under Section 45K
[formerly Section 29] of the Internal Revenue Code. From time to time, issues
arise as to the availability of tax credits and the potential phase-out of
credits with the rising price of oil, as described in "Section 45K Matters"
above. Due to the significance of these issues, it is not possible to predict
the trend of alternative energy revenue in future periods.
Sales of Chemical Reagents. Chemical reagent sales during 2006 were
$34.9 million with a corresponding direct cost of $26.5 million. Chemical
reagent sales during 2005 were $45.0 million with a corresponding direct cost of
$32.1 million. The decrease in chemical reagent sales during 2006 was due to
decreased synthetic fuel production by Headwaters' licensees (resulting in
decreased sales of $4.2 million) and by customers with whom Headwaters does not
have a license agreement (resulting in decreased sales of $5.9 million). The
decrease in synthetic fuel production by licensees and other customers is
primarily due to the threat of phase-out. It is not possible to predict the
trend for sales of chemical reagents in future periods. The gross margin
percentage for 2006 of 24% was approximately 400 basis points lower than for
2005, due primarily to increases in the cost of product, which in turn is
related to increases in the costs of petroleum-based materials. Headwaters
currently believes reagent margins have stabilized at current levels, but
changes in the future could occur, depending upon crude oil prices and the
availability of raw material feedstocks.
License Fees. During 2006, Headwaters recognized license fee revenue
totaling $12.4 million, a decrease of $29.3 million or 70% from $41.7 million of
license fee revenue recognized during 2005. The primary reason for the decrease
in license fee revenue in 2006 compared to 2005 relates to no revenues being
recognized for several licensees whose license agreements call for Headwaters to
be paid a portion of the value of the tax credits earned by the licensee.
Because of the current uncertainty related to phase-out of tax credits for
calendar 2006, certain accounting rules governing revenue recognition, requiring
that the seller's price to the buyer be "fixed or determinable," at this time
preclude revenue recognition for these licensees. Accordingly, revenues for
these licensees, which could total approximately $20.0 million (calculated based
on licensee-reported data) for the June 2006 quarter if there were no phase out
of Section 45K, will not be recognized until such time as they become more
certain as to reasonable estimation. Reference is also made to the policy
disclosures in Headwaters' Form 10-K, Item 7: Management's Discussion and
Analysis of Financial Condition and Results of Operations, Critical Accounting
Policies and Estimates - License Fee Revenue Recognition. In addition, $13.4
million of the decrease in license fee revenue for 2006 was due to higher
revenues in 2005 stemming directly and indirectly from the settlement of the AJG
litigation in 2005, which settlement is described in more detail in Note 14 to
the consolidated financial statements in the Form 10-K.
Pursuant to the terms of an agreement with a certain licensee, this
licensee has set aside substantial amounts for working capital and other
operational contingencies as provided for in the agreement. These amounts may
eventually be paid out to various parties having an interest in the cash flows
from the licensee's operations, including Headwaters, if they are not used for
working capital and other operational contingencies. As a result, Headwaters
currently expects to receive at some future date a portion of those reserves,
the amount of which is not currently determinable and which constitutes a gain
contingency not recognizable as revenue.
Other Alternative Energy Segment Revenues. Sales of synthetic fuel
during 2006 were $10.5 million with a corresponding direct cost of $12.3
million. Sales of synthetic fuel during 2005 were $4.8 million with a
corresponding direct cost of $5.5 million. The increase in sales of synthetic
fuel from 2005 to 2006 was due to the synthetic fuel facilities starting
operations in 2005. Revenue from the sale of synthetic fuel has a negative gross
margin, which is more than compensated for by the income tax credits expected to
be earned from the sales of the synthetic fuel. HTI's revenues are also included
in alternative energy revenue, but comprise a minor portion of total segment
revenue.
Research and Development. Research and development expenses decreased
by $1.4 million to $3.4 million in 2006 from $4.8 million in 2005. The decrease
was primarily attributable to significant one-time stock-based compensation
costs in 2005 related to the implementation in 2005 of SFAS No. 123R, as
described in detail in Note 12 to the consolidated financial statements in
Headwaters' Form 10-K.
Selling, General and Administrative Expenses. These expenses decreased
$17.7 million, or 33% to $35.9 million for 2006 from $53.6 million for 2005. The
decrease in 2006 was due primarily to significant one-time stock-based
compensation costs in 2005 related to the implementation in 2005 of SFAS No.
123R ($22.7 million). In addition, there was a $1.9 million decrease in
payroll-related and incentive compensation expenses in 2006 compared to 2005,
primarily related to Headwaters' financial performance. Partially offsetting
23
these decreases in expenses was a $5.3 million increase in costs related to
legal matters, which increase was due primarily to a credit in legal costs in
2005 of $6.5 million related to the favorable settlement of the AJG litigation.
Other Income and Expense. During 2006, Headwaters reported net other
expense of $7.6 million compared to net other expense of $17.7 million during
2005. The change of $10.1 million was attributable to a decrease in net interest
expense of $3.2 million and a decrease in other expenses of $6.9 million. Net
interest expense decreased from $11.4 million in 2005 to $8.2 million in 2006,
due primarily to significantly lower average levels of long-term debt in 2006
compared to 2005.
The decrease in other expenses of $6.9 million consisted primarily of a
decrease in costs related to Headwaters' investment in the coal-based solid
alternative fuel production facility described in Note 10 to the consolidated
financial statements. The primary reason for decreased costs for this facility
is related to using an estimated phase-out percentage for Section 45K tax
credits for calendar 2006 of approximately 69%, all as explained in Note 7 to
the consolidated financial statements.
The alternative fuel produced at the facility through December 2007
qualifies for tax credits pursuant to Section 45K of the Internal Revenue Code,
and Headwaters is entitled to receive its pro-rata share of such tax credits
generated based upon its percentage of ownership of the facility. Due to the
combined effect of the seasonality of Headwaters' operations and the requirement
to use an estimated effective tax rate for the year in calculating income taxes,
Headwaters is not able to recognize the benefit of all of the tax credits earned
in the December and March quarters in its results of operations for those
quarters. Tax credits earned but not recognized in the December and March
quarters are recognized in the June and September quarters. Even though
Headwaters did not fully recognize its portion of the benefits of the tax
credits generated during 2005 and 2006, Headwaters' pro-rata share of costs
incurred to generate the tax credits reflected in the effective tax rate was
recognized as other expense through June 30, 2005 and 2006.
Income Tax Provision. Headwaters' estimated effective income tax rate
for the fiscal year ending September 30, 2006 is 32.0%, the rate applied to the
nine month period ended June 30, 2006. Additionally, Headwaters recognized a net
$1.7 million benefit during the nine months ended June 30, 2006 ($2.2 million
during the three months ended June 30, 2006) for discrete items that did not
affect the calculation of the estimated effective income tax rate. Using a 32.0%
rate for the nine month period resulted in an income tax rate of approximately
39.4% for the three months ended June 30, 2006, exclusive of the quarter's
discrete items totaling $2.2 million. The rate for 2006 compares to an effective
tax rate of approximately 28.9% for the three months ended June 30, 2005. The
discrete items benefiting the tax rate in 2006 primarily related to the reversal
of accruals for tax liabilities associated with the fiscal year ended September
30, 2002, for which the statute of limitations has expired.
The increase in the effective tax rate for fiscal 2006 as compared to
fiscal 2005 is primarily due to reduced Section 45K [formerly Section 29] tax
credits, as explained in detail in Note 7 to the consolidated financial
statements. Excluding the effect of the tax credits, Headwaters' estimated
effective tax rate for fiscal 2006 would be approximately 40%. For purposes of
calculating an estimated effective tax rate for fiscal 2006, Headwaters assumed
a phase-out percentage for Section 45K tax credits for calendar 2006 of 69% (see
Note 7). While it is not possible to accurately estimate the entire calendar
year 2006 phase-out percentage at the current time, and it is certain that
Headwaters' estimate of the phase-out percentage will change during the year, as
of June 30, 2006, an estimated phase-out percentage of 69% is Headwaters' best
estimate of what the phase-out percentage for calendar 2006 would be, using
available information as of that date. As of March 31, 2006, the estimated
phase-out percentage for calendar 2006 was 37%. The effect of the change in
estimate of the phase-out percentage from 37% to 69% was recorded to income tax
expense in 2006.
Headwaters adjusts its income tax provision each quarter to yield the
estimated effective tax rate for the fiscal year on a cumulative basis, causing
each quarter's effective tax rate to vary somewhat. It is probable that
Headwaters' estimate of its effective tax rate for fiscal 2006 will change in
the future, necessitating an adjustment in the September 2006 quarter to reflect
the impact of the rate change on results for prior fiscal 2006 quarters.
Nine Months Ended June 30, 2006 Compared to Nine Months Ended June 30, 2005
The information set forth below compares Headwaters' operating results
for the nine months ended June 30, 2006 ("2006") with operating results for the
nine months ended June 30, 2005 ("2005").
Revenue. Total revenue for 2006 increased by $96.7 million or 13% to
$846.2 million as compared to $749.5 million for 2005. The major components of
revenue are discussed in the sections below.
Construction Materials Segment. Sales of construction materials during
2006 were $423.7 million with a corresponding direct cost of $288.2 million.
Sales of construction materials during 2005 were $370.5 million with a
24
corresponding direct cost of $248.1 million. The increase in sales of
construction materials during 2006 was due primarily to increases in volume,
which occurred across all major product lines, with a lesser impact from price
increases related to passing on to customers a portion of raw material cost
increases. The primary reasons for the decline in gross margin percentage from
2005 to 2006 were higher raw material costs and manufacturing inefficiencies
related to expansion of capacity and product lines and restructuring of
operations at certain manufacturing facilities.
CCP Segment. CCP revenues for 2006 were $197.7 million with a
corresponding direct cost of $149.0 million. CCP revenues for 2005 were $171.0
million with a corresponding direct cost of $130.9 million. The gross margin
percentage increased approximately 100 basis points from 2005 to 2006. The
increase in CCP revenues and in the gross margin during 2006 were due primarily
to a combination of continued strong demand for CCPs, upward pricing trends in
most concrete markets, and increased project revenues. In addition, weather
conditions in the south central region of the United States have generally been
favorable in 2006. The growth in demand for CCPs is due in part to certain
regional shortages in the availability of portland cement for which CCPs are a
substitute, which can result in an increased percentage of CCPs being used in
concrete. The cement shortages also resulted in increased prices for CCPs in
several markets.
Alternative Energy Segment. Headwaters' alternative energy segment
revenue consists primarily of chemical reagent sales, license fee revenue
related to its solid alternative fuel technologies, and to a lesser extent,
sales of synthetic fuel from two solid alternative fuel production facilities
that Headwaters owns that began operating in 2005. The major components of
revenue for the alternative energy segment are discussed in the sections below.
Sales of Chemical Reagents. Chemical reagent sales during 2006 were
$129.4 million with a corresponding direct cost of $97.5 million. Chemical
reagent sales during 2005 were $121.7 million with a corresponding direct cost
of $85.1 million. The increase in chemical reagent sales during 2006 was due to
increased synthetic fuel production by Headwaters' licensees (resulting in
increased sales of $11.0 million), partially offset by customers with whom
Headwaters does not have a license agreement (resulting in decreased sales of
$3.3 million). Despite the threat of phase-out, overall sales of chemical
reagents for 2006 have increased over 2005; however, sales have slowed
considerably in the quarter ended June 30, 2006 as compared to earlier quarters
and it is not possible to predict the trend for sales of chemical reagents in
future periods. The gross margin percentage for 2006 of 25% was 550 basis points
lower than for 2005, due primarily to increases in the cost of product, which in
turn is related to increases in the costs of petroleum-based materials.
License Fees. During 2006, Headwaters recognized license fee revenue
totaling $56.9 million, a decrease of $24.0 million or 30% from $80.9 million of
license fee revenue recognized during 2005. The primary reason for the decrease
in license fee revenue in 2006 compared to 2005 relates to no revenues being
recognized for several licensees whose license agreements call for Headwaters to
be paid a portion of the value of the tax credits earned by the licensee.
Because of the current uncertainty related to phase-out of tax credits for
calendar 2006, certain accounting rules governing revenue recognition, requiring
that the seller's price to the buyer be "fixed or determinable," at this time
preclude revenue recognition for these licensees. Accordingly, revenues for
these licensees, which could total approximately $30.0 million (calculated based
on licensee-reported data, which amount ultimately depends on the phase-out
percentage of Section 45K) for the March and June 2006 quarters, will not be
recognized until such time as they become more certain as to reasonable
estimation.
Other Alternative Energy Segment Revenues. Sales of synthetic fuel
during 2006 were $33.9 million with a corresponding direct cost of $39.3
million. Sales of synthetic fuel during 2005 were $4.8 million with a
corresponding direct cost of $5.5 million. The increase in sales of synthetic
fuel from 2005 to 2006 was due to the synthetic fuel facilities starting
operations in spring 2005. Revenue from the sale of synthetic fuel has a
negative gross margin, which is more than compensated for by the income tax
credits expected to be earned from the sales of the synthetic fuel. HTI's
revenues are also included in alternative energy revenue, but comprise a minor
portion of total segment revenue.
Research and Development. Research and development expenses decreased
by $0.4 million to $9.7 million in 2006 from $10.1 million in 2005. The decrease
was primarily attributable to significant one-time stock-based compensation
costs in 2005 related to the implementation in 2005 of SFAS No. 123R.
Selling, General and Administrative Expenses. These expenses decreased
$19.4 million, or 16% to $103.2 million for 2006 from $122.6 million for 2005.
The decrease in 2006 was due primarily to significant one-time stock-based
compensation costs in 2005 related to the implementation in 2005 of SFAS No.
123R ($22.7 million). In addition, there was a $1.2 million decrease in
payroll-related and incentive compensation expenses in 2006 compared to 2005
related to Headwaters' financial performance. Partially offsetting these
decreases in expenses was a $2.7 million increase in marketing expense related
to an effort in the construction materials segment to increase awareness and
sales of new products, primarily by Eldorado and Tapco.
25
Other Income and Expense. During 2006, Headwaters reported net other
expense of $30.8 million compared to net other expense of $57.5 million during
2005. The change of $26.7 million was attributable to a decrease in net interest
expense of $20.2 million and a decrease in other expenses of $6.5 million. Net
interest expense decreased from $46.0 million in 2005 to $25.8 million in 2006,
due primarily to significantly lower average levels of long-term debt in 2006
compared to 2005.
The decrease in other expenses of $6.5 million consisted primarily of a
decrease in costs related to Headwaters' investment in the coal-based solid
alternative fuel production facility described in Note 10 to the consolidated
financial statements.
Income Tax Provision. Headwaters' estimated effective income tax rate
for the fiscal year ending September 30, 2006 is 32.0%, the rate applied to the
nine month period ended June 30, 2006. Additionally, Headwaters recognized a net
$1.7 million benefit during the nine months ended June 30, 2006 for discrete
items that did not affect the calculation of the estimated effective income tax
rate. The rate for 2006 compares to an effective tax rate of approximately 30.0%
for the nine months ended June 30, 2005. The discrete items benefiting the tax
rate in 2006 primarily related to the reversal of accruals for tax liabilities
associated with the fiscal year ended September 30, 2002, for which the statute
of limitations has expired.
The increase in the effective tax rate for fiscal 2006 as compared to
fiscal 2005 is primarily due to reduced Section 45K [formerly Section 29] tax
credits, as explained in detail in Note 7 to the consolidated financial
statements. Excluding the effect of the tax credits, Headwaters' estimated
effective tax rate for fiscal 2006 would be approximately 40%. For purposes of
calculating an estimated effective tax rate for fiscal 2006, Headwaters assumed
a phase-out percentage for Section 45K tax credits for calendar 2006 of 69% (see
Note 7). While it is not possible to accurately estimate the entire calendar
year 2006 phase-out percentage at the current time, and it is certain that
Headwaters' estimate of the phase-out percentage will change during the year, as
of June 30, 2006, an estimated phase-out percentage of 69% is Headwaters' best
estimate of what the phase-out percentage for calendar 2006 would be, using
available information as of that date. As of March 31, 2006, the estimated
phase-out percentage for calendar 2006 was 37%.
Headwaters adjusts its income tax provision each quarter to yield the
estimated effective tax rate for the fiscal year on a cumulative basis, causing
each quarter's effective tax rate to vary somewhat. It is probable that
Headwaters' estimate of its effective tax rate for fiscal 2006 will change in
the future, necessitating an adjustment in the September 2006 quarter to reflect
the impact of the rate change on results for prior fiscal 2006 quarters.
Impact of Inflation and Related Matters
Headwaters' operations have been impacted in 2006 by i) rising costs
for chemical reagents in the alternative energy segment; ii) increased cement,
polypropylene and poly-vinyl chloride costs in the construction materials
segment; iii) increased fuel costs that have affected transportation costs in
most of Headwaters' business units; and iv) certain regional shortages of cement
and aggregate materials. The increased costs of chemical reagents,
polypropylene, poly-vinyl chloride and fuel are directly related to the increase
in prices of natural gas, oil and other petroleum-based materials. The increased
costs of cement are caused primarily by a lack of adequate supplies in some
regions of the U.S.
Headwaters has been successful in passing on some, but not all, of the
increased material and transportation costs to customers. It is not possible to
predict the future trend of material and transportation costs, nor the ability
of Headwaters to pass on any future price increases to customers. It is also not
possible to predict the impact of potential future cement supply shortages on
Headwaters' ability to procure needed supplies in its construction materials
business.
Liquidity and Capital Resources
Summary of Cash Flow Activities. Net cash provided by operating
activities during the nine months ended June 30, 2006 ("2006") was $172.7
million compared to $123.6 million during the nine months ended June 30, 2005
("2005"). While net income was not materially different in the two periods,
changes in operating assets and liabilities between 2005 and 2006 were
significant, including in 2006 the receipt of the final $70.0 million payment
due from the litigation settlement reached with AJG in fiscal 2005. In both
periods, the primary investing activity consisted of the purchase of property,
plant and equipment. In 2006, another significant investing activity was
payments for acquisitions. The primary financing activity for both periods
consisted of repayments of long-term debt. In 2005, proceeds from the issuance
of common stock was also a significant financing activity. More details about
Headwaters' investing and financing activities are provided in the following
paragraphs.
Investing Activities. Expenditures for property, plant and equipment in
2006 were not materially different from the 2005 amount. Most of the capital
expenditures in both periods were incurred by the construction materials
segment, however in fiscal 2006, a higher proportion of total capital
expenditures are being incurred by the CCP and alternative energy segments, as
compared to 2005. A significant portion of Headwaters' planned future capital
expenditures represent expansion of operations, rather than maintenance of
26
operating capacity. Capital expenditures for fiscal 2006 are limited to $72.0
million by the senior debt covenants. The unused amounts of Headwaters' annual
capital expenditures limits in the senior debt agreements can generally be
carried over from year to year. As of June 30, 2006, Headwaters was committed to
spend approximately $5.2 million on capital projects that were in various stages
of completion.
Headwaters intends to continue to expand its business through growth of
existing operations, commercialization of technologies currently being
developed, and strategic acquisitions of products or entities that expand
Headwaters' current operating platform. Acquisitions are an important part of
Headwaters' business strategy and to that end, Headwaters routinely reviews
potential complementary acquisitions, including those in the areas of
construction materials, CCP marketing, and coal and catalyst technologies. It is
possible that some portion of future cash and cash equivalents and/or proceeds
from the issuance of stock or debt will be used to fund acquisitions of
complementary businesses in the chemical, energy, building products and related
industries. The senior secured credit agreement limits acquisitions in the
aggregate to $50.0 million of cash consideration and $20.0 million of non-cash
consideration, with no more than $30.0 million of cash consideration in any one
acquisition, unless Headwaters' "total leverage ratio," as defined, is less than
or equal to 3.50:1.0, after giving effect to an acquisition, in which case the
foregoing limitations do not apply. The senior secured credit agreement also
limits the amount Headwaters can invest in joint ventures and other less than
100%-owned entities.
As described in Note 3 to the consolidated financial statements in the
Form 10-K, Headwaters agreed to pay an earn-out to the sellers of SCP if a
specified earnings target was exceeded during the 12 months ended December 31,
2005 (the earn-out period). The earn-out consideration totaled $9.5 million and
was recorded as additional goodwill. It was paid to the former owners of SCP,
one of whom is a current officer of Headwaters, in April 2006.
During the nine months ended June 30, 2006, Headwaters acquired certain
assets and assumed certain liabilities of four privately-held companies. Total
consideration for these four acquisitions was approximately $16.3 million, of
which $14.8 million was paid prior to June 30, 2006. Subsequent to June 30,
2006, Headwaters acquired certain assets and assumed certain liabilities of an
additional company, for consideration of approximately $2.0 million. Pursuant to
contractual terms for four of the acquisitions, additional amounts may be
payable in the future, based on certain net revenues or the achievement of
stipulated revenue or earnings targets in future periods. Four of the five
acquisitions are in the construction materials segment and one is in the
alternative energy segment.
In 2004, Headwaters entered into an agreement with Degussa AG, an
international chemical company based in Germany, to jointly develop and
commercialize a process for the direct synthesis of hydrogen peroxide. Under
terms of the joint venture agreement, Headwaters paid $1.2 million for its
investment in the joint venture in 2004, an additional $1.0 million in October
2005 and is further obligated to pay $1.0 million in fiscal 2006. Headwaters has
also committed to fund 50% of the joint venture's research and development
expenditures, currently limited to (euro)3.0 million, through September 2007, of
which approximately (euro)0.9 million (approximately $1.2 million) remains to be
paid as of June 30, 2006. Although there is no legal obligation to do so, the
joint venture partners currently have long-range plans to eventually invest in
large-scale hydrogen peroxide plants using the process for direct synthesis of
hydrogen peroxide.
In April 2006, Degussa Headwaters Korea Co., Ltd. ("DHK"), a joint
venture in formation between Degussa AG and Headwaters, entered into a Sale and
Purchase Agreement ("Purchase Agreement") as purchaser with Kemira Chemicals
Korea Corporation as seller. The transaction calls for the transfer by the
seller of certain assets and liabilities comprising a hydrogen peroxide
production business located in Ulsan, South Korea. The base purchase price is
(euro)27.5 million payable at closing, which amount will be adjusted by several
factors. Headwaters is a principal obligor with respect to all non-financial
obligations of DHK and with respect to 50% of all financial obligations of DHK
under the Purchase Agreement. The transaction closing is subject to the
fulfillment of certain conditions, including the execution of a joint venture
agreement between Degussa and Headwaters.
Headwaters also owns a 51% interest in a joint venture with Great River
Energy, a Minnesota-based power generation and supply cooperative ("GRE"), which
was formed to construct, own and operate an ethanol plant in North Dakota ("Blue
Flint"). The plant is currently expected to begin operating in early calendar
2007 with estimated ethanol production of 50 million gallons annually. Estimated
costs to construct the ethanol plant are approximately $84.5 million, with an
additional $11.0 million to be used for working capital and start-up costs. As
of June 30, 2006, Blue Flint was committed to spend approximately $43.3 million
in construction costs. Blue Flint expects to fund plant construction and
start-up costs with approximately $76.4 million of debt secured by all the
assets of Blue Flint, along with capital contributions of $9.7 million and $9.4
million from Headwaters and GRE, respectively. Headwaters has made its full
capital contribution as of June 30, 2006. The Blue Flint joint venture, which is
not a variable interest entity, is being accounted for using the equity method
of accounting because both partners have equal voting rights and control over
the joint venture.
Financing Activities. Due to the issuance of senior debt in September
2004 and the covenants associated with that debt, Headwaters currently has
limitations on its ability to obtain significant additional amounts of long-term
27
debt. However, Headwaters has experienced strong positive cash flow from
operations and in fiscal 2005 issued common stock which together has enabled
Headwaters to repay a substantial amount of its long-term debt prior to the
scheduled maturities. Headwaters expects its positive cash flow to continue in
the future and also has the ability to access the equity markets.
Headwaters has an effective universal shelf registration statement on
file with the SEC that can be used for the sale of common stock, preferred
stock, convertible debt and other securities. Approximately $18.0 million
remains available for future offerings of securities under this registration
statement. A prospectus supplement describing the terms of any additional
securities to be issued is required to be filed before any future offering would
commence under the registration statement.
Reference is made to Note 6 to the consolidated financial statements
for information about Headwaters' outstanding long-term debt (including 2006
repayments and future maturities), interest rate hedges, and compliance with
debt covenants. Headwaters may, in the future, make optional prepayments of the
senior debt depending on actual cash flows, Headwaters' current and expected
cash requirements and other applicable factors deemed significant by management.
As provided for in the senior debt agreements, Headwaters has available
$60.0 million under a revolving credit arrangement. Borrowings under the
revolving credit arrangement are generally subject to the terms of the first
lien loan agreement and bear interest at either LIBOR plus 1.75% to 2.5%
(depending on Headwaters' "total leverage ratio," as defined), or the base rate
plus 0.75% to 1.5%. Borrowings and reborrowings of any available portion of the
$60.0 million revolver can be made at any time through September 2009, when all
loans must be repaid and the revolving credit arrangement terminates. The fees
for the unused portion of the revolving credit arrangement range from 0.5% to
0.75% (depending on Headwaters' "total leverage ratio," as defined). There were
no borrowings outstanding under the revolving credit arrangement as of June 30,
2006, or subsequent thereto. The credit agreement also allows for the issuance
of letters of credit, provided there is capacity under the revolving credit
arrangement. As of June 30, 2006, eight letters of credit totaling $6.9 million
were outstanding, with expiration dates ranging from September 2006 to December
2008.
The credit agreements contain restrictions and covenants common to such
agreements, including limitations on the incurrence of additional debt,
investments, merger and acquisition activity, asset sales and liens, annual
capital expenditures in excess of $72.0 million for fiscal 2006 and $75.0
million for fiscal 2007 through 2011, and the payment of dividends, among
others. In addition, Headwaters must maintain certain leverage and fixed charge
coverage ratios, as those terms are defined in the agreements, as follows: i) a
total leverage ratio of 4.25:1.0 or less, declining periodically to 3.5:1.0 in
2010; ii) a maximum ratio of consolidated senior funded indebtedness minus
subordinated indebtedness to EBITDA of 3.25:1.0, declining periodically to
2.5:1.0 in 2010; and iii) a minimum ratio of EBITDA plus rent payments for the
four preceding fiscal quarters to scheduled payments of principal and interest
on all indebtedness for the next four fiscal quarters of 1.10:1.0 through
September 30, 2006, and 1.25:1.0 thereafter.
In 2006, cash proceeds from the exercise of options and employee stock
purchases totaled $8.3 million, compared to $7.8 million of proceeds in 2005.
Option exercise activity is largely dependent on Headwaters' stock price and is
not predictable. To the extent non-qualified stock options are exercised, or
there are disqualifying dispositions of shares obtained upon the exercise of
incentive stock options, Headwaters receives an income tax deduction generally
equal to the income recognized by the optionee. Such amounts, reflected in cash
flows from financing activities in the consolidated statements of cash flows,
were $(2.3) million in 2006 and $6.3 million in 2005. The negative amount in
2006 was caused by a reversal of amounts pertaining to prior periods, stemming
from adjustments related to an ongoing IRS audit.
Working Capital. During 2006, Headwaters' working capital increased by
$23.7 million, to $141.0 million as of June 30, 2006. Headwaters expects
operations to produce positive cash flows in future periods and believes working
capital, along with available borrowings under the revolving credit arrangement,
will be sufficient for operating needs for the next 12 months.
Income Taxes. Headwaters' cash requirements for income taxes generally
approximate the income tax provision; however, there is usually some lag in
paying estimated taxes during a fiscal year due to the seasonality of operations
and because estimated income tax payments are typically based on annualizing the
fiscal year's income based on year-to-date results. There is also some lag in
realizing the cash benefits from the utilization of tax credits due to the
interaction of Headwaters' September 30 fiscal year end and the different fiscal
year ends of the entities through which Headwaters receives the tax credits. In
fiscal 2006, there is more variability in the relationship between the income
tax provision and income tax payments because the effective tax rate calculation
is materially dependent upon the estimated phase-out percentage of Section 45K
tax credits. The phase-out percentage is subject to material change at this date
because it is dependent on oil prices for the remainder of calendar 2006, which
are not predictable. Therefore, the estimated fiscal 2006 effective tax rate
reflected in the consolidated financial statements is also subject to material
change.
28
As discussed previously, cash payments for income taxes are reduced for
tax deductions resulting from disqualifying dispositions of incentive stock
options and from the exercise of non-qualified stock options, which cash amounts
were a negative $2.3 million in 2006. Option exercise activity is largely
dependent on Headwaters' stock price and is not predictable. Likewise, it is not
possible to estimate what tax benefits may be realized from future option
exercises.
Headwaters' estimated effective income tax rate for the fiscal year
ending September 30, 2006 is 32.0%, the rate applied to the nine month period
ended June 30, 2006. Additionally, Headwaters recognized a net $1.7 million
benefit during the nine months ended June 30, 2006 for discrete items that did
not affect the calculation of the estimated effective income tax rate. The rate
for 2006 compares to an effective tax rate of approximately 30.0% for the nine
months ended June 30, 2005. The discrete items benefiting the tax rate in 2006
primarily related to the reversal of accruals for tax liabilities associated
with the fiscal year ended September 30, 2002, for which the statute of
limitations has expired.
The increase in the effective tax rate for fiscal 2006 as compared to
fiscal 2005 is primarily due to reduced Section 45K [formerly Section 29] tax
credits, as explained in detail in Note 7 to the consolidated financial
statements. Excluding the effect of the tax credits, Headwaters' estimated
effective tax rate for fiscal 2006 would be approximately 40%. For purposes of
calculating an estimated effective tax rate for fiscal 2006, Headwaters assumed
a phase-out percentage for Section 45K tax credits for calendar 2006 of 69% (see
Note 7). While it is not possible to accurately estimate the entire calendar
year 2006 phase-out percentage at the current time, and it is certain that
Headwaters' estimate of the phase-out percentage will change during the year, as
of June 30, 2006, an estimated phase-out percentage of 69% is Headwaters' best
estimate of what the phase-out percentage for calendar 2006 would be, using
available information as of that date. As of March 31, 2006, the estimated
phase-out percentage for calendar 2006 was 37%. The effect of the change in
estimate of the phase-out percentage from 37% to 69% was recorded to income tax
expense in the quarter ended June 30, 2006.
Summary of Future Cash Requirements. Significant future cash uses, in
addition to operational working capital requirements, including income tax
payments, are currently expected to consist primarily of capital expenditures,
debt service payments on outstanding long-term debt, and potential additional
acquisitions.
Legal or Contractual Matters
Headwaters has ongoing litigation and asserted claims which have been
incurred during the normal course of business, including the specific matters
discussed in Note 10 to the consolidated financial statements. Headwaters
intends to vigorously defend or resolve these matters by settlement, as
appropriate. Management does not currently believe that the outcome of these
matters will have a material adverse effect on Headwaters' operations, cash
flows or financial position.
Costs paid to outside legal counsel for litigation have historically
comprised a majority of Headwaters' litigation-related costs. During the nine
months ended June 30, 2006, Headwaters recorded a net credit of approximately
$(0.5) million for legal matters, including costs for outside legal counsel. The
credit in costs for legal matters was due to positive developments in certain
legal matters Headwaters is defending, leading to reduced likelihood of ultimate
legal liability. Headwaters currently believes the range of potential loss for
all unresolved matters, excluding costs for outside counsel, is from $1.0
million up to the amounts sought by claimants and has recorded a total liability
as of June 30, 2006 of $1.0 million. Claims and damages sought by claimants in
excess of this amount are not deemed to be probable. Our outside counsel
currently believe that unfavorable outcomes of outstanding litigation are
neither probable nor remote and declined to express opinions concerning the
likely outcomes or liability to Headwaters. It is not possible to estimate what
litigation-related costs will be in future periods.
The matters discussed in Note 10 to the consolidated financial
statements raise difficult and complex legal and factual issues, and the
resolution of these issues is subject to many uncertainties, including the facts
and circumstances of each case, the jurisdiction in which each case is brought,
and the future decisions of juries, judges, and arbitrators. Therefore, although
management believes that the claims asserted against Headwaters in the named
cases lack merit, there is a possibility of material losses in excess of the
amounts accrued if one or more of the cases were to be determined adversely
against Headwaters for a substantial amount of the damages asserted. It is
possible that a change in the estimates of probable liability could occur, and
the changes could be material. Additionally, as with any litigation, these
proceedings require that Headwaters incur substantial costs, including
attorneys' fees, managerial time, and other personnel resources and costs in
pursuing resolution.
During the quarter ended June 30, 2006, the Compensation Committee of
Headwaters' Board of Directors (the "Committee") authorized the grant of
long-term incentive cash bonus awards to certain officers and employees. The
awards were granted subsequent to June 30, 2006 under Headwaters' Long Term
Incentive Compensation Plan approved by stockholders in March 2005. In
accordance with terms of the awards, cash payments will be based on several
factors, including the achievement of stipulated financial goals as measured by
economic value added ("EVA") over a three-year period by Headwaters and its
operating units. Payments for these awards may not exceed $30.0 million in the
aggregate.
29
Also during the June 2006 quarter, the Committee approved "Executive
Change in Control Agreements" with 12 officers, which agreements will be
executed subsequent to June 30, 2006. Upon a change in control, as defined, the
agreements will provide for immediate vesting and exercisability of all
outstanding stock awards. In addition, if termination of employment occurs
within a specified period of a change in control, the agreements provide for i)
severance pay equal to two times the sum of an officer's current annual salary
plus the highest cash bonus paid or payable for any single year in the
three-year period commencing two years prior to the year in which the change in
control occurs; and ii) continuance of health and other benefits and perquisites
for a two-year period following the change in control. If terminations
associated with a change in control would have occurred on June 30, 2006, the
severance payments due to the 12 officers would have aggregated approximately
$19.3 million.
As described in more detail in Note 12 to the consolidated financial
statements in the Form 10-K, during fiscal 2005 the Committee authorized the
grant of several stock incentive awards. At that time, the Committee also
authorized the grant of performance unit awards, to be settled in cash, based on
performance criteria tied to the economic value created or preserved by one of
Headwaters' business units after December 2007. The grants of these performance
units were made in November 2005 and could result in the payment to employees of
a maximum amount of approximately $3.6 million if all performance criteria are
met.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Headwaters is exposed to financial market risks, primarily related to
changes in interest rates. Headwaters does not use derivative financial
instruments for speculative or trading purposes, but has entered into hedge
transactions to limit its variable interest rate exposure, as explained below.
As described in more detail in Note 6 to the consolidated financial
statements, Headwaters has approximately $422.7 million of variable-rate
long-term debt outstanding as of June 30, 2006, consisting of $415.3 million of
senior debt and $7.4 million of notes payable to a bank. There was approximately
$481.4 million of variable-rate long-term debt outstanding as of September 30,
2005.
As required by the senior secured credit facility, Headwaters entered
into certain other agreements to limit its variable interest rate exposure. The
first set of agreements expired on their terms prior to September 30, 2005. The
second set of agreements effectively fixes the LIBOR rate at 3.71% for $150.0
million of this debt for the period September 8, 2005 through September 8, 2007.
Headwaters accounts for the agreements which limit its variable interest rate
exposure as cash flow hedges, and accordingly, the fair market value of the
hedges is reflected in the consolidated balance sheet as either other assets or
other liabilities. The market value of the hedges can fluctuate significantly
over a relatively short period of time. The hedges had a market value at June
30, 2006 of approximately $3.1 million, which, net of $1.2 million of income
taxes, represents other comprehensive income.
Considering all outstanding balances of variable-rate debt (reduced by
the $150.0 million of senior debt that effectively has a fixed interest rate
until September 8, 2007) and required principal repayments, a change in the
interest rate of 1% would change Headwaters' interest expense by approximately
$2.7 million during the 12 months ending June 30, 2007.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures - Headwaters maintains disclosure
controls and procedures that are designed to ensure that information required to
be disclosed by Headwaters in the reports that it files or submits under the
Securities Exchange Act of 1934 (the "Exchange Act"), such as this Quarterly
Report on Form 10-Q, is recorded, processed, summarized and reported within the
time periods specified by SEC rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by Headwaters in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to Headwaters' management, including the Chief Executive Officer ("CEO") and the
Chief Financial Officer ("CFO"), to allow timely decisions regarding required
disclosure.
Headwaters' management evaluated, with the participation of Headwaters'
CEO and CFO, the effectiveness of its disclosure controls and procedures as of
June 30, 2006, pursuant to paragraph (b) of Rules 13a-15 and 15d-15 under the
Exchange Act. This evaluation included a review of the controls' objectives and
design, the operation of the controls, and the effect of the controls on the
information presented in this Quarterly Report. Headwaters' management,
including the CEO and CFO, does not expect that disclosure controls can or will
prevent or detect all errors and all fraud, if any. A control system, no matter
how well designed and operated, can provide only reasonable, not absolute,
assurance that the objectives of the control system are met. Also, the
30
projection of any evaluation of the disclosure controls and procedures to future
periods is subject to the risk that the disclosure controls and procedures may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
Based on their review and evaluation, and subject to the inherent
limitations described above, Headwaters' CEO and CFO have concluded that
Headwaters' disclosure controls and procedures (as defined in Rules 13a-15(e)
and 15d-15(e) under the Exchange Act) were effective as of June 30, 2006.
Internal Control over Financial Reporting - Management is responsible
for establishing and maintaining adequate internal control over financial
reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act.
Headwaters' internal control over financial reporting is designed to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
accounting principles generally accepted in the United States of America.
Because of inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Therefore, even internal
controls determined to be effective can provide only reasonable assurance with
respect to financial statement preparation and presentation. The effectiveness
of Headwaters' internal control over financial reporting is subject to various
inherent limitations, including cost limitations, judgments used in decision
making, assumptions about the likelihood of future events, the possibility of
human error, and the risk of fraud. The projection of any evaluation of
effectiveness to future periods is subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with policies may deteriorate. Because of these limitations, there can be no
assurance that any system of internal control over financial reporting will be
successful in preventing all errors or fraud or in making all material
information known in a timely manner to the appropriate levels of management.
There has been no change in Headwaters' internal control over financial
reporting during the quarter ended June 30, 2006 that has materially affected,
or is reasonably likely to materially affect, Headwaters' internal control over
financial reporting.
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See "Legal or Contractual Matters" in Note 10 to the consolidated
financial statements for a description of current legal proceedings.
ITEM 1A. RISK FACTORS
Risks relating to Headwaters' business and common stock are described
in detail in Item 7 of the Form 10-K. The following information supplements the
information described therein as it relates to Section 45K phase-out.
Section 45K [formerly Section 29] of the Internal Revenue Code
("Section 45K") tax credits are subject to phase-out if the unregulated average
annual oil price reaches the IRS established phase-out range.
Tax credits claimed by an alternative fuel facility owner are reduced
prior to their scheduled expiration on December 31, 2007 if the "reference
price" of oil exceeds the lower end of a phase-out range, and are eliminated
entirely if the reference price exceeds the higher end of that range, with the
beginning and end of the range being adjusted annually for inflation. The
reference price of oil is defined as the U.S. Energy Information Agency's
estimate of the annual average wellhead price per barrel for all domestic crude
oil not subject to regulation by the United States. In April of each year, the
IRS announces the reference price and the phase-out range of oil prices for the
prior calendar year. For example, in April 2006, the IRS announced that the
reference price for calendar 2005 was $50.26 per barrel and that the phase-out
range for 2005 began at $53.20 per barrel and ended with a $0 tax credit at
$66.78 per barrel. Because the calendar year 2005 reference price did not fall
within the range, there was not a phase-out of the credit for qualified fuel
sold in 2005.
For calendar 2006, Headwaters estimates that the phase-out range
(computed by increasing the 2005 inflation adjustment factor by 2%) begins at
$54.27 and completes phase-out at $68.12 per barrel. Congress is considering
legislation to change Section 45K phase-out calculations to a prospective rather
than retrospective application of the reference price. As of the date hereof, it
is too early to accurately estimate a reference price for calendar 2006.
However, Headwaters estimates that based on actual oil prices for January
through April 2006 and published NYMEX oil prices for May through December 2006,
and absent a legislative change to a prospective application of the reference
31
price, a 69% phase-out would result. If the Section 45K tax credits are phased
out in whole or in material part, the amounts and timing of recognition of
Headwaters revenue, net income and cash flow will be severely affected.
The rising price of oil has had a significant impact on the decisions
of facility owners concerning alternative fuel production beginning with the
first quarter of calendar year 2006. Headwaters and its licensees and customers
closely watch oil price trends and will continue to consider whether or not to
operate facilities in the rest of calendar 2006 depending upon their respective
views of future oil prices. Some facility owners have attempted to protect their
positions by purchasing oil futures hedges and have requested that Headwaters
share the cost of such hedges, while others have considered these actions too
risky and expensive, and have elected to simply curtail or eliminate production
based upon an assessment that high oil prices indicate phase-out likelihood.
Thus far in 2006, many of Headwaters' licensees and reagent customers have idled
production at their alternative fuel facilities, bringing the total idled
alternative fuel lines to at least 33, representing approximately 75% of fiscal
2005 reagent sales and license fees. This number could increase at any time and
licensees and reagent customers continue to evaluate their particular
circumstances in light of volatile oil prices and anticipated phase-out of
credits. Headwaters must also make assessments with respect to the continued
operation of its own synthetic fuel production facilities. Decisions to stop
operation of Headwaters' own synthetic fuel production facilities will increase
its tax rate for the year in which production is curtailed; Headwaters'
effective tax rate for 2006 has already been increased. Decisions by Headwaters
or our licensees or customers to further curtail or eliminate production will
severely affect profitability and cash flow, including the timing of recognition
of revenue.
Legislation was proposed in Congress for inclusion in the 2006 tax
reconciliation bill to change Section 45K phase-out calculations to a
prospective rather than retrospective application of the reference price. Such
proposed legislation would have impacted the potential phase-out of production
tax credits for 2006 with the result that customers could resume their
alternative fuel activities. However, this provision was not included in the
reconciliation bill as enacted. The proposed legislation is under consideration
for inclusion in subsequent legislation, such as an "extenders" bill, but
Headwaters cannot predict if any legislation will be enacted as proposed.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
The following exhibits are included herein:
10.93.3 Amendment No. 5 to the Credit Agreement among Headwaters and various lenders *
dated as of June 27, 2006
12 Computation of ratio of earnings to combined fixed charges and preferred *
stock dividends
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer *
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer *
32 Section 1350 Certifications of Chief Executive Officer and Chief Financial *
Officer
99.16 Form of 2006 Long-Term Incentive Cash Bonus Agreement *
99.17 Form of 2006 Executive Change in Control Agreement *
-----------------------
* Filed herewith.
32
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HEADWATERS INCORPORATED
Date: July 27, 2006 By: /s/ Kirk A. Benson
Kirk A. Benson, Chief Executive Officer
(Principal Executive Officer)
Date: July 27, 2006 By: /s/ Scott K. Sorensen
Scott K. Sorensen, Chief Financial Officer
(Principal Financial Officer)
33
