UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended September 30, 2003,
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 0-27808
HEADWATERS INCORPORATED
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(Exact name of registrant as specified in its charter)
Delaware 87-0547337
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(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
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(Address of principal executive offices) (Zip Code)
(801) 984-9400
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock,
$.001 par value
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
The aggregate market value of the voting stock held by non-affiliates
of the registrant as of March 31, 2003 was $374,304,448, based upon the closing
price on the Nasdaq National Market reported for such date. This calculation
does not reflect a determination that persons whose shares are excluded from the
computation are affiliates for any other purpose.
The number of shares outstanding of the registrant's common stock as of
November 30, 2003 was 28,068,818.
___________________________
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the following document are incorporated herein by
reference: Portions of the registrant's definitive proxy statement to be issued
in connection with registrant's annual stockholders' meeting to be held in 2004.
TABLE OF CONTENTS
Page
PART I
ITEM 1. BUSINESS...........................................................3
ITEM 2. PROPERTIES........................................................14
ITEM 3. LEGAL PROCEEDINGS.................................................14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS.............................................16
ITEM 6. SELECTED FINANCIAL DATA...........................................17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.......................................18
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........35
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.......................36
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE........................................36
ITEM 9A. CONTROLS AND PROCEDURES...........................................37
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................37
ITEM 11. EXECUTIVE COMPENSATION............................................37
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT....37
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................38
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES............................38
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
ON FORM 8-K.....................................................38
SIGNATURES...................................................................41
Forward-looking Statements
This Annual Report on Form 10-K, 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," 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 captions entitled "Forward-looking Statements" and
"Risk Factors" in Item 7 hereof. 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.hdwtrs.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 or furnish to the SEC.
PART I
ITEM 1. BUSINESS
General Development of Business
Introduction. Headwaters develops and commercializes technologies that
enhance the value of coal, gas, oil and other natural resources. We are the
largest provider of technologies used to produce coal-based solid synthetic
fuels, and we are the industry leader in managing and marketing coal combustion
products ("CCPs") in the United States. We are developing and commercializing
proprietary technologies to convert or upgrade fossil fuels into higher-value
products and are developing nanocatalyst technologies that have multiple
applications. Headwaters has experienced dramatic growth over the last several
years, generated from internal growth as well as through acquisitions. Our
revenues have grown from $6.7 million in 1999 to $387.6 million for the fiscal
year ended September 30, 2003.
We have successfully commercialized technologies and processes that
enhance the value of coal used to generate electricity. Coal is one of the
world's most abundant and affordable natural resources and is the primary fossil
fuel used world-wide for electricity generation. In 2001, coal represented 62%
of the world's fossil fuel energy reserves, while crude oil and natural gas
represented 20% and 18%, respectively. Coal serves as a primary resource for
baseline electricity production in the United States and was used to produce
approximately half of the electricity generated in the United States during
2002. The United States Department of Energy ("DOE") has predicted that the use
of coal will continue to grow in the United States and throughout the world.
Headwaters focuses on the "coal value chain" which can be categorized
into three major phases: (i) pre-combustion, which includes coal mining,
preparation, treatment, and transportation; (ii) combustion, which results in
energy generation; and (iii) post-combustion, which includes emissions control
and the utilization and disposal of CCPs which are created when coal is burned,
such as fly ash and bottom ash. In the pre-combustion phase, Headwaters'
proprietary technologies and chemical reagents are used to convert coal into a
solid synthetic fuel intended to generate tax credits under Section 29 of the
Internal Revenue Code ("Section 29"). In the post-combustion phase, Headwaters
manages and markets CCPs which would otherwise be disposed of in landfills and
uses CCPs to produce commercial building products.
Headwaters' Company History. Headwaters was incorporated in Delaware in
1995 under the name Covol Technologies, Inc. In September 2000, the Company's
name was changed to Headwaters Incorporated. Headwaters' stock trades under the
Nasdaq symbol HDWR.
As used herein, "Headwaters," "combined company," "company," "we,"
"our" and "us" refers to Headwaters Incorporated and its division Covol Fuels,
together with its consolidated subsidiaries ISG and HTI, unless the context
otherwise requires. "ISG" refers to Headwaters' subsidiary, Headwaters Olysub
Corporation, formerly Industrial Services Group, Inc., and its subsidiary, ISG
Resources, Inc., together with their consolidated subsidiaries, and "HTI" refers
to Headwaters Technology Innovation Group, Inc. together with its consolidated
subsidiaries, unless the context otherwise requires. All of these terms are used
for convenience only, and are not intended as a precise description of any of
the separate companies, each of which manages its own affairs.
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Covol Fuels
Principal Products and their Markets. Through our Covol Fuels operating
division, Headwaters has developed and commercialized technology that interacts
with coal-based feedstocks to produce a solid synthetic fuel intended to be
eligible for Section 29 tax credits. The sale of qualified synthetic fuel
enables facility owners who comply with certain statutory and regulatory
requirements to claim federal tax credits under Section 29, which currently
expires on December 31, 2007. Headwaters has licensed this technology to owners
of solid synthetic fuel facilities for which it receives royalty revenues.
Headwaters also sells proprietary chemical reagents to licensees for use in the
production of the coal-based solid synthetic fuel and to other solid synthetic
fuel facility owners with whom Headwaters has reagent supply agreements.
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Headwaters licenses the Covol Fuels process to owners of synthetic fuel
production facilities and is paid a royalty stream generally based on the tax
credits generated from synthetic fuels sold to utilities and other industrial
coal consumers. Headwaters also receives revenues from the sale of its chemical
reagents. Covol Fuels' licensees and chemical reagent customers include major
utilities in the synthetic fuel industry.
In addition to technology licensing and chemical reagent sales,
Headwaters provides on-site facility services to licensees of its technology and
purchasers of its reagents. Headwaters has experience in producing synthetic
fuel and optimizing the production capabilities of synthetic fuel facilities.
This experience complements Headwaters' ongoing laboratory testing and
development of synthetic fuels. Headwaters employs chemical, electrical and
mechanical engineers and field personnel with extensive plant and equipment
operating experience to perform these on-site facility services and other
technical support functions.
Licensing Fees. In fiscal 2001 and 2002, prior to its acquisition of
ISG, Headwaters generated 95% or more of its revenues through license fees from
its technologies and sale of chemical reagents to owners of coal-based solid
synthetic fuel facilities. In fiscal 2003, these license fees and chemical
reagent sales contributed approximately 42% of revenues and ISG contributed
approximately 57%. See Note 4 to the consolidated financial statements for
revenues, profits and total assets set forth by segment. Headwaters currently
licenses its technologies to 28 of a company-estimated total of 75 coal-based
solid synthetic fuel facilities in the United States. In addition, Covol Fuels
sells its proprietary chemical reagents to 19 of these licensee facilities as
well as to more than ten other synthetic fuel facilities.
Current licensees include electric utility companies, coal companies,
financial institutions and other major businesses in the United States. License
agreements contain a quarterly earned royalty fee generally set at a prescribed
dollar amount per ton or a percentage of the tax credits earned by the licensee.
License agreements generally have a term continuing through the later of January
1, 2008 or the date after which tax credits may not be claimed or are otherwise
not available under Section 29.
Despite the growth in revenues, there continues to be under-utilization
of production capacity in several facilities employing Headwaters' technologies,
because of factors such as feedstock quality and the inability of certain owners
to utilize all the available Section 29 tax credits. See "ITEM 7. MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-Risk
Factors."
Chemical Reagent Sales. The transformation of the feedstock to a
synthetic fuel involves the use of a chemical reagent in a qualified facility.
Headwaters markets two proprietary latex-based chemicals, Covol 298 and Covol
298-1, which are widely used for the production of coal-based solid synthetic
fuel. The chemical reagent alters the molecular structure of the feedstock to
produce a synthetic fuel.
Covol 298 and Covol 298-1 are produced by Dow Reichhold Specialty Latex
LLC ("Dow Reichhold") under long-term agreements. Headwaters does not maintain
or inventory any chemicals. Instead, Headwaters arranges for the shipping of the
chemical reagents directly from Dow Reichhold's production facilities to the
synthetic fuel plants. The chemical reagents can be manufactured in 13 Dow
Reichhold plants throughout North America, assuring short lead-time deliveries
and the ability to meet increasing reagent demand. Additionally, Headwaters has
an arrangement with Dow Reichhold for technical support services relating to new
product development and manufacture.
Headwaters believes the benefits of its proprietary chemical reagents
as compared to competitive materials include clean and efficient combustion
characteristics, ease of application, concentrated form of shipment and lack of
damage to material handling, pulverizing or combustion equipment. Headwaters
believes the chemical reagents used in the Covol Fuels process are
environmentally safe, possess superior handling characteristics, burn
efficiently and are competitively priced. Additionally, Headwaters' chemical
reagents have been reviewed by the IRS and tested by independent laboratories.
The parameters of the Covol Fuels process are consistent with the criteria for
future private letter rulings as outlined by the IRS in Revenue Procedure
2001-30, as modified by Revenue Procedure 2001-34.
On-site Facility Services. In addition to licensing its technology and
supplying chemical reagents, Headwaters also employs hands-on technical account
managers that are available to assist its customers. Headwaters' engineers have
years of experience operating synthetic fuel manufacturing equipment, including
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mixers, extruders, pellet mills, briquetters and dryers. Headwaters' employees
are experts in applying our chemical reagents on multiple types of coal
feedstocks. Headwaters has operated synthetic fuel facilities utilizing multiple
types of coal feedstocks, and has developed and demonstrated process
improvements in commercial facilities. Headwaters has also designed and
constructed reagent mixing and application systems and has retrofitted existing
facilities to use our reagents. For new customers, Headwaters has a mobile,
skid-mounted reagent delivery system that allows for on-site demonstration
testing. Headwaters believes that this full spectrum of services makes it unique
in providing goods and services to the coal-based solid synthetic fuel business.
Headwaters maintains analytical laboratories, including bench-scale
equipment for the production of coal-based solid synthetic fuel and
comprehensive analytical testing equipment for performing standard coal
analyses. We also monitor, document and substantiate the chemical change process
required to obtain Section 29 tax credits.
Sources of Available Raw Materials and Inventory Requirements. Covol
Fuels' chemical reagents are produced by Dow Reichhold under a long-term
agreement. Covol Fuels does not maintain or inventory any chemicals. Instead,
Covol Fuels arranges for the drop shipping of the chemical reagents directly
from Dow Reichhold's production facilities to the synthetic fuel plants. The
chemical reagents can be manufactured in its Dow Reichhold plants throughout
North America assuring short lead-time deliveries and the ability to meet
increasing reagent demand. Separately, the alternative fuel facility owners have
unrelated feedstock agreements that provide a supply of raw coal for processing
at their facilities. These licensees and customers in turn have production
agreements to supply alternative fuel to end users (usually coal-fired
electricity generating facilities).
Major Customers. The following table presents revenues for all
customers that accounted for over 10% of total revenue during 2001, 2002 or
2003. Most of the named customers are energy companies. Affiliate relationships
are determined for the period in which events are calculated.
(thousands of dollars) 2001 2002 2003
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DTE Energy Services, Inc. affiliates $ 5,111 $19,660 $42,013
TECO Coal Corporation affiliates 16,044 20,292 Less than 10%
Marriott International, Inc. affiliates Less than 10% 19,105 Less than 10%
AIG Financial Products Corp. affiliates Less than 10% 16,900 Less than 10%
PacifiCorp affiliates 4,978 Less than 10% Less than 10%
Pace Carbon Fuels, L.L.C. affiliates 4,675 Less than 10% Less than 10%
ISG
ISG's Company History. ISG was incorporated in Delaware in 1997.
Beginning in October 1997, ISG acquired through a series of transactions a
number of companies to form a national CCP business. ISG Resources, Inc., which
was incorporated in Utah in August 1998, and its subsidiaries, operate this
business. Headwaters acquired ISG in September 2002.
Principal Products and their Markets. ISG is currently the largest
manager and marketer of CCPs in the United States and also manages and markets
CCPs in Canada. ISG has long-term exclusive management contracts with coal-fired
electric generating utilities throughout the United States and provides CCP
management services at more than 110 power plants. ISG markets CCPs where
markets exist, and manages much of the disposal of the rest, typically in
landfills. ISG has established long-term relationships with many of the nation's
major utilities.
ISG markets CCPs as a replacement for manufactured or mined materials,
such as portland cement, lime, agricultural gypsum, fired lightweight aggregate,
granite aggregate and limestone. Additionally, ISG's construction materials
subsidiary, American Construction Materials, Inc., manufactures masonry and
stucco construction materials, packaged products and blocks for the construction
industry, which contain a high percentage content of CCPs.
Utilities produce CCPs year-round, including in the winter when demand
for electricity increases in many regions. In comparison, sales of CCPs and
construction materials produced using CCPs are keyed to construction market
demands that tend to follow national trends in construction with predictable
increases during temperate seasons. CCPs must be stored, usually in terminals,
during the off-peak sales periods as well as transported to where they are
needed for use in construction materials. In part because of the cost of
transportation, the market for CCPs used in construction materials is generally
5
regional, although ISG ships products significant distances to states such as
California and Florida that do not have coal-fired electric utilities producing
high quality CCPs. However, ISG enjoys advantages in both logistics and sales
from its status as the largest manager and marketer of CCPs in the United
States. ISG maintains more than 30 stand-alone CCP distribution terminals across
North America, as well as approximately 90 plant site supply facilities. ISG's
operations utilize a fleet of more than 1,000 private railcars and 340 trucks so
that it can meet the transportation needs for both disposing and marketing CCPs.
In addition, ISG has more than 50 area managers and technical sales
representatives nationwide to manage customer relations.
Fly Ash and Other CCPs. The benefits of CCP use in construction
applications include improved product performance, cost savings and positive
environmental impact. Fly ash improves both the chemical and physical
performance of concrete. Physically, fly ash particles are smaller than cement
particles, allowing them to effectively fill voids and create concrete that is
denser and more durable. Fly ash particles are spherical and they have a "ball
bearing" effect, which lubricates the concrete mix and allows enhanced
workability with less water. Chemically, the requirement of less water
contributes to decreased permeability and greater durability of concrete.
Because fly ash is also typically less expensive than the cement it replaces,
concrete producers are able to improve profitability while improving concrete
quality.
When fly ash is used in concrete it provides environmental benefits.
According to the EPA, one ton of fly ash used as a replacement for portland
cement eliminates approximately one ton of carbon dioxide emissions, or the
equivalent of retiring an automobile from the road for two months. These
benefits are recognized in major "green building" movements, such as the United
States Green Building Council's LEED classification system. The value of
utilizing fly ash in concrete has been recognized by numerous federal agencies,
including the United States DOE and Environmental Protection Agency ("EPA"),
which has issued comprehensive procurement guidelines directing federal agencies
to utilize fly ash. Almost all states specify or recommend the use of fly ash in
state and federal transportation projects. Other government entities that
frequently specify or recommend the utilization of fly ash in concrete include
the Federal Highway Administration, the United States Army Corps of Engineers
and the United States Bureau of Reclamation. Numerous state departments of
transportation are also increasing their reliance on fly ash as a component for
improving durability in concrete pavements. Several major cement companies have
identified increasing the use of fly ash as a key environmental strategy for the
next two decades.
High quality fly ash is generally the most profitable CCP, as it has a
variety of higher margin commercial uses. In 2002, ISG sold approximately 5.75
million tons of high quality CCPs, including 5.25 million tons of high quality
fly ash of the approximately 12 million tons of high quality fly ash sold in the
United States. The quality of fly ash produced by the combustion process at
coal-fired facilities varies widely and is affected by the boilers used by the
utilities and by the efficiency of the combustion process. ISG assists its
utility clients in their efforts to improve the production of high quality fly
ash at their facilities. ISG tests the fly ash to certify compliance with
applicable industry standards. A comprehensive quality control system ensures
that customers receive fly ash that conforms to their specifications while ISG's
extensive investment in transportation equipment and terminal facilities
provides reliability of supply.
ISG supports its marketing sales program by focusing on customer
desires for quality and reliability. Marketing efforts emphasize the performance
value of CCPs, as well as the attendant environmental benefits.
ISG undertakes a variety of marketing activities to increase fly ash
sales. These activities include:
o Professional Outreach. To promote the acceptance of fly ash in
construction projects, all levels of ISG's sales and marketing
organization are involved in making regular educational
presentations such as continuing professional education
seminars to architects, engineers, and others engaged in
specifying concrete mix designs.
o Technical Publications. ISG publishes, in print form and on
its web site at www.isgresources.com, extensive technical
reference information pertaining to CCPs and CCP applications.
ISG also prominently promotes the environmental benefits of
CCP use.
o Relationships with Industry Organizations. ISG personnel
maintain active leadership positions in committees of the
American Concrete Institute and the American Society for
Testing and Materials, and serve on the boards of the American
Coal Ash Association, the Western Region Ash Group, the Texas
6
Coal Ash Utilization Group, the Midwest Coal Ash Association
and the American Coal Council. These organizations help
establish standards and educate the construction industry and
the general public about the benefits of CCP use.
o Trade Shows. ISG promotes the use of CCPs at more than 30
local and national trade shows and association meetings each
year. ISG is also an exhibitor at the nation's leading
conferences for utilization of environmentally friendly
building products.
o Government Affairs. ISG has taken a leadership role in
encouraging state and federal legislation and regulations that
lead to greater utilization of fly ash by emphasizing its
environmental, performance and cost advantages. Legislative
recognition of the benefits of fly ash as well as the use of
fly ash in governmental projects helps familiarize
contractors, architects and engineers with the benefits of the
product for other construction uses.
o Advertising. ISG advertises for fly ash sales and utilization
in a number of publications, including: Architectural Record,
Engineering News-Record, Construction Specifier, Concrete
Products, Concrete Producer, Concrete International and
Environmental Design & Construction. ISG's website is also a
source of sales leads.
o Creation of Branded Specialty Products. ISG has developed
several specialty products that increase market penetration of
CCPs and name recognition for ISG's products for road bases,
structural fills, industrial fillers and agricultural
applications. These include:
o Alsil(R)- Processed fly ash used as an industrial
filler;
o C-Stone(TM)- Quality crushed aggregate manufactured
from fly ash and used in road base and feedlot
applications;
o Flexbase(TM) - FGD scrubber sludge, pond ash, and/or
lime proportionally mixed for road base or pond liner
material;
o Powerlite(R) - Processed fly ash and bottom ash,
meeting American Society for Testing and Materials
C331 standards, for use as a high quality aggregate
in the concrete block industry; and
o Peanut Maker(R) - A synthetic gypsum used as a land
plaster in agricultural applications.
New Technologies for CCP Utilization. In an effort to maximize the
percentage of CCPs marketed to end users and to minimize the amount of materials
disposed of in landfills, ISG's research and development activities focus on
expanding the use of CCPs by developing new products that utilize high volumes
of CCPs. Through these research and development activities, ISG has developed
FlexCrete(TM), a new commercial and residential building product in its pilot
stages. FlexCrete(TM) is an aerated concrete product with 60% fly ash content
that is cured at lower temperatures and ambient pressure. We expect
FlexCrete(TM) will offer advantages for construction, including low cost, ease
of use, physical strength, durability, energy efficiency, fire resistance and
environmental sensitivity.
Technologies to Improve Fly Ash Quality. ISG also has developed
technologies that maintain or improve the quality of CCPs, further expanding and
enhancing their marketability. Utilities are switching fuel sources, changing
boiler operations and introducing ammonia into the exhaust gas stream in an
effort to decrease costs and/or to meet increasingly stringent emissions control
regulations. All of these factors can have a negative effect on fly ash quality,
including an increase in the amount of unburned carbon in fly ash and the
presence of ammonia slip. ISG has addressed these challenges with the
development and/or commercialization of two technologies. Designed to be simple,
economical and highly effective, these technologies can be implemented without
the large capital expenditures often associated with controlling quality
problems.
Carbon Fixation. Under certain conditions, unburned carbon in fly ash
inhibits the entrainment of air in concrete, undermining the strength and
integrity of finished product. Technologies designed to remove residual carbon
are often capital intensive and are therefore rarely used. ISG has the exclusive
license in North America to utilize a carbon fixation technology used to
pre-treat fly ash. The technology uses a liquid reagent to coat unburned carbon
particles in the fly ash and hinder the impact on the concrete mix. Carbon is
not removed, but its effects on air entrainment are minimized. The technology
also renders some ash products usable for the first time without having any
impact on the quality of finished concrete. Full scale carbon fixation units
have been installed and are operating at major power plants.
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Ammonia Slip Mitigation. As electric utilities move to implement
stringent new air pollution controls, many are treating boiler exhaust gases
with ammonia to remove NOx. This can result in unreacted ammonia being deposited
on fly ash. The use of ammonia contaminated fly ash in concrete production can
result in the release of ammonia gas, exposing concrete workers to varying
levels of ammonia. ISG has developed a technology that uses a chemical reagent
to mitigate the ammonia slip effects. When water is added to the concrete mix
containing ammoniated fly ash, the reagent converts ammonia to harmless
compounds. The process allows the reagent to be added and blended with the dry
fly ash at any time from when the fly ash is collected at the power plant to
when the fly ash is used in the production of concrete.
American Construction Materials. ISG has focused on increasing the
utilization of CCPs in building products that have not traditionally included
CCPs. To accelerate acceptance of CCPs in these markets, ISG created a
construction materials subsidiary, American Construction Materials, which
includes several well-known brands, such as Magna Wall(R) stuccos and BEST(TM)
and Hill Country Mortar Mix(TM) masonry and mortar cements. ISG operates a
network of manufacturing and distribution facilities and retail supply stores
that are strategically located throughout the southern United States and that
provide access to many of the most rapidly growing regions in the nation. ISG
has formulated masonry cements, mortar cements, stucco and block products to
utilize CCPs in residential and commercial building applications. This strategy
has secured an outlet for previously unutilized CCPs while promoting the
increased use of CCPs as components of building products in the future. Unlike
most of its competitors, ISG has dedicated significant resources to the
acquisition and development of new technologies for the use of CCPs in building
products applications. We believe that strong brand recognition and the high
performance characteristics of our products make us a preferred supplier to home
builders and contractors from Florida to Southern California. A key component of
our growth strategy has been the development of superior products utilizing
innovative fly ash-based formulations.
Sources of Available Raw Materials and Inventory Requirements. Coal is
the largest indigenous fossil fuel resource in the United States, with current
U.S. annual coal production in excess of one billion tons. The use of coal to
generate electricity has nearly tripled in the last 30 years. Coal serves as a
primary resource for baseline electricity production in the United States and
was used to produce approximately half of the electricity generated in the
United States in 2002. The government estimates that annual coal consumption
will increase from 1.06 billion tons to 1.44 billion tons by 2025. The
combustion of coal results in a high percentage of residual materials which
serve as the "raw material" for the CCP industry. According to the American Coal
Ash Association, approximately two-thirds of CCPs produced in 2002 were disposed
of in landfills, providing ample opportunities for continuing increases in CCP
utilization. As long as a significant amount of electricity in this country is
generated from coal-fired generation, ISG believes it will have an adequate
supply of raw materials.
HTI
HTI provides research and development support to Headwaters. HTI
maintains a staff of engineers, scientists and technicians with expertise in the
design and operation of high-pressure and temperature process plants at its
Lawrenceville, New Jersey pilot plant and laboratory facilities. The following
are some of the technologies currently under development.
o Nanocatalyst Technology. HTI has developed the capability to
work at the molecular level in the aligning, spacing and
adhering of nano-sized crystals of precious metals on
substrate materials. The net effect is higher performance with
lower precious metal content, and nearly 100% selectivity for
certain chemical reactions (i.e., byproducts and waste are
minimized and the desired reaction is maximized). Potential
applications for this nanotechnology include new processes for
direct synthesis of hydrogen peroxide and production of
propylene oxide. This same technique can also be used to
regenerate spent precious metal catalysts and to improve
volatile organic compound oxidation, naphtha reforming and
fuel cell catalysts. Headwaters has entered into a preliminary
joint venture agreement for fuel cell technology development
and commercialization with the Dalian Institute of Chemical
Physics of the People's Republic of China.
o Direct Coal Liquefaction Technology. Headwaters has developed
an advanced technology for producing clean liquid fuels
directly from coal. Shenhua Group, China's largest coal
company, has purchased elements of Headwaters' direct coal
liquefaction technology for its plant to be built in Majata,
China. The plant is expected to become the first commercial
direct coal liquefaction plant in the world with an ultimate
capacity of 50,000 barrels per day.
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o Heavy Oil Upgrading Technology. HTI has obtained the exclusive
worldwide license to develop, market and sublicense an
innovative catalytic heavy oil upgrading technology known as
(HC)3. This technology is a hydrocracking process used for
upgrading heavy oil, bitumen or bottom-of-the-barrel residual
oil into synthetic crude or clean liquid fuels. The process
uses a proprietary, highly active molecular catalyst. There
are several heavy oil upgrading plants located around the
world that could immediately apply and benefit from the (HC)3
technology with minimal modification to plant and equipment.
o Gas-To-Liquids Technology. Commercialization of slurry-phase
Fischer-Tropsch ("FT") technology provides a new source of
clean diesel fuels from fossil fuel resources. HTI has
developed a skeletal-iron FT catalyst specifically designed
for slurry-phase reactors that converts gaseous materials into
a range of liquid fuels. We believe that HTI's skeletal-iron
FT catalyst is stronger and more economical to utilize than
conventional FT catalysts, and that existing petrochemical and
chemical plants could be adapted to produce diesel fuel.
Research and Development
In 2001, research and development expenses were $2.4 million,
consisting primarily of acquired in-process research and development related to
the HTI acquisition. In 2002, research and development expenses were $2.3
million, consisting primarily of ongoing activities at HTI. Research and
development expenses increased by $2.4 million to $4.7 million in 2003. The
increase was primarily attributable to the inclusion of additional costs
relating to ISG's research and development activities.
Headwaters' Business Strategy
Headwaters intends to pursue the following business strategy:
o Enable Customers to Maximize Production and Value of Synthetic Fuel
Facilities. In order for our customers to maximize the production and
value of their coal-based synthetic fuel facilities, we will continue
to assist them in operating their facilities more efficiently, and we
will actively market the benefits of synthetic fuel to electric power
generators. Covol Fuels intends to continue to develop technologies
that improve coal handling, enhance coal combustion characteristics and
reduce air emissions.
o Expand Consumption and Enhance Quality of CCPs. We intend to expand our
market presence geographically and continue to seek increased market
acceptance of CCPs through targeted marketing of industry decision
makers, such as architects and engineers, and through efforts to
increase governmental recommendations and mandates to use CCPs. An
important part of our strategy is to focus on alternative uses of CCPs,
including road beds, embankments, building products and waste
stabilization. ISG also intends to continue to seek new business
opportunities with other utilities.
o Leverage Complementary Relationships and Capabilities. Covol Fuels and
ISG each maintains long-standing relationships with many of the largest
coal-fired electricity producers in the United States. Headwaters
believes these complementary relationships will provide opportunities
to expand and strengthen its position among coal-fired power generation
utilities. Headwaters intends to market new technologies and services
to its existing client base, as well as other utilities.
o Develop and License New Technologies. Headwaters will continue to
develop and commercialize technologies that add value to coal, gas, oil
and other natural resources. These efforts will focus on upgrading
heavy oil to lighter fuel, gas-to-liquid fuels conversion and
converting or upgrading fossil fuels into higher value products. In
addition, ISG is developing and/or commercializing new technologies
such as carbon fixation and ammonia removal to improve the quality of
fly ash. HTI's nanocatalyst technologies should provide us with an
opportunity for commercialization of multiple custom designed
catalysts. Headwaters will seek to develop strategic relationships with
major companies in the energy and chemical industries to accelerate
commercialization of its energy and catalyst technologies.
o Pursue Complementary and Expansionary Acquisitions. Headwaters intends
to identify and analyze additional acquisition opportunities to
strengthen its position as a leading value enhancer of fossil fuels and
9
other natural resources. Headwaters will evaluate possible acquisitions
of complementary businesses in the chemical, energy, building products
and related industries. Significant acquisitions may be financed with
additional indebtedness.
Competition
Headwaters experiences competition from traditional coal and fuel
suppliers and natural resource producers, in addition to those companies that
specialize in the use and upgrading of industrial byproducts. Many of these
companies have greater financial, management and other resources than
Headwaters, and may be able to take advantage of acquisitions and other
opportunities more readily.
Coal-based solid synthetic fuels made using Covol Fuels' technologies,
from which Covol Fuels derives license revenues and revenues from sales of
chemical reagents, compete with other synthetic fuel products, as well as
traditional fuels. For Covol Fuels competition may come in the form of the
marketing of competitive chemical reagents and the marketing of end products
qualifying as synthetic fuel. Covol Fuels competes with other companies
possessing technologies to produce coal-based solid synthetic fuels and
companies that produce chemical reagents such as Nalco Chemical Company and
Accretion Technologies, LLC.
Covol Fuels also experiences competition from traditional coal and fuel
suppliers and natural resource producers, in addition to those companies that
specialize in the use and upgrading of industrial byproducts. These companies
may have greater financial, management and other resources than Headwaters has.
Further, many industrial coal users are limited in the amount of synthetic fuel
product they can purchase from Covol Fuels' licensees because they have
committed to purchase a substantial portion of their coal requirements through
long-term contracts for standard coal.
Generally, the business of marketing traditional CCPs and construction
materials is intensely competitive. ISG has substantial competition in three
main areas: obtaining CCP management contracts with utility and other industrial
companies; marketing CCPs and related industrial materials; and marketing its
construction materials. ISG has a presence in every region in the United States
but, because the market for the management of CCPs is highly fragmented and
because the costs of transportation are high relative to sales prices, most of
the competition in the CCP management industry is regional. There are many
local, regional and national companies that compete for market share in these
areas with similar products and with numerous other substitute products.
Although ISG typically has long-term CCP management contracts with its clients,
some of such contracts provide for the termination of such contract at the
convenience of the utility company upon a minimum 90-day notice. Moreover,
certain of ISG's most significant regional CCP competitors appear to be seeking
a broader national presence. These competitors include Lafarge North America
Inc., Boral Material Technologies Inc. and Cemex. Construction materials are
produced and sold regionally by the numerous owners and operators of concrete
ready-mix plants. Producers with sand and gravel sources near growing
metropolitan areas have important transportation advantages. In Texas, ISG's
most important construction materials market, Featherlite Building Products is
among ISG's competitors.
Many of the world's major chemical companies are devoting significant
resources to researching and developing nanocatalysts and catalytic processes.
These companies have greater financial, management and other resources than
Headwaters has. Headwaters' strategy is to enter into license agreements or
joint ventures with major chemical companies for the further development and
commercialization of Headwaters' nanocatalyst technologies.
Intellectual Property
Headwaters itself has one registered trademark and one pending
trademark application.
ISG has 13 U.S. patents that expire between 2009 and 2017 and over 10
U.S. patent applications pending. ISG has 14 registered trademarks and two
pending trademark applications. While these collective patents and trademarks
are important to ISG's competitive position, no single patent or trademark is
material to ISG.
Covol Fuels has nine U.S. patents that expire between 2011 and 2014.
Covol Fuels has one registered trademark.
10
HTI has 17 U.S. patents that expire between 2011 and 2022 and over 15
U.S. patent applications pending. HTI has three registered trademarks and four
pending trademark applications.
There can be no assurance as to the scope of protection afforded by the
patents. In addition, there are other technologies in use and others may
subsequently be developed, which do not, or will not, utilize processes covered
by the patents. There can be no assurance that Headwaters' patents will not be
infringed or challenged by other parties or that Headwaters will not infringe on
patents held by other parties. Because many of these patents represent new
technology, the importance of the patents to Headwaters' business will depend on
its ability to commercialize these technologies successfully, as well as its
ability to protect its technology from infringement or challenge by other
parties.
In addition to patent protection, Headwaters also relies on trade
secrets, know-how, and confidentiality agreements to protect these technologies.
Despite these safeguards, such methods may not afford complete protection and
there can be no assurance that others will not either independently develop such
know-how or unlawfully obtain access to Headwaters' know-how, concepts, ideas,
and documentation.
Since Headwaters' proprietary information is important to its business,
failure to protect ownership of its proprietary information would likely have a
material adverse effect on Headwaters. Headwaters' current revenues are
dependent upon license fees and chemical sales. Headwaters believes that its
patents, trade secrets, know-how and confidential information are the basis upon
which it obtains and secures licensing agreements.
Effect of Federal, State and Local Laws
Section 29. Headwaters' coal-based solid synthetic fuel business is
subject to compliance with the terms of Section 29. The issuance of private
letter rulings ("PLRs") under Section 29 by the Internal Revenue Service ("IRS")
is important to the willingness of the owners of synthetic fuel facilities to
operate and to their ability to transfer ownership of those facilities. The IRS
has suspended the issuance of PLRs to synthetic fuel facility owners several
times in the past, and there can be no assurance that the IRS will not suspend
the issuance of PLRs in the future. Most recently, in June 2003, the IRS stated,
in summary, in Announcement 2003-46 that it "has had reason to question the
scientific validity of test procedures and results that have been presented as
evidence that fuel underwent a significant chemical change, and is currently
reviewing information regarding these test procedures and results," and that
pending its review of the issue it was suspending the issuance of new PLRs
regarding significant chemical change.
The IRS release of Announcement 2003-46 caused certain of Headwaters'
licensees to reduce or cease synthetic fuel production, which resulted in a
material adverse impact on Headwaters' revenues and net income. In October 2003,
the IRS stated in summary in Announcement 2003-70 that it continues to question
whether processes it had approved under its long-standing ruling practice
produce the necessary level of chemical change required under Section 29 and
Revenue Ruling 86-100. Nonetheless, the IRS indicated that it would continue to
issue PLRs regarding chemical change under the standards set forth in Revenue
Procedures 2001-30 and 2001-34, and that the industry's chemical change test
procedures and results are scientifically valid if applied in a consistent and
unbiased manner. Although the IRS resumed its practice of issuing PLRs, it
expressed continuing concerns regarding the sampling and data/record retention
practices prevalent in the synthetic fuels industry.
Also on October 29, 2003, the United States Senate Permanent
Subcommittee on Investigations issued a notification of pending investigations.
The notification listed the synthetic fuel tax credit as a new item, stating:
The Subcommittee has initiated an investigation of potential abuses of
tax credits for producers of synthetic fuel under Section 29 of the
Internal Revenue Code. The Subcommittee anticipates that this
investigation will focus on whether certain synthetic fuel producers
are claiming tax credits under Section 29, even though their product is
not a qualified synthetic fuel under Section 29 and IRS regulations. In
addition, the investigation will address whether certain corporations
are engaging in transactions solely to take advantage of unused Section
29 credits, with no other business purpose. Lastly, the investigation
will address the IRS's efforts to curb abuses related to the Section 29
tax credits.
The effect that the Senate subcommittee investigation of synthetic fuel
tax credits may have on the industry is unknown.
11
Environmental. The coal-based solid synthetic fuel operations of
Headwaters and its licensees are subject to federal, state and local
environmental regulations that impose limitations on the discharge of pollutants
into the air and water and establish standards for the treatment, storage and
disposal of waste products. Moreover, in order to establish and operate the
synthetic fuel plants, power plants and operations to collect and transport CCPs
and bottom ash, we and our licensees and customers have obtained various state
and local permits and must comply with processes and procedures that have been
approved by regulatory authorities. Compliance with permits, regulations and the
approved processes and procedures help protect against pollution and
contamination. We believe that all required permits to construct and operate
these solid synthetic fuel facilities have been obtained and believe they are in
substantial compliance with all relevant laws and regulations governing
synthetic fuel operations.
In spite of safeguards, our operations entail risks of regulatory
noncompliance or accidental discharge that could create an environmental
liability because hazardous materials are used or stored during normal business
operations. For example, we and our subsidiaries use and share other hazardous
chemicals in order to conduct operations involving distillation to purify
products, analysis, packaging of chemicals and the selling and manufacturing of
chemicals in small research volumes. Our subsidiaries also use their facilities
to perform research and development activities involving coal, oil, chemicals
and industrial gases such as hydrogen. As a result, petroleum and other
hazardous materials have been and are present in and on their properties. We
generally hire independent contractors to transport and dispose of any hazardous
materials generated and send any hazardous wastes only to federally approved,
large scale and reputable off-site waste facilities.
The federal Clean Air Act of 1970 and subsequent amendments
(particularly the Clean Air Act Amendments of 1990), and corresponding state
laws, which regulate the emissions of materials into the air, affect the coal
industry both directly and indirectly. The coal industry is directly affected by
Clean Air Act permitting requirements and/or emissions control requirements,
including requirements relating to particulate matter (such as, "fugitive
dust"). The coal industry may also be impacted by future regulation of fine
particulate matter measuring 2.5 micrometers in diameter or smaller. In July
1997, the EPA adopted new, more stringent National Ambient Air Quality
Standards, or NAAQS, for particulate matter and ozone. Although the NAAQS have
been challenged in litigation, slowing their implementation, the standards were
upheld by the United States Supreme Court, and states will ultimately be
required to revise their existing state implementation plans ("SIPs") to attain
and maintain compliance with the new NAAQS. Because electric utilities emit
nitrogen oxide ("NOx"), which are precursors to ozone and particulate matter,
ISG's utility customers are likely to be affected when the new NAAQS are
implemented by the states. State and federal regulations relating to fugitive
dust and the implementation of the new NAAQS may reduce ISG's sources for its
products. The extent of the potential impact of the new NAAQS on the coal
industry will depend on the policies and control strategies associated with the
state implementation process under the Clean Air Act.
The 1990 Clean Air Act Amendments require utilities that are currently
major sources of NOx in moderate or higher ozone non-attainment areas to install
reasonably available control technology for NOx. EPA currently plans to finalize
stricter ozone NAAQS (discussed above) by 2004. EPA promulgated a rule (the "NOx
SIP call") in 1998 requiring 22 eastern states to make substantial reductions in
NOx emissions. Under this rule, EPA expects that states will achieve these
reductions by requiring power plants to make substantial reductions in their NOx
emissions. The NOx SIP call must be implemented by May 31, 2004. In addition to
the NOx SIP call, by May 31, 2004, EPA must directly regulate NOx emissions from
states upwind of four eastern states that petitioned EPA (pursuant to section
126 of the Clean Air Act). The section 126 rule will be withdrawn in any state
that submits an approvable NOx SIP. Installation of reasonably available control
technology and additional control measures required under the NOx SIP call or
the section 126 rule will make it more costly to operate coal-fired utility
power plants and, depending on the requirements of individual SIPs, could make
coal a less attractive fuel alternative in the planning and building of utility
power plants in the future. The effect such regulation or other requirements
that may be imposed in the future could have on the coal industry in general and
on ISG in particular cannot be predicted with certainty. No assurance can be
given that the ongoing implementation of the Clean Air Act (including the 1990
Amendments) or any future regulatory provisions will not materially adversely
affect ISG.
In addition, the 1990 Clean Air Act Amendments require a study of
utility power plant emissions of certain toxic substances, including mercury,
and direct EPA to regulate emissions of these substances, if warranted. EPA has
submitted reports to Congress on Mercury (1997) and Utility Air Toxics (1998).
On December 14, 2000, EPA announced its finding that regulation of hazardous air
pollutant emissions from oil- and coal-fired electric utility steam generating
units is necessary and appropriate. EPA expects to propose emission standards by
12
December 15, 2003 and to finalize them by December 15, 2004. These regulations
are likely to require reductions in mercury emissions, and such requirements, if
promulgated, could result in reduced use of coal if utilities switch to other
sources of fuel.
The Clear Skies Initiative, announced by the Bush Administration in
February 2002 (S.485 and H.R. 999, and revised by S.1844), seeks to develop
strategies for reducing emissions of sulfur dioxide ("SOx"), NOx and mercury
from power plants. Because the Initiative must be implemented by legislation
that has not yet been enacted, its effect on ISG cannot be determined at this
time. However, in February and April 2003, two four-pollutant bills (S.366 and
S.843, respectively) for power plants were referred to the Senate Environment
and Public Works Committee. In addition to the three pollutants covered under
the Clear Skies Initiative, these bills include the greenhouse gas carbon
dioxide. If enacted as written, these bills could result in reduced use of coal
if utilities switch to other sources of fuel as a means of complying with more
stringent emission limits.
Coal-fired boilers have been impacted by regulations under the 1990
Clean Air Act Amendments, which established specific emissions levels for SOx
and NOx in order to reduce acid rain. These emissions levels have required
utilities to undertake many of the following changes: change their fuel
source(s), add scrubbers to capture SOx, add new boiler burner systems to
control NOx, add or modify fuel pulverizers/air handling systems to control NOx,
introduce flue gas conditioning materials to control particulate emissions in
conjunction with meeting SOx emissions targets and in some very isolated cases
shut down a plant. All of these changes can impact the quantity and quality of
CCPs produced at a power plant and can add to the costs of operating a power
plant. Furthermore, proposed regulations to control mercury emissions could
result in implementation of additional technologies at power plants that could
negatively affect fly ash quality.
Further, inappropriate use of CCPs can result in faulty end products.
Since most of the products marketed by ISG typically consist of a mixture of
client-supplied CCPs, ISG does not control the quality of the final end product,
but may share such control with the manufacturer of the ingredient materials.
Therefore, there is a risk of liability regarding the quality of the materials
and end products marketed by ISG. In cases where ISG is responsible for
end-product quality, such as a structural fill (where material is used to fill a
cavity or designated area), ISG depends solely on its own quality assurance
program.
Materials sold by ISG vary in chemical composition. Fossil fuel
combustion wastes have been excluded from regulation as "hazardous wastes" under
subtitle C of the Resource Conservation and Recovery Act ("RCRA"). However, EPA
has determined that national regulations under subtitle D of RCRA (dealing with
state and regional solid waste plans) are warranted for coal combustion
byproducts disposed of in landfills or surface impoundments, or used to fill
surface or underground mines. EPA is planning to publish a proposed rulemaking
under subtitle D of RCRA in January 2004. ISG manages a number of landfill and
pond operations that may be affected by EPA's proposed regulations. In most of
these operations the permitting is contractually retained by the client and the
client would be liable for any costs associated with new permitting
requirements. The effect of such regulations on ISG cannot be completely
ascertained at this time.
ISG is engaged in providing services at one landfill operation that is
permitted and managed as a hazardous waste landfill. ISG provides the services
necessary to landfill the client's hazardous wastes and operates certain
in-plant equipment and systems for the client. Accordingly, there can be no
assurance that ISG will not be named in third-party claims relating to the
project.
CCPs contain small concentrations of metals that are considered as
"hazardous substances" under CERCLA. Land application of CCPs is regulated by a
variety of federal and state statutes, which impose testing and management
requirements to ensure environmental protection. Under limited circumstances,
mismanagement of CCPs can give rise to CERCLA liability.
Electric utility deregulation has slowed substantially from previous
years' predictions. Deregulation could negatively impact ISG because it could
result in some sources of CCPs being put out of service because they are not
economically competitive. On the other hand, deregulation efforts have spurred
renewed interest in construction of new coal-fired electricity generating
capacity. We believe no significant changes to the sources of CCPs under
contract will occur. However, since this change to the industry continues to
evolve, the impact of deregulation cannot be accurately projected, and
Headwaters could be materially adversely affected if major changes occur to
specific sources.
13
Employees
Headwaters currently employs approximately 800 employees full-time. Of
these employees, approximately 43 are in corporate administration, 34 are
employed by Headwaters' Covol Fuels division, 41 are employed by HTI, 487 are
employed by ISG's CCP division and 192 are employed by ISG's construction
materials division. ISG has more than 50 area managers and technical sales
representatives nationwide. Approximately 19 employees work under collective
bargaining agreements.
ITEM 2. PROPERTIES
Headwaters' headquarters are located at 10653 South River Front
Parkway, Suite 300, South Jordan, Utah 84095. The lease for this office space of
approximately 26,500 square feet provides for a six-year term. The monthly rent
is approximately $41,000, with certain adjustments for inflation plus expenses.
ISG owns or leases approximately 20 parcels of real property in 17
states for its fly ash storage and distribution operations. ISG also owns or
leases approximately ten properties in three states for its building products
manufacturing and sales operations.
In 1995, HTI purchased approximately six acres in Lawrenceville, New
Jersey, where its headquarters and research facilities are now located.
ITEM 3. LEGAL PROCEEDINGS
Headwaters has ongoing litigation and claims incurred during the normal
course of business, including the items discussed below. Headwaters intends to
vigorously defend and/or pursue its rights in these actions. Management does not
currently believe that the outcome of these actions will have a material adverse
effect on Headwaters' operations, cash flows or financial position; however, it
is possible that a change in the estimates of probable liability could occur,
and the change could be significant. Additionally, as with any litigation, these
proceedings will require that Headwaters incur substantial costs, including
attorneys' fees, managerial time, and other personnel resources and costs in
pursuing resolution.
Adtech. 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.) In September 2000, Headwaters received a
summons and complaint from the United States District Court for the Western
District of Tennessee filed by Adtech, Inc. against Davidson and Headwaters. In
the action, certain purported officers and directors of Adtech alleged that the
technology purchase transaction was an unauthorized corporate action and that
Davidson and Headwaters conspired together to affect the transfer. In August
2001, the trial court granted Headwaters' motion to dismiss the complaint.
Plaintiffs appealed the case to the Sixth Circuit Court of Appeals. In 2002, the
Sixth Circuit Court of Appeals issued an order i) affirming the District Court's
judgment and order of dismissal, and ii) transferring to the Federal Circuit
Court of Appeals plaintiff's appeal of the District Court's order denying the
motion for relief from judgment. The Federal Circuit Court of Appeals has
affirmed the District Court's order denying the motion for relief from judgment
and the case is now fully resolved.
Boynton. This action is factually related to the Adtech matter. In the
Adtech case, the alleged claims are asserted by certain purported officers and
directors of Adtech, Inc. In the Boynton 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 complaint seeks declaratory relief and compensatory
and punitive damages. Because the resolution of the litigation is uncertain,
legal counsel cannot express an opinion as to the ultimate amount, if any, of
Headwaters' liability.
AGTC. In March 1996, Headwaters entered into an agreement with AGTC and
its associates for certain services related to the identification and selection
of synthetic fuel projects. In March 2002, AGTC filed an arbitration demand
claiming that it is owed a commission under the 1996 agreement for 8% of the
14
revenues received by Headwaters from the Port Hodder project. Headwaters asserts
that AGTC did not perform under the agreement and that the agreement was
terminated and the disputes were settled in July 1996. Headwaters has filed an
answer in the arbitration, denying AGTC's claims and has asserted counterclaims
against AGTC. Because the resolution of the arbitration is uncertain, legal
counsel cannot express an opinion as to the ultimate amount, if any, of
Headwaters' liability.
AJG. In December 1996, Headwaters entered into a technology license and
proprietary chemical reagent sale agreement with AJG Financial Services, Inc.
The agreement called for AJG to pay royalties and to purchase proprietary
chemical reagent material from Headwaters. In October 2000, Headwaters filed a
complaint in the Fourth District Court for the State of Utah against AJG
alleging that it had failed to make payments and to perform other obligations
under the agreement. Headwaters asserts claims including breach of contract,
declaratory judgment, unjust enrichment and accounting and seeks money damages
as well as other relief. AJG's answer to the complaint denied Headwaters' claims
and asserted counter-claims based upon allegations of misrepresentation and
breach of contract. AJG seeks compensatory damages as well as punitive damages.
Headwaters has denied the allegations of AJG's counter-claims. Because the
resolution of the litigation is uncertain, legal counsel cannot express an
opinion as to the ultimate amount of recovery or liability.
Nalco. In October 2000, Headwaters filed a complaint in the United
States District Court for the District of Utah against Nalco Chemical Company
("Nalco"). Headwaters alleged that Nalco, by its sale and marketing of materials
for use in creating synthetic fuel, breached a non-disclosure agreement,
misappropriated trade secrets, and violated patent rights of Headwaters. Nalco
filed an answer denying the allegations in the complaint and asserting
counter-claims alleging patent invalidity, antitrust violations, and
interference with economic relations. Headwaters denied the counter-claims.
Effective in January 2003, the parties settled the dispute and the case was
dismissed. There was no material effect on Headwaters' operations, cash flows or
financial position as a result of the settlement.
ISG Matters. There is litigation and pending and threatened claims made
against certain subsidiaries of ISG with respect to several types of exterior
stucco finish systems manufactured and/or sold by its subsidiaries for
application by contractors, developers and owners on residential and commercial
buildings. This litigation and these claims are controlled by such subsidiaries'
insurance carriers. The plaintiffs and/or claimants in these matters have
alleged that due to some failure of the stucco system itself and/or its
application, the buildings have suffered damage due to the progressive, latent
effects of water penetration through the building's exterior. The most prevalent
type of claim involves alleged defects associated with an artificial stucco
system manufactured by one of ISG's subsidiaries, Best Masonry. Best Masonry
continued to manufacture this system through 1997, and 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 injury 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 provided "reservation of rights" letters. None of the
cases has gone to trial, and while two such cases involve 100 and 800 homes,
respectively, none of the cases includes any claims formally asserted on behalf
of a class. While, to date, none of these proceedings have required that ISG
incur substantial costs, there is no guarantee of coverage or continuing
coverage. These and future proceedings may result in substantial costs to ISG,
including attorneys' fees, managerial time and other personnel resources and
costs. Adverse resolution of these proceedings could have a materially negative
effect on ISG's business, financial condition and results of operation, and its
ability to meet its financial obligations. Although ISG carries general and
product liability insurance, ISG cannot assure that such insurance coverage will
remain available, that ISG's insurance carrier will remain viable or that the
insured amounts will cover all future claims in excess of ISG's uninsured
retention. Future rate increases may also make such insurance uneconomical for
ISG to maintain. In addition, the insurance policies maintained by ISG exclude
claims for damages resulting from exterior insulating finish systems, or EIFS,
that have manifested after March 2003. Because much of the litigation and claims
are at an early stage and resolution is uncertain, legal counsel cannot express
an opinion as to the ultimate amount, if any, of the liability resulting to
Headwaters.
Former Director. Headwaters granted stock options to a member of its
board of directors in 1995. The director resigned from the board in 1996.
Headwaters believes that most of the former director's options terminated
15
unexercised. The former director has claimed that he is entitled to exercise the
options. No lawsuit has been filed in this matter. Resolution is uncertain and
legal counsel cannot express an opinion as to the ultimate amount, if any, of
Headwaters' liability.
Other. Headwaters and its subsidiaries are also involved in other legal
proceedings that have arisen in the normal course of business.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The shares of Headwaters' common stock trade on the Nasdaq National
Market under the symbol "HDWR." Options on Headwaters' common stock are traded
on the Chicago Board Options Exchange under the symbol "HQK." The following
table sets forth for the periods presented, the high and low trading prices of
Headwaters' common stock as reported by Nasdaq.
Fiscal 2002 Low High
- ----------- --- ----
Quarter ended December 31, 2001 $ 9.10 $13.10
Quarter ended March 31, 2002 11.16 15.55
Quarter ended June 30, 2002 11.37 19.15
Quarter ended September 30, 2002 11.87 16.74
Fiscal 2003
- -----------
Quarter ended December 31, 2002 $12.81 $18.03
Quarter ended March 31, 2003 13.50 16.64
Quarter ended June 30, 2003 13.25 20.25
Quarter ended September 30, 2003 12.86 16.30
As of November 30, 2003, there were approximately 366 stockholders of
record of Headwaters' common stock. Headwaters has not paid dividends on its
common stock to date and does not intend to pay dividends on its common stock in
the foreseeable future. Pursuant to debt agreements Headwaters entered into in
September 2002, Headwaters is prohibited from paying cash dividends so long as
any of the long-term debt is outstanding. Headwaters intends to retain earnings
to finance the development and expansion of its business. Payment of common
stock dividends in the future will depend, among other things, upon Headwaters'
debt covenants, its ability to generate earnings, its need for capital, its
investment opportunities and its overall financial condition. . See Note 12 to
the consolidated financial statements for a description of securities authorized
for issuance under equity compensation plans.
Recent Sales of Unregistered Securities
The following sets forth all securities issued by Headwaters during the
year ended September 30, 2003 without registration under the Securities Act of
1933, as amended. No underwriters were involved in any stock issuances nor were
any commissions paid in connection therewith.
During the year ended September 30, 2003, pursuant to the exercise of
options and warrants, approximately 236,000 shares of Headwaters restricted
common stock were issued. Headwaters has several outstanding effective
registration statements filed on Forms S-3 and Forms S-8. All of shares of
restricted common stock issued during the year have been registered under one of
these registration statements
16
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from the consolidated
financial statements of Headwaters. This information should be read in
conjunction with the consolidated financial statements, related notes and other
financial information included herein.
As more fully described in Note 3 to the consolidated financial
statements, in August 2001, Headwaters acquired HTI, the financial statements of
which are consolidated with Headwaters' financial statements using a one-month
lag. Accordingly, no results of operations of HTI were included in the
consolidated statement of income for 2001. HTI's August 31, 2001, 2002 and 2003
balance sheets were consolidated with Headwaters' September 30, 2001, 2002 and
2003 balance sheets and HTI's results of operations for the twelve months ended
August 31, 2002 and 2003 were consolidated with Headwaters' 2002 and 2003
results. Also, as more fully described in Note 3 to the consolidated financial
statements, Headwaters acquired ISG on September 19, 2002 and accordingly, ISG's
results of operations for the period from September 19, 2002 through September
30, 2003 have been consolidated with Headwaters' 2002 and 2003 results. ISG's
results of operations up to September 18, 2002 have not been included in
Headwaters' consolidated results for any period. As more fully described in Note
11 to the consolidated financial statements, in 2001, Headwaters recorded
approximately $7.5 million of income tax benefit primarily related to the
reduction of its deferred tax asset valuation allowance.
The selected financial data as of and for the years ended September 30,
1999 and 2000 and as of September 30, 2001 are derived from audited financial
statements not included herein. The selected financial data as of September 30,
2002 and 2003 and for the years ended September 30, 2001, 2002, and 2003 were
derived from the audited financial statements of Headwaters included elsewhere
herein.
Year ended September 30,
-----------------------------------------------------------------
(in thousands) 1999 2000 2001 2002 2003
- ------------------------------------------------- ------------ ------------ ------------ ------------ -------------
OPERATING DATA:
Total revenue $ 6,719 $ 27,886 $ 45,464 $ 119,345 $ 387,630
Net income (loss) (28,393) 3,682 21,517 24,286 36,631
Diluted earnings (loss) per share 0.07 0.87 0.94 1.30
(2.39)
As of September 30,
-----------------------------------------------------------------
(in thousands) 1999 2000 2001 2002 2003
- ------------------------------------------------- ------------ ------------ ------------ ------------ -------------
BALANCE SHEET DATA:
Working capital (deficit) $ (2,721) $ 8,393 $ 8,619 $ 15,023 $ 14,176
Net property, plant and equipment 14,182 552 2,680 50,549 52,743
Total assets 58,095 33,441 55,375 372,857 373,275
Long-term obligations:
Long-term debt 17,887 5,055 149 154,552 104,044
Unamortized non-refundable license
fees and other long-term liabilities 8,036 7,861 8,711 5,442 4,703
Redeemable convertible preferred
stock 4,332 -- -- -- --
Deferred income taxes -- -- -- 51,357 50,663
Total long-term obligations 30,255 12,916 8,860 211,351 159,410
Total stockholders' equity (deficit) (1,028) 10,747 31,086 98,596 140,157
17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with the information set forth under the caption entitled "ITEM 6. SELECTED
FINANCIAL DATA" and the consolidated financial statements and notes thereto
included elsewhere herein. Headwaters' fiscal year ends on September 30 and
unless otherwise noted, future references to years refer to Headwaters' fiscal
year rather than a calendar year.
Acquisitions of ISG and HTI and Segments
The consolidated financial statements include the accounts of
Headwaters and all of its subsidiaries, only two of which have significant
operations, ISG and HTI. All significant intercompany transactions and accounts
are eliminated in consolidation. ISG was acquired on September 19, 2002 and
accordingly, ISG's results of operations for the period from September 19, 2002
through September 30, 2003 have been consolidated with Headwaters' 2002 and 2003
results. HTI was acquired in August 2001. Due to the time required to obtain
accurate financial information related to HTI's foreign contracts, for financial
reporting purposes HTI's financial statements are consolidated with Headwaters'
financial statements using a one-month lag. Accordingly, no results of
operations of HTI were included in the consolidated statement of income for
2001. HTI's August 31, 2002 and 2003 balance sheets were consolidated with
Headwaters' September 30, 2002 and 2003 balance sheets and HTI's results of
operations for the twelve months ended August 31, 2002 and 2003 were
consolidated with Headwaters' 2002 and 2003 results.
ISG Acquisition. On September 19, 2002, Headwaters acquired 100% of the
common stock of ISG, assumed or paid off all of ISG's outstanding debt and
redeemed all of ISG's outstanding preferred stock. ISG is the leading provider
of high quality fly ash to the building products and ready mix concrete
industries in the United States. ISG also develops, manufactures and distributes
value-added bagged concrete, stucco, mortar and block products that utilize fly
ash through its construction materials segment. Headwaters' historical focus has
been on using technology to add value to fossil fuels, particularly coal. The
acquisition of ISG provided Headwaters with a significant position in the last
phase of the coal value chain due to ISG's competencies in managing CCPs. The
acquisition of ISG also brought to Headwaters substantial management depth,
comprehensive corporate infrastructure and critical mass in revenues and
operating income.
In order to obtain the cash necessary to acquire ISG and retire the ISG
debt, Headwaters issued $175.0 million of new debt consisting of $155.0 million
of senior secured debt with a five-year term and a variable interest rate and
$20.0 million of subordinated debt with an approximate five-year term and a
fixed interest rate (see Note 9 to the consolidated financial statements). ISG
management participated in one-half, or $10.0 million, of the subordinated debt.
Total cash proceeds from the issuance of new debt, net of debt discounts, was
$170.0 million. Headwaters also incurred approximately $6.2 million of debt
issuance costs to place the new debt, which had an initial combined effective
weighted-average interest rate of approximately 9.0%. The total consideration
paid for ISG was $257.9 million and is described in more detail in Note 3 to the
consolidated financial statements.
The ISG acquisition was accounted for using the purchase method of
accounting as required by SFAS No. 141, "Business Combinations." Assets acquired
and liabilities assumed were recorded at their fair values as of September 19,
2002. Approximately $109.2 million of the purchase price was allocated to
identifiable intangible assets consisting primarily of contracts with coal-fired
electric power generation plants and patents. This amount is being amortized
over the estimated combined useful life of 20 years. The remaining purchase
price not attributable to the tangible and identifiable intangible assets was
allocated to goodwill, none of which is tax deductible. All of the intangible
assets and all of the goodwill were allocated to the CCP segment.
HTI Acquisition. In August 2001, Headwaters acquired 100% of the common
stock of HTI, a New Jersey-based company. HTI's activities are directed at
catalyst technologies to convert coal and heavy oil into
environmentally-friendly, higher-value liquid fuels, as well as nanocatalyst
processes and applications. The total consideration paid for HTI was $15.0
million and is described in more detail in Note 3 to the consolidated financial
statements.
The HTI acquisition was accounted for using the purchase method of
accounting. Assets acquired and liabilities assumed were recorded at their fair
values as of the acquisition date. Approximately $9.7 million of the purchase
price was allocated to identifiable intangible assets consisting of existing
patented technology with an estimated useful life of 15 years. Approximately
$2.4 million of the purchase price was allocated to purchased in-process
research and development, consisting primarily of efforts focused on developing
catalysts and catalytic processes to lower the cost of producing synthetic fuels
18
and chemicals while improving energy efficiency and reducing environmental
risks. This amount represented projects that had not reached technological
feasibility and had no alternative use as of the acquisition date, and was
expensed in 2001.
Segments. Until Headwaters acquired ISG in September 2002, Headwaters
operated in and reported as a single industry segment, alternative energy. With
the acquisition of ISG, Headwaters now operates in three business segments,
alternative energy, CCPs, and construction materials. These segments are managed
and evaluated separately by management based on fundamental differences in their
operations, products and services.
The alternative energy segment includes Headwaters' traditional
coal-based solid synthetic fuels business and HTI's business of developing
catalyst technologies to convert coal and heavy oil into
environmentally-friendly, higher-value liquid fuels as well as nanocatalyst
processes and applications. Revenues for this segment primarily include sales of
chemical reagents and license fees.
The CCP segment includes ISG's business of providing fly ash to the
building products and ready mix concrete industries. This segment markets coal
combustion products such as fly ash and bottom ash, known as CCPs. ISG has
long-term contracts, primarily with coal-fired electric power generation plants,
pursuant to which it manages the post-combustion operations for the utilities.
ISG markets CCPs to replace manufactured or mined materials, such as portland
cement, lime, agricultural gypsum, fired lightweight aggregate, granite
aggregate and limestone. CCP revenues consist primarily of the sale of products,
with a small amount of service revenue.
The construction materials segment manufactures and distributes
value-added bagged concrete, stucco, mortar and block products. ISG has
introduced high volumes of CCPs as substitute ingredients in the products the
construction materials segment produces.
Critical Accounting Policies and Estimates
Headwaters' significant accounting policies are identified and
described in Note 2 to the consolidated financial statements. The preparation of
financial statements in conformity with accounting principles generally accepted
in the United States requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements, and
the reported amounts of revenue and expenses during the reporting period.
Headwaters continually evaluates its policies and estimation
procedures. Estimates are often based on historical experience and on
assumptions that are believed to be reasonable under the circumstances, but
which could change in the future. Some of Headwaters' accounting policies and
estimation procedures require the use of substantial judgment, and actual
results could differ materially from the estimates underlying the amounts
reported in the consolidated financial statements. Such policies and estimation
procedures have been reviewed with Headwaters' audit committee. The following is
a discussion of critical accounting policies and estimates.
License Fee Revenue Recognition. Headwaters currently licenses its
technologies to the owners of 28 of a company-estimated 75 coal-based solid
synthetic fuel facilities in the United States. Recurring license fees or
royalty payments are recognized in the period when earned, which generally
coincides with the sale of synthetic fuel by Headwaters' licensees. In most
instances, Headwaters receives timely reports from licensees notifying
Headwaters of the amount of solid synthetic fuel sold and the royalty due
Headwaters under the terms of the respective license fee agreements.
Additionally, Headwaters has experienced a regular pattern of payment by these
licensees of the reported amounts.
Generally, estimates of license fee revenue earned, where required, can
be reliably made based upon historical experience and/or communications from
licensees for whom an established pattern exists. In some cases, however, such
as when a licensee is beginning to produce and sell synthetic fuel or when a
synthetic fuel facility is sold by a licensee to another entity, and for which
there is no pattern or knowledge of past or current production and sales
activity, there may be more limited information upon which to estimate the
license fee revenue earned. In these situations, Headwaters uses such
information as is available and where possible, substantiates the information
through such procedures as observing the levels of chemical reagents purchased
by the licensee and used in the production of the solid synthetic fuel. In
certain limited situations, Headwaters is unable to reliably estimate the
license fee revenues earned during a period, and therefore revenue recognition
is delayed until a future date when sufficient information is known from which
to make a reasonable estimation.
Realizability of Receivables. Allowances are provided for uncollectible
accounts and notes receivable when deemed necessary. Such allowances are based
on an account-by-account analysis of collectibility or impairment. Collateral is
not required for trade receivables, but Headwaters performs periodic credit
evaluations of its customers. Collateral is generally required for notes
receivable and has historically consisted of most or all assets of the debtor.
19
With regard to Headwaters' trade receivables from the alternative
energy segment, past allowances have been minimal as have any required
write-offs. Trade receivables from the CCP and construction materials segments
involve substantially more customers, and receivable allowances are required.
Headwaters reviews the collectibility of its trade receivables as of the end of
each reporting period.
Net losses recognized on notes receivable were approximately $3.7
million in 2001, $0.7 million in 2002 and $2.1 million in 2003. Notes receivable
generally relate to nonoperating activities and accordingly, losses are included
in other expense in the consolidated statements of income. The losses on notes
receivable in 2001 consisted entirely of write-offs or impairments of notes from
unrelated, high-risk entities to which Headwaters loaned funds in late fiscal
2000 and early fiscal 2001, which amounts were determined to be uncollectible or
worthless. Headwaters no longer makes these loans, and in September 2001,
Headwaters sold all its remaining loans and equity investments in these entities
to a limited liability company, in exchange for a $4.0 million note receivable,
due no later than September 2004. This note is being accounted for on the cost
recovery basis. Headwaters reviews collectibility of this note receivable at the
end of each reporting period. This collectibility review consists of
consideration of payments of required interest and principal and the sufficiency
of the collateral to support the outstanding note receivable balance. If an
impairment is indicated, Headwaters writes down the note receivable to its
estimated net realizable value. Impairment losses of approximately $1.0 million
and $2.1 million were recorded in 2002 and 2003, respectively, due to declines
in the value of the underlying collateral, which management deemed other than
temporary, during those periods.
Headwaters considers its receivable allowances adequate as of September
30, 2003; however, changes in economic conditions generally or in specific
markets in which Headwaters operates could have a material effect on required
reserve balances.
Valuation of Long-Lived Assets, including Intangible Assets and
Goodwill. Long-lived assets consist primarily of property, plant and equipment,
intangible assets and goodwill. Intangible assets consist primarily of
identifiable intangible assets obtained in connection with the acquisitions of
ISG (long-term contracts and patents) and HTI (existing patented technology).
These intangible assets are being amortized on the straight-line method over
their remaining estimated useful lives. Goodwill consists of the excess of the
purchase price for ISG and HTI over the fair value of identified assets
acquired, net of liabilities assumed. In accordance with Statement of Financial
Accounting Standards ("SFAS") No. 142, "Accounting for Goodwill and Intangible
Assets," goodwill is not amortized, but is tested at least annually for
impairment. Goodwill is normally tested as of June 30, using a two-step process
that begins with an estimation of the fair value of the reporting unit giving
rise to the goodwill.
Headwaters periodically evaluates the carrying value of long-lived
assets, including intangible assets and goodwill, as well as the related
amortization periods, to determine whether adjustments to these amounts or to
the useful lives are required based on current events and circumstances. Changes
in circumstances such as technological advances, changes to Headwaters' business
model or changes in Headwaters' capital strategy could result in the actual
useful lives differing from Headwaters' current estimates. In those cases where
Headwaters determines that the useful life of property, plant and equipment or
intangible assets should be shortened, Headwaters would amortize the net book
value in excess of salvage value over its revised remaining useful life, thereby
increasing depreciation or amortization expense.
The carrying value of a long-lived asset is considered impaired when
the anticipated cumulative undiscounted cash flow from that asset is less than
its carrying value. In that event, a loss is recognized based on the amount by
which the carrying value exceeds the fair market value of the long-lived asset.
There were no impairment losses recorded for long-lived assets in any of the
years presented. Indicators of impairment include such things as a significant
adverse change in legal factors or in the general business climate or an
expectation that significant assets will be sold or otherwise disposed of.
In accordance with the requirements of SFAS No. 142, Headwaters does
not amortize goodwill. SFAS No. 142 requires Headwaters to periodically perform
tests for goodwill impairment. Step 1 of the initial impairment test was
required to be performed no later than March 31, 2003; thereafter impairment
testing is required to be performed no less often than annually, or sooner if
evidence of possible impairment arises. Impairment testing is performed at the
reporting unit level and Headwaters has identified four reporting units: (i) the
Covol Fuels division and (ii) HTI (which together comprise the alternative
energy segment), (iii) CCPs and (iv) Construction Materials. Currently, goodwill
exists only in the CCPs and HTI reporting units.
Step 1 of impairment testing consists of determining and comparing the
fair values of the reporting units to the carrying values of those reporting
units. If step 1 were to be failed for either the CCPs or HTI reporting units,
indicating a potential impairment, Headwaters would be required to complete step
2, which is a more detailed test to calculate the implied fair value of
goodwill, and compare that value to the carrying value of the goodwill. If the
carrying value of the goodwill exceeds the implied fair value of the goodwill,
an impairment loss is required to be recorded.
20
Headwaters performed step 1 impairment tests of the recorded goodwill
in the CCPs and HTI reporting units as of October 1, 2002, the beginning of
fiscal year 2003. Headwaters performed its annual, recurring tests for potential
impairment using the date of June 30, 2003. The tests indicated that the fair
values of the reporting units exceeded their carrying values as of both October
1, 2002 and June 30, 2003. Accordingly, step 2 of the impairment tests was not
required to be performed, and no impairment charge was necessary.
It is possible that some of Headwaters' tangible or intangible
long-lived assets or goodwill could be impaired in the future and that the
resulting write-downs could be material.
Legal Matters. Headwaters and its subsidiaries are involved in several
legal proceedings and contractual matters that have arisen in the normal course
of business, all as explained in more detail in "ITEM 3. LEGAL PROCEEDINGS" and
Note 14 to the consolidated financial statements. Management in all cases
intends to vigorously defend Headwaters' position. In regards to all of the
unsettled legal matters, legal counsel cannot express an opinion as to the
ultimate amount of recovery or liability. Management does not believe that the
outcome of these matters will have a significant adverse effect upon the
operations, cash flows or the financial position of Headwaters; however, it is
possible that a change in management's estimates of probable liability could
occur, and the change could be significant.
In accounting for legal matters, Headwaters follows the guidance in
SFAS No. 5, "Accounting for Contingencies," under which loss contingencies are
accounted for based upon the likelihood of an impairment of an asset or the
incurrence of a liability. If a loss contingency is "probable" and the amount of
loss can be reasonably estimated, it is accrued. If a loss contingency is
"probable," but the amount of loss cannot be reasonably estimated, or if a loss
contingency is "reasonably possible," disclosure is made. Loss contingencies
that are "remote" are neither accounted for nor disclosed. Gain contingencies
are given no accounting recognition, but are disclosed if material.
Year Ended September 30, 2003 Compared to Year Ended September 30, 2002
The information set forth below compares Headwaters' operating results
for the year ended September 30, 2003 ("2003") with operating results for the
year ended September 30, 2002 ("2002").
Revenue. Total revenue for 2003 increased by $268.3 million or 225% to
$387.6 million as compared to $119.3 million for 2002. The major components of
revenue are discussed in the sections below.
Sales of Chemical Reagents. Chemical reagent sales during 2003 were
$128.4 million with a corresponding direct cost of $87.4 million. Chemical
reagent sales during 2002 were $74.4 million with a corresponding direct cost of
$50.1 million. The increase in chemical reagent sales during 2003 was due to
increased synthetic fuel production by Headwaters' licensees, as well as sales
of chemical reagents to new customers with which Headwaters does not have a
license agreement.
License Fees. During 2003, Headwaters recognized license fee revenue
totaling $35.7 million, an increase of $5.2 million or 17% over $30.5 million of
license fee revenue recognized during 2002. License fees in 2003 consisted of
recurring license fees or royalty payments of $34.5 million and deferred revenue
amortization of $1.2 million. License fees in 2002 consisted of recurring
license fees of $29.0 million and deferred revenue amortization of $1.5 million.
The primary reason for the increase in license fee revenue in 2003 compared to
2002 was a major licensee that purchased four facilities from a former licensee
in October 2001, but did not begin operating those facilities until early
calendar 2002. Headwaters earned approximately $11.3 million in license fees
from this licensee in 2003 and $7.4 million in 2002.
Pursuant to the contractual terms of an agreement with a certain
licensee, the cumulative license fees owed to Headwaters have been placed in
escrow for the benefit of Headwaters pending resolution of certain
contingencies. Headwaters currently expects the escrowed amounts to increase as
additional license fees are generated and that most, if not all, of such amounts
will be recognized as revenue at some future date. As of September 30, 2003, the
license fees, net of anticipated expenses, total approximately $20.0 million.
Certain accounting rules governing revenue recognition require that the seller's
price to the buyer be "fixed or determinable" as well as reasonably certain of
collection. In this situation, those rules appear to currently preclude revenue
recognition. Accordingly, none of the escrowed amounts have been recognized as
revenue in the consolidated statements of income. In addition to these escrowed
amounts, this same licensee has also set aside substantial amounts for various
operational contingencies as provided for in the contractual agreements. These
reserves, if not needed, will eventually be paid out to various parties having
an interest in the cash flows from the licensee's operations, including
Headwaters. 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 therefore, not recognizable.
21
ISG Revenues and Cost of Revenues. CCP revenues and sales of
construction materials and the related cost of revenue captions represent ISG's
revenues and cost of revenues. Because ISG was purchased on September 19, 2002,
there were only 12 days of operations included in 2002 compared to a full year
in 2003.
Depreciation and Amortization. These costs increased by $11.2 million
to $13.0 million in 2003 from $1.8 million in 2002. The increase was primarily
attributable to depreciation and amortization of ISG's tangible and intangible
assets.
Research and Development. Research and development expenses increased
by $2.4 million to $4.7 million in 2003 from $2.3 million in 2002. The increase
was primarily attributable to the inclusion of additional costs relating to
ISG's research and development activities. In 2002, research and development
expenses represented primarily costs related to HTI's activities, which remained
relatively unchanged during 2003.
Selling, General and Administrative Expenses. These expenses increased
$27.0 million to $40.7 million for 2003 from $13.7 million for 2002. The
increase in 2003 was due primarily to the inclusion of ISG's costs, and to a
lesser extent, an increase in professional services expenses of approximately
$1.1 million related to legal actions in which Headwaters is currently involved.
Other Income and Expense. During 2003, Headwaters reported net other
expense of $17.0 million compared to net other expense of $0.8 million during
2002. The change of $16.2 million was attributable to i) an increase in interest
expense of $15.1 million, ii) a decrease in interest income of $0.7 million, and
iii) an increase in net losses on notes receivable and investments of $1.7
million, substantially offset by an increase in net other income of $1.3
million.
Interest expense increased in 2003 due to the substantial increase in
debt incurred in September 2002 to finance the acquisition of ISG. Interest
expense in 2003 includes $1.5 million related to accelerated amortization of
debt discount and debt issue costs associated with $25.5 million of early
repayments of senior debt principal. Interest income decreased from 2002 to 2003
primarily due to lower average balances of cash and short-term investments as a
result of Headwaters using a substantial amount of cash to purchase ISG and
applying available cash generated in 2003 to repay long-term debt. Lower
interest rates in 2003 also affected interest income.
Losses on notes receivable were $1.4 million higher in 2003 as compared
to 2002. In both years, the majority of the losses represented write-downs of a
note receivable which is being accounted for on the cost recovery method. The
write-downs in both years were necessary due to declines in the value of the
underlying collateral. The carrying value of this note receivable at September
30, 2003 was $0.5 million. In 2003, Headwaters also recorded a $0.3 million loss
on an investment.
Net other income increased by $1.3 million in 2003 compared to 2002
primarily due to two non-recurring transactions in 2002. A $1.3 million gain on
sale of assets resulted from the sale of a 50% interest in one of Headwaters'
original synthetic fuel facilities. Also, Headwaters recorded approximately $2.6
million of losses related to the write-off of deferred project / financing costs
resulting from the abandonment of certain projects or the postponement or
redirection of activities for which costs had previously been deferred.
Income Tax Provision. In 2003, Headwaters recorded an income tax
provision at an effective tax rate of approximately 39%. In 2002, the effective
tax rate was approximately 40%.
Year Ended September 30, 2002 Compared to Year Ended September 30, 2001
The information set forth below compares Headwaters' operating results
for the year ended September 30, 2002 ("2002") with operating results for the
year ended September 30, 2001 ("2001").
Revenue. Total revenue for 2002 increased by $73.8 million or 162% to
$119.3 million as compared to $45.5 million for 2001. The major components of
revenue are discussed in the sections below.
Sales of Chemical Reagents. Chemical reagent sales during 2002 were
$74.4 million with a corresponding direct cost of $50.1 million. Chemical
reagent sales during 2001 were $22.4 million with a corresponding direct cost of
$14.5 million. The increase in chemical reagent sales in 2002 over 2001 was due
to increased synthetic fuel production by Headwaters' licensees, as well as
sales of chemical reagents to new customers.
License Fees. During 2002, Headwaters recognized license fee revenue
totaling $30.5 million, an increase of $9.7 million or 47% over $20.8 million of
license fee revenue recognized during 2001. License fees in 2002 consisted of
recurring license fees or royalty payments of $29.0 million and deferred revenue
amortization of $1.5 million. License fees in 2001 consisted of recurring
license fees of $18.8 million and deferred revenue amortization of $2.0 million.
22
A major licensee significantly reduced its production and sale of
synthetic fuel in early 2001 and did not operate its four facilities for most of
2001. This licensee sold the facilities in October 2001, and Headwaters earned
approximately $3.7 million more in license fees from these facilities in 2002
than in 2001. This factor, combined with increased synthetic fuel sales by most
other licensees, caused the increase in license fee revenue for 2002 over 2001.
Other Revenues and Cost of Revenues. CCP revenues and sales of
construction materials and the related cost of revenue captions represent ISG's
revenues and cost of revenues. ISG was purchased on September 19, 2002, and
accordingly, there were only 12 days of operations included in 2002.
Approximately $2.9 million of other revenues and $5.2 million of cost of other
revenues represent HTI's revenues and cost of revenues for 2002. There were no
comparable revenues and cost of revenues for either ISG or HTI in 2001.
Depreciation and Amortization. These costs increased by $1.4 million to
$1.8 million in 2002 from $0.4 million in 2001. The increase was primarily
attributable to the depreciation and amortization of the tangible and intangible
assets acquired in the HTI acquisition in August 2001 ($1.0 million) and the
depreciation and amortization of the tangible and intangible assets acquired in
the ISG acquisition in September 2002 ($0.4 million).
Research and Development. Approximately $2.4 million of the HTI
purchase price was allocated to purchased in-process research and development,
all of which was expensed in 2001. In 2002, research and development expenses of
$2.3 million represented primarily $2.1 million of costs related to HTI
activities.
Selling, General and Administrative Expenses. These expenses increased
$5.1 million or 59% to $13.7 million for 2002 from $8.6 million for 2001. The
increase in 2002 was due primarily to ISG costs of approximately $1.6 million,
an increase in compensation-related costs of approximately $1.2 million, an
increase in professional services expenses of approximately $1.1 million and
smaller increases in most of the other expense categories. The increase in
compensation-related costs related primarily to an increase in incentive-based
pay as a result of improved operating results. The increase in professional
services expenses was due primarily to legal costs associated with legal actions
in which Headwaters is currently involved. The increases in other expense
categories were due primarily to the growth of Headwaters' business during 2002.
Other Income and Expense. During 2002, Headwaters reported net other
expenses of $0.8 million compared to net other expenses of $5.2 million during
2001. The change of $4.4 million or 85% is primarily attributable to i) an
increase in interest and net investment income of $0.3 million, ii) a decrease
in equity and debt investment-related losses of approximately $5.5 million, and
iii) a gain on the sale of assets of approximately $1.3 million; partially
offset by the write-off of deferred project / financing costs of approximately
$2.6 million and an increase in interest expense of approximately $0.3 million.
The increase in interest income from 2001 to 2002 was primarily related
to an increase in the average balance of short-term investments in 2002 over
2001, partially offset by a decrease in interest income from a $6.5 million note
receivable from a licensee that was collected in October 2001.
During 2000, Headwaters made several equity investments in and loans to
unrelated, high-risk entities, and in 2001, Headwaters recorded losses totaling
approximately $6.3 million related to write-offs of these investments and loans.
In September 2001, Headwaters sold all of its remaining high-risk investments in
exchange for a $4.0 million note receivable from a limited liability
corporation. Headwaters wrote down this note receivable as of September 30, 2002
and recorded an impairment loss of approximately $1.0 million in 2002 due to a
decline in the value of the underlying collateral.
The $1.3 million gain on sale of assets resulted from the sale of a 50%
interest in one of Headwaters' original synthetic fuel facilities. Headwaters
recorded approximately $2.6 million of losses related to the write-off of
deferred project / financing costs in 2002 resulting from the abandonment of
certain projects or the postponement or redirection of activities for which
costs had previously been deferred pending the ultimate outcome of the projects
and activities. Interest expense increased in 2002 due to the substantial
increase in outstanding debt incurred in September 2002 to finance the
acquisition of ISG.
Income Taxes. In 2001, Headwaters reported a net income tax benefit of
$7.1 million, consisting of the recognition of $7.5 million of its deferred tax
asset, reduced by $0.1 million of federal alternative minimum tax and $0.3
million of current state income tax expense. In 2002, as a result of recording
the full value of its deferred tax asset in 2001, Headwaters recorded an income
tax provision with an effective tax rate of approximately 40%.
23
Liquidity and Capital Resources
Net cash provided by operations during the fiscal year ended September
30, 2003 ("2003") was $56.4 million compared to $42.8 million of net cash
provided by operations during the fiscal year ended September 30, 2002 ("2002").
Most of the cash flow from operating activities in both periods was attributable
to net income. Consistent with Headwaters' strategic priority to repay debt and
de-leverage its balance sheet, Headwaters used most of the cash generated during
the year ended September 30, 2003 to repay debt. During 2003, investing
activities consisted primarily of payments for the purchase of property, plant
and equipment and proceeds from disposition of property, plant and equipment.
Investing activities in 2002 consisted primarily of cash payments for the
acquisition of ISG of $205.9 million and the collection of a $6.5 million note
receivable. Financing activities in both 2003 and 2002 consisted primarily of
proceeds from and repayments of long-term debt and short-term borrowings, and
proceeds from exercise of options, warrants and employee stock purchases. More
details about these activities are provided in the following paragraphs.
Operating Activities. Cash provided from operations in 2003 of $56.4
million resulted primarily from net income of $36.6 million plus depreciation
and amortization of $13.0 million.
Investing Activities. In 2003, payments for the purchase of property,
plant and equipment totaled $9.7 million. These capital expenditures primarily
related to ISG's business, in particular the CCP segment. Capital expenditures
for 2004 are expected to be comparable with 2003 levels.
In September 2001, Headwaters sold all of its remaining high-risk
investments in exchange for a $4.0 million note receivable from a limited
liability corporation. This note is due no later than September 2004, is
collateralized by the bridge loans and equity investments sold and is being
accounted for on the cost recovery method. In 2003, Headwaters recorded a $2.1
million write-down of this note and as of September 30, 2003 this note has a
carrying value of $0.5 million. Headwaters could incur additional losses if the
remaining balance on the note is not repaid or if the collateral value declines.
At September 30, 2001, Headwaters had outstanding one other note receivable in
the amount of $6.5 million. This note and the related accrued interest were
collected in 2002.
Financing Activities. Headwaters acquired ISG in September 2002. In
order to obtain the cash necessary to acquire ISG and retire the ISG debt,
Headwaters issued $175.0 million of new debt consisting of $155.0 million of
senior secured debt and $20.0 million of subordinated debt (see Note 9 to the
consolidated financial statements). During 2003, principal repayments of the
senior debt totaling $40.1 million were made, including $25.5 million of
optional prepayments. Subsequent to September 30, 2003 and through November 30,
2003, principal repayments totaling $9.7 million have been made, including
optional prepayments of $3.5 million.
In 2003, cash proceeds from the exercise of options, warrants and
employee stock purchases totaled $2.9 million, compared to $5.7 million in 2002.
Option and warrant 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 a tax benefit generally
equal to the income recognized by the optionee. Such amounts, reflected in cash
flows from operations in the consolidated statements of cash flows, were $3.0
million in 2002 and $2.1 million in 2003.
Headwaters intends to continue to expand its business through growth of
existing operations, commercialization of technologies currently being
developed, and strategic acquisitions of entities that operate in adjacent
industries. Currently the senior secured credit facility requires approval for
acquisitions funded with aggregate cash consideration in excess of $50.0
million.
Headwaters has an effective $150.0 million 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. The most likely use of
the shelf registration statement would be to issue equity securities to reduce
long-term debt and for general corporate purposes, including acquisitions. A
prospectus supplement describing the terms of any securities to be issued is
required to be filed before any offering would commence under the registration
statement.
Working Capital. Headwaters' working capital decreased by $0.8 million
from September 30, 2002, to $14.2 million as of September 30, 2003. The most
significant changes in the components of working capital were an increase of
$8.5 million in cash and investments and an increase of $11.9 million in the
current portion of long-term debt, reflecting senior debt repayment obligations
that are higher for 2004 than for 2003. Headwaters expects operations to produce
positive cash flows in future periods, which, combined with current working
capital and the $20.0 million revolving line of credit described below, is
expected to be sufficient for operating needs for the next 12 months.
24
Long-term Debt. In connection with the ISG acquisition, Headwaters
entered into a $175.0 million senior secured credit agreement with a syndication
of lenders, under which a total of $155.0 million was borrowed as a term loan on
the acquisition date. The credit agreement also allows up to $20.0 million to be
borrowed under a revolving credit arrangement. The debt was issued at a 3%
discount and Headwaters received net cash proceeds of $150.4 million. The
original issue discount is being accreted using the effective interest method
and the accretion is recorded as interest expense. The debt is secured by all
assets of Headwaters, bears interest at a variable rate (approximately 5.4% at
September 30, 2003), and is repayable in quarterly installments through August
30, 2007.
In 2003, principal repayments totaling $40.1 million were made, which
included $25.5 million of optional early repayments. Subsequent to September 30,
2003 and through November 30, 2003, principal repayments totaling $9.7 million
were made, which included early repayments of $3.5 million. In certain
situations, for example when Headwaters receives "excess cash flow," as defined,
mandatory prepayments in excess of the scheduled payments are required.
Mandatory prepayments are calculated as a percentage of "excess cash flow,"
ranging up to 100%, which percentage is based on Headwaters' "leverage ratio."
When prepayments are made, required principal repayments for all future periods
are reduced. Headwaters may, in the future, make additional optional prepayments
of the senior debt depending on actual cash flows, Headwaters' current and
expected cash requirements and other factors deemed significant by management.
The credit agreement contains restrictions and covenants common to such
agreements, including limitations on the incurrence of additional debt,
investments, merger and acquisition activity, asset liens, capital expenditures
in excess of $15.0 million in any fiscal year and the payment of dividends,
among others. In addition, Headwaters must maintain certain financial ratios,
including leverage ratios and in respect of interest coverage, as those terms
are defined in the credit agreement. As of September 30, 2003, Headwaters must
maintain a total leverage ratio of 2.5:1.0 or less. The maximum ratio declines
over time until June 30, 2004, at which time the ratio must remain at 2.0:1.0 or
less. There is a similar leverage ratio requirement for the senior debt alone,
which at September 30, 2003 must be 2.0:1.0 or less, declining over time through
June 30, 2004, at which time it must be maintained at 1.5:1.0 or less. The
interest coverage requirement at September 30, 2003 was 4.0:1.0 or more.
Beginning December 31, 2003, the ratio must be maintained at a level of 5.0:1.0
or more. Headwaters is in compliance with all debt covenants.
Under the terms of the senior secured credit agreement, Headwaters may
borrow up to a total of $175.0 million; provided however, except for the initial
$20.0 million of available revolving credit, the maximum borrowing limit is
permanently reduced by the amount of any repayments of the initial $155.0
million term loan borrowed in September 2002. Terms of any additional borrowings
under the credit agreement are generally the same as those described in the
preceding paragraphs. Finally, the credit agreement allows for the issuance of
letters of credit, provided there is capacity under the revolving credit
arrangement. Currently two letters of credit totaling $2.0 million are
outstanding, with expiration dates in March 2004 and November 2004. There have
been no other letters of credit issued and no funds have been borrowed under the
revolving credit arrangement. Headwaters pays a fee of 5/8% on the unused
portion of the revolving credit arrangement.
In connection with the ISG acquisition, Headwaters also entered into a
$20.0 million subordinated loan agreement, under which senior subordinated
debentures were issued at a 2% discount, with Headwaters receiving net cash
proceeds of $19.6 million. The original issue discount is being accreted using
the effective interest method and the accretion is recorded as interest expense.
ISG management participated in one-half, or $10.0 million, of the $20.0 million
of debt issued. The other half was issued to a corporation. The debt is not
secured, bears interest at a rate of 18% per annum payable quarterly, and is due
on September 16, 2007. It is senior to all other debt except the senior secured
debt described previously. The debt agreement allows for optional prepayments.
Any prepayments paid to the corporation are subject to a prepayment charge,
which ranges from 5% of the principal prepaid in the first year to 1% of the
principal prepaid in the last year of the five-year term of the subordinated
loan agreement.
The loan agreement contains restrictions and covenants common to such
agreements, and these are generally consistent with those described above for
the senior secured debt. As of September 30, 2003, Headwaters must maintain a
total leverage ratio of 2.75:1.0 or less. The maximum ratio declines over time
until June 2004, at which time the ratio must remain at 2.25:1.0 or less. The
interest coverage requirement at September 30, 2003 was 3.75:1.0 or more.
Beginning in December 2003, the ratio must be maintained at a level of 4.75:1.0
or more. Headwaters is in compliance with all debt covenants.
Income Taxes. In 2002, Headwaters' cash requirements for income taxes
were not significant due to the availability and utilization of net operating
loss carryforwards ("NOLs"). Most of Headwaters' NOLs were utilized in 2002 and,
accordingly, 2003 cash requirements for income taxes were significant, totaling
$19.4 million. Cash payments for income taxes are reduced for disqualifying
dispositions of shares obtained upon the exercise of stock options as discussed
25
previously which totaled $2.1 million for 2003. As of September 30, 2003,
remaining NOLs are not material. Headwaters' cash requirements for income taxes
in 2004 are expected to approximate the income tax provision, with some lag 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.
Summary of Future Cash Requirements. Significant future cash needs, in
addition to operational working capital requirements, are currently expected to
consist primarily of debt service payments on outstanding long-term debt, income
taxes and capital expenditures.
Contractual Obligations and Contingent Liabilities and Commitments
Other than operating leases for certain equipment and real estate,
Headwaters has no significant off-balance sheet transactions, derivatives or
similar instruments and is not a guarantor of any third-party debt or other
financial obligations. The following table presents a summary of Headwaters'
contractual obligations by period as of September 30, 2003.
Payments due by Period
-----------------------------------------------------------
After 5
(millions of dollars) Total 1 Year 2 -3 Years 4 -5 Years Years
------------------------------------------- ----------- ----------- ----------- ----------- -----------
Senior secured debt $ 114.8 $ 27.4 $ 49.9 $ 37.5 $ --
Senior subordinated debt 20.0 -- -- 20.0 --
Other long-term debt 0.1 0.1 -- -- --
----------- ----------- ----------- ----------- -----------
Total long-term debt 134.9 27.5 49.9 57.5 --
Operating lease obligations 38.0 10.8 14.6 7.8 4.8
Unconditional purchase obligations 35.7 10.6 11.5 5.9 7.7
Capital expenditures 6.0 6.0 -- -- --
Other long-term obligations 1.1 1.0 0.1 -- --
----------- ----------- ----------- ----------- -----------
Total contractual cash obligations $ 215.7 $ 55.9 $ 76.1 $ 71.2 $ 12.5
=========== =========== =========== =========== ===========
Subsequent to September 30, 2003, one of ISG's minimum purchase
contracts was amended. The amendment extended the term of the contract for
several years and increased ISG's total future minimum purchase requirements by
approximately $17.9 million during 2004 through 2011. Under the terms of the
senior secured credit agreement, Headwaters may borrow up to a total of $175.0
million; provided however, except for the initial $20.0 million of available
revolving credit, the maximum borrowing limit is permanently reduced by the
amount of any repayments of the initial $155.0 million borrowed in September
2002. The credit agreement allows for the issuance of letters of credit,
provided there is capacity under the available revolving credit arrangement.
Currently, two letters of credit totaling $2.0 million are outstanding, with
expiration dates in March 2004 and November 2004. There have been no other
letters of credit issued and no funds have been borrowed under the revolving
credit arrangement.
As indicated previously, Headwaters and its subsidiaries are involved
in several legal proceedings and contractual matters that have arisen in the
normal course of business, all as explained in more detail in "Critical
Accounting Policies and Estimates - Legal Matters," above, "ITEM 3. LEGAL
PROCEEDINGS" and Note 14 to the consolidated financial statements.
Senate Permanent Subcommittee on Investigations
On October 29, 2003, the Permanent Subcommittee on Investigations of
the Government Affairs Committee of the United States issued a notification of
pending investigations. The notification listed the synthetic fuel tax credit as
a new item, stating: "The Subcommittee has initiated an investigation of
potential abuses of tax credits by producers of synthetic fuel under Section 29
of the Internal Revenue Code. The Subcommittee anticipates that this
investigation will focus on whether certain synthetic fuel producers are
claiming tax credits under Section 29, even though their product is not a
qualified synthetic fuel under Section 29 and IRS regulations. In addition, the
investigation will address whether certain corporations are engaging in
transactions solely to take advantage of unused Section 29 credits, with no
other business purpose. Lastly, the investigation will address the IRS's efforts
to curb abuses related to the Section 29 tax credits."
The effect that the Senate subcommittee investigation of synthetic fuel
tax credits may have on the industry is unknown. While the investigation is
pending, buyers may be unwilling to engage in transactions to purchase synthetic
fuel facilities. If current owners are unable to sell their facilities,
production may not be maximized, materially adversely affecting Headwaters'
revenues.
26
Recent Accounting Pronouncements
Headwaters has reviewed all recently issued accounting standards,
which have not yet been adopted in order to determine their potential effect, if
any, on the results of operations or financial position of Headwaters. Based on
that review, Headwaters does not currently believe that any of these recent
accounting pronouncements will have a significant effect on its current or
future financial position, results of operations, cash flows or disclosures.
Impact of Inflation
Headwaters' operations were not materially impacted by inflation in
2003.
Forward-looking Statements
Statements in this Annual Report on Form 10-K regarding Headwaters'
expectations as to the managing and marketing of coal combustion products,
operation of facilities utilizing alternative fuel technologies, the marketing
of synthetic fuels, the receipt of licensing fees, royalties, and product sales
revenues, the development, commercialization and financing of new technologies
and other strategic business opportunities and acquisitions and other
information about Headwaters that is not purely historical by nature, including
those statements regarding Headwaters' future business plans, the operation of
facilities, the availability of tax credits, the availability of feedstocks, and
the marketability of the coal combustion products and synthetic fuel, constitute
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. Although Headwaters believes that its
expectations are based on reasonable assumptions within the bounds of its
knowledge of its business and operations, there can be no assurance that actual
results will not differ materially from its expectations. In addition to matters
affecting the coal combustion products and synthetic fuel industries or the
economy generally, factors which could cause actual results to differ from
expectations stated in these forward-looking statements include, among others,
the Risk Factors described in the following section.
Risk Factors
The profitability of Covol Fuels depends on the continued existence of tax
credits under Section 29 of the Internal Revenue Code, which is scheduled to
expire on December 31, 2007.
Covol Fuels' license fees and revenues from sales of chemical reagents
depend on the ability of our licensees and customers to manufacture and sell
qualified synthetic fuels that generate tax credits. Under current law, Section
29 tax credits are not available for synthetic fuel sold after December 31,
2007. In addition, there have been initiatives from time to time to consider the
early repeal or modification of Section 29. If Section 29 expires at the end of
2007or if it is repealed or adversely modified, 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, we do not believe
that production of synthetic fuel will be profitable absent the tax credits. In
addition, if our licensees close their facilities or materially reduce
production activities (whether after 2007, upon earlier repeal or adverse
modification of Section 29 or for any other reason), it would have a material
adverse effect on the revenues and net income of Headwaters.
Furthermore, Section 29 tax credits are subject to phase-out after the
unregulated oil price reaches $49.75 per barrel (the current trading price is
approximately $22.50 per barrel), adjusted annually for inflation.
Ongoing financial profitability of Covol Fuels depends upon our licensees'
demand for Section 29 tax credits, which in turn depends on our licensees'
taxable income.
Covol Fuels' business depends upon the ability of our licensees and
chemical reagent customers to utilize Section 29 tax credits. Their ability to
utilize tax credits, in turn, depends upon their other taxable income. A decline
in the profitability of our licensees could reduce their ability to utilize tax
credits, and, in turn, could lead to a reduction in the production of synthetic
fuel at their facilities. Such licensees could sell their facilities to a
taxpayer with more capacity to utilize the tax credits, but any such transfer
could result in short-term or long-term disruption of operations. Accordingly,
the decline in profitability of our licensees or chemical reagent customers
could have a material adverse effect on the revenues and net income of
Headwaters.
27
IRS reviews under Section 29 may adversely affect our licensees' production of
synthetic fuel.
The issuance of PLRs under Section 29 by the IRS is important to the
willingness of the owners of synthetic fuel facilities to operate and to their
ability to transfer ownership of those facilities. However, PLRs may be modified
or revoked by the IRS.
The IRS has suspended the issuance of PLRs to synthetic fuel facility
owners several times in the past, and there can be no assurance that the IRS
will not suspend the issuance of PLRs in the future. Most recently, in June
2003, the IRS stated in summary in Announcement 2003-46 that it "has had reason
to question the scientific validity of test procedures and results that have
been presented as evidence that fuel underwent a significant chemical change,
and is currently reviewing information regarding these test procedures and
results," and that pending its review of the issue it was suspending the
issuance of new PLRs regarding significant chemical change.
The IRS release of Announcement 2003-46 caused certain of Headwaters'
licensees to reduce or cease synthetic fuel production, which resulted in a
material adverse impact on Headwaters' revenues and net income. In October 2003,
the IRS stated, in summary, in Announcement 2003-70 that it continues to
question whether the processes it had approved under its long-standing ruling
practice produce the necessary level of chemical change required under Section
29 and Revenue Ruling 86-100. Nonetheless, the IRS indicated that it would
continue to issue PLRs regarding chemical change under the standards set forth
in Revenue Procedures 2001-30 and 2001-34, and that the industry's chemical
change test procedures and results are scientifically valid if applied in a
consistent and unbiased manner. Although the IRS resumed its practice of issuing
PLRs, it expressed continuing concerns regarding the sampling and data/record
retention practices prevalent in the synthetic fuels industry.
The full effect that Announcement 2003-70 (or future suspensions or
pronouncements similar to Announcement 2003-46) may have on the industry is
unknown. The expression of IRS concern regarding current practices in the
industry may have a material adverse effect on the willingness of buyers to
engage in transactions or on the willingness of current owners to operate their
facilities. If current owners are unable to sell their facilities or are
unwilling to operate them, production will not be maximized, materially
adversely affecting our revenues and net income. We cannot predict whether the
IRS may conduct reviews or investigations of Section 29 tax credits in the
future, or whether the outcome of IRS audits involving licensees would be
favorable.
Senate investigation of Section 29 tax credits may adversely affect Covol Fuels.
On October 30, 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, among others,
the synthetic fuel tax credit as a new item, stating:
The Subcommittee has initiated an investigation of potential abuses of
tax credits for producers of synthetic fuel under Section 29 of the
Internal Revenue Code. The Subcommittee anticipates that this
investigation will focus on whether certain synthetic fuel producers
are claiming tax credits under Section 29, even though their product is
not a qualified synthetic fuel under Section 29 and IRS regulations. In
addition, the investigation will address whether certain corporations
are engaging in transactions solely to take advantage of unused Section
29 credits, with no other business purpose. Lastly, the investigation
will address the IRS's efforts to curb abuses related to the Section 29
tax credits.
The effect that the Senate subcommittee investigation of synthetic fuel
tax credits may have on the industry is unknown. While the investigation is
pending, it may have a material adverse effect on the willingness of buyers to
engage in transactions to purchase synthetic fuel facilities or on the
willingness of current owners to operate their facilities, and may materially
adversely affect our revenues and net income. We cannot make any assurances as
to the timing or ultimate outcome of the subcommittee investigation, nor can we
predict whether Congress or others may conduct investigations of Section 29 tax
credits in the future.
28
Covol Fuels' licensees are subject to audit by the IRS, and the IRS may
challenge or disallow Section 29 tax credits claimed.
Licensees are subject to audit by the IRS. The IRS may challenge
whether Covol Fuels' licensees satisfy the requirements of Section 29, or
applicable PLRs, or may attempt to disallow Section 29 tax credits for some
other reason. Headwaters understands that the IRS has recently initiated audits
of certain taxpayers who claimed Section 29 tax credits during open tax years,
and the outcome of any such audit is uncertain. In the event that tax credits
are disallowed, licensees may seek recovery from Covol Fuels for operational or
other reasons, although we believe there would be no basis for such claims. The
inability of a licensee to claim Section 29 tax credits also would reduce our
future income from the licensee. In addition, IRS audit activity may have a
material adverse effect on the willingness of buyers to engage in transactions
to purchase synthetic fuel facilities or on the willingness of current owners to
operate their facilities. If current owners are unable to sell their facilities
or are unwilling to operate them at full capacity, production will not be
maximized, materially adversely affecting our revenues and net income.
Demand for Section 29 tax credits may be influenced by negative publicity
involving the industry or transactions principally motivated by the reduction of
taxes.
There has been recent public scrutiny, by the media and by
policymakers, of Section 29. Outside the Section 29 context, there has been
increased public scrutiny of transactions motivated principally by the reduction
of federal income taxes. Our licensees could determine that the risk of negative
publicity or public scrutiny associated with the Section 29 tax credits exceeds
the financial benefits from the utilization of the credits. Such licensees may
seek to mitigate or eliminate such risk by reducing or ceasing production of
synthetic fuel or disposing of their facilities, resulting in short-term or
long-term disruption of operations, in which case our revenues could be
materially adversely affected.
Ongoing financial profitability of Covol Fuels depends on a small number of
licensees.
Covol Fuels has licensed its coal-based solid synthetic fuel technology
to a limited number of licensees. Under current law, facilities must have been
placed into service prior to July 1, 1998 to be eligible for Section 29 tax
credits, so Covol Fuels' business primarily depends on existing licensees and
chemical reagent customers. If any of Covol Fuels' significant licensees or
chemical reagent customers shuts down its facilities, operates its facilities at
low production levels or sells its facilities resulting in short-term or
long-term disruption of operations, our revenues and net income could be
materially adversely affected. Covol Fuels' licensees must address all
operational issues including, but not limited to, feedstock availability, cost,
moisture content, Btu content, correct chemical reagent formulation and
application, operability of equipment, product durability and overall costs of
operations. In some cases, licensees may be forced to relocate plants and enter
into new strategic contracts to address marketing and operational issues.
Licensee plant relocations disrupt production and delay generation of license
fees paid to us.
The growth of Covol Fuels' revenues has depended in part on increased
production over time of coal-based solid synthetic fuel by its licensees. While
to date efficiencies in production and improvements in equipment and processes
used at facilities have allowed increased production, capacity is ultimately
finite for the specific facilities and could limit growth in the future.
Covol Fuels must be able to develop and improve synthetic fuel technologies.
For Covol Fuels to remain competitive, we must be able to develop or
refine our technologies to keep up with future synthetic fuel requirements. As
licensees develop and modify their operations and choices of coal feedstocks, we
will need to modify existing methods or find new methods, know-how, additives
and other techniques to meet licensee and customer demands, such as demands for
improved efficiencies, lower costs and improvements in synthetic fuel products,
including chemical change and improved combustion characteristics. If we are
unable to develop or refine our technologies, the revenues and business of Covol
Fuels could be materially harmed.
ISG's growth is dependent upon increased use and market acceptance of fly ash.
ISG's growth has been and continues to be dependent upon the increased
use of fly ash in the production of concrete. ISG's marketing initiatives
29
emphasize the environmental, cost and performance advantages of replacing
portland cement with fly ash in the production of concrete. If ISG's marketing
initiatives are not successful, ISG may not be able to sustain its growth.
ISG's business is dependent upon the price and supply of fly ash alternatives.
A significant portion of ISG's business is based on the use of fly ash
as a replacement for portland cement in concrete products. There is currently an
overcapacity of cement in the world market, causing potential price decreases.
The markets for ISG's products are regional, in part because of the costs in
transporting CCPs, and ISG's business is affected by the availability and cost
of competing products in the specific regions where it conducts business. If
competing products become available at more competitive costs, ISG's sales,
revenue and net income could decrease.
ISG's business could be adversely affected by fluctuations in weather and
construction cycles.
ISG manages and markets CCPs and uses CCPs to produce construction
materials. Utilities produce CCPs year-round, including in the winter when
electricity demands increase. In comparison, sales of CCPs are generally keyed
to construction market demands that tend to follow national trends in
construction with predictable increases during temperate seasons. ISG's CCP
sales have historically reflected these seasonal trends, with the largest
percentage of total annual revenues being realized in the quarters ended June 30
and September 30. Low seasonal demand normally results in reduced shipments and
revenues in the quarter ended March 31.
The CCP industry is cyclical because of its dependence on building
construction and highway construction, including infrastructure repair, and is
affected by changes in general and local economic conditions. State construction
budgets are affected adversely by economic downturns. A downturn in the economy
in one or more markets that ISG serves could have a material adverse effect on
ISG's sales.
If ISG's coal-fired electric utility industry suppliers fail to provide ISG with
high quality CCPs on a timely basis, ISG's costs could increase and our growth
could be hindered.
ISG relies on the production of CCPs by coal-fired electric utilities.
ISG has occasionally experienced delays and other problems in obtaining high
quality CCPs from its suppliers and may in the future be unable to obtain high
quality CCPs on the scale and within the time frames required by ISG to meet its
customers' needs. If ISG is unable to obtain CCPs, or if it experiences a delay
in the delivery of high quality CCPs, ISG may be forced to incur significant
unanticipated expenses to secure alternative sources or to otherwise maintain
supply to its customers. Moreover, its revenues could be adversely affected if
these customers choose to find alternatives to ISG products.
HTI's technologies may not be commercially developed and marketed profitably.
Although HTI has developed and patented several technologies,
commercialization of these technologies is in initial stages. Market acceptance
of these technologies will depend on our ability to enter into agreements with
licensees or joint venturers to further develop and provide adequate funding to
commercialize the technologies. We can give no assurance that we will be able to
enter into these agreements or that adequate funding will be available to fully
develop and successfully commercialize its technologies or that they can be
marketed profitably.
HTI will conduct business in China, where intellectual property and other laws,
as well as business conditions, could create risks.
HTI has entered into agreements with Shenhua Group, the largest coal
company in the People's Republic of China, to license its direct coal
liquefaction technology for use in a plant in China. We have entered into a
preliminary joint venture agreement for fuel cell technology development and
commercialization with the Dalian Institute of Chemical Physics in China, using
our nanotechnology. In addition, other HTI activities are likely to involve
licensing of other technologies in China. There is the risk that foreign
intellectual property laws will not protect our intellectual property to the
same extent as under United States laws, leaving us vulnerable to competitors
who may attempt to copy our products, processes or technologies. Further, the
legal system of China is based on statutory law. Under this system, prior court
decisions may be cited as persuasive authority but do not have binding
precedential effect. Since 1979, the Chinese government has been developing a
comprehensive system of commercial laws and considerable progress has been made
in the promulgation of laws and regulations dealing with economic matters, such
30
as corporate organization and governance, foreign investment, commerce, taxation
and trade. As these laws, regulations and legal requirements are relatively new
and because of the limited volume of published case law and judicial
interpretations and the non-binding nature of prior court decisions, the
interpretation and enforcement of these laws, regulations and legal requirements
involve some uncertainty. These uncertainties could limit the legal protection
or recourse available to us. In addition, dependence on foreign licenses and
conducting foreign operations may subject us to increased risk from political
change, ownership issues or repatriation or currency exchange concerns.
Environmental regulations could adversely affect our business.
Our operations and those of our suppliers and customers involved in
coal-based energy generation, primarily utilities, are subject to federal, state
and local environmental regulation. See "ITEM 1. BUSINESS--Effect of Federal
State and Local Laws" for a broader discussion of regulation issues affecting
Headwaters.
The coal-based solid synthetic fuel operations of Headwaters and its
licensees are subject to federal, state and local environmental regulations that
impose limitations on the discharge of pollutants into the air and water and
establish standards for the treatment, storage and disposal of waste products.
In order to establish and operate the synthetic fuel plants, power plants and
operations to collect and transport CCPs and bottom ash, we and our licensees
and customers have obtained various state and local permits and must comply with
processes and procedures that have been approved by regulatory authorities.
Compliance with permits, regulations and the approved processes and procedures
help protect against pollution and contamination, and are critical to our
business. Although we believe that we and our licensees and customers are in
substantial compliance with environmental regulations, permits and approved
processes and procedures, any failure to comply could result in the issuance of
substantial fines and penalties and cause us to incur environmental liabilities.
The federal Clean Air Act of 1970 and subsequent amendments
(particularly the Clean Air Act Amendments of 1990), and corresponding state
laws, regulate the emissions of materials into the air, and in certain
circumstances require installation of emission control technologies that affect
the operation of coal-fired utility power plants. Current and future emission
regulations may have an adverse impact on the quantity and quality of CCPs
produced by utilities and may add to the costs of operating a power plant.
Because ISG manages and markets CCPs produced by coal-fired utilities,
regulations that restrict coal-burning, or make it more expensive or affect the
quantity and quality of CCPs produced by utilities could adversely affect ISG's
business.
Materials sold by ISG vary in chemical composition. While CCPs
generally have been excluded from regulation as "hazardous wastes," the EPA is
planning to publish proposed rules in January 2004 which will address, among
other things, state and regional solid waste plans for CCPs disposed of in
landfills or surface impoundments, or used to fill surface or underground mines.
These proposed rules could make coal burning more expensive or less attractive
to ISG's utility clients. ISG manages a number of landfill and pond operations
that may be affected by EPA's proposed regulations. ISG is engaged in providing
services at one landfill operation that is permitted and managed as a hazardous
waste landfill. ISG provides the services necessary to landfill the client's
hazardous wastes and operates certain in-plant equipment and systems for the
client. Accordingly, there can be no assurance that ISG will not be named in any
third-party claims relating to the project.
CCPs contain small concentrations of metals that are considered as
"hazardous substances" under CERCLA. Land application of CCPs is regulated by a
variety of federal and state statutes, which impose testing and management
requirements to ensure environmental protection. Under certain circumstances,
mismanagement of CCPs could give rise to CERCLA liability.
HTI's ordinary course of business requires using its facilities to
perform research and development activities involving coal, oil, chemicals and
energy technologies, including liquefaction of coal. As a result, petroleum and
other hazardous materials have been and are present in and on HTI's properties.
Regulatory noncompliance or accidental discharges, in spite of safeguards, could
create an environmental liability. Therefore our operations entail risk of
environmental damage, and we could incur liabilities in the future arising from
the discharge of pollutants into the environment or from waste disposal
practices.
31
We are involved in significant litigation and are subject to potential claims
relating to our business.
We are a party to some significant legal proceedings and are subject to
potential claims regarding operation of our business. These proceedings will
require that we incur substantial costs, including attorneys' fees, managerial
time and other personnel resources and costs in pursuing resolution. Adverse
resolution of these proceedings could have a materially negative effect on our
business. See "Legal Proceedings" for a description of the material pending
legal proceedings and potential claims regarding our business.
We have significant competition.
Headwaters experiences competition from traditional coal and fuel
suppliers and natural resource producers, in addition to those companies that
specialize in the use and upgrading of industrial byproducts. Many of these
companies have greater financial, management and other resources than Headwaters
and may be able to take advantage of acquisitions and other opportunities more
readily. There can be no assurance that Headwaters will be able to do so
successfully.
Coal-based solid synthetic fuels made using Covol Fuels' technologies,
from which Covol Fuels derives license revenues and revenues from sales of
chemical reagents, compete with other synthetic fuel products, as well as
traditional fuels. For Covol Fuels competition may come in the form of the
marketing of competitive chemical reagents and the marketing of end products
qualifying as synthetic fuel. Covol Fuels competes with other companies
possessing technologies to produce coal-based solid synthetic fuels and
companies that produce chemical reagents such as Nalco Chemical Company and
Accretion Technologies, LLC.
Covol Fuels also experiences competition from traditional coal and fuel
suppliers and natural resource producers, in addition to those companies that
specialize in the use and upgrading of industrial byproducts. These companies
may have greater financial, management and other resources than Headwaters has.
Further, many industrial coal users are limited in the amount of synthetic fuel
product they can purchase from Covol Fuels' licensees because they have
committed to purchase a substantial portion of their coal requirements through
long-term contracts for standard coal.
Synthetic fuel technology and the use of CCPs are the subject of
extensive research and development by our competitors. If competitive
technologies are developed that greatly increase the demand for CCPs or reduce
the costs of synthetic fuels or other resources, the economic viability of our
technologies and business could be adversely affected.
Generally, the business of marketing traditional CCPs and construction
materials is intensely competitive. ISG has substantial competition in three
main areas: obtaining CCP management contracts with utility and other industrial
companies; marketing CCPs and related industrial materials; and marketing its
construction materials. ISG has a presence in every region in the United States,
but because the market for the management of CCPs is highly fragmented and
because the costs of transportation are high relative to sales prices, most of
the competition in the CCP management industry is regional. There are many
local, regional and national companies that compete for market share in these
areas with similar products and with numerous other substitute products.
Although ISG typically has long-term CCP management contracts with its clients,
some of such contracts provide for the termination of such contract at the
convenience of the utility company upon a minimum 90-day notice. Moreover,
certain of ISG's most significant regional CCP competitors appear to be seeking
a broader national presence. These competitors include Lafarge North America
Inc., Boral Material Technologies Inc. and Cemex. Construction materials are
produced and sold regionally by the numerous owners and operators of concrete
ready-mix plants. Producers with sand and gravel sources near growing
metropolitan areas have important transportation advantages. In Texas, ISG's
most important construction materials market, Featherlite Building Products is
among ISG's competitors. Certain of these competitors have substantially greater
resources than Headwaters and ISG. If they were to begin to compete in the
national market, or in regions where they currently do not have operations,
ISG's business may be materially adversely affected.
Many of the world's major chemical companies are devoting significant
resources to researching and developing nanocatalysts and catalytic processes.
These companies have greater financial, management and other resources than
Headwaters has. Headwaters' strategy is to enter into license agreements or
joint ventures with major chemical companies for the further development and
commercialization of Headwaters' nanocatalyst technologies.
32
Our business strategy to grow through acquisitions may not be successful.
An important business strategy of Headwaters is growth through
acquisitions. Our ability to successfully implement our strategy is subject to a
number of risks, including difficulties in identifying acceptable acquisition
candidates, consummating acquisitions on favorable terms and obtaining adequate
financing, which may adversely affect our ability to develop new products and
services and to compete in our rapidly changing marketplace. In addition, if we
consummate acquisitions through an exchange of our securities, our existing
stockholders could suffer dilution. Successful management and integration of
acquisitions are subject to a number of risks, including difficulties in
assimilating acquired operations, including loss of key employees, diversion of
management's attention from core business operations, assumption of contingent
liabilities, and incurrence of potentially significant write-offs. There can be
no assurance that we will be successful in implementing our acquisition
strategy, that such strategy will improve our operating results or that these
activities will not have a dilutive effect on existing stockholders.
If we are unable to manage the growth of our business successfully, our revenues
and business prospects could suffer.
We have experienced significant growth recently, both internally and
through acquisitions. We may not be able to successfully manage the increased
scope of our operations or a significantly larger and more geographically
diverse workforce as we expand. Any failure to successfully manage growth could
harm our business and financial results. Additionally, growth increases the
demands on our management, our internal systems, procedures and controls. To
successfully manage growth, we must add administrative staff and periodically
update and strengthen our operating, financial and other systems, procedures and
controls, which will increase our costs and may reduce our profitability. We may
be unable to successfully implement improvements to our information and control
systems in an efficient or timely manner and may discover deficiencies in
existing systems and controls.
Our business could be harmed if we are unable to protect our proprietary
intellectual property.
We rely primarily on a combination of trade secrets, patents, copyright
and trademark laws and confidentiality procedures to protect our intellectual
property. Despite these precautions, unauthorized third parties may
misappropriate, infringe upon, copy or reverse engineer portions of our
technology. We do not know if current or future patent applications will be
issued with the scope of the claims sought, if at all, or whether any patents
issued will be challenged or invalidated. Our business could be harmed if we
infringe upon the intellectual property rights of others. We have been, and may
be in the future, notified that we may be infringing intellectual property
rights possessed by third parties. If any such claims are asserted against us,
we may seek to enter into royalty or licensing arrangements. There is a risk in
these situations that no license will be available or that a license will not be
available on reasonable terms, precluding our use of the applicable technology.
Alternatively, we may decide to litigate such claims or attempt to design around
the patented technology. These actions could be costly and would divert the
efforts and attention of our management and technical personnel. As a result,
any infringement claims by third parties or claims for indemnification by
customers resulting from infringement claims, whether or not proven to be true,
may materially harm our business and prospects.
We have significant debt service requirements.
As of November 30, 2003, we had approximately $125.2 million of total
debt outstanding, including approximately $3.2 million of original issue
discount, substantially all of which was incurred in connection with the
acquisition of ISG. Subject to restrictions in our senior secured credit
facility and our senior subordinated debentures, we may also incur significant
amounts of additional debt for working capital, capital expenditures and other
purposes. Our combined debt total could have important consequences for our
company, including the following:
o we may have difficulty borrowing money for working capital,
capital expenditures, acquisitions or other purposes;
o we will need to use a large portion of our cash flow to pay
interest and the required principal payments on borrowings
under our senior secured credit facility, which will reduce
the amount of money available to finance our operations,
capital expenditures and other activities;
33
o our senior debt has a variable rate of interest, which exposes
us to the risk of increased interest rates;
o borrowings under our senior secured credit facility are
secured by all our assets;
o we may be more vulnerable to economic downturns and adverse
developments in our business;
o we may be less flexible in responding to changing business and
economic conditions, including increased competition and
demand for new products and services; and
o we may not be able to implement our business plans.
Our ability to make scheduled payments of the principal of, to pay
interest on or to refinance our indebtedness depends on our future performance,
which to a certain extent is subject to economic, financial, competitive and
other factors beyond our control. There can be no assurance that our business
will continue to generate cash flow from operations in the future sufficient to
service our debt and make necessary capital expenditures. If unable to generate
such cash flow, we may be required to adopt one or more alternatives, such as
selling assets, restructuring debt or obtaining additional equity capital. There
can be no assurance that any of these strategies could be effected on
satisfactory terms or without substantial additional expense to us. Significant
acquisitions may be funded with additional indebtedness, which would increase
debt service requirements. These and other factors could have a material adverse
effect on our results of operations, liquidity and financial condition.
Covenant restrictions under our senior secured credit facility and senior
subordinated debentures may limit our ability to operate our business.
Our senior secured credit facility and senior subordinated debentures
contain, among other things, covenants that may restrict our ability to finance
future operations or capital needs, to acquire additional businesses or to
engage in other business activities. Currently the senior secured credit
facility requires approval for acquisitions funded with aggregate cash
consideration in excess of $50 million. In addition, our senior secured credit
facility and senior subordinated debentures sets forth covenants requiring us to
maintain specified financial ratios and satisfy certain financial condition
tests which may require that we take action to reduce our debt or to act in a
manner contrary to our business objectives. A breach of any of these covenants
could result in a default under our senior secured credit facility and senior
subordinated debentures, in which event our lenders could elect to declare all
amounts outstanding to be immediately due and payable, which could materially
adversely affect our business.
Our stock price has been and could remain volatile.
The market price for our common stock has been and may continue to be
volatile and subject to significant price and volume fluctuations in response to
market and other factors, including the following, some of which are beyond our
control:
o variations in our quarterly operating results from our
expectations or those of securities analysts or investors;
o downward revisions in securities analysts' estimates or
changes in general market conditions;
o IRS or other governmental actions, including Congressional
hearings and investigations relating to Section 29 tax credits
and media coverage relating thereto;
o announcement by us or our competitors of significant
acquisitions, strategic partnerships, joint ventures or
capital commitments;
o additions or departures of key personnel;
o insider selling or buying;
o regulatory developments affecting our industry;
o general technological or economic trends; and
o other matters discussed in "Risk Factors."
34
In the past, following periods of volatility in the market price of
their stock, many companies have been the subject of securities class action
litigation. If we became involved in securities class action litigation in the
future, it could result in substantial costs and diversion of our management's
attention and resources and could harm our stock price, business, prospects,
results of operations and financial condition.
Future sales of our common stock could adversely affect our stock price.
Substantial sales of our common stock in the public market, or the
perception by the market that such sales could occur, could lower our stock
price or make it difficult for us to raise additional equity capital in the
future. As of November 30, 2003, we had 28,068,818 shares of common stock
outstanding.
As of November 30, 2003, options and warrants to purchase 3,432,046
shares of our common stock were issued and outstanding at a weighted average
exercise price of $10.60 per share, of which options and warrants to purchase
1,886,325 shares had vested.
Headwaters has in place a registration statement registering up to $150
million in securities. The securities registered under the registration
statement may be offered to the public in the future by means of a prospectus
supplement.
We cannot predict if future sales of our common stock, or the
availability of our common stock for sale, will harm the market price for our
common stock or our ability to raise capital by offering equity securities.
We have never paid dividends and do not anticipate paying any dividends on our
common stock in the future, so any short-term return on your investment will
depend on the market price of our capital stock.
We currently intend to retain any earnings to finance our operations
and growth. The terms and conditions of our senior secured credit facility and
senior subordinated debentures restrict and limit payments or distributions in
respect of our capital stock.
Delaware law and our charter documents may impede or discourage a takeover,
which could cause the market price of our shares to decline.
We are a Delaware corporation, and the anti-takeover provisions of
Delaware law impose various impediments to the ability of a third party to
acquire control of us, even if a change in control would be beneficial to our
existing stockholders. In addition, our board of directors has the power,
without stockholder approval, to designate the terms of one or more series of
preferred stock and issue shares of preferred stock, which could be used
defensively if a takeover is threatened. The ability of our board of directors
to create and issue a new series of preferred stock and certain provisions of
Delaware law and our certificate of incorporation and bylaws could impede a
merger, takeover or other business combination involving us or discourage a
potential acquirer from making a tender offer for our common stock, which, under
certain circumstances, could reduce the market price of our common stock.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE 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, and no significant derivative
financial instruments were outstanding as of September 30, 2003 or subsequent
thereto.
The majority of Headwaters' short-term investments, all of which are
classified as trading securities, consist of fixed-rate U.S. government
securities or securities backed by the U.S. government. Changes in interest
rates can affect the market value of these investments, which are carried at
market value in the consolidated balance sheets. The periodic adjustments to
reflect changes in market value are included in interest and net investment
income in the consolidated statements of income. Based on the current amount of
short-term investments and expected near-term changes in the amount of
short-term investments, Headwaters does not expect any material near-term
investment losses to result from changes in interest rates.
35
As described in more detail in Note 9 to the consolidated financial
statements, Headwaters has outstanding $114.9 million of variable-rate long-term
debt as of September 30, 2003, which is repayable through August 2007. The
interest rate on this debt as of September 30, 2003 was approximately 5.4%. In
October 2003, Headwaters locked in a rate of 5.4% for three months and in
January 2004, Headwaters can lock in a new rate for one, three, or six months. A
change in the interest rate of 1% would change interest expense by approximately
$1.0 million during the next 12 months, considering required principal
repayments.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary financial data required by
this Item 8 are set forth in Item 15 of this Form 10-K. All information that has
been omitted is either inapplicable or not required.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
As described in more detail in the following paragraphs, Headwaters
dismissed Arthur Andersen LLP ("AA") as its independent accountants on May 10,
2002 and appointed PricewaterhouseCoopers LLP ("PwC"). On October 14, 2002,
Headwaters dismissed PwC and appointed Ernst & Young LLP ("E&Y").
On September 19, 2002, Headwaters acquired 100% of the common stock of
ISG. E&Y audited ISG since its inception. ISG's revenues comprised approximately
65% of the consolidated revenues of the combined entity and ISG operated in 35
states and Canada. In addition, approximately 85% of Headwaters' employees came
from the ISG acquisition. On October 14, 2002, Headwaters decided to retain E&Y
as its independent accountants for the new combined company and accordingly
dismissed PwC. Headwaters' Audit Committee participated in and approved the
decision to change independent accountants.
Headwaters did not consult with E&Y on any application of accounting
principles or any other matter during the two fiscal years ended September 30,
2001 or subsequent thereto.
The reports of PwC on the financial statements for the fiscal years
audited by them contained no adverse opinion or disclaimer of opinion and were
not qualified or modified as to uncertainty, audit scope or accounting
principle.
In connection with its audits for the two most recent fiscal years and
through October 14, 2002, there were no disagreements with PwC on any matter of
accounting principles or practices, financial statement disclosure, or auditing
scope or procedure, which disagreements if not resolved to the satisfaction of
PwC would have caused them to make reference thereto in their reports on the
financial statements for such years.
During the two most recent fiscal years and through October 14, 2002,
there were no reportable events (as defined in Regulation S-K Item
304(a)(1)(v)).
The Registrant requested that PwC furnish it with a letter addressed to
the Securities and Exchange Commission stating whether or not it agrees with the
above statements. A copy of such letter is filed as Exhibit 16 to this Form
10-K.
Due to events involving Headwaters' former auditors, AA, on May 10,
2002 Headwaters Incorporated dismissed AA as its independent accountants. The
Registrant's Audit Committee participated in and approved the decision to change
independent accountants.
The reports of AA on the financial statements for the two fiscal years
audited by them (fiscal 2000 and fiscal 2001) contained no adverse opinion or
disclaimer of opinion and were not qualified or modified as to uncertainty,
audit scope or accounting principle.
In connection with its audits for those two fiscal years and through
May 10, 2002, there were no disagreements with AA on any matter of accounting
principles or practices, financial statement disclosure, or auditing scope or
procedure, which disagreements if not resolved to the satisfaction of AA would
have caused them to make reference thereto in their reports on the financial
statements for such years.
36
During fiscal 2000 and fiscal 2001 and through May 10, 2002, there were
no reportable events (as defined in Regulation S-K Item 304(a)(1)(v)).
The Registrant requested that AA furnish it with a letter addressed to
the Securities and Exchange Commission stating whether or not it agrees with the
above statements. A copy of such letter is filed as Exhibit 16.1 to this Form
10-K.
On May 10, 2002, the Audit Committee appointed PwC as Headwaters'
independent accountants. Headwaters has not consulted with PwC on any
application of accounting principles or any other matter during the two fiscal
years ended September 30, 2001 or subsequent thereto, except for consultations
in the capacity as Headwaters' independent accountants up to July 19, 2000.
There were no disagreements with accountants on accounting or financial
statement disclosure subsequent to the appointment of AA on July 19, 2000.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure controls are procedures that are designed with an objective
of ensuring that information required to be disclosed in Headwaters' periodic
reports filed with the SEC, such as this Annual Report on Form 10-K, is
recorded, processed, summarized and reported within the time periods specified
by SEC rules and forms. Disclosure controls include, without limitation,
controls and procedures designed to ensure that such information is accumulated
and communicated to Headwaters' management, including the Chief Executive
Officer ("CEO") and the Chief Financial Officer ("CFO"), in order to allow
timely consideration regarding required disclosures.
The evaluation of Headwaters' disclosure controls by the CEO and CFO
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
Annual 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, projections of any evaluation of the disclosure
controls and procedures to future periods are 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 as of September 30, 2003, and
subject to the inherent limitations as 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 Securities Exchange Act of 1934) are
effective. In addition, they are not aware of any change in Headwaters' internal
control over financial reporting during the quarter ended September 30, 2003
that has materially affected, or is reasonably likely to materially affect,
Headwaters' internal control over financial reporting.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information to be set forth under the captions "Executive Officers"
and "Proposal No. 1 - Election of Directors" in Headwaters' Proxy Statement to
be filed in January 2003 for the Annual Meeting of Stockholders to be held in
2004 (the "Proxy Statement"), is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information to be set forth under the caption "Executive
Compensation and Related Information" in the Proxy Statement is incorporated
herein by reference; provided, however, that Headwaters specifically excludes
from such incorporation by reference any information set forth under the
captions "Compensation Committee Report on Executive Compensation" and
"Stockholder Return Performance Graph" in the Proxy Statement.
37
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Security ownership of certain beneficial owners and management to be
set forth under the caption "Security Ownership of Certain Beneficial Owners and
Management" in the Proxy Statement is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information to be set forth under the caption "Transactions with
Related Parties" in the Proxy Statement is incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information to be set forth under the caption "Accounting Fees and
Services" in the Proxy Statement is incorporated herein by reference.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
Consolidated Financial Statements of Headwaters Incorporated Page
Report of Independent Auditors for 2002 and 2003 F-1
Report of Former Independent Auditors for 2001 F-2
Consolidated Balance Sheets as of September 30, 2002 and 2003 F-3
Consolidated Statements of Income for the years ended
September 30, 2001, 2002 and 2003 F-4
Consolidated Statements of Changes in Stockholders' Equity
for the years ended September 30, 2001, 2002 and 2003 F-5
Consolidated Statements of Cash Flows for the years ended
September 30, 2001, 2002 and 2003 F-7
Notes to Consolidated Financial Statements F-9
2. Financial Statement Schedules
All financial statement schedules for which provision is made in the
applicable accounting regulations of the Securities and Exchange Commission are
not required under the related instructions, are inapplicable, or the required
information has been provided in the consolidated financial statements or notes
thereto.
3. Listing of Exhibits
Certain other instruments which would otherwise be required to be
listed below have not been so listed because such instruments do not authorize
securities in an amount which exceeds 10% of the total assets of Headwaters and
its subsidiaries on a consolidated basis and Headwaters agrees to furnish a copy
of any such instrument to the Commission upon request.
For convenience, the name Headwaters is used throughout this listing
although in some cases the name Covol was used in the original instrument.
Exhibit No. Description Location
- ----------- ----------- --------
3.1.9 Restated Certificate of Incorporation of Headwaters dated August 14, 2001 (4)
3.2.4 Restated By-Laws of Headwaters (12)
10.54 Employment Agreement effective May 1, 1998 with Steven G. Stewart (2)
10.60 Employment Agreement dated October 25, 2002 with Kirk A. Benson (12)
38
10.60.0 Amendment to Employment Agreement with Kirk A. Benson dated July 9, 2003 (14)
10.60.3 ISG Employment Agreement dated October 1, 2001 with Raul Deju (12)
10.72 Agreement and Plan of Reorganization between Headwaters and Hydrocarbon (3)
Technologies, Inc. dated May 2, 2001
10.72.1 Share Exchange Agreement between Headwaters and Hydrocarbon Technologies, Inc. (3)
dated May 2, 2001
10.72.2 Amendment No. 1 to Agreement and Plan of Reorganization between Headwaters and (4)
Hydrocarbon Technologies, Inc. dated August 21, 2001
10.72.3 Amendment No. 1 to Share Exchange Agreement between Headwaters and Hydrocarbon (4)
Technologies, Inc. dated August 21, 2001
10.73 Contribution and Subscription Agreement among Headwaters and Avintaquin Capital, (5)
LLC dated September 24, 2001
10.73.1 Promissory Note from Avintaquin Capital, LLC in favor of Headwaters dated (5)
September 24, 2001
10.74 Asset Purchase Agreement between Headwaters and Red Hawk Energy, LLC dated (7)
December 28, 2001
10.75 Agreement and Plan of Merger between Headwaters and Industrial Services Group, (9)
Inc. dated July 15, 2002
10.75.1 Form of Registration Rights Agreement between Headwaters and the Stockholders of (9)
Industrial Services Group, dated as of September 19, 2002
10.75.2 First Amendment to Agreement and Plan of Merger and Equityholder Agreements among (10)
Headwaters, Industrial Services Group, Inc. and Equityholders of Industrial
Services Group, Inc. dated September 19, 2002
10.76 Senior Credit Agreement for $175,000,000 among Headwaters and various lenders (10)
dated September 19, 2002
10.77 Loan Agreement for $20,000,000 between Headwaters and Allied Capital Corporation (10)
dated September 19, 2002
10.77.1 Participation Agreement among Allied Capital Corporation, Headwaters and other (10)
Participants dated September 19, 2002
10.83 Incentive Agreement between Headwaters and Raul A. Deju dated as of November 12, (13)
2002
12 Computation of ratio of earnings to combined fixed charges and preferred stock *
dividends
14 Code of Ethics *
16.1 Letter regarding change in certifying accountant (11)
16.2 Letter regarding change in certifying accountant (Originally designated as (8)
Exhibit No. 16)
21 List of Subsidiaries of Headwaters *
23.1 Consent of Ernst & Young LLP *
23.2 Consent of PricewaterhouseCoopers LLP *
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 *
99.1 Amended 2000 Employee Stock Purchase Plan (originally designated as Exhibit No. (6)
99.2)
99.2 1995 Stock Option Plan (originally designated as Exhibit No. 10.5) (1)
99.2.1 First Amendment to the 1995 Stock Option Plan (originally designated as Exhibit (1)
10.5.1)
99.2.2 1996 Stock Option Agreement (12)
99.2.3 1998 Stock Option Agreement (12)
99.2.4 2001 Stock Option Agreement (12)
99.2.5 2002 Stock Option Agreement (12)
99.3 Incentive Bonus Plan dated 1 October 2003 *
99.7 2003 Stock Incentive Plan (13)
99.8 General Employee Bonus Plan dated 1 October 2003 *
- -----------------
* Filed herewith.
Unless another exhibit number is indicated as the exhibit number for the exhibit
as "originally filed," the exhibit number in the filing in which any exhibit was
originally filed and to which reference is made hereby is the same as the
exhibit number assigned herein to the exhibit.
(1) Incorporated by reference to the indicated exhibit filed with
Headwaters' Registration Statement on Form 10, filed February 26, 1996.
(2) Incorporated by reference to the indicated exhibit filed with
Headwaters' Annual Report on Form 10-K, for the fiscal year ended
September 30, 1998.
39
(3) Incorporated by reference to the indicated exhibit filed with
Headwaters' Quarterly Report on Form 10-Q, for the quarter ended June
30, 2001.
(4) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for events dated August 14,
2001 and August 28, 2001, filed September 12, 2001.
(5) Incorporated by reference to the indicated exhibit filed with
Headwaters' Annual Report on Form 10-K, for the fiscal year ended
September 30, 2001.
(6) Incorporated by reference to the indicated exhibit filed with
Headwaters' Quarterly Report on Form 10-Q, for the quarter ended
December 31, 2001.
(7) Incorporated by reference to the indicated exhibit filed with
Headwaters' Quarterly Report on Form 10-Q, for the quarter ended March
31, 2002.
(8) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated May 10,
2002, filed May 10, 2002.
(9) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated July 15,
2002, filed July 18, 2002.
(10) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated September
19, 2002, filed October 4, 2002.
(11) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated October 14,
2002, filed October 18, 2002.
(12) Incorporated by reference to the indicated exhibit filed with
Headwaters' Annual Report on Form 10-K, for the fiscal year ended
September 30, 2002.
(13) Incorporated by reference to the indicated exhibit filed with
Headwaters' Quarterly Report on Form 10-Q, for the quarter ended
December 31, 2002.
(14) Incorporated by reference to the indicated exhibit filed with
Headwaters' Quarterly Report on Form 10-Q, for the quarter ended June
30, 2003.
Report on Form 8-K
The following report on Form 8-K was filed during the quarter ended
September 30, 2003:
Form 8-K filed on July 23, 2003 to furnish information announcing
Headwaters' results for the quarter ended June 30, 2003.
Exhibits
The response to this portion of Item 15 is submitted as a separate
section of this report. See Item 15 (a) 3 above.
Financial Statement Schedules
The response to this portion of Item 15 is submitted as a separate
section of this report. See Item 15 (a) 2 above.
40
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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
By: /s/ Kirk A. Benson
-----------------------------------
Kirk A. Benson
Chief Executive Officer
(Principal Executive Officer)
By: /s/ Steven G. Stewart
-----------------------------------
Steven G. Stewart
Chief Financial Officer (Principal
Financial and Accounting Officer)
Date: December 5, 2003
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Kirk A. Benson Director and Chief Executive December 5, 2003
- ----------------------- Officer (Principal Executive
Kirk A. Benson Officer)
/s/ Steven G. Stewart Chief Financial Officer December 5, 2003
- ----------------------- (Principal Financial and
Steven G. Stewart Accounting Officer)
/s/ James A. Herickhoff Director December 5, 2003
- -----------------------
James A. Herickhoff
/s/ Raymond J. Weller Director December 5, 2003
- -----------------------
Raymond J. Weller
/s/ E. J. "Jake" Garn Director December 5, 2003
- -----------------------
E. J. "Jake" Garn
/s/ R. Sam Christensen Director December 5, 2003
- -----------------------
R. Sam Christensen
/s/ William S. Dickinson Director December 5, 2003
- -----------------------
William S. Dickinson
/s/ Malyn K. Malquist Director December 5, 2003
- -----------------------
Malyn K. Malquist
41
Report of Independent Auditors
The Board of Directors and Stockholders
Headwaters Incorporated
We have audited the accompanying consolidated balance sheets of Headwaters
Incorporated as of September 30, 2002 and 2003, and the related consolidated
statements of income, changes in stockholders' equity, and cash flows for each
of the two years in the period ended September 30, 2003. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Headwaters
Incorporated at September 30, 2002 and 2003, and the consolidated results of its
operations and its cash flows for each of the two years in the period ended
September 30, 2003, in conformity with accounting principles generally accepted
in the United States.
/s/ Ernst & Young LLP
Salt Lake City, Utah
October 31, 2003
F-1
Report of Former Independent Auditors
To the Board of Directors and Stockholders
of Headwaters Incorporated:
In our opinion, the accompanying consolidated statements of income, changes in
stockholders' equity, and cash flows of Headwaters Incorporated and its
subsidiaries present fairly, in all material respects, the results of their
operations and their cash flows for the year ended September 30, 2001 in
conformity with accounting principles generally accepted in the United States of
America. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audit. We conducted our audit of these statements in
accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Salt Lake City, Utah
July 15, 2002
F-2
HEADWATERS INCORPORATED
CONSOLIDATED BALANCE SHEETS
As of September 30,
-----------------------------
(thousands of dollars and shares, except per-share data) 2002 2003
- ------------------------------------------------------------------------------------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 7,284 $ 18,732
Short-term trading investments 5,907 2,921
Trade receivables, net 50,331 52,399
Inventories 8,442 7,827
Other current assets 5,969 6,005
------------- -------------
Total current assets 77,933 87,884
------------- -------------
Property, plant and equipment, net 50,549 52,743
------------- -------------
Other assets:
Intangible assets, net 118,918 112,414
Goodwill 113,367 112,131
Debt issue costs and other assets 12,090 8,103
------------- -------------
Total other assets 244,375 232,648
------------- -------------
Total assets $ 372,857 $ 373,275
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 17,215 $ 17,177
Accrued personnel costs 8,773 8,669
Other accrued liabilities 16,966 16,522
Current portion of long-term debt 15,578 27,475
Current portion of unamortized non-refundable license fees 4,378 3,865
------------- -------------
Total current liabilities 62,910 73,708
------------- -------------
Long-term liabilities:
Long-term debt 154,552 104,044
Deferred income taxes 51,357 50,663
Unamortized non-refundable license fees and other long-term liabilities 5,442 4,703
------------- -------------
Total long-term liabilities 211,351 159,410
------------- -------------
Total liabilities 274,261 233,118
------------- -------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.001 par value; authorized 50,000 shares; issued and
outstanding 27,327 shares at September 30, 2002 (including 526 shares
held in treasury), and 27,878 shares at September 30, 2003 (including
467 shares held in treasury) 27 28
Capital in excess of par value 126,265 130,936
Retained earnings (accumulated deficit) (24,418) 12,213
Treasury stock, at cost (3,013) (2,783)
Other (265) (237)
------------- -------------
Total stockholders' equity 98,596 140,157
------------- -------------
Total liabilities and stockholders' equity $ 372,857 $ 373,275
============= =============
See accompanying notes.
F-3
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF INCOME
Year ended September 30,
-----------------------------------------------
(thousands of dollars, except per-share data) 2001 2002 2003
- ----------------------------------------------------------------------------------------------------------------------------
Revenue:
Sales of chemical reagents $ 22,407 $ 74,419 $ 128,375
License fees 20,765 30,456 35,726
Coal combustion products revenues -- 6,818 169,938
Sales of construction materials -- 1,774 49,350
Other revenues 2,292 5,878 4,241
-------------- -------------- --------------
Total revenue 45,464 119,345 387,630
-------------- -------------- --------------
Operating costs and expenses:
Cost of chemical reagents sold 14,524 50,134 87,386
Cost of coal combustion products revenues -- 3,764 123,146
Cost of construction materials sold -- 1,388 37,689
Cost of other revenues -- 5,244 3,919
Depreciation and amortization 355 1,760 12,982
Research and development 2,400 2,322 4,674
Selling, general and administrative 8,554 13,699 40,715
-------------- -------------- --------------
Total operating costs and expenses 25,833 78,311 310,511
-------------- -------------- --------------
Operating income 19,631 41,034 77,119
-------------- -------------- --------------
Other income (expense):
Interest and net investment income 726 1,000 310
Interest expense (224) (553) (15,687)
Losses on notes receivable and investments (6,265) (743) (2,436)
Other, net 600 (502) 775
-------------- -------------- --------------
Total other income (expense), net (5,163) (798) (17,038)
-------------- -------------- --------------
Income before income taxes 14,468 40,236 60,081
Income tax benefit (provision) 7,049 (15,950) (23,450)
-------------- -------------- --------------
Net income $ 21,517 $ 24,286 $ 36,631
============== ============== ==============
Basic earnings per share $ 0.94 $ 1.00 $ 1.35
============== ============== ==============
Diluted earnings per share $ 0.87 $ 0.94 $ 1.30
============== ============== ==============
See accompanying notes.
F-4
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Convertible
preferred Common Retained Common
stock stock Capital in earnings stock Total
-------------- -------------- excess (accumulated held in stockholders'
(thousands of dollars and shares) Shares Amount Shares Amount of par value deficit) treasury Other equity
- -----------------------------------------------------------------------------------------------------------------------------------
Balances as of
September 30, 2000 17 $ 1 23,341 $ 23 $ 82,659 $ (70,221) $ (734) $ (981) $ 10,747
Common stock issued on
conversion of convertible
preferred stock (17) 443 -- -- (1)
Preferred stock cash dividends (695) (695)
Exercise of stock options
and warrants 860 1 1,925 1,926
Tax benefit from exercise
of stock options 1,690 1,690
Common stock issued in
connection with purchase of
Hydrocarbon Technologies, Inc.,
net of estimated registration costs 593 1 5,434 5,435
Common stock options issued in
connection with purchase of
Hydrocarbon Technologies, Inc. 1,325 1,325
Write-up of related party note
receivable to collateral value (541) (541)
Cancellation of related party
note receivable and transfer of the
collateral shares to treasury stock (1,007) 1,007 --
Purchase of 1,648 shares of treasury
stock, at cost (10,510) (10,510)
34 shares of treasury stock
transferred to employee stock
purchase plan, at cost 101 101
Cancellation of 1,430 shares
of treasury stock (1,430) (1) (9,112) 9,112 (1)
Amortization of deferred
compensation from stock options 93 93
Net income for the year
ended September 30, 2001 21,517 21,517
---- ------ ------- ----- --------- --------- --------- ------- --------
Balances as of September 30, 2001 -- $ -- 23,807 $ 24 $ 83,226 $ (48,704) $ (3,038) $ (422) $ 31,086
==== ====== ======= ===== ========= ========= ========= ======= ========
See accompanying notes.
F-5
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY, continued
Convertible
preferred Common Retained Common
stock stock Capital in earnings stock Total
-------------- -------------- excess (accumulated held in stockholders'
(thousands of dollars and shares) Shares Amount Shares Amount of par value deficit) treasury Other equity
- -----------------------------------------------------------------------------------------------------------------------------------
Balances as of September 30, 2001 -- $ -- 23,807 $ 24 $ 83,226 $ (48,704) $ (3,038) $ (422) $ 31,086
Exercise of stock options and
warrants 1,315 1 5,383 5,384
Tax benefit from exercise of
stock options 2,990 2,990
Common stock issued in connection
with acquisition of Hydrocarbon
Technologies, Inc. 178 -- 2,823 2,823
Common stock issued in connection
with acquisition of Industrial
Services Group, Inc. 2,100 2 32,716 32,718
Purchase of 83 shares of treasury
stock, at cost (1,188) (1,188)
32 shares of treasury stock
transferred to employee stock
purchase plan, at cost 214 126 340
Cancellation of 73 shares of
treasury stock (73) -- (1,087) 1,087 --
Amortization of deferred
compensation from stock
options and other 157 157
Net income for the year ended
September 30, 2002 24,286 24,286
---- ------ ------- ----- --------- --------- --------- ------- --------
Balances as of September 30, 2002 -- -- 27,327 27 126,265 (24,418) (3,013) (265) 98,596
---- ------ ------- ----- --------- --------- --------- ------- --------
Exercise of stock options
and warrants 551 1 2,139 2,140
Tax benefit from exercise of
stock options 2,050 2,050
59 shares of treasury stock
transferred to employee stock
purchase plan, at cost 482 230 712
Amortization of deferred
compensation from stock
options and other 28 28
Net income for the year
ended September 30, 2003 36,631 36,631
---- ------ ------- ----- --------- --------- --------- ------- --------
Balances as of September 30, 2003 -- $-- 27,878 $28 $130,936 $ 12,213 $(2,783) $(237) $140,157
==== ====== ======= ===== ========= ========= ========= ======= ========
See accompanying notes.
F-6
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year ended September 30,
--------------------------------------
(thousands of dollars) 2001 2002 2003
- -------------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ 21,517 $ 24,286 $ 36,631
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization 355 1,760 12,982
Interest expense related to amortization of debt discount and
debt issue costs 79 136 3,857
Deferred income taxes (9,160) 11,540 (878)
Income tax benefit from exercise of stock options 1,690 2,990 2,050
Amortization of non-refundable license fees (2,015) (1,471) (1,178)
Net gain on disposition of property, plant and equipment (42) (1,249) (188)
Write-downs of notes receivable and related accrued interest 3,200 986 2,142
Losses on investments 3,018 -- 294
Acquired in-process research and development 2,400 -- --
Write-up of related party note receivable (541) -- --
Other changes in operating assets and liabilities, net of effect of
acquisitions of Industrial Services Group, Inc. and Hydrocarbon
Technologies, Inc.:
Short-term trading investments 925 141 2,986
Receivables (987) (7,742) (2,068)
Inventories and other current assets 26 351 (463)
Accounts payable and accrued liabilities 958 7,193 1,373
Unamortized non-refundable license fees (1,587) 3,982 (513)
Other, net (29) (126) (636)
----------- ----------- -----------
Net cash provided by operating activities 19,807 42,777 56,391
----------- ----------- -----------
Cash flows from investing activities:
Payments for acquisition of Industrial Services Group, Inc.,
net of cash acquired -- (205,900) --
Payments for acquisition of Hydrocarbon Technologies, Inc.,
net of cash acquired (4,845) (419) --
Purchase of property, plant and equipment (170) (796) (9,716)
Proceeds from disposition of property, plant and equipment 168 115 2,685
Collections on notes receivable -- 6,912 54
Net increase in other assets (180) (40) (594)
Investments in and loans to non-affiliated companies (4,636) (294) --
----------- ----------- -----------
Net cash used in investing activities (9,663) (200,422) (7,571)
----------- ----------- -----------
Cash flows from financing activities:
Payments on long-term debt and short-term borrowings (9,941) (6,412) (40,224)
Net proceeds from issuance of long-term debt and short-term borrowings 8,991 165,806 --
Proceeds from exercise of options and warrants 1,926 5,384 2,140
Employee stock purchases 101 340 712
Purchase of common stock for the treasury (10,510) (1,188) --
Preferred stock dividends (695) -- --
----------- ----------- -----------
Net cash provided by (used in) financing activities (10,128) 163,930 (37,372)
----------- ----------- -----------
Net increase in cash and cash equivalents 16 6,285 11,448
Cash and cash equivalents, beginning of year 983 999 7,284
----------- ----------- -----------
Cash and cash equivalents, end of year $ 999 $ 7,284 $ 18,732
=========== =========== ===========
See accompanying notes.
F-7
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
Year ended September 30,
--------------------------------------
(thousands of dollars) 2001 2002 2003
- -------------------------------------------------------------------------------------------------------------------------------
Supplemental schedule of non-cash investing and financing activities:
Common stock issued in connection with acquisition of Industrial
Services Group, Inc. $ -- $ 32,718 $ --
Common stock issued in connection with acquisition of Hydrocarbon
Technologies, Inc. 5,435 2,823 --
Common stock options issued in connection with acquisition of Hydrocarbon
Technologies, Inc. 1,325 -- --
Cancellation of treasury stock (9,112) (1,087) --
Exchange of equity investments in and loans to non-affiliated companies for
long-term note receivable from non-affiliate 4,000 -- --
Common stock issued on conversion of convertible preferred stock and in
payment of dividends 3,100 -- --
Cancellation of related party note receivable and transfer of the collateral
shares to treasury stock 1,007 -- --
Supplemental disclosure of cash flow information:
Cash paid for interest $ 269 $ 39 $ 10,054
Cash paid for income taxes 283 322 19,356
See accompanying notes.
F-8
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2003
___________
1. Organization and Description of Business
Headwaters Incorporated is incorporated in Delaware. Headwaters owns 100%
of Industrial Services Group, Inc. ("ISG"), a Utah-based company formed in
1997 and acquired by Headwaters in September 2002 (see Note 3). Headwaters
also owns 100% of Headwaters Technology Innovation Group, Inc. ("HTI")
(formerly Hydrocarbon Technologies, Inc.), a New Jersey company formed in
1995 and acquired by Headwaters in August 2001. Headwaters' fiscal year
ends on September 30 and unless otherwise noted, future references to years
refer to Headwaters' fiscal year rather than a calendar year. Headwaters'
focus is on enhancing the value of coal, gas, oil and other natural
resources. Headwaters currently generates revenue from licensing its
chemical technologies to produce synthetic fuel and from managing coal
combustion products ("CCPs"). Headwaters intends to continue to expand its
business through growth of existing operations, commercialization of
technologies currently being developed, and strategic acquisitions of
entities that operate in adjacent industries.
Through its proprietary Covol Fuels process, Headwaters adds value to the
production of coal-based solid synthetic fuels primarily for use in
electric power generation plants. Headwaters currently licenses its
technologies to the owners of 28 of a company-estimated 75 coal-based solid
synthetic fuel facilities in the United States. ISG, through its
wholly-owned subsidiary ISG Resources, Inc., is the nation's largest
provider of CCP management and marketing services to the electric power
industry, serving more than 100 coal-fired electric power generation plants
nationwide. Through its distribution network of over 130 locations, ISG is
the leading provider of high quality fly ash to the building products and
ready mix concrete industries in the United States. ISG's construction
materials segment develops, manufactures and distributes value-added bagged
concrete, stucco, mortar and block products that utilize fly ash. ISG also
develops and deploys technologies for maintaining and improving fly ash
quality. Headwaters, through its wholly-owned subsidiary HTI, conducts
research and development activities directed at catalyst technologies to
convert coal and heavy oil into environmentally-friendly, high-value liquid
fuels. In addition, HTI has developed a unique process to custom design
nanocatalysts that could be used in multiple industrial applications.
2. Summary of Significant Accounting Policies
Principles of Consolidation - The consolidated financial statements include
the accounts of Headwaters and all of its subsidiaries, only two of which
have significant operations, ISG and HTI. All significant intercompany
transactions and accounts are eliminated in consolidation. ISG was acquired
on September 19, 2002 and accordingly, ISG's results of operations for the
period from September 19, 2002 through September 30, 2003 have been
consolidated with Headwaters' 2002 and 2003 results. HTI was acquired in
August 2001. Due to the time required to obtain accurate financial
information related to HTI's foreign contracts, for financial reporting
purposes HTI's financial statements are consolidated with Headwaters'
financial statements using a one-month lag. Accordingly, no results of
operations of HTI were included in the consolidated statement of income for
2001. HTI's August 31, 2002 and 2003 balance sheets were consolidated with
Headwaters' September 30, 2002 and 2003 balance sheets and HTI's results of
operations for the twelve months ended August 31, 2002 and 2003 were
consolidated with Headwaters' 2002 and 2003 results.
Segment Reporting, Major Customers and Other Concentrations of Risk - Until
Headwaters acquired ISG in September 2002, Headwaters operated in and
reported as a single industry segment, alternative energy. With the
acquisition of ISG in September 2002, Headwaters now operates in three
business segments, alternative energy, CCPs, and construction materials
(formerly "manufactured products"). Additional information about these
segments is presented in Note 4. The following table presents revenues for
all customers that accounted for over 10% of total revenue during 2001,
2002 or 2003. All of these revenues are attributable to the alternative
energy segment, and most of the customers are energy companies.
(thousands of dollars) 2001 2002 2003
---------------------------------------- ---------------- -------------- --------------
DTE Energy Services, Inc. affiliates $ 5,111 $19,660 $42,013
TECO Coal Corporation affiliates 16,044 20,292 Less than 10%
Marriott International, Inc. affiliates Less than 10% 19,105 Less than 10%
AIG Financial Products Corp. affiliates Less than 10% 16,900 Less than 10%
PacifiCorp affiliates 4,978 Less than 10% Less than 10%
Pace Carbon Fuels, L.L.C. affiliates 4,675 Less than 10% Less than 10%
F-9
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
At September 30, 2003, Headwaters had trade receivable balances totaling
approximately $1,895,000 from DTE Energy Services, Inc. affiliates.
Substantially all of Headwaters' revenues were generated from sales in the
United States. Headwaters purchases all of the chemical reagent that is
sold to licensees and other customers from a single large international
chemical company. Management believes that if necessary, the chemical
reagent could be obtained from other suppliers. Headwaters has no other
significant unusual credit risks or concentrations.
Revenue Recognition - Alternative Energy Segment. Headwaters currently
licenses its technologies to the owners of 28 coal-based solid synthetic
fuel facilities from which Headwaters earns license fees and/or profits
from the sales of chemical reagents. Non-refundable advance license fees
and royalty payments have been received from certain licensees under
various terms and conditions. These non-refundable license fees and
royalties have been deferred and are being recognized on a straight-line
basis over the period covered by the related license and royalty
agreements, generally through calendar 2007. Recurring license fees or
royalty payments are recognized in the period when earned, which generally
coincides with the sale of synthetic fuel by Headwaters' licensees. In
certain instances, Headwaters is required to pay to third parties a portion
of license fees received or cash proceeds from the sale of chemical
reagents. In such cases, Headwaters records the net proceeds as revenue.
Revenues from the sales of chemical reagents are recognized upon delivery
of product to the licensee or non-licensee customer.
HTI's revenue consists of contract services for businesses and U.S.
government agencies and is included in the caption "Other revenues" in the
consolidated statements of income. HTI's costs related to this revenue are
included in "Cost of other revenues." In accounting for long-term
contracts, HTI primarily uses the percentage of completion method of
accounting, on the basis of the relationship between effort expended and
total estimated effort for the contract. If estimates of costs to complete
a contract indicate a loss, a provision is made for the total anticipated
loss.
CCP and Construction Materials Segments. Revenue from the sale of CCPs and
construction materials is recognized upon passage of title to the customer,
which generally coincides with physical delivery and acceptance. CCP
revenues also include transportation charges associated with delivering
material to customers when the transportation is contractually provided for
between the customer and ISG. Service revenues include revenues earned
under long-term contracts to dispose of residual materials created by
coal-fired electric power generation and revenues earned in connection with
certain construction-related projects that are incidental to ISG's primary
business. Service revenues under long-term contracts are recognized
concurrently with the removal of the material and are typically based on
the number of tons of material removed at an established price per ton.
Contracts generally range from five to fifteen years, with most contracts
being renewed upon expiration. Construction-related projects are generally
billed on a time and materials basis; therefore, the revenues and related
costs are recognized when the time is incurred and the materials are
consumed.
The cost of CCPs sold primarily represents amounts paid to utility
companies to purchase product together with storage and transportation
costs to deliver the product to customers. In accordance with certain
utility company contracts, the cost of CCPs purchased from those utilities
is based on a percentage of the "net revenues" from the sale of the CCPs
purchased. Cost of services sold includes landfill fees and transportation
charges to deliver the product to the landfill.
Cash and Cash Equivalents - Headwaters considers all highly liquid debt
instruments with an original maturity of three months or less to be cash
equivalents. Certain cash and cash equivalents are deposited with financial
institutions, and at times such amounts may exceed insured depository
limits.
Short-term Investments - Short-term investments consist primarily of
mortgage- and other asset-backed securities, corporate bonds, U.S.
government securities and equity securities. By policy, Headwaters invests
primarily in U.S. government securities or securities backed by the U.S.
government. All investments are defined as trading securities and are
stated at market value as determined by the most recently traded price of
each security at the balance sheet date. Unrealized gains and losses are
included in earnings. Approximately $285,000 of investment gains in 2002
and $7,000 of investment losses in 2003 related to securities held at
September 30, 2002 and 2003, respectively.
Receivables - Allowances are provided for uncollectible accounts when
deemed necessary. Such allowances are based on an account-by-account
analysis of collectibility or impairment. Collateral is not required for
F-10
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
trade receivables, but Headwaters performs periodic credit evaluations of
its customers. Collateral is generally required for notes receivable and
has historically consisted of most or all assets of the debtor.
Inventories - Inventories are stated at the lower of cost or market (net
realizable value). For the CCPs segment, cost is determined using the
first-in, first-out method. For the construction materials and alternative
energy segments, cost is determined using the weighted-average cost method.
Property, Plant and Equipment - Property, plant and equipment are recorded
at cost. Major improvements are capitalized; maintenance, repairs and minor
improvements are charged to expense as incurred. Assets are depreciated
using the straight-line method over their estimated useful lives, limited
to the lease terms for improvements to leased assets. Upon the sale or
retirement of property, plant and equipment, any gain or loss on
disposition is reflected in results of operations, and the related asset
cost and accumulated depreciation are removed from the respective accounts.
Intangible Assets and Goodwill - Intangible assets consist primarily of
identifiable intangible assets obtained in connection with the acquisitions
of ISG (long-term contracts and patents) and HTI (existing patented
technology). These intangible assets are being amortized on the
straight-line method over their remaining estimated useful lives. Goodwill
consists of the excess of the purchase price for ISG and HTI over the fair
value of identified assets acquired, net of liabilities assumed. In
accordance with Statement of Financial Accounting Standards ("SFAS") No.
142, "Accounting for Goodwill and Intangible Assets," goodwill is not
amortized, but is tested at least annually for impairment. Goodwill is
normally tested as of June 30, using a two-step process that begins with an
estimation of the fair value of the reporting unit giving rise to the
goodwill (see Note 8).
Valuation of Long-Lived Assets - Headwaters periodically evaluates the
carrying value of long-lived assets, including intangible assets and
goodwill, as well as the related amortization periods, to determine whether
adjustments to these amounts or to the useful lives are required based on
current events and circumstances. The carrying value of a long-lived asset
is considered impaired when the anticipated cumulative undiscounted cash
flow from that asset is less than its carrying value. In that event, a loss
is recognized based on the amount by which the carrying value exceeds the
fair market value of the long-lived asset. There were no impairment losses
recorded for long-lived assets in any of the years presented.
Debt Issue Costs - Debt issue costs represent direct costs incurred related
to the issuance of the long-term debt used to acquire ISG. These costs are
amortized to interest expense over the lives of the respective debt issues
using the effective interest method.
Equity Investments - In 2001, Headwaters recognized approximately
$2,607,000 of losses related to its equity in investments accounted for
using the equity method. These losses are included in other expense in the
consolidated statement of income. Headwaters has had no equity investments
since 2001.
Research and Development Costs - Research and development costs are
expensed as incurred.
Income Taxes - Headwaters accounts for income taxes using the asset and
liability approach. Headwaters recognizes deferred income tax assets or
liabilities for the expected future tax consequences of events that have
been recognized in the financial statements or income tax returns. Deferred
income tax assets or liabilities are determined based upon the differences
between the financial statement and tax bases of assets and liabilities
using enacted tax rates expected to apply when the differences are expected
to be settled or realized. Deferred income tax assets are reviewed
periodically for recoverability and valuation allowances are provided as
necessary. Headwaters files a consolidated tax return with its
subsidiaries.
Common Stock Options - Headwaters has elected to continue to apply the
intrinsic value method as prescribed by APB 25 in accounting for options
granted to employees, officers and directors and does not currently plan to
change to the fair value method. The alternative fair value method of
accounting prescribed by SFAS No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"), requires the use of option valuation models
that were not developed for use in valuing employee stock options, as
discussed below. Under APB 25, no compensation expense is recognized for
F-11
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
stock option grants to employees, officers and directors when the exercise
price of stock options equals or exceeds the market price of Headwaters'
common stock on the date of grant.
In years prior to 1998, certain options were granted with terms considered
compensatory. In such instances, the related compensation cost is amortized
to expense over the applicable vesting period on a straight-line basis.
Amortized compensation expense related to compensatory options granted in
prior years was approximately $93,000 in 2001 and 2002 and $91,000 in 2003.
If the fair value provision of SFAS No. 123 would have been applied to all
options granted, compensation expense would have been approximately
$2,553,000, $2,479,000 and $4,097,000 for 2001, 2002 and 2003,
respectively, and net income and earnings per share would have been changed
to the pro forma amounts shown in the table below:
(thousands of dollars, except per-share data) 2001 2002 2003
---------------------------------------------------------------- ------------ ------------- ------------
Net income attributable to common stockholders - as reported $21,404 $24,286 $36,631
Pro forma additional compensation expense (2,460) (2,386) (4,006)
------------ ------------- ------------
Net income attributable to common stockholders - pro forma $18,944 $21,900 $32,625
============ ============= ============
Basic earnings per share - as reported $0.94 $1.00 $1.35
- pro forma $0.83 $0.90 $1.20
Diluted earnings per share - as reported $0.87 $0.94 $1.30
- pro forma $0.77 $0.85 $1.16
The fair values of stock option grants for 2001, 2002 and 2003 were
determined using the Black-Scholes option pricing model and the following
assumptions: expected stock price volatility of 40% to 90%, risk-free
interest rates ranging from 1.3% to 5.0%, weighted average expected option
lives of 4 to 5 years, and no dividend yield. The Black-Scholes option
valuation model was developed for use in estimating the fair value of
traded options that have no vesting restrictions and that are fully
transferable. In addition, option valuation models require the input of
highly subjective assumptions including expected stock price volatility.
Because Headwaters' stock options have characteristics significantly
different from those of traded options, and because changes in the
subjective input assumptions can materially affect their fair value, in
management's opinion, the existing models do not necessarily provide a
reliable measure of the fair value of stock options.
Earnings per Share Calculation - Earnings per share has been computed based
on the weighted-average number of common shares outstanding. Diluted
earnings per share computations reflect the increase in weighted-average
common shares outstanding that would result from the assumed exercise of
outstanding stock options and warrants, calculated using the treasury stock
method, and the assumed conversion of convertible securities, using the
if-converted method, where such options, warrants, and convertible
securities are dilutive.
Use of Estimates - The preparation of financial statements in conformity
with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosures of contingent assets and
liabilities at the date of the financial statements, and the reported
amounts of revenue and expenses during the reporting period. Actual results
could differ materially from those estimates.
Recent Accounting Pronouncements - Headwaters has reviewed all recently
issued accounting standards, which have not yet been adopted in order to
determine their potential effect, if any, on the results of operations or
financial position of Headwaters. Based on that review, Headwaters does not
currently believe that any of these recent accounting pronouncements will
have a significant effect on its current or future financial position,
results of operations, cash flows or disclosures.
Reclassifications - Certain prior year amounts have been reclassified to
conform with the current year's presentation. The reclassifications had no
effect on net income or total assets.
F-12
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
3. Acquisitions of ISG and HTI
ISG Acquisition - On September 19, 2002, Headwaters acquired 100% of the
common stock of ISG, assumed or paid off all of ISG's outstanding debt and
redeemed all of ISG's outstanding preferred stock. ISG is the leading
provider of high quality fly ash to the building products and ready mix
concrete industries in the United States. ISG also develops, manufactures
and distributes value-added bagged concrete, stucco, mortar and block
products that utilize fly ash through its construction materials segment.
Headwaters' historical focus has been on using technology to add value to
fossil fuels, particularly coal. The acquisition of ISG provided Headwaters
with a significant position in the last phase of the coal value chain due
to ISG's competencies in managing CCPs. The acquisition of ISG also brought
to Headwaters substantial management depth, comprehensive corporate
infrastructure and critical mass in revenues and operating income.
In order to obtain the cash necessary to acquire ISG and retire the ISG
debt, Headwaters issued $175,000,000 of new debt consisting of $155,000,000
of senior secured debt with a five-year term and a variable interest rate
and $20,000,000 of subordinated debt with an approximate five-year term and
a fixed interest rate (see Note 9). ISG management participated in
one-half, or $10,000,000, of the subordinated debt. Total cash proceeds
from the issuance of new debt, net of debt discounts, was $169,950,000.
Headwaters also incurred approximately $6,200,000 of debt issuance costs to
place the new debt, which had an initial combined effective
weighted-average interest rate of approximately 9.0%.
The following table sets forth the total consideration paid for ISG:
(thousands of dollars and shares, except per-share amount)
---------------------------------------------------------------------------
Fair value of Headwaters stock (2,100 shares at $15.58 per share) $ 32,718
Cash paid to ISG stockholders 32,700
Cash paid to retire ISG debt and related accrued interest 184,638
Costs directly related to acquisition 7,800
--------
$257,856
========
The value of Headwaters' 2,100,000 shares of common stock issued was
determined using the average market price of Headwaters' stock over a
five-day period, consisting of the day the terms of acquisition were agreed
to and announced and two days prior to and two days subsequent to that day.
The ISG acquisition was accounted for using the purchase method of
accounting as required by SFAS No.141, "Business Combinations." Assets
acquired and liabilities assumed were recorded at their estimated fair
values as of September 19, 2002. An adjusted allocation of the purchase
price, which was not materially different from the preliminary allocation,
was completed in 2003. The adjustments made relate primarily to the
completion of property, plant and equipment valuations, income tax returns
for ISG for the period ended September 18, 2002 and certain valuations of
other liabilities acquired. Approximately $109,164,000 of the purchase
price was allocated to identifiable intangible assets consisting primarily
of contracts with coal-fired electric power generation plants and patents.
This amount is being amortized over the estimated combined useful life of
20 years. The remaining purchase price not attributable to the tangible and
identifiable intangible assets was allocated to goodwill, none of which is
tax deductible. All of the intangible assets and all of the goodwill were
allocated to the CCP segment.
F-13
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
The following table sets forth the allocation of the total consideration to
the tangible and intangible assets acquired and liabilities assumed:
(thousands of dollars)
-------------------------------------------------------------------------
Cash $ 19,238
Trade receivables 33,820
Inventory and other assets 11,794
Net property, plant and equipment 48,981
Intangible assets acquired:
Contracts 106,400
Patents 2,764
Goodwill 107,873
Accounts payable and accrued liabilities (24,294)
Net deferred income tax liabilities (48,720)
-------------
Net assets acquired $257,856
=============
HTI Acquisition - In August 2001, Headwaters acquired 100% of the common
stock of HTI, a New Jersey-based company. HTI's activities are directed at
catalyst technologies to convert coal and heavy oil into
environmentally-friendly, higher-value liquid fuels, as well as
nanocatalyst processes and applications. The following table sets forth the
total consideration paid for HTI:
(thousands of dollars and shares, except per-share amounts)
-----------------------------------------------------------------------------------------------------
Fair value of Headwaters stock issued in 2001 (593 shares at $9.25 per share) $ 5,485
Fair value of Headwaters stock issued in 2002 (178 shares at $15.87 per share) 2,823
Fair value of options to purchase 144 shares of Headwaters' common stock issued in
exchange for 152 outstanding vested HTI options 1,325
Cash paid to HTI stockholders 1,814
Cash paid to retire HTI note payable to a bank, plus pre-acquisition loans by
Headwaters to HTI 2,560
Costs directly related to acquisition 1,009
------------
$15,016
============
The value of the 593,000 shares of Headwaters common stock issued at
closing was determined using the average market price of Headwaters' stock
over a three-day period, consisting of the day the terms of acquisition
were agreed to and one day prior to and one day subsequent to that day
($9.25). The value of the 178,000 shares of common stock issued in 2002 was
determined using the average market price of Headwaters' stock over a
three-day period, consisting of the day a final settlement was reached
regarding all outstanding contingent payments and one day prior to and one
day subsequent to that day ($15.87). For purposes of computing the
estimated fair value of the Headwaters stock options issued in exchange for
outstanding HTI options, the Black-Scholes model was used with the
following assumptions: expected stock price volatility of 90%, risk free
interest rates of 3.5% to 4.0%, weighted-average expected option lives of
one to three years, no dividend yield, and a fair value of Headwaters'
stock of $9.25 per share.
The following table sets forth the allocation of the total consideration to
the tangible and intangible assets acquired and liabilities assumed:
(thousands of dollars)
---------------------------------------------------------------------------
Tangible assets acquired, net of liabilities assumed $ 1,388
Intangible assets acquired:
Existing patented technology 9,700
Acquired in-process research and development 2,400
Goodwill 4,258
Net deferred income tax liabilities (2,730)
------------
Net assets acquired $15,016
============
F-14
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
The HTI acquisition was accounted for using the purchase method of
accounting. Assets acquired and liabilities assumed were recorded at their
fair values as of the acquisition date. Approximately $9,700,000 of the
purchase price was allocated to identifiable intangible assets consisting
of existing patented technology with an estimated useful life of 15 years.
Approximately $2,400,000 of the purchase price was allocated to purchased
in-process research and development, consisting primarily of efforts
focused on developing catalysts and catalytic processes to lower the cost
of producing synthetic fuels and chemicals while improving energy
efficiency and reducing environmental risks. This amount represented
projects that had not reached technological feasibility and had no
alternative use as of the acquisition date, and was expensed in 2001.
4. Segment Reporting
Until Headwaters acquired ISG in September 2002, Headwaters operated in and
reported as a single industry segment, alternative energy. With the
acquisition of ISG, Headwaters now operates in three business segments,
alternative energy, CCPs, and construction materials. These segments are
managed and evaluated separately by management based on fundamental
differences in their operations, products and services.
The alternative energy segment includes Headwaters' traditional coal-based
solid synthetic fuels business and HTI's business of developing catalyst
technologies to convert coal and heavy oil into environmentally-friendly,
higher-value liquid fuels, as well as nanocatalyst processes and
applications. Revenues for this segment primarily include sales of chemical
reagents and license fees.
The CCP segment includes ISG's business of providing fly ash to the
building products and ready mix concrete industries. This segment markets
coal combustion products such as fly ash and bottom ash, known as CCPs. ISG
has long-term contracts, primarily with coal-fired electric power
generation plants, pursuant to which it manages the post-combustion
operations for the utilities. ISG markets CCPs to replace manufactured or
mined materials, such as portland cement, lime, agricultural gypsum, fired
lightweight aggregate, granite aggregate and limestone. CCP revenues
consist primarily of the sale of products, with a small amount of service
revenue.
The construction materials segment manufactures and distributes value-added
bagged concrete, stucco, mortar and block products. ISG has introduced high
volumes of CCPs as substitute ingredients in the products the construction
materials segment produces.
The following segment information for 2002 and 2003 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 Note 2. Performance of the segments is evaluated
primarily on operating income. Intersegment sales are immaterial. Segment
costs and expenses considered in deriving segment operating income include
cost of revenues, depreciation and 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 overheads. 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.
F-15
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
2002
--------------------------------------------------------------------
Alternative Construction
(thousands of dollars) Energy CCPs Materials Corporate Totals
------------------------------------------- ------------- ------------ --------------- ------------ ------------
Segment revenue $ 110,753 $ 6,818 $ 1,774 $ -- $ 119,345
============= ============ =============== ============ ============
Depreciation and amortization $ (1,265) $ (380) $ (32) $ (83) $ (1,760)
============= ============ =============== ============ ============
Operating income (loss) $ 48,348 $ 1,514 $ 118 $ (8,946) $ 41,034
============= ============ =============== ============
Net interest income 447
Other income (expense), net (1,245)
Income tax provision (15,950)
------------
Net income $ 24,286
============
Capital expenditures $ 546 $ 236 $ -- $ 14 $ 796
============= ============ =============== ============ ============
Segment assets $ 36,060 $ 286,002 $ 21,869 $ 28,926 $ 372,857
============= ============ =============== ============ ============
2003
--------------------------------------------------------------------
Alternative Construction
(thousands of dollars) Energy CCPs Materials Corporate Totals
------------------------------------------- ------------- ------------ --------------- ------------ ------------
Segment revenue $ 168,342 $ 169,938 $ 49,350 $ -- $ 387,630
============= ============ =============== ============ ============
Depreciation and amortization $ (1,254) $ (10,822) $ (624) $ (282) $ (12,982)
============= ============ =============== ============ ============
Operating income (loss) $ 68,108 $ 16,897 $ 11,036 $ (18,922) $ 77,119
============= ============ =============== ============
Net interest expense (15,377)
Other income (expense), net (1,661)
Income tax provision (23,450)
------------
Net income $ 36,631
============
Capital expenditures $ 166 $ 8,297 $ 732 $ 521 $ 9,716
============= ============ =============== ============ ============
Segment assets $ 34,959 $ 283,916 $ 22,341 $ 32,059 $ 373,275
============= ============ =============== ============ ============
5. Receivables
Activity in the trade receivables allowance account was as follows:
Balance at Charges to Addition Balance at
beginning bad debt from ISG Accounts end of
(thousands of dollars) of period expense acquisition written off period
------------------------------------------- ------------- ------------ ------------- ------------- ------------
Fiscal year ended September 30, 2001 $ -- $ -- $ -- $ -- $ --
Fiscal year ended September 30, 2002 -- -- 412 -- 412
Fiscal year ended September 30, 2003 412 516 -- (351) 577
F-16
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
Notes receivable consisted of the following at September 30:
(thousands of dollars) 2002 2003
--------------------------------------------------------------------------------- ----------- ------------
Unsecured note receivable plus accrued interest arising from the sale of
assets to a limited liability corporation with an effective 6.35%
interest rate (which exceeds the stated rate). Principal, along with
accrued interest, is due in four $500 installments from December 2003
through December 2006. In 2002, Headwaters recorded a gain of approximately
$1,342 on the sale of assets. $1,893 $2,016
Note receivable from a limited liability company, bearing interest at
LIBOR plus 0.9% (2.2% at September 30, 2003) payable quarterly, with
principal due no later than September 2004. This note is collateralized
by certain bridge loans and equity investments sold by Headwaters to this
entity in September 2001. Following payment of the note principal,
Headwaters has the right to receive the first $1,000 plus 20% of any
additional cash received by the limited liability corporation related to
the assets sold by Headwaters. This note is being accounted for on the
cost recovery basis. Impairment losses of approximately $986 and $2,142 were
recorded in 2002 and 2003, respectively, due to declines in the value of the
underlying collateral during those periods. 2,700 504
----------- ------------
$4,593 $2,520
Less amount classified as current -- (500)
----------- ------------
Total long-term notes and accrued interest receivable $4,593 $2,020
=========== ============
Notes receivable generally relate to nonoperating activities and
accordingly, losses are included in other expense in the consolidated
statements of income. Net losses recognized on notes receivable were
approximately $3,658,000 in 2001, $743,000 in 2002 and $2,142,000 in 2003.
Notes and Interest Receivable - Related Parties, Collateralized by Common
Stock - In January 2001, Headwaters accepted from a stockholder as full
satisfaction of a 6%, collateral-based $5,000,000 note receivable, i)
150,000 shares of Headwaters stock and options to acquire 25,000 shares of
Headwaters common stock for $1.50 per share that collateralized the note,
both of which were cancelled, and ii) a new 6% collateralized promissory
note receivable in the principal amount of $1,750,000. Prior to this
transaction, the original note receivable was being carried at the value of
the underlying collateral. In 2001, Headwaters recognized a gain of
approximately $541,000, representing the increase in value of that
collateral from September 30, 2000 to the date the collateral was
surrendered by the stockholder in payment of the note. Headwaters recorded
the new note receivable at $0 due to substantial uncertainty of both the
collectibility of the new note and the value of the new collateral. In
October 2001, a $750,000 payment was received on the new promissory note,
which amount, along with certain other assets, was accepted as full
satisfaction of the new promissory note. The $750,000 gain on this
transaction was recognized in 2002 and recorded as other income. Due to
substantial uncertainty regarding both value and realization, Headwaters
recorded the other assets obtained in that transaction at $0.
6. Inventories
Inventories consisted of the following at September 30:
(thousands of dollars) 2002 2003
----------------------------------------------- ----------- ----------
Raw materials $1,198 $1,059
Finished goods 7,244 6,768
----------- ----------
$8,442 $7,827
=========== ==========
F-17
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
7. Property, Plant and Equipment
Property, plant and equipment consisted of the following at September 30:
Estimated useful
(thousands of dollars) lives 2002 2003
---------------------------------------- ------------------- ----------- ------------
Land and improvements 30 years $ 9,227 $10,428
Buildings and improvements 5 - 40 years 10,488 10,128
Equipment and vehicles 3 - 30 years 28,171 31,090
Construction in progress 3,523 7,793
----------- ------------
51,409 59,439
Less accumulated depreciation (860) (6,696)
----------- ------------
Net property, plant and equipment $50,549 $52,743
=========== ============
Depreciation expense was approximately $93,000 in 2001, $669,000 in 2002
and $6,387,000 in 2003.
8. Intangible Assets and Goodwill
Intangible Assets - With the exception of certain disclosures that were not
permitted to be early implemented, Headwaters implemented SFAS No. 142
effective with the acquisitions of HTI in August 2001 and ISG in September
2002. Effective October 1, 2002, Headwaters fully implemented SFAS No. 142,
which mandates the following disclosures.
Headwaters has no 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:
2002 2003
-------------------------------- --------------------------------
Gross Gross
Estimated Carrying Accumulated Carrying Accumulated
(thousands of dollars) useful lives Amount Amortization Amount Amortization
----------------------------- -------------- --------------- ---------------- --------------- ----------------
ISG contracts 20 years $106,400 $ 179 $106,400 $5,499
HTI patented technologies 15 years 9,700 647 9,700 1,293
ISG patents 7 1/2 years 2,764 4 2,764 373
Other 9 - 10 years 1,522 638 1,522 807
--------------- ---------------- --------------- ----------------
$120,386 $1,468 $120,386 $7,972
=============== ================ =============== ================
Total amortization expense related to intangible assets was approximately
$168,000 in 2001, $998,000 in 2002 and $6,504,000 in 2003. Total estimated
annual amortization expense for fiscal years 2004 through 2007 is
approximately $6,500,000 per year. Total estimated annual amortization
expense for fiscal year 2008 is approximately $6,380,000.
Goodwill - In accordance with the requirements of SFAS No. 142, Headwaters
does not amortize goodwill, all of which relates to the acquisitions of ISG
and HTI. SFAS No. 142 requires Headwaters to periodically perform tests for
goodwill impairment. Step 1 of the initial impairment test was required to
be performed no later than March 31, 2003; thereafter impairment testing is
required to be performed no less often than annually, or sooner if evidence
of possible impairment arises. Impairment testing is performed at the
reporting unit level and Headwaters has identified four reporting units:
(i) the Covol Fuels division and (ii) HTI (which together comprise the
alternative energy segment), (iii) CCPs and (iv) Construction Materials.
Currently, goodwill exists only in the CCPs and HTI reporting units.
Step 1 of impairment testing consists of determining and comparing the fair
values of the reporting units to the carrying values of those reporting
units. If step 1 were to be failed for either the CCPs or HTI reporting
units, indicating a potential impairment, Headwaters would be required to
complete step 2, which is a more detailed test to calculate the implied
fair value of goodwill, and compare that value to the carrying value of the
goodwill. If the carrying value of the goodwill exceeds the implied fair
value of the goodwill, an impairment loss is required to be recorded.
F-18
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
Headwaters performed step 1 impairment tests of the recorded goodwill in
the CCPs and HTI reporting units as of October 1, 2002, the beginning of
fiscal year 2003. Headwaters performed its annual, recurring tests for
potential impairment using the date of June 30, 2003. The tests indicated
that the fair values of the reporting units exceeded their carrying values
as of both October 1, 2002 and June 30, 2003. Accordingly, step 2 of the
impairment tests was not required to be performed, and no impairment charge
was necessary.
9. Liabilities
Other Accrued Liabilities - Other accrued liabilities consisted of the
following at September 30:
(thousands of dollars) 2002 2003
----------------------------------------------------- ---------- ----------
Cost of CCPs and chemical reagents not yet invoiced $ 4,860 $ 5,520
Interest 394 2,420
Income taxes 1,244 1,561
Royalties due to third parties 1,808 1,532
ISG transportation costs 2,542 1,142
Costs related to ISG acquisition 1,201 --
Other 4,917 4,347
---------- ----------
$16,966 $16,522
========== ==========
Long-term Debt - Long-term debt consisted of the following at September 30:
(thousands of dollars) 2002 2003
----------------------------------------------------------------------------- ------------- -----------
Senior secured debt with a face amount totaling $155,000 at September 30,
2002 and $114,851 at September 30, 2003 $ 150,378 $ 111,766
Senior subordinated debentures with a face amount totaling $20,000 19,603 19,682
Other 149 71
------------- -----------
170,130 131,519
Less: current portion (15,578) (27,475)
------------- -----------
Long-term debt $ 154,552 $ 104,044
============= ===========
Senior Secured Debt - In connection with the ISG acquisition, Headwaters
entered into a $175,000,000 senior secured credit agreement with a
syndication of lenders, under which a total of $155,000,000 was borrowed as
a term loan on the acquisition date. The credit agreement also allows up to
$20,000,000 to be borrowed under a revolving credit arrangement. The debt
was issued at a 3% discount and Headwaters received net cash proceeds of
$150,350,000. The original issue discount is being accreted using the
effective interest method and the accretion is recorded as interest
expense. The debt is secured by all assets of Headwaters, bears interest at
a variable rate (approximately 5.4% at September 30, 2003), and is
repayable in quarterly installments through August 30, 2007.
In 2003, principal repayments totaling $40,149,000 were made, including
$25,500,000 of optional prepayments. Subsequent to September 30, 2003 and
through November 30, 2003, principal repayments totaling $9,714,000 have
been made, including optional prepayments of $3,471,000. In certain
situations, for example when Headwaters receives "excess cash flow," as
defined, mandatory prepayments in excess of the scheduled payments are
required. Mandatory prepayments are calculated as a percentage of "excess
cash flow," ranging up to 100%, which percentage is based on Headwaters'
"leverage ratio." When prepayments are made, required principal repayments
for all future periods are reduced.
The credit agreement contains restrictions and covenants common to such
agreements, including limitations on the incurrence of additional debt,
investments, merger and acquisition activity, asset liens, capital
expenditures in excess of $15,000,000 in any fiscal year and the payment of
dividends, among others. In addition, Headwaters must maintain certain
financial ratios, including leverage ratios and in respect of interest
coverage, as those terms are defined in the credit agreement. As of
F-19
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
September 30, 2003, Headwaters must maintain a total leverage ratio of
2.5:1.0 or less. The maximum ratio declines over time until June 30, 2004,
at which time the ratio must remain at 2.0:1.0 or less. There is a similar
leverage ratio requirement for the senior debt alone, which at September
30, 2003 must be 2.0:1.0 or less, declining over time through June 30,
2004, at which time it must be maintained at 1.5:1.0 or less. The interest
coverage requirement at September 30, 2003 was 4.0:1.0 or more. Beginning
December 31, 2003, the ratio must be maintained at a level of 5.0:1.0 or
more. Headwaters is in compliance with all debt covenants as of September
30, 2003.
Under the terms of the senior secured credit agreement, Headwaters may
borrow up to a total of $175,000,000; provided however, except for the
initial $20,000,000 of available revolving credit, the maximum borrowing
limit is permanently reduced by the amount of any repayments of the initial
$155,000,000 term loan borrowed in September 2002. Terms of any additional
borrowings under the credit agreement are generally the same as those
described in the preceding paragraphs. Finally, the credit agreement allows
for the issuance of letters of credit, provided there is capacity under the
revolving credit arrangement. Currently two letters of credit totaling
$1,970,000 are outstanding, with expiration dates in March 2004 and
November 2004. There have been no other letters of credit issued and no
funds have been borrowed under the revolving credit arrangement. Headwaters
pays a fee of 5/8% on the unused portion of the revolving credit
arrangement.
Senior Subordinated Debentures - In connection with the ISG acquisition,
Headwaters also entered into a $20,000,000 subordinated loan agreement,
under which senior subordinated debentures were issued at a 2% discount,
with Headwaters receiving net cash proceeds of $19,600,000. The original
issue discount is being accreted using the effective interest method and
the accretion is recorded as interest expense. ISG management participated
in one-half, or $10,000,000, of the $20,000,000 of debt issued. The other
half was issued to a corporation. The debt is not secured, bears interest
at a rate of 18% per annum payable quarterly, and is due on September 16,
2007. It is senior to all other debt except the senior secured debt
described previously. The debt agreement allows for optional prepayments.
Any prepayments paid to the corporation are subject to a prepayment charge,
which ranges from 5% of the principal prepaid in the first year to 1% of
the principal prepaid in the last year of the five-year term of the
subordinated loan agreement.
The loan agreement contains restrictions and covenants common to such
agreements, and these are generally consistent with those described above
for the senior secured debt. As of September 30, 2003, Headwaters must
maintain a total leverage ratio of 2.75:1.0 or less. The maximum ratio
declines over time until June 2004, at which time the ratio must remain at
2.25:1.0 or less. The interest coverage requirement at September 30, 2003
was 3.75:1.0 or more. Beginning in December 2003, the ratio must be
maintained at a level of 4.75:1.0 or more. Headwaters is in compliance with
all debt covenants as of September 30, 2003.
Interest Rates and Debt Maturities - The weighted-average interest rate on
the face amount of outstanding long-term debt, disregarding amortization of
debt issue costs and debt discount, was approximately 7.3% at September 30,
2002 and 7.2% at September 30, 2003. Future maturities of long-term debt as
of September 30, 2003 were as follows:
(thousands
Year ending September 30, of dollars)
---------------------------------- -------------
2004 $ 27,475
2005 24,985
2006 24,987
2007 57,474
2008 1
-------------
Total cash payments 134,922
Unamortized debt discount (3,403)
-------------
Net carrying value $131,519
=============
Interest Costs - As a result of the early repayments of principal totaling
$25,500,000 in 2003, additional non-cash interest expense of approximately
$1,458,000 was incurred, representing accelerated amortization of debt
discount and debt issue costs associated with those principal amounts.
F-20
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
During 2001, Headwaters incurred total interest costs of approximately
$224,000, including approximately $79,000 of non-cash interest expense.
During 2002, Headwaters incurred total interest costs of approximately
$553,000, including approximately $136,000 of non-cash interest expense.
During 2003, Headwaters incurred total interest costs of approximately
$15,917,000, including approximately $3,857,000 of non-cash interest
expense and approximately $230,000 of interest costs that were capitalized.
No interest costs were capitalized in 2001 or 2002.
10. Fair Value of Financial Instruments
Headwaters' financial instruments consist primarily of cash and cash
equivalents, short-term investments, trade and notes receivable, accounts
payable and long-term debt. All of these financial instruments except
long-term debt are either carried at fair value in the balance sheet or are
of a short-term nature. Accordingly, the carrying values for these
financial instruments as reflected in the consolidated balance sheets
closely approximated their fair values.
Substantially all of Headwaters' long-term debt consists of debt issued in
connection with the ISG acquisition in September 2002. Due to the short
amount of time that elapsed between the issuance of the debt in September
2002 and September 30, 2002, the fair value of outstanding debt as of
September 30, 2002 was deemed to approximate the face value of the debt as
of that date, or approximately $175,000,000. If all of Headwaters'
outstanding debt carried an average interest rate of 7%, management's
estimate of the market interest rate as of September 30, 2003, the fair
value of Headwaters' total long-term debt at September 30, 2003 would be
approximately $131,500,000.
11. Income Taxes
In 2001, Headwaters reported a net income tax benefit of $7,049,000,
consisting of the recognition of $7,470,000 of its deferred tax asset,
reduced by $100,000 of federal alternative minimum tax and $321,000 of
current state income tax expense. Headwaters recorded income tax provisions
with an effective tax rate of approximately 40% and 39% in 2002 and 2003,
respectively.
The income tax provision (benefit) consisted of the following for the years
ended September 30:
(thousands of dollars) 2001 2002 2003
--------------------------------------------------------- ------------- ------------- -------------
Current tax provision:
Federal $ 100 $ 3,490 $20,726
State 321 920 3,602
------------- ------------- -------------
Total current tax provision 421 4,410 24,328
Deferred tax provision (benefit):
Federal (7,870) 9,720 (774)
State 400 1,820 (104)
------------- ------------- -------------
Total deferred tax provision (benefit) (7,470) 11,540 (878)
------------- ------------- -------------
Total income tax provision (benefit) $(7,049) $15,950 $23,450
============= ============= =============
As of September 30, 2001, Headwaters had net operating loss carryforwards
("NOLs") of approximately $24,000,000 and research and development tax
credit carryforwards of approximately $220,000 for federal income tax
purposes. During 2002, Headwaters utilized all of those NOLs and tax credit
carryforwards except for approximately $935,000 of HTI's acquisition date
NOLs that were subject to an annual limitation following HTI's change in
ownership. As of September 30, 2003, Headwaters has NOLs for federal income
tax purposes of approximately $150,000, all of which are expected to be
utilized in 2004.
F-21
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
The provision (benefit) for income taxes differs from the statutory federal
income tax rate due to the following:
(thousands of dollars) 2001 2002 2003
--------------------------------------------------------- ------------- ------------- -------------
Tax provision at 35% statutory rate $ 5,064 $ 14,083 $ 21,028
State income taxes, net of federal tax effect 470 1,780 2,352
Change in valuation allowance (14,200) -- --
Alternative minimum tax 100 -- --
Acquired in-process research and development 918 -- --
Other, primarily redetermination of prior years'
tax estimates 599 87 70
------------- ------------- -------------
Income tax provision (benefit) $ (7,049) $ 15,950 $ 23,450
============= ============= =============
The valuation allowance decreased by $14,200,000 during 2001, primarily due
to results of operations in 2001 and expected future results of operations
as of September 30, 2001. The components of Headwaters' deferred income tax
assets and liabilities were as follows as of September 30:
(thousands of dollars) 2002 2003
--------------------------------------------------------- ------------- -------------
Deferred tax assets:
Unamortized non-refundable license fees $ 2,491 $ 1,885
Write-down of notes receivable 760 1,606
Estimated liabilities 2,103 1,430
Federal and state net operating loss carryforwards 411 424
Allowance for bad debts 164 224
Other -- 225
------------- -------------
Total deferred tax assets 5,929 5,794
------------- -------------
Deferred tax liabilities:
Intangible assets (45,128) (44,439)
Property, plant and equipment (7,401) (7,679)
Other (2,943) (3,628)
------------- -------------
Total deferred tax liabilities (55,472) (55,746)
------------- -------------
Net deferred tax liability $ (49,543) $ (49,952)
============= =============
12. Stockholders' Equity
Preferred Stock - In 2001, all of the outstanding shares of convertible
preferred stock, consisting of 3,000 shares of Series A and 14,310 shares
of Series B, were converted into a total of approximately 443,000 shares of
common stock, representing a conversion price of $7.00 per common share.
Headwaters paid the accrued but undeclared dividends of approximately
$695,000 in cash rather than allowing conversion into common stock at a
price below market. Headwaters has 10,000,000 shares of authorized
preferred stock, none of which was issued or outstanding as of September
30, 2002 or 2003.
Stock Options - As of September 30, 2003, Headwaters had three stock option
plans (the "Option Plans") under which 4,250,000 shares of common stock
were reserved for ultimate issuance. As of September 30, 2003, options for
approximately 424,000 shares of common stock could be granted under the
Plans. A committee of Headwaters' Board of Directors (the "Committee"), or
in its absence the Board, administers and interprets the Option Plans. This
Committee is authorized to grant options and other awards both under the
Option Plans and outside the Option Plans to eligible employees, officers,
directors, and consultants of Headwaters. Two of the Option Plans provide
for the granting of both incentive stock options and non-statutory stock
options; the other Option Plan provides only for the granting of
non-statutory stock options. Terms of options granted under the Option
Plans, including vesting requirements, are determined by the Committee.
Options granted under the Option Plans vest over periods ranging up to ten
years, expire ten years from the date of grant and are not transferable
other than by will or by the laws of descent and distribution. Incentive
stock option grants must meet the requirements of the Internal Revenue
Code.
F-22
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
The following table is a summary of activity for all of Headwaters' stock
options, including options not granted under the Option Plans, for the
years ended September 30:
2001 2002 2003
----------------------- ---------------------- -----------------------
Weighted- Weighted- Weighted-
average average average
exercise exercise exercise
(thousands of shares) Shares price Shares price Shares price
---------------------------------------- ---------- ------------ --------- ------------ ---------- ------------
Outstanding at beginning of year 3,822 $5.16 3,283 $ 5.80 2,990 $ 7.56
Granted 251 9.15 611 13.38 1,188 16.45
Granted in exchange for HTI options 144 0.07 -- -- -- --
Exercised (822) 2.42 (852) 5.02 (514) 4.05
Canceled (112) 8.42 (52) 6.60 (49) 14.48
---------- ------------ --------- ------------ ---------- ------------
Outstanding at end of year 3,283 $5.80 2,990 $ 7.56 3,615 $10.88
========== ============ ========= ============ ========== ============
Exercisable at end of year 2,171 $5.70 1,898 $ 6.08 1,992 $ 7.51
========== ============ ========= ============ ========== ============
Weighted-average fair value of options
granted during the year below market $9.18 none none
Weighted-average fair value of options
granted during the year at market $5.20 $ 7.35 $ 7.16
Weighted-average fair value of options
granted during the year above market none none none
The following table summarizes information about all stock options
outstanding at September 30, 2003:
(thousands of
shares) Outstanding options Exercisable options
--------------------- ------------------------------------------------- ----------------------------
Number Weighted-average Weighted- Number Weighted-
outstanding at remaining average exercisable at average
Range of exercise September 30, contractual life exercise September 30, exercise
prices 2003 in years price 2003 price
--------------------- ----------------- ----------------- ------------- --------------- ------------
$0.01 to $4.13 820 3.2 $ 2.88 783 $ 2.94
$5.00 to $11.50 602 5.2 7.10 520 6.81
$12.63 to $12.97 642 5.8 12.86 496 12.90
$13.56 to $15.48 689 8.9 14.25 193 14.01
$16.89 to $16.97 862 9.3 16.93 0 0.00
----------------- ---------------
3,615 1,992
================= ===============
Common Stock Warrants - As of September 30, 2003, there were warrants
outstanding for the purchase of approximately 56,000 shares of common stock
at a price of $1.56 per share. The warrants expire in March 2005.
F-23
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
Stockholder Approval of Options and Warrants - The following table presents
information related to stockholder approval of options and warrants, as of
September 30, 2003.
(thousands of shares)
---------------------------------- ----------------------- -------------------------- ------------------------------
Shares to be issued Weighted-average Shares remaining available
upon exercise of exercise price of for future issuance under
Plan Category options and warrants outstanding options and existing equity compensation
warrants plans
---------------------------------- ----------------------- -------------------------- ------------------------------
Option plans approved by
stockholders 2,386 $10.23 386
Option plans and warrants
not approved by stockholders 1,285 11.67 38
----------------------- -------------------------- ------------------------------
Total 3,671 $10.73 424
======================= ========================== ==============================
As discussed above, Headwaters has three primary stock option plans under
which options have been granted. Headwaters has also issued options and
warrants not covered by any plan. Stockholders have approved two of the
three primary stock option plans; stockholders have not approved the other
stock option plan. The amounts included in the caption "not approved by
stockholders" in the above table represent amounts applicable under i) the
stock option plan not approved by stockholders, ii) all stock options
granted outside of any stock option plan, and iii) all outstanding
warrants.
13. Earnings per Share
The following table sets forth the computation of basic and diluted
earnings per share for the years ended September 30:
(thousands of dollars and shares, except per-share data) 2001 2002 2003
------------------------------------------------------------------ ------------ ----------- -----------
Numerator:
Net income $ 21,517 $ 24,286 $ 36,631
Undeclared preferred stock dividends (113) -- --
------------ ----------- -----------
Numerator for basic earnings per share - net income attributable
to common stockholders 21,404 24,286 36,631
Effect of dilutive securities - preferred stock dividends 113 -- --
------------ ----------- -----------
Numerator for diluted earnings per share - net income
attributable to common stockholders after assumed conversions $ 21,517 $ 24,286 $ 36,631
============ =========== ===========
Denominator:
Denominator for basic earnings per share - weighted-average
shares outstanding 22,787 24,234 27,083
Effect of dilutive securities:
Shares issuable upon exercise of options and warrants 1,582 1,491 1,112
Shares issuable upon conversion of preferred stock 268 -- --
------------ ----------- -----------
Total dilutive potential shares 1,850 1,491 1,112
------------ ----------- -----------
Denominator for diluted earnings per share - weighted-average
shares outstanding after assumed exercises and conversions 24,637 25,725 28,195
============ =========== ===========
Basic earnings per share $ 0.94 $ 1.00 $ 1.35
============ =========== ===========
Diluted earnings per share $ 0.87 $ 0.94 $ 1.30
============ =========== ===========
During the periods presented, Headwaters' potentially dilutive securities
consisted only of options and warrants for the purchase of common stock
and, for 2001only, convertible preferred stock. Anti-dilutive securities
not considered in the diluted earnings per share calculation totaled
approximately 1,375,000 shares in 2001, 210,000 shares in 2002 and 655,000
shares in 2003.
F-24
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
14. Commitments and Contingencies
Commitments and contingencies as of September 30, 2003 not disclosed
elsewhere, are as follows:
Leases - Rental expense was approximately $204,000 in 2001, $720,000 in
2002 and $11,999,000 in 2003. Headwaters has noncancellable operating
leases for certain facilities and equipment. Most of these leases have
renewal terms and expire in various years through 2017. As of September 30,
2003, minimum rental payments due under these leases are as follows:
(thousands
Year ending September 30: of dollars)
----------------------------- ------------------
2004 $10,841
2005 8,286
2006 6,290
2007 5,091
2008 2,691
Thereafter 4,815
------------------
$38,014
==================
Sale, Purchase and Royalty Commitments - Certain ISG contracts with its
customers and suppliers require ISG to make minimum sales and purchases.
Actual sales and purchases under contracts with minimum requirements were
$895,000 and $11,446,000, respectively, for 2003. At September 30, 2003,
these minimum requirements are as follows:
(thousands of dollars)
------------------------------
Minimum Minimum
Year ending September 30: sales purchases
------------------------------ -------------- ---------------
2004 $ 599 $10,622
2005 615 7,614
2006 515 3,915
2007 375 2,930
2008 375 2,940
Thereafter 438 7,717
-------------- ---------------
$2,917 $35,738
============== ===============
Subsequent to September 30, 2003, one of ISG's minimum purchase contracts
was amended. The amendment extended the term of the contract for several
years and increased ISG's total future minimum purchase requirements by
approximately $17,925,000 during 2004 through 2011.
ISG has a minimum royalty commitment on certain net sales for calendar
2003. Remaining minimum royalty commitments as of September 30, 2003 total
approximately $125,000. If ISG continues the royalty agreement with the
licensor beyond 2003, minimum royalty payments will be $500,000 per year.
If ISG terminates the royalty agreement, a one-time payment of $500,000 is
required.
Employee Benefit Plans - Headwaters' Board of Directors has approved three
employee benefit plans that were operative during 2001, 2002 and 2003: the
Headwaters Incorporated 401(k) Profit Sharing Plan, the 2000 Employee Stock
Purchase Plan, and the Headwaters Incorporated Incentive Bonus Plan.
Substantially all employees of Headwaters are eligible to participate in
the 401(k) and Stock Purchase Plans after meeting certain age and length of
employment requirements. Only designated employees are eligible to
participate in the Incentive Bonus Plan.
401(k) Plan. Under the terms of the 401(k) Plan, eligible employees may
elect to make tax-deferred contributions of up to 50% of their
compensation, subject to statutory limitations. Headwaters matches employee
contributions up to a specified maximum rate and these matching
contributions vest after a three-year period. Headwaters is not required to
be profitable to make matching contributions.
F-25
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
Stock Purchase Plan. The 2000 Employee Stock Purchase Plan provides
eligible employees with an opportunity to increase their proprietary
interest in Headwaters by purchasing Headwaters common stock on favorable
terms and to pay for such purchases through payroll deductions. A total of
500,000 shares of common stock were initially reserved for issuance under
the Plan, and approximately 360,000 shares are available for future
issuance as of September 30, 2003. Under the Plan, employees purchase
shares of stock directly from Headwaters, which shares are made available
primarily from treasury shares repurchased on the open market or from
authorized but unissued shares, if necessary. The Plan is intended to
comply with Section 423 of the Internal Revenue Code, but is not subject to
the requirements of ERISA. Employees purchase stock through payroll
deductions of 1% to 10% of cash compensation, subject to certain
limitations. The stock is purchased in a series of quarterly offerings. The
cost per share to the employee is 85% of the lesser of the fair market
value at the beginning or the end of the offering period.
Incentive Bonus Plan. The Incentive Bonus Plan, approved annually by the
Compensation Committee of the Board of Directors, provides for annual cash
bonuses to be paid if Headwaters accomplishes certain financial goals and
if participating employees meet individual goals. A participant's cash
bonus is based on Headwaters' success in meeting specified financial
performance targets approved by the Compensation Committee of the Board of
Directors, the employee's base pay, and individual performance during the
year. Headwaters' financial goals are based upon an economic value added
concept ("EVA") that purports to more closely align with a company's share
price performance than other measurements of performance.
Total expense for all of these benefit plans combined was approximately
$2,082,000 in 2001, $3,300,000 in 2002 and $5,768,000 in 2003. Subsequent
to September 30, 2003, Headwaters' Board of Directors approved a General
Employee Bonus Plan covering substantially all employees not otherwise
eligible to participate in any other performance-based bonus compensation
arrangement (including the Incentive Bonus Plan described above and sales
commission arrangements). A participant's cash bonus is based on the
employee's base pay and individual performance during the year.
Medical Insurance - Effective January 1, 2003, Headwaters adopted a
self-insured medical insurance plan for employees of all of its
subsidiaries. This plan has stop-loss coverage for amounts in excess of
$75,000 per individual and approximately $6,000,000 in the aggregate for
the plan year ending December 31, 2003. Headwaters has contracted with a
third-party administrator to assist in the payment and administration of
claims. Insurance claims are recognized as expenses when incurred and
include an estimate of costs for claims incurred but not reported at the
balance sheet date. As of September 30, 2003, approximately $924,000 is
accrued for claims incurred from January though September 30, 2003 that
have not been paid.
Employment Agreements - Headwaters and its subsidiaries have entered into
employment agreements with its Chief Executive Officer and 18 other
officers and employees. The agreements have original terms ranging from two
to five years and are generally renewable by Headwaters, usually for
one-year terms. They provide for annual salaries currently ranging from
approximately $65,000 to $400,000 annually per person. The annual
commitment under all agreements combined is currently approximately
$2,800,000. All agreements provide for termination benefits, ranging from
at least six months' salary, up to a maximum period equal to the remaining
term of the agreement.
Incentive Agreements with ISG Principals - In January 2003, Headwaters
executed incentive agreements, with an effective date of November 2002,
with three of the former stockholders and officers of ISG, all of whom were
officers of either Headwaters or ISG following the ISG acquisition. The
agreements called for contingent payments totaling up to $5,000,000 in the
event of (i) a change in control, as defined, or (ii) continuing employment
through September 2004 and an increase in the average stock price for
Headwaters' common stock for any calendar quarter exceeding $20 per share.
The maximum payments would be required if there were a change in control
prior to October 2004, or if the officers remain employed through September
2004 and the average stock price for any calendar quarter reaches $25 per
share or more. Subsequent to September 30, 2003, two of the three officers
resigned their positions. As a result, the maximum payment that could now
be required under the remaining incentive agreement is $1,500,000.
Property, Plant and Equipment - As of September 30, 2003, Headwaters was
committed to spend approximately $6,000,000 to complete capital projects
that were in various stages of completion.
F-26
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
Legal or Contractual Matters - Headwaters has ongoing litigation and claims
incurred during the normal course of business, including the items
discussed below. Headwaters intends to vigorously defend and/or pursue its
rights in these actions. Management does not currently believe that the
outcome of these actions will have a material adverse effect on Headwaters'
operations, cash flows or financial position; however, it is possible that
a change in the estimates of probable liability could occur, and the change
could be significant. Additionally, as with any litigation, these
proceedings will require that Headwaters incur substantial costs, including
attorneys' fees, managerial time, and other personnel resources and costs
in pursuing resolution.
Adtech. 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.) In September 2000,
Headwaters received a summons and complaint from the United States District
Court for the Western District of Tennessee filed by Adtech, Inc. against
Davidson and Headwaters. In the action, certain purported officers and
directors of Adtech alleged that the technology purchase transaction was an
unauthorized corporate action and that Davidson and Headwaters conspired
together to affect the transfer. In August 2001, the trial court granted
Headwaters' motion to dismiss the complaint. Plaintiffs appealed the case
to the Sixth Circuit Court of Appeals. In 2002, the Sixth Circuit Court of
Appeals issued an order i) affirming the District Court's judgment and
order of dismissal, and ii) transferring to the Federal Circuit Court of
Appeals plaintiff's appeal of the District Court's order denying the motion
for relief from judgment. The Federal Circuit Court of Appeals has affirmed
the District Court's order denying the motion for relief from judgment and
the case is now fully resolved.
Boynton. This action is factually related to the Adtech matter. In the
Adtech case, the alleged claims are asserted by certain purported officers
and directors of Adtech, Inc. In the Boynton 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
complaint seeks declaratory relief and compensatory and punitive damages.
Because the resolution of the litigation is uncertain, legal counsel cannot
express an opinion as to the ultimate amount, if any, of Headwaters'
liability.
AGTC. In March 1996, Headwaters entered into an agreement with AGTC and its
associates for certain services related to the identification and selection
of synthetic fuel projects. In March 2002, AGTC filed an arbitration demand
claiming that it is owed a commission under the 1996 agreement for 8% of
the revenues received by Headwaters from the Port Hodder project.
Headwaters asserts that AGTC did not perform under the agreement and that
the agreement was terminated and the disputes were settled in July 1996.
Headwaters has filed an answer in the arbitration, denying AGTC's claims
and has asserted counterclaims against AGTC. Because the resolution of the
arbitration is uncertain, legal counsel cannot express an opinion as to the
ultimate amount, if any, of Headwaters' liability.
AJG. In December 1996, Headwaters entered into a technology license and
proprietary chemical reagent sale agreement with AJG Financial Services,
Inc. The agreement called for AJG to pay royalties and to purchase
proprietary chemical reagent material from Headwaters. In October 2000,
Headwaters filed a complaint in the Fourth District Court for the State of
Utah against AJG alleging that it had failed to make payments and to
perform other obligations under the agreement. Headwaters asserts claims
including breach of contract, declaratory judgment, unjust enrichment and
accounting and seeks money damages as well as other relief. AJG's answer to
the complaint denied Headwaters' claims and asserted counter-claims based
upon allegations of misrepresentation and breach of contract. AJG seeks
compensatory damages as well as punitive damages. Headwaters has denied the
allegations of AJG's counter-claims. Because the resolution of the
litigation is uncertain, legal counsel cannot express an opinion as to the
ultimate amount of recovery or liability.
F-27
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
Nalco. In October 2000, Headwaters filed a complaint in the United States
District Court for the District of Utah against Nalco Chemical Company
("Nalco"). Headwaters alleged that Nalco, by its sale and marketing of
materials for use in creating synthetic fuel, breached a non-disclosure
agreement, misappropriated trade secrets, and violated patent rights of
Headwaters. Nalco filed an answer denying the allegations in the complaint
and asserting counter-claims alleging patent invalidity, antitrust
violations, and interference with economic relations. Headwaters denied the
counter-claims. Effective in January 2003, the parties settled the dispute
and the case was dismissed. There was no material effect on Headwaters'
operations, cash flows or financial position as a result of the settlement.
ISG Matters. There is litigation and pending and threatened claims made
against certain subsidiaries of ISG with respect to several types of
exterior stucco finish systems manufactured and/or sold by its subsidiaries
for application by contractors, developers and owners on residential and
commercial buildings. This litigation and these claims are controlled by
such subsidiaries' insurance carriers. The plaintiffs and/or claimants in
these matters have alleged that due to some failure of the stucco system
itself and/or its application, the buildings have suffered damage due to
the progressive, latent effects of water penetration through the building's
exterior. The most prevalent type of claim involves alleged defects
associated with an artificial stucco system manufactured by one of ISG's
subsidiaries, Best Masonry. Best Masonry continued to manufacture this
system through 1997, and 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
injury 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 provided "reservation of
rights" letters. None of the cases has gone to trial, and while two such
cases involve 100 and 800 homes, respectively, none of the cases includes
any claims formally asserted on behalf of a class. While, to date, none of
these proceedings have required that ISG incur substantial costs, there is
no guarantee of coverage or continuing coverage. These and future
proceedings may result in substantial costs to ISG, including attorneys'
fees, managerial time and other personnel resources and costs. Adverse
resolution of these proceedings could have a materially negative effect on
ISG's business, financial condition and results of operation, and its
ability to meet its financial obligations. Although ISG carries general and
product liability insurance, ISG cannot assure that such insurance coverage
will remain available, that ISG's insurance carrier will remain viable or
that the insured amounts will cover all future claims in excess of ISG's
uninsured retention. Future rate increases may also make such insurance
uneconomical for ISG to maintain. In addition, the insurance policies
maintained by ISG exclude claims for damages resulting from exterior
insulating finish systems, or EIFS, that have manifested after March 2003.
Because much of the litigation and claims are at an early stage and
resolution is uncertain, legal counsel cannot express an opinion as to the
ultimate amount, if any, of the liability resulting to Headwaters.
Former Director. Headwaters granted stock options to a member of its board
of directors in 1995. The director resigned from the board in 1996.
Headwaters believes that most of the former director's options terminated
unexercised. The former director has claimed that he is entitled to
exercise the options. No lawsuit has been filed in this matter. Resolution
is uncertain and legal counsel cannot express an opinion as to the ultimate
amount, if any, of Headwaters' liability.
Other. Headwaters and its subsidiaries are also involved in other legal
perceedings that have arisen in the normal course of business.
Favorable Resolution to Section 29 Examination by the IRS - An essential
element for the production of qualified solid synthetic fuel under Section
29 of the Internal Revenue Code requires that coal undergo significant
chemical change. In June 2003, the IRS issued Announcement 2003-46 which
stated that the IRS "had reason to question the scientific validity of test
procedures and results that have been presented as evidence that fuel
underwent a significant chemical change, and is currently reviewing
information regarding these test procedures and results." At the same time,
the IRS announced that the issuance of new private letter rulings ("PLRs")
regarding significant chemical change would be suspended during its review.
PLRs from the IRS are requested by taxpayers to gain assurance that the tax
treatment proposed by the taxpayer is acceptable to the IRS.
F-28
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
The June 2003 IRS announcement caused certain Headwaters licensees to
temporarily reduce or stop synthetic fuel production, which caused a
decline in reagent sold and license fees, resulting in a material negative
impact on Headwaters' revenue and net income for the September 2003
quarter. In response to the IRS review, Headwaters joined with industry
participants and government officials to address the actions and concerns
of the IRS. On October 29, 2003, the IRS issued Announcement 2003-70,
stating that it would resume its issuance of PLRs on significant chemical
change. Announcement 2003-70 also provides that the industry's chemical
change test procedures and results are scientifically valid if
appropriately applied.
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, stating: "The Subcommittee has initiated an investigation of
potential abuses of tax credits of producers of synthetic fuel under
Section 29 of the Internal Revenue Code. The Subcommittee anticipates that
this investigation will focus on whether certain synthetic fuel producers
are claiming tax credits under Section 29, even though their product is not
a qualified synthetic fuel under Section 29 and IRS regulations. In
addition, the investigation will address whether certain corporations are
engaging in transactions solely to take advantage of unused Section 29
credits, with no other business purpose. Lastly, the investigation will
address the IRS's efforts to curb abuses related to the Section 29 tax
credits."
The effect that the Senate subcommittee investigation of synthetic fuel tax
credits may have on the industry is unknown. While the investigation is
pending, buyers may be unwilling to engage in transactions to purchase
synthetic fuel facilities. If current owners are unable to sell their
facilities, production may not be maximized, materially adversely affecting
Headwaters' revenues.
License Fees - Pursuant to the contractual terms of an agreement with a
certain licensee, the cumulative license fees owed to Headwaters have been
placed in escrow for the benefit of Headwaters pending resolution of
certain contingencies. Headwaters currently expects the escrowed amounts to
increase as additional license fees are generated and that most, if not
all, of such amounts will be recognized as revenue at some future date. As
of September 30, 2003, the license fees, net of anticipated expenses, total
approximately $20,000,000. Certain accounting rules governing revenue
recognition require that the seller's price to the buyer be "fixed or
determinable" as well as reasonably certain of collection. In this
situation, those rules appear to currently preclude revenue recognition.
Accordingly, none of the escrowed amounts have been recognized as revenue
in the consolidated statements of income. In addition to these escrowed
amounts, this same licensee has also set aside substantial amounts for
various operational contingencies as provided for in the contractual
agreements. These reserves, if not needed, will eventually be paid out to
various parties having an interest in the cash flows from the licensee's
operations, including Headwaters. 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 therefore, not recognizable.
15. SEC Shelf Registration
Headwaters has an effective $150,000,000 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. The most
likely use of the shelf registration statement would be to issue equity
securities to reduce long-term debt and for general corporate purposes,
including acquisitions. A prospectus supplement describing the terms of any
securities to be issued is required to be filed before any offering would
commence under the registration statement.
16. Related Party Transactions
In addition to related party transactions disclosed elsewhere, Headwaters
purchases certain insurance benefits for its employees from various
companies for which a director of Headwaters acts as a broker or agent.
Gross payments to those insurance companies totaled approximately $381,000
in 2001, $532,000 in 2002 and $510,000 in 2003.
F-29
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2003
___________
17. Quarterly Financial Data (unaudited)
Summarized unaudited quarterly financial data for 2002 and 2003 is as
follows:
2002
----------------------------------------------------------------
First Second Third Fourth
(thousands of dollars, except per-share data) quarter quarter quarter quarter (2) Full year
---------------------------------------------- ----------- ------------ ------------ ------------- ------------
Net revenue $18,422 $25,256 $31,968 $43,699 $119,345
Gross profit (1) 10,212 11,503 15,661 20,853 58,229
Net income (2) 4,727 5,459 6,736 7,364 24,286
Basic earnings per share 0.20 0.23 0.27 0.30 1.00
Diluted earnings per share 0.19 0.21 0.26 0.28 0.94
2003
----------------------------------------------------------------
First Second Third Fourth
(thousands of dollars, except per-share data) quarter quarter quarter quarter (3) Full year
---------------------------------------------- ----------- ------------ ------------ ------------- ------------
Net revenue $88,709 $86,053 $106,396 $106,472 $387,630
Gross profit (1) 30,733 29,394 34,974 34,284 129,385
Net income (3) 8,052 6,789 10,544 11,246 36,631
Basic earnings per share 0.30 0.25 0.39 0.41 1.35
Diluted earnings per share 0.29 0.24 0.37 0.40 1.30
- -----------------------
(1) Gross profit is derived by subtracting cost of revenues and industry
segment depreciation expense from total revenue.
(2) In the fourth quarter of 2002, Headwaters recorded approximately $2,568,000
of losses related to the write-off of deferred project / financing costs
incurred in 2002 because management decided not to pursue the proposed
projects / financings. Also, Headwaters recorded an impairment loss of
approximately $986,000 related to a note receivable (see Note 5).
(3) In the fourth quarter of 2003, revenue and net income were negatively
affected by IRS actions (see Note 14 - Favorable Resolution to Section 29
Examination by the IRS). Also in the fourth quarter of 2003, Headwaters
recorded income tax expense at an effective income tax rate of
approximately 37%, compared to an effective income tax rate of
approximately 40% for the first nine months of the year. The lower rate for
the fourth quarter was required to reduce the effective income tax rate for
the year to approximately 39%. This reduction was primarily a result of
lower expected state income tax expense.
F-30