UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 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
-----------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 87-0547337
- --------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
10653 South River Front Parkway, Suite 300
South Jordan, Utah 84095
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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)
Not applicable
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(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
The number of shares outstanding of the Registrant's common stock as of January
31, 2004 was 33,202,247.
HEADWATERS INCORPORATED
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Page No.
ITEM 1. FINANCIAL STATEMENTS (Unaudited):
Condensed Consolidated Balance Sheets - As of
September 30, 2003 and December 31, 2003 ................... 3
Condensed Consolidated Statements of Income - For the
three months ended December 31, 2002 and 2003 .............. 4
Condensed Consolidated Statement of Changes in
Stockholders' Equity - For the three months ended
December 31, 2003........................................... 5
Condensed Consolidated Statements of Cash Flows - For the
three months ended December 31, 2002 and 2003............... 6
Notes to Condensed Consolidated Financial Statements ......... 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS......................... 16
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.... 20
ITEM 4. CONTROLS AND PROCEDURES....................................... 20
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS ............................................ 21
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS .................... 21
ITEM 3. DEFAULTS UPON SENIOR SECURITIES .............................. 21
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS .......... 21
ITEM 5. OTHER INFORMATION............................................. 21
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ............................. 21
SIGNATURES.................................................................. 23
Forward-looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995 regarding
future events and our future results that are based on current expectations,
estimates, forecasts, and projections about the industries in which we operate
and the beliefs and assumptions of our management. Actual results may vary
materially from such expectations. Words such as "expects," "anticipates,"
"targets," "goals," "projects," "believes," "seeks," "estimates," 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 of our Annual Report on Form 10-K for the year ended
September 30, 2003. 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.
2
ITEM 1. FINANCIAL STATEMENTS
- -----------------------------
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, December 31,
(in thousands, except per-share data) 2003 2003
- --------------------------------------------------------------------------------------------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 18,732 $ 21,600
Short-term trading investments 2,921 34,632
Trade receivables, net 52,399 51,679
Inventories 7,827 9,217
Other current assets 6,005 5,188
---------------- ---------------
Total current assets 87,884 122,316
---------------- ---------------
Property, plant and equipment, net 52,743 54,141
---------------- ---------------
Other assets:
Intangible assets, net 112,414 110,735
Goodwill 112,131 112,131
Debt issue costs and other assets 8,103 6,044
---------------- ---------------
Total other assets 232,648 228,910
---------------- ---------------
Total assets $ 373,275 $ 405,367
================ ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 17,177 $ 12,434
Accrued personnel costs 8,669 5,209
Other accrued liabilities 16,522 18,279
Current portion of long-term debt 27,475 17,695
Current portion of unamortized non-refundable license fees 3,865 1,394
---------------- ---------------
Total current liabilities 73,708 55,011
---------------- ---------------
Long-term liabilities:
Long-term debt 104,044 54,960
Deferred income taxes 50,663 51,266
Unamortized non-refundable license fees and other long-term liabilities 4,703 4,348
---------------- ---------------
Total long-term liabilities 159,410 110,574
---------------- ---------------
Total liabilities 233,118 165,585
---------------- ---------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.001 par value; authorized 50,000 shares, issued and
outstanding 27,878 shares at September 30, 2003 (including 467 shares
held in treasury) and 32,835 shares at December 31, 2003 (including
447 shares held in treasury) 28 33
Capital in excess of par value 130,936 220,375
Retained earnings 12,213 22,305
Treasury stock, at cost (2,783) (2,717)
Other (237) (214)
---------------- ---------------
Total stockholders' equity 140,157 239,782
---------------- ---------------
Total liabilities and stockholders' equity $ 373,275 $ 405,367
================ ===============
See accompanying notes.
3
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended December 31,
--------------------------------
(in thousands, except per-share data) 2002 2003
- ------------------------------------------------------------------------------------------------------------------------------
Revenue:
Sales of chemical reagents $ 29,068 $ 30,881
License fees 8,778 9,555
Coal combustion products revenues 38,286 45,100
Sales of construction materials 11,084 11,933
Other revenues 1,493 4,000
---------------- --------------
Total revenue 88,709 101,469
---------------- --------------
Operating costs and expenses:
Cost of chemical reagents sold 19,011 21,261
Cost of coal combustion products revenues 27,996 32,245
Cost of construction materials sold 8,405 9,227
Cost of other revenues 998 65
Depreciation and amortization 3,084 3,267
Research and development 1,014 1,996
Selling, general and administrative 10,224 11,359
---------------- --------------
Total operating costs and expenses 70,732 79,420
---------------- --------------
Operating income 17,977 22,049
---------------- --------------
Other income (expense):
Interest and net investment income 90 48
Interest expense (4,526) (5,340)
Loss on note receivable -- (534)
Other, net 61 29
---------------- --------------
Total other income (expense), net (4,375) (5,797)
---------------- --------------
Income before income taxes 13,602 16,252
Income tax provision (5,550) (6,160)
---------------- --------------
Net income $ 8,052 $ 10,092
================ ==============
Basic earnings per common share $ 0.30 $ 0.36
================ ==============
Diluted earnings per common share $ 0.29 $ 0.35
================ ==============
See accompanying notes.
4
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
For the Three Months Ended December 31, 2003
Common stock Capital in Total
-------------------- excess Retained Common stock stockholders'
(in thousands) Shares Amount of par value earnings held in treasury Other equity
- -----------------------------------------------------------------------------------------------------------------------------------
Balances as of September 30, 2003 27,878 $ 28 $ 130,936 $ 12,213 $ (2,783) $ (237) $ 140,157
Common stock issued for cash, net of
offering costs of $6,187 4,750 5 86,433 86,438
Exercise of stock options 207 -- 2,228 2,228
Tax benefit from exercise of
stock options 570 570
20 shares of treasury stock
transferred to employee
stock purchase plan, at cost 208 66 274
Amortization of deferred
compensation from stock
options 23 23
Net income for the three months
ended December 31, 2003 10,092 10,092
------ ------- ----------- ----------- ------------ -------- -----------
Balances as of December 31, 2003 32,835 $ 33 $ 220,375 $ 22,305 $ (2,717) $ (214) $ 239,782
====== ======= =========== =========== ============ ======== ===========
See accompanying notes.
5
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended December 31,
--------------------------------
(in thousands) 2002 2003
- -------------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ $ 8,052 $ 10,092
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Depreciation and amortization 3,084 3,267
Non cash interest expense related to amortization of debt discount
and debt issue costs 951 2,588
Deferred income taxes 1,500 306
Income tax benefit from exercise of stock options 570 570
Amortization of non-refundable license fees (294) (294)
Net loss (gain) on disposition of property, plant and equipment (19) 213
Write-down of note receivable -- 534
Decrease (increase) in short-term trading investments 217 (31,711)
Other changes in operating assets and liabilities, net (2,573) (8,449)
-------------- --------------
Net cash provided by (used in) operating activities 11,488 (22,884)
-------------- --------------
Cash flows from investing activities:
Purchase of property, plant and equipment (718) (3,106)
Proceeds from disposition of property, plant and equipment -- 24
Net increase in other assets (56) --
-------------- --------------
Net cash used in investing activities (774) (3,082)
-------------- --------------
Cash flows from financing activities:
Net proceeds from issuance of common stock -- 86,438
Payments on long-term debt (9,895) (60,106)
Proceeds from exercise of options 63 2,228
Employee stock purchases 145 274
-------------- --------------
Net cash provided by (used in) financing activities (9,687) 28,834
-------------- --------------
Net increase in cash and cash equivalents 1,027 2,868
Cash and cash equivalents, beginning of period 7,284 18,732
-------------- --------------
Cash and cash equivalents, end of period $ 8,311 $ 21,600
============== ==============
See accompanying notes.
6
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003
(Unaudited)
1. Nature of Operations and Basis of Presentation
- ---------------------------------------------------
Operations - Headwaters Incorporated is incorporated in Delaware.
Headwaters owns 100% of Industrial Services Group, Inc. ("ISG"), a
Utah-based company acquired by Headwaters in September 2002. Headwaters
also owns 100% of Headwaters Technology Innovation Group, Inc. ("HTI")
(formerly Hydrocarbon Technologies, Inc.), a New Jersey company acquired by
Headwaters in August 2001. 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.
Basis of Presentation - The accompanying unaudited condensed consolidated
financial statements have been prepared in accordance with the rules and
regulations of the Securities and Exchange Commission ("SEC") for quarterly
reports on Form 10-Q. In the opinion of management, all adjustments
considered necessary for a fair presentation have been included, and
consist of normal recurring adjustments, including the transaction
described in Note 9. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with accounting
principles generally accepted in the United States have been condensed or
omitted. These financial statements should be read in conjunction with the
consolidated financial statements and notes thereto included in Headwaters'
Annual Report on Form 10-K for the year ended September 30, 2003 ("Form
10-K").
Headwaters' fiscal year ends on September 30 and unless otherwise noted,
future references to 2002 refer to Headwaters' fiscal quarter ended
December 31, 2002, and references to 2003 refer to Headwaters' fiscal
quarter ended December 31, 2003. 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. Due
to the time required to obtain accurate financial information related to
HTI's foreign contracts, for financial reporting purposes HTI's financial
statements have historically been consolidated with Headwaters' financial
statements using a one-month lag. During 2003, Headwaters eliminated this
one-month lag because of the decreased significance of HTI's foreign
contracts. Accordingly, four months of HTI's results of operations have
been included in the consolidated statement of income for 2003. Due to the
seasonality of ISG's business and other factors, Headwaters' consolidated
results of operations for 2003 are not indicative of the results to be
expected for the full fiscal 2004 year.
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 developed for use in valuing traded stock options, as discussed
below. Under APB 25, no compensation expense is recognized for 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.
7
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003
(Unaudited)
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 $23,000 in both 2002 and 2003. If the fair
value provision of SFAS No. 123 would have been applied to all options
granted, compensation expense would have been approximately $833,000 and
$995,000 in 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:
(in thousands, except per-share data) 2002 2003
------------------------------------------------------------------------
Net income - as reported $ 8,052 $ 10,092
Pro forma additional compensation expense (810) (972)
---------- ----------
Net income - pro forma $ 7,242 $ 9,120
========== ==========
Basic earnings per share - as reported $ 0.30 $ 0.36
- pro forma $ 0.27 $ 0.33
Diluted earnings per share - as reported $ 0.29 $ 0.35
- pro forma $ 0.26 $ 0.31
The fair values of stock option grants for 2002 and 2003 were determined
using the Black-Scholes option pricing model and the following assumptions:
expected stock price volatility of 40% to 60%, risk-free interest rates
ranging from 1.3% to 4.0%, 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.
Reclassifications - Certain prior period amounts have been reclassified to
conform with the current period's presentation. The reclassifications had
no effect on net income or total assets.
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.
8
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003
(Unaudited)
2. Segment Reporting
- ----------------------
The following segment information has been prepared in accordance with SFAS
No. 131, "Disclosure about Segments of an Enterprise and Related
Information," all as explained in more detail in the notes to the financial
statements in Headwaters' Form 10-K. 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.
2002
--------------------------------------------------------------------
Alternative Construction
(in thousands) Energy CCPs Materials Corporate Totals
------------------------------------------ ------------- ------------ ---------------- ------------ -----------
Segment revenue $ 39,339 $ 38,286 $ 11,084 $ -- $ 88,709
============ =========== ============ ========== ==========
Depreciation and amortization $ (323) $ (2,539) $ (174) $ (48) $ (3,084)
============ =========== ============ ========== ==========
Operating income (loss) $ 16,312 $ 4,029 $ 789 $ (3,153) 17,977
============ =========== ============ ==========
Net interest expense (4,436)
Other income (expense), net 61
Income tax provision (5,550)
----------
Net income $ 8,052
==========
Capital expenditures $ 109 $ 568 $ 28 $ 13 $ 718
============ =========== ============ ========== ==========
2003
--------------------------------------------------------------------
Alternative Construction
(in thousands) Energy CCPs Materials Corporate Totals
------------------------------------------ ------------- ------------ ---------------- ------------ -----------
Segment revenue $ 44,436 $ 45,100 $ 11,933 $ -- $ 101,469
============ =========== ============ ========== ==========
Depreciation and amortization $ (350) $ (2,691) $ (167) $ (59) $ (3,267)
============ =========== ============ ========== ==========
Operating income (loss) $ 18,536 $ 6,323 $ 739 $ (3,549) 22,049
============ =========== ============ ==========
Net interest expense (5,292)
Other income (expense), net (505)
Income tax provision (6,160)
----------
Net income $ 10,092
==========
Capital expenditures $ 147 $ 2,883 $ 64 $ 12 $ 3,106
============ =========== ============ ========== ==========
Segment assets as of December 31, 2003 $ 39,576 $ 279,560 $ 22,947 $ 63,284 $ 405,367
============ =========== ============ ========== ==========
3. Issuance of Securities
- ---------------------------
Headwaters has an effective universal shelf registration statement on file
with the SEC that can be used for the sale of common stock, preferred
stock, convertible debt and other securities. In December 2003, Headwaters
filed a prospectus supplement to the shelf registration statement and
subsequently issued 4,750,000 shares of common stock under this shelf
registration statement in an underwritten public offering for proceeds of
$86,438,000, net of offering costs of $6,187,000. In January 2004, an
additional 208,457 shares of common stock were issued upon exercise of the
underwriters' over-allotment option for proceeds of $3,821,000, net of
offering costs of $244,000. Following these issuances of common stock,
approximately $53,000,000 remains available for future offerings of
securities under the shelf registration statement. A prospectus supplement
describing the terms of any additional securities to be issued is required
to be filed before any future offering would commence under the
registration statement.
9
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003
(Unaudited)
4. Inventories
- ----------------
Inventories consisted of the following at:
September 30, December 31,
(in thousands) 2003 2003
---------------------------------------------------------------------------
Raw materials $ 1,059 $ 1,382
Finished goods 6,768 7,835
-------------- ---------------
$ 7,827 $ 9,217
============== ===============
5. Intangible Assets
- ----------------------
Intangible Assets - 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, 2003 December 31, 2003
-------------------------------- --------------------------------
Gross Gross
Estimated Carrying Accumulated Carrying Accumulated
(in thousands) useful lives Amount Amortization Amount Amortization
--------------------------------------------------------------------------------------------------------------
ISG contracts 20 years $ 106,400 $ 5,499 $ 106,400 $ 6,829
HTI patented technologies 15 years 9,700 1,293 9,700 1,508
ISG patents 7 1/2 years 2,764 373 2,764 465
Other 9 - 10 years 1,522 807 1,522 849
----------- ----------- ----------- -----------
$ 120,386 $ 7,972 $ 120,386 $ 9,651
=========== =========== =========== ===========
Total amortization expense related to intangible assets was approximately
$1,626,000 and $1,679,000 for 2002 and 2003, respectively. Total estimated
annual amortization expense for fiscal year 2004 is approximately
$6,560,000. Total estimated annual amortization expense for fiscal years
2005 through 2007 is approximately $6,500,000 per year. Total estimated
annual amortization expense for fiscal year 2008 is approximately
$6,380,000.
6. Long-term Debt
- -------------------
Long-term debt consisted of the following at:
September 30, December 31,
(in thousands) 2003 2003
-------------------------------------------------------------------------------------------------
Senior secured debt with a face amount totaling $114,851 at
September 30, 2003 and $75,137 at December 31, 2003 $ 111,766 $ 72,601
Senior subordinated debentures with a face amount totaling
$20,000 19,682 --
Other 71 54
--------------- -------------
131,519 72,655
Less: current portion (27,475) (17,695)
--------------- -------------
Total long-term debt $ 104,044 $ 54,960
=============== =============
Senior Secured Credit Agreement - 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 December 31, 2003), and is repayable
in quarterly installments through August 30, 2007.
In 2003, principal repayments totaling $39,714,000 were made, including
$33,471,000 of optional prepayments. Subsequent to December 31, 2003 and
through January 31, 2004, principal repayments totaling $5,420,000 were
10
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003
(Unaudited)
made, including an optional prepayment of $1,000,000. 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 and as of January 31, 2004 totaled
approximately $8,715,000 for the remainder of fiscal 2004, approximately
$17,429,000 in each of the fiscal years 2005 and 2006, and approximately
$26,144,000 in fiscal 2007.
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
December 31, 2003, Headwaters must maintain a total leverage ratio of
2.25:1.0 or less. Beginning June 30, 2004, 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 December 31, 2003 must be 1.75:1.0 or less. Beginning June
30, 2004, the ratio must be maintained at 1.5:1.0 or less. The interest
coverage requirement at December 31, 2003 and thereafter is 5.0:1.0 or
more. Headwaters is in compliance with all debt covenants as of December
31, 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 has been accreted using the effective interest method and
the accretion 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 debentures were due in 2007; however, in
December 2003, the debentures were repaid in full, including a 4% or
$400,000 prepayment charge paid to the corporation holding $10,000,000 of
the debentures. This charge, along with all remaining unamortized debt
discount and debt issue costs, is included in interest expense in the
consolidated statement of income.
Interest Costs - As a result of the early repayments of senior debt and
senior subordinated debentures totaling $6,000,000 in 2002 and $53,471,000
in 2003, additional non-cash interest expense of approximately $365,000 and
$2,237,000, respectively, was incurred, representing accelerated
amortization of debt discount and debt issue costs associated with those
principal amounts.
During 2002, Headwaters incurred total interest costs of approximately
$4,533,000, including approximately $951,000 of non-cash interest expense
and approximately $7,000 of interest costs that were capitalized. During
2003, Headwaters incurred total interest costs of approximately $5,501,000,
including approximately $2,588,000 of non-cash interest expense and
approximately $161,000 of interest costs that were capitalized. 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 7.2% at September 30, 2003 and 5.4% at December 31, 2003.
11
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003
(Unaudited)
7. Income Taxes
- -----------------
The income tax provision consisted of the following:
(in thousands) 2002 2003
-----------------------------------------------------------------------------------------------------------
Current tax provision:
Federal $ 3,450 $ 5,392
State 600 462
------------- -------------
Total current tax provision 4,050 5,854
Deferred tax provision:
Federal 1,350 282
State 150 24
------------- -------------
Total deferred tax provision 1,500 306
------------- -------------
Total income tax provision $ 5,550 $ 6,160
============= =============
8. Earnings per Share
- -----------------------
(in thousands, except per-share data) 2002 2003
-----------------------------------------------------------------------------------------------------------
Numerator - Net income $ 8,052 $ 10,092
============= =============
Denominator:
Denominator for basic earnings per share
- weighted-average shares outstanding 26,834 27,961
Effect of dilutive securities - shares issuable
upon exercise of options and warrants 1,332 1,121
------------- -------------
Denominator for diluted earnings per share
- weighted-average shares outstanding
after assumed exercises 28,166 29,082
============= =============
Basic earnings per share $ 0.30 $ 0.36
============= =============
Diluted earnings per share $ 0.29 $ 0.35
============= =============
Anti-dilutive securities not considered in the diluted earnings per share
calculation, consisting of out-of-the money options, totaled approximately
290,000 and 15,000 shares in 2002 and 2003, respectively.
9. Other Revenue
- ------------------
In 2003, Headwaters recorded $3,625,000 of other revenue representing fees
for technology licensed by HTI to a Chinese company. This amount was paid
to HTI in January 2004.
10. Commitments and Contingencies
- ----------------------------------
Commitments and contingencies as of December 31, 2003 not disclosed
elsewhere, are as follows:
Purchase Commitments - Certain ISG contracts with its suppliers require ISG
to make minimum purchases. During 2003, one of ISG's minimum purchase
contracts was amended. The amendment decreased the annual purchase
commitment and also extended the term of the contract for several years.
Due to the extended life of the contract, ISG's total future minimum
purchase requirements increased by approximately $17,925,000 during 2004
through 2011.
Medical Insurance - Effective January 1, 2003, Headwaters adopted a
self-insured medical insurance plan for employees of all of its
subsidiaries. This plan had stop-loss coverage for amounts in excess of
12
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003
(Unaudited)
$75,000 per individual and approximately $6,000,000 in the aggregate for
the plan year ended December 31, 2003. Headwaters 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 December 31, 2003, approximately $947,000 is
accrued for claims incurred from January though December 31, 2003 that have
not been paid. Headwaters has continued its coverage under the self-insured
medical plan for calendar 2004; however, the stop-loss coverage amounts
have changed to $100,000 per individual and approximately $7,500,000 in the
aggregate.
Incentive Agreements with ISG Principals - In January 2003, Headwaters
executed incentive agreements 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. In 2003, two of the
three officers resigned their positions. As a result, the maximum payment
that could be required under the remaining incentive agreement is
$1,500,000.
Property, Plant and Equipment - As of December 31, 2003, Headwaters was
committed to spend approximately $5,000,000 to complete capital projects
that were in various stages of completion.
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 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.
Boynton. In October 1998, Headwaters entered into a technology purchase
agreement with James G. Davidson and Adtech, Inc. The transaction
transferred certain patent and royalty rights to Headwaters related to a
synthetic fuel technology invented by Davidson. (This technology is
distinct from the technology developed by Headwaters.) This action is
factually related to an earlier action brought by certain purported
officers and directors of Adtech, Inc. That action was dismissed by the
United States District Court for the Western District of Tennessee and the
District Court's order of dismissal was affirmed on appeal. In the current
action, the allegations arise from the same facts, but the claims are
asserted by certain purported stockholders of Adtech. In June 2002,
Headwaters received a summons and complaint from the United States District
Court for the Western District of Tennessee alleging, among other things,
fraud, conspiracy, constructive trust, conversion, patent infringement and
interference with contract arising out of the 1998 technology purchase
agreement entered into between Davidson and Adtech on the one hand, and
Headwaters on the other. The complaint seeks declaratory relief and
compensatory and punitive damages. The District Court has dismissed all
claims against Headwaters except conspiracy and constructive trust. 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
in Salt Lake City, Utah claiming that it is owed commissions 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
13
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003
(Unaudited)
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.
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 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 or claimants in these
matters have alleged that due to some failure of the stucco system itself
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 insurance 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 resolution of the litigation and claims is uncertain, legal counsel
cannot express an opinion as to the ultimate amount, if any, of Headwaters'
liability.
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
proceedings that have arisen in the normal course of business.
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
14
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003
(Unaudited)
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 the
contractual terms. As of December 31, 2003, the escrowed license fees, net
of anticipated expenses, totaled approximately $20,000,000. Depending upon
the time of resolution of the contractual terms, these escrowed amounts
could increase as additional license fees are generated. The escrowed
amounts as of December 31, 2003 are expected to be recognized as revenue at
some future date. 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 the escrowed amounts, this same licensee has also set aside
substantial amounts for working capital and other operational contingencies
as provided for in the contractual agreements. These amounts 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
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
- --------------------------------------------------------------------------------
The following discussion and analysis should be read in conjunction
with the accompanying unaudited consolidated financial statements and notes
thereto included elsewhere herein. Headwaters' fiscal year ends on September 30
and unless otherwise noted, future references to 2002 refer to Headwaters'
fiscal quarter ended December 31, 2002, and references to 2003 refer to
Headwaters' fiscal quarter ended December 31, 2003.
Consolidation 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. Due to the time required to obtain accurate
financial information related to HTI's foreign contracts, for financial
reporting purposes HTI's financial statements have historically been
consolidated with Headwaters' financial statements using a one-month lag. During
2003, Headwaters eliminated this one-month lag because of the decreased
significance of HTI's foreign contracts. Accordingly, four months of HTI's
results of operations have been included in the consolidated statement of income
for 2003.
Segments. Headwaters 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.
Due to the seasonality of ISG's business and other factors, Headwaters'
consolidated results of operations for 2003 are not indicative of the results to
be expected for the full fiscal 2004 year.
Three Months Ended December 31, 2003 Compared to Three Months Ended
December 31, 2002
The information set forth below compares Headwaters' operating results
for the three months ended December 31, 2003 ("2003") with operating results for
the three months ended December 31, 2002 ("2002").
Revenue. Total revenue for 2003 increased by $12.8 million or 14% to
$101.5 million as compared to $88.7 million for 2002. The major components of
revenue are discussed in the sections below.
Sales of Chemical Reagents. Chemical reagent sales during 2003 were
$30.9 million with a corresponding direct cost of $21.3 million. Chemical
reagent sales during 2002 were $29.1 million with a corresponding direct cost of
$19.0 million. The increase in chemical reagent sales during 2003 was due
primarily to increased synthetic fuel production by Headwaters' licensees,
partially offset by decreased synthetic fuel production by customers with which
Headwaters does not have a license agreement. The gross margin percentage
decreased from 2002 to 2003 due primarily to differing chemical reagent formula
requirements of certain licensees and other customers, higher chemical reagent
costs, and to a lesser extent, pricing discounts.
License Fees. During 2003, Headwaters recognized license fee revenue
totaling $9.6 million, an increase of $0.8 million or 9% over $8.8 million of
license fee revenue recognized during 2002. The primary reason for the increase
in license fee revenue in 2003 compared to 2002 was increased synthetic fuel
production by Headwaters' licensees.
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 the contractual
16
terms. As of December 31, 2003, the escrowed license fees, net of anticipated
expenses, totaled approximately $20.0 million. Depending upon the time of
resolution of the contractual terms, these escrowed amounts could increase as
additional license fees are generated. The escrowed amounts as of December 31,
2003 are expected to be recognized as revenue at some future date. 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 the escrowed amounts, this same licensee has also set
aside substantial amounts for working capital and other operational
contingencies as provided for in the contractual agreements. These amounts 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.
CCP Revenues. CCP revenues for 2003 were $45.1 million with a
corresponding direct cost of $32.2 million. CCP revenues for 2002 were $38.3
million with a corresponding direct cost of $28.0 million. The increase in CCP
revenues during 2003 was due primarily to increases in certain service revenues,
increased demand for high quality fly ash products, price increases in certain
markets, generally improved weather conditions and an improved construction
business environment. The gross margin percentage increased from 2002 to 2003
due primarily to benefits realized from the renegotiation of a long-term
materials contract and the effect of increased revenues without a corresponding
increase in fixed operating costs.
Sales of Construction Materials. Sales of construction materials during
2003 were $11.9 million with a corresponding direct cost of $9.2 million. Sales
of construction materials during 2002 were $11.1 million with a corresponding
direct cost of $8.4 million. The increase in sales of construction materials
during 2003 was due primarily to the effect of generally improved weather
conditions, an improved construction business environment and cost improvements
resulting from the continuing integration of Headwaters' fly ash construction
material operations under the name of American Construction Materials.
Depreciation and Amortization. These costs increased by $0.2 million to
$3.3 million in 2003 from $3.1 million in 2002. The increase was primarily
attributable to higher property, plant and equipment balances in 2003 and an
extra month of depreciation and amortization of HTI's tangible and intangible
assets in 2003.
Research and Development. Research and development expenses increased
by $1.0 million to $2.0 million in 2003 from $1.0 million in 2002. The increase
was primarily attributable to increased HTI research and development activities
and an extra month of HTI expenses in 2003. Management currently expects fiscal
2004 research and development expenses to outpace the level of expenses for 2003
as a result of continued emphasis on HTI's activities.
Selling, General and Administrative Expenses. These expenses increased
$1.2 million to $11.4 million for 2003 from $10.2 million for 2002. The increase
in 2003 was due primarily to increased incentive pay expenses, along with
certain increases in various other costs incidental to growth, such as
payroll-related costs and insurance. The increase in incentive pay expenses was
the result of obligations arising from Headwaters' bonus plans, due in turn to
improved operating results in 2003 compared to 2002.
Other Income and Expense. During 2003, Headwaters reported net other
expense of $5.8 million compared to net other expense of $4.4 million during
2002. The change of $1.4 million was primarily attributable to an increase in
interest expense of $0.8 million in 2003 and a $0.5 million loss on a note
receivable in 2003.
Interest expense increased from $4.5 million in 2002 to $5.3 million in
2003 due primarily to the substantial increase in debt repayments that were made
in 2003 compared to 2002. In 2003, debt repayments totaled approximately $60.0
million, which included $53.5 million of early repayments. In 2002, debt
repayments totaled approximately $10.0 million, which included $6.0 million of
early repayments. As a result of the increase in repayments in 2003, non-cash
interest expense, representing amortization of debt discount and debt issue
costs, increased from $1.0 million in 2002 to $2.6 million. Partially offsetting
this large increase in non-cash interest expense was a decrease in cash interest
expense in 2003 due to the significantly lower levels of outstanding long-term
debt in 2003 compared to 2002.
A loss of $0.5 million was recorded on a note receivable in 2003. There
were no such losses recorded in 2002.
Income Tax Provision. In 2003, Headwaters recorded an income tax
provision at an effective tax rate of approximately 38%. In 2002, the effective
tax rate was approximately 41%. The primary reason for the decrease in the
effective tax rate was decreased state income taxes due to tax planning
strategies implemented for fiscal year 2004.
17
Liquidity and Capital Resources
- -------------------------------
Summary of Cash Flow Activities. Net cash used in operating activities
during the quarter ended December 31, 2003 ("2003") was $22.9 million compared
to $11.5 million of net cash provided by operations during the quarter ended
December 31, 2002 ("2002"). The primary reason for the significant use of cash
in operating activities in 2003 was an increase in short-term trading
investments of $31.7 million. Absent the use of cash to purchase short-term
trading investments, there would have been $8.8 million of cash provided by
operations in 2003, most of which was attributable to net income. In December
2003, Headwaters issued 4.75 million shares of common stock under an effective
shelf registration statement for net proceeds of $86.4 million. Consistent with
Headwaters' strategic priority to repay debt and de-leverage its balance sheet,
Headwaters used $50.0 million of the cash generated from the issuance of common
stock to repay debt and the remaining proceeds were invested in short-term
trading investments as previously discussed. During 2003, investing activities
consisted primarily of payments for the purchase of property, plant and
equipment. More details about these activities are provided in the following
paragraphs.
Investing Activities. In 2003, payments for the purchase of property,
plant and equipment totaled $3.1 million. These capital expenditures primarily
related to ISG's business, in particular the CCP segment. Total capital
expenditures for fiscal year 2004 are expected to be comparable with fiscal year
2003 levels.
Headwaters has two notes receivable with a combined carrying value of
approximately $2.0 million at December 31, 2003. In 2003, Headwaters recorded a
$0.5 million write-down of one of these notes, which now has a carrying value of
$1.5 million. The other note receivable, which has a carrying value of $0.5
million, is supported by collateral. Headwaters could incur additional losses if
the remaining balances on the notes are not repaid or if the collateral value of
the second note declines.
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. It is possible that some portion of cash and cash equivalents and
short-term trading investments will be used to fund acquisitions of
complementary businesses in the chemical, energy, building products and related
industries. Acquisitions are an important part of Headwaters' business strategy
and to that end, Headwaters routinely reviews complementary acquisitions,
including those in the areas of CCP marketing and construction materials and
coal and catalyst technologies. Currently the senior secured credit facility
requires approval for acquisitions funded with aggregate cash consideration in
excess of $50.0 million.
Financing Activities. Headwaters has an effective universal shelf
registration statement on file with the SEC that can be used for the sale of
common stock, preferred stock, convertible debt and other securities. In
December 2003, Headwaters filed a prospectus supplement to the shelf
registration statement and subsequently issued 4.75 million shares of common
stock under this shelf registration statement in an underwritten public offering
for proceeds of $86.4 million, net of offering costs of $6.2 million. In January
2004, an additional 0.2 million shares of common stock were issued upon exercise
of the underwriters' over-allotment option for proceeds of $3.8 million, net of
offering costs of $0.2 million. Following these issuances of common stock,
approximately $53.0 million remains available for future offerings of securities
under the shelf registration statement. A prospectus supplement describing the
terms of any additional securities to be issued is required to be filed before
any future offering would commence under the registration statement.
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 is secured by all assets
of Headwaters, bears interest at a variable rate (approximately 5.4% at December
31, 2003), and is repayable in quarterly installments through August 30, 2007.
In 2003, principal repayments on the senior debt totaling $39.7 million
were made, including $33.5 million of optional prepayments. Subsequent to
December 31, 2003 and through January 31, 2004, principal repayments totaling
$5.4 million were made, including an optional prepayment of $1.0 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 and as of January 31, 2004 totaled approximately $8.7 million for
the remainder of fiscal 2004, approximately $17.4 million in each of the fiscal
years 2005 and 2006, and approximately $26.1 million in fiscal 2007.
In connection with the ISG acquisition, Headwaters also entered into a
$20.0 million subordinated loan agreement, under which senior subordinated
debentures were issued. 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 debentures were due in 2007; however, in December 2003, the
debentures were repaid in full, including a 4% or $0.4 million prepayment charge
18
paid to the corporation holding $10.0 million of the debentures. This charge,
along with all remaining unamortized debt discount and debt issue costs, is
included in interest expense in the consolidated statement of income.
In 2003, cash proceeds from the exercise of options and employee stock
purchases totaled $2.5 million, compared to $0.2 million in 2002. Option
exercise activity is largely dependent on Headwaters' stock price and is not
predictable. To the extent non-qualified stock options are exercised, or there
are disqualifying dispositions of shares obtained upon the exercise of incentive
stock options, Headwaters receives an income tax deduction generally equal to
the income recognized by the optionee. Such amounts, reflected in cash flows
from operations in the consolidated statements of cash flows, were $0.6 million
in both 2002 and 2003. These income tax deductions do not impact income tax
expense and the effective income tax rate; rather they are reflected as
increases in capital in excess of par value in the consolidated balance sheet.
Working Capital. Headwaters' working capital increased by $53.1 million
from September 30, 2003, to $67.3 million as of December 31, 2003. The most
significant changes in the components of working capital were an increase of
$34.6 million in cash and investments and a decrease of $9.8 million in the
current portion of long-term debt. The increase in cash and investments was due
primarily to the issuance of common stock previously described. 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, is expected to be sufficient for operating needs for the next 12 months.
Long-term Debt. 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 senior secured 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 December 31, 2003, Headwaters
must maintain a total leverage ratio of 2.25:1.0 or less. Beginning June 30,
2004, 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 December 31, 2003 must be
1.75:1.0 or less. Beginning June 30, 2004, the ratio must be maintained at
1.5:1.0 or less. The interest coverage requirement at December 31, 2003 and
thereafter is 5.0:1.0 or more. Headwaters is in compliance with all debt
covenants as of December 31, 2003.
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.
Income Taxes. As discussed previously, cash payments for income taxes
are reduced for disqualifying dispositions of shares obtained upon the exercise
of stock options, which totaled $0.6 million for 2003. Headwaters' cash
requirements for income taxes in fiscal 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.
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."
19
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.
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.
Forward-looking Statements
- --------------------------
Statements in this Quarterly Report on Form 10-Q 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 "Risk Factors" in Item 7 of our Annual Report on
Form 10-K for the year ended September 30, 2003.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- ------------------------------------------------------------------
Headwaters is exposed to financial market risks, primarily related to
changes in interest rates. Headwaters does not use derivative financial
instruments for speculative or trading purposes, and no significant derivative
financial instruments were outstanding as of December 31, 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.
As described in more detail in Note 6 to the consolidated financial
statements, Headwaters has outstanding $75.1 million of variable-rate long-term
debt as of December 31, 2003, which is repayable through August 2007. The
interest rate on this debt as of December 31, 2003 was approximately 5.4%. In
January 2004, Headwaters locked in a rate of 5.4% for three months and in April
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 $0.7
million during the next 12 months, considering required principal repayments.
ITEM 4. 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 Quarterly Report on Form 10-Q, 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.
20
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
Quarterly Report. Headwaters' management, including the CEO and CFO, does not
expect that disclosure controls can or will prevent or detect all errors and all
fraud, if any. A control system, no matter how well designed and operated, can
provide only reasonable, not absolute, assurance that the objectives of the
control system are met. Also, 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 December 31, 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 December 31, 2003 that
has materially affected, or is reasonably likely to materially affect,
Headwaters' internal control over financial reporting.
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
- -------------------------
See "Legal or Contractual Matters" in Note 10 to the consolidated
financial statements for a description of current legal proceedings.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
- -------------------------------------------------
Recent Sales of Unregistered Securities
During the quarter ended December 31, 2003, pursuant to the exercise of
options, approximately 3,000 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 the shares of restricted common stock
issued during the quarter have been registered under one of these registration
statements.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
- ---------------------------------------
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- -----------------------------------------------------------
None.
ITEM 5. OTHER INFORMATION
- -------------------------
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
- ----------------------------------------
(a) The following exhibits are included herein:
12 Computation of ratio of earnings to combined fixed
charges and preferred stock dividends *
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief
Executive Officer *
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief
Financial Officer *
32 Section 1350 Certifications of Chief Executive
Officer and Chief Financial Officer *
---------------------
* Filed herewith.
21
(b) The following Forms 8-K were filed with the SEC during the
quarter ended December 31, 2003:
o Form 8-K dated November 5, 2003 announcing
Headwaters' results for the quarter and fiscal year
ended September 30, 2003.
o Form 8-K dated December 18, 2003 to file i) an
underwriting agreement between Headwaters and Morgan
Stanley & Co. Incorporated, and ii) Amendment No. 1
to Senior Credit Agreement among Headwaters and
various lenders.
22
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HEADWATERS INCORPORATED
Date: February 13, 2004 By: /s/ Kirk A. Benson
-----------------------------------------
Kirk A. Benson, Chief Executive Officer
(Principal Executive Officer)
Date: February 13, 2004 By: /s/ Steven G. Stewart
-----------------------------------------
Steven G. Stewart, Chief Financial Officer
(Principal Financial Officer)
23