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, 2004
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
---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
(801) 984-9400
----------------------------------------------------
(Registrant's telephone number, including area code)
Not applicable
----------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is 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, 2005 was 34,020,876.
HEADWATERS INCORPORATED
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Page No.
ITEM 1. FINANCIAL STATEMENTS (Unaudited):
Condensed Consolidated Balance Sheets - As of
September 30, 2004 and December 31, 2004..................... 3
Condensed Consolidated Statements of Income - For the
three months ended December 31, 2003 and 2004................ 4
Condensed Consolidated Statement of Changes in Stockholders'
Equity - For the three months ended December 31, 2004........ 5
Condensed Consolidated Statements of Cash Flows - For the
three months ended December 31, 2003 and 2004................ 6
Notes to Condensed Consolidated Financial Statements........... 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS..........................20
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.....28
ITEM 4. CONTROLS AND PROCEDURES........................................29
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS..............................................29
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS....29
ITEM 3. DEFAULTS UPON SENIOR SECURITIES................................29
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............30
ITEM 5. OTHER INFORMATION..............................................30
ITEM 6. EXHIBITS.......................................................30
SIGNATURES...................................................................31
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 caption entitled "Risk Factors" in Item 7 of our
Annual Report on Form 10-K for the year ended September 30, 2004. There can be
no assurance that our results of operations will not be adversely affected by
such factors. Unless legally required, we undertake no obligation to revise or
update any forward-looking statements for any reason. Readers are cautioned not
to place undue reliance on these forward-looking statements, which speak only as
of the date of this report.
Our internet address is www.headwaters.com. There we make available, free of
charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K and any amendments to those reports, as soon as reasonably
practicable after we electronically file such material with, or furnish it to,
the Securities and Exchange Commission ("SEC"). Our reports can be accessed
through the investor relations section of our web site. The information found on
our web site is not part of this or any report we file with or furnish to the
SEC.
2
ITEM 1. FINANCIAL STATEMENTS
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, December 31,
(in thousands, except per-share data) 2004 2004
- --------------------------------------------------------------------------------------------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 20,851 $ --
Short-term trading investments 6,735 --
Trade receivables, net 129,899 108,831
Inventories 43,812 45,778
Current and deferred income taxes 15,933 4,549
Other current assets 13,333 13,381
----------------------------------
Total current assets 230,563 172,539
----------------------------------
Property, plant and equipment, net 157,611 161,579
----------------------------------
Other assets:
Intangible assets, net 298,803 292,686
Goodwill 815,396 815,396
Debt issue costs and other assets 38,406 46,242
----------------------------------
Total other assets 1,152,605 1,154,324
----------------------------------
Total assets $1,540,779 $1,488,442
==================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 29,238 $ 26,004
Accrued personnel costs 26,213 18,470
Other accrued liabilities 72,852 59,845
Current portion of long-term debt 57,873 19,682
----------------------------------
Total current liabilities 186,176 124,001
----------------------------------
Long-term liabilities:
Long-term debt 914,641 902,623
Deferred income taxes 121,469 121,469
Other long-term liabilities 10,338 15,511
----------------------------------
Total long-term liabilities 1,046,448 1,039,603
----------------------------------
Total liabilities 1,232,624 1,163,604
----------------------------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.001 par value; authorized 50,000 shares; issued and
outstanding: 33,775 shares at September 30, 2004 (including 414 shares
held in treasury) and 33,988 shares at December 31, 2004 (including 399
shares held in treasury) 34 34
Capital in excess of par value 235,581 239,127
Retained earnings 76,530 89,538
Treasury stock, at cost (2,610) (2,564)
Other (1,380) (1,297)
----------------------------------
Total stockholders' equity 308,155 324,838
----------------------------------
Total liabilities and stockholders' equity $1,540,779 $1,488,442
==================================
See accompanying notes.
3
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended December 31,
--------------------------------
(in thousands, except per-share data) 2003 2004
- ------------------------------------------------------------------------------------------------------------------------------
Revenue:
Sales of chemical reagents $ 30,881 $ 36,777
License fees 9,555 14,598
Coal combustion products revenues 45,100 53,052
Sales of construction materials 11,933 113,729
Other revenues 4,000 260
--------------------------------
Total revenue 101,469 218,416
--------------------------------
Operating costs and expenses:
Cost of chemical reagents sold 21,261 24,558
Cost of coal combustion products revenues 33,396 40,995
Cost of construction materials sold 9,394 76,468
Other operating costs 65 97
Amortization 1,720 6,181
Research and development 2,073 2,286
Selling, general and administrative 11,511 30,100
--------------------------------
Total operating costs and expenses 79,420 180,685
--------------------------------
Operating income 22,049 37,731
--------------------------------
Other income (expense):
Interest and net investment income 48 59
Interest expense (5,340) (15,864)
Loss on note receivable (534) --
Other, net 29 (1,918)
--------------------------------
Total other income (expense), net (5,797) (17,723)
--------------------------------
Income before income taxes 16,252 20,008
Income tax provision (6,160) (7,000)
--------------------------------
Net income $ 10,092 $ 13,008
================================
Basic earnings per share $ 0.36 $ 0.39
================================
Diluted earnings per share $ 0.35 $ 0.34
================================
See accompanying notes.
4
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
For the Three Months Ended December 31, 2004
Common stock Capital in Total
-------------------- excess Retained Treasury stock, stockholders'
(in thousands) Shares Amount of par value earnings at cost Other equity
- ----------------------------------------------------------------------------------------------------------------------------------
Balances as of September 30, 2004 33,775 $34 $235,581 $76,530 $(2,610) $(1,380) $308,155
Exercise of stock options 213 -- 1,177 1,177
Tax benefit from exercise of stock
options 2,020 2,020
15 shares of treasury stock
transferred to employee stock
purchase plan, at cost 349 46 395
Amortization of deferred compensation
from stock options and restricted
stock 83 83
Net income for the three months
ended December 31, 2004 13,008 13,008
-------------------------------------------------------------------------------------------
Balances as of December 31, 2004 33,988 $34 $239,127 $89,538 $(2,564) $(1,297) $324,838
===========================================================================================
See accompanying notes.
5
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended December 31,
-------------------------------
(in thousands) 2003 2004
- --------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ 10,092 $ 13,008
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Depreciation and amortization 3,302 13,670
Non cash interest expense related to amortization of debt discount and
debt issue costs 2,588 1,941
Income tax benefit from exercise of stock options 570 2,020
Net loss on disposition of property, plant and equipment 213 139
Write-down of note receivable 534 --
Decrease (increase) in short-term trading investments (31,711) 6,735
Other changes in operating assets and liabilities, net (8,472) 4,275
------------------------------
Net cash provided by (used in) operating activities (22,884) 41,788
------------------------------
Cash flows from investing activities:
Purchase of property, plant and equipment (3,106) (11,900)
Net increase in investments and other assets -- (1,820)
Proceeds from disposition of property, plant and equipment 24 --
------------------------------
Net cash used in investing activities (3,082) (13,720)
------------------------------
Cash flows from financing activities:
Net proceeds from issuance of long-term debt -- 718
Payments on long-term debt (60,106) (51,209)
Proceeds from exercise of options 2,228 1,177
Employee stock purchases 274 395
Net proceeds from issuance of common stock 86,438 --
------------------------------
Net cash provided by (used in) financing activities 28,834 (48,919)
------------------------------
Net increase (decrease) in cash and cash equivalents 2,868 (20,851)
Cash and cash equivalents, beginning of period 18,732 20,851
------------------------------
Cash and cash equivalents, end of period $ 21,600 $ --
==============================
Supplemental schedule of non-cash investing and financing activities -
Purchase of variable interest in solid alternative fuel facility in
exchange for commitment to make future payments $ -- $ 7,500
==============================
See accompanying notes.
6
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
1. Nature of Operations and Basis of Presentation
Organization and Description of Business - Headwaters Incorporated is
incorporated in Delaware. Headwaters owns 100% of the following
subsidiaries: Headwaters Resources, Inc. and Headwaters Construction
Materials, Inc. (the two of which combined were formerly Industrial
Services Group, Inc., a Utah-based company acquired by Headwaters in
September 2002) ("ISG"); Headwaters Technology Innovation Group, Inc.
(formerly Hydrocarbon Technologies, Inc., a New Jersey company acquired in
August 2001) ("HTI"); VFL Technology Corporation, a Pennsylvania company
acquired in April 2004 ("VFL"); Eldorado Stone, LLC, a Delaware company
acquired in June 2004 ("Eldorado"); Southwest Concrete Products, L.P., a
Texas company acquired in July 2004 ("SCP"); and Tapco Holdings, Inc., a
Michigan company acquired in September 2004 ("Tapco").
Headwaters' focus is on enhancing the value of energy resources in an
environmentally responsible manner; promoting the expanded use of coal
combustion products ("CCPs"); developing HTI's energy and nanocatalysis
technologies; and expanding Headwaters' construction materials business,
including opportunities to utilize products from other Headwaters
operations in the production of construction materials. Headwaters
currently generates revenue from licensing its chemical technologies to
produce solid alternative fuel, from marketing CCPs, and from the sale of
construction materials. 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 alternative 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
alternative fuel facilities in the United States. Through its wholly-owned
subsidiary HTI, Headwaters 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.
ISG's CCP operations and VFL (together referred to as Headwaters'
Resources, Inc., or "Resources") represent the nation's largest provider of
CCP management and marketing services to the electric utility industry,
serving more than 100 coal-fired electric power generation plants
nationwide. Through its distribution network of over 110 locations,
Resources is the leading provider of high quality fly ash to the building
products and ready mix concrete industries in the United States. Resources
also develops and deploys technologies for maintaining and improving fly
ash quality.
Headwaters' construction materials segment develops, manufactures and
distributes value-added bagged concrete, stucco, mortar and block products
that utilize fly ash, and with the acquisitions of Eldorado and SCP,
manufactured stone and expanded concrete block products. Tapco is a leading
designer, manufacturer and marketer of building products used in exterior
residential home improvement and construction.
Basis of Presentation - The accompanying unaudited condensed consolidated
financial statements have been prepared in accordance with the rules and
regulations of the Securities and Exchange Commission ("SEC") for quarterly
reports on Form 10-Q. In the opinion of management, all adjustments
considered necessary for a fair presentation have been included, and
consist of normal recurring adjustments. Certain information and footnote
disclosures normally included in financial statements prepared in
accordance with U.S. generally accepted accounting principles have been
condensed or omitted. These financial statements should be read in
conjunction with the consolidated financial statements and notes thereto
included in Headwaters' Annual Report on Form 10-K for the year ended
September 30, 2004 ("Form 10-K").
Headwaters' fiscal year ends on September 30 and unless otherwise noted,
future references to 2003 refer to Headwaters' fiscal quarter ended
December 31, 2003, and references to 2004 refer to Headwaters' fiscal
quarter ended December 31, 2004. The consolidated financial statements
include the accounts of Headwaters, all of its subsidiaries and other
entities in which Headwaters has a controlling financial interest. 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
7
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
with Headwaters' financial statements using a one-month lag. Effective
October 1, 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 the operations of
the CCP and construction materials segments and other factors, Headwaters'
consolidated results of operations for 2004 are not indicative of the
results to be expected for the full fiscal 2005 year.
Common Stock Options and Restricted Stock Grants - Headwaters has elected
to continue to apply the intrinsic value method as prescribed by APB 25 in
accounting for options and restricted stock grants to employees, officers
and directors and does not currently plan to change to the fair value
method until required by changes in accounting standards (see "Recent
Accounting Pronouncements" below). The alternative fair value method of
accounting prescribed by SFAS No. 123, "Accounting for Stock-Based
Compensation" ("SFAS No. 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
options and restricted stock grants to employees, officers and directors
when the exercise price of stock options or restricted stock 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 addition, in fiscal 2004, Headwaters issued restricted
stock to certain officers and employees, also with terms considered
compensatory, because the restricted stock was issued at no cost to the
recipients. In such instances, compensation cost is amortized to expense
over the applicable vesting period on a straight-line basis. If the fair
value provision of SFAS No. 123 would have been applied to all options and
restricted stock grants, net income and earnings per share would have been
changed to the pro forma amounts shown in the following table.
Three Months Ended December 31,
-------------------------------
(in thousands, except per-share data) 2003 2004
-----------------------------------------------------------------------------------------------------------
Reported net income $10,092 $13,008
Add actual amortization expense included in
reported net income 23 83
Deduct expense determined under fair value
provision of SFAS No. 123 (995) (1,954)
-----------------------------
Pro forma net income $ 9,120 $11,137
=============================
Basic earnings per share - as reported $ 0.36 $ 0.39
- pro forma $ 0.33 $ 0.33
Diluted earnings per share - as reported $ 0.35 $ 0.34
- pro forma $ 0.31 $ 0.30
The fair values of stock option grants for 2003 and 2004 were determined
using the Black-Scholes option pricing model and the following assumptions:
expected stock price volatility of 40%, risk-free interest rates ranging
from 1.3% to 4.5%, weighted average expected option lives of 3 to 4 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 and restricted stock.
Recent Accounting Pronouncements - In September 2004, the Emerging Issues
Task Force ("EITF") reached a consensus requiring the inclusion of
contingently convertible securities in diluted earnings per share ("EPS")
calculations. This consensus (EITF Issue 04-08, "The Effect of Contingently
Convertible Debt on Diluted Earnings per Share") is effective for periods
8
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
ending after December 15, 2004 and required Headwaters to include in its
2004 diluted EPS calculation, on an if-converted basis, the additional
shares issuable under the terms of Headwaters' outstanding convertible
senior subordinated notes described in Note 6. The EITF consensus must be
applied to all applicable prior periods, which for Headwaters will be the
quarters ended June 30, 2004 and September 30, 2004. See Note 8 for more
information on the effect on Headwaters' EPS of implementing the EITF
consensus.
In December 2004, the Financial Accounting Standards Board issued SFAS No.
123 (revised 2004), "Share-Based Payment," ("SFAS No. 123R"), which is
effective for interim periods beginning after June 15, 2005. SFAS No. 123R
revises SFAS No. 123 and supersedes APB 25 and requires companies to
expense the value of employee stock options and similar awards. Pro forma
disclosure will not be an alternative. SFAS No. 123R also amends SFAS No.
95, Statement of Cash Flows, to require tax benefits from share-based
payments to be reported as a financing cash flow rather than an operating
cash flow, as required under current literature.
Headwaters is studying the implications of SFAS No. 123R and currently
expects it to have a material effect on Headwaters' reported financial
results of operations, beginning with the quarter ending September 30,
2005, the quarter Headwaters expects to adopt the new standard. SFAS No.
123R permits companies to adopt its requirements using one of two methods:
i) a "modified prospective" method in which compensation cost is recognized
beginning with the effective date based on the requirements of SFAS No.
123R for all share-based payments granted after the effective date, plus
compensation cost under the requirements of SFAS No. 123 for all awards
granted to employees prior to the effective date of SFAS No. 123R that
remain unvested on the effective date; or ii) a "modified retrospective"
method which includes the requirements of the modified prospective method,
but also permits companies to restate based on the amounts previously
recognized under SFAS No. 123 for purposes of pro forma disclosures for
either all prior periods, or by restating only the prior interim periods of
the year of adoption. Headwaters has not yet determined which method will
be used when SFAS No. 123R is adopted.
The impact of adoption of SFAS No. 123R cannot be predicted at this time
because it will depend on levels of share-based payments granted in the
future. However, had Headwaters adopted SFAS No. 123R in prior periods, the
impact of this standard would have approximated the impact of SFAS No. 123
as described above in the disclosure of pro forma net income and earnings
per share. Adoption of SFAS No. 123R will also reduce net cash flow from
operating activities and increase net cash flow from financing activities.
While Headwaters cannot estimate what those amounts will be in the future,
the amounts for 2003 and 2004 were $570,000 and $2,020,000, respectively.
Headwaters has reviewed all other 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 other 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 period amounts have been reclassified to
conform to the current period's presentation. The reclassifications had no
effect on net income or total assets.
2. Segment Reporting
The following segment information has been prepared in accordance with SFAS
No. 131, "Disclosure about Segments of an Enterprise and Related
Information." The accounting policies of the segments are the same as those
described in the notes to the financial statements in Headwaters' Form
10-K. 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 overhead. Segment assets reflect those specifically
attributable to individual segments and primarily include accounts
receivable, inventories, property, plant and equipment, intangible assets
and goodwill. Other assets are included in the "Corporate" column.
9
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
Segment information for 2004 includes the results of operations for all of
the four fiscal 2004 acquisitions described in the Form 10-K, while the
segment information for 2003 includes no such results since none of the
acquisitions were consummated prior to December 31, 2003.
Three Months Ended December 31, 2003
---------------------------------------------------------------------
Alternative Construction
(in thousands) Energy CCPs Materials Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $44,436 $ 45,100 $ 11,933 $ -- $ 101,469
=====================================================================
Depreciation and amortization $ (367) $ (2,709) $ (167) $ (59) $ (3,302)
=====================================================================
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 $ 2,561 $ 386 $ 12 $ 3,106
=====================================================================
Three Months Ended December 31, 2004
---------------------------------------------------------------------
Alternative Construction
(in thousands) Energy CCPs Materials Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $51,635 $ 53,052 $ 113,729 $ -- $ 218,416
=====================================================================
Depreciation and amortization $ (992) $ (3,166) $ (9,415) $ (97) $ (13,670)
=====================================================================
Operating income (loss) $21,436 $ 5,648 $ 15,472 $(4,825) $ 37,731
========================================================
Net interest expense (15,805)
Other income (expense), net (1,918)
Income tax provision (7,000)
------------
Net income $ 13,008
============
Capital expenditures $ 413 $ 1,175 $ 10,175 $ 137 $ 11,900
=====================================================================
Segment Assets as of December 31, 2004 $54,207 $307,560 $1,092,251 $34,424 $1,488,442
=====================================================================
3. Equity Securities
Authorized Common Stock - In January 2005, Headwaters' Board of Directors
approved an increase in the authorized shares of common stock from
50,000,000 to 100,000,000. This action is subject to stockholder approval
and will be voted on at the annual meeting of stockholders on March 1,
2005.
2003 Stock Incentive Plan Awards - During the quarter ended December 31,
2004, Headwaters granted to directors and employees options to purchase
approximately 185,000 shares of common stock, all under terms of the 2003
Stock Incentive Plan. The stock options vest over periods ranging from
three to five years and have exercise prices ranging from $31.25 to $32.77
per share, the fair market value of Headwaters' common stock on the grant
dates.
SEC Shelf Registrations - Headwaters has an effective universal shelf
registration statement on file with the SEC that can be used for the sale
of common stock, preferred stock, convertible debt and other securities.
Approximately $53,000,000 remains available for future offerings of
securities under the shelf registration statement. A prospectus supplement
describing the terms of any securities to be issued is required to be filed
before any future offering would commence under the registration statement.
In January 2005, Headwaters filed another Form S-3 shelf registration
statement with the SEC that, once declared effective by the SEC and
following the issuance of a prospectus supplement, could be used for the
sale of up to $175,000,000 of common stock.
10
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
4. Inventories
Inventories consisted of the following at:
September 30, December 31,
(in thousands) 2004 2004
--------------------------------------------------------------------
Raw materials $ 8,517 $ 8,484
Work in process 187 207
Finished goods 35,108 37,087
--------------------------------
$43,812 $45,778
================================
5. Intangible Assets
Intangible Assets - Headwaters has no identified intangible assets that are
not being amortized. The following table summarizes the gross carrying
amounts and the related accumulated amortization of all amortizable
intangible assets as of:
September 30, 2004 December 31, 2004
-------------------------------- --------------------------------
Gross Gross
Estimated Carrying Accumulated Carrying Accumulated
(in thousands) useful lives Amount Amortization Amount Amortization
---------------------------------------------------------------------------------------------------------------
CCP contracts 8 - 20 years $117,690 $11,524 $117,690 $13,208
Customer relationships 7 1/2 - 15 years 68,331 452 68,331 1,688
Trade names 5 - 20 years 63,657 268 63,657 1,111
Patents and patented
technologies 7 1/2 - 15 years 52,464 2,969 52,464 4,222
Non-competition agreements 2 - 3 1/2 years 10,422 867 10,422 1,885
Other 9 - 17 1/4 years 3,382 1,063 3,382 1,146
--------------- ---------------- --------------- ----------------
$315,946 $17,143 $315,946 $23,260
=============== ================ =============== ================
Total amortization expense related to intangible assets was approximately
$1,679,000 and $6,117,000 for 2003 and 2004, respectively. Total estimated
annual amortization expense is as follows for the fiscal years presented.
(in
Year ending September 30, thousands)
------------------------- -------------
2005 $24,449
2006 24,244
2007 21,899
2008 20,350
2009 20,138
2010 19,804
6. Long-term Debt
Long-term debt consisted of the following at:
September 30, December 31,
(in thousands) 2004 2004
-----------------------------------------------------------------------
Senior secured debt $790,000 $740,000
Convertible senior subordinated notes 172,500 172,500
Notes payable to a bank 9,787 9,597
Other 227 208
-----------------------------
972,514 922,305
Less: current portion (57,873) (19,682)
-----------------------------
Total long-term debt $914,641 $902,623
============= ===============
11
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
Senior Secured Credit Agreements - In September 2004 and as amended in
October 2004, Headwaters entered into two credit agreements with a
syndication of lenders under which a total of $790,000,000 was borrowed
under term loan arrangements and which provide for $60,000,000 to be
borrowed under a revolving credit arrangement. The proceeds were used to
acquire Tapco and repay in full the remaining balance due under Headwaters'
former senior secured credit agreement obtained in March 2004. The
$790,000,000 of term loan borrowings consisted of a first lien term loan in
the amount of $640,000,000 and a second lien term loan in the amount of
$150,000,000. Both term loans are secured by all assets of Headwaters and
are senior in priority to all other debt, with the exception of the
specific SCP assets that collateralize the notes payable to banks discussed
below.
The first lien term loan bears interest, at Headwaters' option, at either
i) the London Interbank Offered Rate ("LIBOR") plus 3.0%, if the "total
leverage ratio," as defined, is less than or equal to 3.75:1.0, and if not,
at LIBOR plus 3.25%, or ii) the "base rate" plus 2.0%, if the total
leverage ratio is less than or equal to 3.75:1.0, and if not, at the base
rate plus 2.25%. Base rate is defined as the higher of the rate announced
by Morgan Stanley Senior Funding and the overnight rate charged by the
Federal Reserve Bank of New York plus 0.5%. The initial interest rate on
the first lien debt was set at 6.5%, but was subsequently reduced to
approximately 5.4% in 2004 pursuant to the terms of the agreement. The
second lien term loan bears interest, also at Headwaters' option, at either
LIBOR plus 5.5%, or the "base rate" plus 4.5%. The initial interest rate on
the second lien debt was set at 9.75%, but was subsequently reduced to
approximately 7.7% in 2004 pursuant to the terms of the agreement.
Headwaters can lock in new rates for both the first lien and second lien
loans for one, two, three or six months. The most recent rate change, which
did not result in a material change, occurred in January 2005.
The first lien term loan is repayable in quarterly installments of
principal and interest, with minimum required quarterly principal
repayments of $12,000,000 commencing in November 2004 through August 2007,
then $4,000,000 through August 2010, with three repayments of approximately
$149,333,000 each through April 2011, the termination date of the first
lien loan agreement. The second lien term loan is due September 2012, with
no required principal repayments prior to that time. Interest is generally
due on a quarterly basis. There are mandatory prepayments of the first lien
term loan in the event of certain asset sales and debt and equity issuances
and from "excess cash flow," as defined in the agreement. Optional
prepayments of the first lien term loan are permitted without penalty or
premium. Optional prepayments of the second lien term loan are permissible
only to the extent Headwaters issues new equity securities and then are
further limited to a maximum of $50,000,000, so long as the first lien term
loan remains outstanding. Any optional prepayments of the second lien term
loan bear a penalty of 3% of prepayments made in the first year, 2% of
prepayments made in the second year, and 1% of prepayments made in the
third year. Once repaid in full or in part, no further reborrowings under
either of the term loan arrangements can be made. In 2004, Headwaters
repaid a total of $50,000,000 of the first lien term loan, which otherwise
would have been due during the period from November 2004 through November
2005. As a result of the early repayment of debt, there was an acceleration
of amortization of the related debt issue costs totaling approximately
$965,000, all of which was charged to interest expense in 2004.
Borrowings under the revolving credit arrangement are generally subject to
the terms of the first lien loan agreement and bear interest at either
LIBOR plus 1.75% to 2.5%, or the base rate plus 0.75% to 1.5%. Borrowings
and reborrowings of any available portion of the $60,000,000 revolver can
be made at any time through September 2009, at which time all loans must be
repaid and the revolving credit arrangement terminates. The fees for the
unused portion of the revolving credit arrangement range from 0.5% to
0.75%. During 2004, Headwaters borrowed $1,000,000 under terms of the
revolving credit arrangement, all of which was repaid prior to December 31,
2004. In January 2005, Headwaters borrowed $12,000,000 under terms of the
revolving credit arrangement, all of which was outstanding as of January
31, 2005. Finally, the credit agreement allows for the issuance of letters
of credit, provided there is capacity under the revolving credit
arrangement. As of December 31, 2004, three letters of credit totaling
$2,088,000 were outstanding, with expiration dates ranging from February
2005 to June 2005.
The credit agreements contain restrictions and covenants common to such
agreements, including limitations on the incurrence of additional debt,
investments, merger and acquisition activity, asset sales and liens,
capital expenditures in excess of $50,000,000 in any fiscal year
(increasing to $60,000,000 in 2011) and the payment of dividends, among
others. In addition, Headwaters must maintain certain leverage and fixed
charge coverage ratios, as those terms are defined in the agreements. Under
the most restrictive covenants, contained in the first lien agreement,
Headwaters must maintain i) a total leverage ratio of 5.0:1.0 or less,
12
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
declining periodically to 3.5:1.0 in 2010; ii) a maximum ratio of
consolidated senior funded indebtedness minus subordinated indebtedness to
EBITDA of 4.0:1.0, declining periodically to 2.5:1.0 in 2010; and iii) a
minimum ratio of EBITDA plus rent payments for the four preceding fiscal
quarters to scheduled payments of principal and interest on all
indebtedness for the next four fiscal quarters of 1.10:1.0 through
September 30, 2006, and 1.25:1.0 thereafter. Headwaters is in compliance
with all debt covenants as of December 31, 2004.
As required by the new senior secured credit facility, Headwaters entered
into certain other agreements to limit its variable interest rate exposure.
The first set of agreements effectively established the maximum LIBOR rate
for $300,000,000 of the senior secured debt at 5.0% through September 8,
2005. The second set of agreements effectively sets the LIBOR rate at 3.71%
for $300,000,000 of this debt for the period commencing September 8, 2005
through September 8, 2007. Headwaters accounts for these agreements as cash
flow hedges, and accordingly, the fair market value of the hedges is
reflected in the consolidated balance sheet as either other assets or other
liabilities. The hedges had an immaterial fair market value at December 31,
2004.
Convertible Senior Subordinated Notes - In connection with the Eldorado
acquisition, Headwaters issued $172,500,000 of 2 7/8% convertible senior
subordinated notes due 2016. These notes are subordinate to the senior
secured debt described above. Holders of the notes may convert the notes
into shares of Headwaters' common stock at a conversion rate of 33.3333
shares per $1,000 principal amount ($30 conversion price), or 5,750,000
aggregate shares of common stock, contingent upon certain events. The
conversion rate adjusts for events related to Headwaters' common stock,
including common stock issued as a dividend, rights or warrants to purchase
common stock issued to all holders of Headwaters' common stock, and other
similar rights or events that apply to all holders of common stock.
The notes are convertible if any of the following five criteria are met: 1)
satisfaction of a market price condition which becomes operative if the
common stock trading price reaches $39 per share for a certain period of
time prior to June 1, 2011 and at any time after that date; 2) a credit
rating, if any, assigned to the notes is three or more rating subcategories
below the initial rating, if any; 3) the notes trade at 98% of the product
of the common stock trading price and the number of shares of common stock
issuable upon conversion of $1,000 principal amount of the notes, except
this provision is not available if the closing common stock price is
between 100% and 130% of the current conversion price of the notes; 4)
Headwaters calls the notes for redemption; and 5) certain corporate
transactions occur, including distribution of rights or warrants to all
common stockholders entitling them to purchase common stock at less than
the current market price or distribution of common stock, cash or other
assets, debt securities or certain rights to purchase securities where the
distribution has a per share value exceeding 5% of the closing common stock
price on the day immediately preceding the declaration date for such
distribution. In addition, the notes are convertible if Headwaters enters
into an agreement pursuant to which Headwaters' common stock would be
converted into cash, securities or other property.
Headwaters may call the notes for redemption at any time on or after June
1, 2007 and prior to June 4, 2011 if the closing common stock price exceeds
130% of the conversion price for 20 trading days in any consecutive 30-day
trading period (in which case Headwaters must provide a "make whole"
payment of the present value of all remaining interest payments on the
redeemed notes through June 1, 2011). In addition, the holder of the notes
has the right to require Headwaters to repurchase all or a portion of the
notes on June 1, 2011 or if a fundamental change in common stock has
occurred, including termination of trading. Subsequent to June 1, 2011, the
notes require an additional interest payment equal to 0.40% of the average
trading price of the notes if the trading price equals 120% or more of the
principal amount of the notes.
Headwaters has included the additional shares of common stock contingently
issuable under the notes in its 2004 diluted EPS calculation, on an
if-converted basis, in accordance with the new requirements of EITF 04-08
(see Note 8).
Notes Payable to a Bank - In connection with the acquisition of SCP in July
2004, Headwaters assumed SCP's obligations under its notes payable to a
bank. The notes require monthly interest and quarterly principal payments.
Two of the notes bear interest at LIBOR plus 0.5%, subject to an interest
rate floor of 4.5% (4.5% at December 31, 2004), and the remaining note (in
the amount of $3,000,000) bears interest at 0.5% below the bank's base rate
13
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
(4.75% at December 31, 2004). Because the notes are callable by the bank,
Headwaters has included the outstanding balance in current portion of
long-term debt in the consolidated balance sheet. The notes are
collateralized by certain assets of SCP and contain financial covenants
specific to SCP, including a minimum fixed charge coverage ratio, a
leverage ratio requirement, and limitations on capital expenditures.
Headwaters was in compliance with all debt covenants as of December 31,
2004.
Interest Costs - During 2003 and 2004, Headwaters incurred total interest
costs of approximately $5,501,000 and $15,991,000, respectively, including
approximately $2,588,000 and $1,941,000, respectively, of non-cash interest
expense and approximately $161,000 and $127,000, respectively, 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, was approximately 6.3% at September 30, 2004 and 5.2% at
December 31, 2004.
7. Income Taxes
Headwaters' effective income tax rate for 2004 was approximately 35%, the
estimated rate for the fiscal year ending September 30, 2005. This compares
to an effective tax rate of approximately 38% for 2003. The primary reason
for the decrease in the effective tax rate is federal income tax credits
available as a result of Headwaters' investment in an entity that owns and
operates a coal-based solid alternative fuel production facility (see Note
9). The alternative fuel produced at the facility through December 2007
qualifies for tax credits pursuant to Section 29 of the Internal Revenue
Code. Excluding the effect of the tax credits, Headwaters' effective tax
rate in 2004 would have been approximately 40%.
8. Earnings per Share
Three Months Ended December 31,
(in thousands, except per-share data) 2003 2004
----------------------------------------------------------------------------------
Numerator:
Numerator for basic earnings per share -
net income $10,092 $13,008
Interest expense related to convertible
senior subordinated notes, net of taxes -- 978
-----------------------------------
Numerator for diluted earnings per share -
net income plus interest expense related
to convertible notes, net of taxes $10,092 $13,986
===================================
Denominator:
Denominator for basic earnings per share
- weighted-average shares outstanding 27,961 33,439
Effect of dilutive securities:
Shares issuable upon exercise of
options and warrants 1,121 1,362
Shares issuable upon conversion of
convertible senior subordinated notes -- 5,750
----------------- -----------------
Total potential dilutive shares 1,121 7,112
----------------- -----------------
Denominator for diluted earnings per
share - weighted-average shares
outstanding after assumed exercises
and conversions 29,082 40,551
================= =================
Basic earnings per share $ 0.36 $ 0.39
================= =================
Diluted earnings per share $ 0.35 $ 0.34
================= =================
In September 2004, the EITF reached a consensus (EITF Issue 04-08)
requiring the inclusion of contingently convertible securities in diluted
EPS calculations. This consensus is effective for periods ending after
December 15, 2004 and required Headwaters to include in its 2004 diluted
14
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
EPS calculation, on an if-converted basis, the additional shares issuable
under the terms of Headwaters' outstanding convertible senior subordinated
notes described in Note 6. The EITF consensus must be applied to all
applicable prior periods, which for Headwaters will be the quarters ended
June 30, 2004 and September 30, 2004.
Anti-dilutive securities not considered in the diluted earnings per share
calculation, consisting of out-of-the money options, totaled approximately
15,000 and 110,000 shares for 2003 and 2004, respectively.
9. Commitments and Contingencies
Commitments and contingencies as of December 31, 2004 not disclosed
elsewhere, are as follows:
Employee Benefit Plans - In 2004, Headwaters' Board of Directors approved a
Deferred Compensation Plan for certain designated employees, which plan
became effective on January 1, 2005. In January 2005, Headwaters' Board of
Directors adopted, subject to stockholder approval, the Headwaters
Incorporated Long Term Incentive Compensation Plan ("LTIP") under which
employees of Headwaters selected to participate by the Compensation
Committee will be eligible to receive long-term incentive-based
compensation. The LTIP will be voted on at the annual meeting of
stockholders on March 1, 2005.
Medical Insurance - Effective January 1, 2003, Headwaters adopted a
self-insured medical insurance plan for its employees and the employees of
all of its subsidiaries existing at that time. For the plan year ended
December 31, 2004, there is stop-loss coverage for amounts in excess of
$100,000 per individual and approximately $7,500,000 in the aggregate.
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 December 31, 2004,
approximately $869,000 is accrued for claims incurred from January through
December 31, 2004 that have not been paid or reported.
Tapco also has a self-insured medical insurance plan covering substantially
all of its employees. This plan is administered by a third party and for
the plan year ended December 31, 2004 has stop-loss coverage for amounts in
excess of $125,000 per individual per year. As of December 31, 2004,
approximately $743,000 is accrued for claims incurred that have not been
paid or reported.
Property, Plant and Equipment - As of December 31, 2004, Headwaters was
committed to spend approximately $12,600,000 to complete capital projects
that were in various stages of completion.
Solid Alternative Fuel Facility - In September 2004, Headwaters purchased a
9% variable interest in an entity that owns and operates a coal-based solid
alternative fuel production facility, where Headwaters is not the primary
beneficiary. In December 2004, Headwaters purchased an additional 10%
variable interest in this same entity. Headwaters' 19% minority interest
was acquired in exchange for initial cash payments totaling $500,000 and an
obligation to pay $15,000,000 in monthly installments from October 2004
through December 2007. This obligation, recorded in other accrued
liabilities and other long-term liabilities in the consolidated balance
sheet, bears interest at an 8% rate. Headwaters also has agreed to make
additional payments to the seller based on a pro-rata allocation of the tax
credits generated by the facility, and its pro-rata share of operating
expenses, also through December 2007. These additional payments and
operating expenses, along with the amortization of the $15,500,000
investment, are recorded in other expense in the consolidated statement of
income.
The alternative fuel produced at the facility through December 2007
qualifies for tax credits pursuant to Section 29 of the Internal Revenue
Code, and Headwaters is entitled to receive its pro-rata share of such tax
credits generated. Headwaters has the ability, under certain conditions, to
limit its liability under the fixed payment obligations of $15,000,000;
therefore, Headwaters' obligation to support the facility's future
operations and make all of the above-described payments is effectively
limited to the tax benefits Headwaters receives.
15
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
Joint Venture Obligations - In September 2004, Headwaters entered into an
agreement with an international chemical company, based in Germany, to
jointly develop and commercialize a process for the direct synthesis of
hydrogen peroxide. Under terms of the joint venture agreement, Headwaters
paid $1,245,000 for its investment in the joint venture and is further
obligated to pay an additional $1,000,000 in 2005 and $1,000,000 in 2006.
Headwaters has also committed to fund 50% of the joint venture's research
and development expenditures, currently limited to (euro)3,000,000
(approximately $4,100,000 at December 31, 2004), through September 2007.
Although there is no legal obligation to do so, the joint venture partners
currently have long-range plans to eventually invest in large-scale
hydrogen peroxide plants using the process for direct synthesis of hydrogen
peroxide.
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 or resolve these
matters by settlement, as appropriate. Management does not currently
believe that the outcome of these matters will have a material adverse
effect on Headwaters' operations, cash flows or financial position.
In fiscal 2004, Headwaters accrued approximately $1,400,000 of reserves for
legal matters because it concluded that claims and damages sought by
claimants in excess of that amount were not probable. During the quarter
ended December 31, 2004, Headwaters expensed $270,000 for legal matters.
Our outside counsel believe that unfavorable outcomes are neither probable
nor remote and declined to express opinions concerning the likely outcomes
or liability of Headwaters. The reserves represent the amounts Headwaters
would be willing to pay to reach a settlement. However, these cases raise
difficult and complex legal and factual issues, and the resolution of these
issues is subject to many uncertainties, including the facts and
circumstances of each case, the jurisdiction in which each case is brought,
and the future decisions of juries, judges, and arbitrators. Therefore,
although management believes that the claims asserted against Headwaters in
the named cases lack merit, there is a possibility of material losses in
excess of the amounts accrued if one or more of the cases were to be
determined adversely against Headwaters for a substantial amount of the
damages asserted.
Headwaters currently believes the range of potential loss, excluding costs
for outside counsel, is from $520,000 up to the amounts sought by
claimants. It is possible that a change in the estimates of probable
liability could occur, and the changes could be significant. Additionally,
as with any litigation, these proceedings require that Headwaters incur
substantial costs, including attorneys' fees, managerial time, and other
personnel resources and costs in pursuing resolution. Costs paid to outside
legal counsel for litigation, which comprise the majority of Headwaters'
litigation-related costs, totaled approximately $462,000 in 2003 and
$1,609,000 in 2004. It is not possible to estimate what these costs will be
in future periods.
Boynton. In October 1998, Headwaters entered into a technology purchase
agreement with James G. Davidson and Adtech, Inc. The transaction
transferred certain patent and royalty rights to Headwaters related to a
synthetic fuel technology invented by Davidson. (This technology is
distinct from the technology developed by Headwaters.) This action is
factually related to an earlier action brought by certain purported
officers and directors of Adtech, Inc. That action was dismissed by the
United States District Court for the Western District of Tennessee and the
District Court's order of dismissal was affirmed on appeal. In the current
action, the allegations arise from the same facts, but the claims are
asserted by certain purported stockholders of Adtech. In June 2002,
Headwaters received a summons and complaint from the United States District
Court for the Western District of Tennessee alleging, among other things,
fraud, conspiracy, constructive trust, conversion, patent infringement and
interference with contract arising out of the 1998 technology purchase
agreement entered into between Davidson and Adtech on the one hand, and
Headwaters on the other. The plaintiffs seek declaratory relief and
compensatory damages in the approximate amount of between $15,000,000 and
$25,000,000 and punitive damages. The District Court has dismissed all
claims against Headwaters except conspiracy and constructive trust. The
Court has scheduled trial for April 2005. 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
16
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
Hodder project. AGTC is seeking approximate damages in the arbitration
between $520,000 and $14,300,000. 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 filed an answer in the
arbitration, denying AGTC's claims and asserting counterclaims against
AGTC. The arbitrator conducted hearings during July and August of 2004 and
has received a post-arbitration briefing and issued a decision on December
17, 2004. The arbitrator found liability against Headwaters in the amount
of $520,000 plus prejudgment interest in the amount of approximately
$403,000, all of which was accrued as of December 31, 2004 and paid in
January 2005 in full settlement of the matter.
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 in the approximate amount of $71,000,000 and punitive
damages. Headwaters has denied the allegations of AJG's counter-claims.
This litigation reached the trial phase in January 2005 and is anticipated
to conclude in February 2005. Because the resolution of the litigation is
uncertain, legal counsel cannot express an opinion as to the ultimate
amount of recovery or liability.
McEwan. In 1995, Headwaters granted stock options to a member of its board
of directors, Lloyd McEwan. The director resigned from the board in 1996.
Headwaters has declined McEwan's attempts to exercise most of the options
on grounds that the options terminated. In June 2004, McEwan filed a
complaint in the Fourth District Court for the State of Utah against
Headwaters alleging breach of contract, breach of implied covenant of good
faith and fair dealing, fraud, and misrepresentation. McEwan seeks
declaratory relief as well as compensatory damages in the approximate
amount of $2,750,000 and punitive damages. Headwaters has filed an answer
denying McEwan's claims and has asserted counterclaims against McEwan.
Because resolution of the litigation is uncertain, legal counsel cannot
express an opinion as to the ultimate amount of liability or recovery.
Headwaters Construction Materials Matters. There are litigation and pending
and threatened claims made against certain subsidiaries of Headwaters
Construction Materials with respect to several types of exterior finish
systems manufactured and sold by its subsidiaries for application by
contractors on residential and commercial buildings. Typically, litigation
and these claims are controlled by such subsidiaries' insurance carriers.
The plaintiffs or claimants in these matters have alleged that the
structures have suffered damage from latent or progressive water
penetration due to some alleged failure of the building product or wall
system. The most prevalent type of claim involves alleged defects
associated with components of an Exterior Insulation and Finish System
("EIFS") which was produced for a limited time (through 1997) by Best
Masonry & Tool Supply and Don's Building Supply. There is a 10-year
projected claim period following discontinuation of the product.
Typically, the claims cite damages for alleged personal injuries and
punitive damages for alleged unfair business practices in addition to
asserting more conventional damage claims for alleged economic loss and
damage to property. To date, claims made against such subsidiaries have
been paid by their insurers, with the exception of minor deductibles,
although such insurance carriers typically have issued "reservation of
rights" letters to Headwaters Resources. 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
Headwaters Resources incur substantial costs, there is no guarantee of
insurance coverage or continuing coverage. These and future proceedings may
result in substantial costs to Headwaters Resources, including attorneys'
fees, managerial time and other personnel resources and costs. Adverse
resolution of these proceedings could have a materially negative effect on
Headwaters Resources' business, financial condition, and results of
operation, and its ability to meet its financial obligations. Although
Headwaters Resources carries general and product liability insurance,
Headwaters Resources cannot assure that such insurance coverage will remain
17
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
(Unaudited)
available, that Headwaters Resources' insurance carrier will remain viable,
or that the insured amounts will cover all future claims in excess of
Headwaters Resources' uninsured retention. Future rate increases may also
make such insurance uneconomical for Headwaters Resources to maintain. In
addition, the insurance policies maintained by Headwaters Resources 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 Resources' liability.
Other. Headwaters and its subsidiaries are also involved in other legal
proceedings that have arisen in the normal course of business.
Section 29 Matters - Headwaters Energy Services' license fees and revenues
from sales of chemical reagents depend on the ability of licensees and
customers to manufacture and sell qualified synthetic fuels that generate
tax credits under Section 29 of the Internal Revenue Code. From time to
time, issues arise as to the availability of tax credits, including the
items discussed below.
Legislation. Under current law, Section 29 tax credits for synthetic fuel
produced from coal expire on December 31, 2007. In addition, there have
been initiatives from time to time to consider the early repeal or
modification of Section 29. For example, during calendar 2004, a bill was
introduced in the United States House of Representatives that would repeal
the Section 29 credit for synthetic fuel produced from coal. Although the
bill did not pass Congress in calendar 2004, the bill could be reintroduced
in 2005. If Section 29 expires at the end of 2007 or 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, Headwaters does not believe
that production of synthetic fuel will be profitable absent the tax
credits. In addition, if Headwaters' licensees close their facilities or
materially reduce production activities (whether after 2007, or 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.
Phase-Out. Section 29 tax credits are subject to phase-out after the
average annual wellhead domestic oil price ("reference price") reaches a
beginning phase-out threshold price, and is eliminated entirely if the
reference price reaches the full phase-out price. For calendar 2003, the
reference price was $27.56 per barrel and the phase-out range began at
$50.14 and would have fully phased out tax credits at $62.94 per barrel.
For calendar 2004, an estimated partial year reference price (through
November 2004) is $36.80 per barrel, and an estimate of the phase-out range
(using 2% inflation) begins at $51.14 and completes phase-out at $64.20 per
barrel. The one-day cash trading price on January 31, 2005 was $47.76 per
barrel.
IRS Audits. Licensees are subject to audit by the IRS. The IRS may
challenge whether Headwaters Energy Services' licensees satisfy the
requirements of Section 29, or applicable Private Letter Rulings, including
placed-in-service requirements, or may attempt to disallow Section 29 tax
credits for some other reason. The IRS has initiated audits of certain
licensee-taxpayers who claimed Section 29 tax credits, and the outcome of
any such audit is uncertain. In calendar 2004, a licensee announced that
IRS field auditors had issued a notice of proposed adjustment challenging
the placed-in-service date of three of its synthetic fuel facilities. The
licensee believes that the facilities meet the placed-in-service
requirement, however, the timing and final results of the audit are
unknown. The inability of a licensee to claim Section 29 tax credits would
reduce Headwaters' future income from the licensee.
Senate Permanent Subcommittee on Investigations. On October 29, 2003, the
Permanent Subcommittee on Investigations of the Government Affairs
Committee of the United States Senate issued a notification of pending
investigations. The notification listed the synthetic fuel tax credit as a
new item. In March 2004, the Subcommittee described its investigation as
follows: "The Subcommittee is continuing its investigation [of] tax credits
claimed under Section 29 of the Internal Revenue Code for the sale of
coal-based synthetic fuels. This investigation is examining the utilization
of these tax credits, the nature of the technologies and fuels created, the
use of these fuels, and others [sic] aspects of Section 29. The
investigation will also address the IRS' administration of Section 29 tax
credits." The Subcommittee conducted numerous interviews and received large
volumes of data between December 2003 and March 2004. Since that time, to
Headwaters' knowledge, there has been little activity regarding the
investigation. Headwaters cannot make any assurances as to the timing or
ultimate outcome of the Subcommittee investigation, nor can Headwaters
18
predict whether Congress or others may conduct investigations of Section 29
tax credits in the future. The Subcommittee investigation 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 Headwaters' revenues and net income.
License Fees - Pursuant to the contractual terms of an agreement with a
certain licensee, this licensee has set aside substantial amounts for
working capital and other operational contingencies as provided for in the
contractual agreements. These amounts may eventually be paid out to various
parties having an interest in the cash flows from the licensee's
operations, including Headwaters, if they are not used for working capital
and other operational contingencies. As a result, Headwaters currently
expects to receive at some future date a portion of those reserves, the
amount of which is not currently determinable and therefore, not
recognizable.
19
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with the accompanying unaudited consolidated financial statements and notes
thereto included elsewhere herein. Headwaters' fiscal year ends on September 30
and unless otherwise noted, future references to 2003 refer to Headwaters'
fiscal quarter ended December 31, 2003, and references to 2004 refer to
Headwaters' fiscal quarter ended December 31, 2004.
Introduction
Over the last three years, Headwaters has executed on its two-fold plan
of maximizing cash flow from its existing operating business units and
diversifying revenues from over-reliance on the alternative energy segment. With
the addition of the CCP management and marketing business through the
acquisition of ISG in 2002, and the growth of the construction materials
business culminating in the acquisitions of Eldorado and Tapco in fiscal 2004,
Headwaters has achieved revenue growth and diversification into three business
segments. Because Headwaters has also incurred increased indebtedness to make
strategic acquisitions and related capital expenditures, one of management's key
financial objectives is to continue to focus on increased cash flows for
purposes of reducing indebtedness as quickly as possible.
Headwaters' acquisition strategy targets businesses that are leading
players in their respective industries, enjoy healthy margins from products and
services and are not capital intensive, thus providing additional cash flow that
complements the financial performance of Headwaters' existing business segments.
Headwaters is also committed to the internal development of its energy-related
technologies and nanotechnology through HTI; it has invested in and expects to
continue to maintain its research and development activities.
As a result of its diversification into CCPs and construction
materials, Headwaters is affected by seasonality, with its highest revenues
produced in the June and September quarters. With CCPs, Headwaters' strategy is
to continue to negotiate long-term contracts so that it may invest in transport
and storage infrastructure for the marketing and sale of CCPs. Headwaters also
intends to continue to expand usage of high value CCPs, develop uses for lower
value CCPs and expand usage of CCPs both in its construction products and the
industry in general.
Headwaters' acquisitions of Eldorado and Tapco have created a
concentration in the residential housing market; however, the cyclicality and
interest-rate sensitivity of this business is mitigated by the fact that
approximately 75% of Tapco's products are used in the home improvement and
remodeling market, which is typically counter cyclical to the new construction
market because remodeling is generally less expensive than a new home and is
often required to maintain older homes and preserve their value. As a result,
during economic downturns, Tapco's products have experienced strong growth
rates. In light of Headwaters' leading market shares in Eldorado's and Tapco's
markets, Headwaters will need to increase production capacity for Eldorado and
develop and promote new products from Tapco in order to continue the current
growth rate in this segment.
In fiscal 2005, Headwaters is focusing on integration of its new
acquisitions, including the marketing of diverse construction materials products
through its national distribution network, and expansion of the corporate
infrastructure necessary to provide the information and services that the
business segments need to operate at optimal levels. Headwaters is highly
leveraged as a result of the fiscal 2004 acquisitions. This leverage makes
continued diversification at historical levels more difficult. Headwaters
intends to focus on repaying its current debt as quickly as possible while
continuing to look for diversification opportunities within prescribed
parameters.
Consolidation, Acquisitions and Segments
Consolidation and Acquisitions. The consolidated financial statements
include the accounts of Headwaters, all of its subsidiaries and other entities
in which Headwaters has a controlling financial interest. Headwaters also
consolidates any variable interest entities for which it is the primary
beneficiary; however, as of December 31, 2004, there are none. For investments
in companies in which Headwaters has a significant influence over operating and
financial decisions (generally defined as owning a voting or economic interest
of 20% to 50%), Headwaters applies the equity method of accounting. In instances
where Headwaters' investment is less than 20% and significant influence does not
exist, investments are carried at cost. All significant intercompany
transactions and accounts are eliminated in consolidation.
Headwaters acquired VFL on April 9, 2004, Eldorado Stone on June 2,
2004, SCP on July 2, 2004, and Tapco on September 8, 2004. Accordingly, these
entities' results of operations have been consolidated with Headwaters' 2004
results, but the 2003 results includes nothing related to these companies
because none of the acquisitions were consummated prior to December 31, 2003.
Due to the significance of these acquisitions, in many instances the 2004
consolidated financial statements and components of those financial statements
included in the following discussion and analysis are not comparable to the 2003
20
financial statements or components thereof. Also, due to the seasonality of the
operations of the CCP and construction materials segments and other factors,
Headwaters' consolidated results of operations for 2004 are not indicative of
the results to be expected for the full fiscal 2005 year.
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. Effective October 1, 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.
As described in more detail in Note 3 to the consolidated financial
statements in the Form 10-K, the determination of the final purchase price, and
the allocation thereof, for both Eldorado and Tapco has not been finalized.
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 alternative 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 markets coal combustion products such as fly ash and
bottom ash, known as CCPs, to the building products and ready mix concrete
industries. Headwaters markets CCPs to replace manufactured or mined materials,
such as portland cement, lime, agricultural gypsum, fired lightweight aggregate,
granite aggregate and limestone. Headwaters has long-term contracts, primarily
with coal-fueled electric power generation plants pursuant to which it manages
the post-combustion operations for the utilities. CCP revenues consist primarily
of product sales with a smaller amount of service revenue. VFL has been included
in Headwaters' CCP segment since its acquisition in April 2004.
Prior to 2004, the businesses in the construction materials segment
manufactured and distributed value-added bagged concrete, stucco, mortar and
block products. The acquisition of SCP expanded Headwaters' concrete block
business and the acquisition of Eldorado added manufactured architectural stone
to the construction materials product line. Tapco is a leading designer,
manufacturer and marketer of building products used in exterior residential home
improvement and construction. Revenues for the construction materials segment
consist of product sales to wholesale and retail distributors, contractors and
other users of building products and construction materials.
Three Months Ended December 31, 2004 Compared to Three Months Ended December 31,
2003
The information set forth below compares Headwaters' operating results
for the three months ended December 31, 2004 ("2004") with operating results for
the three months ended December 31, 2003 ("2003").
Revenue. Total revenue for 2004 increased by $116.9 million or 115% to
$218.4 million as compared to $101.5 million for 2003. The major components of
revenue are discussed in the sections below.
Sales of Chemical Reagents. Chemical reagent sales during 2004 were
$36.8 million with a corresponding direct cost of $24.6 million. Chemical
reagent sales during 2003 were $30.9 million with a corresponding direct cost of
$21.3 million. The increase in chemical reagent sales during 2004 was due
primarily to significantly increased synthetic fuel production by Headwaters'
licensees (resulting in increased sales of $2.2 million) and by customers with
which Headwaters does not have a license agreement (resulting in increased sales
of $3.7 million). Of the increased sales to customers, $1.7 million represents
sales of chemical reagent to the entity that owns and operates a coal-based
solid alternative fuel production facility in which Headwaters initially
invested in September 2004 (see Note 9 to the consolidated financial
statements). It is not possible to predict the trend of sales of chemical
reagents. The gross margin percentage for 2004 of 33% was 2% higher than for
2003, due primarily to changes in customer mix.
License Fees. During 2004, Headwaters recognized license fee revenue
totaling $14.6 million, an increase of $5.0 million or 52% over $9.6 million of
license fee revenue recognized during 2003. The primary reason for the increase
in license fee revenue in 2004 compared to 2003 was the recognition in 2004 of
$4.0 million of revenue from one of Headwaters' licensees for which no revenue
was recognized in 2003. For more information about the revenue related to this
licensee, see "License Fee Revenue Recognition" in the "Critical Accounting
Policies and Estimates" section of Headwaters' Form 10-K. Also, pursuant to the
contractual terms of the agreement with this same licensee, this licensee has
set aside substantial amounts for working capital and other operational
contingencies as provided for in the contractual agreements. These amounts may
21
eventually be paid out to various parties having an interest in the cash flows
from the licensee's operations, including Headwaters, if they are not used for
working capital and other operational contingencies. As a result, Headwaters
currently expects to receive at some future date a portion of those reserves,
the amount of which is not currently determinable and therefore, not
recognizable.
CCP Revenues. CCP revenues for 2004 were $53.1 million with a
corresponding direct cost of $41.0 million. CCP revenues for 2003 were $45.1
million with a corresponding direct cost of $33.4 million. The increase in CCP
revenues during 2004 was due primarily to the acquisition of VFL in April 2004
(VFL's revenues for 2004 totaled $8.6 million). The gross margin percentage
decreased from 2003 to 2004 by approximately 3% due primarily to VFL (which
typically has lower gross margins than the legacy CCP business), one-time
benefits realized in 2003 from the renegotiation of a long-term materials
contract, and adverse weather conditions in Texas in 2004.
Sales of Construction Materials. Sales of construction materials during
2004 were $113.7 million with a corresponding direct cost of $76.5 million.
Sales of construction materials during 2003 were $11.9 million with a
corresponding direct cost of $9.4 million. The increase in sales of construction
materials during 2004 was due primarily to the acquisitions of Eldorado in June
2004, SCP in July 2004 and Tapco in September 2004. Revenues for these acquired
companies for 2004 totaled $102.0 million. The increase in gross margin
percentage from 2003 to 2004 was due primarily to significantly higher margins
from the operations of the acquired businesses.
Amortization. These costs increased by $4.5 million to $6.2 million in
2004 from $1.7 million in 2003. The increase was primarily attributable to the
fiscal 2004 acquisitions and the resulting increases in amortizable intangible
assets. For this same reason, Headwaters expects fiscal 2005 amortization
expense to be substantially higher than it was for fiscal 2004.
Research and Development. Research and development expenses increased
by $0.2 million to $2.3 million in 2004 from $2.1 million in 2003. The increase
was primarily attributable to increased HTI research and development activities,
partially offset by an extra month of HTI expenses in 2003. Headwaters remains
committed to HTI's research and development efforts and future expenses are
likely to outpace fiscal 2004 levels as a result of continuing efforts to
commercialize existing technologies.
Selling, General and Administrative Expenses. These expenses increased
$18.6 million to $30.1 million for 2004 from $11.5 million for 2003. The
increase in 2004 was due primarily to the fiscal 2004 acquisitions ($16.4
million), increases in litigation-related costs ($1.1 million), and certain
increases in various other costs incidental to growth, primarily payroll-related
costs ($0.9 million). As a result of the fiscal 2004 acquisitions, fiscal 2005
selling, general and administrative expenses are expected to be substantially
higher than for fiscal 2004, but should be more comparable to fiscal 2004 levels
when viewed as a percentage of revenues.
Other Income and Expense. During 2004, Headwaters reported net other
expense of $17.7 million compared to net other expense of $5.8 million during
2003. The change of $11.9 million was primarily attributable to an increase in
interest expense of $10.6 million in 2004 and a net increase in other expenses
of approximately $1.4 million in 2004.
Interest expense increased from $5.3 million in 2003 to $15.9 million
in 2004 due primarily to significantly higher average levels of long-term debt
in 2004 compared to 2003, primarily related to the fiscal 2004 acquisitions. In
both periods, debt repayments (totaling approximately $60.1 million in 2003 and
$51.2 million in 2004) consisted primarily of early repayments. Non-cash
interest expense, representing amortization of debt discount (in 2003 only) and
debt issue costs (in both 2003 and 2004), was $2.6 million in 2003 and $1.9
million in 2004. Due to the substantially higher amounts of outstanding debt at
December 31, 2004 than existed for most of fiscal 2004, interest expense in
fiscal 2005 is expected to be substantially higher than for comparable periods
in fiscal 2004.
The net change in other expenses of $1.4 million consisted primarily of
Headwaters' pro-rata share in 2004 of operating expenses related to its
investment in the coal-based solid alternative fuel production facility
described in Note 9 to the consolidated financial statements, along with
amortization of the related $15.5 million investment (together totaling
approximately $2.3 million), partially offset by a $0.5 million write-off in
2003 of a note receivable and a net change in other items totaling $0.4 million.
Income Tax Provision. Headwaters' effective income tax rate for 2004
was approximately 35%, the estimated rate for the fiscal year ending September
30, 2005. This compares to an effective tax rate of approximately 38% for 2003.
The primary reason for the decrease in the effective tax rate is federal income
tax credits available as a result of Headwaters' investment in an entity that
owns and operates a coal-based solid alternative fuel production facility (see
Note 9 to the consolidated financial statements). The alternative fuel produced
at the facility through December 2007 qualifies for tax credits pursuant to
Section 29 of the Internal Revenue Code. Excluding the effect of the tax
credits, Headwaters' effective tax rate in 2004 would have been approximately
40%.
22
Liquidity and Capital Resources
Summary of Cash Flow Activities. Net cash provided by operating
activities during 2004 was $41.8 million compared to $22.9 million of net cash
used in operating activities during 2003. The change was primarily attributable
to changes in short-term trading investments ($38.4 million) and other operating
assets and liabilities ($12.7 million), and to a lesser extent, increased net
income and depreciation and amortization (together $13.3 million) in 2004.
In 2003, Headwaters issued 4.75 million shares of common stock under an
effective shelf registration statement for net cash proceeds of $86.4 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
approximately $3.9 million). Headwaters used $50.0 million of the cash generated
from the issuance of common stock to repay debt, and the remaining proceeds were
temporarily invested in short-term trading investments and ultimately used for
acquisitions. During 2004, a total of $51.2 million of debt was repaid, compared
to a total of $60.1 million in 2003. New debt issuances in both periods were not
material. During both periods, investing activities consisted primarily of the
purchase of property, plant and equipment. More details about Headwaters'
investing and financing activities are provided in the following paragraphs.
Investing Activities. As described in more detail in Note 3 to the
consolidated financial statements in the Form 10-K, Headwaters acquired four
companies in fiscal 2004. Primarily as a result of these acquisitions,
expenditures for property, plant and equipment increased substantially from 2003
($3.1 million) to 2004 ($11.9 million). These capital expenditures primarily
related to the CCPs and construction materials segments and for fiscal 2005 will
be much higher than for fiscal 2004. Capital expenditures for fiscal 2005 are
currently expected to approximate the limitation on such expenditures included
in the senior debt covenants of $50.0 million. As of December 31, 2004,
Headwaters was committed to spend approximately $12.6 million to complete
capital projects that were in various stages of completion.
Headwaters intends to continue to expand its business through growth of
existing operations, commercialization of technologies currently being
developed, and strategic acquisitions of entities that operate in adjacent
industries. Acquisitions are an important part of Headwaters' business strategy
and to that end, Headwaters routinely reviews potential complementary
acquisitions, including those in the areas of CCP marketing, construction
materials, and coal and catalyst technologies. It is possible that some portion
of future cash and cash equivalents and/or proceeds from the issuance of stock
or debt will be used to fund acquisitions of complementary businesses in the
chemical, energy, building products and related industries. The new senior
secured credit agreement limits acquisitions to $50.0 million each fiscal year,
of which cash consideration may not exceed $30.0 million, unless Headwaters'
"total leverage ratio," as defined, is less than or equal to 3.50:1.0, after
giving effect to an acquisition, in which case the foregoing $30.0 million cash
limitation does not apply.
As described in more detail in Note 9 to the consolidated financial
statements, in September 2004, Headwaters purchased a 9% variable interest in an
entity that owns and operates a coal-based solid alternative fuel production
facility, where Headwaters is not the primary beneficiary. In December 2004,
Headwaters purchased an additional 10% variable interest in this same entity.
Headwaters' 19% minority interest was acquired in exchange for initial cash
payments totaling $0.5 million and an obligation to pay $15.0 million in monthly
installments from October 2004 through December 2007. This obligation, recorded
in other accrued liabilities and other long-term liabilities in the consolidated
balance sheet, bears interest at an 8% rate. Headwaters also has agreed to make
additional payments to the seller based on a pro-rata allocation of the tax
credits generated by the facility, and its pro-rata share of operating expenses,
also through December 2007. These additional payments and operating expenses,
along with the amortization of the $15.0 million investment, are recorded in
other expense in the consolidated statement of income.
The alternative fuel produced at the facility through December 2007
qualifies for tax credits pursuant to Section 29 of the Internal Revenue Code,
and Headwaters is entitled to receive its pro-rata share of such tax credits
generated. The IRS has issued a Private Letter Ruling to the owners of the
facility. Headwaters has the ability, under certain conditions, to limit its
liability under the fixed payment obligations of $15.0 million; therefore,
Headwaters' obligation to support the facility's future operations and make all
of the above-described payments is effectively limited to the tax benefits
Headwaters receives. The total amounts that Headwaters will be required to pay
are directly impacted by the amounts of solid alternative fuel produced at the
facility, including the original fixed payment obligations of $15.5 million.
In September 2004, Headwaters entered into an agreement with an
international chemical company, based in Germany, to jointly develop and
commercialize a process for the direct synthesis of hydrogen peroxide. Under
terms of the joint venture agreement, Headwaters paid $1.2 million for its
investment in the joint venture and is further obligated to pay an additional
$1.0 million in 2005 and $1.0 million in 2006. Headwaters has also committed to
fund 50% of the joint venture's research and development expenditures, currently
limited to (euro)3.0 million (approximately $4.1 million at December 31, 2004),
through September 2007. Although there is no legal obligation to do so, the
joint venture partners currently have long-range plans to eventually invest in
large-scale hydrogen peroxide plants using the process for direct synthesis of
hydrogen peroxide.
23
Financing Activities. Due to the issuance of senior debt in September
2004 and the covenants associated with that debt, as described below, Headwaters
currently has limited ability to obtain significant additional amounts of
long-term debt. However, Headwaters has experienced strong positive cash flow
from operations which has enabled Headwaters to repay its long-term debt prior
to the scheduled maturities. Headwaters expects its strong positive cash flow to
continue in the future and also has the ability to access the equity markets.
Headwaters has an effective universal shelf registration statement on
file with the SEC that can be used for the sale of common stock, preferred
stock, convertible debt and other securities. In December 2003, Headwaters filed
a prospectus supplement to the shelf registration statement and issued 4.75
million shares of common stock under this shelf registration statement in an
underwritten public offering for net proceeds of $86.4 million. As of December
31, 2004, approximately $53.0 million remains available for future offerings of
securities under the shelf registration statement. A prospectus supplement
describing the terms of any securities to be issued is required to be filed
before any future offering would commence under the registration statement.
In January 2005, Headwaters filed another Form S-3 shelf registration
statement with the SEC that, once declared effective by the SEC and following
the issuance of a prospectus supplement, could be used for the sale of up to
$175.0 million of common stock. Also in January 2005, Headwaters' Board of
Directors approved an increase in the authorized shares of common stock from
50.0 million to 100.0 million. This action is subject to stockholder approval
and will be voted on at the annual meeting of stockholders on March 1, 2005.
Senior Secured Credit Agreements - In September 2004 and as amended in
October 2004, Headwaters entered into two credit agreements with a syndication
of lenders under which a total of $790.0 million was borrowed under term loan
arrangements and which provide for $60.0 million to be borrowed under a
revolving credit arrangement. The proceeds were used to acquire Tapco and repay
in full the remaining balance due under Headwaters' former senior secured credit
agreement obtained in March 2004. The $790.0 million of term loan borrowings
consisted of a first lien term loan in the amount of $640.0 million and a second
lien term loan in the amount of $150.0 million. Both term loans are secured by
all assets of Headwaters and are senior in priority to all other debt, with the
exception of the specific SCP assets that collateralize the notes payable to
banks discussed below.
The first lien term loan bears interest, at Headwaters' option, at
either i) the London Interbank Offered Rate ("LIBOR") plus 3.0%, if the "total
leverage ratio," as defined, is less than or equal to 3.75:1.0, and if not, at
LIBOR plus 3.25%, or ii) the "base rate" plus 2.0%, if the total leverage ratio
is less than or equal to 3.75:1.0, and if not, at the base rate plus 2.25%. Base
rate is defined as the higher of the rate announced by Morgan Stanley Senior
Funding and the overnight rate charged by the Federal Reserve Bank of New York
plus 0.5%. The initial interest rate on the first lien debt was set at 6.5%, but
was subsequently reduced to approximately 5.4% in 2004 pursuant to the terms of
the agreement. The second lien term loan bears interest, also at Headwaters'
option, at either LIBOR plus 5.5%, or the "base rate" plus 4.5%. The initial
interest rate on the second lien debt was set at 9.75%, but was subsequently
reduced to approximately 7.7% in 2004 pursuant to the terms of the agreement.
Headwaters can lock in new rates for both the first lien and second lien loans
for one, two, three or six months. The most recent rate change, which did not
result in a material change, occurred in January 2005.
The first lien term loan is repayable in quarterly installments of
principal and interest, with minimum required quarterly principal repayments of
$12.0 million commencing in November 2004 through August 2007, then $4.0 million
through August 2010, with three repayments of approximately $149.3 million each
through April 2011, the termination date of the first lien loan agreement. The
second lien term loan is due September 2012, with no required principal
repayments prior to that time. Interest is generally due on a quarterly basis.
There are mandatory prepayments of the first lien term loan in the event of
certain asset sales and debt and equity issuances and from "excess cash flow,"
as defined in the agreement. Optional prepayments of the first lien term loan
are permitted without penalty or premium. Optional prepayments of the second
lien term loan are permissible only to the extent Headwaters issues new equity
securities and then are further limited to a maximum of $50.0 million, so long
as the first lien term loan remains outstanding. Any optional prepayments of the
second lien term loan bear a penalty of 3% of prepayments made in the first
year, 2% of prepayments made in the second year, and 1% of prepayments made in
the third year. Once repaid in full or in part, no further reborrowings under
either of the term loan arrangements can be made. In 2004, Headwaters repaid a
total of $50.0 million of the first lien term loan, which otherwise would have
been due during the period from November 2004 through November 2005. As a result
of the early repayment of debt, there was an acceleration of amortization of the
related debt issue costs totaling approximately $1.0 million, all of which was
charged to interest expense in 2004.
As required by the new senior secured credit facility, Headwaters
entered into certain other agreements to limit its variable interest rate
exposure. The first set of agreements effectively established the maximum LIBOR
rate for $300.0 million of the senior secured debt at 5.0% through September 8,
2005. The second set of agreements effectively sets the LIBOR rate at 3.71% for
$300.0 million of this debt for the period commencing September 8, 2005 through
September 8, 2007. Headwaters accounts for these agreements as cash flow hedges,
24
and accordingly, the fair market value of the hedges is reflected in the
consolidated balance sheet as either other assets or other liabilities. The
hedges had an immaterial fair market value at December 31, 2004.
Convertible Senior Subordinated Notes - In connection with the Eldorado
acquisition, Headwaters issued $172.5 million of 2 7/8% convertible senior
subordinated notes due 2016. These notes are subordinate to the senior secured
debt described above. Holders of the notes may convert the notes into shares of
Headwaters' common stock at a conversion rate of 33.3333 shares per $1,000
principal amount ($30 conversion price), or 5.75 million aggregate shares of
common stock, contingent upon certain events. The conversion rate adjusts for
events related to Headwaters' common stock, including common stock issued as a
dividend, rights or warrants to purchase common stock issued to all holders of
Headwaters' common stock, and other similar rights or events that apply to all
holders of common stock.
The notes are convertible if any of the following five criteria are
met: 1) satisfaction of a market price condition which becomes operative if the
common stock trading price reaches $39 per share for a certain period of time
prior to June 1, 2011 and at any time after that date; 2) a credit rating, if
any, assigned to the notes is three or more rating subcategories below the
initial rating, if any; 3) the notes trade at 98% of the product of the common
stock trading price and the number of shares of common stock issuable upon
conversion of $1,000 principal amount of the notes, except this provision is not
available if the closing common stock price is between 100% and 130% of the
current conversion price of the notes; 4) Headwaters calls the notes for
redemption; and 5) certain corporate transactions occur, including distribution
of rights or warrants to all common stockholders entitling them to purchase
common stock at less than the current market price or distribution of common
stock, cash or other assets, debt securities or certain rights to purchase
securities where the distribution has a per share value exceeding 5% of the
closing common stock price on the day immediately preceding the declaration date
for such distribution. In addition, the notes are convertible if Headwaters
enters into an agreement pursuant to which Headwaters' common stock would be
converted into cash, securities or other property.
Headwaters may call the notes for redemption at any time on or after
June 1, 2007 and prior to June 4, 2011 if the closing common stock price exceeds
130% of the conversion price for 20 trading days in any consecutive 30-day
trading period (in which case Headwaters must provide a "make whole" payment of
the present value of all remaining interest payments on the redeemed notes
through June 1, 2011). In addition, the holder of the notes has the right to
require Headwaters to repurchase all or a portion of the notes on June 1, 2011
or if a fundamental change in common stock has occurred, including termination
of trading. Subsequent to June 1, 2011, the notes require an additional interest
payment equal to 0.40% of the average trading price of the notes if the trading
price equals 120% or more of the principal amount of the notes.
Headwaters has included the additional shares of common stock
contingently issuable under the notes in its 2004 diluted EPS calculation, on an
if-converted basis, in accordance with the new requirements of EITF 04-08 (see
Note 8 to the consolidated financial statements).
Notes Payable to a Bank - In connection with the acquisition of SCP in
July 2004, Headwaters assumed SCP's obligations under its notes payable to a
bank ($9.6 million as of December 31, 2004). The notes require monthly interest
and quarterly principal payments. Two of the notes bear interest at LIBOR plus
0.5%, subject to an interest rate floor of 4.5% (4.5% at December 31, 2004), and
the remaining note (in the amount of $3.0 million) bears interest at 0.5% below
the bank's base rate (4.75% at December 31, 2004). Because the notes are
callable by the bank, Headwaters has included the outstanding balance in current
portion of long-term debt in the consolidated balance sheet. The notes are
collateralized by certain assets of SCP and contain financial covenants specific
to SCP, including a minimum fixed charge coverage ratio, a leverage ratio
requirement, and limitations on capital expenditures. Headwaters was in
compliance with all debt covenants as of December 31, 2004.
Options and Employee Stock Purchases - In 2004, cash proceeds from the
exercise of options and employee stock purchases totaled $1.6 million, compared
to $2.5 million in 2003. 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 2003 and $2.0 million in 2004.
These income tax deductions do not affect income tax expense or 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. In 2004, Headwaters' working capital increased by $4.1
million, to $48.5 million as of December 31, 2004. Headwaters expects operations
to produce positive cash flows in future periods, which, when combined with
current working capital, is expected to be sufficient for operating needs for
fiscal 2005.
25
Long-term Debt. Due to the September 2004 issuance of senior debt and
the covenants associated with that debt, as described below, Headwaters
currently has limited ability to obtain significant additional amounts of
long-term debt. However, as provided for in the senior debt agreements,
Headwaters has available $60.0 million under a revolving credit arrangement.
Borrowings under the revolving credit arrangement are generally subject to the
terms of the first lien loan agreement and bear interest at either LIBOR plus
1.75% to 2.5%, or the base rate plus 0.75% to 1.5%. Borrowings and reborrowings
of any available portion of the $60.0 million revolver can be made at any time
through September 2009, at which time all loans must be repaid and the revolving
credit arrangement terminates. The fees for the unused portion of the revolving
credit arrangement range from 0.5% to 0.75%. During 2004, Headwaters borrowed
$1.0 million under terms of the revolving credit arrangement, all of which was
repaid prior to December 31, 2004. In January 2005, Headwaters borrowed $12.0
million under terms of the revolving credit arrangement, all of which was
outstanding as of January 31, 2005. Finally, the credit agreement allows for the
issuance of letters of credit, provided there is capacity under the revolving
credit arrangement. As of December 31, 2004, three letters of credit totaling
$2.1 million were outstanding, with expiration dates ranging from February 2005
to June 2005.
Headwaters may, in the future, make optional prepayments of the senior
debt depending on actual cash flows, Headwaters' current and expected cash
requirements and other factors deemed significant by management.
The senior secured credit agreements contain restrictions and covenants
common to such agreements, including limitations on the incurrence of additional
debt, investments, merger and acquisition activity, asset sales and liens,
capital expenditures in excess of $50.0 million in any fiscal year (increasing
to $60.0 million in 2011) and the payment of dividends, among others. In
addition, Headwaters must maintain certain leverage and fixed charge coverage
ratios, as those terms are defined in the agreements. Under the most restrictive
covenants, contained in the first lien agreement, Headwaters must maintain i) a
total leverage ratio of 5.0:1.0 or less, declining periodically to 3.5:1.0 in
2010; ii) a maximum ratio of consolidated senior funded indebtedness minus
subordinated indebtedness to EBITDA of 4.0:1.0, declining periodically to
2.5:1.0 in 2010; and iii) a minimum ratio of EBITDA plus rent payments for the
four preceding fiscal quarters to scheduled payments of principal and interest
on all indebtedness for the next four fiscal quarters of 1.10:1.0 through
September 30, 2006, and 1.25:1.0 thereafter. Headwaters is in compliance with
all debt covenants as of December 31, 2004.
As described above, Headwaters has approximately $749.6 million of
variable-rate long-term debt outstanding as of December 31, 2004, consisting of
$740.0 million of senior debt and $9.6 million of notes payable to a bank. A
change in the interest rate of 1% would change Headwaters' interest expense by
approximately $7.5 million during the year ending September 30, 2005,
considering all outstanding balances of variable-rate debt and required
principal repayments.
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 $2.0 million in 2004. Headwaters' cash
requirements for income taxes in 2005 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.
Headwaters' effective income tax rate for 2004 was approximately 35%,
the estimated rate for the fiscal year ending September 30, 2005. This compares
to an effective tax rate of approximately 38% for 2003. The primary reason for
the decrease in the effective tax rate is federal income tax credits available
as a result of Headwaters' investment in an entity that owns and operates a
coal-based solid alternative fuel production facility (see Note 9 to the
consolidated financial statements). The alternative fuel produced at the
facility through December 2007 qualifies for tax credits pursuant to Section 29
of the Internal Revenue Code. Excluding the effect of the tax credits,
Headwaters' effective tax rate in 2004 would have been approximately 40%.
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.
Legal or Contractual Matters
Headwaters has ongoing litigation and claims incurred during the normal
course of business, including the items discussed in Note 9 to the consolidated
financial statements. Headwaters intends to vigorously defend or resolve these
matters by settlement, as appropriate. Management does not currently believe
that the outcome of these matters will have a material adverse effect on
Headwaters' operations, cash flows or financial position.
In fiscal 2004, Headwaters accrued approximately $1.4 million of
reserves for legal matters because it concluded that claims and damages sought
by claimants in excess of that amount were not probable. During the quarter
ended December 31, 2004, Headwaters expensed $0.3 million for legal matters. Our
outside counsel believe that unfavorable outcomes are neither probable nor
remote and declined to express opinions concerning the likely outcomes or
liability of Headwaters. The reserves represent the amounts Headwaters would be
willing to pay to reach a settlement. However, these cases raise difficult and
26
complex legal and factual issues, and the resolution of these issues is subject
to many uncertainties, including the facts and circumstances of each case, the
jurisdiction in which each case is brought, and the future decisions of juries,
judges, and arbitrators. Therefore, although management believes that the claims
asserted against Headwaters in the named cases lack merit, there is a
possibility of material losses in excess of the amounts accrued if one or more
of the cases were to be determined adversely against Headwaters for a
substantial amount of the damages asserted.
Headwaters currently believes the range of potential loss, excluding
costs for outside counsel, is from $0.5 million up to the amounts sought by
claimants. It is possible that a change in the estimates of probable liability
could occur, and the changes could be significant. Additionally, as with any
litigation, these proceedings require that Headwaters incur substantial costs,
including attorneys' fees, managerial time, and other personnel resources and
costs in pursuing resolution. Costs paid to outside legal counsel for
litigation, which comprise the majority of Headwaters' litigation-related costs,
totaled approximately $0.5 million in 2003 and $1.6 million in 2004. It is not
possible to estimate what these costs will be in future periods.
Section 29 Matters
Headwaters Energy Services' license fees and revenues from sales of
chemical reagents depend on the ability of licensees and customers to
manufacture and sell qualified synthetic fuels that generate tax credits under
Section 29 of the Internal Revenue Code. From time to time, issues arise as to
the availability of tax credits, including the items discussed below.
Legislation. Under current law, Section 29 tax credits for synthetic
fuel produced from coal expire on December 31, 2007. In addition, there have
been initiatives from time to time to consider the early repeal or modification
of Section 29. For example, during calendar 2004, a bill was introduced in the
United States House of Representatives that would repeal the Section 29 credit
for synthetic fuel produced from coal. Although the bill did not pass Congress
in calendar 2004, the bill could be reintroduced in 2005. If Section 29 expires
at the end of 2007 or 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,
Headwaters does not believe that production of synthetic fuel will be profitable
absent the tax credits. In addition, if Headwaters' licensees close their
facilities or materially reduce production activities (whether after 2007, or
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.
Phase-Out. Section 29 tax credits are subject to phase-out after the
average annual wellhead domestic oil price ("reference price") reaches a
beginning phase-out threshold price, and is eliminated entirely if the reference
price reaches the full phase-out price. For calendar 2003, the reference price
was $27.56 per barrel and the phase-out range began at $50.14 and would have
fully phased out tax credits at $62.94 per barrel. For calendar 2004, an
estimated partial year reference price (through November 2004) is $36.80 per
barrel, and an estimate of the phase-out range (using 2% inflation) begins at
$51.14 and completes phase-out at $64.20 per barrel. The one-day cash trading
price on January 31, 2005 was $47.76 per barrel.
IRS Audits. Licensees are subject to audit by the IRS. The IRS may
challenge whether Headwaters Energy Services' licensees satisfy the requirements
of Section 29, or applicable Private Letter Rulings, including placed-in-service
requirements, or may attempt to disallow Section 29 tax credits for some other
reason. The IRS has initiated audits of certain licensee-taxpayers who claimed
Section 29 tax credits, and the outcome of any such audit is uncertain. In
calendar 2004, a licensee announced that IRS field auditors had issued a notice
of proposed adjustment challenging the placed-in-service date of three of its
synthetic fuel facilities. The licensee believes that the facilities meet the
placed-in-service requirement, however, the timing and final results of the
audit are unknown. The inability of a licensee to claim Section 29 tax credits
would reduce Headwaters' future income from the licensee.
Senate Permanent Subcommittee on Investigations. On October 29, 2003,
the Permanent Subcommittee on Investigations of the Government Affairs Committee
of the United States Senate issued a notification of pending investigations. The
notification listed the synthetic fuel tax credit as a new item. In March 2004,
the Subcommittee described its investigation as follows: "The Subcommittee is
continuing its investigation [of] tax credits claimed under Section 29 of the
Internal Revenue Code for the sale of coal-based synthetic fuels. This
investigation is examining the utilization of these tax credits, the nature of
the technologies and fuels created, the use of these fuels, and others [sic]
aspects of Section 29. The investigation will also address the IRS'
administration of Section 29 tax credits." The Subcommittee conducted numerous
interviews and received large volumes of data between December 2003 and March
2004. Since that time, to Headwaters' knowledge, there has been little activity
regarding the investigation. Headwaters cannot make any assurances as to the
timing or ultimate outcome of the Subcommittee investigation, nor can Headwaters
predict whether Congress or others may conduct investigations of Section 29 tax
credits in the future. The Subcommittee investigation 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 Headwaters'
revenues and net income.
27
Recent Accounting Pronouncements
In September 2004, the Emerging Issues Task Force ("EITF") reached a
consensus requiring the inclusion of contingently convertible securities in
diluted earnings per share ("EPS") calculations. This consensus (EITF Issue
04-08, "The Effect of Contingently Convertible Debt on Diluted Earnings per
Share") is effective for periods ending after December 15, 2004 and required
Headwaters to include in its 2004 diluted EPS calculation, on an if-converted
basis, the additional shares issuable under the terms of Headwaters' outstanding
convertible senior subordinated notes described in Note 6 to the consolidated
financial statements. The EITF consensus must be applied to all applicable prior
periods, which for Headwaters will be the quarters ended June 30, 2004 and
September 30, 2004. See Note 8 to the consolidated financial statements for more
information on the effect on Headwaters' EPS of implementing the EITF consensus.
In December 2004, the Financial Accounting Standards Board issued SFAS
No. 123 (revised 2004), "Share-Based Payment," ("SFAS No. 123R"), which is
effective for interim periods beginning after June 15, 2005. SFAS No. 123R
revises SFAS No. 123 and supersedes APB 25 and requires companies to expense the
value of employee stock options and similar awards. Pro forma disclosure will
not be an alternative. SFAS No. 123R also amends SFAS No. 95, Statement of Cash
Flows, to require tax benefits from share-based payments to be reported as a
financing cash flow rather than an operating cash flow, as required under
current literature.
Headwaters is studying the implications of SFAS No. 123R and currently
expects it to have a material effect on Headwaters' reported financial results
of operations, beginning with the quarter ending September 30, 2005, the quarter
Headwaters expects to adopt the new standard. SFAS No. 123R permits companies to
adopt its requirements using one of two methods: i) a "modified prospective"
method in which compensation cost is recognized beginning with the effective
date based on the requirements of SFAS No. 123R for all share-based payments
granted after the effective date, plus compensation cost under the requirements
of SFAS No. 123 for all awards granted to employees prior to the effective date
of SFAS No. 123R that remain unvested on the effective date; or ii) a "modified
retrospective" method which includes the requirements of the modified
prospective method, but also permits companies to restate based on the amounts
previously recognized under SFAS No. 123 for purposes of pro forma disclosures
for either all prior periods, or by restating only the prior interim periods of
the year of adoption. Headwaters has not yet determined which method will be
used when SFAS No. 123R is adopted.
The impact of adoption of SFAS No. 123R cannot be predicted at this
time because it will depend on levels of share-based payments granted in the
future. However, had Headwaters adopted SFAS No. 123R in prior periods, the
impact of this standard would have approximated the impact of SFAS No. 123 as
described in Note 1 to the consolidated financial statements in the disclosure
of pro forma net income and earnings per share. Adoption of SFAS No. 123R will
also reduce net cash flow from operating activities and increase net cash flow
from financing activities. While Headwaters cannot estimate what those amounts
will be in the future, the amounts for 2003 and 2004 were $0.6 million and $2.0
million, respectively.
Headwaters has reviewed all other 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 other
recent accounting pronouncements will have a significant effect on its current
or future financial position, results of operations, cash flows or disclosures.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Headwaters is exposed to financial market risks, primarily related to
changes in interest rates. Headwaters does not use derivative financial
instruments for speculative or trading purposes, but has entered into hedge
transactions to limit its variable interest rate exposure, as explained below.
As described in more detail in Note 6 to the consolidated financial
statements, Headwaters has approximately $749.6 million of variable-rate
long-term debt outstanding as of December 31, 2004, consisting of $740.0 million
of senior debt and $9.6 million of notes payable to a bank.
The $740.0 million of term loan borrowings under the senior debt
agreements consisted of a first lien term loan in the amount of $590.0 million
and a second lien term loan in the amount of $150.0 million. The first lien term
loan bears interest, at Headwaters' option, at either i) the London Interbank
Offered Rate ("LIBOR") plus 3.0%, if the "total leverage ratio," as defined, is
less than or equal to 3.75:1.0, and if not, at LIBOR plus 3.25%, or ii) the
"base rate" plus 2.0%, if the total leverage ratio is less than or equal to
3.75:1.0, and if not, at the base rate plus 2.25%. Base rate is defined as the
higher of the rate announced by Morgan Stanley Senior Funding and the overnight
rate charged by the Federal Reserve Bank of New York plus 0.5%. The interest
rate on the first lien debt at December 31, 2004 was approximately 5.4%. The
second lien term loan bears interest, also at Headwaters' option, at either
28
LIBOR plus 5.5%, or the "base rate" plus 4.5%. The interest rate on the second
lien debt at December 31, 2004 was approximately 7.7%. Headwaters can lock in
new rates for both the first lien and second lien loans for one, two, three or
six months. The most recent rate change, which did not result in a material
change, occurred in January 2005.
In connection with the new senior secured credit facility, Headwaters
entered into certain hedge agreements to limit its variable interest rate
exposure. The first set of agreements effectively established the maximum LIBOR
rate for $300.0 million of debt at 5.0% through September 8, 2005. The second
set of agreements effectively sets the LIBOR rate at 3.71% for $300.0 million of
debt for the period commencing September 8, 2005 through September 8, 2007.
Headwaters accounts for these agreements as cash flow hedges, and accordingly,
the fair market value of the hedges is reflected in the consolidated balance
sheet as either other assets or other liabilities. The hedges had an immaterial
fair market value at December 31, 2004.
In connection with the acquisition of SCP in July 2004, Headwaters
assumed SCP's obligations under its notes payable to a bank, totaling $9.6
million as of December 31, 2004. Two of the notes bear interest at LIBOR plus
0.5%, subject to an interest rate floor of 4.5% (4.5% at December 31, 2004), and
the remaining note (in the amount of $3.0 million) bears interest at 0.5% below
the bank's base rate (4.75% at December 31, 2004).
A change in the interest rate of 1% would change Headwaters' interest
expense by approximately $7.5 million during the year ending September 30, 2005,
considering all outstanding balances of variable-rate debt and 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, regulations 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
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, 2004, 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, 2004 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 9 to the consolidated
financial statements for a description of current legal proceedings.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
29
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
The following exhibits are included herein:
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.
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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 7, 2005 By: /s/ Kirk A. Benson
-------------------------------------------
Kirk A. Benson, Chief Executive Officer
(Principal Executive Officer)
Date: February 7, 2005 By: /s/ Steven G. Stewart
-------------------------------------------
Steven G. Stewart, Chief Financial Officer
(Principal Financial Officer)
31