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 March 31, 2005
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 April
29, 2005 was 41,357,243.
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 March 31, 2005...................... 3
Condensed Consolidated Statements of Income - For the
three and six months ended March 31, 2004 and 2005......... 4
Condensed Consolidated Statement of Changes in
Stockholders' Equity - For the six months ended
March 31, 2005............................................. 5
Condensed Consolidated Statements of Cash Flows - For
the six months ended March 31, 2004 and 2005............... 6
Notes to Condensed Consolidated Financial Statements....... 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.......................................22
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK......33
ITEM 4. CONTROLS AND PROCEDURES.........................................34
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS...............................................35
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.....35
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.................................35
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.............35
ITEM 5. OTHER INFORMATION...............................................35
ITEM 6. EXHIBITS........................................................35
SIGNATURES...................................................................36
Forward-looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995 regarding
future events and our future results that are based on current expectations,
estimates, forecasts, and projections about the industries in which we operate
and the beliefs and assumptions of our management. Actual results may vary
materially from such expectations. Words such as "expects," "anticipates,"
"targets," "goals," "projects," "believes," "seeks," "estimates," or variations
of such words and similar expressions, are intended to identify such
forward-looking statements. In addition, any statements that refer to
projections of our future financial performance, our anticipated growth and
trends in our businesses, and other characterizations of future events or
circumstances, are forward-looking. For a discussion of the factors that could
cause actual results to differ from expectations, please see the risk factors
described in Item 7 of our Annual Report on Form 10-K for the year ended
September 30, 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, March 31,
(in thousands, except per-share data) 2004 2005
- --------------------------------------------------------------------------------------------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 20,851 $ 5,943
Short-term trading investments 6,735 --
Trade receivables, net 129,899 122,900
Inventories 43,812 57,002
Current and deferred income taxes 15,933 12,710
Other 13,333 16,801
--------------------------
Total current assets 230,563 215,356
--------------------------
Property, plant and equipment, net 157,611 166,214
--------------------------
Other assets:
Intangible assets, net 298,803 286,578
Goodwill 815,396 815,396
Other 38,406 48,850
--------------------------
Total other assets 1,152,605 1,150,824
--------------------------
Total assets $ 1,540,779 $ 1,532,394
==========================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 29,238 $ 36,739
Accrued personnel costs 26,213 26,873
Other accrued liabilities 72,852 52,401
Current portion of long-term debt 57,873 26,093
--------------------------
Total current liabilities 186,176 142,106
--------------------------
Long-term liabilities:
Long-term debt 914,641 708,569
Deferred income taxes 121,469 123,079
Other 10,338 13,361
--------------------------
Total long-term liabilities 1,046,448 845,009
--------------------------
Total liabilities 1,232,624 987,115
--------------------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.001 par value; authorized 100,000 shares; issued and
outstanding: 33,775 shares at September 30, 2004 (including 414 shares
held in treasury) and 41,319 shares at March 31, 2005 (including 385
shares held in treasury) 34 41
Capital in excess of par value 235,581 444,934
Retained earnings 76,530 101,531
Treasury stock and other (3,990) (1,227)
--------------------------
Total stockholders' equity 308,155 545,279
--------------------------
Total liabilities and stockholders' equity $ 1,540,779 $ 1,532,394
==========================
See accompanying notes.
3
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended Six Months Ended
March 31, March 31,
--------------------------------- --------------------------------
(in thousands, except per-share data) 2004 2005 2004 2005
- ------------------------------------------------------------------------------------------------------------------------------
Revenue:
Construction materials $ 11,248 $ 109,157 $ 23,181 $ 222,885
Coal combustion products 39,592 48,467 84,692 101,519
Alternative energy 68,681 64,768 113,116 116,404
-------------------------------------------------------------
Total revenue 119,521 222,392 220,989 440,808
-------------------------------------------------------------
Operating costs and expenses:
Construction materials 9,950 73,685 19,344 150,153
Coal combustion products 29,666 38,335 63,063 79,330
Alternative energy 22,011 28,590 43,336 53,245
Amortization 1,664 6,181 3,384 12,362
Research and development 1,517 2,876 3,591 5,162
Selling, general and administrative 16,690 34,212 28,200 64,312
-------------------------------------------------------------
Total operating costs and expenses 81,498 183,879 160,918 364,564
-------------------------------------------------------------
Operating income 38,023 38,513 60,071 76,244
-------------------------------------------------------------
Other income (expense):
Net interest expense (5,697) (18,798) (10,988) (34,603)
Other, net (1,889) (3,222) (2,394) (5,140)
-------------------------------------------------------------
Total other income (expense), net (7,586) (22,020) (13,382) (39,743)
-------------------------------------------------------------
Income before income taxes 30,437 16,493 46,689 36,501
Income tax provision (11,810) (4,500) (17,970) (11,500)
-------------------------------------------------------------
Net income $ 18,627 $ 11,993 $ 28,719 $ 25,001
=============================================================
Basic earnings per share $ 0.57 $ 0.33 $ 0.95 $ 0.72
=============================================================
Diluted earnings per share $ 0.55 $ 0.30 $ 0.91 $ 0.65
=============================================================
See accompanying notes.
4
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
For the Six Months Ended March 31, 2005
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 644 -- 4,120 4,120
Tax benefit from exercise of stock
options 5,295 5,295
29 shares of treasury stock
transferred to employee stock
purchase plan, at cost 684 87 771
Common stock issued for cash, net of
commissions and offering costs
of $11,189 6,900 7 199,254 199,261
Amortization of deferred compensation
from stock options and restricted
stock 166 166
Other comprehensive income -
unrealized gain on cash flow hedges,
net of taxes 2,510 2,510
Net income for the six months ended
March 31, 2005 25,001 25,001
------------------------------------------------------------------------------------------
Balances as of March 31, 2005 41,319 $41 $444,934 $101,531 $(2,523) $ 1,296 $545,279
==========================================================================================
See accompanying notes.
5
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended March 31,
--------------------------------
(in thousands) 2004 2005
- -------------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ 28,719 $ 25,001
Adjustments to reconcile net income to net cash provided by (used in) operating
activities:
Depreciation and amortization 6,507 27,849
Non cash interest expense related to amortization of debt
discount and debt issue costs 7,631 6,741
Deferred income taxes 743 (3,755)
Income tax benefit from exercise of stock options 2,910 5,295
Net loss on disposition of property, plant and equipment 663 97
Write-down of notes receivable 1,038 --
Decrease (increase) in short-term trading investments (30,647) 6,735
Decrease (increase) in trade receivables (34,625) 6,999
Increase in inventories (2,097) (12,717)
Increase (decrease) in accounts payable and accrued liabilities 2,431 (13,437)
Other changes in operating assets and liabilities, net (332) (1,353)
---------------------------
Net cash provided by (used in) operating activities (17,059) 47,455
---------------------------
Cash flows from investing activities:
Purchase of property, plant and equipment (4,890) (23,509)
Net increase in investments and other assets (2,451) (4,289)
Proceeds from disposition of property, plant and equipment 53 182
---------------------------
Net cash used in investing activities (7,288) (27,616)
---------------------------
Cash flows from financing activities:
Net proceeds from issuance of common stock 90,303 199,261
Net proceeds from issuance of long-term debt 49,205 14,953
Payments on long-term debt (134,876) (253,852)
Proceeds from exercise of options and warrants 5,082 4,120
Employee stock purchases 436 771
---------------------------
Net cash provided by (used in) financing activities 10,150 (34,747)
---------------------------
Net decrease in cash and cash equivalents (14,197) (14,908)
Cash and cash equivalents, beginning of period 18,732 20,851
---------------------------
Cash and cash equivalents, end of period $ 4,535 $ 5,943
===========================
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
March 31, 2005
(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; expanding Headwaters' construction
materials business, including opportunities to utilize products from other
Headwaters operations in the production of construction materials;
promoting the expanded use of coal combustion products ("CCPs"); and
developing HTI's energy and nanocatalysis technologies. Headwaters
currently generates revenue from the sale of construction materials, from
marketing CCPs, and from licensing its chemical technologies to produce
solid alternative fuel. 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.
Headwaters' construction materials segment develops, manufactures and
distributes 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.
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.
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 and sells chemical
reagents to licensees and other customers. Through its wholly-owned
subsidiary HTI, Headwaters conducts research and development activities
directed at catalysts and processes to convert coal and heavy oil into
environmentally-friendly, high-value liquid fuels. In addition, HTI has
developed a unique process to custom design nanocatalysts that could be
used in multiple industrial applications.
Basis of Presentation - The accompanying unaudited condensed consolidated
financial statements have been prepared in accordance with the rules and
regulations of the Securities and Exchange Commission ("SEC") for quarterly
reports on Form 10-Q. In the opinion of management, all adjustments
considered necessary for a fair presentation have been included, and
consist of normal recurring adjustments. 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") and in Headwaters' Quarterly Report on
Form 10-Q for the quarter ended December 31, 2004.
Headwaters' fiscal year ends on September 30 and unless otherwise noted,
future references to 2004 refer to Headwaters' fiscal quarter and/or
six-month period ended March 31, 2004, and references to 2005 refer to
Headwaters' fiscal quarter and/or six-month period ended March 31, 2005.
The consolidated financial statements include the accounts of Headwaters,
all of its subsidiaries and other entities in which Headwaters has a
7
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
controlling financial interest. All significant intercompany transactions
and accounts are eliminated in consolidation. Due to the seasonality of the
operations of the construction materials and CCP segments and other
factors, Headwaters' consolidated results of operations for 2005 are not
indicative of the results to be expected for the full fiscal 2005 year.
As referred to above and described in detail in Headwaters' Form 10-K,
Headwaters acquired four companies in fiscal 2004. As reported in the Form
10-K, the purchase price and final purchase price allocation for both VFL
and SCP were completed in fiscal 2004 (however, as described in Note 3 to
the consolidated financial statements in the Form 10-K, Headwaters agreed
to pay an earn-out to the sellers of SCP if certain SCP earnings targets
are exceeded during the 12 months ending December 31, 2005). Headwaters
expects to finalize the determination of the purchase price and the
purchase price allocation for both Eldorado and Tapco in the quarter ending
June 30, 2005.
Common Stock Options and Restricted Stock Grants - Headwaters has elected
to continue to apply the intrinsic value method as prescribed by APB
Opinion No. 25 ("APB 25") in accounting for options and restricted stock
grants to employees, officers and directors and is currently considering
when to adopt the fair value method 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 March 31, Six Months Ended March 31,
--------------------------------------------------------------
(in thousands, except per-share data) 2004 2005 2004 2005
-----------------------------------------------------------------------------------------------------------
Reported net income $18,627 $11,993 $28,719 $25,001
Add actual amortization expense included in
reported net income 22 83 45 166
Deduct expense determined under fair value
provision of SFAS No. 123 (1,021) (2,102) (2,015) (4,056)
--------------------------------------------------------------
Pro forma net income $17,628 $ 9,974 $26,749 $21,111
==============================================================
Basic earnings per share - as reported $ 0.57 $ 0.33 $ 0.95 $ 0.72
- pro forma $ 0.54 $ 0.28 $ 0.88 $ 0.61
Diluted earnings per share - as reported $ 0.55 $ 0.30 $ 0.91 $ 0.65
- pro forma $ $0.52 $ 0.26 $ 0.85 $ 0.55
The fair values of stock option grants for 2004 and 2005 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
beyond vesting date, 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.
8
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
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") was effective for periods
ending after December 15, 2004 and required Headwaters to include in its
2005 diluted EPS calculations, 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 are 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 November 2004, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 151, "Inventory Costs," which clarifies the accounting for
abnormal amounts of idle facility expense, freight, handling costs, and
spoilage, requiring that such costs be recognized as current-period costs
regardless of whether they meet the criterion of "so abnormal," currently
required by the guidance in ARB No. 43, Chapter 4, "Inventory Pricing."
SFAS No. 151 is effective for inventory costs incurred during fiscal years
beginning after June 15, 2005, which for Headwaters will be fiscal 2006.
Because the provisions of this standard must be applied prospectively,
there will be no effect on previously-issued financial statements of
Headwaters. It is not possible to predict the effect SFAS No. 151 might
have on future reported results because it will depend on the levels of
"abnormal" inventory costs incurred in the future, if any.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based
Payment," ("SFAS No. 123R"), which was to be effective for interim periods
beginning after June 15, 2005. In April 2005, the SEC announced that it
would allow registrants to delay the adoption of SFAS No. 123R to no later
than the beginning of the first fiscal year beginning after June 15, 2005,
which for Headwaters would be fiscal 2006. 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 no
longer 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 expects it to have a material effect on Headwaters'
reported results of operations when adopted, although it will have limited
impact on cash flow. Headwaters may early adopt SFAS No. 123R beginning in
either the June or September 2005 quarters.
SFAS No. 123R permits public 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 (including the stock appreciation rights and stock options granted
in May 2005, as described in Note 9). However, had Headwaters adopted
SFAS No. 123R in prior periods, Headwaters believes the impact of this
standard would have approximated the impact of SFAS No. 123 as reflected
above in the disclosures 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 the six months ended March 31, 2004 and 2005 were $2,910,000
and $5,295,000, 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.
9
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
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.
Segment information for 2005 includes the results of operations for all of
the four fiscal 2004 acquisitions described in the Form 10-K, while the
segment information for 2004 includes no such results since none of the
acquisitions were consummated prior to March 31, 2004.
Three Months Ended March 31, 2004
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $ 11,248 $39,592 $68,681 $ -- $119,521
=====================================================================
Depreciation and amortization $ (162) $(2,683) $ (293) $ (67) $ (3,205)
=====================================================================
Operating income (loss) $ (904) $ 4,814 $40,893 $(6,780) $ 38,023
=======================================================
Net interest expense (5,697)
Other income (expense), net (1,889)
Income tax provision (11,810)
-------------
Net income $ 18,627
=============
Capital expenditures $ 937 $ 663 $ 165 $ 19 $ 1,784
=====================================================================
Three Months Ended March 31, 2005
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $109,157 $48,467 $64,768 $ -- $222,392
=====================================================================
Depreciation and amortization $ (9,348) $(3,173) $(1,556) $ (102) $(14,179)
=====================================================================
Operating income (loss) $ 13,057 $ 4,025 $30,159 $(8,728) $ 38,513
=======================================================
Net interest expense (18,798)
Other income (expense), net (3,222)
Income tax provision (4,500)
-------------
Net income $ 11,993
=============
Capital expenditures $10,379 $ 617 $ 521 $ 92 $ 11,609
=====================================================================
10
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
Six Months Ended March 31, 2004
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $ 23,181 $84,692 $113,116 $ -- $220,989
=====================================================================
Depreciation and amortization $ (329) $(5,392) $ (660) $ (126) $ (6,507)
=====================================================================
Operating income (loss) $ (165) $11,136 $ 59,429 $(10,329) $ 60,071
=======================================================
Net interest expense (10,988)
Other income (expense), net (2,394)
Income tax provision (17,970)
-------------
Net income $ 28,719
=============
Capital expenditures $ 1,323 $ 3,224 $ 312 $ 31 $ 4,890
=====================================================================
Six Months Ended March 31, 2005
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $ 222,885 $101,519 $116,404 $ -- $ 440,808
=====================================================================
Depreciation and amortization $ (18,763) $ (6,339) $ (2,548) $ (199) $ (27,849)
=====================================================================
Operating income (loss) $ 28,529 $ 9,673 $ 51,595 $(13,553) $ 76,244
=======================================================
Net interest expense (34,603)
Other income (expense), net (5,140)
Income tax provision (11,500)
-------------
Net income $ 25,001
=============
Capital expenditures $ 20,554 $ 1,792 $ 934 $ 229 $ 23,509
=====================================================================
Segment Assets as of March 31, 2005 $1,106,743 $308,359 $ 63,274 $ 54,018 $1,532,394
=====================================================================
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 was approved at the annual meeting
of stockholders on March 1, 2005.
Issuance of Common Stock - In January 2005, Headwaters filed a Form S-3
shelf registration statement with the SEC that was declared effective for
the sale of up to $175,000,000 of common stock. Headwaters also 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 (under which approximately $53,000,000 was available
as of January 2005).
In February 2005, Headwaters filed a prospectus supplement to the shelf
registration statements and in March 2005 issued 6,900,000 shares of common
stock in an underwritten public offering. Proceeds of $199,261,000 were
received, net of commissions and offering costs of $11,189,000. Following
this issuance of common stock, approximately $18,000,000 remains available
for future offerings of securities under the universal shelf registration
statement. A prospectus supplement describing the terms of any additional
securities to be issued is required to be filed before any future offering
would commence under the registration statement.
New York Stock Exchange Listing - Headwaters' common stock traded on the
Nasdaq National Market until April 6, 2005, at which time it began trading
on the New York Stock Exchange under the symbol "HW."
11
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
Stock Incentive Awards - As described in more detail in Note 9, in May
2005, the Compensation Committee of Headwaters' Board of Directors (the
"Committee") granted to certain officers and employees stock incentive
awards consisting of stock appreciation rights and stock options. The
Committee is also considering the potential acceleration of vesting of
outstanding stock options not currently vested.
4. Inventories
Inventories consisted of the following at:
September 30, March 31,
(in thousands) 2004 2005
----------------------------------------------------------------
Raw materials $ 8,517 $ 9,534
Finished goods 35,295 47,468
--------------------------------
$43,812 $57,002
================================
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 March 31, 2005
-----------------------------------------------------------------
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 $14,890
Customer relationships 7 1/2 - 15 years 68,331 452 68,331 2,925
Trade names 5 - 20 years 63,657 268 63,657 1,955
Patents and patented
technologies 7 1/2 - 15 years 52,464 2,969 52,464 5,476
Non-competition agreements 2 - 3 1/2 years 10,422 867 10,422 2,903
Other 9 - 17 1/4 years 3,382 1,063 3,382 1,219
-----------------------------------------------------------------
$315,946 $17,143 $315,946 $29,368
=================================================================
Total amortization expense related to intangible assets was approximately
$1,659,000 and $3,338,000 for the three- and six-month periods ended March
31, 2004, respectively, and approximately $6,108,000 and $12,225,000 for
the three- and six-month periods ended March 31, 2005, 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
12
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
6. Long-term Debt
Long-term debt consisted of the following at:
September 30, March 31,
(in thousands) 2004 2005
----------------------------------------------------------------------
Senior secured debt $790,000 $552,673
Convertible senior subordinated notes 172,500 172,500
Notes payable to a bank 9,787 9,300
Other 227 189
------------------------------
972,514 734,662
Less: current portion (57,873) (26,093)
------------------------------
Total long-term debt $914,641 $708,569
==============================
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 up to $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 executed 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. In March 2005, another amendment to the credit agreements was
entered into which modified certain terms of the credit facility, all as
described in more detail in the following paragraphs.
The first lien term loan bears interest, at Headwaters' option, at either
i) the London Interbank Offered Rate ("LIBOR") plus 2.0%, 2.25%, or 2.5%,
depending on the credit ratings that have been most recently announced for
the loans by Standard & Poors Ratings Services ("S&P") and Moody's
Investors Service, Inc. ("Moody's"); or ii) the "base rate" plus 1.0%,
1.25%, or 1.5%, again depending on the credit ratings announced by S&P and
Moody's. Base rate is defined as the higher of the rate announced by Morgan
Stanley Senior Funding and the overnight rate charged by the Federal
Reserve Bank of New York plus 0.5%. The initial interest rate on the first
lien debt was set at 6.5%, but was subsequently reduced to approximately
5.4% during the quarter ended December 31, 2004 pursuant to the terms of
the agreement. The interest rate on the first lien debt was approximately
4.9% at March 31, 2005. 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% during the quarter ended
December 31, 2004 pursuant to the terms of the agreement. The interest rate
on the second lien debt was approximately 8.2% at March 31, 2005.
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
occurred in March 2005.
The first lien term loan ($442,673,000 outstanding at March 31, 2005) is
repayable in quarterly installments of principal and interest, with minimum
required quarterly principal repayments of approximately $3,354,000
commencing in November 2005 through August 2010, with three repayments of
approximately $125,200,000 each through April 2011, the termination date of
the first lien loan agreement. The second lien term loan ($100,000,000
outstanding at March 31, 2005) 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 generally permitted without penalty or premium, except where
the proceeds for repayment are obtained from a "financing," as defined,
consummated for the purpose of lowering the interest rate on the first lien
debt, in which case there is a 1% prepayment penalty. Optional prepayments
of the second lien term loan under the original terms of the credit
agreement were permissible only to the extent Headwaters issued new equity
securities and then were further limited to a maximum of $50,000,000, so
long as the first lien term loan remained outstanding. As amended, 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
13
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
year, and 1% of prepayments made in the third year, and further, subsequent
to September 8, 2005, Headwaters can prepay the second lien debt with
available cash flow, unrestricted as to source. Once repaid in full or in
part, no further reborrowings under either of the term loan arrangements
can be made.
During the quarter ended December 31, 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. In March
2005, Headwaters repaid $147,327,000 of the first lien term loan and
$50,000,000 of the second lien term loan. As a result of the early
repayments of debt, there was an acceleration of amortization of the
related debt issue costs totaling approximately $3,954,000 and $4,919,000
for the three- and six-month periods ended March 31, 2005, respectively,
all of which was charged to interest expense. A 3% prepayment penalty of
$1,500,000 was paid related to the early repayment of $50,000,000 of second
lien term debt, which was also charged to interest expense.
Borrowings under the revolving credit arrangement are generally subject to
the terms of the first lien loan agreement and bear interest at either
LIBOR plus 1.75% to 2.5% (depending on Headwaters' "total leverage ratio,"
as defined), or the base rate plus 0.75% to 1.5%. Borrowings and
reborrowings of any available portion of the $60,000,000 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%
(depending on Headwaters' "total leverage ratio," as defined). During the
period ended March 31, 2005, Headwaters borrowed $16,000,000 under terms of
the revolving credit arrangement, $6,000,000 of which was repaid prior to
March 31, 2005. In April 2005, Headwaters borrowed an additional
$15,000,000 under terms of the revolving credit arrangement. All amounts
outstanding under the revolving credit arrangement have been repaid as of
the filing date of this Form 10-Q. Finally, the credit agreement allows for
the issuance of letters of credit, provided there is capacity under the
revolving credit arrangement. As of March 31, 2005, two letters of credit
totaling $588,000 were outstanding, with expiration dates in June 2005 and
September 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, annual
capital expenditures in excess of $62,000,000 for fiscal years 2005 and
2006, $55,000,000 for fiscal years 2007 through 2010 and $60,000,000 for
fiscal year 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 March 31, 2005.
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 a market value at March 31, 2005 of approximately
$4,120,000, which, net of $1,610,000 of income taxes, represents other
comprehensive income for the period ended March 31, 2005 (yielding
approximately $14,500,000 and $27,500,000, respectively, of total
comprehensive income for the three- and six-month periods ended March 31,
2005). The market value of the hedges can fluctuate significantly over a
relatively short period of time and as of April 29, 2005, the market value
of the hedges had decreased to approximately $2,400,000. Effective with the
March 2005 amendment to the credit facility, Headwaters was allowed to
reduce its hedges to $150,000,000 of the senior debt and in May 2005,
Headwaters reduced the hedges to that level, realizing a gain of
approximately $964,000.
14
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
Convertible Senior Subordinated Notes - In connection with the Eldorado
acquisition, Headwaters issued $172,500,000 of 2 ?% 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 2005 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
and bear interest at variable rates, which as of March 31, 2005, ranged
from 4.5% to 5.25%. 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 March 31, 2005.
Interest Costs - During the three- and six-month periods ended March 31,
2004, Headwaters incurred total interest costs of approximately $6,124,000
and $11,624,000, respectively, including approximately $5,043,000 and
$7,631,000, respectively, of non-cash interest expense and approximately
$113,000 and $274,000, respectively, of interest costs that were
capitalized. During the three- and six-month periods ended March 31, 2005,
Headwaters incurred total interest costs of approximately $18,929,000 and
$34,921,000, respectively, including approximately $4,800,000 and
$6,741,000, respectively, of non-cash interest expense and approximately
$113,000 and $240,000, 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 4.9% at March 31, 2005.
15
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
7. Income Taxes
Headwaters' effective income tax rate for the six months ended March 31,
2005 was approximately 31.5% (27.3% for the three months ended March 31,
2005), the estimated rate for the fiscal year ending September 30, 2005.
This compares to an effective tax rate of approximately 38.5% for the six
months ended March 31, 2004 (38.8% for the three months ended March 31,
2004). The primary reason for the decrease in the effective tax rate is the
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 2005 would have been
approximately 40%.
8. Earnings per Share
Three Months Ended March 31, Six Months Ended March 31,
(in thousands, except per-share data) 2004 2005 2004 2005
------------------------------------------------------------------------------------------------------------
Numerator:
Numerator for basic earnings per share -
net income $18,627 $11,993 $28,719 $25,001
Interest expense related to convertible
senior subordinated notes, net of taxes -- 1,070 -- 2,048
----------------------------------------------------------------
Numerator for diluted earnings per share -
net income plus interest expense related
to convertible notes, net of taxes $18,627 $13,063 $28,719 $27,049
================================================================
Denominator:
Denominator for basic earnings per share -
weighted-average shares outstanding 32,782 36,172 30,371 34,806
Effect of dilutive securities:
Shares issuable upon exercise of options
and warrants 1,322 1,146 1,222 1,254
Shares issuable upon conversion of
convertible senior subordinated notes -- 5,750 -- 5,750
----------------------------------------------------------------
Total potential dilutive shares 1,322 6,896 1,222 7,004
----------------------------------------------------------------
Denominator for diluted earnings per
share - weighted-average shares outstanding
after assumed exercises and conversions 34,104 43,068 31,593 41,810
================================================================
Basic earnings per share $ 0.57 $ 0.33 $ 0.95 $0.72
================================================================
Diluted earnings per share $ 0.55 $ 0.30 $ 0.91 $0.65
================================================================
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 2005 diluted
EPS calculations, 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
calculations, consisting of out-of-the money options, totaled approximately
0 and 180,000 shares for the three months ended March 31, 2004 and 2005,
respectively; and approximately 10,000 and 150,000 shares for the six
months ended March 31, 2004 and 2005, respectively.
16
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
9. Commitments and Contingencies
Commitments and contingencies as of March 31, 2005 not disclosed elsewhere
are as follows:
Employee Benefit Plans and Incentive Awards - During the quarter ended
December 31, 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 the Headwaters Incorporated Long Term Incentive
Compensation Plan ("LTIP") under which employees of Headwaters selected to
participate by the Compensation Committee (the "Committee") are eligible to
receive long-term incentive-based compensation. The LTIP was approved at
the annual meeting of stockholders on March 1, 2005.
In conjunction with the gain to be recognized from the AJG litigation
settlement (discussed under "Legal or Contractual Matters," following), the
Committee initiated several incentive award grants in May to certain
officers and employees. The Committee granted i) approximately 3,040,000
stock appreciation rights ("SARs"), ii) stock options for the purchase of
approximately 30,000 shares of common stock, iii) incentive cash bonuses
and iv) performance unit awards. Approximately 1,870,000 of the SARs vest
at grant date and require a payment by grantees of $2.00 per SAR, payable
over a five-year period. Also, these SARs are allowed to appreciate to a
maximum gain equal to the fair market value of Headwaters' common stock at
the date of grant. Approximately 1,170,000 of the SARs will vest over a
five-year period, and approximately 1,120,000 of these SARs will be
exercisable based on the achievement of performance criteria related to
growth in the "economic value added" of Headwaters. All of the SARs and
stock options were granted under terms of existing stock option and stock
incentive plans. The SARs and stock options have an exercise price of
$31.97 per share, the fair market value of Headwaters' common stock on the
date of grant. All SARs will be settled in stock when exercised by
grantees. The incentive cash bonuses approximated $5,500,000. The
performance unit awards have a potential value totaling approximately
$6,100,000, payable in cash, if certain performance criteria are met prior
to December 2009.
The Committee is also considering the potential acceleration of vesting of
outstanding stock options not currently vested. Headwaters is currently
reviewing the costs related to accelerating the vesting of options and is
considering the appropriate accounting for these costs, along with the
costs of the incentive awards granted, under current accounting literature
as well as under the new requirements of SFAS No. 123R (see Note 1).
Headwaters expects these costs will be substantial, and a majority of such
costs could be required to be reflected as expense in the quarter ending
June 30, 2005, especially if Headwaters early adopts SFAS No. 123R in the
June 2005 quarter, which management is considering.
Medical Insurance - Headwaters has adopted self-insured medical insurance
plans that cover substantially all employees. There is stop-loss coverage
for amounts in excess of $100,000 to $125,000 per individual per year.
Headwaters has contracted with third-party administrators to assist in the
payment and administration of claims. Insurance claims are recognized as
expense when incurred and include an estimate of costs for claims incurred
but not reported at the balance sheet date. As of March 31, 2005,
approximately $3,710,000 is accrued for claims incurred on or before March
31, 2005 that have not been paid or reported.
Property, Plant and Equipment - As of March 31, 2005, Headwaters was
committed to spend approximately $11,700,000 on 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 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
17
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
liabilities and other long-term liabilities in the consolidated balance
sheet (totaling $13,968,000 at March 31, 2005), bears interest at an 8%
rate. Headwaters also agreed to make additional payments to the seller
based on a pro-rata allocation of the tax credits generated by the
facility, also through December 2007. These additional contractual
payments, 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. Due to the combined effect of the seasonality of
Headwaters' operations and the requirement to use an estimated effective
tax rate for the year in calculating income taxes, Headwaters is not able
to recognize the benefit of all of the tax credits earned in the December
and March quarters in its results of operations for those quarters. Tax
credits earned but not recognized in the December and March quarters will
be recognized in the June and September quarters. Even though Headwaters
can not fully recognize its portion of the benefits of the tax credits
generated in 2005, Headwaters' pro-rata share of costs incurred to generate
those tax credits has been recognized as other expense. Headwaters has the
ability, under certain conditions, to limit its liability under the fixed
payment obligations currently totaling $13,968,000; therefore, Headwaters'
obligation to make all of the above-described payments is effectively
limited to the tax benefits Headwaters receives.
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 $3,900,000 at March 31, 2005), 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
asserted 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 for legal
matters based on the most likely amounts of Headwaters' liabilities or
amounts that Headwaters was willing to settle for. Claims and damages
sought by claimants in excess of those amounts were not deemed to be
probable. During the six months ended March 31, 2005, Headwaters expensed
$2,790,000 for legal matters (excluding costs for legal counsel). Our
outside counsel currently believe that unfavorable outcomes of outstanding
litigation are neither probable nor remote and declined to express opinions
concerning the likely outcomes or liability to Headwaters. The liability
recorded as of March 31, 2005, totaling $2,500,000, represents the amount
Headwaters would be willing to pay to reach settlements of outstanding
cases. 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 $2,500,000 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 material. Additionally, as
with any litigation, these proceedings require that Headwaters incur
substantial costs, including attorneys' fees, managerial time, and other
personnel resources and costs in pursuing resolution. Costs paid to outside
legal counsel for litigation, which have historically comprised the
majority of Headwaters' litigation-related costs, totaled approximately
$1,099,000 and $2,615,000 for the six months ended March 31, 2004 and 2005,
respectively. It is not possible to estimate what these costs will be in
future periods.
18
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
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 September 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
Hodder project. AGTC was seeking approximate damages in the arbitration
between $520,000 and $14,300,000. Headwaters asserted 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
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 provided for AJG to pay royalties and allowed AJG 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 asserted
claims including breach of contract and sought 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.
This litigation came to the trial phase in January 2005. The jury reached a
verdict substantially in favor of Headwaters and the court entered a
judgment for Headwaters against AJG in the amount of approximately
$175,000,000 which included approximately $32,000,000 in prejudgment
interest. In May 2005, Headwaters and AJG entered into a settlement
agreement calling for payments to Headwaters in the amount of $50,000,000
at the time of settlement (which payment was received in May 2005),
$70,000,000 (related to a contract modification for use of technology) in
January 2006, and certain quarterly payments based upon tax credits
associated with AJG's facilities for calendar years 2005 through 2007.
Payments based upon tax credits associated with AJG's facilities for the
first three quarters of calendar year 2005 will be payable in January 2006,
with all other quarterly payments for 2005 through 2007 payable 45 days
after the end of each quarter. Payments based upon tax credits for 2005
through 2007 are subject to downward adjustment or elimination if a
phase-out of section 29 tax credits occurs due to high oil prices.
Headwaters currently expects to recognize the $50,000,000 gain, net of
payments due to a third party (which are currently being determined), in
the quarter ending June 30, 2005. The $70,000,000, net of payments due to a
third party, will be recognized as revenue beginning April 2005 through
2007, and the future quarterly payments based upon tax credits will be
recognized as revenue in accordance with Headwaters' revenue recognition
policy for license fee revenue (see "Revenue Recognition" in Note 2 to the
consolidated financial statements in Headwaters' Form 10-K).
19
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
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
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. Most recently, in April 2005, an amendment to
Section 29 was proposed in the House Ways and Means Committee of the United
States House of Representatives that would have repealed the Section 29
credit for synthetic fuel produced from coal. The committee failed to
approve the proposed amendment, but the amendment could be reintroduced. 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
20
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
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 2004, the
reference price was $36.75 per barrel and the phase-out range began at
$51.35 and would have fully phased out tax credits at $64.47 per barrel.
For calendar 2005, an estimated partial year reference price (through March
2005) is $42.92 per barrel, and an estimate of the phase-out range (using
2% inflation) begins at $52.38 and completes phase-out at $65.76 per
barrel. The one-day cash trading price (which historically has trended
somewhat higher than the reference price) on April 29, 2005 was $49.73 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 2005, 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.
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.
21
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 2004 refer to Headwaters'
fiscal quarter and/or six-month period ended March 31, 2004, and references to
2005 refer to Headwaters' fiscal quarter and/or six-month period ended March 31,
2005.
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, that enjoy healthy margins from products
and services and that 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 HTI's
energy-related technologies and nanotechnology and has invested in and expects
to continue to invest in research and development activities.
As a result of its diversification into CCPs and construction
materials, Headwaters is affected by seasonality, with the 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 segment 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 historically 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 market new products from Tapco in order to maintain the
historical growth rates of this segment.
In fiscal 2005, Headwaters is focusing on integration of its recent
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, but has reduced its
outstanding debt through cash flow from operations and most recently from an
underwritten public offering of common stock in March 2005. Higher leverage
levels make continued diversification at historical levels more difficult.
Headwaters intends to continue to focus on repaying long-term 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 March 31, 2005, there were 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' 2005
results, but the 2004 results include nothing related to these companies because
none of the acquisitions were consummated prior to March 31, 2004. 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 2005 financial
22
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 2005 are not indicative of the results to
be expected for the full fiscal 2005 year.
As described in more detail in Note 1 to the consolidated financial
statements included herein and 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, construction
materials, CCPs and alternative energy. These segments are managed and evaluated
separately by management based on fundamental differences in their operations,
products and services.
Prior to 2004, the businesses in the construction materials segment
manufactured and distributed 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.
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.
The alternative energy segment includes Headwaters' traditional
coal-based solid alternative fuels business and HTI's business of developing
catalysts and processes 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.
Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004
The information set forth below compares Headwaters' operating results
for the three months ended March 31, 2005 ("2005") with operating results for
the three months ended March 31, 2004 ("2004").
Revenue. Total revenue for 2005 increased by $102.9 million or 86% to
$222.4 million as compared to $119.5 million for 2004. The major components of
revenue are discussed in the sections below.
Sales of Construction Materials. Sales of construction materials during
2005 were $109.2 million with a corresponding direct cost of $73.7 million.
Sales of construction materials during 2004 were $11.2 million with a
corresponding direct cost of $10.0 million. The increase in sales of
construction materials during 2005 was due primarily to the acquisitions of
Eldorado, SCP and Tapco in fiscal 2004. Revenues for these acquired companies
for 2005 totaled $97.1 million. The increase in gross margin percentage from
2004 to 2005 was due primarily to significantly higher margins from the
operations of the acquired businesses.
CCP Revenues. CCP revenues for 2005 were $48.5 million with a
corresponding direct cost of $38.3 million. CCP revenues for 2004 were $39.6
million with a corresponding direct cost of $29.7 million. The increase in CCP
revenues during 2005 was due primarily to the acquisition of VFL in April 2004
(VFL's revenues for 2005 totaled $8.4 million). The gross margin percentage
decreased from 2004 to 2005 by approximately 4% due primarily to one-time
service revenue in 2004 and VFL, which typically has lower gross margins than
the legacy CCP business.
Alternative Energy. Headwaters' alternative energy segment revenue
consists primarily of chemical reagent sales and license fee revenue related to
its solid alternative fuel technologies. HTI's revenues are also included in
alternative energy revenue and have historically comprised a minor portion of
total segment revenue.
Sales of Chemical Reagents. Chemical reagent sales (included in
alternative energy revenue in the accompanying consolidated statements of
income) during 2005 were $39.9 million with a corresponding direct cost of $28.4
million. Chemical reagent sales during 2004 were $32.2 million with a
corresponding direct cost of $21.8 million. The increase in chemical reagent
sales during 2005 was due primarily to increased synthetic fuel production by
Headwaters' licensees (resulting in increased sales of $4.1 million) and by
customers with which Headwaters does not have a license agreement (resulting in
increased sales of $3.6 million). Of the increased sales to customers, $1.9
million represents sales of chemical reagent related to the coal-based solid
alternative fuel production facility in which Headwaters is a minority owner
23
(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
2005 of 29% was 3% lower than for 2004, due primarily to increases in the cost
of product, which in turn is related to recent increases in the costs of
petroleum-based materials, and to a lesser extent, changes in customer mix.
Additional cost increases could occur and to the extent Headwaters is not able
to pass on such increases to customers, margins will be adversely affected.
Headwaters currently expects gross margin percentages for the rest of fiscal
2005 to continue to trend below fiscal 2004 levels.
License Fees. During 2005, Headwaters recognized license fee revenue
(included in alternative energy revenue in the accompanying consolidated
statements of income) totaling $24.6 million, a decrease of $11.7 million or 32%
from $36.3 million of license fee revenue recognized during 2004. The primary
reason for the decrease in license fee revenue in 2005 compared to 2004 was the
recognition in 2004 of $24.9 million of net revenue representing funds
previously deposited in an escrow account by one of Headwaters' licensees, all
relating to alternative fuel sold prior to December 31, 2003. Headwaters also
recognized approximately $3.0 million of revenue in 2004 relating to the March
2004 quarter. In 2005, Headwaters recognized a total of $11.3 million of revenue
from this licensee, for a net decrease of $16.6 million from 2004 to 2005. For
more information about the 2004 revenue related to this licensee, see "License
Fee Revenue Recognition" in the "Critical Accounting Policies and Estimates"
section of Item 7 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 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.
Amortization. These costs increased by $4.5 million to $6.2 million in
2005 from $1.7 million in 2004. 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 $1.4 million to $2.9 million in 2005 from $1.5 million in 2004. The increase
was primarily attributable to increased HTI research and development activities.
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
$17.5 million to $34.2 million for 2005 from $16.7 million for 2004. The
increase in 2005 was due primarily to the fiscal 2004 acquisitions ($16.5
million) and an increase in litigation-related costs ($2.8 million), partially
offset by a net decrease in other costs ($1.8 million). Selling, general and
administrative expenses in 2004 included higher amounts for incentive pay
expenses as a result of obligations arising from Headwaters' bonus plans, due in
turn to the revenue recognized from escrowed funds, as previously discussed. 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 revenue.
Other Income and Expense. During 2005, Headwaters reported net other
expense of $22.0 million compared to net other expense of $7.6 million during
2004. The change of $14.4 million was attributable to an increase in net
interest expense of $13.1 million in 2005 and a net increase in other expenses
of approximately $1.3 million in 2005.
Net interest expense increased from $5.7 million in 2004 to $18.8
million in 2005 due primarily to significantly higher average levels of
long-term debt in 2005 compared to 2004, primarily related to the fiscal 2004
acquisitions. In both periods, debt repayments (totaling approximately $74.8
million in 2004 and $202.6 million in 2005) consisted primarily of early
repayments. Non-cash interest expense, representing amortization of debt
discount (in 2004 only) and debt issue costs (in both 2004 and 2005), was $5.0
million in 2004 and $4.8 million in 2005. Due to the substantially higher
amounts of outstanding debt at March 31, 2005 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 $1.3 million consisted primarily of
an increase in other expenses (totaling approximately $3.3 million) related to
Headwaters' costs related to its investment in the coal-based solid alternative
fuel production facility described in Note 9 to the consolidated financial
statements, including amortization of the related $15.5 million investment,
partially offset by approximately $1.7 million of asset write-offs in 2004 that
did not recur in 2005.
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. Due to the combined effect of the seasonality of Headwaters'
operations and the requirement to use an estimated effective tax rate for the
year in calculating income taxes, Headwaters is not able to recognize the
24
benefit of all of the tax credits earned in the December and March quarters in
its results of operations for those quarters. Tax credits earned but not
recognized in the December and March quarters will be recognized in the June and
September quarters. Even though Headwaters can not fully recognize its portion
of the benefits of the tax credits generated in 2005, Headwaters' pro-rata share
of costs incurred to generate those tax credits has been recognized as other
expense.
Income Tax Provision. Headwaters' effective income tax rate for 2005
was approximately 27%. This compares to an effective tax rate of approximately
39% for 2004 and 35% for the quarter ended December 31, 2004. Headwaters'
effective income tax rate for the entire fiscal 2005 year is currently estimated
to be 31.5%. The primary reason for the decreases 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.
Headwaters adjusts its income tax provision each quarter to yield the
estimated effective tax rate for the fiscal year on a cumulative basis, causing
each quarter's effective tax rate to vary somewhat. It is possible that
Headwaters' estimate of its effective tax rate for fiscal 2005 will change in
future periods, necessitating an adjustment in future periods to reflect the
impact of the rate change on results for prior fiscal 2005 periods. Excluding
the effect of the tax credits, Headwaters' effective tax rate in 2005 would have
been approximately 40%.
Six Months Ended March 31, 2005 Compared to Six Months Ended March 31, 2004
The information set forth below compares Headwaters' operating results
for the six months ended March 31, 2005 ("2005") with operating results for the
six months ended March 31, 2004 ("2004").
Revenue. Total revenue for 2005 increased by $219.8 million or 99% to
$440.8 million as compared to $221.0 million for 2004. The major components of
revenue are discussed in the sections below.
Sales of Construction Materials. Sales of construction materials during
2005 were $222.9 million with a corresponding direct cost of $150.2 million.
Sales of construction materials during 2004 were $23.2 million with a
corresponding direct cost of $19.3 million. The increase in sales of
construction materials during 2005 was due primarily to the acquisitions of
Eldorado, SCP and Tapco in fiscal 2004. Revenues for these acquired companies
for 2005 totaled $199.2 million. The increase in gross margin percentage from
2004 to 2005 was due primarily to significantly higher margins from the
operations of the acquired businesses.
CCP Revenues. CCP revenues for 2005 were $101.5 million with a
corresponding direct cost of $79.3 million. CCP revenues for 2004 were $84.7
million with a corresponding direct cost of $63.1 million. The increase in CCP
revenues during 2005 was due primarily to the acquisition of VFL in April 2004
(VFL's revenues for 2005 totaled $17.0 million). The gross margin percentage
decreased from 2004 to 2005 by approximately 4% due primarily to one-time
service revenue in 2004 and VFL, which typically has lower gross margins than
the legacy CCP business.
Sales of Chemical Reagents. Chemical reagent sales (included in
alternative energy revenue in the accompanying consolidated statements of
income) during 2005 were $76.7 million with a corresponding direct cost of $53.0
million. Chemical reagent sales during 2004 were $63.1 million with a
corresponding direct cost of $43.0 million. The increase in chemical reagent
sales during 2005 was due primarily to increased synthetic fuel production by
Headwaters' licensees (resulting in increased sales of $6.3 million) and by
customers with which Headwaters does not have a license agreement (resulting in
increased sales of $7.3 million). Of the increased sales to customers, $3.5
million represents sales of chemical reagent related to the coal-based solid
alternative fuel production facility in which Headwaters is a minority owner.
The gross margin percentage for 2005 of 31% was 1% lower than for 2004, due
primarily to increases in the cost of product, which in turn is related to
recent increases in the costs of petroleum-based materials, and to a lesser
extent, changes in customer mix.
License Fees. During 2005, Headwaters recognized license fee revenue
(included in alternative energy revenue in the accompanying consolidated
statements of income) totaling $39.2 million, a decrease of $6.6 million or 14%
from $45.8 million of license fee revenue recognized during 2004. The primary
reason for the decrease in license fee revenue in 2005 compared to 2004 was the
recognition in 2004 of $24.9 million of net revenue representing funds
previously deposited in an escrow account by one of Headwaters' licensees, all
relating to alternative fuel sold prior to December 31, 2003. Headwaters also
recognized approximately $3.0 million of revenue in 2004 relating to the March
2004 quarter. In 2005, Headwaters recognized a total of $15.3 million of revenue
from this licensee, for a net decrease of $12.6 million from 2004 to 2005.
Amortization. These costs increased by $9.0 million to $12.4 million in
2005 from $3.4 million in 2004. The increase was primarily attributable to the
fiscal 2004 acquisitions and the resulting increases in amortizable intangible
assets.
Research and Development. Research and development expenses increased
by $1.6 million to $5.2 million in 2005 from $3.6 million in 2004. The increase
was primarily attributable to increased HTI research and development activities.
25
Selling, General and Administrative Expenses. These expenses increased
$36.1 million to $64.3 million for 2005 from $28.2 million for 2004. The
increase in 2005 was due primarily to the fiscal 2004 acquisitions ($32.5
million) and an increase in litigation-related costs ($4.0 million), partially
offset by a net decreases in other costs ($0.4 million). Selling, general and
administrative expenses in 2004 included higher amounts for incentive pay
expenses as a result of obligations arising from Headwaters' bonus plans, due in
turn to the revenue recognized from escrowed funds, as previously discussed.
Other Income and Expense. During 2005, Headwaters reported net other
expense of $39.7 million compared to net other expense of $13.4 million during
2004. The change of $26.3 million was attributable to an increase in net
interest expense of $23.6 million in 2005 and a net increase in other expenses
of approximately $2.7 million in 2005.
Net interest expense increased from $11.0 million in 2004 to $34.6
million in 2005 due primarily to significantly higher average levels of
long-term debt in 2005 compared to 2004, primarily related to the fiscal 2004
acquisitions. In both periods, debt repayments (totaling approximately $134.9
million in 2004 and $253.9 million in 2005) consisted primarily of early
repayments. Non-cash interest expense, representing amortization of debt
discount (in 2004 only) and debt issue costs (in both 2004 and 2005), was $7.6
million in 2004 and $6.7 million in 2005.
The net change in other expenses of $2.7 million consisted primarily of
an increase in other expenses (totaling approximately $5.7 million) related to
Headwaters' costs related to its investment in the coal-based solid alternative
fuel production facility described in Note 9 to the consolidated financial
statements, including amortization of the related $15.5 million investment,
partially offset by approximately $2.2 million of asset write-offs in 2004 that
did not recur in 2005 and a reduction in losses on disposition of property,
plant and equipment of approximately $0.6 million.
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. Due to the combined effect of the seasonality of Headwaters'
operations and the requirement to use an estimated effective tax rate for the
year in calculating income taxes, Headwaters is not able to recognize the
benefit of all of the tax credits earned in the December and March quarters in
its results of operations for those quarters. Tax credits earned but not
recognized in the December and March quarters will be recognized in the June and
September quarters. Even though Headwaters can not fully recognize its portion
of the benefits of the tax credits generated in 2005, Headwaters' pro-rata share
of costs incurred to generate those tax credits has been recognized as other
expense.
Income Tax Provision. Headwaters' effective income tax rate for 2005
was approximately 31.5%. This compares to an effective tax rate of approximately
38.5% for 2004. 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 It is possible that
Headwaters' estimate of its effective income tax rate for fiscal 2005 will
change in future periods, necessitating an adjustment in future periods to
reflect the impact of the change on results for prior fiscal 2005 periods.
Excluding the effect of the tax credits, Headwaters' effective tax rate in 2005
would have been approximately 40%.
Impact of Inflation
Headwaters' operations have been impacted in 2005 by rising costs for
chemical reagents in the alternative energy segment, by increased cement and
polypropylene costs in the construction materials segment and by increased fuel
costs that have affected transportation costs in most business units. The
increased costs of chemical reagents, polypropylene and fuel are directly
related to the increase in prices of oil and other petroleum-based materials.
Headwaters has been successful in passing on some, but not all, of these
increased material and transportation costs to customers. It is not possible to
predict the future trend of material and transportation costs, nor the ability
of Headwaters to pass on any potential future price increases to customers.
Liquidity and Capital Resources
Summary of Cash Flow Activities. Net cash provided by operating
activities during 2005 was $47.5 million compared to $17.1 million of net cash
used in operating activities during 2004. The change was primarily attributable
to changes in short-term trading investments ($37.4 million), trade receivables
($41.6 million), and depreciation and amortization ($21.3 million), partially
offset by changes in inventories ($10.6 million) and accounts payable and
accrued liabilities ($15.9 million).
In 2004, Headwaters issued 5.0 million shares of common stock in an
underwritten public offering for net cash proceeds of $90.3 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. In 2005, Headwaters
issued 6.9 million shares of common stock in another underwritten public
offering for net cash proceeds of $199.3 million. Headwaters also used these
proceeds to repay debt. During 2005, $238.9 million of debt was repaid, net of
proceeds from issuance of debt, compared to a net $85.7 million of debt
repayments in 2004. During both periods, investing activities consisted
26
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 2004
($4.9 million) to 2005 ($23.5 million). These capital expenditures primarily
relate to the construction materials and CCPs segments and for fiscal 2005 will
continue to be much higher than for comparative periods in fiscal 2004. Capital
expenditures for fiscal 2005 are currently expected to approximate the
limitation on such expenditures of $62.0 million included in the senior debt
covenants. As of March 31, 2005, Headwaters was committed to spend approximately
$11.7 million on capital projects that were in various stages of completion.
Headwaters intends to continue to expand its business through growth of
existing operations, commercialization of technologies currently being
developed, and strategic acquisitions of 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 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 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 (totaling $14.0 million at March 31, 2005), bears interest at an
8% rate. Headwaters also agreed to make additional payments to the seller based
on a pro-rata allocation of the tax credits generated by the facility, also
through December 2007. These additional contractual payments, along with the
amortization of the $15.5 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 currently totaling $14.0 million;
therefore, Headwaters' obligation to make all of the above-described payments is
effectively limited to the tax benefits Headwaters receives.
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 $3.9 million at March 31, 2005),
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.
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 and has issued common stock which together has enabled
Headwaters to repay a substantial amount of its long-term debt prior to the
scheduled maturities. Headwaters expects its 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 approximately $18.0 million
of common stock, preferred stock, convertible debt and other securities. 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.
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 up to $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
27
agreement executed 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. In March 2005, another amendment to the credit agreements
was entered into which modified certain terms of the credit facility, all as
described in more detail in the following paragraphs.
The first lien term loan bears interest, at Headwaters' option, at
either i) the London Interbank Offered Rate ("LIBOR") plus 2.0%, 2.25%, or 2.5%,
depending on the credit ratings that have been most recently announced for the
loans by Standard & Poors Ratings Services ("S&P") and Moody's Investors
Service, Inc. ("Moody's"); or ii) the "base rate" plus 1.0%, 1.25%, or 1.5%,
again depending on the credit ratings announced by S&P and Moody's. Base rate is
defined as the higher of the rate announced by Morgan Stanley Senior Funding and
the overnight rate charged by the Federal Reserve Bank of New York plus 0.5%.
The initial interest rate on the first lien debt was set at 6.5%, but was
subsequently reduced to approximately 5.4% during the quarter ended December 31,
2004 pursuant to the terms of the agreement. The interest rate on the first lien
debt was approximately 4.9% at March 31, 2005. 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% during the quarter
ended December 31, 2004 pursuant to the terms of the agreement. The interest
rate on the second lien debt was approximately 8.2% at March 31, 2005.
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 occurred in March
2005.
The first lien term loan ($442.7 million outstanding at March 31, 2005)
is repayable in quarterly installments of principal and interest, with minimum
required quarterly principal repayments of approximately $3.4 million commencing
in November 2005 through August 2010, with three repayments of approximately
$125.2 million each through April 2011, the termination date of the first lien
loan agreement. The second lien term loan ($100.0 million outstanding at March
31, 2005) 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 generally permitted without penalty or premium, except where the
proceeds for repayment are obtained from a "financing," as defined, consummated
for the purpose of lowering the interest rate on the first lien debt, in which
case there is a 1% prepayment penalty. Optional prepayments of the second lien
term loan under the original terms of the credit agreement were permissible only
to the extent Headwaters issued new equity securities and then were further
limited to a maximum of $50.0 million, so long as the first lien term loan
remained outstanding. As amended, 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, and further, subsequent to September 8, 2005, Headwaters can prepay the
second lien debt with available cash flow, unrestricted as to source. Once
repaid in full or in part, no further reborrowings under either of the term loan
arrangements can be made.
During the quarter ended December 31, 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. In March 2005,
Headwaters repaid $147.3 million of the first lien term loan and $50.0 million
of the second lien term loan. As a result of the early repayments of debt, there
was an acceleration of amortization of the related debt issue costs totaling
approximately $4.0 and $4.9 million for the three- and six-month periods ended
March 31, 2005, respectively, all of which was charged to interest expense. A 3%
prepayment penalty of $1.5 million was paid related to the early repayment of
$50.0 million of second lien term debt, which was also charged to interest
expense.
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,
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 a market value at March 31, 2005 of approximately $4.1
million, which, net of $1.6 million of income taxes, represents other
comprehensive income for the period ended March 31, 2005 (yielding approximately
$14.5 million and $27.5 million, respectively, of total comprehensive income for
the three- and six-month periods ended March 31, 2005). The market value of the
hedges can fluctuate significantly over a relatively short period of time and as
of April 29, 2005, the market value of the hedges had decreased to approximately
$2.4 million. Effective with the March 2005 amendment to the credit facility,
Headwaters was allowed to reduce its hedges to $150.0 million of the senior debt
and in May 2005, Headwaters reduced the hedges to that level, realizing a gain
of approximately $1.0 million.
28
Convertible Senior Subordinated Notes - In connection with the Eldorado
acquisition, Headwaters issued $172.5 million of 2 ?% 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 2005 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. The notes require monthly interest and quarterly principal payments and
bear interest at variable rates, which as of March 31, 2005, ranged from 4.5% to
5.25%. 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 March 31, 2005.
Options and Employee Stock Purchases - In 2005, cash proceeds from the
exercise of options and employee stock purchases totaled $4.9 million, compared
to $5.5 million in 2004. 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 $2.9 million in 2004 and $5.3 million in 2005.
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 2005, Headwaters' working capital increased by
$28.9 million, to $73.3 million as of March 31, 2005. Headwaters expects
operations to produce positive cash flows in future periods. Additionally,
Headwaters received $50.0 million in May 2005 from the settlement of contract
litigation and will receive $70.0 million in January 2006 (see Note 9 to the
consolidated financial statements). As a result of all of these factors,
Headwaters expects working capital will be sufficient for operating needs for
the remainder of fiscal 2005 and beyond.
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
29
terms of the first lien loan agreement and bear interest at either LIBOR plus
1.75% to 2.5% (depending on Headwaters' "total leverage ratio," as defined), or
the base rate plus 0.75% to 1.5%. Borrowings and reborrowings of any available
portion of the $60.0 million revolver can be made at any time through September
2009, 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% (depending on Headwaters' "total leverage
ratio," as defined). During the period ended March 31, 2005, Headwaters borrowed
$16.0 million under terms of the revolving credit arrangement, $6.0 million of
which was repaid prior to March 31, 2005. In April 2005, Headwaters borrowed an
additional $15.0 million under terms of the revolving credit arrangement. All
amounts outstanding under the revolving credit arrangement have been repaid as
of the filing date of this Form 10-Q. Finally, the credit agreement allows for
the issuance of letters of credit, provided there is capacity under the
revolving credit arrangement. As of March 31, 2005, two letters of credit
totaling $0.6 million were outstanding, with expiration dates in June 2005 and
September 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,
annual capital expenditures in excess of $62.0 million for fiscal years 2005 and
2006, $55.0 million for fiscal years 2007 through 2010 and $60.0 million for
fiscal year 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 March 31, 2005.
As described above, Headwaters has approximately $562.0 million of
variable-rate long-term debt outstanding as of March 31, 2005, consisting of
$552.7 million of senior debt and $9.3 million of notes payable to a bank.
Disregarding the effect of the hedges described above, a change in the interest
rate of 1% would change Headwaters' interest expense by approximately $5.5
million during the 12 months ending March 31, 2006, 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 $5.3 million in 2005. Headwaters' cash
requirements for income taxes in fiscal 2005 are expected to generally
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 2005 was approximately 31.5%,
the estimated rate for the fiscal year ending September 30, 2005. This compares
to an effective tax rate of approximately 38.5% for 2004. The primary reason for
the decrease in the effective tax rate is the 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 2005 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 asserted 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 $1.4 million for legal
matters based on the most likely amounts of Headwaters' liabilities or amounts
that Headwaters was willing to settle for. Claims and damages sought by
claimants in excess of those amounts were not deemed to be probable. During the
six months ended March 31, 2005, Headwaters expensed $2.8 million for legal
matters (excluding costs for legal counsel). Our outside counsel currently
believe that unfavorable outcomes of outstanding litigation are neither probable
nor remote and declined to express opinions concerning the likely outcomes or
30
liability to Headwaters. The liability recorded as of March 31, 2005, totaling
$2.5 million, represents the amount Headwaters would be willing to pay to reach
settlements of outstanding cases. 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 $2.5 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 material. Additionally, as with any
litigation, these proceedings require that Headwaters incur substantial costs,
including attorneys' fees, managerial time, and other personnel resources and
costs in pursuing resolution. Costs paid to outside legal counsel for
litigation, which have historically comprised the majority of Headwaters'
litigation-related costs, totaled approximately $1.1 million and $2.6 million
for the six months ended March 31, 2004 and 2005, respectively. It is not
possible to estimate what these costs will be in future periods.
In December 1996, Headwaters entered into a technology license and
proprietary chemical reagent sale agreement with AJG Financial Services, Inc.
The agreement provided for AJG to pay royalties and allowed AJG 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 asserted claims including breach of
contract and sought 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.
This litigation came to the trial phase in January 2005. The jury
reached a verdict substantially in favor of Headwaters and the court entered a
judgment for Headwaters against AJG in the amount of approximately $175.0
million which included approximately $32.0 million in prejudgment interest. In
May 2005, Headwaters and AJG entered into a settlement agreement calling for
payments to Headwaters in the amount of $50.0 million at the time of settlement
(which payment was received in May 2005), $70.0 million (related to a contract
modification for use of technology) in January 2006, and certain quarterly
payments based upon tax credits associated with AJG's facilities for calendar
years 2005 through 2007. Payments based upon tax credits associated with AJG's
facilities for the first three quarters of calendar year 2005 will be payable in
January 2006, with all other quarterly payments for 2005 through 2007 payable 45
days after the end of each quarter. Payments based upon tax credits for 2005
through 2007 are subject to downward adjustment or elimination if a phase-out of
section 29 tax credits occurs due to high oil prices. Headwaters currently
expects to recognize the $50.0 million gain, net of payments due to a third
party (which are currently being determined), in the quarter ending June 30,
2005. The $70.0 million, net of payments due to a third party, will be
recognized as revenue beginning April 2005 through 2007, and the future
quarterly payments based upon tax credits will be recognized as revenue in
accordance with Headwaters' revenue recognition policy for license fee revenue
(see "Revenue Recognition" in Note 2 to the consolidated financial statements in
Headwaters' Form 10-K).
In conjunction with the gain to be recognized from the AJG litigation
settlement, the Compensation Committee of the Board of Directors ("Committee")
initiated several incentive award grants in May to certain officers and
employees. The Committee made awards that are intended to accelerate
approximately five years of long-term incentive compensation into the June 2005
quarter. A significant portion of the awards are based on grantees achieving
certain performance goals and/or growth in the "economic value added" of
Headwaters, all of which the Committee believes would lead to the creation of
significant long-term stockholder value. If Headwaters early adopts SFAS No.
123R, it will record significant long-term incentive compensation expense in the
June 2005 quarter.
The Committee granted i) approximately 3.0 million stock appreciation
rights ("SARs"), ii) stock options for the purchase of approximately 0.1 million
shares of common stock, iii) incentive cash bonuses and iv) performance unit
awards. Approximately 1.9 million of the SARs vest at grant date and require a
payment by grantees of $2.00 per SAR, payable over a five-year period. Also,
these SARs are allowed to appreciate to a maximum gain equal to the fair market
value of Headwaters' common stock at the date of grant. Approximately 1.2
million of the SARs will vest over a five-year period, and approximately 1.1
million of these SARs will be exercisable based on the achievement of
performance criteria related to growth in the "economic value added" of
Headwaters. All of the SARs and stock options were granted under terms of
existing stock option and stock incentive plans. The SARs and stock options have
an exercise price of $31.97 per share, the fair market value of Headwaters'
common stock on the date of grant. All SARs will be settled in stock when
exercised by grantees. The incentive cash bonuses approximated $5.5 million. The
performance unit awards have a potential value totaling approximately $6.1
million, payable in cash, if certain performance criteria are met prior to
December 2009.
31
The Committee is also considering the potential acceleration of vesting
of outstanding stock options not currently vested. Headwaters is currently
reviewing the costs related to accelerating the vesting of options and is
considering the appropriate accounting for these costs, along with the costs of
the incentive awards granted, under current accounting literature as well as
under the new requirements of SFAS No. 123R. Headwaters expects these costs will
be substantial, and a majority of such costs could be required to be reflected
as expense in the quarter ending June 30, 2005, especially if Headwaters early
adopts SFAS No. 123R in the June 2005 quarter, which management is considering.
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. Most recently, in April 2005, an amendment to Section 29 was
proposed in the House Ways and Means Committee of the United States House of
Representatives that would have repealed the Section 29 credit for synthetic
fuel produced from coal. The committee failed to approve the proposed amendment,
but the amendment could be reintroduced. 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 2004, the reference price
was $36.75 per barrel and the phase-out range began at $51.35 and would have
fully phased out tax credits at $64.47 per barrel. For calendar 2005, an
estimated partial year reference price (through March 2005) is $42.92 per
barrel, and an estimate of the phase-out range (using 2% inflation) begins at
$52.38 and completes phase-out at $65.76 per barrel. The one-day cash trading
price (which historically has trended somewhat higher than the reference price)
on April 29, 2005 was $49.73 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
2005. 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.
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
32
04-08, "The Effect of Contingently Convertible Debt on Diluted Earnings per
Share") was effective for periods ending after December 15, 2004 and required
Headwaters to include in its 2005 diluted EPS calculations, 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 are 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 November 2004, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 151, "Inventory Costs," which clarifies the accounting for
abnormal amounts of idle facility expense, freight, handling costs, and
spoilage, requiring that such costs be recognized as current-period costs
regardless of whether they meet the criterion of "so abnormal," currently
required by the guidance in ARB No. 43, Chapter 4, "Inventory Pricing." SFAS No.
151 is effective for inventory costs incurred during fiscal years beginning
after June 15, 2005, which for Headwaters will be fiscal 2006. Because the
provisions of this standard must be applied prospectively, there will be no
effect on previously-issued financial statements of Headwaters. It is not
possible to predict the effect SFAS No. 151 might have on future reported
results because it will depend on the levels of "abnormal" inventory costs
incurred in the future, if any.
In December 2004, the FASB issued SFAS No. 123 (revised 2004),
"Share-Based Payment," ("SFAS No. 123R"), which was to be effective for interim
periods beginning after June 15, 2005. In April 2005, the SEC announced that it
would allow registrants to delay the adoption of SFAS No. 123R to no later than
the beginning of the first fiscal year beginning after June 15, 2005, which for
Headwaters would be fiscal 2006. 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 no longer 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 expects
it to have a material effect on Headwaters' reported results of operations when
adopted, although it will have limited impact on cash flow. Headwaters may early
adopt SFAS No. 123R beginning in either the June or September 2005 quarters.
SFAS No. 123R permits public 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 (including the stock appreciation rights and stock options granted in May
2005, as described in Note 9). However, had Headwaters adopted SFAS No. 123R in
prior periods, Headwaters believes the impact of this standard would have
approximated the impact of SFAS No. 123 as reflected above in the disclosures 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 the six months ended March 31, 2004 and 2005
were $2.9 million and $5.3 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 $562.0 million of variable-rate
long-term debt outstanding as of March 31, 2005, consisting of $552.7 million of
senior debt and $9.3 million of notes payable to a bank.
The $552.7 million of term loan borrowings under the senior debt
agreements consisted of a first lien term loan in the amount of $452.7 million
and a second lien term loan in the amount of $100.0 million. The first lien term
loan bears interest, at Headwaters' option, at either i) the London Interbank
Offered Rate ("LIBOR") plus 2.0%, 2.25%, or 2.5%, depending on the credit
33
ratings that have been most recently announced for the loans by Standard & Poors
Ratings Services ("S&P") and Moody's Investors Service, Inc. ("Moody's"); or ii)
the "base rate" plus 1.0%, 1.25%, or 1.5%, again depending on the credit ratings
announced by S&P and Moody's. Base rate is defined as the higher of the rate
announced by Morgan Stanley Senior Funding and the overnight rate charged by the
Federal Reserve Bank of New York plus 0.5%. The initial interest rate on the
first lien debt was set at 6.5%, but was subsequently reduced to approximately
5.4% during the quarter ended December 31, 2004 pursuant to the terms of the
agreement. The interest rate on the first lien debt was approximately 4.9% at
March 31, 2005. 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% during the quarter ended December 31, 2004
pursuant to the terms of the agreement. The interest rate on the second lien
debt was approximately 8.2% at March 31, 2005. 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 occurred in March.
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 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,
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 a market value at March 31, 2005 of approximately $4.1
million, which, net of $1.6 million of income taxes, represents other
comprehensive income for the period ended March 31, 2005 (yielding approximately
$14.5 million and $27.5 million, respectively, of total comprehensive income for
the three- and six-month periods ended March 31, 2005). The market value of the
hedges can fluctuate significantly over a relatively short period of time and as
of April 29, 2005, the market value of the hedges had decreased to approximately
$2.4 million. Effective with the March 2005 amendment to the credit facility,
Headwaters was allowed to reduce its hedges to $150.0 million of the senior debt
and in May 2005, Headwaters reduced the hedges to that level, realizing a gain
of approximately $1.0 million.
In connection with the acquisition of SCP in July 2004, Headwaters
assumed SCP's obligations under its notes payable to a bank. The notes require
monthly interest and quarterly principal payments and bear interest at variable
rates, which as of March 31, 2005, ranged from 4.5% to 5.25%.
Disregarding the effect of the hedges described above, a change in the
interest rate of 1% would change Headwaters' interest expense by approximately
$5.5 million during the 12 months ending March 31, 2006, 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 March 31, 2005, 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 March 31, 2005 that
has materially affected, or is reasonably likely to materially affect,
Headwaters' internal control over financial reporting.
34
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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On March 1, 2005, Headwaters held its 2005 annual Meeting of
Stockholders. Items voted on and the results of voting are described in
Headwaters' Form 8-K, filed March 3, 2005, which Form 8-K is incorporated herein
by reference.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
The following exhibits are included herein:
10.94 Settlement Agreement and Mutual Release dated *
May 1, 2005 between Headwaters, AJG Financial Services,
Inc. and others
12 Computation of ratio of earnings to combined fixed *
charges and preferred stock dividends
14 Code of Ethics *
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief *
Executive Officer
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief *
Financial Officer
32 Section 1350 Certifications of Chief Executive Officer *
and Chief Financial Officer
99.11 Nominating and Corporate Governance Committee Charter, *
dated April 25, 2005
99.12 Audit Committee Charter, dated March 9, 2005 *
99.13 Compensation Committee Charter, dated March 9, 2005 *
99.14 Form of 2005 Stock Appreciation Right Grant and related *
Stock Appreciation Right Agreement (vested)
99.15 Form of 2005 Stock Appreciation Right Grant and *
related Stock Appreciation Right Agreement (scheduled
vesting)
-----------------------
* Filed herewith.
35
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: May 9, 2005 By: /s/ Kirk A. Benson
------------------------------------------
Kirk A. Benson, Chief Executive Officer
(Principal Executive Officer)
Date: May 9, 2005 By: /s/ Steven G. Stewart
------------------------------------------
Steven G. Stewart, Chief Financial Officer
(Principal Financial Officer)
36