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 June 30, 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
incorporation or organization) Identification No.)
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 July 29,
2005 was 41,564,604.
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 June 30, 2005 ..........................3
Condensed Consolidated Statements of Income - For the three
and nine months ended June 30, 2004 and 2005 ..................4
Condensed Consolidated Statement of Changes in Stockholders'
Equity - For the nine months ended June 30, 2005...............5
Condensed Consolidated Statements of Cash Flows - For the
nine months ended June 30, 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.......................................25
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK......38
ITEM 4. CONTROLS AND PROCEDURES.........................................39
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS ..............................................39
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS ....40
ITEM 3. DEFAULTS UPON SENIOR SECURITIES ................................40
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ............40
ITEM 5. OTHER INFORMATION...............................................40
ITEM 6. EXHIBITS .......................................................40
SIGNATURES....................................................................41
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, June 30,
(in thousands, except per-share data) 2004 2005
- --------------------------------------------------------------------------------------------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 20,851 $ 10,878
Trade receivables, net 129,899 162,296
Other receivable -- 70,000
Inventories 43,812 61,749
Current and deferred income taxes 15,933 14,066
Other 20,068 9,698
-------------------------------
Total current assets 230,563 328,687
-------------------------------
Property, plant and equipment, net 157,611 178,641
-------------------------------
Other assets:
Intangible assets, net 298,803 283,698
Goodwill 815,396 813,814
Other 38,406 39,736
-------------------------------
Total other assets 1,152,605 1,137,248
-------------------------------
Total assets $1,540,779 $1,644,576
===============================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 29,238 $ 33,348
Deferred license fee revenue 7,227 32,347
Accrued personnel costs 26,213 31,472
Accrued income taxes -- 29,254
Other accrued liabilities 65,625 57,443
Current portion of long-term debt 57,873 19,149
-------------------------------
Total current liabilities 186,176 203,013
-------------------------------
Long-term liabilities:
Long-term debt 914,641 655,189
Deferred income taxes 121,469 108,399
Other 10,338 47,587
-------------------------------
Total long-term liabilities 1,046,448 811,175
-------------------------------
Total liabilities 1,232,624 1,014,188
-------------------------------
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 41,471 shares at June 30, 2005 (including 362
shares held in treasury) 34 41
Capital in excess of par value 235,581 479,385
Retained earnings 76,530 152,931
Treasury stock and other (3,990) (1,969)
-------------------------------
Total stockholders' equity 308,155 630,388
-------------------------------
Total liabilities and stockholders' equity $1,540,779 $1,644,576
===============================
See accompanying notes.
3
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended June 30, Nine Months Ended June 30,
------------------------------------------------------------------
(in thousands, except per-share data) 2004 2005 2004 2005
- -------------------------------------------------------------------------------------------------------------------------------
Revenue:
Construction materials $ 26,780 $147,582 $ 49,961 $370,467
Coal combustion products 58,670 69,453 143,363 170,973
Alternative energy 48,868 91,694 161,984 208,097
------------------------------------------------------------------
Total revenue 134,318 308,729 355,308 749,537
------------------------------------------------------------------
Operating costs and expenses (1):
Construction materials 20,001 97,720 39,425 248,140
Coal combustion products 43,794 51,436 106,857 130,882
Alternative energy 23,829 37,874 67,166 91,119
Amortization 2,356 6,126 5,740 18,322
Research and development 1,740 4,758 5,331 10,109
Contract litigation settlement -- (38,252) -- (38,252)
Selling, general and administrative 14,813 53,598 42,934 122,585
------------------------------------------------------------------
Total operating costs and expenses 106,533 213,260 267,453 582,905
------------------------------------------------------------------
Operating income 27,785 95,469 87,855 166,632
------------------------------------------------------------------
Other income (expense):
Net interest expense (1,265) (11,364) (12,253) (45,967)
Other, net 275 (6,375) (2,118) (11,514)
------------------------------------------------------------------
Total other income (expense), net (990) (17,739) (14,371) (57,481)
------------------------------------------------------------------
Income before income taxes 26,795 77,730 73,484 109,151
Income tax provision (10,735) (22,440) (28,705) (32,750)
------------------------------------------------------------------
Net income $ 16,060 $ 55,290 $ 44,779 $ 76,401
==================================================================
Basic earnings per share $ 0.48 $ 1.35 $ 1.43 $ 2.07
==================================================================
Diluted earnings per share $ 0.45 $ 1.17 $ 1.36 $ 1.81
==================================================================
Non-cash stock-based compensation expense included in
operating costs and expenses (1):
Construction materials $ -- $ 1,079 $ -- $ 1,346
Coal combustion products -- 374 -- 541
Research and development -- 1,576 -- 1,765
Selling, general and administrative -- 24,169 -- 28,792
------------------------------------------------------------------
Total stock-based compensation expense $ -- $ 27,198 $ -- $ 32,444
==================================================================
(1) Refer to Note 3 for a description of stock-based compensation expense
recorded in 2005.
See accompanying notes.
4
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
For the Nine Months Ended June 30, 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 796 -- 6,378 6,378
Tax benefit from exercise of stock options 6,309 6,309
52 shares of treasury stock transferred to
employee stock purchase plan, at cost 1,243 151 1,394
Common stock issued for cash, net of
commissions and other offering costs
totaling $11,633 6,900 7 198,810 198,817
Stock-based compensation 31,064 1,380 32,444
Other comprehensive income - unrealized
gain on cash flow hedges, net of taxes 490 490
Net income for the nine months ended
June 30, 2005 76,401 76,401
----------------------------------------------------------------------------------
Balances as of June 30, 2005 41,471 $41 $479,385 $152,931 $(2,459) $ 490 $630,388
==================================================================================
See accompanying notes.
5
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended June 30,
--------------------------------
(in thousands) 2004 2005
- -------------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ 44,779 $ 76,401
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 11,636 41,318
Non-cash stock-based compensation expense -- 32,444
Non-cash interest expense related to amortization of debt discount and
debt issue costs 7,798 8,744
Deferred income taxes (2,245) (18,355)
Amortization of non-refundable license fees (885) (11,327)
Net loss on disposition of property, plant and equipment 794 125
Income tax benefit from exercise of stock options 3,320 --
Write-down of notes receivable 1,038 --
Increase in trade receivables (2,510) (32,397)
Increase in inventories (1,139) (17,937)
Increase in accounts payable and accrued liabilities 19,054 53,898
Other changes in operating assets and liabilities, net (25,416) (9,265)
--------------------------------
Net cash provided by operating activities 56,224 123,649
--------------------------------
Cash flows from investing activities:
Purchase of property, plant and equipment (9,869) (43,047)
Net increase in intangible and other assets (1,015) (3,894)
Proceeds from disposition of property, plant and equipment 53 265
Payments for acquisitions, net of cash acquired (213,285) --
--------------------------------
Net cash used in investing activities (224,116) (46,676)
--------------------------------
Cash flows from financing activities:
Net proceeds from issuance of common stock 90,258 198,817
Net proceeds from issuance of long-term debt 269,239 29,332
Payments on long-term debt (206,973) (329,176)
Proceeds from exercise of stock options and warrants 6,620 6,378
Income tax benefit from exercise of stock options -- 6,309
Employee stock purchases 739 1,394
--------------------------------
Net cash provided by (used in) financing activities 159,883 (86,946)
--------------------------------
Net decrease in cash and cash equivalents (8,009) (9,973)
Cash and cash equivalents, beginning of period 18,732 20,851
--------------------------------
Cash and cash equivalents, end of period $ 10,723 $ 10,878
================================
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
June 30, 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
products or entities that expand Headwaters' current operating platform.
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 an expanded array of 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, with the exception of the
adjustments related to the settlement of contract litigation described in
Note 10 and stock-based compensation. As described in more detail in Note
3, Headwaters early adopted the fair value method of accounting for
stock-based compensation required by SFAS No. 123 (revised 2004),
"Share-Based Payment" ("SFAS No. 123R"), effective as of October 1, 2004,
the beginning of Headwaters' 2005 fiscal year. Accordingly, Headwaters
restated its statement of income for the six months ended March 31, 2005
and the restated amounts have been used in deriving the statement of income
amounts reported for the nine months ended June 30, 2005.
Certain information and footnote disclosures normally included in annual
financial statements prepared in accordance with U.S. generally accepted
accounting principles have been condensed or omitted. These financial
7
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
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 Reports on Form 10-Q for the quarters ended December 31, 2004 and
March 31, 2005.
Headwaters' fiscal year ends on September 30 and unless otherwise noted,
future references to 2004 refer to Headwaters' fiscal quarter and/or
nine-month period ended June 30, 2004, and references to 2005 refer to
Headwaters' fiscal quarter and/or nine-month period ended June 30, 2005.
The consolidated financial statements include the accounts of Headwaters,
all of its subsidiaries and other entities in which Headwaters has a
controlling financial interest. All significant intercompany transactions
and accounts are eliminated in consolidation. Due to the 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
finalized the determination of the purchase price and the purchase price
allocation for Eldorado in the quarter ended June 30, 2005 (see Note 9) and
expects to finalize the determination of the purchase price and the
purchase price allocation for Tapco in the quarter ending September 30,
2005.
Stock-Based Compensation - Through March 31, 2005, Headwaters applied the
intrinsic value method as prescribed by APB Opinion No. 25, "Accounting for
Stock Issued to Employees" ("APB 25") in accounting for options, restricted
stock and other stock-based compensation to employees, officers and
directors, instead of using the fair value method prescribed by SFAS No.
123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"). Under APB
25, no compensation expense was recognized for stock-based compensation to
employees, officers and directors when the exercise price of the awards
equaled or exceeded 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 has been and continues to
be charged to expense over the applicable vesting periods on a
straight-line basis. If the fair value provision of SFAS No. 123 would have
been applied to all stock-based compensation for periods prior to fiscal
2005, net income and earnings per share would have been changed to the pro
forma amounts shown in the following table for the periods indicated.
Three Months Ended Nine Months Ended
(in thousands, except per-share data) June 30, 2004 June 30, 2004
------------------------------------------------------------------------------------
Reported net income $16,060 $44,779
Add actual compensation expense included in
reported net income 160 205
Deduct expense determined under fair value
provision of SFAS No. 123 (905) (2,920)
-----------------------------------------
Pro forma net income $15,315 $42,064
=========================================
Basic earnings per share - as reported $0.48 $1.43
- pro forma $0.46 $1.34
Diluted earnings per share - as reported $0.45 $1.36
- pro forma $0.43 $1.28
The fair values of stock option grants for 2004 were determined using the
Black-Scholes-Merton option pricing model ("B-S-M model") and the following
assumptions: expected stock price volatility of 40%, risk-free interest
rates ranging from 1.5% to 4.5%, weighted average expected option lives of
3 years beyond vesting date, and no dividend yield. The B-S-M 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 certain subjective
8
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
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, restricted stock and other stock-based compensation.
Recent Accounting Pronouncements - 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.
Headwaters has reviewed all other recently issued accounting standards
which have not yet been adopted in order to determine their potential
effect, if any, on the results of operations or financial position of
Headwaters. Based on that review, Headwaters does not currently believe
that any of these other recent accounting pronouncements will have a
significant effect on its current or future financial position, results of
operations, cash flows or disclosures.
Reclassifications - Certain prior period amounts have been reclassified to
conform to the current period's presentation, including some changes
resulting from the adoption of SFAS No. 123R, as explained in Note 3. 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
four of the fiscal 2004 acquisitions described in the Form 10-K, while the
segment information for 2004 includes only the results of operations of VFL
for three months and Eldorado for one month.
Three Months Ended June 30, 2004
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $26,780 $58,670 $48,868 $ -- $134,318
=====================================================================
Depreciation and amortization $ (977) $(3,669) $ (391) $ (92) $ (5,129)
=====================================================================
Operating income (loss) $ 3,374 $ 8,691 $20,362 $ (4,642) $ 27,785
=======================================================
Net interest expense (1,265)
Other income (expense), net 275
Income tax provision (10,735)
-------------
Net income $ 16,060
=============
Capital expenditures $ 2,405 $ 2,408 $ 108 $ 58 $ 4,979
=====================================================================
9
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
Three Months Ended June 30, 2005
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $147,582 $69,453 $91,694 $ -- $308,729
=====================================================================
Depreciation and amortization $ (8,700) $(3,192) $(1,662) $ (81) $(13,635)
=====================================================================
Operating income (loss) $ 16,919 $ 9,297 $86,261 $ (17,008) $ 95,469
======================================================
Net interest expense (11,364)
Other income (expense), net (6,375)
Income tax provision (22,440)
-------------
Net income $ 55,290
=============
Capital expenditures $ 14,393 $ 2,265 $ 2,839 $ 41 $ 19,538
=====================================================================
Nine Months Ended June 30, 2004
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $49,961 $143,363 $161,984 $ -- $355,308
=====================================================================
Depreciation and amortization $(1,306) $ (9,061) $ (1,051) $ (218) $(11,636)
=====================================================================
Operating income (loss) $ 3,208 $ 19,828 $ 79,791 $ (14,972) $ 87,855
=======================================================
Net interest expense (12,253)
Other income (expense), net (2,118)
Income tax provision (28,705)
-------------
Net income $ 44,779
=============
Capital expenditures $ 3,728 $ 5,632 $ 420 $ 89 $ 9,869
=====================================================================
Nine Months Ended June 30, 2005
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $ 370,467 $170,973 $208,097 $ -- $ 749,537
=====================================================================
Depreciation and amortization $ (27,445) $ (9,487) $ (4,154) $ (232) $ (41,318)
=====================================================================
Operating income (loss) $ 43,593 $ 18,089 $137,175 $(32,225) $ 166,632
=======================================================
Net interest expense (45,967)
Other income (expense), net (11,514)
Income tax provision (32,750)
-------------
Net income $ 76,401
=============
Capital expenditures $ 33,382 $ 5,664 $ 3,770 $ 231 $ 43,047
=====================================================================
Segment Assets as of June 30, 2005 $1,135,629 $314,013 $146,285 $ 48,649 $1,644,576
=====================================================================
3. Equity Securities and Stock-Based Compensation
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.
10
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
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 for
the sale of common stock, preferred stock, convertible debt and other
securities. 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
$198,817,000 were received, net of commissions and other offering costs
totaling $11,633,000. 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."
Grants of Stock Incentive Awards - 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 ("SARs") and stock options. In summary, the Committee
granted approximately 2,913,000 SARs and approximately 30,000 options for
the purchase of shares of common stock. Approximately 1,995,000 of the SARs
vested at grant date, a majority of which require a payment by grantees of
$2.00 per SAR, payable over a 52-month period. Also, the maximum gain that
may be received for each of these SARs is limited to the fair market value
of one share of Headwaters' common stock at the date of grant (or $31.97
per SAR). The grant of these immediate-vested SARs resulted in
approximately $16,190,000 of compensation expense being recorded in the
quarter ended June 30, 2005, which was calculated in accordance with SFAS
No. 123R as described below under "Stock-Based Compensation." The remaining
SARs which were granted (approximately 918,000) vest over five years, and
approximately 873,000 of these SARs are exercisable based on the
achievement of performance criteria related to the economic growth ("EVA")
of Headwaters during the five-year period. The Committee also approved the
acceleration of vesting of certain outstanding stock options.
All of the SARs and stock options were granted under existing stock option
and stock incentive plans and all have an exercise price of $31.97 per
share, the fair market value of Headwaters' common stock on the date of
grant, and a contractual term of 10 years. All SARs will be settled in
Headwaters' common stock when exercised by grantees. The Committee also
approved the acceleration of vesting of options for the purchase of
approximately 1,059,000 shares for 138 officers, directors and employees
which were not fully vested as of the date of acceleration (prior to
acceleration, there were in total unvested outstanding options to purchase
approximately 1,291,000 shares). Options for which vesting was accelerated
consisted of all options with an exercise price equal to or greater than
$21.29 per share and all but 172,000 of the options accelerated were "in
the money" at the date of acceleration. Of the options accelerated, options
to purchase a total of approximately 523,000 shares of common stock were
options granted to directors and executive officers of Headwaters. Total
compensation expense of approximately $9,320,000 was recognized related to
the acceleration of vesting of options.
In addition to the above actions, the Committee also authorized the grant
of performance unit awards, to be settled in cash, based on performance
criteria tied to the economic value created or preserved by one of
Headwaters' business units after December 2007; however, no grants of
performance units have yet been made.
Stock-Based Compensation - During the quarter ended June 30, 2005,
Headwaters adopted SFAS No. 123R effective as of October 1, 2004, the
beginning of Headwaters' 2005 fiscal year (the "modified retrospective"
method, with restatement limited to interim periods in the year of
adoption, as permitted by SFAS No. 123R). Accordingly, Headwaters has
adjusted the amounts reported in its consolidated statement of income for
the six months ended March 31, 2005 in deriving the statement of income
amounts reported for the nine months ended June 30, 2005. The application
of SFAS No. 123R for the six months ended March 31, 2005 had the effect of
reducing net income for that period by $3,890,000, the same amount as
reported in the pro forma SFAS No. 123 footnote disclosure in Headwaters'
March 31, 2005 Form 10-Q.
SFAS No. 123R revises SFAS No. 123 and supersedes APB 25 and requires
companies to expense the value of employee stock options and other
equity-based awards. For the three- and nine-month periods ended June 30,
11
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
2005, Headwaters recorded a total of $27,198,000 and $32,444,000,
respectively, of pre-tax expense related to stock-based compensation,
substantially all of which related to the adoption of SFAS No. 123R, and
none of which involved the expenditure of cash. The total income tax
benefit recognized in the consolidated income statement for stock-based
compensation was approximately $10,500,000 for the nine months ended June
30, 2005. Due to immateriality, Headwaters did not capitalize any
compensation cost as part of the cost of any asset. Beginning October 1,
2004, Headwaters reclassified certain stock-based compensation expense
recorded in prior periods to conform to the current period presentation so
that stock-based compensation expense is reported within the same operating
expense line items as used for cash compensation expense. The tax benefits
resulting from exercise of stock options are reflected in the consolidated
statements of changes in stockholders' equity and cash flows.
Headwaters recognizes compensation expense equal to the grant-date fair
value of stock-based awards for all awards expected to vest, over the
period during which the related service is rendered by grantees. The fair
value of stock-based awards is determined primarily using the B-S-M model,
which is the same valuation model used previously in valuing stock options
for the pro forma footnote disclosures under the requirements of SFAS No.
123 (see Note 1). Headwaters uses the "graded vesting" or accelerated
method to value awards and to allocate those values over the requisite
service periods, again the same method as used previously in determining
pro forma expense under SFAS No. 123.
The adoption of SFAS No. 123R had the following effect on reported amounts
for the nine months ended June 30, 2005:
Under Previous SFAS No. 123R
(in thousands, except per-share data) Accounting Adjustments As Reported
----------------------------------------------------------------------------------------------
Income before income taxes $141,295 $(32,144) $109,151
Net income $ 98,901 $(22,500) $ 76,401
Basic earnings per share $ 2.68 $ (0.61) $ 2.07
Diluted earnings per share $ 2.32 $ (0.51) $ 1.81
Cash flows from operating activities $129,958 $ (6,309) $123,649
Cash flows from financing activities $(93,255) $ 6,309 $(86,946)
A significant amount of the effect of the SFAS No. 123R adjustments
reported above resulted from the expense associated with the
immediately-vested SARs granted in 2005 and from the acceleration of
vesting of certain stock options which occurred in May 2005, all as
discussed previously. As reflected in the table above and in the
consolidated statements of cash flows, the adoption of SFAS No. 123R
required reclassification of the tax benefits from exercise of stock-based
awards (consisting solely of stock options) as a cash flow from financing
activities instead of a cash flow from operating activities, the required
classification under prior accounting rules. In addition, SFAS No. 123R
mandated certain changes in the calculation of diluted earnings per share,
as described in more detail in Note 8.
Valuation Assumptions for 2005 Awards - The fair values of stock options
and SARs granted in 2005 were estimated using the B-S-M model, adjusted
where necessary to account for specific terms of awards that the B-S-M
model does not have the capability to consider. Headwaters used the
services of an independent valuation firm to validate its fair value
estimates and assumptions and also to determine certain necessary
adjustments to the B-S-M model output. One such instance was in determining
the fair value of the immediate-vested SARs which have a cap on allowed
appreciation. For these SARs, the output determined by the B-S-M model was
reduced by an amount determined by a Quasi-Monte Carlo simulation to
reflect the reduction in fair value associated with the appreciation cap.
12
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
The following assumptions were used in determining the fair values of the
May 2005 awards. The assumptions used in determining the fair values of
awards granted earlier in 2005, which were much smaller in number, are
materially consistent with, but not identical to, these assumptions.
Expected stock volatility 30%
Risk-free interest rates 3.8% - 4.25%
Expected lives (beyond vest dates) - 5-year vesting SARs
and options 3.5 years
Expected lives (beyond vest date) - immediate-vested SARs 5 years
Dividend yield 0%
Reduction in value from B-S-M output for SAR appreciation cap 24%
Reduction in value from B-S-M output for grantee payment for SARs $0.30
Estimated forfeiture rate 5%
Expected stock price volatility was estimated using historical volatilities
of Headwaters' stock, implied volatilities of traded options on Headwaters'
stock, volatility predicted by a "Generalized AutoRegressive Conditional
Heteroskedasticity" model, and an analysis of volatilities used by other
public companies in comparable lines of business to Headwaters. Risk-free
interest rates used were the US Treasury bond yields with terms
corresponding to the expected terms of the awards being valued. In
estimating expected lives, Headwaters considered the contractual and
vesting terms of awards, along with historical experience; however, due to
insufficient historical data from which to reliably estimate expected
lives, Headwaters used estimates based on the "simplified method" set forth
by the SEC in Staff Accounting Bulletin No. 107, where expected life is
estimated by summing the award's vesting term and the contractual term and
dividing that result by two. The reduction in value related to grantee
payment for certain immediate-vesting SARs was estimated by management
based on the terms of the payment requirements and other factors. The
estimated forfeiture rate was based primarily on historical data.
Stock Incentive Plans - As of June 30, 2005, Headwaters had four stock
incentive plans (the "Plans"), three of which have been approved by
stockholders. A total of 7,900,000 shares of common stock have been
reserved for ultimate issuance under the Plans. One of the Plans, the 1995
Stock Option Plan, has since expired and awards can no longer be granted
under that plan. As of June 30, 2005, options, SARs and other awards for
approximately 1,100,000 shares of common stock could be granted under the
other three Plans.
A committee of Headwaters' Board of Directors (the "Committee"), or in its
absence, the full Board of Directors, administers and interprets the Plans.
This Committee is authorized to grant options and other awards both under
the Plans and outside of any Plan to eligible employees, officers,
directors, and consultants of Headwaters. Terms of options and other awards
granted under the Plans, including vesting requirements, are determined by
the Committee and historically have varied significantly. Options and other
awards granted under the Plans vest over periods ranging from zero to ten
years, expire ten years from the date of grant and are not transferable
other than by will or by the laws of descent and distribution. Incentive
stock option grants must meet the requirements of the Internal Revenue
Code.
13
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
Stock Options - The following table summarizes the activity for all of
Headwaters' stock options, including options not granted under the Plans,
for the nine months ended June 30, 2005.
Weighted- Weighted-average
average remaining Aggregate
exercise contractual term intrinsic
(in thousands, except exercise prices) Shares price in years value
------------------------------------------------------------------------------------------------------
Outstanding at beginning of year 3,798 $15.53
Granted 214 32.63
Exercised (796) 8.01
Forfeited or expired (47) 16.66
--------------------------
Outstanding at June 30, 2005 3,169 $18.55 7.3 $50,150
=========================================================
Exercisable at June 30, 2005 2,836 $18.70 7.3 $44,460
=========================================================
The weighted-average grant-date fair value of options granted during the
nine months ended June 30, 2005 was $13.26. The total intrinsic value of
options exercised during the nine months ended June 30, 2005 was
approximately $18,927,000. The total fair value of options vested during
the nine months ended June 30, 2005 was approximately $23,440,000.
SARs - The following table summarizes the activity for all of Headwaters'
SARs for the nine months ended June 30, 2005. As noted previously,
outstanding SARs either were vested on the date of grant (1,995,000), or
will vest over a five-year period (918,000). Substantially all of the SARs
that vest over five years are exercisable based on the achievement of
performance criteria related to the economic growth of Headwaters during
the five-year period. Headwaters currently expects the performance criteria
to be achieved. If this expectation changes in the future, some or all of
the compensation expense recognized up to that time would be reversed.
Weighted- Weighted-average
average remaining Aggregate
exercise contractual term intrinsic
(in thousands, except exercise prices) Shares price in years value
------------------------------------------------------------------------------------------------------
Outstanding at beginning of year 0 $ 0
Granted 2,913 31.97
Exercised 0 0
Forfeited or expired 0 0
--------------------------
Outstanding at June 30, 2005 2,913 $31.97 9.8 $7,020
=========================================================
Exercisable at June 30, 2005 1,995 $31.97 9.8 $4,810
=========================================================
The weighted-average grant-date fair value of SARs granted during the nine
months ended June 30, 2005 was $9.63. The total intrinsic value of SARs
exercised during the nine months ended June 30, 2005 was $0. The total fair
value of SARs vested during the nine months ended June 30, 2005 was
approximately $16,190,000.
Unrecognized Compensation Cost and Other Stock-Based Awards - As of June
30, 2005, there is approximately $12,340,000 of total compensation cost
related to nonvested awards not yet recognized. This unrecognized
compensation cost is expected to be recognized over a weighted-average
period of 1.9 years.
In addition to stock options and SARs, Headwaters issued approximately
61,000 shares of restricted common stock to officers and employees in 2004.
The restricted stock was issued at no cost to the recipients and vests over
five years. Headwaters also recognizes compensation expense in connection
with its Employee Stock Purchase Plan ("ESPP"). Compensation expense
related to restricted stock and the ESPP is not material.
14
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
4. Inventories
Inventories consisted of the following at:
(in thousands) September 30, 2004 June 30, 2005
--------------------------------------------------------------
Raw materials $ 8,517 $12,652
Finished goods 35,295 49,097
-----------------------------------
$43,812 $61,749
===================================
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 June 30, 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 $16,573
Customer relationships 7 1/2 - 15 years 68,331 452 68,331 4,159
Trade names 5 - 20 years 63,657 268 63,657 2,799
Patents and patented
technologies 7 1/2 - 15 years 52,464 2,969 55,337 6,760
Non-competition agreements 2 - 3 1/2 years 10,422 867 10,422 3,920
Other 9 - 17 1/4 years 3,382 1,063 3,780 1,308
-----------------------------------------------------------------
$315,946 $17,143 $319,217 $35,519
=================================================================
Total amortization expense related to intangible assets was approximately
$2,189,000 and $5,527,000 for the three- and nine-month periods ended June
30, 2004, respectively, and approximately $6,151,000 and $18,376,000 for
the three- and nine-month periods ended June 30, 2005, respectively. Total
estimated annual amortization expense is as follows for the fiscal years
presented.
Year ending September 30, (in thousands)
-----------------------------------------------------
2005 $24,525
2006 24,426
2007 22,080
2008 20,532
2009 20,319
2010 19,986
6. Long-term Debt
Long-term debt consisted of the following at:
September 30, June 30,
(in thousands) 2004 2005
----------------------------------------------------------------------
Senior secured debt $790,000 $492,673
Convertible senior subordinated notes 172,500 172,500
Notes payable to a bank 9,787 9,002
Other 227 163
----------------------------
972,514 674,338
Less: current portion (57,873) (19,149)
----------------------------
Total long-term debt $914,641 $655,189
============================
15
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
Senior Secured Credit Agreements - In September 2004 and as amended in
October 2004, Headwaters entered into two credit agreements with a
syndication of lenders under which a total of $790,000,000 was borrowed
under term loan arrangements and which provide for 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
5.5% at June 30, 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 8.7% at June 30, 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 June
2005.
The first lien term loan ($442,673,000 outstanding at June 30, 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 ($50,000,000
outstanding at June 30, 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
year, 1% of prepayments made in the third year, and nothing thereafter.
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. In May 2005, Headwaters repaid
$50,000,000 of the second lien term loan. As a result of the early
repayments of debt, there were accelerations of amortization of the related
debt issue costs totaling approximately $1,276,000 and $6,195,000 for the
three- and nine-month periods ended June 30, 2005, respectively, all of
which was charged to interest expense. Prepayment penalties totaling
$3,000,000 were paid related to the early repayments of $100,000,000 of
second lien term debt, which amount was also charged to interest expense.
16
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
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
nine months ended June 30, 2005, Headwaters borrowed $31,000,000 under
terms of the revolving credit arrangement, all of which was repaid prior to
June 30, 2005. Finally, the credit agreement allows for the issuance of
letters of credit, provided there is capacity under the revolving credit
arrangement. As of June 30, 2005, six letters of credit totaling $5,503,000
were outstanding, with expiration dates ranging from September 2005 to
December 2006.
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 June 30, 2005.
As required by the senior secured credit facility, Headwaters entered into
certain other agreements to limit its variable interest rate exposure. The
first set of agreements effectively established the maximum LIBOR rate for
$300,000,000 ($150,000,000 as of June 30, 2005) of the senior secured debt
at 5.0% through September 8, 2005. The second set of agreements effectively
set the LIBOR rate at 3.71% for $300,000,000 ($150,000,000 as of June 30,
2005) of this debt for the period commencing September 8, 2005 through
September 8, 2007. During the quarter ended June 30, 2005, Headwaters
reduced the amount of senior debt hedged from $300,000,000 to $150,000,000,
as allowed under terms of the amended credit facility, and recognized a
gain of approximately $964,000, which was recorded as a reduction in
interest expense.
Headwaters accounts for the 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
market value of the hedges can fluctuate significantly over a relatively
short period of time. The hedges had a market value at June 30, 2005 of
approximately $800,000, which, net of $310,000 of income taxes, represents
other comprehensive income for the nine months ended June 30, 2005. Total
comprehensive income was approximately $53,270,000 and $76,890,000,
respectively, for the three- and nine-month periods ended June 30, 2005.
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, prior
to June 1, 2011 and at any time after that date, in any calendar quarter
the closing price of Headwaters' common stock exceeds $39 per share for at
least 20 trading days in the 30 consecutive trading days ending on the last
trading day of the preceding calendar quarter; 2) a credit rating, if any,
assigned to the notes is three or more rating subcategories below the
initial rating, if any; 3) the notes trade at less than 98% of the product
17
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
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 diluted earnings per share ("EPS")
calculation on an if-converted basis, in accordance with the 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 June 30, 2005, ranged from
4.5% to 5.75%. 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 is in compliance with all
debt covenants as of June 30, 2005.
Interest Costs - During the three- and nine-month periods ended June 30,
2004, Headwaters incurred total interest costs of approximately $1,355,000
and $12,978,000, respectively, including approximately $167,000 and
$7,798,000, respectively, of non-cash interest expense and approximately
$71,000 and $345,000, respectively, of interest costs that were
capitalized. During the three- and nine-month periods ended June 30, 2005,
Headwaters incurred total interest costs of approximately $11,963,000 and
$46,645,000, respectively, including approximately $2,004,000 and
$8,744,000, respectively, of non-cash interest expense and approximately
$131,000 and $370,000, 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
and the gain realized upon reduction of the interest rate hedges, was
approximately 6.3% at September 30, 2004 and 5.0% at June 30, 2005.
7. Income Taxes
Headwaters' effective income tax rate for the nine months ended June 30,
2005 was approximately 30% (29% for the three months ended June 30, 2005),
the estimated rate for the fiscal year ending September 30, 2005. This
compares to an effective tax rate of approximately 39% for the nine months
ended June 30, 2004 (40% for the three months ended June 30, 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 10), as well as Headwaters' ownership of two
other alternative fuel production facilities that began operating in 2005.
The alternative fuel produced at these three facilities 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 39.5%.
18
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
8. Earnings per Share
Three Months Ended June 30, Nine Months Ended June 30,
(in thousands, except per-share data) 2004 2005 2004 2005
------------------------------------------------------------------------------------------------------------
Numerator:
Numerator for basic earnings per share -
net income $16,060 $55,290 $44,779 $76,401
Interest expense related to convertible
senior subordinated notes, net of taxes 298 1,052 298 3,100
----------------------------------------------------------------
Numerator for diluted earnings per share -
net income plus interest expense
related to convertible notes, net of taxes $16,358 $56,342 $45,077 $79,501
================================================================
Denominator:
Denominator for basic earnings per share-
weighted-average shares outstanding 33,118 41,019 31,287 36,877
Effect of dilutive securities:
Shares issuable upon exercise of
options, warrants and SARs 1,200 1,227 1,214 1,245
Shares issuable upon conversion of
convertible senior subordinated notes 1,917 5,750 639 5,750
----------------------------------------------------------------
Total potential dilutive shares 3,117 6,977 1,853 6,995
----------------------------------------------------------------
Denominator for diluted earnings per
share - weighted-average shares
outstanding after assumed exercises
and conversions 36,235 47,996 33,140 43,872
================================================================
Basic earnings per share $ 0.48 $ 1.35 $ 1.43 $ 2.07
================================================================
Diluted earnings per share $ 0.45 $ 1.17 $ 1.36 $ 1.81
================================================================
In September 2004, the Emerging Issues Task Force ("EITF") reached a
consensus requiring the inclusion of contingently convertible securities in
diluted 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.
Accordingly, the amounts reflected above for 2004 have been changed from
the amounts previously reported to conform to the requirements of EITF
04-08.
Also, SFAS No. 123R changed the method of applying the treasury stock
method in determining the potential dilutiveness of stock-based awards for
diluted earnings per share calculations. In accordance with the
requirements of SFAS No. 123R, the 2005 EPS calculations above considered
all of the following as assumed proceeds in using the treasury stock method
to calculate whether and to what extent options and SARs were dilutive: i)
the amounts employees must pay upon exercise; plus ii) the average amount
of compensation cost during the period, if any, attributed to future
service, but not yet recognized; plus iii) the amount of tax benefits, if
any, that would be credited to additional paid-in capital if the award were
to be exercised.
Anti-dilutive securities not considered in the diluted earnings per share
calculations consisted of out-of-the money options of approximately 0 and
10,000 shares for the three- and nine-month periods ended June 30, 2004,
respectively; and approximately 240,000 and 180,000 shares for the three-
and nine-month periods ended June 30, 2005, respectively. In addition,
approximately 1,150,000 SARs were not included in the earnings per share
calculations for 2005 because they were anti-dilutive.
19
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
9. Eldorado Acquisition
Eldorado - On June 2, 2004, Headwaters acquired 100% of the ownership
interests of Eldorado and paid off all of Eldorado's outstanding debt. As
described in more detail in Note 3 to the consolidated financial statements
included in the Form 10-K, the Eldorado acquisition was accounted for using
the purchase method of accounting as required by SFAS No. 141, "Business
Combinations." Assets acquired and liabilities assumed were initially
recorded at their estimated fair values as of June 2, 2004. An adjustment
of the purchase price and the allocation thereof, which are not materially
different from the preliminary purchase price and allocation as reflected
in the Form 10-K, were completed during the quarter ended June 30, 2005.
The only adjustment to the purchase price consisted of a $2,725,000
increase in the purchase price to reflect additional consideration paid to
the former owners, which consideration was dependent upon final
determination of the working capital in existence at the date of
acquisition. The adjustments to the allocation of the purchase price
resulted primarily from the final determination of current and deferred
income taxes.
The following table sets forth the final determination of the total
consideration paid to acquire Eldorado.
(in thousands)
------------------------------------------------------------------------------------------
Cash paid to Eldorado owners $139,707
Cash paid to retire Eldorado debt and related accrued interest 69,650
Costs directly related to acquisition 3,800
--------------
$213,157
==============
The following table sets forth the preliminary allocation of the
consideration to the tangible and intangible assets acquired and
liabilities assumed, both as presented in the Form 10-K, as well as the
final allocation.
Preliminary Final
(in thousands) Allocation Allocation
------------------------------------------------------------------------------------------
Cash $ 662 $ 662
Trade receivables, net 16,650 16,650
Inventories 16,610 16,610
Deferred income taxes -- 5,438
Other assets 2,553 2,347
Property, plant and equipment 23,367 23,333
Intangible assets acquired:
Non-competition agreements (3 - 3 1/2 years) 6,252 6,252
Other (5 - 10 years) 2,782 2,782
Goodwill 160,263 158,681
Accounts payable and accrued liabilities (18,707) (19,598)
------------------------------
Net assets acquired $210,432 $213,157
==============================
10. Commitments and Contingencies
Commitments and contingencies as of June 30, 2005 not disclosed elsewhere
are as follows:
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 $175,000 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 June 30, 2005,
approximately $3,140,000 is accrued for claims incurred on or before June
30, 2005 that have not been paid or reported.
Property, Plant and Equipment - As of June 30, 2005, Headwaters was
committed to spend approximately $7,770,000 on capital projects that were
in various stages of completion.
20
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
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
liabilities and other long-term liabilities in the consolidated balance
sheet (totaling $13,436,000 at June 30, 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 are
recognized in the June and September quarters (including the quarter ended
June 30, 2005). Even though Headwaters did not fully recognize its portion
of the benefits of the tax credits generated during the six months ended
March 31, 2005, Headwaters' pro-rata share of costs incurred to generate
those tax credits was recognized as other expense through March 31, 2005.
Headwaters has the ability, under certain conditions, to limit its
liability under the fixed payment obligations currently totaling
$13,436,000; 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 $3,600,000 at June 30, 2005), through September 2007, of
which approximately (euro)620,000 (approximately $750,000) has been paid
through June 30, 2005. 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 nine months ended June 30, 2005, Headwaters expensed
$3,050,000 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 June 30, 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.
21
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
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
$2,288,000 and $3,968,000 for the nine months ended June 30, 2004 and 2005,
respectively (the amount for 2005 is exclusive of a reimbursement of legal
costs for approximately $6,509,000 received in connection with the AJG
litigation settlement discussed below). It is not possible to estimate what
litigation-related costs will be in future periods.
Boynton. In October 1998, Headwaters entered into a technology purchase
agreement with James G. Davidson and Adtech, Inc. The transaction
transferred certain patent and royalty rights to Headwaters related to a
synthetic fuel technology invented by Davidson. (This technology is
distinct from the technology developed by Headwaters.) This action is
factually related to an earlier action brought by certain purported
officers and directors of Adtech, Inc. That action was dismissed by the
United States District Court for the Western District of Tennessee and the
District Court's order of dismissal was affirmed on appeal. In the current
action, the allegations arise from the same facts, but the claims are
asserted by certain purported stockholders of Adtech. In June 2002,
Headwaters received a summons and complaint from the United States District
Court for the Western District of Tennessee alleging, among other things,
fraud, conspiracy, constructive trust, conversion, patent infringement and
interference with contract arising out of the 1998 technology purchase
agreement entered into between Davidson and Adtech on the one hand, and
Headwaters on the other. The plaintiffs seek declaratory relief and
compensatory damages in the approximate amount of between $15,000,000 and
$25,000,000 and punitive damages. The District Court has dismissed all
claims against Headwaters except conspiracy and constructive trust. The
Court has scheduled trial for 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.
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 which provided 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 recognized the $50,000,000 contract litigation settlement gain,
net of payments due to a third party, as a reduction in operating costs and
expenses in the quarter ended June 30, 2005. The $70,000,000, net of
payments due to a third party, is being recognized as revenue over calendar
years 2005 through 2007; however, because the settlement agreement was not
reached until May, six months of revenue covering the period January 1,
2005 through June 30, 2005 was recognized in the quarter ended June 30,
2005. The ongoing quarterly payments based upon tax credits are being
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).
22
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
In connection with the settlement of the AJG litigation, Headwaters also
recognized as revenue approximately $8,185,000 of revenue from a licensee
with an indirect interest in that litigation, all of which related to
periods prior to January 1, 2005. Ongoing revenue from this licensee is
also being recognized in accordance with Headwaters' revenue recognition
policy for license fee revenue.
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 ("HCM") with respect to several types of exterior
finish systems manufactured and sold by its subsidiaries for application by
contractors on residential and commercial buildings. Typically, litigation
and these claims are controlled by such subsidiaries' insurance carriers.
The plaintiffs or claimants in these matters have alleged that the
structures have suffered damage from latent or progressive water
penetration due to some alleged failure of the building product or wall
system. The most prevalent type of claim involves alleged defects
associated with components of an Exterior 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. None of the cases has gone to trial. While, to date, none
of these proceedings have required that HCM incur substantial costs, there
is no guarantee of insurance coverage or continuing coverage. These and
future proceedings may result in substantial costs to HCM, including
attorneys' fees, managerial time and other personnel resources and costs.
Adverse resolution of these proceedings could have a materially negative
effect on HCM's business, financial condition, and results of operation,
and its ability to meet its financial obligations. Although HCM carries
general and product liability insurance, HCM cannot assure that such
insurance coverage will remain available, that HCM's insurance carrier will
remain viable, or that the insured amounts will cover all future claims in
excess of HCM's uninsured retention. Future rate increases may also make
such insurance uneconomical for HCM to maintain. In addition, the insurance
policies maintained by HCM exclude claims for damages resulting from
exterior insulating finish systems, or EIFS, that have manifested after
March 2003. Because resolution of the litigation and claims is uncertain,
legal counsel cannot express an opinion as to the ultimate amount, if any,
of HCM's liability.
Other. Headwaters and its subsidiaries are also involved in other legal
proceedings that have arisen in the normal course of business.
Section 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
23
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)
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 are 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 May
2005) is $44.18 per barrel, and an estimate of the phase-out range
(computed by increasing the 2004 inflation adjustment factor by 2%) 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
pricing data used for the reference price) on August 1, 2005 was $61.57 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 audits is uncertain. 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.
24
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 nine-month period ended June 30, 2004, and references to
2005 refer to Headwaters' fiscal quarter and/or nine-month period ended June 30,
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 existing 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. In March 2005,
Headwaters announced a non-binding memorandum of understanding to participate in
a joint venture to build and operate an ethanol plant. Headwaters is also
investigating other alternative energy projects.
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
transportation 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. This market 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 generated from operations, from an underwritten
public offering of common stock in March 2005 and from proceeds from settlement
of litigation in May 2005. High leverage makes 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 June 30, 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
25
results, but the 2004 results include only VFL for three months and Eldorado
Stone for one month. Due to the significance of the 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 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 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. The acquisition of Tapco, a leading
designer, manufacturer and marketer of building products used in exterior
residential home improvement and construction, added significantly to this
segment. 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.
Critical Accounting Policies and Estimates
Headwaters has described its critical accounting policies and estimates
in "Management's Discussion and Analysis" in its Form 10-K for the year ended
September 30, 2004. The following describes changes to certain policies
effective as of the quarter ended June 30, 2005.
Stock-Based Compensation. As described in more detail in Note 3 to the
consolidated financial statements, Headwaters adopted the fair value method of
accounting for stock-based compensation required by SFAS No. 123R, effective as
of October 1, 2004, the beginning of Headwaters' 2005 fiscal year. SFAS No. 123R
revises SFAS No. 123 and supersedes APB 25 and requires companies to expense the
value of employee stock options and other equity-based awards. For the three-
and nine-month periods ended June 30, 2005, Headwaters recorded a total of $27.2
million and $32.4 million, respectively, of pre-tax expense related to
stock-based compensation, substantially all of which related to the adoption of
SFAS No. 123R, and none of which involved the expenditure of cash. Due to
immateriality, Headwaters did not capitalize any compensation cost as part of
the cost of any asset. Beginning October 1, 2004, Headwaters reclassified
certain stock-based compensation expense recorded in prior periods to conform to
the current period presentation so that stock-based compensation expense is
reported within the same operating expense line items as used for cash
compensation expense. The tax benefits resulting from exercise of stock options
are reflected in the consolidated statements of changes in stockholders' equity
and cash flows.
Headwaters recognizes compensation expense equal to the grant-date fair
value of stock-based awards for all awards expected to vest, over the period
during which the related service is rendered by grantees. The fair value of
stock-based awards is determined primarily using the Black-Scholes-Merton
("B-S-M") model, which is the same valuation model used previously in valuing
stock options for the pro forma footnote disclosures under the requirements of
SFAS No. 123 (see Note 1 to the consolidated financial statements). Headwaters
uses the "graded vesting" or accelerated method to value awards and to allocate
those values over the requisite service periods, again the same method as used
previously in determining pro forma expense under SFAS No. 123.
The B-S-M model requires assumptions as to expected stock volatility,
expected lives, rate of forfeitures and other factors. Judgment is involved in
determining appropriate assumptions to use and different assumptions can yield
materially different results. Headwaters uses various methods, along with
historical data and other information, to make reasonable assumptions regarding
26
inputs to the B-S-M model. In addition, in 2005, Headwaters used the services of
an independent valuation firm to validate its fair value estimates and
assumptions and also to determine certain necessary adjustments to the B-S-M
model output. One such instance was in determining the fair value of
immediate-vested SARs which have a cap on allowed appreciation. For these SARs,
the output determined by the B-S-M model was reduced by an amount determined by
a Quasi-Monte Carlo simulation to reflect the reduction in fair value associated
with the appreciation cap.
Substantially all of the SARs that vest over five years are exercisable
based on the achievement of performance criteria related to the economic growth
of Headwaters during the five-year period. Headwaters currently expects the
performance criteria to be achieved. If this expectation changes in the future,
some or all of the compensation expense recognized up to that time would be
reversed.
Headwaters implemented SFAS No. 123R effective as of October 1, 2004,
using the modified retrospective method with restatement limited to interim
periods in the year of adoption, as permitted by SFAS No. 123R. Accordingly,
Headwaters has adjusted the amounts reported in its consolidated statement of
income for the six months ended March 31, 2005 in deriving the statement of
income amounts reported for the nine months ended June 30, 2005. The application
of SFAS No. 123R for the six months ended March 31, 2005 had the effect of
reducing net income for that period by $3.9 million, the same amount as reported
in the pro forma SFAS No. 123 footnote disclosure in Headwaters' March 31, 2005
Form 10-Q.
The adoption of SFAS No. 123R had the following effect on reported amounts
for the nine months ended June 30, 2005:
Under Previous SFAS No. 123R
(in millions, except per-share data) Accounting Adjustments As Reported
--------------------------------------------------------------------------------------------
Income before income taxes $141.3 $(32.1) $109.2
Net income $ 98.9 $(22.5) $ 76.4
Basic earnings per share $ 2.68 $ (0.61) $ 2.07
Diluted earnings per share $ 2.32 $ (0.51) $ 1.81
Cash flows from operating activities $130.0 $ (6.3) $123.7
Cash flows from financing activities $(93.3) $ 6.3 $(87.0)
A significant amount of the effect of the SFAS No. 123R adjustments
reported above resulted from the expense associated with the immediately-vested
SARs granted in 2005 and from the acceleration of vesting of certain stock
options which occurred in May 2005, all as discussed in Note 3. As a result of
the adoption of SFAS No. 123R, Headwaters' will recognize additional non-cash
compensation expense in future periods. As of June 30, 2005, there is
approximately $12.3 million of total compensation cost related to nonvested
awards not yet recognized. This unrecognized compensation cost is expected to be
recognized over a weighted-average period of 1.9 years.
As reflected in the table above and in the consolidated statements of
cash flows, the adoption of SFAS No. 123R required reclassification of the tax
benefits from exercise of stock-based awards (consisting solely of stock
options) as a cash flow from financing activities instead of a cash flow from
operating activities, the required classification under prior accounting rules.
In addition, SFAS No. 123R mandated certain changes in the calculation of
diluted earnings per share, as described in more detail in Note 8 to the
consolidated financial statements.
The adoption of SFAS No. 123R, combined with the settlement of the AJG
litigation described in Note 10 to the consolidated financial statements, was a
contributing factor in Headwaters' decision to grant employee incentive awards
in May 2005, in particular to grant more SARs, including many that vested
immediately, or are exercisable only to the extent performance criteria are met,
and to grant fewer options, and to accelerate the vesting of stock options.
Three Months Ended June 30, 2005 Compared to Three Months Ended June 30, 2004
The information set forth below compares Headwaters' operating results
for the three months ended June 30, 2005 ("2005") with operating results for the
three months ended June 30, 2004 ("2004").
Revenue. Total revenue for 2005 increased by $174.4 million or 130% to
$308.7 million as compared to $134.3 million for 2004. The major components of
revenue are discussed in the sections below.
Construction Materials Segment. Sales of construction materials during
2005 were $147.6 million with a corresponding direct cost of $97.7 million
(which cost included $1.1 million of stock-based compensation related to the
adoption of SFAS No. 123R). Sales of construction materials during 2004 were
$26.8 million with a corresponding direct cost of $20.0 million (which included
no stock-based compensation). The increase in sales of construction materials
27
during 2005 was due primarily to the acquisitions of Eldorado, SCP and Tapco in
fiscal 2004. 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 Segment. CCP revenues for 2005 were $69.5 million with a
corresponding direct cost of $51.4 million. CCP revenues for 2004 were $58.7
million with a corresponding direct cost of $43.8 million. The increase in CCP
revenues and gross margin during 2005 was due primarily to growth in demand for
CCPs, partially due to shortages in portland cement for which CCPs are a
substitute, which can result in an increased percentage of CCPs being used in
concrete. The cement shortages also resulted in increased prices in several
markets.
Alternative Energy Segment. Headwaters' alternative energy segment
revenue consists primarily of chemical reagent sales, license fee revenue
related to its solid alternative fuel technologies, and to a lesser extent,
sales of synthetic fuel from two solid alternative fuel production facilities
that it owns that began operating in 2005. HTI's revenues are also included in
alternative energy revenue, but 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 $45.0 million with a corresponding direct cost of $32.1
million. Chemical reagent sales during 2004 were $35.3 million with a
corresponding direct cost of $23.8 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 $5.8 million) and by
customers with which Headwaters does not have a license agreement (resulting in
increased sales of $3.9 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
(see Note 10 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 4% 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 $41.7 million, an increase of $28.3 million or
211% from $13.4 million of license fee revenue recognized during 2004. The
primary reasons for the increase in license fee revenue in 2005 compared to 2004
related to the settlement of the AJG litigation described in Note 10 to the
consolidated financial statements ($24.3 million of the increase). In addition,
license fee revenue from licensees not associated with the litigation also
increased from 2004 to 2005 ($4.0 million of the increase).
In May 2005, Headwaters and AJG entered into a settlement agreement
which provided for payments to Headwaters in the amount of $50.0 million at the
time of settlement (discussed below in the caption "Contract Litigation
Settlement"), $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.
The $70.0 million, net of payments due to a third party, is being recognized as
revenue over calendar years 2005 through 2007; however, because the settlement
agreement was not reached until May, six months of revenue covering the period
January 1, 2005 through June 30, 2005 was recognized in the quarter ended June
30, 2005. The ongoing quarterly payments are being recognized as revenue in
accordance with Headwaters' revenue recognition policy for license fee revenue.
In total, Headwaters recognized approximately $15.3 million of license fees from
AJG in 2005 ($15.0 million of which directly related to the settlement of
litigation), compared to $0.4 million of license fee revenue from AJG in 2004.
In connection with the settlement of the AJG litigation, Headwaters
also recognized as revenue approximately $8.2 million of revenue from a licensee
with an indirect interest in that litigation, all of which related to periods
prior to January 1, 2005. Ongoing revenue from this licensee is also being
recognized in accordance with Headwaters' revenue recognition policy for license
fee revenue and was approximately $1.1 million in 2005.
Pursuant to the contractual terms of an agreement with a licensee, the
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 $3.7 million to $6.1 million in
2005 from $2.4 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.
28
Research and Development. Research and development expenses increased
by $3.1 million to $4.8 million in 2005 from $1.7 million in 2004. The increase
was primarily attributable to increased HTI research and development activities
and the recognition of approximately $1.6 million of stock-based compensation
expense in 2005 related to the adoption of SFAS No. 123R. No such expense was
recorded in 2004. 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.
Contract Litigation Settlement. As described in Note 10 to the
consolidated financial statements, in May 2005, Headwaters settled its
litigation with AJG. In connection with the litigation settlement, a payment of
$50.0 million was received in May. This amount, net of payments due to a third
party and less the amount recognized as a reimbursement of legal fees
(approximately $6.5 million), was reflected as a reduction in operating costs
and expenses because it represents a non-recurring litigation settlement that is
not reflective of Headwaters' revenue components described above, but is
directly related to Headwaters' operating activities.
Selling, General and Administrative Expenses. These expenses increased
$38.8 million to $53.6 million for 2005 from $14.8 million for 2004. The
increase in 2005 was due primarily to an increase in stock-based compensation
expense of approximately $24.2 million, the fiscal 2004 acquisitions ($15.9
million) and incentive cash bonuses paid in connection with the settlement of
the AJG litigation ($5.8 million), partially reduced by the reimbursement of
legal fees incurred in the AJG litigation ($6.5 million). A substantial portion
of the expense related to stock-based compensation related to expense associated
with the grant of immediate-vested SARs and the acceleration of vesting of
certain stock options ($22.7 million), as explained in more detail in Note 3 to
the consolidated financial statements. These two events are not likely to recur
in the foreseeable future. There was no stock-based compensation included in
selling, general, and administrative expenses in 2004. As a result of the fiscal
2004 acquisitions and the stock-based compensation recorded in 2005, fiscal 2005
selling, general and administrative expenses are expected to be substantially
higher than for fiscal 2004.
Other Income and Expense. During 2005, Headwaters reported net other
expense of $17.7 million compared to net other expense of $1.0 million during
2004. The change of $16.7 million was attributable to an increase in net
interest expense of $10.1 million in 2005 and a net increase in other expenses
of approximately $6.6 million in 2005.
Net interest expense increased from $1.3 million in 2004 to $11.4
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. Also, Headwaters incurred approximately $2.8 million of interest
expense related to the early repayment of $50.0 million of second lien senior
debt in May 2005, consisting of accelerated amortization of debt issue costs of
$1.3 million plus $1.5 million of prepayment penalties. In connection with the
reduction of the amount of senior debt hedged from $300.0 million to $150.0
million, as allowed under terms of the amended credit facility, Headwaters
recognized a gain of approximately $1.0 million, which was recorded as a
reduction in interest expense. Due to the substantially higher amounts of
outstanding debt at June 30, 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 $6.6 million consisted primarily of
an increase in other expenses (totaling approximately $6.3 million) representing
Headwaters' costs related to its investment in the coal-based solid alternative
fuel production facility described in Note 10 to the consolidated financial
statements, including amortization of the related $15.5 million investment.
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 are recognized in the June and
September quarters. Even though Headwaters did not fully recognize its portion
of the benefits of the tax credits generated during the six months ended March
31, 2005, Headwaters' pro-rata share of costs incurred to generate those tax
credits was recognized as other expense through March 31, 2005.
Income Tax Provision. Headwaters' effective income tax rate for 2005
was approximately 29%. This compares to an effective tax rate of approximately
40% for 2004 and 31.5% for the six months ended March 31, 2005. Headwaters'
effective income tax rate for the entire fiscal 2005 year is currently estimated
to be 30%. The primary reason for the decreases 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 10 to the consolidated financial statements), as well as
Headwaters' ownership of two other significantly smaller alternative fuel
production facilities that began operating in 2005. The alternative fuel
produced at these three facilities 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 39.5%.
29
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
the future, necessitating an adjustment in the quarter ending September 30, 2005
to reflect the impact of the rate change on results for prior fiscal 2005
quarters.
Nine Months Ended June 30, 2005 Compared to Nine Months Ended June 30, 2004
The information set forth below compares Headwaters' operating results
for the nine months ended June 30, 2005 ("2005") with operating results for the
nine months ended June 30, 2004 ("2004").
Revenue. Total revenue for 2005 increased by $394.2 million or 111% to
$749.5 million as compared to $355.3 million for 2004. The major components of
revenue are discussed in the sections below.
Construction Materials Segment. Sales of construction materials during
2005 were $370.5 million with a corresponding direct cost of $248.1 million
(which cost included $1.3 million of stock-based compensation related to the
adoption of SFAS No. 123R). Sales of construction materials during 2004 were
$50.0 million with a corresponding direct cost of $39.4 million (which included
no stock-based compensation). The increase in sales of construction materials
during 2005 was due primarily to the acquisitions of Eldorado, SCP and Tapco in
fiscal 2004. 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 Segment. CCP revenues for 2005 were $171.0 million with a
corresponding direct cost of $130.9 million. CCP revenues for 2004 were $143.4
million with a corresponding direct cost of $106.9 million. The increase in CCP
revenues during 2005 was due primarily to the acquisition of VFL in April 2004
and growth in demand for CCPs, partially due to shortages in portland cement for
which CCPs are a substitute, which can result in an increased percentage of CCPs
being used in concrete. The cement shortages also resulted in increased prices
in several markets. The gross margin percentage decreased from 2004 to 2005 by
approximately 2% due primarily to VFL, which typically has lower gross margins
than the legacy CCP business. VFL's impact on gross margin in 2005 was more
significant than in 2004 because there are only three months of VFL activity in
2004 and nine months in 2005.
Sales of Chemical Reagents. Chemical reagent sales (included in
alternative energy revenue in the accompanying consolidated statements of
income) during 2005 were $121.7 million with a corresponding direct cost of
$85.1 million. Chemical reagent sales during 2004 were $98.4 million with a
corresponding direct cost of $66.8 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 $12.1 million) and by
customers with which Headwaters does not have a license agreement (resulting in
increased sales of $11.2 million). Of the increased sales to customers, $5.5
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 30% was 2% 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 $80.9 million, an increase of $21.6 million or
36% from $59.3 million of license fee revenue recognized during 2004. The
primary reasons for the increase in license fee revenue in 2005 compared to 2004
related to the settlement of the AJG litigation described in Note 10 to the
consolidated financial statements ($24.3 million in total). Headwaters
recognized approximately $16.0 million of license fees from AJG in 2005 ($15.0
million of which directly related to the settlement of litigation with AJG),
compared to $1.0 million of license fee revenue from AJG in 2004. In connection
with the settlement of the AJG litigation, Headwaters also recognized as revenue
approximately $9.3 million of revenue from a licensee with an indirect interest
in that litigation. In addition, total license fee revenue from other licensees
increased $9.3 million from 2004 to 2005 as a result of increased production of
alternative fuel by these licensees.
Offsetting these increases, was a $12.0 million decrease in revenue
recognized from a licensee for which Headwaters recognized $24.9 million of net
revenue in 2004, representing funds previously deposited in an escrow account
pending resolution of certain contingencies, all relating to alternative fuel
sold prior to December 31, 2003. Headwaters recognized a total of approximately
$32.9 million of revenue in 2004 from this licensee and $20.9 million of revenue
in 2005.
Amortization. These costs increased by $12.6 million to $18.3 million
in 2005 from $5.7 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 $4.8 million to $10.1 million in 2005 from $5.3 million in 2004. The increase
was primarily attributable to increased HTI research and development activities
and approximately $1.8 million of stock-based compensation expense in 2005
related to the adoption of SFAS No. 123R. No such expense was recorded in 2004.
30
Contract Litigation Settlement. As described in Note 10 to the
consolidated financial statements, in May 2005, Headwaters settled its
litigation with AJG. In connection with the litigation settlement, a payment of
$50.0 million was received in May, which, net of payments due to a third party
and less the amount recognized as a reimbursement of legal fees (approximately
$6.5 million), was reflected as a reduction in operating costs and expenses.
Selling, General and Administrative Expenses. These expenses increased
$79.7 million to $122.6 million for 2005 from $42.9 million for 2004. The
increase in 2005 was due primarily to an increase in stock-based compensation
expense of approximately $28.8 million and the fiscal 2004 acquisitions ($48.4
million). A substantial portion of the expense related to stock-based
compensation related to expense associated with the grant of immediate-vested
SARs and the acceleration of vesting of certain stock options ($22.7 million),
as explained in more detail in Note 3 to the consolidated financial statements.
These two events are not likely to recur in the foreseeable future. There was no
stock-based compensation included in selling, general, and administrative
expenses in 2004.
Other Income and Expense. During 2005, Headwaters reported net other
expense of $57.5 million compared to net other expense of $14.4 million during
2004. The change of $43.1 million was attributable to an increase in net
interest expense of $33.7 million in 2005 and a net increase in other expenses
of approximately $9.4 million in 2005.
Net interest expense increased from $12.3 million in 2004 to $46.0
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. Also, Headwaters incurred approximately $9.2 million of interest
expense related to the early repayment of senior debt in 2005, consisting of
accelerated amortization of debt issue costs of $6.2 million plus $3.0 million
of prepayment penalties. In connection with the reduction of the amount of
senior debt hedged from $300.0 million to $150.0 million, Headwaters recognized
a gain of approximately $1.0 million, which was recorded as a reduction in
interest expense.
The net change in other expenses of $9.4 million consisted primarily of
an increase in other expenses (totaling approximately $12.0 million)
representing Headwaters' costs related to its investment in the coal-based solid
alternative fuel production facility, partially reduced by $2.2 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
benefit of all of the tax credits earned in the December and March quarters in
its results of operations for those quarters. Tax credits earned but not
recognized in the December and March quarters are recognized in the June and
September quarters. Even though Headwaters did not fully recognize its portion
of the benefits of the tax credits generated during the six months ended March
31, 2005, Headwaters' pro-rata share of costs incurred to generate those tax
credits was recognized as other expense through March 31, 2005.
Income Tax Provision. Headwaters' effective income tax rate for 2005
was approximately 30%. This compares to an effective tax rate of approximately
39% 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 10 to the consolidated financial statements), as
well as Headwaters' ownership of two other alternative fuel production
facilities that began operating in 2005. The alternative fuel produced at these
three facilities 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
39.5%. It is possible that Headwaters' estimate of its effective tax rate for
fiscal 2005 will change in the future, necessitating an adjustment in the
quarter ending September 30, 2005 to reflect the impact of the rate change on
results for prior fiscal 2005 periods.
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 $123.6 million compared to $56.2 million during 2004.
The change was attributable to increases in 2005 in net income ($31.6 million),
depreciation and amortization ($29.7 million) and non-cash stock-based
compensation ($32.4 million), reduced by deferred taxes ($16.1 million) and
other items ($10.2 million).
31
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 $198.8 million. Headwaters also used these
proceeds to repay debt. During 2005, $299.9 million of debt was repaid, net of
proceeds from issuance of debt, compared to a net $62.3 million increase in debt
in 2004. In 2004, the primary investing activity consisted of the acquisitions
of VFL and Eldorado for total net cash payments of $213.3 million. In 2005 the
primary investing activity consisted of the purchase of property, plant and
equipment for total cash payments of $43.0 million. 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
($9.9 million) to 2005 ($43.0 million). These capital expenditures primarily
relate to the construction materials segment 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 June 30, 2005, Headwaters was committed to spend approximately
$7.8 million on capital projects that were in various stages of completion.
Headwaters intends to continue to expand its business through growth of
existing operations, commercialization of technologies currently being
developed, and strategic acquisitions of products or entities that expand
Headwaters' current operating platform. Acquisitions are an important part of
Headwaters' business strategy and to that end, Headwaters routinely reviews
potential complementary acquisitions, including those in the areas of 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 10 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 $13.4 million at June 30, 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 $13.4 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 $3.6 million at June 30, 2005),
through September 2007, of which approximately (euro)0.6 million (approximately
$0.7 million) has been paid through June 30, 2005. 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.
32
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
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 5.5% at June 30, 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 8.7% at June 30, 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 June 2005.
The first lien term loan ($442.7 million outstanding at June 30, 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 ($50.0 million outstanding at June 30,
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, 1% of prepayments made in the third year,
and nothing thereafter. 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. In May 2005, Headwaters repaid $50.0 million of
the second lien term loan. As a result of the early repayments of debt, there
were accelerations of amortization of the related debt issue costs totaling
approximately $6.2 million for 2005, all of which was charged to interest
expense. Prepayment penalties totaling $3.0 million were paid related to the
early repayments of $100.0 million of second lien term debt, which amount was
also charged to interest expense.
As required by the senior secured credit facility, Headwaters entered
into certain other agreements to limit its variable interest rate exposure. The
first set of agreements effectively established the maximum LIBOR rate for
$300.0 million ($150.0 million as of June 30, 2005) of the senior secured debt
at 5.0% through September 8, 2005. The second set of agreements effectively set
the LIBOR rate at 3.71% for $300.0 million ($150.0 million as of June 30, 2005)
of this debt for the period commencing September 8, 2005 through September 8,
2007. During the quarter ended June 30, 2005, Headwaters reduced the amount of
33
senior debt hedged from $300.0 million to $150.0 million, as allowed under terms
of the amended credit facility, and recognized a gain of approximately $1.0
million, which was recorded as a reduction in interest expense.
Headwaters accounts for the 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
market value of the hedges can fluctuate significantly over a relatively short
period of time. The hedges had a market value at June 30, 2005 of approximately
$0.8 million, which, net of $0.3 million of income taxes, represents other
comprehensive income for the nine months ended June 30, 2005. Total
comprehensive income was approximately $76.9 million for 2005.
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,
prior to June 1, 2011 and at any time after that date, in any calendar quarter
the closing price of Headwaters' common stock exceeds $39 per share for at least
20 trading days in the 30 consecutive trading days ending on the last trading
day of the preceding calendar quarter; 2) a credit rating, if any, assigned to
the notes is three or more rating subcategories below the initial rating, if
any; 3) the notes trade at less than 98% of the product of the common stock
trading price and the number of shares of common stock issuable upon conversion
of $1,000 principal amount of the notes, except this provision is not available
if the closing common stock price is between 100% and 130% of the current
conversion price of the notes; 4) Headwaters calls the notes for redemption; and
5) certain corporate transactions occur, including distribution of rights or
warrants to all common stockholders entitling them to purchase common stock at
less than the current market price or distribution of common stock, cash or
other assets, debt securities or certain rights to purchase securities where the
distribution has a per share value exceeding 5% of the closing common stock
price on the day immediately preceding the declaration date for such
distribution. In addition, the notes are convertible if Headwaters enters into
an agreement pursuant to which Headwaters' common stock would be converted into
cash, securities or other property.
Headwaters may call the notes for redemption at any time on or after
June 1, 2007 and prior to June 4, 2011 if the closing common stock price exceeds
130% of the conversion price for 20 trading days in any consecutive 30-day
trading period (in which case Headwaters must provide a "make whole" payment of
the present value of all remaining interest payments on the redeemed notes
through June 1, 2011). In addition, the holder of the notes has the right to
require Headwaters to repurchase all or a portion of the notes on June 1, 2011
or if a fundamental change in common stock has occurred, including termination
of trading. Subsequent to June 1, 2011, the notes require an additional interest
payment equal to 0.40% of the average trading price of the notes if the trading
price equals 120% or more of the principal amount of the notes.
Headwaters has included the additional shares of common stock
contingently issuable under the notes in its diluted EPS calculation on an
if-converted basis, in accordance with the 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 June 30, 2005, ranged from 4.5% to
5.75%. 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 is in compliance with all debt covenants as of June 30, 2005.
Options and Employee Stock Purchases - In 2005, cash proceeds from the
exercise of options and employee stock purchases totaled $7.8 million, compared
to $7.4 million of proceeds 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 2004 and in cash flows from financing activities in 2005 (in
accordance with the requirements of SFAS No. 123R) in the consolidated
statements of cash flows, were $3.3 million in 2004 and $6.3 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.
34
Working Capital. In 2005, Headwaters' working capital increased by
$81.3 million, to $125.7 million as of June 30, 2005. Headwaters expects
operations to produce positive cash flows in future periods. Additionally,
Headwaters will receive more than $70.0 million in January 2006 as part of the
settlement of the AJG litigation (see Note 10 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 next 12 months.
Long-term Debt. Due to the September 2004 issuance of senior debt and
the covenants associated with that debt, as described below, Headwaters
currently has limited ability to obtain significant additional amounts of
long-term debt. However, as provided for in the senior debt agreements,
Headwaters has available $60.0 million under a revolving credit arrangement.
Borrowings under the revolving credit arrangement are generally subject to the
terms of the first lien loan agreement and bear interest at either LIBOR plus
1.75% to 2.5% (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 2005, Headwaters borrowed $31.0 million under terms
of the revolving credit arrangement, all of which was repaid prior to June 30,
2005. Finally, the credit agreement allows for the issuance of letters of
credit, provided there is capacity under the revolving credit arrangement. As of
June 30, 2005, six letters of credit totaling $5.5 million were outstanding,
with expiration dates ranging from September 2005 to December 2006.
Headwaters may, in the future, make optional prepayments of the senior
debt depending on actual cash flows, Headwaters' current and expected cash
requirements and other applicable factors deemed significant by management.
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 June 30, 2005.
As described above, Headwaters has approximately $501.7 million of
variable-rate long-term debt outstanding as of June 30, 2005, consisting of
$492.7 million of senior debt and $9.0 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 $5.0
million during the 12 months ending June 30, 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 tax deductions resulting from disqualifying dispositions of
incentive stock options and from the exercise of non-qualified stock options,
which reduction totaled $6.3 million in 2005. Headwaters' cash requirements for
income taxes are expected to generally approximate the income tax provision.
There is some lag in paying estimated taxes during a fiscal year due to the
seasonality of operations and because estimated income tax payments are
typically based on annualizing the fiscal year's income based on year-to-date
results; however, there is also some lag in realizing the cash benefits from the
utilization of tax credits due to the interaction of Headwaters' September 30
fiscal year and the different fiscal years of the entities through which
Headwaters receives the tax credits.
Headwaters' effective income tax rate for 2005 was approximately 30%.
This compares to an effective tax rate of approximately 39% 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 10 to the consolidated financial statements), as well as Headwaters'
ownership of two other alternative fuel production facilities that began
operating in 2005. The alternative fuel produced at these three facilities
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 39.5%.
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.
35
Legal or Contractual Matters
Headwaters has ongoing litigation and asserted claims incurred during
the normal course of business, including the items discussed below and in Note
10 to the consolidated financial statements. Headwaters intends to vigorously
defend or resolve these matters by settlement, as appropriate. Management does
not currently believe that the outcome of these matters will have a material
adverse effect on Headwaters' operations, cash flows or financial position.
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
nine months ended June 30, 2005, Headwaters expensed $3.1 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
liability to Headwaters. The liability recorded as of June 30, 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 $2.3 million and $4.0 million
for the nine months ended June 30, 2004 and 2005, respectively (the amount for
2005 is exclusive of the reimbursement of legal costs received in connection
with the AJG litigation settlement discussed below). It is not possible to
estimate what litigation-related 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 which provided
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 recognized the $50.0 million contract litigation settlement
gain, net of payments due to a third party, as a reduction in operating costs
and expenses in the quarter ended June 30, 2005. The $70.0 million, net of
payments due to a third party, is being recognized as revenue over calendar
years 2005 through 2007; however, because the settlement agreement was not
reached until May, six months of revenue covering the period January 1, 2005
through June 30, 2005 was recognized in the quarter ended June 30, 2005. The
ongoing quarterly payments based upon tax credits is being 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 connection with the settlement of the AJG litigation, Headwaters
also recognized as revenue approximately $8.2 million of revenue from a licensee
with an indirect interest in that litigation, all of which related to periods
prior to January 1, 2005. Ongoing revenue from this licensee will also be
recognized in accordance with Headwaters' revenue recognition policy for license
fee revenue.
36
As described in Note 3 to the consolidated financial statements, in May
2005, in conjunction with the gain recognized from the AJG litigation
settlement, the Compensation Committee of the Board of Directors ("Committee")
granted to certain officers and employees stock incentive awards consisting of
stock appreciation rights ("SARs") and stock options. The Committee also
approved the acceleration of vesting of certain outstanding stock options and
the payment of incentive cash bonuses totaling approximately $5.8 million, which
were paid in May 2005. The stock incentive awards were 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 the achievement of
performance criteria related to the economic growth ("EVA") of Headwaters, which
the Committee believes would lead to the creation of significant long-term
stockholder value.
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 are 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 May 31, 2005) is $44.18
per barrel, and an estimate of the phase-out range (using 2% inflation) begins
when the reference oil price is approximately $52.38 per barrel. Section 29 tax
credits are reduced proportionately until completely phased out at approximately
$65.76 per barrel. The phase-out range is adjusted each year for inflation,
using the inflation adjustment factor published by the Department of the
Treasury. An estimate of the phase-out range for calendar 2006 (computed by
increasing the inflation adjustment factor by 2% for both 2005 and 2006) could
be in the range of $53.43 to $67.07 per barrel.
The reference price is computed each month by averaging 24 different
price points across the United States. The computed monthly price is averaged
for the 12 calendar months, resulting in the reference price for the year. It is
estimated that the reference price for the first five months of 2005 was $44.18.
Using this reference price for the first five months, the reference price for
the remainder of calendar 2005 would have to average approximately $58.24 before
the calendar year reference price would be at the beginning of the phase-out
range.
The one-day cash trading price on August 1, 2005 was $61.57 per barrel.
Generally, in 2005, the reference price has been between $5.00 to $7.00 per
barrel lower than quoted NYMEX prices. Thus the NYMEX price would have to be
approximately $61.00 to $65.00 per barrel for the remainder of calendar 2005
before the reference price would be at the beginning of the phase-out range.
Others have estimated the NYMEX price would have to be as high as $68.00 per
barrel for the remainder of 2005. Given the adjustment for inflation for the
phase-out range, the NYMEX price would have to be approximately $61.00 for the
entire year in calendar 2006 to be at the low end of the phase-out range, and
$74.00 to be at the upper end of the phase-out range. NYMEX future prices for
2006 average approximately $64.00 per barrel.
Headwaters believes that synthetic fuel facility owners can
economically operate their facilities at least midway through the phase-out
range ($66.00 to $67.00), or at a NYMEX price of approximately $67.00 per
barrel. Also, some of the owners have devised hedges and have indicated to
Headwaters that they will continue to operate even if oil prices increase above
the phase-out threshold. However, the decision to operate or not operate a
facility is the unique decision of each facility owner/operator and the
variables will be different in each situation.
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
37
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 audits is uncertain. 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 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.
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 $501.7 million of variable-rate
long-term debt outstanding as of June 30, 2005, consisting of $492.7 million of
senior debt and $9.0 million of notes payable to a bank.
The $492.7 million of term loan borrowings under the senior debt
agreements consisted of a first lien term loan in the amount of $442.7 million
and a second lien term loan in the amount of $50.0 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
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 interest rate on the first lien
debt was approximately 5.5% at June 30, 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 interest rate on the second lien debt was approximately
8.7% at June 30, 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 June.
In connection with the 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 ($150.0 million as of June 30, 2005) of the senior
secured debt at 5.0% through September 8, 2005. The second set of agreements
effectively set the LIBOR rate at 3.71% for $300.0 million ($150.0 million as of
38
June 30, 2005) of this debt for the period commencing September 8, 2005 through
September 8, 2007. During the quarter ended June 30, 2005, Headwaters reduced
the amount of senior debt hedged from $300.0 million to $150.0 million, as
allowed under terms of the amended credit facility, and recognized a gain of
approximately $1.0 million, which was recorded as a reduction in interest
expense.
Headwaters accounts for the 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
market value of the hedges can fluctuate significantly over a relatively short
period of time. The hedges had a market value at June 30, 2005 of approximately
$0.8 million, which, net of $0.3 million of income taxes, represents other
comprehensive income for the nine months ended June 30, 2005. Total
comprehensive income was approximately $53.3 million and $76.9 million,
respectively, for the three- and nine-month periods ended June 30, 2005.
In connection with the acquisition of SCP in July 2004, Headwaters
assumed SCP's obligations under its notes payable to a bank. The notes require
monthly interest and quarterly principal payments and bear interest at variable
rates, which as of June 30, 2005, ranged from 4.5% to 5.75%.
Disregarding the effect of the hedges described above, a change in the
interest rate of 1% would change Headwaters' interest expense by approximately
$5.0 million during the 12 months ending June 30, 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 June 30, 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 June 30, 2005 that has
materially affected, or is reasonably likely to materially affect, Headwaters'
internal control over financial reporting.
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See "Legal or Contractual Matters" in Note 10 to the consolidated
financial statements for a description of current legal proceedings.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
39
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
The following exhibits are included herein:
12 Computation of ratio of earnings to combined *
fixed charges and preferred stock dividends
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief *
Executive Officer
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief *
Financial Officer
32 Section 1350 Certifications of Chief Executive *
Officer and Chief Financial Officer
99.1.1 Amended 2000 Employee Stock Purchase Plan, as *
further amended
-----------------------
* Filed herewith.
40
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: August 4, 2005 By: /s/ Kirk A. Benson
---------------------------------------
Kirk A. Benson, Chief Executive Officer
(Principal Executive Officer)
Date: August 4, 2005 By: /s/ Steven G. Stewart
---------------------------------------
Steven G. Stewart, Chief Financial
Officer (Principal Financial Officer)
41