UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended September 30, 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 1-32459
HEADWATERS INCORPORATED
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(Exact name of registrant as specified in its charter)
Delaware 87-0547337
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
10653 South River Front Parkway, Suite 300
South Jordan, Utah 84095
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(Address of principal executive offices) (Zip Code)
(801) 984-9400
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock,
$.001 par value
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X]
The aggregate market value of the voting stock held by non-affiliates of
the registrant as of March 31, 2005 was $1,316,610,041, based upon the closing
price on the Nasdaq National Market reported for such date. This calculation
does not reflect a determination that persons whose shares are excluded from the
computation are affiliates for any other purpose.
The number of shares outstanding of the registrant's common stock as of
November 18, 2005 was 41,944,711.
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DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement to be issued in
connection with registrant's annual stockholders' meeting to be held in 2006 are
incorporated by reference into Part III of this report on Form 10-K.
TABLE OF CONTENTS
Page
PART I
ITEM 1. BUSINESS.............................................................3
ITEM 2. PROPERTIES..........................................................20
ITEM 3. LEGAL PROCEEDINGS...................................................20
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.................22
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.................23
ITEM 6. SELECTED FINANCIAL DATA.............................................23
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.............................................24
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..........51
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.........................52
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE..............................................52
ITEM 9A. CONTROLS AND PROCEDURES.............................................52
ITEM 9B. OTHER INFORMATION...................................................54
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT..................55
ITEM 11. EXECUTIVE COMPENSATION..............................................55
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS........55
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS......................55
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES..............................55
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES..........................56
SIGNATURES....................................................................59
Forward-looking Statements
This Annual Report on Form 10-K contains forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995 regarding future
events and our future results that are based on current expectations, estimates,
forecasts, and projections about the industries in which we operate and the
beliefs and assumptions of our management. Actual results may vary materially
from such expectations. Words such as "expects," "anticipates," "targets,"
"goals," "projects," "believes," "seeks," "estimates," 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 hereof. There can
be no assurance that our results of operations will not be adversely affected by
such factors. Unless legally required, we undertake no obligation to revise or
update any forward-looking statements for any reason. Readers are cautioned not
to place undue reliance on these forward-looking statements, which speak only as
of the date of this report.
Our internet address is www.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.
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PART I
ITEM 1. BUSINESS
General Development of Business
Introduction. Headwaters is a diversified company providing products,
technologies and services to the energy and construction materials industries.
In executing our mission of "adding value to energy," we have built businesses
and competencies that we believe will sustain our pursuit of profitable growth
through maintaining leadership positions in our markets and the innovative
implementation of new technologies. We believe our business units deliver strong
and stable cash flow and demonstrate our commitment to sustainable and ethical
business practices. We strive to create a sustainable environment by conserving
natural resources, minimizing waste, creating products using less energy, and
leading our industries to a higher environmental standard.
Our energy services business unit is a market leader in providing
technologies used to produce coal-based solid alternative fuels. We use our
engineered fuels expertise to develop new opportunities in the burgeoning clean
coal marketplace and are in the process of developing a range of breakthrough
technologies that improve natural resource utilization.
We create value for coal-fueled power generators from their coal
combustion products ("CCPs"). CCPs, such as fly ash and bottom ash, are created
when coal is burned. CCPs have traditionally been an environmental and economic
burden for power generators but, when properly managed, can produce additional
value for utilities. We create commercial value for CCPs principally by
supplying CCPs as a replacement for portland cement in a variety of concrete
infrastructure projects and building products. Our resources business unit is
the largest manager and marketer of CCPs in the United States.
Our construction materials business is an industry leader in two fast
growing product categories, manufactured stone and specialty siding. Revenue
from construction materials is diversified geographically and also by market,
including new residential, remodeling and commercial markets. We believe our
acquisitions in this area have enhanced the stability of our cash flows,
broadened the distribution channels for our products and provided a source of
funds for future growth.
Through our technology innovation group we develop and commercialize
proprietary technologies to convert or upgrade fossil fuels into higher-value
products, including heavy oil upgrading and coal liquefaction. Our nanocatalyst
technology has potential in multiple industrial and chemical applications. We
view innovation and commercialization of new technologies as a key component of
our future growth.
Headwaters conducts its business primarily through the following
business units:
Headwaters Energy Services ("HES") is, we believe, the market leader in
enhancing the value of coal used in power generation through licensing
proprietary technologies and selling chemical reagents that convert coal into a
solid alternative fuel. This solid alternative fuel qualifies for tax credits
under Section 29 of the Internal Revenue Code based upon the Btu content of the
alternative fuel produced and sold. We currently license our technologies to 28
of a company-estimated 75 coal-based solid alternative fuel facilities in the
United States. In addition, in fiscal 2005 we sold our proprietary chemical
reagents to approximately 34 facilities owned by our licensees and other
customers. The sale of qualified alternative fuel enables facility owners who
comply with certain statutory and regulatory requirements to claim federal tax
credits under Section 29, which currently expires on December 31, 2007. The
intent of Section 29 is to reduce dependence on foreign sources of energy by
more efficiently using domestic energy resources. HES is also actively involved
in multiple clean coal initiatives. These initiatives provide HES with an
opportunity to reduce SOx, NOx and mercury from coal, greatly increasing coal's
cleanliness and usability.
Headwaters Resources ("HRI") manages CCPs on an exclusive basis for
many of the nation's largest coal-fueled utilities. HRI has expanded the
commercial use of CCPs and continues to drive market recognition of the
performance, economic and environmental benefits of CCPs. Sales of high-value
CCPs used principally as a replacement for portland cement in concrete were
approximately 6.3 million tons in calendar 2004. Concrete made with fly ash is
stronger, more durable, less permeable and more corrosion resistant than
concrete made without fly ash. Further, concrete made with fly ash is easier to
work with than concrete made without fly ash due, in part, to its better pumping
and forming properties. Fly ash use displaces cement production, resulting in
lower greenhouse gas emissions. According to American Coal Ash Association
("AACA") 2004 estimates, fly ash replaces approximately 11% of the portland
cement used in concrete manufactured in the United States. Broader recognition
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of the performance, economic and environmental benefits of fly ash has led the
United States Environmental Protection Agency ("EPA") and many state regulators
to recommend or specify its use.
Headwaters Construction Materials ("HCM") produces construction
materials that minimize waste, conserve natural resources, and/or use less
energy in manufacturing or application. In June 2004, we acquired Eldorado
Stone, LLC ("Eldorado") a market leader in designing, manufacturing and
marketing manufactured stone products, and in September 2004, we acquired Tapco
Holdings, Inc. ("Tapco"), a leading manufacturer of building products
accessories (such as window shutters, gable vents and mounting blocks) and
professional tools used in exterior residential remodeling and construction. The
acquisitions of Tapco and Eldorado have significantly transformed HCM and given
us a national presence in commercial, residential and remodeling markets. We
believe that we are now one of the leading national manufacturers of
manufactured stone, the leading national manufacturer of injection-molded
accessories for the residential remodeling market and a leading supplier of
concrete blocks in Texas. We believe the acquisition of Tapco has reduced HCM's
dependence on new construction since the majority of Tapco's sales are
associated with the remodeling market. In addition to strengthening HCM's cash
flow capabilities, we believe our recent acquisitions have also positioned HCM
for significant growth. Through Tapco and Eldorado, we now participate in what
we believe to be two of the highest growth segments within the siding industry,
manufactured stone and specialty siding.
Headwaters Technology Innovation Group ("HTI") develops and
commercializes proprietary technologies to convert or upgrade fossil fuels into
higher-value products and develops nanocatalyst technologies that have multiple
industrial and chemical applications. The energy-related technologies developed
or under development include direct coal liquefaction, the conversion of
gas-to-liquid fuels and the upgrading of heavy oil to lighter materials. HTI has
also developed a proprietary nanocatalyst technology that will allow for the
custom design of catalysts on an atomic scale for multiple industrial
applications, which should reduce costs and increase the efficiency of chemical
reactions. We intend to continue to seek out opportunities to utilize our
nanocatalyst technology to lower production costs, as we believe nanotechnology
represents the future of energy and chemical sustainability. The ability to
align, space and adhere materials at the molecular level creates value due to
the size, shape and composition of these materials. We believe that the
nanocatalysts developed by HTI can increase the conversion of heavy oil to
usable materials, maximize efficiency in chemical and energy production, improve
the environment and create other value added opportunities.
Headwaters' Company History. Headwaters was incorporated in Delaware in
1995 under the name Covol Technologies, Inc. In September 2000, its name was
changed to Headwaters Incorporated. Headwaters' stock trades under the New York
Stock Exchange symbol "HW."
As used herein, "Headwaters," "combined company," "we," "our" and "us"
refer to Headwaters Incorporated and its consolidated subsidiaries, including
Headwaters Energy Services Corp. and its subsidiaries and affiliates; Headwaters
Resources, Inc. and its subsidiaries; Headwaters Construction Materials, Inc.
and its subsidiaries and affiliates, including Eldorado Stone LLC and Tapco
Holdings, Inc., and Headwaters Technology Innovation Group, Inc. and its
subsidiaries and affiliates; unless the context otherwise requires. As used in
this report, "HES" refers to Headwaters Energy Services Corp., together with its
consolidated subsidiaries and affiliates; "HRI" refers to Headwaters Resources,
Inc. and its consolidated subsidiaries; "HCM" refers to Headwaters Construction
Materials, Inc., together with its consolidated subsidiaries and affiliates,
including "Eldorado", which refers to HCM Stone, LLC and Eldorado Stone LLC and
all of their subsidiaries; and "Tapco," which refers to Tapco Holdings, Inc.,
and its subsidiaries, and "HTI" refers to Headwaters Technology Innovation
Group, Inc., together with its consolidated subsidiaries and affiliates; unless
the context otherwise requires.
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Headwaters Energy Services
Principal Products and their Markets. Headwaters Energy Services Corp.,
together with its subsidiaries and affiliates (collectively "HES"), develops and
commercializes technologies that interact with coal-based feedstocks to produce
a solid alternative fuel intended to be eligible for Section 29 tax credits. The
sale of qualified alternative fuel enables facility owners who comply with
certain statutory and regulatory requirements to claim federal tax credits under
Section 29, which currently expires on December 31, 2007. In August 2005,
Congress enacted the Energy Policy Act of 2005, which redesignated the Section
29 tax credit as a Section 45K general business credit, effective January 1,
2006. For convenience, this code section will be referred to herein as "Section
29." Headwaters has licensed its technology to owners of solid alternative fuel
facilities for which it receives royalty revenues. Headwaters also sells
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proprietary chemical reagents to licensees for use in the production of the
coal-based solid alternative fuel and to other solid alternative fuel facility
owners with whom Headwaters has reagent supply agreements.
Licensees. Headwaters licenses its technologies to 28 of a
company-estimated total of 75 coal-based solid alternative fuel facilities in
the United States. In addition, during fiscal 2005 Headwaters sold its
proprietary chemical reagents to approximately 34 licensee and other alternative
fuel facilities.
Current licensees include electric utility companies, coal companies,
financial institutions and other major businesses in the United States. License
agreements contain a quarterly earned royalty fee generally set at a prescribed
dollar amount per ton or a percentage of the tax credits earned by the licensee.
License agreements generally have a term continuing through the later of January
1, 2008 or the date after which tax credits may not be claimed or are otherwise
not available under Section 29.
Chemical Reagent Sales. The transformation of the feedstock to an
alternative fuel involves the use of a chemical reagent in a qualified facility.
Headwaters primarily markets two proprietary latex-based chemicals, Covol 298
and Covol 298-1, which are widely used for the production of coal-based solid
alternative fuel. The chemical reagent alters the molecular structure of the
feedstock to produce an alternative fuel.
Headwaters believes the benefits of its proprietary chemical reagents
as compared to competitive materials include clean and efficient combustion
characteristics, ease of application, concentrated form of shipment and lack of
damage to material handling, pulverizing or combustion equipment. Headwaters
believes the chemical reagents used in the HES process are environmentally safe,
possess superior handling characteristics, burn efficiently and are
competitively priced. Additionally, Headwaters' chemical reagents have been
reviewed often by the IRS and tested by independent laboratories. The parameters
of the HES process are consistent with the criteria for future private letter
rulings as outlined by the IRS in Revenue Procedure 2001-30, as modified by
Revenue Procedure 2001-34 and IRS Announcement 2003-70.
On-site Facility Services. In addition to licensing its technology and
supplying chemical reagents, HES employs chemical, electrical and mechanical
engineers and field personnel with extensive plant and equipment operating
experience to perform on-site facility services and other technical support
functions. HES's engineers have years of experience operating alternative fuel
manufacturing equipment, including mixers, extruders, pellet mills, briquetters
and dryers. HES's employees are experienced in applying its chemical reagents on
multiple types of coal feedstocks. HES has operated alternative fuel facilities
utilizing multiple types of coal feedstocks and has developed and demonstrated
process improvements in commercial facilities. HES has also designed and
constructed reagent mixing and application systems and has retrofitted existing
facilities to use its reagents. For new customers, HES has a mobile,
skid-mounted reagent delivery system that allows for on-site demonstration
testing. HES believes that this full spectrum of services makes it unique in
providing goods and services to the coal-based solid alternative fuel business.
HES maintains analytical laboratories, including bench-scale equipment
for the production of coal-based solid alternative fuel and comprehensive
analytical testing equipment for performing standard coal analyses. Headwaters
also monitors, documents and substantiates the chemical change process required
to obtain Section 29 tax credits.
Sources of Available Raw Materials and Inventory Requirements.
Headwaters' chemical reagents are produced by Dow Reichhold Specialty Latex LLC
("Dow Reichhold") under long-term agreements. Headwaters does not maintain or
inventory any chemicals. Instead, Headwaters arranges for the drop shipping of
the chemical reagents directly from Dow Reichhold's production facilities to the
alternative fuel plants. The chemical reagents can be manufactured in its Dow
Reichhold plants throughout North America allowing Headwaters to meet reagent
demand with short lead-time deliveries. Separately, the alternative fuel
facility owners have unrelated feedstock agreements that provide a supply of raw
coal for processing at their facilities. These licensees and customers in turn
have production agreements to supply alternative fuel to end users (usually
coal-fueled electricity generating facilities).
New Business Opportunities.
Dry Coal Cleaning. HES is commercializing a dry coal cleaning process
that upgrades low value coal. In this process ash and other impurities are
separated from the coal utilizing air as the separating medium. The resultant
coal product is lower in ash, including sulfur, mercury and other impurities,
and higher in Btu value. HES is constructing its first facility in central Utah
with commercial operation anticipated during the quarter ending March 31, 2006.
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Ethanol. In March of 2005 HES announced a non-binding memorandum of
understanding to enter into a joint venture with Great River Energy ("GRE") of
Elk River, Minnesota to develop and construct a 50 million gallon per year
ethanol production facility. The joint venture will be named Blue Flint Ethanol,
LLC and will be owned 51% by HES and 49% by GRE. Blue Flint will be located at
the GRE Coal Creek pulverized coal electric power station near Underwood, North
Dakota. Coal Creek station will supply steam, water and other services to Blue
Flint. Headwaters will operate the facility. As of the date hereof, HES is
continuing development of the project.
Coal Drying Marketing. In March 2005 HES also announced a letter of
intent with GRE to market the coal drying technology developed by GRE at its
Coal Creek station. This technology utilizes waste heat from the power plant to
dry high moisture coal which will result in higher boiler efficiencies during
the combustion process. This technology can be utilized with lignite and other
high moisture coals.
Headwaters Resources
Principal Products and their Markets. Headwaters Resources is currently
the largest manager and marketer of coal combustion products ("CCPs") in the
United States and also manages and markets CCPs in Canada and Puerto Rico. HRI
has a number of long-term exclusive management contracts with coal-fueled
electric generating utilities throughout the United States and provides CCP
management services at more than 110 locations. HRI markets CCPs in areas where
sufficient demand exists, and manages much of the disposal of the rest of the
CCPs it obtains, typically in landfills. HRI has established long-term
relationships with many of the nation's major utilities and also assists
utilities with their overall CCP management programs.
HRI markets CCPs as a replacement for manufactured or mined materials
such as portland cement, lime, agricultural gypsum, fired lightweight aggregate,
granite aggregate and limestone. Additionally, HRI provides its affiliate,
Headwaters Construction Materials, CCPs for use in certain construction products
such as mortars, stucco and concrete blocks.
Utilities produce CCPs year-round, including in the winter when demand
for electricity increases in many regions. In comparison, sales of CCPs and
construction materials produced using CCPs are keyed to construction market
demands that tend to follow national trends in construction with predictable
increases during temperate seasons. CCPs must be stored, usually in terminals,
during the off-peak sales periods as well as transported to where they are
needed for use in construction. In part because of the cost of transportation,
the market for CCPs used in construction is generally regional, although HRI
ships products significant distances to states such as California and Florida
that have limited coal-fueled electric utilities producing high quality CCPs.
HRI enjoys advantages in both logistics and sales from its status as the largest
manager and marketer of CCPs in the United States. HRI maintains more than 30
stand-alone CCP distribution terminals across North America, as well as
approximately 90 plant-site supply facilities. HRI owns or leases approximately
1,450 rail cars and more than 190 trucks, and also contracts with other carriers
so that it can meet its transportation needs for the marketing and disposal of
CCPs. In addition, HRI has more than 50 area managers and technical sales
representatives nationwide to manage customer relations.
Fly Ash and Other CCPs. The benefits of CCP use in construction
applications include improved product performance, cost savings and positive
environmental impact. Fly ash improves both the chemical and physical
performance of concrete. Chemically, fly ash combines silicon with free lime
created by cement hydration to produce additional binding ability within
concrete - decreasing permeability and enhancing durability. Physically, fly ash
particles are smaller than cement particles, allowing them to effectively fill
voids and create concrete that is denser and more durable. Fly ash particles are
spherical and have a "ball bearing" effect which lubricates the concrete mix and
allows enhanced workability with less water. The requirement of less water also
contributes to decreased permeability and greater durability of concrete.
Because fly ash is also typically less expensive than the cement it replaces,
concrete producers are able to improve profitability while improving concrete
quality.
When fly ash is used in concrete it provides environmental benefits. In
addition to conserving landfill space, fly ash usage conserves energy and
reduces green house gas emissions. According to the EPA, one ton of fly ash used
as a replacement for portland cement eliminates approximately one ton of carbon
dioxide emissions associated with cement production. This is the equivalent of
retiring an automobile from the road for two months. These benefits are
recognized in major "green building" movements, such as the United States Green
Building Council's LEED classification system. The value of utilizing fly ash in
concrete has been recognized by numerous federal agencies, including the United
States Department of Energy and EPA, which has issued comprehensive procurement
guidelines directing federal agencies to utilize fly ash. The EPA has also
created the Coal Combustion Products Partnership ("C2P2") to nationally promote
CCP utilization. Almost all states specify or recommend the use of fly ash in
state and federal transportation projects. Other government entities that
frequently specify or recommend the utilization of fly ash in concrete include
the Federal Highway Administration, the United States Army Corps of Engineers
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and the United States Bureau of Reclamation. Numerous state departments of
transportation are also increasing their reliance on fly ash as a component for
improving durability in concrete pavements. Several major cement companies have
identified increasing the use of fly ash as a key environmental strategy for the
next two decades.
Higher quality fly ash and other high value CCPs have the greatest
value to HRI because of the wide variety of higher margin commercial uses. In
calendar 2004, HRI sold approximately 6.3 million tons of high value CCPs. The
quality of fly ash produced by the combustion process at coal-fueled facilities
varies widely and is affected by the type of coal feedstock used and the boilers
maintained by the utilities. HRI assists its utility clients in their efforts to
improve the production of high value CCPs at their facilities. HRI tests fly ash
to certify compliance with applicable industry standards. A quality control
system ensures that customers have a specific quality of CCPs for various
applications while HRI's extensive investment in transportation equipment and
terminal facilities provides reliability of supply.
HRI supports its marketing sales program by focusing on customer
desires for quality and reliability. Marketing efforts emphasize the performance
value of CCPs, as well as the attendant environmental benefits.
HRI undertakes a variety of marketing activities to increase fly ash
sales. These activities include:
o Professional Outreach. To promote the acceptance of fly ash in
construction projects, all levels of HRI's sales and marketing
organization are involved in making regular educational
presentations such as continuing professional education
seminars to architects, engineers, and others engaged in
specifying concrete mix designs.
o Technical Publications. HRI publishes technical reference
information pertaining to CCPs and CCP applications. HRI also
prominently promotes the environmental benefits of CCP use.
o Relationships with Industry Organizations. HRI personnel
maintain active leadership positions in committees of the
American Concrete Institute and the American Society for
Testing and Materials, and serve on the boards of the American
Coal Ash Association, the Western Region Ash Group, the Texas
Coal Ash Utilization Group, the Midwest Coal Ash Association
and the American Coal Council. These organizations help
establish standards and educate the construction industry and
the general public about the benefits of CCP use.
o Trade Shows. HRI promotes the use of CCPs at more than 30
local and national trade shows and association meetings each
year. HRI is also an exhibitor at the nation's leading
conferences for utilization of environmentally friendly
building products.
o Government Affairs. HRI has taken a leadership role in
encouraging state and federal legislation and regulations that
lead to greater utilization of fly ash by emphasizing its
environmental, performance and cost advantages. Legislative
recognition of the benefits of fly ash as well as the use of
fly ash in governmental projects helps familiarize
contractors, architects and engineers with the benefits of the
product for other construction uses.
o Advertising. HRI advertises for fly ash sales and utilization
in a number of publications, including: Architectural Record,
Construction Specifier, Concrete Products, Concrete Producer,
Concrete International and Environmental Design &
Construction.
o Creation of Branded Specialty Products. HRI has developed
several specialty products that increase market penetration of
CCPs and name recognition for HRI's products for road bases,
structural fills, industrial fillers and agricultural
applications. These include:
o Alsil(R) - Processed fly ash used as an industrial
filler;
o C-Stone(TM) - Quality crushed aggregate manufactured
from fly ash and used in road base and feedlot
applications;
o Flexbase(TM) - Flue Gas Desulphurization (FGD)
scrubber sludge, pond ash, and/or lime proportionally
mixed for road base or pond liner material;
o Powerlite(R) - Processed fly ash and bottom ash,
meeting American Society for Testing and Materials
C331 standards, for use as a high quality aggregate
in the concrete block industry; and
7
o Peanut Maker(R) - A synthetic gypsum used as a land
plaster in agricultural applications.
New Technologies for CCP Utilization. In an effort to maximize the
percentage of CCPs marketed to end users and to minimize the amount of materials
disposed of in landfills, HRI's research and development activities focus on
expanding the use of CCPs by developing new products that utilize high volumes
of CCPs. Through these research and development activities, HRI has developed
FlexCrete(TM), a new commercial and residential building product in its early
commercialization stages. FlexCrete(TM) is an aerated concrete product with
approximately 50% fly ash content. HRI expects FlexCrete(TM) will offer
advantages for construction, including low cost, ease of use, physical strength,
durability, energy efficiency, fire resistance and environmental sensitivity.
Technologies to Improve Fly Ash Quality. HRI has also developed
technologies that maintain or improve the quality of CCPs, further expanding and
enhancing their marketability. Utilities are switching fuel sources, changing
boiler operations and introducing ammonia into the exhaust gas stream in an
effort to decrease costs and/or to meet increasingly stringent emissions control
regulations. All of these factors can have a negative effect on fly ash quality,
including an increase in the amount of unburned carbon in fly ash and the
presence of ammonia slip. HRI has addressed these challenges with the
development and/or commercialization of two technologies. Designed to be simple,
economical and highly effective, these technologies can be implemented without
the large capital expenditures often associated with controlling quality
problems.
Carbon Fixation. Under certain conditions, unburned carbon in fly ash
inhibits the entrainment of air in concrete thereby reducing its resistance to
the effects of freeze-thaw conditions. Technologies designed to remove residual
carbon are often capital intensive and are therefore rarely used. HRI has the
exclusive license in North America to utilize a carbon fixation technology used
to pre-treat fly ash. The technology uses a liquid reagent to coat unburned
carbon particles in the fly ash and hinder the impact on the concrete mix.
Carbon is not removed, but its effects on air entrainment are minimized. The
technology also renders some ash products usable for the first time without
having any adverse effects on the quality of finished concrete. Full scale
carbon fixation units have been installed and are operating at major power
plants.
Ammonia Slip Mitigation. As electric utilities move to implement
stringent new air pollution controls, many are treating boiler exhaust gases
with ammonia to remove NOx. This can result in unreacted ammonia being deposited
on fly ash. The use of ammonia contaminated fly ash in concrete production can
result in the release of ammonia gas, exposing concrete workers to varying
levels of ammonia. HRI has developed a technology that uses a chemical reagent
to mitigate the ammonia slip effects. When water is added to the concrete mix
containing ammoniated fly ash, the reagent converts ammonia to harmless
compounds. The process allows the reagent to be added and blended with the dry
fly ash at any time from when the fly ash is collected at the power plant to
when the fly ash is used in the production of concrete.
Sources of Available Raw Materials and Inventory Requirements. Coal is
the largest indigenous fossil fuel resource in the United States. The U.S.
Department of Energy (DOE) estimates that in 2004 annual coal production was in
excess of 1.1 billion tons. Almost 91% of all coal consumed in the United States
was for electrical power generation. The DOE further estimates that 2004 U.S.
coal consumption for electrical power generation was slightly more than one
billion tons. Coal serves as a primary resource for baseline electricity
production in the United States and was used to produce approximately half of
the electricity generated in the United States. The combustion of coal results
in a high percentage of residual materials which serve as the "raw material" for
the CCP industry. According to the American Coal Ash Association, for 2004 about
49 million tons of CCPs were beneficially used in the United States of the
approximately 122 million tons generated. This provides for opportunities for
continuing increases in CCP utilization. As long as a significant amount of
electricity in this country is generated from coal-fueled generation, HRI
believes it will have an adequate supply of raw materials.
Headwaters Construction Materials
Principal Products and their Markets. Headwaters Construction Materials
is a nation-wide market leader in designing, manufacturing and marketing
shutters, gable vents, mounting blocks and tools (under various Tapco brands),
and architectural manufactured stone (under the Eldorado Stone(R) brand). In
addition, HCM is a regional leader in manufacturing and distributing concrete
blocks and other masonry units (under the Southwest and Palestine brands), as
well as various mortars and stuccos (under the Best Masonry, Magna Wall(R) and
other brands). The acquisitions of Tapco, Eldorado and Southwest in 2004 have
significantly transformed Headwaters Construction Materials business unit and
given Headwaters a national presence in the commercial and residential
improvement market. HCM uses fly ash in the manufacture of most of its block,
mortar and stucco products and intends to use fly ash in its manufactured stone
products.
8
Eldorado
In June 2004, Headwaters acquired Eldorado Stone, LLC, together with
its wholly-owned subsidiaries.
Principal Products and their Markets. Eldorado offers a wide variety of
high-quality, hand-made manufactured stone products to meet a variety of design
needs. Eldorado's architectural manufactured stone siding incorporates several
key features important to a successful siding product, including: high aesthetic
quality, ease of installation, durability, low maintenance, reasonable cost and
widespread availability. Eldorado's product line has been designed and is
manufactured to be one of the most realistic architectural stone products in the
world. Eldorado's architectural stone siding is a lightweight, adhered siding
product used by national, regional and local architectural firms, real estate
developers, contractors, builders and homeowners. Eldorado Stone(R) is used in
construction projects ranging from large-scale residential housing developments
and commercial projects to do-it-yourself home improvement jobs. In addition to
its use as a primary siding material, the Eldorado product line is used in a
variety of external and internal home applications such as walls, archways,
fireplaces and landscaping. For 2006, Eldorado has plans to introduce an
architectural brick veneer product. Headwaters believes that Eldorado's focus on
product quality, breadth and innovation, combined with a geographically
diversified manufacturing platform, provides it with significant advantages in
leading architects, builders and end-users to choose Eldorado over traditional
materials such as natural stone, brick or stucco.
Eldorado Stone(R) is available in 60 distinct stone types, developed
from 12 stone profiles and crafted in a variety of natural colors designed by
Eldorado's artistic staff. Eldorado also offers regional stone products based on
the characteristics of the stone native to the regions. Each stone profile is
manufactured using numerous real stone models, which creates a realistic,
non-repetitive, natural stone look and is crafted in a variety of natural
colors. Eldorado believes its collection developed over the last 35 years of
more than 20,000 natural stones, which are used as models for the profiles, is
not easily replicated.
Manufacturing. Eldorado manufactures the molds for its stone profiles
as well as the manufactured stone created from these molds. Although Eldorado
does not currently use fly ash in its manufactured stone products, they intend
to replace a portion of the cement used in the production of Eldorado Stone(R)
with fly ash for greater durability, aesthetic enhancement and environmental
advantages. Headwaters believes that Eldorado's existing plants may be modified
to allow this substitution without material additional expense and is in the
process of testing new mix designs using fly ash. Eldorado has made recent
investments in both its manufacturing operations and sales and marketing
capabilities. It has initiated production at its new Rancho Cucamonga,
California facility and has expanded its customer service operations and
staffing. Eldorado currently manufactures its products through a network of
plants strategically situated throughout the U.S. in proximity to its customers.
These locations allow for a high level of customer service, shorter lead times
and lower freight costs. Eldorado has manufacturing facilities at locations
including: Rancho Cucamonga, California; Pueblo, Colorado; Dublin, Georgia,
Apple Creek Ohio; Greencastle, Pennsylvania ; Carnation, Washington; and Royal
City, Washington. In addition, Eldorado has three distribution centers located
at: Stockton, California; Portland, Oregon; and Arlington, Washington.
Sales and Marketing. Eldorado distributes its architectural
manufactured stone products primarily on a wholesale basis through a network of
distributors, including masonry and stone suppliers, roofing and siding
materials distributors, fireplace suppliers and other contractor specialty
stores. Eldorado also has a small direct sales force. Eldorado's sales force
works closely with architects and contractors to provide information concerning
the attributes and ease of installation of its manufactured product and to
promote market acceptance over traditional building materials.
Southwest Concrete Products
In July 2004 HCM purchased the assets of Southwest Concrete Products,
LP through HCM's indirect subsidiary, HCM Block & Brick, LP ("Southwest" or
"SCP"). Southwest is a leading manufacturer of concrete blocks in South Texas.
Principal Products and their Markets. Southwest, together with HCM's
existing operations (Palestine Concrete Tile Co., LP), makes HCM one of the
largest manufacturers and sellers of concrete block in the Texas market, one of
America's largest block markets. The Southwest acquisition also provides
Headwaters with the opportunity to use fly ash in the manufacturing process for
concrete block, brick and foundation blocks.
Manufacturing. Southwest operates three of the most modern concrete
block and brick manufacturing facilities in the industry. It has recently
launched a new line of concrete bricks. Southwest has operations in Alleyton,
San Antonio and Houston which complement HCM's similar operations in Dallas and
Palestine, Texas.
9
Sales and Marketing. Combining SCP's modern manufacturing facilities
for concrete block and brick with those of HCM provides coverage of all the key
metropolitan areas in Texas, without duplication of facilities. The established
position of the combined block facilities may also provide Eldorado strategic
locations for expansion.
Tapco
In September 2004 Headwaters acquired Tapco Holdings, Inc. Tapco is a
leading designer, manufacturer and marketer of building products and
professional tools used in exterior residential home improvement and
construction.
Principal Products and their Markets. Tapco's building products, which
are either injection-molded or extruded, enhance the appearance of homes and
include decorative window shutters, gable vents, and mounting blocks for
exterior fixtures, roof ventilation, window and door trim products and specialty
siding products. Professional tools include portable cutting and shaping tools
used by contractors, on-site, to fabricate customized aluminum shapes that
complement the installation of exterior siding.
Tapco markets its products under the brands "Tapco Integrated Tool
Systems," "Mid-America Siding Components," "Builders Edge," "Atlantic Premium
Shutters," "Vantage," and "The Foundry." Tapco markets its injection-molded
building product accessories to retailers and mass merchandisers through its
Builders Edge and Vantage brands and to the manufactured housing market through
the MHP brand. In addition, Tapco markets its tools through its Tapco brand, its
functional shutters and storm protection systems through its Atlantic Premium
Shutters brand, and its specialty siding product through its Foundry brand.
Building Products. Tapco designs, manufactures and markets
injection-molded window shutters, gable vents and exterior fixture mounting
blocks. In addition, Tapco manufactures roof vents, specialty vents, window
headers, door surrounds, accent windows, functional shutters and specialty vinyl
siding. Tapco's building products serve the needs of the siding, roofing, and
window and door installation industries. Tapco's injection-molded products are
designed to enhance the exterior appearance of the home while delivering
durability at a lower cost compared to similar aluminum, wood and plastic
products while the functional shutters enhance the exterior appearance of the
home and can be manufactured to meet certain hurricane codes. The
injection-molded exterior products feature co-polymer construction and U.V.
stabilized molded-through color.
o Decorative Shutters. Tapco offers the industry's most complete
line of standard and custom plastic window shutters, with an
extensive number of sizes and colors. Standard shutters, both
open louver and raised panel, are available in two widths, 14
standard lengths, 20 colors and paintable. Style-a-Shutter,
Tapco's line of custom shutters and matching shutter
components, is available in up to 13 widths, practically any
length, 24 styles, 18 colors and paintable. All of Tapco's
shutters feature the Shutter-Lok fastening system, which
facilitates ease of installation on any siding material
including wood, aluminum, vinyl, stucco, hardboard or brick.
o Gable Vents. GableMaster gable vents accommodate any
architectural style with over 35 size and design variations
available in over 220 colors including paintable and
stainable. Style-a-Vent, Tapco's line of custom vents, is
available in many shapes and sizes and in two colors.
GableMaster vents not only provide the needed ventilation, but
also add an important aesthetic benefit to a home. Each gable
vent features a patented lock-on ring, which significantly
reduces installation time by eliminating the need for caulking
or channeling and, like Tapco's shutters, can be easily
installed on any siding material. The GableMaster product line
is screened for insect protection and includes a double baffle
system for weather resistance.
o Mounting Blocks. Tapco manufactures the industry's most
extensive line of mounting blocks, used for the mounting of
exterior fixtures such as lights, electrical outlets, faucets,
doorbells, and address plates. Each mounting block also
features a patented lock-on ring for easy installation and
comes in 27 different styles and over 220 colors.
o Roof Vents. Tapco produces a line of roof ventilation
products, including ridge, hip, and stack covers. Tapco
believes that its roof ventilation products are the industry
leaders in terms of functionality, durability, and appearance.
o Specialty Vents. Tapco manufactures a broad line of specialty
vents, including air intake and exhaust vents, dryer vents and
foundation vents in over 200 colors including paintable.
10
o Functional Shutters. Tapco manufactures functional shutter
systems for storm protection and decorative applications under
the Atlantic Premium Shutters brand. They are available in
numerous styles and almost any size and any color.
o Specialty Siding. Tapco manufactures specialty siding (replica
cedar and shake siding) under the Foundry brand. Tapco's
specialty siding product is available in 13 different profiles
and more than 40 different colors. The siding can be used for
accent applications or whole house applications and can be
installed easily by a professional siding installer. The
Foundry's specialty siding utilizes a proprietary extrusion
and in-line forming process for production, as opposed to the
injection-molded process utilized by most competitors. The
extrusion process allows for changes in profiles and panel
dimensions at a lower cost than injection molding. This cost
savings has allowed Tapco to sell it at a lower price point
than traditional injection molded specialty siding products.
In addition, the installation process of Tapco's specialty
siding is the same as traditional siding, unlike the
specialized installation process required by competitors'
specialty siding products. The Foundry siding can be installed
faster and with less scrap than its injection-molded specialty
siding competitors. These characteristics increase the
profitability of using The Foundry's product relative to other
types of vinyl siding.
o Window and Door Trim. Tapco also manufactures a variety of
other window and door trim items such as window headers, door
surrounds and exterior trim. These items are available in over
22 colors and will fit most windows and doors.
o Professional Tools. Tapco believes it is the largest
manufacturer of portable cutting and shaping tools for the
professional siding contractor in the United States. These
tools enable installers of vinyl and aluminum siding to form
virtually any required shape on-site. Tapco's principal
installation tool is the bending brake. Brakes hold sheet
metal in place for bending and cutting during the installation
process. Tapco's MAX II, Pro-14 and Pro-19 brakes feature deep
working areas, enabling greater flexibility in making any
shape, and strong locking systems. Tapco's Pro-III
Port-O-Bender is the best selling portable brake. Tapco also
manufactures a brake, the MAX II Port-O-Bender, that is
designed to shape heavier gauge metal that is typically used
in commercial buildings. Tapco also offers numerous
accessories for brakes which include the Pro Cut-Off,
Side-Winder and Brake Buddy.
Distribution. Tapco's products are distributed throughout the United
States and Canada through four primary distribution channels: one-step
distributors that sell directly to contractors, two-step distributors that sell
Tapco's products to lumberyards and one-step distributors, retail home
centers/mass merchandisers, and manufactured housing.
Tapco distributes its accessory products to the one-step and two-step
distribution channels under the Mid-America Siding Components brand; the Foundry
brand, and the Atlantic Premium Shutters brand. Tapco distributes its accessory
products to the retail mass merchandiser channel through Builders Edge(R) and
Vantage(R) brands. Tapco distributes its products to the manufactured housing
industry through Manufactured Housing Products ("MHP"), a division of Metamora
Products Corporation. MHP has an exclusive supplier relationship with one of the
largest distributors to the manufactured housing market. Tapco also distributes
its products through all of the major vinyl siding, roofing, and window
distributors. Many competitors, in contrast, manufacture accessory products as
an adjunct to their core siding business.
Tapco's large number of distribution points is due in large part to the
strong customer "pull thru" demand for its products. Tapco seeks to be the
leader in each meaningful distribution channel by providing the broadest
selection of products coupled with high levels of customer service. Tapco is
able to secure multiple distribution points in local markets because its
products are not limited to any of the major branded roofing, siding, window and
door distributors. Many of Tapco's competitors offer products as an adjunct to
their core roofing, siding, window or door operations. As a result, their
distribution is typically limited to the authorized distributor of their core
branded products.
Sales and Marketing Organization. Tapco's sales and marketing
organization supports the one-step, two-step distribution, and retail channels
through various networks of sales support that include almost 200 independent
sales representatives and a small group of business development managers,
regional sales managers and sales executives.
Tapco maintains relationships with thousands of local contractors,
professional builders, and other end-users by participating in over 1,000 local
shows and five national shows annually. Local shows, sponsored by local
distributors, enable Tapco to promote its products through hands-on comparisons
11
to competing products. These shows enable Tapco to receive useful feedback from
local contractors, which leads to new product ideas, as well as significant
goodwill within the trade.
Tapco supports distributors with product literature, displays, DVDs,
product training programs and showroom merchandising designed to increase
awareness among homeowners and contractors about the benefits of Tapco's
products. In addition, Tapco maintains a large mailing list of active
contractors, which Tapco gathers from warranty registration cards, local and
national shows and requests for CDs and product literature.
Major Customers. Tapco has a large customer base. Because all of the
one- and two-step distributors have multiple locations and each individual
location has autonomy to stock various products from different suppliers, the
number of ship-to locations is a better measure of the breadth of sales than is
the total number of customers. In the residential home improvement and building
products market, Tapco has over 4,500 non-retail ship-to locations and over
5,400 retail ship-to locations. Sales are broadly diversified across customers
and ship-to locations. For fiscal 2005, two retail home center customers
together represented approximately 22% of Tapco's total sales.
Manufacturing. Tapco conducts its manufacturing, distribution and sales
operations through 14 facilities, which total approximately 850,000 square feet.
Tapco's manufacturing assets include more than 100 injection molding presses,
almost all of which are automated through robotics or conveyor systems. Robotic
automation has reduced cycle times and helped reduce waste by keeping cycle
times consistent from part to part. Tapco has realized cycle time improvements
on all presses utilizing automation. Tapco's high volume allows it to invest in
multi-cavity tooling, resulting in significantly lower unit costs over single
cavity tooling.
Tapco follows strict quality control standards in its efforts to
produce products of consistent quality and free of production flaws. Any
nonconforming plastic parts are reused as raw material, further minimizing
waste. Tapco mandates quality control checks at each step of the manufacturing
process.
Sources of Available Raw Materials. Tapco has long-standing
relationships with its major suppliers. The raw materials Tapco purchases
include polypropylene and styrene pellets, plastic extrusions, and packaging
materials for Tapco's building product lines. Tapco primarily purchases
polypropylene and styrene from single (separate) suppliers. In addition, Tapco
purchases fabricated anodized aluminum, hinges and other components, and
packaging materials for its professional installation tools. Historically, Tapco
has not experienced difficulty in obtaining raw materials or components to meet
its production requirements. From time to time, prices for some of the raw
materials used in Tapco's production/assembly process fluctuate significantly.
Although Tapco does not have any contracts with its suppliers and purchases
supplies on a purchase order basis, Tapco occasionally makes volume purchases of
materials to lock-in pricing.
Headwaters Technology Innovation Group
Headwaters Technology Innovation Group, Inc., together with its
subsidiaries and affiliates (collectively "HTI"), provides research and
development support to Headwaters. HTI maintains a staff of engineers,
scientists and technicians with expertise in the design and operation of
high-pressure and temperature process plants at its Lawrenceville, New Jersey
pilot plant and laboratory facilities. The following are some of the
technologies currently under development.
o Nanocatalyst Technology. HTI has developed the capability to work at
the molecular level in the composition, aligning, spacing and adhering
of nano-sized crystals of precious and transition metals on substrate
materials. The net effect is higher performance with lower precious
metal content, nearly 100% selectivity for certain chemical reactions
(i.e., the desired reaction is maximized with byproducts and waste
minimized), long life and custom designed nanocatalysts. Potential
applications for this nanotechnology include new processes for direct
synthesis of hydrogen peroxide for the production of chemicals such as
propylene oxide. This same technique can also be used to improve
existing catalysts for chemical and refining processes. Applications
under pilot scale development include a naphtha reforming catalyst for
gasoline blending and synthetic fibers and plastics, and a NOx
reduction catalyst for coal combustion in collaboration with Headwaters
Energy Services. HTI is also conducting laboratory testing on the
application of the technology to volatile organic compound oxidation,
high performance catalysts for fuel cells and pharmaceuticals, and
production of nanomaterials and nanofillers such as carbon nanorings
and flame retardants. HTI does not necessarily plan to commercially
produce all of these products in their highly competitive and regulated
industries but is exploring partnerships to develop, manufacture and
market nanocatalysts and other products. In September 2004 HTI entered
into a joint venture with Degussa AG, located in Dusseldorf, Germany,
to develop and commercialize a process for the direct synthesis of
hydrogen peroxide (H2O2). The venture aims to invest in large
12
facilities to produce low-cost hydrogen peroxide for chemical
intermediates. High-volume producers will be able to use the H2O2 from
these facilities to produce intermediates such as propylene oxide (PO).
Subject to terms and conditions of the agreement, the joint venture
intends to complete process development by 2007, and will be
responsible for any subsequent development and commercialization of
manufacturing facilities. In October 2005, the joint venture announced
the success of pilot plant operations and the building of a
demonstration plant expected to commence operations in 2006, the next
step in commercial development of the process.
o Coal Liquefaction Technology. HTI's technology for producing clean
liquid fuels from coal was evaluated during 2005 in a commercial
prefeasibility study commissioned by Oil India Limited, a Government of
India enterprise. Oil India is a public sector company engaged in
energy services in the Assam Region of northeastern India, and area
rich in natural resources but distant from established oil refining
operations. HTI believes that its direct coal liquefaction ("DCL")
technology may assist Oil India in converting the Assam region's
abundant and soluble coal into transportation fuels. The technology
involved encompasses some of the same elements that the Shenhua Group,
China's largest coal company, purchased from HTI in 2004 for their DCL
project in Majiata, China. HTI also has developed a catalyst
specifically designed for application in slurry-phase Fischer-Tropsch
("FT") reactors that convert gaseous materials into a range of liquid
fuels and chemicals, e.g., propylene. When the FT process is applied to
gas derived from coal, the process is referred to as indirect coal
liquefaction ("ICL"). Headwaters has entered into agreements with the
government of the Philippines and with a private company in China, for
feasibility and pilot plant studies related to site-specific
applications of HTI's coal-to-liquids technologies, including both
direct and indirect coal liquefaction. In August 2005 Headwaters
announced that it was investigating potential development of ICL liquid
fuels projects in the United States.
o Heavy Oil Upgrading Technology. HTI holds an exclusive, worldwide
license to develop, market and sublicense a unique technology known as
"(HC)3TM", for the catalytic hydrocracking of heavy residual oils such
as petroleum vacuum residue (so-called "bottom of the barrel") and tar
sand bitumen. The process uses a proprietary, highly active,
molecular-scale catalyst to efficiently convert all components of heavy
oils, including the asphaltenic components, which are generally
considered the most difficult to process. In 2005, Headwaters entered
into an agreement to begin the basic engineering design of a
grass-roots plant for North West Upgrading LLC of Calgary, Canada. That
plant, which will feature a 25,000 barrel-per-day (HC)3 heavy oil
hydrocracker, was being designed by HTI at the end of 2005 and is
scheduled to come on-stream in 2009. Additionally, HTI plans to
continue discussions with operators of several heavy oil upgrading
facilities (in the U.S. and overseas) to explore how the addition of
the (HC)3 technology to their existing refineries could increase
product yields and reduce downtime caused by equipment fouling with
minimal modifications to the existing facilities. In November 2005
Headwaters announced that HTI had begun its first commercial scale
demonstration of the (HC)3 technology at a large commercial refinery.
Segments and Major Customers
Headwaters operates in three business segments, construction materials,
CCPs and alternative energy. Additional information about segments is presented
in Note 4 to the consolidated financial statements. The following table presents
revenues for all customers that accounted for over 10% of total revenue during
2003 and 2004. All of these revenues are attributable to the alternative energy
segment. No customer accounted for over 10% of total revenue in 2005.
(in thousands) 2003 2004
-----------------------------------------------------------------------
Pace Carbon Fuels, L.L.C. affiliates Less than 10% $57,602 (10.4%)
DTE Energy Services, Inc. affiliates $42,013 (10.8%) Less than 10%
Research and Development
In 2003, Headwaters' research and development expenses were $5.0
million, attributable primarily to activities at HTI and HRI. In 2004, research
and development expenses increased to approximately $7.6 million, with the
increase attributable primarily to activities at HTI. In 2005, Headwaters'
research and development expenses were approximately $12.6 million, with the
increase again primarily attributable to HTI.
13
Competition
Each of Headwaters' business units experiences competition. Many of our
competitors have greater financial, management and other resources, and may be
able to take advantage of acquisitions and other opportunities more readily.
Coal-based solid alternative fuels made using HES' technologies, from
which we derive license fee revenues and revenues from sales of chemical
reagents, compete with other alternative fuel products, as well as traditional
fuels. For HES, competition may come in the form of the marketing of competitive
chemical reagents and the marketing of end products qualifying as alternative
fuel. HES competes with other companies possessing technologies to produce
coal-based solid alternative fuels and companies that produce chemical reagents
such as Nalco Chemical Company and Accretion Technologies, LLC.
HES also experiences competition from traditional coal and fuel
suppliers and natural resource producers. Further, many industrial coal users
are limited in the amount of alternative fuel product they can purchase from
HES' licensees because they have committed to purchase a substantial portion of
their coal requirements through long-term contracts for standard coal.
The business of marketing traditional CCPs is intensely competitive.
HRI has substantial competition in two main areas: obtaining CCP management
contracts with utility and other industrial companies; and marketing CCPs and
related industrial materials. HRI has a presence in every region in the United
States but, because the market for the management of CCPs is highly fragmented
and because the costs of transportation are high relative to sales prices, most
of the competition in the CCP management industry is regional. There are many
local, regional and national companies that compete for market share in these
areas with similar products and with numerous other substitute products.
Although HRI has a number of long-term CCP management contracts with its
clients, some of these contracts provide for the termination of the contract at
the convenience of the utility company upon a minimum 90-day notice. Moreover,
certain of HRI's most significant regional CCP competitors appear to be seeking
a broader national presence. These competitors include Lafarge North America
Inc., Boral Material Technologies Inc. and Cemex. Construction materials are
produced and sold regionally by the numerous owners and operators of concrete
ready-mix plants. Producers with sand and gravel sources near growing
metropolitan areas have important transportation advantages.
HCM has competition from numerous, larger manufacturers of mortars,
stuccos and concrete masonry units. With respect to concrete masonry units,
national and regional competition includes Oldcastle, Featherlite and Pavestone.
In addition, notwithstanding Eldorado's large market share as a producer of
manufactured architectural stone, Eldorado faces significant competition from
other national and regional producers of similar products, and in particular
from Owens Corning. Tapco's primary competition includes Alcoa and Pinckney in
the accessories market, and CertainTeed and Nailite in the specialty siding
market.
HTI also experiences competition from many of the world's major energy
and chemical companies. Major catalyst developers include Johnson Matthey and
Engelhard, among others. Those companies are devoting significant resources to
researching and developing nanocatalysts and catalytic processes. These
companies have greater financial, management and other resources than we have.
Positive and Negative Factors. There are positive and negative factors
pertaining to the competitive position of Headwaters and its subsidiaries. HRI's
competitive position has positive factors of a leading market position and
long-term contracts. In addition, HRI has built a nationwide CCP distribution
system not enjoyed by its competition. Negatively, HRI is sometimes adversely
affected by inclement weather slowing concrete construction (the largest market
for CCPs). HRI is also facing increasingly aggressive competition in marketing
and sales of CCPs.
HES enjoys the benefits of a leading market position in the Section 29
licensing and reagent sales businesses, license agreements that extend through
the life of Section 29, and a manufacturing process and reagent products that
have withstood IRS scrutiny. From a broader alternative fuel industry
perspective, HES suffers from greater dependence on United States tax policy and
administration than some competitors in alternative fuels.
HCM's block and bagged products business is not national in breadth,
although the block business enjoys a strong regional market position in Texas.
Where its market strength is limited, the HCM block and bagged products
businesses do not have strong economies of scale, price leadership, and have
only limited product brand strength.
Eldorado's competitive position has some identifiable positive factors.
Eldorado has developed a recognized name in the manufactured stone veneer
industry and a strong market share. Its product has excellent authenticity and
broad selection alternatives. Negatively, Eldorado has a limited, albeit
14
growing, distribution network, strong competition from regional producers that
do not have long shipping routes, and financial limitations that may not be
shared by its largest national competitor.
Tapco has a leading market position in its siding accessories business
because of its strong ability to manufacture and distribute a broad range of
products economically and rapidly. However, Tapco's strong market position
suggests that its future growth will come largely from finding new products to
put into its manufacturing and distribution channels, not from increasing market
share in the siding accessories industry.
Most of Headwaters' business units are experiencing greater competition
for key raw materials including latex, styrene, polypropylene, cement and
aggregates. This competition has contributed to shortages and price increases
for raw materials used by Headwaters.
Intellectual Property
Below is a summary of Headwaters' intellectual property. Collectively,
the intellectual property is important to Headwaters, although there is no
single patent or trademark that is itself material to Headwaters at the present
time.
Headwaters itself has one registered trademark and one pending
trademark application.
Headwaters Energy Services has nine U.S. patents and one registered
trademark.
Headwaters Technology Innovation Group has 17 U. S. patents and 35 U.S.
patent applications pending. There are also 16 foreign patents applications
pending. Headwaters Technology Innovation Group has six U.S. registered
trademarks and one pending application.
Headwaters Resources has 13 U.S. patents and 7 U.S. patent applications
pending. Headwaters Resources also has two foreign patents with five pending
foreign applications. Headwaters Resources has 15 U.S. registered trademarks and
four pending applications.
Headwaters Construction Materials has 81 U.S. patents and 40 U.S.
patent applications pending (primarily for Tapco). There are 12 foreign patents
and five foreign patent applications pending. Headwaters Construction Materials
has 58 U.S. registered trademarks, 35 U.S. trademark applications pending, 21
foreign trademarks, and 27 foreign trademark applications pending.
There can be no assurance as to the scope of protection afforded by the
patents. In addition, there are other technologies in use and others may
subsequently be developed, which do not, or will not, utilize processes covered
by the patents. There can be no assurance that Headwaters' patents will not be
infringed or challenged by other parties or that Headwaters will not infringe on
patents held by other parties. Because many of these patents represent new
technology, the importance of the patents to Headwaters' business will depend on
its ability to commercialize these technologies successfully, as well as its
ability to protect its technology from infringement or challenge by other
parties.
In addition to patent protection, Headwaters also relies on trade
secrets, know-how, and confidentiality agreements to protect these technologies.
Despite these safeguards, such methods may not afford complete protection and
there can be no assurance that others will not either independently develop such
know-how or unlawfully obtain access to Headwaters' know-how, concepts, ideas,
and documentation. Since Headwaters' proprietary information is important to its
business, failure to protect ownership of its proprietary information would
likely have a material adverse effect on Headwaters.
Regulation
Section 29. Headwaters' coal-based solid alternative (or synthetic)
fuel business is subject to compliance with the terms of Section 29 of the
Internal Revenue Code. Under current law, Section 29 tax credits for alternative
fuel produced from coal expires on December 31, 2007. There have been
initiatives from time to time to consider the early repeal or modification of
Section 29. For example, in 2005, a bill was introduced in the United States
House of Representatives that would repeal the Section 29 credit for alternative
fuel produced from coal. While this bill did not pass Congress, it or other or
similar legislation could be reintroduced in the future. In August 2005,
Congress enacted the Energy Policy Act of 2005, which redesignated the Section
29 tax credit as a Section 45K general business credit, effective January 1,
2006.
The IRS has suspended the issuance of private letter ruling ("PLRs") to
alternative fuel facility owners several times in the past. Most recently, in
June 2003, the IRS stated, in summary, in Announcement 2003-46 that it "has had
reason to question the scientific validity of test procedures and results that
have been presented as evidence that fuel underwent a significant chemical
15
change, and is currently reviewing information regarding these test procedures
and results," and that pending its review of the issue it was suspending the
issuance of new PLRs regarding significant chemical change.
The IRS release of Announcement 2003-46 caused certain of Headwaters'
licensees to reduce or cease alternative fuel production, which resulted in a
reduction of Headwaters' revenue and net income. In October 2003, the IRS stated
in summary in Announcement 2003-70 that it continues to question whether
processes it had approved under its long-standing ruling practice produce the
necessary level of chemical change required under Section 29 and Revenue Ruling
86-100. Nonetheless, the IRS indicated that it would continue to issue PLRs
regarding chemical change under the standards set forth in Revenue Procedures
2001-30 and 2001-34, and that the industry's chemical change test procedures and
results are scientifically valid if applied in a consistent and unbiased manner.
Although the IRS resumed its practice of issuing PLRs, it expressed continuing
concerns regarding the sampling and data/record retention practices prevalent in
the alternative fuels industry, and PLRs issued following the release of
Announcement 2003-70 have required taxpayers (i) to maintain sampling and
quality control procedures that conform to American Society for Testing and
Materials or other appropriate industry guidelines at the alternative fuel
facilities, (ii) to obtain regular reports from independent laboratories that
have analyzed the fuel produced in such facilities to verify that the coal used
to produce the fuel undergoes a significant chemical change and (iii) to
maintain records and data underlying the reports that taxpayers obtain from
independent laboratories including raw Fourier Transform InfraRed ("FTIR") data
and processed FTIR data sufficient to document the selection of absorption peaks
and integration points.
Also in October 2003, the United States Senate Permanent Subcommittee
on Investigations issued a notification of pending investigations. The
notification listed the alternative fuel tax credit as a new item. In July 2005,
the Subcommittee described its investigation as follows: "The Subcommittee is
continuing its investigation [of] tax credits claimed by Section 29 of the
Internal Revenue Code for the sale of coal-based synthetic fuels. The
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 then, there has been
little activity on the investigation. The effect that the Senate subcommittee
investigation of alternative fuel tax credits may have on the industry is
unknown. If the investigation results in a negative Subcommittee report, it may
have a material adverse effect on the willingness of buyers to engage in
transactions to purchase alternative fuel facilities or on the willingness of
current owners to operate their facilities, and may materially adversely affect
Headwaters' revenues and net income. The Subcommittee has not scheduled a
hearing of the date hereof. Headwaters cannot predict the timing or ultimate
outcome of the Subcommittee investigation, nor whether Congress or others may
conduct investigations of Section 29 tax credits in the future.
Section 29 Phase-Out. In addition, tax credits claimed by an
alternative fuel plant operator may begin to be phased out or eliminated prior
to the expiration date of December 31, 2007, if the "reference price" of oil
exceeds an annual range of oil prices, adjusted annually for inflation. In April
2005, the IRS announced that the phase-out range for 2004 began at a reference
price of $51.35 per barrel and ended with a $0 tax credit at $64.47 per barrel.
Because the calendar year 2004 reference price of oil was below the bottom end
of the range, there was no phase-out of the credit for qualified fuel sold in
2004. Bases upon 2005 oil prices as of the date hereof, Headwaters does not
believe that there will be any phase-out of Section 29 tax credits for calendar
2005. It is not possible to predict whether oil prices for 2006 might result in
a tax credit phase-out in calendar 2006.
The reference price of oil and the inflation adjustment factor ("IAF")
are determined annually (and released in the first week of April for the
previous year), while the predetermined oil price range is fixed, but adjusted
annually for inflation. The reference price of oil is defined as the annual
average wellhead price per barrel for all. domestic crude oil not subject to
regulation by the U.S. There are approximately 24 states/regions that comprise
the U.S. average crude oil price as determined by the United States Energy
Information Administration, with western U.S. crude oil prices often
significantly lower than other, more recognized crude oil types.
Licensees are subject to audit by the IRS. The IRS may challenge
whether Headwaters' licensees satisfy the requirements of Section 29, or
applicable PLRs, including placed-in-service requirements, or may attempt to
disallow Section 29 tax credits for some other reason. The IRS has initiated
audits of certain licensee-taxpayers who claimed Section 29 tax credits, and the
outcome of any such audit is uncertain. The inability of a licensee to claim
Section 29 tax credits would reduce Headwaters' future income from the licensee.
16
Environmental. Headwaters' operations and those of its suppliers and
customers involved in coal-based energy generation, primarily utilities, are
subject to federal, state and local environmental regulation. The coal-based
solid synthetic fuel operations of Headwaters and its licensees are subject to
federal, state and local environmental regulations that impose limitations on
the discharge of pollutants into the air and water and establish standards for
the treatment, storage and disposal of waste products, which add to the cost of
doing business and expose Headwaters to potential fines for non-compliance.
Moreover, in order to establish and operate the synthetic fuel plants, power
plants and operations to collect and transport CCPs and bottom ash, Headwaters'
and its licensees and customers have obtained various state and local permits
and must comply with processes and procedures that have been approved by
regulatory authorities. Compliance with permits, regulations and the approved
processes and procedures help protect against pollution and contamination and
are critical to Headwaters' business. Any failure to comply could result in the
issuance of substantial fines and penalties and cause Headwaters to incur
environmental liabilities.
Headwaters believes that all required permits to construct and operate
these solid alternative fuel facilities have been or will be obtained and
believe the facilities are in substantial compliance with all relevant laws and
regulations governing alternative fuel operations.
In spite of safeguards, Headwaters' operations entail risks of
regulatory noncompliance or accidental discharge that could create an
environmental liability because hazardous materials are used or stored during
normal business operations. For example, Headwaters and its subsidiaries use and
share other hazardous chemicals in order to conduct operations involving
distillation to purify products, analysis, packaging of chemicals and the
selling, warehousing and manufacturing of organic chemicals in small research
volumes. Headwaters' subsidiaries also use their facilities to perform research
and development activities involving coal, oil, chemicals and industrial gases
such as hydrogen. As a result, petroleum and other hazardous materials have been
and are present in and on their properties. Headwaters generally hires
independent contractors to transport and dispose of any hazardous materials
generated and send any hazardous wastes only to federally approved, large scale
and reputable off-site waste facilities.
The federal Clean Air Act of 1970 and subsequent amendments
(particularly the Clean Air Act Amendments of 1990), and corresponding state
laws, which regulate the emissions of materials into the air, affect the coal
industry both directly and indirectly. The coal industry is directly affected by
Clean Air Act permitting requirements and/or emissions control requirements,
including requirements relating to particulate matter (such as, "fugitive
dust"). The coal industry may also be impacted by future regulation of fine
particulate matter measuring 2.5 micrometers in diameter or smaller. In July
1997, the EPA adopted new, more stringent National Ambient Air Quality
Standards, or NAAQS, for particulate matter and ozone. Although the NAAQS were
challenged in litigation, slowing their implementation, the standards were
upheld by the United States Supreme Court, and states will ultimately be
required to revise their existing state implementation plans ("SIPs") to attain
and maintain compliance with the new NAAQS. The new eight-hour ozone
nonattainment designations and classifications were published April 30, 2004,
along with Phase 1 of the final implementation rule for the eight-hour standard.
Both rules took effect June 15, 2004, and both are currently being litigated.
EPA signed the final Phase 2 implementation rule for the eight-hour standard on
November 9, 2005 (the rule has not yet been published in the Federal Register).
EPA published the final nonattainment designations for fine particulate matter
(PM 2.5) on January 5, 2005, effective April 5, 2005; and published the proposed
PM 2.5 implementation rule on November 1, 2005. Because electric utilities emit
NOx, which are precursors to ozone and particulate matter, HRI's utility
customers are likely to be affected when the new NAAQS are implemented by the
states. State and federal regulations relating to fugitive dust and the
implementation of the new NAAQS may reduce HRI's sources for its products. The
extent of the potential impact of the new NAAQS on the coal industry will depend
on the policies and control strategies associated with the state implementation
process under the Clean Air Act.
The 1990 Clean Air Act Amendments require utilities that are currently
major sources of NOx in moderate or higher ozone non-attainment areas to install
reasonably available control technology for NOx. EPA promulgated a rule (the
"NOx SIP call") in 1998 requiring 22 eastern states to make substantial
reductions in NOx emissions. Court action eliminated one state and portions of
two others from the rule. Under this rule, EPA expects that states will achieve
these reductions by requiring power plants to make substantial reductions in
their NOx emissions. The affected states were required to implement Phase I of
the NOx SIP call by May 31, 2004. On April 21, 2004, EPA published Phase II of
the NOx SIP call, which will require an additional reduction of about 100,000
tons of NOx per year by 2007. In addition to the NOx SIP call, EPA's April 21,
2004 rule also addressed the requirement that it directly regulate NOx emissions
from states upwind of four eastern states that petitioned EPA (pursuant to
section 126 of the Clean Air Act). The section 126 rule will be withdrawn in any
17
state that submits an approvable NOx SIP. Installation of reasonably available
control technology and additional control measures required under the NOx SIP
call or the section 126 rule will make it more costly to operate coal-fueled
utility power plants and, depending on the requirements of individual SIPs,
could make coal a less attractive fuel alternative in the planning and building
of utility power plants in the future. The effect such regulation or other
requirements that may be imposed in the future could have on the coal industry
in general and on HRI in particular cannot be predicted with certainty. No
assurance can be given that the ongoing implementation of the Clean Air Act
(including the 1990 Amendments) or any future regulatory provisions will not
materially adversely affect HRI.
In addition, the 1990 Clean Air Act Amendments require a study of
utility power plant emissions of certain toxic substances, including mercury,
and direct EPA to regulate emissions of these substances, if warranted. EPA has
submitted reports to Congress on Mercury (1997) and Utility Air Toxics (1998).
On December 14, 2000, EPA announced its finding that regulation of hazardous air
pollutant emissions from oil- and coal-fueled electric utility steam generating
units is necessary and appropriate. However, on March 29, 2005, EPA published a
notice revising the regulatory finding, and removing oil- and coal-fueled
electric utility steam generating units from the list of hazardous air
pollutants. Its rationale was partly based on two other rules promulgated at
approximately the same time it took this action. On May 18, 2005, effective July
18, 2005, EPA published the final Clean Air Mercury Rule, for reducing mercury
emissions from new or reconstructed coal-burning power plants under the New
Source Performance Standards program (rather than the hazardous air pollutant
program). Additionally, on May 12, 2005, EPA published the Clean Air Interstate
Rule, which would require coal-burning power plants to upgrade their facilities
to reduce emissions of sulfur dioxide ("SOx") and NOx (and which, EPA
determined, would also contribute to reduction of mercury emissions as a
co-benefit). Taken together, these rules, if they are implemented in their
current form, could result in reduced use of coal if utilities switch to other
sources of fuel. However, all three rulemakings are currently being challenged
in litigation. In addition, petitions for reconsideration have been submitted to
EPA for all three rulemakings. On October 28, 2005, EPA published notices
granting petitions for reconsideration of both: (i) certain aspects of the Clean
Air Mercury Rule; and (ii) the action removing certain electric utility steam
generating units from the hazardous air pollutant program. EPA has not yet
announced its decision on pending petitions for reconsideration of the Clean Air
Interstate Rule. In light of the ongoing litigation and reconsideration
activities, one or more of these rules ultimately may be revised in ways that
cannot presently be anticipated.
The Clear Skies Initiative, first announced by the Bush Administration
in February 2002, seeks to develop strategies for reducing emissions of SOx, NOx
and mercury from power plants. Because the Initiative must be implemented by
legislation that has not yet been enacted, its effect on HRI cannot be
determined at this time. Neither the Clear Skies legislation nor the competing
four-pollutant bills for power plants (which would additionally regulate the
greenhouse gas carbon dioxide) were enacted in the 108th Congress. The
Administration announced its intent to make enactment of Clear Skies legislation
a priority in the 109th Congress, and accordingly reintroduced the Clear Skies
Initiative in January 2005 (S. 131). Four-pollutant legislation (S. 150) has
also been introduced in 2005, and the disagreement over regulation of carbon
dioxide resulted in the failure of S. 131 to make it out of committee. If
enacted, S. 150, which has been referred to the Senate Committee on Environment
and Public Works, could result in reduced use of coal if utilities switch to
other sources of fuel as a means of complying with more stringent emission
limits. Many of the goals of Clear Skies legislation will be accomplished by the
final Clean Air Mercury Rule and the Clean Air Interstate Rule (see discussion
above).
In an effort to stimulate the use of clean coal, the recently enacted
Energy Policy Act of 2005 provides funding for the deployment of clean coal
technologies. The Act requires the Secretary of Energy to establish periodic
milestones for funded projects, by the year 2020, to remove at least 97% of
sulfur dioxide; to emit no more than .08 lbs of NOx per million Btu; to achieve
at least 90% reductions in mercury emissions; and to achieve a thermal
efficiency of at least 43% for coal of more than 9,000 Btu, 41% for coal of
7,000-9,000 Btu; and 39% for coal of less than 7,000 Btu.
Coal-fueled boilers have been impacted by regulations under the 1990
Clean Air Act Amendments, which established specific emissions levels for SOx
and NOx in order to reduce acid rain. These emissions levels have required
utilities to undertake many of the following changes: change their fuel
source(s), add scrubbers to capture SOx, add new boiler burner systems to
control NOx, add or modify fuel pulverizers/air handling systems to control NOx,
introduce flue gas conditioning materials to control particulate emissions in
conjunction with meeting SOx emissions targets and in some very isolated cases
shut down a plant. All of these changes can impact the quantity and quality of
CCPs produced at a power plant and can add to the costs of operating a power
plant. Furthermore, the Clean Air Mercury Rule could result in implementation of
additional technologies at power plants that could negatively affect fly ash
quality.
Inappropriate use of CCPs can result in faulty end products. In some
cases the products marketed by HRI consist of a mixture of client-supplied
18
materials, including CCPs, HRI does not in all cases control the quality of the
final end product, but may share such control with the manufacturer of the
ingredient materials. Therefore, there is a risk of liability regarding the
quality of the materials and end products marketed by HRI. In cases where HRI is
responsible for end-product quality, such as a structural fill (where material
is used to fill a cavity or designated area), HRI depends solely on its own
quality assurance program.
Materials sold by HRI vary in chemical composition. Fossil fuel
combustion wastes have been excluded from regulation as "hazardous wastes" under
subtitle C of the Resource Conservation and Recovery Act ("RCRA"). However, EPA
has determined that national regulations under subtitle D of RCRA (dealing with
state and regional solid waste plans) are warranted for coal combustion
byproducts disposed of in landfills or surface impoundments, or used to fill
surface or underground mines. EPA is planning to publish proposed rules for CCPs
generated by commercial electric power producers in August 2006 and for
management of CCPs at mine facilities in October 2007 which will address, among
other things, state and regional solid waste plans for CCPs disposed of in
landfills or surface impoundments, or used to fill surface or underground mines.
These proposed rules could make coal burning more expensive or less attractive
to HRI's utility clients. HRI manages a number of landfill and pond operations
that may be affected by EPA's proposed regulations. In most of these operations
the permitting is contractually retained by the client and the client would be
liable for any costs associated with new permitting requirements. The effect of
such regulations on HRI cannot be completely ascertained at this time.
HRI is engaged in providing services at one landfill operation that is
permitted and managed as a hazardous waste landfill. HRI provides the services
necessary to landfill the client's hazardous wastes and operates certain
in-plant equipment and systems for the client. Accordingly, there can be no
assurance that HRI will not be named in third-party claims relating to the
project.
CCPs may contain small concentrations of metals that are considered as
"hazardous substances" under the Comprehensive Environmental Response
Compensation and Liability Act ("CERCLA"). Land application of CCPs is regulated
by a variety of federal and state statutes, which impose testing and management
requirements to ensure environmental protection. Under limited circumstances,
mismanagement of CCPs can give rise to CERCLA liability.
A number of agencies are studying the issue of nanotechnology,
including the National Toxicology Program ("NTP"), the National Institute for
Safety and Health ("NIOSH"), and the U.S. Environmental Protection Agency
("EPA"). Many of these efforts are being coordinated through the interagency
Nanoscale Science, Engineering and Technology ("NSET") subcommittee of the White
House Office of Science and Technology Policy, National Science and Technology
Council. Nanoscale materials have been nominated to the NTP for toxicological
evaluation. NIOSH, EPA and the National Science Foundation are seeking
applications for research proposals on the potential implications of
nanotechnology and manufactured nanomaterials on human health and the
environment. In addition, EPA is studying how nanomaterials should be approached
under existing laws, such as the Toxic Substances Control Act, and whether new
regulations may be needed. One or more of these efforts may eventually result in
regulations which potentially could affect Headwaters' business in the area of
nanotechnology. At this time, it is not possible to say more precisely what form
these regulations may take.
Employees
Headwaters employs approximately 4,500 full-time employees. There are
approximately 70 employees in Headwaters' corporate administration. The
following lists the approximate number of employees by business unit:
Headwaters Energy Services, 35
Headwaters Resources, 735
Headwaters Technology Innovation Group, 60
Headwaters Construction Materials, 3,600
Forty-six employees work under collective bargaining agreements.
19
ITEM 2. PROPERTIES
Headwaters' headquarters are located at 10653 South River Front
Parkway, Suite 300, South Jordan, Utah 84095. The lease for this office space of
approximately 31,000 square feet has a term expiring July 2008. The monthly rent
is approximately $54,500, with certain adjustments for inflation plus expenses.
HES directs its operations primarily from Headwaters' South Jordan,
Utah location. HES leases a small parcel in Fluvanna County, Virginia and owns
approximately 30 acres in Carbon County, Utah for synfuel and coal cleaning
operations.
HTI owns approximately six acres in Lawrenceville, New Jersey where it
maintains offices and its research facilities.
HRI owns or leases 16 properties nationwide for its fly ash storage and
distribution operations with East, Central, and West regional divisions.
Headwaters Resources also conducts operations at more than 100 other sites via
rights granted in various CCP through-put, handling and marketing contracts (for
example, operating a storage or load-out facility located on utility-owned
properties).
HCM owns or leases 53 properties nationwide for its building products
manufacturing, distribution, and sales operations. Tapco is headquartered in
Wixom, Michigan and has major manufacturing facilities in Metamora, Michigan and
Elkland, Pennsylvania. Eldorado is headquartered in San Marcos, California and
has major manufacturing facilities in Rancho Cucamonga, California, Greencastle,
Pennsylvania and Dublin, Georgia.
ITEM 3. LEGAL PROCEEDINGS
Headwaters has ongoing litigation and asserted claims which have been
incurred during the normal course of business, including the specific matters
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 2005, Headwaters incurred approximately $4.3 million of expense for
legal matters, exclusive of costs for outside legal counsel. This amount
includes accruals for or payments made relating to settlements achieved, plus
Headwaters' estimates of the probable liability for unresolved matters, giving
consideration in certain instances to amounts for which Headwaters is willing to
settle. Headwaters currently believes the range of potential loss for all
unresolved matters, excluding costs for outside counsel, is from $4.0 million up
to the amounts sought by claimants and has recorded a total liability as of
September 30, 2005 of $4.0 million. Claims and damages sought by claimants in
excess of this amount are not deemed to be probable. 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 matters discussed below 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. Therefore, 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 $3.0 million in 2003, $3.8 million in 2004 and $5.4
million in 2005 (exclusive of a reimbursement of legal costs in 2005 for
approximately $6.5 million 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.
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
20
compensatory damages in the approximate amount of $2.75 million 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.
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 $175.0
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 are
expected to be received 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 limited to a maximum of $5.0 million
per quarter and 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 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).
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.
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 $15.0 million and $25.0 million and
punitive damages. The District Court has dismissed all claims against Headwaters
except conspiracy and constructive trust. The Court has scheduled trial for
February 2006. Because the resolution of the litigation is uncertain, legal
counsel cannot express an opinion as to the ultimate amount, if any, of
Headwaters' liability.
Headwaters Construction Materials Matters. There are litigation and
pending and threatened claims made against certain subsidiaries of 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
21
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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
22
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
Since April 6, 2005, the shares of Headwaters' common stock have traded
on the New York Stock Exchange under the symbol "HW." Prior to that time, the
shares traded on the Nasdaq National Market under the symbol "HDWR." Options on
Headwaters' common stock are traded on the Chicago Board Options Exchange under
the symbol "HQK." The following table sets forth for the periods presented, the
high and low trading prices of Headwaters' common stock as reported by the New
York Stock Exchange or Nasdaq, as applicable.
Fiscal 2004 Low High
- ----------- --- ----
Quarter ended December 31, 2003 $14.78 $20.87
Quarter ended March 31, 2004 19.50 25.99
Quarter ended June 30, 2004 19.50 29.60
Quarter ended September 30, 2004 23.12 32.02
Fiscal 2005
- -----------
Quarter ended December 31, 2004 $27.52 $34.96
Quarter ended March 31, 2005 26.31 34.49
Quarter ended June 30, 2005 29.08 35.57
Quarter ended September 30, 2005 33.90 45.75
As of November 18, 2005, there were 335 stockholders of record of
Headwaters' common stock. Headwaters has not paid dividends on its common stock
to date and does not intend to pay dividends on its common stock in the
foreseeable future. Pursuant to the terms of Headwaters' senior secured credit
arrangement (see Note 9 to the consolidated financial statements), Headwaters is
prohibited from paying cash dividends so long as any of the long-term debt is
outstanding. Headwaters intends to retain earnings to finance the development
and expansion of its business. Payment of common stock dividends in the future
will depend, among other things, upon Headwaters' debt covenants, its ability to
generate earnings, its need for capital, its investment opportunities and its
overall financial condition.
The information required by this item regarding equity compensation
plans is incorporated by reference to the information set forth in Item 12 of
this Annual Report on Form 10-K. See Note 12 to the consolidated financial
statements for a description of securities authorized for issuance under equity
compensation plans.
We did not make any unregistered sales of our equity securities during
the year ended September 30, 2005. We did not repurchase any shares of our
equity securities during the fourth quarter of the year ended September 30,
2005.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from the consolidated
financial statements of Headwaters. This information should be read in
conjunction with the consolidated financial statements, related notes and other
financial information included herein. The selected financial data as of and for
the years ended September 30, 2001 and 2002 and as of September 30, 2003 are
derived from audited financial statements not included herein. The selected
financial data as of September 30, 2004 and 2005 and for the years ended
September 30, 2003, 2004, and 2005 were derived from the audited financial
statements of Headwaters included elsewhere herein.
As more fully described in Notes 1 and 3 to the consolidated financial
statements, Headwaters acquired HTI in August 2001, HRI in September 2002, VFL
in April 2004, Eldorado Stone in June 2004, SCP in July 2004, and Tapco Holdings
in September 2004. All of these entities' results of operations for the periods
from the acquisition dates through September 30, 2005 have been consolidated
with Headwaters' results. None of their results of operations up to the dates of
acquisition have been included in Headwaters' consolidated results.
In 2001, Headwaters recorded approximately $7.5 million of income tax
benefit primarily related to the reduction of its deferred tax asset valuation
allowance. In 2004, Headwaters recognized revenue relating to funds deposited in
an escrow account totaling approximately $27.9 million, most of which related to
23
prior periods (see Note 14 to the consolidated financial statements). In
addition, revenue and net income for 2004 and 2005 were materially affected by
the 2004 acquisitions (see Note 3 to the consolidated financial statements). In
2005, Headwaters successfully settled certain litigation which resulted in
increased operating income, primarily related to prior periods, of approximately
$52.4 million (see Note 14 to the consolidated financial statements). Also in
2005, Headwaters early adopted the fair value method of accounting for
stock-based compensation required by SFAS No. 123R and recorded approximately
$33.8 million of stock-based compensation expense (see Note 12 to the
consolidated financial statements).
Year ended September 30,
------------------------------------------------------------------
(in thousands, except per share data) 2001 2002 2003 2004 2005
- ------------------------------------------------- ------------ ------------ ------------ ------------ --------------
OPERATING DATA:
Total revenue $45,464 $119,345 $387,630 $ 553,955 $1,064,639
Net income 21,517 24,286 36,631 64,317 121,278
Diluted earnings per share 0.87 0.94 1.30 1.88 2.79
As of September 30,
------------------------------------------------------------------
(in thousands) 2001 2002 2003 2004 2005
- ------------------------------------------------- ------------ ------------ ------------ ------------ --------------
BALANCE SHEET DATA:
Working capital $ 8,619 $ 15,023 $ 14,176 $ 44,387 $ 117,336
Net property, plant and equipment 2,680 50,549 52,743 157,611 190,450
Total assets 55,375 372,857 373,275 1,540,779 1,671,656
Long-term liabilities:
Long-term debt 149 154,552 104,044 914,641 601,811
Deferred income taxes -- 51,357 50,663 121,469 108,449
Other 8,711 5,442 4,703 10,338 37,345
------------ ------------ ------------ ------------ --------------
Total long-term liabilities 8,860 211,351 159,410 1,046,448 747,605
Total stockholders' equity 31,086 98,596 140,157 308,155 686,313
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with the information set forth under the caption entitled "ITEM 6. SELECTED
FINANCIAL DATA" and the consolidated financial statements and notes thereto
included elsewhere herein. Headwaters' fiscal year ends on September 30 and
unless otherwise noted, future references to years refer to Headwaters' fiscal
year rather than a calendar year.
Introduction
During the past several years, Headwaters has executed on its two-fold
plan of maximizing cash flow from its existing operating business units and
diversifying from over-reliance on the legacy alternative energy segment. With
the addition and expansion of the CCP management and marketing business through
the acquisitions of ISG in 2002 and VFL in 2004, and the growth of the
construction materials business, culminating in the acquisitions of Eldorado,
Tapco and SCP in 2004, Headwaters has achieved revenue growth and
diversification into three business segments. Because Headwaters also incurred
increased indebtedness to make strategic acquisitions, one of management's
ongoing financial objectives is to continue to focus on increased cash flows for
purposes of reducing indebtedness.
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 overly capital intensive, thus providing
additional cash flow that complements the financial performance of Headwaters'
existing business segments. Headwaters is also committed to continuing to invest
in HTI's research and development activities which are focused on energy-related
technologies and nanotechnology. In 2005, Headwaters announced a non-binding
memorandum of understanding to participate in a joint venture to build and
operate an ethanol plant. Headwaters continues to move forward on this project
24
and is also investigating other alternative energy projects such as coal
cleaning and the use of nanocatalysts to engineer coal for emissions reduction.
As a result of its diversification into CCPs and construction
materials, Headwaters is affected by seasonality, with the highest revenues and
profitability 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 its efforts to expand usage of
high-value CCPs and develop uses for lower-value CCPs, including the expanded
usage of CCPs in its construction materials businesses 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 may be 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 growth. In light of Headwaters' leading market shares in Eldorado's
and Tapco's markets, Headwaters has increased production capacity for Eldorado
and has initiated the development and marketing of new products from Tapco in
order to maintain the historical growth rates of the construction materials
segment.
In 2005, Headwaters focused on integration of its recent acquisitions,
including the marketing of diverse construction materials products through its
national distribution network, and developing the corporate infrastructure
necessary to provide the information and services that the business segments
need to operate at optimal levels. Headwaters became highly leveraged as a
result of the fiscal 2004 acquisitions, but has reduced its outstanding debt in
2005 through cash generated from operations, from an underwritten public
offering of common stock and from proceeds from settlement of litigation.
Headwaters intends to continue to focus on repaying long-term debt 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 is also
required to consolidate any variable interest entities for which it is the
primary beneficiary; however, as of September 30, 2005, there are none. For
investments in companies in which Headwaters has a significant influence over
operating and financial decisions (generally defined as owning a voting or
economic interest of 20% to 50%), Headwaters applies the equity method of
accounting. In instances where Headwaters' investment is less than 20% and
significant influence does not exist, investments are carried at cost. All
significant intercompany transactions and accounts are eliminated in
consolidation.
Headwaters acquired VFL on April 9, 2004, Eldorado Stone on June 2,
2004, SCP on July 2, 2004, and Tapco on September 8, 2004. These entities'
results of operations for the periods from the acquisition dates through
September 30, 2005 have been consolidated with Headwaters' 2004 and 2005 results
and their operations up to the dates of acquisition have not been included in
Headwaters' consolidated results for any period. 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.
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.
25
Prior to 2004, the businesses in the construction materials segment
manufactured and distributed value-added bagged concrete, stucco, mortar and
block products. The acquisition of SCP expanded Headwaters' concrete block
business and the acquisition of Eldorado added manufactured architectural stone
to the construction materials product line. 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-fired 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' legacy coal-based
solid alternative fuels business and HTI's business of developing catalyst
technologies to convert coal and heavy oil into higher-value liquid fuels, as
well as nanocatalyst processes and applications. Revenues for this segment
consist primarily of sales of chemical reagents and license fees.
Critical Accounting Policies and Estimates
Headwaters' significant accounting policies are identified and
described in Note 2 to the consolidated financial statements. The preparation of
consolidated financial statements in conformity with U. S. generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements, and
the reported amounts of revenue and expenses during the reporting period. Actual
results could differ materially from those estimates.
Headwaters continually evaluates its policies and estimation
procedures. Estimates are often based on historical experience and on
assumptions that are believed to be reasonable under the circumstances, but
which could change in the future. Some of Headwaters' accounting policies and
estimation procedures require the use of substantial judgment, and actual
results could differ materially from the estimates underlying the amounts
reported in the consolidated financial statements. Such policies and estimation
procedures have been reviewed with Headwaters' Audit Committee. The following is
a discussion of critical accounting policies and estimates.
License Fee Revenue Recognition. Headwaters currently licenses its
technologies to the owners of 28 coal-based solid alternative fuel facilities in
the United States. Recurring license fees or royalty payments are recognized in
the period when earned, which coincides with the sale of synthetic fuel by
Headwaters' licensees. In most instances, Headwaters receives timely reports
from licensees notifying Headwaters of the amount of solid synthetic fuel sold
and the royalty due Headwaters under the terms of the respective license fee
agreements. Additionally, Headwaters has experienced a regular pattern of
payment by these licensees of the reported amounts.
Estimates of license fee revenue earned, where required, can be
reliably made based upon historical experience and/or communications from
licensees with whom an established pattern exists. In some cases, however, such
as when a licensee is beginning to produce and sell synthetic fuel or when a
synthetic fuel facility is sold by a licensee to another entity, and for which
there is no pattern or knowledge of past or current production and sales
activity, there may be more limited information available to estimate the
license fee revenue earned. In these situations, Headwaters uses such
information as is available and where possible, substantiates the information
through such procedures as observing the levels of chemical reagents purchased
by the licensee and used in the production of the solid synthetic fuel. In
certain limited situations, Headwaters is unable to reliably estimate the
license fee revenues earned during a period, and revenue recognition is delayed
until a future date when sufficient information is known from which to make a
reasonable estimation.
Pursuant to the contractual terms of an agreement with one licensee,
the license fees owed to Headwaters, which accumulated during a period of
approximately two and a half years, were placed in escrow for the benefit of
Headwaters, pending resolution of an audit of the licensee by the IRS.
Prior to December 31, 2003, certain accounting rules governing revenue
recognition, requiring that the seller's price to the buyer be "fixed or
determinable" as well as reasonably certain of collection, appeared to preclude
revenue recognition for the amounts placed in escrow because they were
26
potentially subject to adjustment based on the outcome of the IRS audit.
Accordingly, none of the escrowed amounts were recognized as revenue in the
consolidated statements of income through December 31, 2003. During the March
2004 quarter, the fieldwork for the tax audit of the licensee was completed and
there were no proposed adjustments to the tax credits claimed by the licensee.
As a result, in March 2004 Headwaters recognized revenue, net of the amount
Headwaters was required to pay to a third party, relating to the funds deposited
in the escrow account totaling approximately $27.9 million. Approximately $3.0
million of this amount related to revenue recorded in the March 2004 quarter and
approximately $25.0 million was recorded as revenue related to prior periods.
Interest income of approximately $0.2 million was also recognized. During the
June 2004 quarter, the IRS completed its administrative review of the licensee's
tax audit and the escrowed amounts were disbursed from the escrow account and
paid to Headwaters.
In addition to the escrowed amounts, this same licensee has also set
aside substantial amounts for working capital and other operational
contingencies as provided for in the contractual agreements. These amounts 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.
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
received 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 are being recognized as
revenue in accordance with Headwaters' revenue recognition policy for license
fee revenue.
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.
Valuation of Long-Lived Assets, including Intangible Assets and
Goodwill. Long-lived assets consist primarily of property, plant and equipment,
intangible assets and goodwill. Intangible assets consist primarily of
identifiable intangible assets obtained in connection with acquisitions. (See
"Acquisitions" above and Note 3 to the consolidated financial statements for a
detailed discussion of the purchase price allocations for the 2004 acquisitions,
including the valuations of intangible assets.) These intangible assets are
being amortized on the straight-line method over their estimated useful lives.
Goodwill consists of the excess of the purchase price for businesses
acquired over the fair value of identified assets acquired, net of liabilities
assumed. In accordance with Statement of Financial Accounting Standards ("SFAS")
27
No. 142, "Accounting for Goodwill and Intangible Assets," goodwill is not
amortized, but is tested at least annually for impairment, as of June 30, using
a two-step process that begins with an estimation of the fair values of the
reporting units with goodwill. Currently, five reporting units have goodwill, as
follows: (i) HTI, (ii) CCPs, (iii) Eldorado, (iv) SCP, and (v) Tapco.
Step 1 of impairment testing consists of determining and comparing the
fair values of the reporting units to the carrying values of those reporting
units. If step 1 is failed for any of the reporting units, indicating a
potential impairment, Headwaters would be required to complete step 2, which is
a more detailed test to calculate the implied fair value of goodwill, and
compare that value to the carrying value of the goodwill. If the carrying value
of the goodwill exceeds the implied fair value of the goodwill, an impairment
loss is required to be recorded.
Headwaters has performed step 1 impairment tests of recorded goodwill
as of June 30, 2003, 2004 and 2005, all of which indicated that the fair values
of the reporting units exceeded their carrying values. Accordingly, step 2 of
the impairment tests was not required to be performed, and no impairment charge
was necessary.
In addition to its annual review, Headwaters evaluates, based on
current events and circumstances, the carrying value of long-lived assets,
including intangible assets and goodwill, as well as the related amortization
periods, to determine whether adjustments to these amounts or to the useful
lives are required. Changes in circumstances such as technological advances, or
changes in Headwaters' business model or capital strategy could result in the
actual useful lives differing from Headwaters' current estimates. In those cases
where Headwaters determines that the useful life of property, plant and
equipment or intangible assets should be shortened, Headwaters would amortize
the net book value in excess of salvage value over its revised remaining useful
life, thereby increasing depreciation or amortization expense.
The carrying value of a long-lived asset is considered impaired when
the anticipated cumulative undiscounted cash flow from that asset is less than
its carrying value. In that event, a loss is recognized based on the amount by
which the carrying value exceeds the fair market value of the long-lived asset.
Indicators of impairment include such things as a significant adverse change in
legal factors or in the general business climate, a decline in operating
performance indicators, a significant change in competition, or an expectation
that significant assets will be sold or otherwise disposed of.
It is possible that some of Headwaters' tangible or intangible
long-lived assets or goodwill could be impaired in the future and that resulting
write-downs could be material.
Stock-Based Compensation. As described in more detail in Note 12 to the
consolidated financial statements, Headwaters early 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 2005, Headwaters recorded a total of $33.8 million 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 and stock appreciation rights ("SARs") 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 2 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 price
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 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 adjustment was used in determining the fair value of 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.
28
Substantially all of the SARs that Headwaters awarded in 2005 that vest
over five years are exercisable based on the achievement of performance criteria
related to the economic growth ("EVA") 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 adjusted the amounts previously reported in its consolidated
statement of income for the six months ended March 31, 2005 in deriving the
statement of income amounts reported for 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 2005:
Under Previous SFAS No. 123R
(in millions, except per-share data) Accounting Adjustments As Reported
-----------------------------------------------------------------------------------------
Income before income taxes $ 197.2 $(33.4) $163.8
Net income $ 142.7 $(21.4) $121.3
Basic earnings per share $ 3.75 $(0.56) $ 3.19
Diluted earnings per share $ 3.26 $(0.47) $ 2.79
Cash flows from operating activities $ 159.3 $ (8.1) $151.2
Cash flows from financing activities $(106.5) $ 8.1 $(98.4)
A significant amount of the effect of the SFAS No. 123R adjustments
reported above resulted from the expense associated with immediately-vested SARs
granted in 2005 and from the acceleration of vesting of certain stock options
which also occurred in 2005, all as discussed in Note 12. As a result of the
adoption of SFAS No. 123R, Headwaters' will recognize additional non-cash
compensation expense in future periods. As of September 30, 2005, there is
approximately $14.1 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 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 13 to the consolidated financial statements.
The adoption of SFAS No. 123R, combined with the settlement of the AJG
litigation described in Note 14 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.
Year Ended September 30, 2005 Compared to Year Ended September 30, 2004
The information set forth below compares Headwaters' operating results
for the year ended September 30, 2005 ("2005") with operating results for the
year ended September 30, 2004 ("2004").
Revenue. Total revenue for 2005 increased by $511 million or 92% to
$1.065 billion as compared to $554 million for 2004. The major components of
revenue are discussed in the sections below.
Construction Materials Segment. Sales of construction materials during
2005 were $519.9 million with a corresponding direct cost of $346.5 million.
Sales of construction materials during 2004 were $134.0 million with a
corresponding direct cost of $95.3 million. The increase in sales of
construction materials during 2005 was due primarily to the acquisitions of
Eldorado, SCP and Tapco in fiscal 2004. 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 $246.8 million with a
corresponding direct cost of $186.1 million. CCP revenues for 2004 were $210.2
million with a corresponding direct cost of $155.8 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
29
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
for CCPs in several markets. The gross margin percentage decreased from 2004 to
2005 by approximately 1% 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 was only six months of VFL activity
in 2004.
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. Revenue from the sale of synthetic
fuel has a negative gross margin, but is more than compensated for from the
income tax credits earned from the sales of the synthetic fuel. HTI's revenues
are also included in alternative energy revenue, but comprise a minor portion of
total segment revenue.
Sales of Chemical Reagents. Chemical reagent sales during 2005 were
$170.3 million with a corresponding direct cost of $120.6 million. Chemical
reagent sales during 2004 were $132.6 million with a corresponding direct cost
of $89.8 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 $21.8 million) and by customers with whom
Headwaters does not have a license agreement (resulting in increased sales of
$15.9 million). Of the increased sales to customers, $7.4 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 14 to the
consolidated financial statements). It is not possible to predict the trend of
sales of chemical reagents. The gross margin percentage for 2005 of 29% was 3%
lower than for 2004, due primarily to increases in the cost of product, which in
turn is related to recent increases in the costs of petroleum-based materials,
and to a lesser extent, changes in customer mix. Headwaters believes additional
cost increases are likely in future periods and that some but not all of such
increases can be passed on to customers, potentially adversely affecting margins
in future periods.
License Fees. During 2005, Headwaters recognized license fee revenue
totaling $109.3 million, an increase of $36.6 million or 50% from $72.7 million
of license fee revenue recognized during 2004. The primary reasons for the
increase in license fee revenue in 2005 compared to 2004 relate to the
settlement of the AJG litigation described below and in Note 14 to the
consolidated financial statements ($35.1 million in total). In addition, license
fee revenue from licensees not associated with the litigation increased $1.5
million from 2004 to 2005 as a result of increased production of alternative
fuel by these licensees.
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 $26.2 million of license fees from
AJG in 2005 ($24.8 million of which directly related to the settlement of
litigation), compared to $1.4 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 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 $2.3 million in 2005.
Offsetting these increases, was a $11.1 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
$37.1 million of revenue from this licensee in 2004 and $26.0 million of revenue
in 2005. For more information about the revenue related to this licensee, see
"License Fee Revenue Recognition" in the "Critical Accounting Policies and
Estimates" section above.
Pursuant to the contractual terms of an agreement with this same
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
30
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.
Headwaters' 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 and the potential phase-out of credits with the rising price of oil,
as described in "Section 29 Matters" below. Due to the potential significance of
these issues, it is not possible to predict the trend of license fees or
alternative energy revenue in future periods.
Amortization. These costs increased by $15.4 million to $24.5 million
in 2005 from $9.1 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 $5.0 million to $12.6 million in 2005 from $7.6 million in 2004. The increase
was primarily attributable to increased HTI research and development activities
and the recognition of approximately $1.9 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 more likely to approximate 2005 amounts than
previous year amounts.
Contract Litigation Settlement. As described in Note 14 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
$87.1 million to $155.3 million for 2005 from $68.2 million for 2004. The
increase in 2005 was due primarily to an increase in stock-based compensation
expense of approximately $29.7 million and the fiscal 2004 acquisitions
(approximately $53.1 million). A substantial portion of the expense related to
stock-based compensation represent the 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 12 to the consolidated
financial statements. These two events are not likely to recur in the
foreseeable future. There was only $0.3 million of stock-based compensation
included in selling, general, and administrative expenses in 2004.
Other Income and Expense. During 2005, Headwaters reported net other
expense of $73.1 million compared to net other expense of $22.7 million during
2004. The change of $50.4 million was attributable to an increase in net
interest expense of $38.9 million in 2005 and a net increase in other expenses
of approximately $11.5 million in 2005.
Net interest expense increased from $18.5 million in 2004 to $57.4
million in 2005 due primarily to significantly higher average levels of
long-term debt in 2005 compared to 2004, as a result of the fiscal 2004
acquisitions. Headwaters incurred approximately $11.4 million of interest
expense related to the early repayment of senior debt in 2005, consisting of
accelerated amortization of debt issue costs of $7.4 million plus $4.0 million
of prepayment penalties. In connection with the reduction of the amount of
senior debt hedged from $300.0 million to $150.0 million, 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.
The net change in other expenses of $11.5 million consisted primarily
of a $16.1 million increase in costs related to Headwaters' investment in the
coal-based solid alternative fuel production facility described in Note 14 to
the consolidated financial statements, partially reduced by $4.0 million of
losses on notes receivable and other asset write-offs in 2004 that did not recur
in 2005 and an increase of $0.8 million in gain on disposition of property,
plant and equipment.
Income Tax Provision. Headwaters' effective income tax rate for 2005
was approximately 26%. 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 14 to the consolidated financial statements), as
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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
38.5%.
Year Ended September 30, 2004 Compared to Year Ended September 30, 2003
The information set forth below compares Headwaters' operating results
for the year ended September 30, 2004 ("2004") with operating results for the
year ended September 30, 2003 ("2003").
Revenue. Total revenue for 2004 increased by $166.4 million or 43% to
$554.0 million as compared to $387.6 million for 2003. The major components of
revenue are discussed in the sections below.
Construction Materials Segment. Sales of construction materials during
2004 were $134.0 million with a corresponding direct cost of $95.3 million.
Sales of construction materials during 2003 were $49.4 million with a
corresponding direct cost of $38.3 million. The increase in sales of
construction materials during 2004 was due primarily to the acquisitions of
Eldorado in June 2004, SCP in July 2004 and Tapco in September 2004. Revenues
for these acquired companies for 2004 totaled $84.1 million. The increase in
gross margin percentage from 2003 to 2004 was due primarily to significantly
higher margins from the operations of the acquired businesses, partially offset
by certain inventory and other balance sheet adjustments, some of which related
to original purchase price allocations, related to the legacy construction
materials businesses.
CCP Segment. CCP revenues for 2004 were $210.2 million with a
corresponding direct cost of $155.8 million. CCP revenues for 2003 were $169.9
million with a corresponding direct cost of $128.1 million. The increase in CCP
revenues during 2004 was due primarily to increased demand for high value CCP
products, the acquisition of VFL in April 2004, and the renegotiation of certain
service agreements. The increased demand for high value fly ash products was the
result of continued strength in the construction market coupled with a tight
market for cement, with cement shortages occurring in some regional markets.
These conditions allowed Headwaters to increase prices in certain CCP markets.
VFL's revenues for 2004 totaled $16.9 million. The gross margin percentage
increased from 2003 to 2004 by approximately 1% due primarily to benefits
realized from the renegotiation of the service agreements.
Sales of Chemical Reagents. Chemical reagent sales during 2004 were
$132.6 million with a corresponding direct cost of $89.8 million. Chemical
reagent sales during 2003 were $128.4 million with a corresponding direct cost
of $87.4 million. The increase in chemical reagent sales during 2004 was due
primarily to significantly increased synthetic fuel production by Headwaters'
licensees (resulting in increased sales of $13.9 million), largely offset by
decreased synthetic fuel production by customers with which Headwaters does not
have a license agreement (resulting in decreased sales of $9.7 million). The
gross margin percentage for 2004 of 32% was approximately the same as for 2003.
License Fees. During 2004, Headwaters recognized license fee revenue
totaling $72.7 million, an increase of $37.0 million or 104% over $35.7 million
of license fee revenue recognized during 2003. The primary reason for the
increase in license fee revenue in 2004 compared to 2003 was the recognition in
March 2004 of $24.9 million of net revenue relating to funds previously
deposited in an escrow account by one of Headwaters' licensees relating to
alternative fuel sold prior to December 31, 2003, plus approximately $12.2
million of net revenue relating to the March, June and September 2004 quarters.
Amortization. Amortization increased by $2.6 million to $9.1 million in
2004 from $6.5 million in 2003. The increase was primarily attributable to the
2004 acquisitions and the resulting increase in amortizable intangible assets.
Research and Development. Research and development expenses increased
by $2.6 million to $7.6 million in 2004 from $5.0 million in 2003. The increase
was primarily attributable to increased HTI research and development activities.
Selling, General and Administrative Expenses. These expenses increased
$26.8 million to $68.2 million for 2004 from $41.4 million for 2003. The
increase in 2004 was due primarily to the 2004 acquisitions ($13.2 million) and
increased incentive pay expenses ($8.4 million), along with certain increases in
various other costs incidental to growth, primarily payroll-related costs. The
increase in incentive pay expenses was the result of obligations under
Headwaters' incentive bonus plans, resulting from improved operating results in
2004, a significant portion of which related to revenue recognized from escrowed
funds in March 2004, as previously discussed.
32
Other Income and Expense. During 2004, Headwaters reported net other
expense of $22.6 million compared to net other expense of $17.0 million during
2003. The change of $5.6 million was primarily attributable to an increase in
net interest expense of $3.1 million in 2004 and a net increase in other
expenses of $2.5 million in 2004.
Net interest expense increased from $15.4 million in 2003 to $18.5
million in 2004, due primarily to higher average levels of long-term debt in
2004 compared to 2003, primarily related to the 2004 acquisitions, and
accelerated non-cash interest expense related to the substantial increase in
debt repayments that were made in 2004 compared to 2003. In 2004, debt
repayments totaled approximately $287.2 million, which consisted largely of
early repayments. In 2003, debt repayments totaled approximately $40.2 million.
As a result of the increase in repayments in 2004, non-cash interest expense,
representing amortization of debt discount and debt issue costs, increased from
$3.9 million in 2003 to $6.0 million in 2004.
The net change in other expenses of $2.5 million consisted primarily of
a write-off of $0.8 million of deferred acquisition costs related to projects
that were abandoned in 2004 and an increase of $1.4 million in losses on
disposition of property, plant and equipment in 2004.
Income Tax Provision. In 2004, Headwaters recorded an income tax
provision at an effective tax rate of approximately 38.8%. In 2003, the
effective tax rate was approximately the same at 39.0%.
Impact of Inflation and Related Matters
Headwaters' operations have been impacted in 2005 by rising costs for
chemical reagents in the alternative energy segment, by increased cement,
polypropylene and poly-vinyl chloride costs in the construction materials
segment and by increased fuel costs that have affected transportation costs in
most of Headwaters' business units. The increased costs of chemical reagents,
polypropylene, poly-vinyl chloride and fuel are directly related to the increase
in prices of oil and other petroleum-based materials. The increased costs of
cement are caused primarily by a lack of adequate supplies in some regions of
the U.S.
Headwaters has been successful in passing on some, but not all, of the
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 future price increases to customers. It is also not
possible to predict the impact of potential future cement supply shortages on
Headwaters' ability to procure needed supplies in its construction materials
business.
Liquidity and Capital Resources
Summary of Cash Flow Activities. Net cash provided by operating
activities during 2005 was $151.2 million compared to $91.9 million during 2004.
The change was attributable to increases in 2005 in net income ($57.0 million),
depreciation and amortization ($36.2 million) and non-cash stock-based
compensation ($33.5 million), reduced by deferred taxes ($31.2 million) and
other items ($36.2 million net).
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, $320.2 million of debt was repaid, net of
proceeds from issuance of debt, compared to a net $780.9 million increase in
debt in 2004. In 2004, the primary investing activity consisted of four
acquisitions resulting in total net cash payments of $952.3 million. In 2005 the
primary investing activity consisted of the purchase of property, plant and
equipment for total cash payments of $56.6 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, Headwaters acquired four companies in fiscal
2004. Primarily as a result of these acquisitions, expenditures for property,
plant and equipment increased substantially from 2004 ($14.0 million) to 2005
($56.6 million). These capital expenditures primarily relate to the construction
materials segment ($44.4 million). Capital expenditures for 2006 are currently
expected to approximate the limitation on such expenditures of $72.0 million
included in the senior debt covenants. A significant portion of Headwaters' 2006
capital expenditures relate to expansion of operations, rather than
"maintenance" of operating capacity, and a significant portion of the
anticipated increase in capital expenditures from 2005 to 2006 is expected to be
in the CCP and alternative energy segments. The "unused" amounts of the annual
capital expenditures limits in the senior debt agreements can generally be
33
"carried over" from year to year. As of September 30, 2005, Headwaters was
committed to spend approximately $7.4 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
construction materials, CCP marketing, 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. The senior secured
credit agreement also limits the amount Headwaters can invest in joint ventures
and other less than 100%-owned entities.
In 2004, Headwaters acquired certain assets of SCP and assumed all of
SCP's outstanding debt. Headwaters agreed to pay an earn-out to the sellers if
certain earnings targets are exceeded during the 12 months ending December 31,
2005 (the "earn-out period"). The additional earn-out consideration will be the
product of 5.7 times the amount that earnings before interest, taxes,
depreciation and amortization ("EBITDA") of SCP exceed $5.5 million during the
earn-out period. Headwaters currently expects earn-out consideration in the
range of approximately $10.0 million to $12.5 million could be paid, depending
on performance.
As described in more detail in Note 14 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 $12.2 million at September 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 $12.2 million;
therefore, Headwaters' obligation to make all of the above-described payments is
effectively limited to the tax benefits Headwaters receives.
In 2004, Headwaters entered into an agreement with Degussa AG, 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 in 2004, an additional $1.0 million in October
2005 and is further obligated to pay $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, through September 2007, of
which approximately (euro)2.0 million (approximately $2.4 million) remains to be
paid as of September 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.
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
34
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, Headwaters
entered into two credit agreements with a syndication of lenders. The credit
agreements have since been amended, most recently in October 2005. A total of
$790.0 million was originally borrowed under the credit facility, which also
provides for up to $60.0 million of borrowings under a revolving credit
arrangement. The original 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 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. As of September 30, 2005, the second lien
term loan has been repaid in its entirety. With certain limited exceptions, the
first lien term loan is secured by all assets of Headwaters and is senior in
priority to all other debt except for the specific SCP assets that collateralize
the notes payable to banks discussed below. The terms of the credit facility, as
amended, are 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 5.9% at September 30, 2005. The second lien term loan
bore 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. Headwaters can
lock in new LIBOR rates for the first lien loan for one, two, three or six
months. The most recent rate change occurred in October 2005.
The first lien term loan ($442.7 million outstanding at September 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 from November 2010 through April 2011, the
termination date. Interest is generally due on a quarterly basis.
During 2005, Headwaters repaid a total of $197.3 million of the first
lien term loan and all of the second lien term loan ($150.0 million). As a
result of the early repayments, accelerations of amortization of the related
debt issue costs totaling approximately $7.4 million were charged to interest
expense. Prepayment penalties totaling $4.0 million were paid related to the
early repayments of the second lien term debt, which amount was also charged to
interest expense.
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 were restricted and required prepayment penalties ranging up to 3% of the
prepayments made in the first year and 2% in the second year. Once repaid in
full or in part, no further reborrowings under either of the term loan
arrangements can be made.
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 (subsequently reduced to $150.0 million) 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 September
30, 2005) of this debt for the period commencing September 8, 2005 through
September 8, 2007. During 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 which limit its variable
interest rate exposure 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 September 30, 2005 of approximately $2.1 million, which, net of $0.8
million of income taxes, represents other comprehensive income for 2005. Total
comprehensive income was approximately $122.6 million for 2005. Total
comprehensive income did not differ from net income in 2003 or 2004.
Convertible Senior Subordinated Notes - In connection with the Eldorado
acquisition, Headwaters issued $172.5 million of 2.875% 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
35
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 calculations on an
if-converted basis, as described in more detail in Note 13 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 September 30, 2005, ranged from
4.5% to 6.25%. Because the notes are callable by the bank, Headwaters has
included the outstanding balance in current portion of long-term debt in the
consolidated balance sheet. The notes are collateralized by certain assets of
SCP and contain financial covenants specific to SCP, including a minimum fixed
charge coverage ratio, a leverage ratio requirement, and limitations on capital
expenditures. Headwaters is in compliance with all debt covenants as of
September 30, 2005.
Options and Employee Stock Purchases - In 2005, cash proceeds from the
exercise of options and employee stock purchases totaled $14.9 million, compared
to $9.1 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 $4.1 million in 2004 and $8.1 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.
36
Working Capital. In 2005, Headwaters' working capital increased by
$72.9 million, to $117.3 million as of September 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 14 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, when 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). As of September 30, 2005, Headwaters had $30.0 million of borrowings
outstanding under the revolving credit arrangement. Because Headwaters' intent
was to repay the outstanding borrowings under the revolving credit arrangement
within 12 months, this amount is reflected as current in the consolidated
balance sheet as of September 30, 2005. The credit agreement also allows for the
issuance of letters of credit, provided there is capacity under the revolving
credit arrangement. As of September 30, 2005, six letters of credit totaling
$5.5 million were outstanding, with expiration dates ranging from January 2006
to December 2006. Subsequent to September 30, 2005, an additional letter of
credit was issued in the amount of $2.7 million, expiring in October 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 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 2005, $72.0 million for 2006
and $75.0 million for 2007 through 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 4.5:1.0 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 3.5:1.0, 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 September 30, 2005.
As described above, Headwaters has approximately $481.4 million of
variable-rate long-term debt outstanding as of September 30, 2005, consisting of
$472.7 million of senior debt and $8.7 million of notes payable to a bank.
Considering all outstanding balances of variable-rate debt (reduced by the
$150.0 million of senior debt that effectively has a fixed interest rate until
September 8, 2007) and required principal repayments, a change in the interest
rate of 1% would change Headwaters' interest expense by approximately $3.0
million during the 12 months ending September 30, 2006.
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 $8.1 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. 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 end and the different fiscal year ends of the entities through which
Headwaters receives the tax credits.
Headwaters' effective income tax rate for 2005 was approximately 26%.
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 14 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
37
Internal Revenue Code. Excluding the effect of the tax credits, Headwaters'
effective tax rate in 2005 would have been approximately 38.5%.
Summary of Future Cash Requirements. Significant future cash uses, in
addition to operational working capital requirements, are currently expected to
consist primarily of debt service payments on outstanding long-term debt,
capital expenditures and income taxes.
Off-Balance Sheet Arrangements
Although Headwaters has operating leases for certain facilities and
equipment, and hedge agreements to limit its exposure to interest rate
increases, Headwaters does not have any off-balance sheet arrangements that
have, or are reasonably likely to have, a current or future effect on its
financial condition, changes in financial condition, revenues or expenses,
results of operations, liquidity, capital expenditures, or capital resources
that are material to investors.
Contractual Obligations and Contingent Liabilities and Commitments
The following table presents a summary of Headwaters' contractual
obligations by period as of September 30, 2005.
Payments due by Fiscal Year
-----------------------------------------------------------
2007 - 2009 - After
(in millions) Total 2006 2008 2010 2010
-------------------------------------------------------------------------------------------------------
Senior secured debt $472.7 $ 43.5 $ 26.8 $ 26.8 $375.6
Convertible senior subordinated notes 172.5 -- -- -- 172.5
Other long-term debt 8.8 8.7 0.1 -- --
-----------------------------------------------------------
Total long-term debt 654.0 52.2 26.9 26.8 548.1
Interest payments on long-term debt 183.4 31.7 58.9 55.6 37.2
Operating lease obligations 71.2 20.0 29.4 13.4 8.4
Unconditional purchase obligations 50.8 12.2 16.4 14.5 7.7
Investment and joint venture obligations 16.6 8.3 8.3 -- --
Capital expenditures 7.4 7.4 -- -- --
Other long-term obligations 6.6 3.0 2.4 1.2 --
-----------------------------------------------------------
Total contractual cash obligations $990.0 $134.8 $142.3 $111.5 $601.4
===========================================================
As provided for in the senior debt agreements, Headwaters has available
$60.0 million under a revolving credit arrangement. Borrowings and reborrowings
of any available portion of the $60.0 million revolver can be made at any time
through September 2009, when all loans must be repaid and the revolving credit
arrangement terminates. As of September 30, 2005, Headwaters had $30.0 million
of borrowings outstanding under the revolving credit arrangement. The credit
agreement allows for the issuance of letters of credit, provided there is
capacity under the revolving credit arrangement. As of September 30, 2005, six
letters of credit totaling $5.5 million were outstanding, with expiration dates
ranging from January 2006 to December 2006. Subsequent to September 30, 2005, an
additional letter of credit was issued in the amount of $2.7 million, expiring
in October 2006.
In 2004, Headwaters acquired certain assets of SCP and assumed all of
SCP's outstanding debt. Headwaters agreed to pay an earn-out to the sellers if
certain earnings targets are exceeded during the 12 months ending December 31,
2005 (the "earn-out period"). The additional earn-out consideration will be the
product of 5.7 times the amount that earnings before interest, taxes,
depreciation and amortization ("EBITDA") of SCP exceed $5.5 million during the
earn-out period. Headwaters currently expects earn-out consideration in the
range of approximately $10.0 million to $12.5 million could be paid, depending
on performance.
Subsequent to September 30, 2005, Tapco acquired certain assets and
assumed certain liabilities of Max Manufacturing & Roofing, LLC. Total
consideration, including potential future deferred payments, is not material.
Headwaters has ongoing litigation and asserted claims which have been
incurred during the normal course of business, including the items discussed
below and in Note 14 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.
38
In 2005, Headwaters incurred approximately $4.3 million of expense for
legal matters, exclusive of costs for outside legal counsel. This amount
includes accruals for or payments made relating to settlements achieved, plus
Headwaters' estimates of the probable liability for unresolved matters, giving
consideration in certain instances to amounts for which Headwaters is willing to
settle. Headwaters currently believes the range of potential loss for unresolved
matters, excluding costs for outside counsel, is from $4.0 million up to the
amounts sought by claimants and has recorded a total liability as of September
30, 2005 of $4.0 million. Claims and damages sought by claimants in excess of
this amount are not deemed to be probable. 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 matters discussed in Note 14 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. Therefore, 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 $3.0 million in 2003, $3.8 million in 2004 and $5.4
million in 2005 (exclusive of a reimbursement of legal costs in 2005 for
approximately $6.5 million 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 are
expected to be received 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. The ongoing quarterly payments based upon tax credits
are being recognized as revenue in accordance with Headwaters' revenue
recognition policy for license fee revenue.
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.
As described in Note 12 to the consolidated financial statements, in
2005, in conjunction with the gain recognized from the AJG litigation
settlement, the Compensation Committee of the Board of Directors ("Committee")
39
granted to certain officers and employees stock incentive awards consisting of
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 2005. The stock
incentive awards were intended to accelerate approximately five years of
long-term incentive compensation into 2005. A significant portion of the awards
is 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. 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.
The grants of performance units were not made until November 2005 and could
result in the payments to employees of a maximum amount of approximately $3.6
million if all performance criteria are met.
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 or other similar legislation 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, through August 31, 2005, the average reference price is $47.85 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.
In an environment of high oil prices, the risk of phase-out increases.
Headwaters' customers and licensees will make their own assessments of phase-out
risk. If customers and licensees perceive a potential negative impact from
phase-out, they may reduce or stop synthetic fuel production or require
Headwaters to share in the costs associated with phase-out. These events may
materially adversely affect Headwaters' future revenue and net income.
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
40
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 is fiscal 2006. Because the provisions
of this standard must be applied prospectively, there will be no effect on
previously-issued financial statements. 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.
Risks Relating to Our Business
Section 29 of the Internal Revenue Code ("Section 29") tax credits are subject
to phase-out if the unregulated average annual oil price reaches $51.35 per
barrel in calendar 2004.
Tax credits claimed by an alternative fuel facility operator may begin
to be phased out or eliminated prior to their scheduled expiration on December
31, 2007 if the "reference price" of oil exceeds an average annual range of oil
prices, adjusted annually for inflation. In April of each year, the Internal
Revenue Service ("IRS") announces the phase-out range of oil prices for the
prior tax year. For example, in April 2005, the IRS announced that the phase-out
range for 2004 began at $51.35 per barrel and ended with a $0 tax credit at
$64.47 per barrel. Because the calendar year 2004 average oil price did not fall
within the range, there was not a phase-out of the credit for qualified fuel
sold in 2004. Based upon 2005 oil prices as of the date hereof, Headwaters does
not believe that there will be any phase-out of Section 29 tax credits for
calendar 2005. However, it is not possible to predict whether oil prices for
calendar 2006 might result in a tax credit phase-out in calendar 2006. If the
Section 29 tax credits are phased out in whole or in material part, HES'
profitability will be severely affected.
The reference price of oil and the inflation adjustment factor ("IAF")
are determined annually (and released in the first week of April for the
previous year), while the predetermined oil price range is fixed, but adjusted
annually for inflation. The reference price of oil is defined as the annual
average wellhead price per barrel for all domestic crude oil not subject to
regulation by the United States. Tax credits are usually claimed by corporations
according to the tax year in which the alternative fuel is actually produced and
sold, which may be different than the calendar year. Since the government
updates phase-out criteria each April for alternative fuel produced during the
previous calendar year, it is possible that the price of oil could impact the
decisions of facility owners to continue alternative fuel production beginning
with the first quarter of calendar year 2006.
During 2005, uncertainties surrounding crude oil production from
foreign sources, growing concerns of remaining world oil reserves, and weather,
among other things, have resulted in annual average oil prices that approach the
lower threshold of the phase-out range. Headwaters' licensees and customers
continue to closely watch oil price trends and will consider whether or not to
operate their facilities in 2006 depending upon their view of future oil prices.
Some facility owners have attempted to protect their positions by purchasing oil
futures hedges and requiring that Headwaters share the cost of such hedges,
while others have considered these actions too risky and expensive, and may
elect to simply curtail or eliminate production should high oil prices indicate
phase-out likelihood. Decisions by Headwaters' licensees or customers to curtail
or eliminate production will severely affect our profitability.
A significant increase in the price of petrochemical feedstocks used to make
latex materials which are in turn used in the production of Headwaters Energy
Services reagents that cannot be passed on to customers could have a significant
41
adverse effect on net income. Further, Headwaters Energy Services depends upon a
single supplier for the production of reagents, the interruption of which would
materially disrupt Headwaters Energy Services' ability to supply products to its
customers, resulting in lost revenues and the potential loss of customers.
HES reagents, which provide a majority of HES' revenues, are
manufactured from latex by a single supplier, Dow Reichhold LLC. The price of
latex is primarily a function of manufacturing capacity, demand and the prices
of petrochemical feedstocks, crude oil and natural gas liquids. Historically,
the market price of latex has fluctuated, and significantly increased in 2005.
Further significant increases in the price of latex that cannot be passed on to
customers could have a significant adverse effect on our net income. HES does
not inventory reagents for sale to customers and alternative sources meeting
HES' requirements would be difficult to arrange. Therefore, HES' ability to
provide reagents to its customers could be materially disrupted if the supply of
reagents or feedstock latex materials were interrupted for any reason. Such an
interruption and the resulting inability to supply HES' customers with reagents
could adversely impact HES' revenues and potentially our relationships with HES'
customers.
If the tax credits under Section 29 of the Internal Revenue Code are repealed or
adversely modified, Headwaters Energy Services' profitability will be severely
affected.
HES' license fees and revenues from sales of chemical reagents depend
on the ability of our licensees and customers to manufacture and sell qualified
alternative fuels that generate tax credits. Under current law, Section 29 tax
credits are not available for alternative fuel sold after December 31, 2007. In
addition, there have been initiatives from time to time to consider the early
repeal or modification of Section 29. For example, in February 2005, a bill was
reintroduced in the United States House of Representatives that would repeal the
Section 29 credit for alternative fuel produced from coal. If Section 29 expires
at the end of 2007 or if it is repealed or adversely modified, alternative fuel
facilities would probably either close or substantially curtail production. At
this time, given current prices of coal and costs of alternative fuel
production, we do not believe that production of alternative fuel will be
profitable absent the tax credits. In addition, if our licensees close their
facilities or materially reduce production activities (whether after 2007, upon
earlier repeal or adverse modification of Section 29 or for any other reason),
it would have a material adverse effect on the revenues and net income of
Headwaters.
If our licensees' demand for Section 29 tax credits decreases, Headwaters Energy
Services' revenues will decrease.
HES' business depends upon the ability of our licensees and chemical
reagent customers to utilize Section 29 tax credits as payments under our
contracts are ultimately based on our customers' production of alternative
fuels. Their ability to utilize tax credits depends upon their taxable income. A
decline in the profitability of our licensees could reduce their ability to
utilize tax credits, and, in turn, could lead to a reduction in the production
of alternative fuel at their facilities. Such licensees could sell their
facilities to a taxpayer with more capacity to utilize the tax credits, but any
such transfer could result in short-term or long-term disruption of operations,
and therefore adversely affect our revenues and net income.
IRS reviews under Section 29 may adversely affect our licensees' production of
alternative fuel and therefore may adversely affect Headwaters Energy Services'
profitability.
The issuance of private letter rulings ("PLRs") under Section 29 by the
IRS is important to the willingness of the owners of alternative fuel facilities
to operate and to their ability to transfer ownership of those facilities.
However, PLRs may be modified or revoked by the IRS.
The IRS has suspended the issuance of PLRs to alternative fuel facility
owners several times in the past, including most recently in 2003, and the IRS
may suspend the issuance of PLRs in the future. In 2003, following an IRS
announcement that it would suspend issuance of PLRs because it questioned the
scientific validity of procedures and tests performed by alternative fuel
facility operators to determine that the fuel satisfied the requirements of
Section 29, certain of Headwaters' licensees reduced or ceased production, which
resulted in a material impact on Headwaters' revenue and net income. While the
IRS later indicated it would resume the issuance of PLRs, it has continued to
express concerns regarding the sampling and data/record retention practices
prevalent in the alternative fuels industry and subsequent PLRs have required
taxpayers (i) to maintain sampling and quality control procedures that conform
to American Society for Testing and Materials or other appropriate industry
guidelines at the alternative fuel facilities, (ii) to obtain regular reports
from independent laboratories that have analyzed the fuel produced in such
facilities to verify that the coal used to produce the fuel undergoes a
significant chemical change and (iii) to maintain records and data underlying
the reports that taxpayers obtain from independent laboratories including raw
42
Fourier Transform InfraRed ("FTIR") data and processed FTIR data sufficient to
document the selection of absorption peaks and integration points. The
expression of IRS concern regarding current practices in the industry may
adversely affect the willingness of buyers to engage in transactions or on the
willingness of current owners to operate their facilities. If current owners are
unable to sell their facilities or are unwilling to operate them, production
will not be maximized, thereby materially decreasing our revenues and net
income. We cannot predict whether the IRS may conduct reviews or investigations
of Section 29 tax credits in the future, or whether the outcome of IRS audits
involving licensees would be favorable.
Senate investigation of Section 29 tax credits may adversely affect production
by our licensees and decrease the profitability of Headwaters Energy Services.
On October 30, 2003, the Permanent Subcommittee on Investigations of
the Government Affairs Committee of the United States Senate (the
"Subcommittee") issued a notification of pending investigations. The
notification listed, among others, the alternative fuel tax credit as a new item
to be reviewed. If the pending investigation or any future Congressional action
results in findings or announcements negative to the industry, it may adversely
affect the willingness of buyers to engage in transactions to purchase
alternative fuel facilities or the willingness of current owners to operate
their facilities, which would have a direct, negative impact on our revenues and
net income.
In July 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 our
knowledge, there has been little activity regarding the investigation.
If the IRS challenges or disallows Section 29 tax credits claimed by our
licensees, Headwaters Energy Services' profitability may decrease because future
production by these licensees may decrease.
Licensees are subject to audit by the IRS. The IRS may challenge
whether HES' licensees satisfy the requirements of Section 29, or applicable
PLRs, including placed-in-service requirements, or may attempt to disallow
Section 29 tax credits for some other reason. The IRS has initiated audits of
certain licensee-taxpayers who claimed Section 29 tax credits, and the outcome
of any such audit is uncertain. In 2004, a licensee announced that IRS field
auditors issued a notice of proposed adjustment challenging the
placed-in-service date of three of its alternative fuel facilities. The licensee
believes that the facilities meet the placed-in-service requirement; however,
the timing and final results of the audit are unknown. In the event that tax
credits are disallowed, licensees may seek recovery from Headwaters Energy
Services for operational or other reasons, although we believe there would be no
basis for such claims. The inability of a licensee to claim Section 29 tax
credits also would reduce our future revenue from the licensee. In addition, IRS
audit activity may have adversely affected the willingness of buyers to engage
in transactions to purchase alternative fuel facilities or on the willingness of
current owners to operate their facilities. If current owners are unable to sell
their facilities or are unwilling to operate them at full capacity, production
will not be maximized, which could have a significant negative effect on our
revenues and net income.
If our licensees' demand for Section 29 tax credits is adversely influenced by
negative publicity involving the industry or transactions principally motivated
by the reduction of taxes, Headwaters Energy Services' profitability will
decrease.
There has been public scrutiny of Section 29, by the media and by
policymakers. Outside the Section 29 context, there has been increased public
scrutiny of transactions motivated principally by the reduction of federal
income taxes. Our licensees could determine that the risk of negative publicity
or public scrutiny associated with the Section 29 tax credits exceeds the
financial benefits from the utilization of the credits. Such licensees may seek
to mitigate or eliminate such risk by reducing or ceasing production of
alternative fuel or disposing of their facilities, resulting in short-term or
long-term disruption of operations, in which case our revenues and profitability
would decrease.
43
Headwaters Energy Services' revenues result from a small number of licensees and
customers, so that any short-term or long-term decisions by one or a small
number of licensees and customers to decrease or halt production would cause our
profitability to decrease.
HES has 28 licensed facilities using its coal-based synthetic fuel
technologies. In addition, HES sells reagents used at approximately 34
facilities owned by our licensees and other customers. License fees and reagent
sales accounted for approximately 26% of our total revenues in the fiscal year
ended September 30, 2005 and a higher percentage of our net income. Under
current law, facilities must have been placed into service prior to July 1, 1998
to be eligible for Section 29 tax credits, so HES' business primarily depends on
existing licensees and chemical reagent customers. If any of HES' significant
licensees or chemical reagent customers shuts down its facilities, operates its
facilities at low production levels or sells its facilities resulting in
short-term or long-term disruption of operations, our revenues and net income
could be materially adversely affected. HES' licensees must address all
operational issues including, but not limited to, feedstock availability, cost,
moisture content, British thermal unit ("Btu") content, correct chemical reagent
formulation and application, operability of equipment, product durability and
overall costs of operations. In some cases, licensees may be forced to relocate
plants and enter into new strategic contracts to address marketing and
operational issues. Licensee plant relocations disrupt production and delay
generation of license fees paid to us.
The growth of HES' revenues has depended in part on increased
production over time of coal-based solid alternative fuel by its licensees. For
the past several years, efficiencies in production and improvements in equipment
and processes used at facilities have allowed increased production. However,
facilities may be at or near capacity which could limit future growth.
Headwaters Resources primarily sells fly ash for use in concrete; if use of fly
ash does not increase, Headwaters Resources may not grow.
HRI's growth has been and continues to be dependent upon the increased
use of fly ash in the production of concrete. HRI's marketing initiatives
emphasize the environmental, cost and performance advantages of replacing
portland cement with fly ash in the production of concrete. If HRI's marketing
initiatives are not successful, HRI may not be able to sustain its growth.
If portland cement or competing replacement products are available at lower
prices than fly ash, our sales of fly ash as a replacement for portland cement
in concrete products could suffer, causing a decline in Headwaters Resources'
revenues and net income.
An estimated 70% of HRI's revenues for the fiscal year ended September
30, 2005 were derived from the sale of fly ash as a replacement for portland
cement in concrete products. At times, there may be an overcapacity of cement in
regional markets, causing potential price decreases. The markets for HRI's
products are regional, in part because of the costs of transporting CCPs, and
HRI's business is affected by the availability and cost of competing products in
the specific regions where it conducts business. If competing products become
available at prices equal to or less than fly ash, HRI's revenues and net income
could decrease.
Because demand for CCPs sold by Headwaters Resources is affected by fluctuations
in weather and construction cycles, Headwaters Resources' revenues and net
income could decrease significantly as a result of unexpected or severe weather
or slowdowns in the construction industry.
HRI manages and markets CCPs and uses CCPs to produce construction
materials. Utilities produce CCPs year-round. In comparison, sales of CCPs are
generally keyed to construction market demands that tend to follow national
trends in construction with predictable increases during temperate seasons and
decreases during periods of severe weather. HRI's CCP sales have historically
reflected these seasonal trends, with the largest percentage of total annual
revenues being realized in the quarters ended June 30 and September 30. Low
seasonal demand normally results in reduced shipments and revenues in the
quarters ended December 31 and March 31.
The CCP industry is cyclical because of its dependence on building
construction and highway construction, including infrastructure repair, and is
also affected by changes in general and local economic conditions. State
construction budgets are affected adversely by economic downturns. HRI's sales
could significantly decrease as a result of a downturn in the economy in one or
more markets that it serves.
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If Headwaters Resources' coal-fueled electric utility industry suppliers fail to
provide Headwaters Resources with high-value CCPs on a timely basis, Headwaters
Resources' costs could increase and our growth could be hindered.
HRI relies on the production of CCPs by coal-fueled electric utilities.
HRI has occasionally experienced delays and other problems in obtaining
high-value CCPs from its suppliers and may in the future be unable to obtain
high-value CCPs on the scale and within the time frames required by HRI to meet
its customers' needs. If HRI is unable to obtain CCPs or if it experiences a
delay in the delivery of high-value or quality CCPs, HRI may be forced to incur
significant unanticipated expenses to secure alternative sources or to otherwise
maintain supply to its customers. Moreover, its revenues could be adversely
affected if these customers choose to find alternatives to HRI's products.
A significant increase in the price of materials used in the production of
Eldorado's products that cannot be passed on to customers could have a
significant adverse effect on net income. Furthermore, Eldorado depends upon
limited sources for certain key production materials, the interruption of which
would materially disrupt Eldorado's ability to manufacture products and supply
products to its customers, resulting in lost revenues and the potential loss of
customers.
Eldorado's manufacturing processes require key production materials
including cement, oxides, packaging materials, and certain types of rubber based
products. The suppliers of these materials to Eldorado may experience capacity
or supply constraints in meeting market demand that limit Eldorado's ability to
obtain needed production materials on a timely basis or at expected prices.
Eldorado has no long-term contracts with suppliers. Eldorado does not currently
maintain large inventories of production materials and alternative sources
meeting Eldorado's requirements could be difficult to arrange in the short term.
A significant increase in the price of these materials that cannot be passed on
to customers could have a significant adverse effect on our net income.
Additionally, Eldorado's manufacturing and ability to provide products to its
customers could be materially disrupted if this supply of materials was
interrupted for any reason. Such an interruption and the resulting inability to
supply Eldorado's customers with products could adversely impact Eldorado's
revenues and potentially our relationships with Eldorado's customers.
With our recent acquisitions of Eldorado and Tapco, Headwaters Construction
Materials has grown to be a significant part of our business and our future
profitability is therefore increasingly dependent upon our operations in this
industry segment.
In June 2004, we acquired Eldorado, and in September 2004, we acquired
Tapco. With the Eldorado and Tapco acquisitions, HCM has grown to be a
significant part of our business. This business unit produced approximately $520
million in revenues (or approximately 49% of total revenue) for fiscal year
2005. Headwaters' future profitability therefore is highly dependent upon its
ability to operate successfully in this industry segment where our operations to
date have not been significant to our total revenues.
Tapco's and Eldorado's growth require continued investment of capital. If we
cannot invest additional capital into Tapco and Eldorado, we may not be able to
sustain or increase Tapco's and Eldorado's growth.
Tapco and Eldorado operations both require maintenance and growth
capital. Current levels of capital expenditures may be insufficient to support
and sustain Tapco's and Eldorado's growth. Our senior secured credit facilities
limit capital expenditures for all of Headwaters to approximately $72 million
for fiscal year 2006. We believe that we will need substantially all of this
capital expenditure limitation in fiscal year 2006 for operation maintenance,
growth of existing businesses, and new growth initiatives.
Because Tapco's and Eldorado's markets are heavily dependent on the residential
construction and remodeling market, Tapco's and Eldorado's revenues could
decrease as a result of events outside our control that impact home construction
and home improvement activity.
Tapco's and Eldorado's construction markets are seasonal. The majority
of their sales are in the residential construction market, which tends to slow
down in the winter months. If there is more severe weather than normal, an
increase in interest rates, a limit on availability of credit for homeowners
which results in a slowdown in new construction or remodeling and repair
activities, or other events outside of our control, there may be a negative
effect on Tapco's and Eldorado's revenues if they are not able to increase
market share.
Interruption of Tapco's ability to immediately ship individual or custom product
orders could harm Tapco's reputation and result in lost revenues if customers
turn to other sources for products.
45
Tapco's construction materials business is highly dependent upon rapid
shipments to contractors and distributors throughout the United States of
individual orders, a large portion of which orders are manufactured upon demand
to meet customer specifications. If there is significant interruption of
business at any of Tapco's manufacturing plants or with Tapco's computer systems
that track customer orders and production, Tapco is at risk of harming its
reputation for speed and reliability with important customers and losing
short-term and long-term revenues if these customers turn to other sources.
A significant increase in the price of petrochemical feedstocks used to make
polypropylene which is in turn used in the production of Tapco's products that
cannot be passed on to customers could have a significant adverse effect on net
income. Further, Tapco depends upon a single source for polypropylene, the
interruption of which would materially disrupt Tapco's ability to manufacture
products and supply products to its customers, resulting in lost revenues and
the potential loss of customers.
Certain of Tapco's products, which provide a majority of Tapco's
revenues, are manufactured from polypropylene, which material is sold to Tapco
by a single supplier. The price of polypropylene is primarily a function of
manufacturing capacity, demand and the prices of petrochemical feedstocks, crude
oil and natural gas liquids. Historically, the market price of polypropylene has
fluctuated, and significantly increased in 2005. A significant increase in the
price of polypropylene that cannot be passed on to customers could have a
significant adverse effect on our net income. There is no long-term contract
with Tapco's polypropylene supplier. Tapco does not maintain large inventories
of polypropylene and alternative sources meeting Tapco's requirements could be
difficult to arrange in the short term. Therefore, Tapco's manufacturing and
ability to provide products to its customers could be materially disrupted if
this supply of polypropylene was interrupted for any reason. Such an
interruption and the resulting inability to supply Tapco's customers with
products could adversely impact Tapco's revenues and potentially our
relationships with Tapco's customers.
Tapco's revenues would be materially adversely affected if it lost one or both
of its two major customers.
Two of Tapco's customers together accounted for approximately 22% of
its revenues in its fiscal year ended September 30, 2005. There are no long-term
contracts in place with these customers. Accordingly, a loss of or significant
decrease in demand from these customers would have a material adverse effect on
Tapco's business.
Headwaters' new businesses, processes and technologies may not be successfully
developed, operated and marketed, which could affect our future profitability.
Although Headwaters has developed several new businesses, processes and
technologies (e.g., ethanol, (HC)3 and dry coal cleaning), commercialization of
these businesses and technologies are in early stages. Commercial success of
these new businesses and technologies will depend on our ability to enter into
agreements with customers, licensees and/or joint venturers to further develop
and provide adequate funding to commercialize the new businesses and
technologies, as well as to develop markets for the products and technologies.
We may not be able to enter into these agreements and adequate funding may not
be available to fully develop and successfully commercialize our new businesses
and technologies. Further, we may not be able to profitably operate our new
businesses or market our technologies or products produced from them.
Headwaters Technology Innovation Group is conducting business in China, where
intellectual property and other laws, as well as business conditions, may leave
our intellectual property, products and technologies vulnerable to duplication
by competitors and create uncertainties as to our legal rights against such
competitors' actions.
HTI has and is expected to continue to license or otherwise make its
technology, including its nanotechnology and coal liquefaction technology,
available to entities in China. There is a risk that foreign intellectual
property laws will not protect HTI's intellectual property to the same extent as
under United States laws, leaving us vulnerable to competitors who may attempt
to copy our products, processes or technologies. Further, the legal system of
China is based on statutory law. Under this system, prior court decisions may be
cited as persuasive authority but do not have binding precedential effect. Since
1979, the Chinese government has been developing a comprehensive system of
commercial laws and considerable progress has been made in the promulgation of
laws and regulations dealing with economic matters, such as corporate
organization and governance, foreign investment, commerce, taxation and trade.
As these laws, regulations and legal requirements are relatively new and because
of the limited volume of published case law and judicial interpretations and the
non-binding nature of prior court decisions, the interpretation and enforcement
of these laws, regulations and legal requirements involve some uncertainty.
These uncertainties could limit the legal protection or recourse available to
us. In addition, dependence on foreign licenses and conducting foreign
operations may subject us to increased risk from political change, ownership
issues or repatriation or currency exchange concerns.
46
Significant increases in energy and transportation costs that cannot be passed
on to customers could have significant adverse effect on net income.
We purchase a significant amount of energy from various sources to
conduct our operations, including fossil fuels and electricity for production of
building products and diesel fuel for distribution of our products and for
production-related vehicles. In addition, fuel cost increases have increased
truck and rail carrier transportation costs for our products. Fuel cost
increases have in the past and may in the future adversely affect the results of
our operations and our financial condition. Prices and availability of all
petroleum products are subject to political, economic and market factors that
are generally outside of our control.
We operate in industries subject to significant environmental regulation, and
compliance with and changes in regulation could add significantly to the costs
of conducting business.
The coal-based solid alternative fuel operations of HES and the fly ash
operations of HRI and their respective customers and licensees are subject to
federal, state and local environmental regulations that impose limitations on
the discharge of pollutants into the air and water and establish standards for
the treatment, storage and disposal of waste products, which add to the costs of
doing business and expose us to potential fines for non-compliance. If the costs
of environmental compliance increase for any reason, we may not be able to pass
on these costs to customers. In order to establish and operate the alternative
fuel plants, power plants and operations to collect and transport CCPs and
bottom ash, we, our licensees and customers have obtained various state and
local permits and must comply with processes and procedures that have been
approved by regulatory authorities. Any failure to comply could result in the
issuance of substantial fines and penalties and cause us to incur environmental
liabilities.
Certain Eldorado, Southwest and Tapco manufacturing operations are also
subject to environmental regulations and permit requirements. If Eldorado,
Southwest and Tapco cannot obtain or maintain required environmental permits for
their existing and planned manufacturing facilities in a timely manner or at
all, they may be subject to additional costs and/or fines.
HTI's ordinary course of business requires using its facilities to
perform research and development activities involving coal, oil, chemicals and
energy technologies, including liquefaction of coal. As a result, petroleum and
other hazardous materials have been and are present in and on HTI's properties.
Regulatory noncompliance or accidental discharges, fires, or explosions, in
spite of safeguards, could create environmental or safety liabilities.
Therefore, our operations entail risk of environmental damage and injury to
people, and we could incur liabilities in the future arising from the discharge
of pollutants into the environment, waste disposal practices, or accidents.
We are involved in litigation and claims for which we incur significant costs
and are exposed to significant liability.
Headwaters is a party to some significant legal proceedings and is
subject to potential claims regarding operation of its business. These
proceedings will require that Headwaters incur substantial costs, including
attorneys' fees, managerial time and other personnel resources and costs in
pursuing resolution, and adverse resolution of these proceedings could hurt
Headwaters' reputation. With respect to the cases referred to in our "Item 3.
LEGAL PROCEEDINGS" of this Form 10-K, the following amount of damages are being
sought by the counter parties:
McEwan: McEwan seeks declaratory relief as well as compensatory
damages in the approximate amount of $3 million plus punitive
damages.
Boynton: Boynton seeks declaratory relief as well as compensatory
damages in the approximate amount of $25 million plus punitive
damages;
Headwaters has ongoing litigation and claims incurred during the normal
course of business, including the items referred to above. Headwaters intends to
vigorously defend and/or pursue its rights in these actions. We do not currently
believe that the outcome of these actions will have a material adverse effect on
Headwaters' operations, cash flows or financial position; however, it is
possible that a change in the estimates of probable liability could occur, and
the change could be significant.
We have significant competition in our industries which may cause demand for our
products and services to decrease.
47
Headwaters experiences significant competition in all of its segments
and geographic regions. A failure to compete effectively or increased
competition could lead to price cuts, reduced gross margins and loss of market
share, which could decrease our profitability. Many of our competitors have
greater financial, management and other resources than us and may be able to
take advantage of acquisitions and other opportunities more readily. In certain
instances we must compete on the basis of superior products and services rather
than price, thereby increasing the costs of marketing its services to remain
competitive.
HES competes with other companies possessing technologies to produce
coal-based solid alternative fuels and companies that produce chemical reagents.
It also experiences competition from traditional coal and fuel suppliers and
companies involved with natural resources, in addition to those companies that
specialize in the use and upgrading of industrial byproducts. These companies
may have greater financial, management and other resources than we have and may
develop superior, or more cost-effective, technologies. This could result in a
decrease in market share and therefore revenues.
HRI has substantial competition in two main areas: obtaining CCP
management contracts with utility and other industrial companies; and marketing
CCPs and related industrial materials. There are many local, regional and
national companies that compete for market share in these areas with similar
products and with numerous other substitute products. Although HRI typically has
long-term CCP management contracts with its clients, some of such contracts
provide for the termination of such contracts at the convenience of the utility
company upon a minimum 90-day notice. Moreover, certain of HRI'S most
significant regional CCP competitors appear to be seeking a broader national
presence, and some of these competitors have substantially greater resources
than Headwaters and HRI. If they were to begin to compete in the national
market, or in regions where they currently do not have operations, HRI could
lose market share and associated revenues.
HCM competes against numerous national and regional building products
manufacturers, some of which are significantly larger than Headwaters and may
have greater financial, manufacturing and distribution resources than
Headwaters.
For the HTI business, many of the world's major chemical companies are
devoting significant resources to researching and developing nanocatalysts,
catalytic processes, and coal to liquid processes. These companies have greater
financial, management and other resources than Headwaters.
Our business strategy to diversify and grow through acquisitions may result in
integration costs, failures and dilution to existing stockholders.
An important business strategy of Headwaters has been and continues to
be diversification and growth through acquisitions. Our ability to successfully
implement our strategy is subject to a number of risks, including difficulties
in identifying acceptable acquisition candidates, consummating acquisitions on
favorable terms and obtaining adequate financing, which may adversely affect our
ability to develop new products and services and to compete in our markets. In
addition, if we consummate acquisitions through an exchange of our securities,
our existing stockholders could suffer dilution.
If we do not successfully integrate newly acquired businesses with our
existing businesses, we may not realize the expected benefits of the
acquisitions, and the resources and attention required for successful
integration may interrupt the business activities of acquired businesses and our
existing businesses. Successful management and integration of acquisitions are
subject to a number of risks, including difficulties in assimilating acquired
operations, loss of key employees, diversion of management's attention from core
business operations, assumption of contingent liabilities, incurrence of
potentially significant write-offs, and various employee issues, such as issues
related to human resource benefit plans, and an increase in EEOC claims and
claims for workers' compensation. Each business acquisition also requires us to
expand our operational and financial systems, which increases the complexity of
our information technology systems. Implementation of controls, systems and
procedures may be costly and time-consuming and may not be effective. This
strategy may not improve our operating results and acquisitions may have a
dilutive effect on existing stockholders.
If our internal controls over financial reporting under Section 404 of the
Sarbanes-Oxley Act are not adequate, our reputation could be harmed and we could
be subject to regulatory scrutiny, civil or criminal penalties or stockholder
litigation.
Section 404 of the Sarbanes-Oxley Act of 2002 requires that we evaluate
and report on our system of internal controls beginning with this Annual Report
on Form 10-K. If we fail to maintain the adequacy of our internal controls, we
48
could be subject to regulatory scrutiny, civil or criminal penalties or
stockholder litigation. Any inability to provide reliable financial reports
could harm our business. Section 404 of the Sarbanes-Oxley Act also requires
that our independent auditors report on management's evaluation of our system of
internal controls. Headwaters has documented and tested its system of internal
controls to provide the basis for our report. Further, the growth and
diversification of our business through acquisitions complicates the process of
developing, documenting, maintaining and testing internal controls. No assurance
can be given that in the future there may not be significant deficiencies or
material weaknesses that would be required to be reported.
If we are unable to manage the growth of our business successfully, our revenues
and business prospects could suffer.
We have experienced significant growth recently, both internally and
through acquisitions. We may not be able to successfully manage the increased
scope of our operations or a significantly larger and more geographically
diverse workforce as we expand. Any failure to successfully manage growth could
harm our business and financial results. Additionally, growth increases the
demands on our management, our internal systems, procedures and controls. To
successfully manage growth, we must add administrative staff and periodically
update and strengthen our operating, financial and other systems, procedures and
controls, which will increase our costs and may reduce our profitability. We may
be unable to successfully implement improvements to our information and control
systems in an efficient or timely manner and may discover deficiencies in
existing or future systems and controls.
Unauthorized use of or infringement claims regarding our proprietary
intellectual property could adversely affect our ability to conduct our
business.
We rely primarily on a combination of trade secrets, patents, copyright
and trademark laws and confidentiality procedures to protect our intellectual
property. Despite these precautions, unauthorized third parties may
misappropriate, infringe upon, copy or reverse engineer portions of our
technology or products. We do not know if current or future patent applications
will be issued with the scope of the claims sought, if at all, or whether any
patents issued will be challenged or invalidated. Our business could be harmed
if we infringe upon the intellectual property rights of others. We have been,
and may be in the future, notified that we may be infringing intellectual
property rights possessed by third parties. If any such claims are asserted
against us, we may seek to enter into royalty or licensing arrangements. There
is a risk in these situations that no license will be available or that a
license will not be available on reasonable terms, precluding our use of the
applicable technology. Alternatively, we may decide to litigate such claims or
attempt to design around the patented technology. To date, while no single
patent or trademark is material to our business and the issues described in this
paragraph have not resulted in significant cost or had an adverse impact on our
business, future actions could be costly and would divert the efforts and
attention of our management and technical personnel.
Our capital structure affects our flexibility in responding to changing business
and economic conditions and results in high interest costs.
As of September 30, 2005, we had approximately $654 million of total
debt outstanding, including $473 million of senior indebtedness under our senior
secured credit facilities and $172.5 million of our 2.875% convertible senior
subordinated notes (the "Convertible Notes"). Subject to restrictions in our
senior secured credit facility, we may also incur significant amounts of
additional debt for working capital, capital expenditures and other purposes.
Our combined debt total could have important consequences, including the
following:
o we may have difficulty borrowing money for working capital,
capital expenditures, acquisitions or other purposes because
of our existing debt load and because our borrowings are
secured by all of our assets;
o we will need to use a large portion of our cash flow to pay
interest and the required principal payments on our debt,
which will reduce the amount of money available to finance our
operations, capital expenditures and other activities; and
o over 65% of our senior secured credit facilities has a
variable rate of interest, which exposes us to the risk of
increased interest rates.
49
Our ability to make scheduled payments of the principal of, to pay
interest on or to refinance our indebtedness depends on our future performance,
which to a certain extent is subject to economic, financial, competitive and
other factors beyond our control. Our business may not continue to generate cash
flow from operations in the future sufficient to service our debt and make
necessary capital expenditures. If unable to generate such cash flow, we may be
required to adopt one or more alternatives, such as selling assets,
restructuring debt or obtaining additional equity capital on terms that may be
onerous or highly dilutive.
Covenant restrictions under our senior secured credit facility may limit our
ability to operate our business in a manner required to sustain profitability
and generate growth.
Our senior secured credit facilities, contain, among other things,
covenants that may restrict our ability to finance future operations or capital
needs, to acquire additional businesses or to engage in other business
activities. The senior secured credit facilities impose specified limitations on
joint venture investments and new acquisitions. In addition, our senior secured
credit facilities set forth covenants requiring us to maintain specified
financial ratios and to satisfy certain financial condition tests which may
require that we take action to reduce our debt or to act in a manner contrary to
our business objectives. A breach of any of these covenants could result in a
default under our senior secured credit facilities, in which event our lenders
could elect to declare all amounts outstanding to be immediately due and
payable. If we are not able to repay our obligations when they become due or are
accelerated, the lenders could foreclose on our assets. The indenture for the
notes does not restrict the amount of indebtedness, including senior
indebtedness, that we may incur.
Risks Related to our Common Stock
The price of our common stock historically has been volatile. This volatility
may affect the price at which you could sell your common stock, and the sale of
substantial amounts of our common stock could adversely affect the price of our
common stock.
The market price for our common stock has varied between a high of
$45.75 in July 2005 and a low of $26.31 in January 2005 in the twelve month
period ended October 31, 2005. This volatility may affect the price at which you
could sell your common stock, and the sale of substantial amounts of our common
stock could adversely affect the price of our common stock. Our stock price is
likely to continue to be volatile and subject to significant price and volume
fluctuations in response to market and other factors, including the other
factors discussed in "Risks Relating to Our Business;" variations in our
quarterly operating results from our expectations or those of securities
analysts or investors; downward revisions in securities analysts' estimates; and
announcement by us or our competitors of significant acquisitions, strategic
partnerships, joint ventures or capital commitments.
In the past, following periods of volatility in the market price of
their stock, many companies have been the subject of securities class action
litigation. If we became involved in securities class action litigation in the
future, it could result in substantial costs and diversion of our management's
attention and resources and could harm our stock price, business, prospects,
results of operations and financial condition.
In addition, the broader stock market has experienced significant price
and volume fluctuations in recent years. This volatility has affected the market
prices of securities issued by many companies for reasons unrelated to their
operating performance and may adversely affect the price of our common stock. In
addition, our announcements of our quarterly operating results, changes in
general conditions in the economy or the financial markets and other
developments affecting us, our affiliates or our competitors could cause the
market price of our common stock to fluctuate substantially.
In addition, the sale of substantial amounts of our common stock could
adversely impact its price. As of September 30, 2005, we had outstanding
approximately 41.8 million shares of our common stock and options to purchase
approximately 2.8 million shares of our common stock (of which approximately 2.5
million were exercisable as of that date). We also had outstanding approximately
3.0 million stock appreciation rights as of September 30, 2005, of which
approximately 2.0 million were exercisable. The sale or the availability for
sale of a large number of shares of our common stock in the public market could
cause the price of our common stock to decline.
Conversion of the Convertible Notes may cause volatility in our stock price and
will dilute the ownership interest of existing stockholders.
Although our diluted earnings per share calculation treats the
Convertible Notes as if they were already converted into common stock, sales in
the public market of the common stock issuable upon such conversion could
adversely affect prevailing market prices of our common stock. Anticipated
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conversion of the notes into shares of our common stock could depress the price
of our common stock. In addition, the existence of the Convertible Notes may
encourage short selling by market participants because the conversion of the
notes could be used to satisfy short positions. Conversion of the Convertible
Notes will dilute the ownership interests of existing stockholders, including
holders who had previously converted their notes.
We have never paid dividends and do not anticipate paying any dividends on our
common stock in the future, so any short-term return on your investment will
depend on the market price of our capital stock.
We currently intend to retain any earnings to finance our operations
and growth. The terms and conditions of our senior secured credit facility
restrict and limit payments or distributions in respect of our capital stock.
Delaware law and our charter documents may impede or discourage a takeover,
which could cause the market price of our shares to decline.
We are a Delaware corporation, and the anti-takeover provisions of
Delaware law impose various impediments to the ability of a third party to
acquire control of us, even if a change in control would be beneficial to our
existing stockholders. In addition, our board of directors has the power,
without stockholder approval, to designate the terms of one or more series of
preferred stock and issue shares of preferred stock, including the adoption of a
"poison pill," which could be used defensively if a takeover is threatened. The
ability of our board of directors to create and issue a new series of preferred
stock and certain provisions of Delaware law and our certificate of
incorporation and bylaws could impede a merger, takeover or other business
combination involving us or discourage a potential acquirer from making a tender
offer for our common stock, which, under certain circumstances, could reduce the
market price of our common stock.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Headwaters is exposed to financial market risks, primarily related to
changes in interest rates. Headwaters does not use derivative financial
instruments for speculative or trading purposes, but has entered into hedge
transactions to limit its variable interest rate exposure, as explained below.
As described in more detail in Note 9 to the consolidated financial
statements, Headwaters has approximately $481.4 million of variable-rate
long-term debt outstanding as of September 30, 2005, consisting of $472.7
million of senior debt and $8.7 million of notes payable to a bank. There was
approximately $799.8 million of variable-rate long-term debt outstanding as of
September 30, 2004.
The $472.7 million of borrowings under the senior debt agreement
consisted of a first lien term loan in the amount of $442.7 million and
outstanding borrowings under the revolving credit arrangement of $30.0 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 5.9% at September 30, 2005.
Headwaters can lock in new rates for the first lien loan for one, two, three or
six months. The most recent rate change occurred in October 2005. Outstanding
borrowings under the revolving credit arrangement 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%.
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 (subsequently reduced to $150.0 million) 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
September 30, 2005) of this debt for the period commencing September 8, 2005
through September 8, 2007. During 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 which limit its variable
interest rate exposure 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
51
value at September 30, 2005 of approximately $2.1 million, which, net of $0.8
million of income taxes, represents other comprehensive income for 2005. Total
comprehensive income was approximately $122.6 million for 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, totaling
$8.7 million, require monthly interest and quarterly principal payments and bear
interest at variable rates, which as of September 30, 2005, ranged from 4.5% to
6.25%.
Considering all outstanding balances of variable-rate debt (reduced by
the $150.0 million of senior debt that effectively has a fixed interest rate
until September 8, 2007) and required principal repayments, a change in the
interest rate of 1% would change Headwaters' interest expense by approximately
$3.0 million during the 12 months ending September 30, 2006.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary financial data required by
this Item 8 are set forth in Item 15 of this Form 10-K. All information that has
been omitted is either inapplicable or not required.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures - Headwaters maintains disclosure
controls and procedures that are designed to ensure that information required to
be disclosed by Headwaters in the reports that it files or submits under the
Securities Exchange Act of 1934 (the "Exchange Act"), such as this Annual Report
on Form 10-K, is recorded, processed, summarized and reported within the time
periods specified by SEC rules and forms. Disclosure controls and procedures
include, without limitation, controls and procedures designed to ensure that
information required to be disclosed by Headwaters in the reports that it files
or submits under the Exchange Act is accumulated and communicated to Headwaters'
management, including the Chief Executive Officer ("CEO") and the Chief
Financial Officer ("CFO"), to allow timely decisions regarding required
disclosure.
Headwaters' management evaluated, with the participation of Headwaters'
CEO and CFO, the effectiveness of its disclosure controls and procedures as of
September 30, 2005, pursuant to paragraph (b) of Rules 13a-15 and 15d-15 under
the Exchange Act. This evaluation included a review of the controls' objectives
and design, the operation of the controls, and the effect of the controls on the
information presented in this Annual Report. Headwaters' management, including
the CEO and CFO, does not expect that disclosure controls can or will prevent or
detect all errors and all fraud, if any. A control system, no matter how well
designed and operated, can provide only reasonable, not absolute, assurance that
the objectives of the control system are met. Also, the projection of any
evaluation of the disclosure controls and procedures to future periods is
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, and subject to the inherent
limitations 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 Exchange Act) were effective as of September 30, 2005.
Internal Control over Financial Reporting - Management is responsible
for establishing and maintaining adequate internal control over financial
reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act.
Headwaters' internal control over financial reporting is designed to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
accounting principles generally accepted in the United States of America.
Because of inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Therefore, even internal
controls determined to be effective can provide only reasonable assurance with
respect to financial statement preparation and presentation. The effectiveness
of Headwaters' internal control over financial reporting is subject to various
inherent limitations, including cost limitations, judgments used in decision
52
making, assumptions about the likelihood of future events, the possibility of
human error, and the risk of fraud. The projection of any evaluation of
effectiveness to future periods is subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with policies may deteriorate. Because of these limitations, there can be no
assurance that any system of internal control over financial reporting will be
successful in preventing all errors or fraud or in making all material
information known in a timely manner to the appropriate levels of management.
There has been no change in Headwaters' internal control over financial
reporting during the quarter ended September 30, 2005 that has materially
affected, or is reasonably likely to materially affect, Headwaters' internal
control over financial reporting.
Management's Report on Internal Control over Financial Reporting
Headwaters' management is responsible for establishing and maintaining
adequate internal control over financial reporting. Headwaters' internal control
system has been designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation and presentation of
Headwaters' financial statements.
Headwaters' management has assessed the effectiveness of internal
control over financial reporting as of September 30, 2005 using the criteria
issued by the Committee of Sponsoring Organizations of the Treadway Commission
in "Internal Control -- Integrated Framework." Based on that assessment,
management believes that Headwaters' internal control over financial reporting
was effective as of September 30, 2005.
Ernst & Young LLP, the independent registered public accounting firm
which audits Headwaters' consolidated financial statements, has issued the
following attestation report on management's assessment of internal control over
financial reporting.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Headwaters Incorporated
We have audited management's assessment, included in the section entitled
"Management's Report on Internal Control over Financial Reporting" of Item 9A of
Headwaters Incorporated's Form 10-K, that Headwaters Incorporated maintained
effective internal control over financial reporting as of September 30, 2005,
based on criteria established in Internal Control--Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission (the
COSO criteria). Headwaters Incorporated's management is responsible for
maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting.
Our responsibility is to express an opinion on management's assessment and an
opinion on the effectiveness of the Company's internal control over financial
reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
53
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, management's assessment that Headwaters Incorporated maintained
effective internal control over financial reporting as of September 30, 2005, is
fairly stated, in all material respects, based on the COSO criteria. Also, in
our opinion, Headwaters Incorporated maintained, in all material respects,
effective internal control over financial reporting as of September 30, 2005,
based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheets of
Headwaters Incorporated as of September 30, 2004 and 2005, and the related
consolidated statements of income, stockholders' equity, and cash flows for each
of the three years in the period ended September 30, 2005 of Headwaters
Incorporated and our report dated November 30, 2005 expressed an unqualified
opinion thereon.
/s/ Ernst & Young LLP
Salt Lake City, Utah
November 30, 2005
ITEM 9B. OTHER INFORMATION
None.
54
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The applicable information to be set forth under the captions
"Executive Officers," "Corporate Governance," "Section 16(a) Beneficial
Ownership Reporting Compliance" and "Proposal No. 1 - Election of Directors" in
Headwaters' Proxy Statement to be filed in January 2006 for the Annual Meeting
of Stockholders to be held in 2006 (the "Proxy Statement"), is incorporated
herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The applicable information to be set forth under the captions
"Executive Compensation and Related Information" and "Corporate Governance" in
the Proxy Statement is incorporated herein by reference; provided, however, that
Headwaters specifically excludes from such incorporation by reference any
information set forth under the captions "Compensation Committee Report on
Executive Compensation" and "Stockholder Return Performance Graph" in the Proxy
Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information to be set forth under the captions "Summary Information
about Equity Compensation Plans" and "Security Ownership of Certain Beneficial
Owners and Management" in the Proxy Statement is incorporated herein by
reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information to be set forth under the caption "Transactions with
Related Parties" in the Proxy Statement is incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information to be set forth under the caption "Audit and Non-Audit
Fees" in the Proxy Statement is incorporated herein by reference.
55
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) 1. Financial Statements
Consolidated Financial Statements of Headwaters Incorporated Page
Report of Independent Registered Public Accounting Firm F-1
Consolidated Balance Sheets as of September 30, 2004 and 2005 F-2
Consolidated Statements of Income
for the years ended September 30, 2003, 2004 and 2005 F-3
Consolidated Statements of Changes in Stockholders' Equity
for the years ended September 30, 2003, 2004 and 2005 F-4
Consolidated Statements of Cash Flows
for the years ended September 30, 2003, 2004 and 2005 F-6
Notes to Consolidated Financial Statements F-7
2. Financial Statement Schedules
All financial statement schedules for which provision is made in the
applicable accounting regulations of the Securities and Exchange Commission are
not required under the related instructions, are inapplicable, or the required
information has been provided in the consolidated financial statements or notes
thereto.
3. Listing of Exhibits
For convenience, the name Headwaters is used throughout this listing
although in some cases the name Covol was used in the original instrument.
Exhibit No. Description Location
----------- ----------- --------
3.1.9 Amended and Restated Certificate of Incorporation of Headwaters dated 1 March 2005 (12)
3.2.4 Restated By-Laws of Headwaters (4)
10.60 Employment Agreement dated August 25, 2005 with Kirk A. Benson (17)
10.75 Agreement and Plan of Merger between Headwaters and Industrial Services Group, (2)
Inc. dated July 15, 2002
10.75.2 First Amendment to Agreement and Plan of Merger and Equityholder Agreements among (3)
Headwaters, Industrial Services Group, Inc. and Equityholders of Industrial
Services Group, Inc. dated September 19, 2002
10.85 Agreement and Plan of Merger between Headwaters and VFL Technology Corporation (6)
dated February 10, 2004
10.86 Securities Purchase Agreement by and among Eldorado Stone Holdings Co., LP, et (7)
al. and Headwaters dated April 21, 2004
10.87 Indenture dated as of June 1, 2004 between Headwaters and Wells Fargo Bank, as (8)
Trustee, relating to 2-7/8% Convertible Senior Subordinated Notes due 2016
10.88 Asset Purchase Agreement between Headwaters and Southwest Concrete Products, LP (8)
10.89 Agreement and Plan of Merger by and among Headwaters Incorporated, Headwaters T (9)
Acquisition Corp., and Tapco Holdings, Inc., dated as of September 8, 2004
10.90 Employment Agreement with John N. Lawless, III dated September 22, 2004 (10)
10.90.1 Nonstatutory Stock Option Grant effective as of September 22, 2004 (10)
10.90.2 Executive Change in Control Agreement with John N. Lawless, III effective as of (10)
September 22, 2004
10.91 Credit Agreement among Headwaters and various lenders dated September 8, 2004 (11)
10.92 Second Lien Credit Agreement among Headwaters and various lenders dated September (11)
8, 2004
10.93 Amendment No. 2 to the Credit Agreement among Headwaters and various lenders (13)
dated as of March 14, 2005
10.93.1 Amendment No. 3 to the Credit Agreement among Headwaters and various lenders (15)
dated as of May 19, 2005
56
10.93.2 Amendment No. 4 to the Credit Agreement among Headwaters and various lenders (19)
dated as of October 26, 2005
10.94 Settlement Agreement and Mutual Release dated May 1, 2005 between Headwaters, AJG (14)
Financial Services, Inc. and others
10.95 Offer of Employment dated September 12, 2005 between Scott K. Sorensen and (18)
Headwaters (received September 14, 2005)
10.95.1 Executive Severance Agreement dated September 20, 2005 between Scott K. Sorensen (18)
and Headwaters
12 Computation of ratio of earnings to combined fixed charges and preferred stock *
dividends
14 Code of Ethics (14)
21 List of Subsidiaries of Headwaters *
23.1 Consent of Ernst & Young LLP *
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer *
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer *
32 Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer *
99.1.1 Amended 2000 Employee Stock Purchase Plan, as further amended (16)
99.2 1995 Stock Option Plan (originally designated as Exhibit No. 10.5) (1)
99.2.1 First Amendment to the 1995 Stock Option Plan (originally designated as Exhibit (1)
10.5.1)
99.2.2 1996 Stock Option Agreement (4)
99.2.3 1998 Stock Option Agreement (4)
99.2.4 2001 Stock Option Agreement (4)
99.2.5 2002 Stock Option Agreement (4)
99.4 2002 Stock Incentive Plan (11)
99.7 2003 Stock Incentive Plan (5)
99.9 Short Term Incentive Bonus Plan (Effective 1 October 2005) (12)
99.10 Long Term Incentive Compensation Plan (Effective 1 March 2005) (12)
99.11 Nominating and Corporate Governance Committee Charter, dated April 25, 2005 (14)
99.12 Audit Committee Charter, dated March 9, 2005 (14)
99.13 Compensation Committee Charter, dated March 9, 2005 (14)
99.14 Form of 2005 Stock Appreciation Right Grant and related Stock Appreciation Right (14)
Agreement (vested)
99.15 Form of 2005 Stock Appreciation Right Grant and related Stock Appreciation Right (14)
Agreement (scheduled vesting)
- -----------------------
* Filed herewith.
Unless another exhibit number is indicated as the exhibit number for the exhibit
as "originally filed," the exhibit number in the filing in which any exhibit was
originally filed and to which reference is made hereby is the same as the
exhibit number assigned herein to the exhibit.
(1) Incorporated by reference to the indicated exhibit filed with
Headwaters' Registration Statement on Form 10, filed February 26, 1996.
(2) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated July 15,
2002, filed July 18, 2002.
(3) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated September
19, 2002, filed October 4, 2002.
(4) Incorporated by reference to the indicated exhibit filed with
Headwaters' Annual Report on Form 10-K, for the fiscal year ended
September 30, 2002.
(5) Incorporated by reference to the indicated exhibit filed with
Headwaters' Quarterly Report on Form 10-Q, for the quarter ended
December 31, 2002.
(6) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K/A, for the event dated April 9,
2004, filed December 7, 2004.
(7) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K/A, for the event dated April 21,
2004, filed December 7, 2004.
(8) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K/A, for the event dated July 7,
2004, filed December 7, 2004.
(9) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K/A, for the event dated September
8, filed December 13, 2004.
57
(10) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated September
22, 2004, filed September 28, 2004.
(11) Incorporated by reference to the indicated exhibit filed with
Headwaters' Annual Report on Form 10-K, for the fiscal year ended
September 30, 2004.
(12) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated March 1,
2005, filed March 3, 2005.
(13) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated March 14,
2005, filed March 17, 2005.
(14) Incorporated by reference to the indicated exhibit filed with
Headwaters' Quarterly Report on Form 10-Q, for the quarter ended March
31, 2005.
(15) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated May 27,
2005, filed June 1, 2005.
(16) Incorporated by reference to the indicated exhibit filed with
Headwaters' Quarterly Report on Form 10-Q, for the quarter ended June
30, 2005.
(17) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated August 25,
2005, filed August 29, 2005.
(18) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated September
14, 2005, filed September 20, 2005.
(19) Incorporated by reference to the indicated exhibit filed with
Headwaters' Current Report on Form 8-K, for the event dated November 8,
2005, filed November 8, 2005.
(b) Exhibits
The response to this portion of Item 15 is submitted as a separate
section of this report. See Item 15 (a) 3 above.
(c) Financial Statement Schedules
The response to this portion of Item 15 is submitted as a separate
section of this report. See Item 15 (a) 2 above.
58
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
HEADWATERS INCORPORATED
By: /s/ Kirk A. Benson
-------------------------------
Kirk A. Benson
Chief Executive Officer
(Principal Executive Officer)
By: /s/ Scott K. Sorensen
-------------------------------
Scott K. Sorensen
Chief Financial Officer
(Principal Financial and
Accounting Officer)
Date: December 2, 2005
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Harlan M. Hatfield and Scott K. Sorensen, and
each of them, his/her true and lawful attorneys-in-fact and agents, each with
full power of substitution and resubstitution, for him/her and in his/her name,
place and stead, in any and all capacities, to sign any and all amendments to
this report on Form 10-K, and to file the same, with exhibits thereto and other
documents in connection therewith, with the Securities and Exchange Commission,
granting unto said attorneys-in-fact and agents, and each of them, full power
and authority to do and perform each and every act and thing requisite and
necessary to be done, as fully to all intents and purposes as he/she might or
could do in person, hereby ratifying and confirming all that each of said
attorneys-in-fact and agents or their substitute or substitutes may lawfully do
or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Kirk A. Benson Director and Chief Executive Officer December 2, 2005
- --------------------- (Principal Executive Officer)
Kirk A. Benson
/s/ Scott K. Sorensen Chief Financial Officer (Principal December 2, 2005
- --------------------- Financial and Accounting Officer)
Scott K. Sorensen
/s/ James A. Herickhoff Director December 2, 2005
- ------------------------
James A. Herickhoff
/s/ Raymond J. Weller Director December 2, 2005
- ----------------------
Raymond J. Weller
/s/ E. J. "Jake" Garn Director December 2, 2005
- ----------------------
E. J. "Jake" Garn
/s/ R. Sam Christensen Director December 2, 2005
- -----------------------
R. Sam Christensen
/s/ William S. Dickinson Director December 2, 2005
- -------------------------
William S. Dickinson
/s/ Malyn K. Malquist Director December 2, 2005
- ----------------------
Malyn K. Malquist
/s/ Blake O. Fisher, Jr. Director December 2, 2005
- -------------------------
Blake O. Fisher, Jr.
59
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Headwaters Incorporated
We have audited the accompanying consolidated balance sheets of Headwaters
Incorporated as of September 30, 2004 and 2005, and the related consolidated
statements of income, changes in stockholders' equity, and cash flows for each
of the three years in the period ended September 30, 2005. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Headwaters
Incorporated at September 30, 2004 and 2005, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
September 30, 2005, in conformity with U.S. generally accepted accounting
principles.
As discussed in Notes 2 and 12 to the financial statements, in 2005 the Company
changed its method of accounting for stock-based compensation.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of Headwaters
Incorporated's internal control over financial reporting as of September 30,
2005, based on criteria established in Internal Control-Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
and our report dated November 30, 2005 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Salt Lake City, Utah
November 30, 2005
F-1
HEADWATERS INCORPORATED
CONSOLIDATED BALANCE SHEETS
As of September 30,
------------------------------
(in thousands, except per-share data) 2004 2005
- -------------------------------------------------------------------------------------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 20,851 $ 13,666
Trade receivables, net 129,899 174,127
Other receivable -- 70,000
Inventories 43,812 60,519
Current and deferred income taxes 15,933 28,577
Other 20,068 8,185
------------------------------
Total current assets 230,563 355,074
------------------------------
Property, plant and equipment, net 157,611 190,450
------------------------------
Other assets:
Intangible assets, net 297,818 276,248
Goodwill 815,396 811,545
Debt issue costs and other assets 39,391 38,339
------------------------------
Total other assets 1,152,605 1,126,132
------------------------------
Total assets $1,540,779 $1,671,656
==============================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 29,238 $ 43,957
Accrued personnel costs 26,213 33,584
Accrued income taxes -- 14,941
Other accrued liabilities 65,625 66,191
Deferred license fee revenue 7,227 26,858
Current portion of long-term debt 57,873 52,207
------------------------------
Total current liabilities 186,176 237,738
------------------------------
Long-term liabilities:
Long-term debt 914,641 601,811
Deferred income taxes 121,469 108,449
Other 10,338 37,345
------------------------------
Total long-term liabilities 1,046,448 747,605
------------------------------
Total liabilities 1,232,624 985,343
------------------------------
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 41,842 shares at September 30, 2005 (including
347 shares held in treasury) 34 42
Capital in excess of par value 235,581 489,602
Retained earnings 76,530 197,808
Treasury stock and other (3,990) (1,139)
------------------------------
Total stockholders' equity 308,155 686,313
------------------------------
Total liabilities and stockholders' equity $1,540,779 $1,671,656
==============================
See accompanying notes.
F-2
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF INCOME
Year ended September 30,
-------------------------------------------------
(in thousands, except per-share data) 2003 2004 2005
- -----------------------------------------------------------------------------------------------------------------------------
Revenue:
Construction materials $ 49,350 $134,027 $ 519,926
Coal combustion products 169,938 210,155 246,819
Alternative energy 168,342 209,773 297,894
-------------------------------------------------
Total revenue 387,630 553,955 1,064,639
Operating costs and expenses:
Construction materials 38,313 95,263 346,521
Coal combustion products 128,080 155,777 186,133
Alternative energy 91,305 90,225 140,973
Amortization 6,504 9,107 24,465
Research and development 4,958 7,605 12,621
Contract litigation settlement -- -- (38,252)
Selling, general and administrative 41,351 68,221 155,305
-------------------------------------------------
Total operating costs and expenses 310,511 426,198 827,766
-------------------------------------------------
Operating income 77,119 127,757 236,873
-------------------------------------------------
Other income (expense):
Net interest expense (15,377) (18,509) (57,433)
Losses on notes receivable (2,142) (2,621) --
Other, net 481 (1,520) (15,632)
-------------------------------------------------
Total other income (expense), net (17,038) (22,650) (73,065)
-------------------------------------------------
Income before income taxes 60,081 105,107 163,808
Income tax provision (23,450) (40,790) (42,530)
-------------------------------------------------
Net income $ 36,631 $ 64,317 $ 121,278
=================================================
Basic earnings per share $ 1.35 $ 2.02 $ 3.19
=================================================
Diluted earnings per share $ 1.30 $ 1.88 $ 2.79
=================================================
See accompanying notes.
F-3
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Retained
Common Stock Capital in earnings Treasury Total
----------------- excess (accumulated stock, stockholders'
(in thousands) Shares Amount of par value deficit) at cost Other equity
- -----------------------------------------------------------------------------------------------------------------------------------
Balances as of September 30, 2002 27,327 $27 $126,265 $(24,418) $(3,013) $ (265) $ 98,596
Exercise of stock options and warrants 551 1 2,139 2,140
Tax benefit from exercise of stock options 2,050 2,050
59 shares of treasury stock transferred to
employee stock purchase plan, at cost 482 230 712
Other 28 28
Net income for the year ended September 30, 2003 36,631 36,631
------------------------------------------------------------------------------
Balances as of September 30, 2003 27,878 28 130,936 12,213 (2,783) (237) 140,157
------------------------------------------------------------------------------
Exercise of stock options and warrants 878 1 8,119 8,120
Tax benefit from exercise of stock options 4,070 4,070
53 shares of treasury stock transferred to
employee stock purchase plan, at cost 771 173 944
Common stock issued for cash, net of commissions
and other offering costs totaling $6,432 4,958 5 90,253 90,258
Issuance of restricted stock 61 -- 1,432 (1,432) --
Other 289 289
Net income for the year ended September 30, 2004 64,317 64,317
------------------------------------------------------------------------------
Balances as of September 30, 2004 33,775 $34 $235,581 $ 76,530 $(2,610) $(1,380) $308,155
------------------------------------------------------------------------------
See accompanying notes.
F-4
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (continued)
Retained
Common Stock Capital in earnings Treasury Total
----------------- excess (accumulated stock, stockholders'
(in thousands) Shares Amount of par value deficit) 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 and stock
appreciation rights 1,167 1 13,051 13,052
Tax benefit from exercise of stock options
and stock appreciation rights 8,098 8,098
67 shares of treasury stock transferred to
employee stock purchase plan, at cost 1,630 191 1,821
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 32,432 1,380 33,812
Other comprehensive income - unrealized gain
on cash flow hedges, net of taxes 1,280 1,280
Net income for the year ended
September 30, 2005 121,278 121,278
---------------------------------------------------------------------------------
Balances as of September 30, 2005 41,842 $42 $489,602 $197,808 $(2,419) $ 1,280 $686,313
=================================================================================
See accompanying notes.
F-5
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year ended September 30,
---------------------------------------
(in thousands) 2003 2004 2005
- -------------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ 36,631 $ 64,317 $ 121,278
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization 12,891 20,189 56,376
Non-cash stock-based compensation expense 91 289 33,812
Non-cash interest expense related to amortization of debt issue costs
and debt discount 3,857 6,031 10,634
Deferred income taxes (878) (1,283) (32,529)
Amortization of non-refundable license fees (1,178) (1,179) (16,844)
Net loss (gain) on disposition of property, plant and equipment (188) 1,254 461
Income tax benefit from exercise of stock options 2,050 4,070 --
Write-down of notes receivable 2,142 2,621 --
Increase in trade receivables (2,068) (10,620) (44,228)
Decrease (increase) in inventories 615 1,186 (16,957)
Increase in accounts payable and accrued liabilities 860 9,671 46,799
Other changes in operating assets and liabilities, net 1,566 (4,615) (7,571)
---------------------------------------
Net cash provided by operating activities 56,391 91,931 151,231
---------------------------------------
Cash flows from investing activities:
Purchase of property, plant and equipment (9,716) (13,967) (56,648)
Net increase in intangible and other assets (540) (7,794) (3,723)
Proceeds from disposition of property, plant and equipment 2,685 4,037 331
Payments for acquisitions, net of cash acquired of $11,834:
VFL Technology Corporation -- (4,171) --
Eldorado Stone, LLC -- (209,770) --
Southwest Concrete Products, L.P. -- (24,691) --
Tapco Holdings, Inc. -- (713,683) --
---------------------------------------
Net cash used in investing activities (7,571) (970,039) (60,040)
---------------------------------------
Cash flows from financing activities:
Net proceeds from issuance of common stock -- 90,258 198,817
Net proceeds from issuance of long-term debt -- 1,068,138 59,332
Payments on long-term debt (40,224) (287,233) (379,496)
Proceeds from exercise of stock options and warrants 2,140 8,120 13,052
Income tax benefit from exercise of stock options and stock
appreciation rights -- -- 8,098
Employee stock purchases 712 944 1,821
---------------------------------------
Net cash provided by (used in) financing activities (37,372) 880,227 (98,376)
---------------------------------------
Net increase (decrease) in cash and cash equivalents 11,448 2,119 (7,185)
Cash and cash equivalents, beginning of year 7,284 18,732 20,851
---------------------------------------
Cash and cash equivalents, end of year $ 18,732 $ 20,851 $ 13,666
=======================================
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 $ 7,500
Issuance of restricted stock -- 1,432 --
Supplemental disclosure of cash flow information:
Cash paid for interest $10,054 $ 11,063 $ 46,416
Cash paid for income taxes 19,356 35,622 43,531
See accompanying notes.
F-6
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2005
-----------
1. 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") (see Note 3).
Headwaters' fiscal year ends on September 30 and unless otherwise noted,
future references to years refer to Headwaters' fiscal year rather than a
calendar year.
Headwaters' focus is on enhancing the value of 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 high-value liquid
fuels. In addition, HTI has developed a unique process to custom design
nanocatalysts that could be used in multiple industrial applications.
2. Summary of Significant Accounting Policies
Principles of Consolidation - The consolidated financial statements include
the accounts of Headwaters, all of its subsidiaries and other entities in
which Headwaters has a controlling financial interest. In accordance with
Financial Accounting Standards Board Interpretation No. 46, "Consolidation
of Variable Interest Entities," as revised, Headwaters is required to
consolidate any variable interest entities for which it is the primary
beneficiary; however as of September 30, 2005, there are none. For
investments in companies in which Headwaters has a significant influence
over operating and financial decisions (generally defined as owning a voting
or economic interest of 20% to 50%), Headwaters applies the equity method of
accounting. In instances where Headwaters' investment is less than 20% and
significant influence does not exist, investments are carried at cost. All
significant intercompany transactions and accounts are eliminated in
consolidation.
As referred to above and described in detail in Note 3, Headwaters acquired
VFL on April 9, 2004, Eldorado Stone on June 2, 2004, SCP on July 2, 2004,
and Tapco on September 8, 2004. These entities' results of operations for
the periods from the acquisition dates through September 30, 2005 have been
consolidated with Headwaters' 2004 and 2005 results and their operations up
F-7
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
to the dates of acquisition have not been included in Headwaters'
consolidated results for any period. Determination of the purchase price and
final purchase price allocation for VFL and SCP were completed in 2004
(however, as described in Note 3, 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 and
Tapco in 2005.
Use of Estimates - The preparation of consolidated financial statements in
conformity with U.S. generally accepted accounting principles requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosures of contingent assets and
liabilities at the date of the financial statements, and the reported
amounts of revenue and expenses during the reporting period. Actual results
could differ materially from those estimates.
Segment Reporting, Major Customers and Other Concentrations of Risk -
Headwaters operates in three business segments, construction materials, CCPs
and alternative energy. VFL operates in the CCP segment and all of the other
businesses acquired by Headwaters in 2004 operate in the construction
materials segment. Additional information about segments is presented in
Note 4. The following table presents revenues for all customers that
accounted for over 10% of total revenue during 2003 and 2004. All of these
revenues are attributable to the alternative energy segment. No customer
accounted for over 10% of total revenue in 2005.
(in thousands) 2003 2004
------------------------------------------------------------------------
Pace Carbon Fuels, L.L.C. affiliates Less than 10% $57,602 (10.4%)
DTE Energy Services, Inc. affiliates $42,013 (10.8%) Less than 10%
Substantially all of Headwaters' revenues were generated from sales in the
United States. Headwaters purchases all of the chemical reagent that is sold
to licensees and other customers from a single large international chemical
company and Tapco purchases all of the polypropylene used in its building
products from a single supplier. Management believes that if necessary, the
chemical reagent and polypropylene could be obtained from other suppliers,
although changes in suppliers would be disruptive. Headwaters has no other
significant unusual trade credit risks or concentrations.
Revenue Recognition - Alternative Energy Segment. Headwaters currently
licenses its technologies to the owners of 28 coal-based solid alternative
fuel facilities from which Headwaters earns license fees and/or profits from
the sale of chemical reagents. Non-refundable advance license fees and
royalty payments have been received from certain licensees under various
terms and conditions. These non-refundable license fees and royalties have
been deferred and are being recognized on a straight-line basis through
December 31, 2007, the period covered by the related license and royalty
agreements. Recurring license fees or royalty payments are recognized in the
period when earned, which coincides with the sale of alternative fuel by
Headwaters' licensees. In certain instances, Headwaters is required to pay
to third parties a portion of license fees received or cash proceeds from
the sale of chemical reagents. In such cases, Headwaters records the net
proceeds as revenue. Revenues from the sale of chemical reagents are
recognized upon delivery of product and assumption of the risk of loss by
the licensee or non-licensee customer.
CCP and Construction Materials Segments. Revenue from the sale of CCPs and
construction materials is recognized upon passage of title to the customer,
which coincides with physical delivery and assumption of the risk of loss by
the customer. Estimated sales rebates, discounts and allowances are provided
for at the time of sale and are based upon established policies and
historical experience. Revenues include transportation charges and shipping
and handling fees associated with delivering material and products to
customers when the transportation or shipping and handling is contractually
provided for between the customer and Headwaters.
CCP service revenues include revenues earned under long-term contracts to
dispose of residual materials created by coal-fired electric power
generation and revenues earned in connection with certain
construction-related projects that are incidental to Resources' primary
business. Service revenues under long-term contracts are recognized
concurrently with the removal of material and are based on the number of
tons of material removed at the established price per ton.
F-8
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
Construction-related projects are billed on a time and materials basis;
therefore, the revenues and related costs are recognized when the time is
incurred and the materials are consumed.
The cost of CCPs sold primarily represents amounts paid to utility companies
to purchase product, together with storage and transportation costs to
deliver the product to customers. In accordance with certain utility company
contracts, the cost of CCPs purchased from those utilities is based on a
percentage of the "net revenues" from the sale of the CCPs purchased. Cost
of services sold includes landfill fees and transportation charges to
deliver non-marketable CCPs to the landfill. Cost of construction materials
sold includes shipping and handling fees.
Cash and Cash Equivalents - Headwaters considers all short-term highly
liquid investments with an original maturity of three months or less to be
cash equivalents. Certain cash and cash equivalents are deposited with
financial institutions, and at times such amounts may exceed insured
depository limits.
Receivables - Allowances are provided for uncollectible accounts and notes
when deemed necessary. Such allowances are based on an account-by-account
analysis of collectibility or impairment plus a provision for non-customer
specific defaults based upon historical collection experience. Collateral is
not required for trade receivables, but Headwaters performs periodic credit
evaluations of its customers. Collateral is generally required for notes
receivable.
Inventories - Inventories are stated at the lower of cost or market (net
realizable value). Cost includes direct material, transportation, direct
labor and allocations of manufacturing overhead costs and is determined
primarily using the first-in, first-out method.
Property, Plant and Equipment - Property, plant and equipment are recorded
at cost. For significant self-constructed assets, cost includes direct labor
and interest. Expenditures for major improvements are capitalized;
expenditures for maintenance, repairs and minor improvements are charged to
expense as incurred. Assets are depreciated using the straight-line method
over their estimated useful lives, limited to the lease terms for
improvements to leased assets. Upon the sale or retirement of property,
plant and equipment, any gain or loss on disposition is reflected in results
of operations, and the related asset cost and accumulated depreciation are
removed from the respective accounts.
Intangible Assets and Goodwill - Intangible assets consist primarily of
identifiable intangible assets obtained in connection with acquisitions (see
Note 3). Intangible assets are amortized using the straight-line method over
their estimated useful lives. Goodwill consists of the excess of the
purchase price for businesses acquired over the fair value of identified
assets acquired, net of liabilities assumed. In accordance with Statement of
Financial Accounting Standards ("SFAS") No. 142, "Accounting for Goodwill
and Intangible Assets," goodwill is not amortized, but is tested at least
annually for impairment, as of June 30, using a two-step process that begins
with an estimation of the fair values of the reporting units giving rise to
the goodwill (see Note 8).
Valuation of Long-Lived Assets - Headwaters evaluates the carrying value of
long-lived assets, including intangible assets and goodwill, as well as the
related amortization periods, to determine whether adjustments to these
amounts or to the useful lives are required based on current events and
circumstances. The carrying value of a long-lived asset is considered
impaired when the anticipated cumulative undiscounted cash flow from that
asset is less than its carrying value. In that event, a loss is recognized
based on the amount by which the carrying value exceeds the fair market
value of the long-lived asset. There were no material impairment losses
recorded for long-lived assets in any of the years presented.
Debt Issue Costs - Debt issue costs represent direct costs incurred for the
issuance of long-term debt. These costs are amortized to interest expense
over the lives of the respective debt issues using the effective interest
method. When debt is repaid early, the portion of unamortized debt issue
costs related to the early principal repayment is written off and included
in interest expense.
Financial Instruments - Derivatives are recorded in the consolidated balance
sheet at fair value, as required by SFAS No. 133, "Accounting for Derivative
F-9
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
Instruments and Hedging Activities," as amended ("SFAS No. 133"). Accounting
for changes in the fair value of a derivative depends on the intended use of
the derivative, which is established at inception. For derivatives
designated as cash flow hedges and which meet the effectiveness guidelines
of SFAS No. 133, changes in fair value, to the extent effective, are
recognized in other comprehensive income until the hedged item is recognized
in earnings. Hedge effectiveness is measured at least quarterly based on the
relative changes in fair value between the derivative contract and the
hedged item over time. Any change in fair value of a derivative resulting
from ineffectiveness, or an excluded component of the gain or loss, is
recognized immediately and is recorded as interest expense.
Headwaters formally documents all hedge transactions at inception of the
contract, including identification of the hedging instruments and the hedged
items, as well as its risk management objectives and strategies for
undertaking the hedge transaction. This process includes linking the
derivatives that are designated as hedges to specific assets, liabilities,
firm commitments or forecasted transactions. Headwaters also formally
assesses the effectiveness of its hedging relationships on an ongoing basis.
As described in more detail in Note 9, Headwaters entered into hedge
agreements in September 2004 to limit its exposure for interest rate
movements, but has not entered into any other hedge transactions.
Income Taxes - Headwaters accounts for income taxes using the asset and
liability approach. Headwaters recognizes deferred income tax assets or
liabilities for the expected future tax consequences of events that have
been recognized in the financial statements or income tax returns. Deferred
income tax assets or liabilities are determined based upon the differences
between the financial statement and tax bases of assets and liabilities
using enacted tax rates expected to apply when the differences are expected
to be settled or realized. Deferred income tax assets are reviewed
periodically based on changing events for recoverability, and valuation
allowances are provided as necessary. Headwaters files a consolidated
federal income tax return with substantially all of its subsidiaries.
Research and Development Costs - Research and development costs consist
primarily of personnel-related costs and are expensed as incurred.
Advertising Costs - Advertising costs are expensed as incurred, except for
the cost of certain materials which are capitalized and amortized to expense
as the materials are distributed. Total advertising costs were approximately
$7,832,000 in 2005 and were not material in 2003 or 2004.
Warranty Costs - Provision is made for warranty costs at the time of sale,
based upon established policies and historical experience. Total warranty
costs were not material in any of the periods presented.
Contingencies - In accounting for legal matters and other contingencies,
Headwaters follows the guidance in SFAS No. 5, "Accounting for
Contingencies," under which loss contingencies are accounted for based upon
the likelihood of an impairment of an asset or the incurrence of a
liability. If a loss contingency is "probable" and the amount of loss can be
reasonably estimated, it is accrued. If a loss contingency is "probable,"
but the amount of loss cannot be reasonably estimated, disclosure is made.
If a loss contingency is "reasonably possible," disclosure is made,
including the potential range of loss, if determinable. Loss contingencies
that are "remote" are neither accounted for nor disclosed. Gain
contingencies are given no accounting recognition, but are disclosed if
material.
Stock-Based Compensation - As described in more detail in Note 12, in the
quarter ended June 30, 2005 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 2005 fiscal year.
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
F-10
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
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 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 2005, net income and earnings
per share would have been changed to the pro forma amounts shown in the
following table for the years indicated.
(in thousands, except per-share data) 2003 2004
--------------------------------------------------------------------
Reported net income $36,631 $64,317
Add actual compensation expense included
in reported net income 91 289
Deduct expense determined under fair value
provision of SFAS No. 123 (4,097) (4,090)
---------------------
Pro forma net income $32,625 $60,516
=====================
Basic earnings per share - as reported $ 1.35 $ 2.02
- pro forma $ 1.20 $ 1.90
Diluted earnings per share - as reported $ 1.30 $ 1.88
- pro forma $ 1.16 $ 1.77
The fair values of stock option grants for 2003 and 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 1.3% to 4.5%, weighted average expected option
lives of 3 to 4 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
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.
Earnings per Share Calculation - Earnings per share ("EPS") has been
computed based on the weighted-average number of common shares outstanding.
Diluted EPS computations reflect the increase in weighted-average common
shares outstanding that would result from the assumed exercise of
outstanding stock-based awards, calculated using the treasury stock method
(as modified by SFAS No. 123R), and the assumed conversion of convertible
securities, using the if-converted method, when such stock-based awards and
convertible securities are dilutive.
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 is fiscal 2006. Because the provisions of this standard must be
applied prospectively, there will be no effect on previously-issued
financial statements. 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.
F-11
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
Reclassifications - Certain prior year amounts have been reclassified to
conform to the current year's presentation including some changes resulting
from the adoption of SFAS No. 123R, as explained in Note 12. The
reclassifications had no effect on net income or total assets.
3. Acquisitions
As described in the following paragraphs, Headwaters acquired four companies
in 2004.
VFL - On April 9, 2004, Headwaters acquired 100% of the common stock of VFL
and assumed all of VFL's outstanding debt. VFL is based in West Chester,
Pennsylvania and manages approximately two million tons of CCPs annually. In
addition, VFL has operating knowledge relating to the use of low value CCPs
in value-added applications. The acquisition of VFL broadens the scope of
services that Headwaters' CCP segment offers, as well as its client base,
principally on the East coast of the United States and in the Ohio River
Valley. VFL's results of operations have been included in Headwaters'
consolidated statement of income since April 9, 2004. In connection with the
VFL acquisition, Headwaters issued $19,000,000 of notes payable to the VFL
stockholders, all of which were repaid in 2004.
The following table sets forth the total consideration paid to acquire VFL.
(in thousands)
----------------------------------------------------------------
Cash paid to VFL stockholders $ 3,982
Notes payable issued to VFL stockholders 19,000
VFL debt assumed by Headwaters 6,749
Costs directly related to acquisition 225
----------
$29,956
==========
The VFL acquisition was accounted for using the purchase method of
accounting as required by SFAS No. 141, "Business Combinations." The
consideration Headwaters paid for VFL was negotiated at arms length and
assets acquired and liabilities assumed were recorded at their estimated
fair values as of April 9, 2004. Approximately $11,290,000 of the purchase
price was allocated to identifiable intangible assets consisting of
contracts with utility companies, industrial clients and municipalities.
This amount is being amortized over an estimated average useful life of
eight years. The remaining purchase price not attributable to the tangible
and identifiable intangible assets was allocated to goodwill, all of which
is tax deductible. All of the intangible assets and goodwill have been
allocated to Headwaters' CCP segment.
The following table sets forth the allocation of the total consideration
paid to the tangible and intangible assets acquired and liabilities assumed.
(in thousands)
-------------------------------------------------------------------
Cash $ 36
Trade receivables, net 4,287
Other assets 860
Property, plant and equipment 8,808
Intangible assets acquired - contracts (8 years 11,290
Goodwill 8,125
Accounts payable and accrued liabilities (3,450)
----------
Net assets acquired $29,956
==========
Eldorado - On June 2, 2004, Headwaters acquired 100% of the ownership
interests of Eldorado and paid off all of Eldorado's outstanding debt.
Eldorado is based in San Marcos, California and is a leading manufacturer of
architectural manufactured stone. With over 700 distributors, Eldorado
provides Headwaters with a national platform for expanded marketing of
"green" building products, such as mortar and stucco made with reclaimed fly
ash from coal combustion. Eldorado also provides critical mass and improved
margins for the construction materials segment. Eldorado's results of
operations have been included in Headwaters' consolidated statement of
income since June 2, 2004.
F-12
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
In connection with the Eldorado acquisition, Headwaters issued $172,500,000
of convertible senior subordinated debt and also borrowed funds under its
senior secured revolving credit arrangement and an arrangement with an
investment company, the latter two of which were repaid in 2004. Headwaters
incurred approximately $6,200,000 of debt issue costs in connection with the
issuance of the convertible senior subordinated debt, all of which is
described in more detail in Note 9.
The Eldorado acquisition was accounted for using the purchase method of
accounting. The consideration Headwaters paid for Eldorado was negotiated at
arms length and 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 2004 Form 10-K, were completed during 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 total
consideration paid to acquire Eldorado, as preliminarily determined and
previously reflected in the 2004 Form 10-K, and as finally determined.
(in thousands) Preliminary Final
------------------------------------------------------------------------------------------
Cash paid to Eldorado owners $136,982 $139,707
Cash paid to retire Eldorado debt and related
accrued interest 69,650 69,650
Costs directly related to acquisition 3,800 3,800
------------------------------
$210,432 $213,157
==============================
The following table sets forth the preliminary and final allocations of the
total consideration paid to the tangible and intangible assets acquired and
liabilities assumed.
(in thousands) Preliminary Final
------------------------------------------------------------------------------------------
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
==============================
Eldorado sells its products through an extensive distribution network. In
addition, Eldorado employs a group of talented artists who create the molds
used to produce the manufactured stone product. The quality of these molds
adds significant value to the end product. Eldorado's manufacturing process,
market presence and the quality of its product, including product design and
product breadth, are major elements contributing to Eldorado's high value
and related purchase price. These items, combined with Eldorado's high
growth and extensive distribution network are not separable and,
accordingly, contributed to a significant amount of goodwill. Approximately
$9,034,000 of the purchase price was allocated to identifiable intangible
assets, consisting primarily of non-compete agreements. The intangible
assets are being amortized over estimated useful lives ranging from three to
ten years, with a combined weighted average life of approximately four
years. The remaining purchase price not attributable to the tangible and
F-13
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
identifiable intangible assets was allocated to goodwill, most of which is
tax deductible. All of the intangible assets and goodwill were allocated to
Headwaters' construction materials segment.
SCP - On July 2, 2004, Headwaters acquired certain assets of SCP and assumed
all of SCP's outstanding debt. SCP is based in Alleyton, Texas and is a
leading manufacturer of concrete blocks in South Texas, complementing
Headwaters' similar operations in Dallas and East Texas. SCP provides
Headwaters with modern concrete-based manufacturing facilities and the
opportunity to increase the use of CCPs in the manufacture of block and
brick. SCP also has an experienced management team and the president of SCP
subsequently assumed responsibility for all of Headwaters' construction
materials operations other than for Eldorado and Tapco. SCP's results of
operations have been included in Headwaters' consolidated statement of
income since July 2, 2004.
The following table sets forth the total consideration paid to acquire SCP.
(in thousands)
------------------------------------------------------------------
Cash paid to SCP owners $25,210
SCP debt assumed by Headwaters 9,787
Costs directly related to acquisition 300
-----------
$35,297
===========
Headwaters also agreed to pay an earn-out to the sellers if certain earnings
targets are exceeded during the 12 months ending December 31, 2005 (the
"earn-out period"). The additional earn-out consideration will be the
product of 5.7 times the amount that earnings before interest, taxes,
depreciation and amortization ("EBITDA") of SCP exceed $5,500,000 during the
earn-out period. Headwaters currently expects earn-out consideration in the
range of approximately $10,000,000 to $12,500,000 could be paid, depending
on performance, at which time goodwill will be increased accordingly.
The SCP acquisition was accounted for using the purchase method of
accounting. The consideration Headwaters paid for SCP was negotiated at arms
length and assets acquired and liabilities assumed were recorded at their
estimated fair values as of July 2, 2004. Approximately $6,890,000 of the
purchase price was allocated to identifiable intangible assets, consisting
primarily of customer relationships. The intangible assets are being
amortized over estimated useful lives ranging from two to ten years, with a
combined weighted average life of approximately seven years. The remaining
purchase price not attributable to the tangible and identifiable intangible
assets was allocated to goodwill, substantially all of which is tax
deductible. All of the intangible assets and goodwill have been allocated to
Headwaters' construction materials segment.
The following table sets forth the allocation of the total consideration to
the tangible and intangible assets acquired and liabilities assumed.
(in thousands)
-------------------------------------------------------------------
Cash $ 819
Trade receivables, net 4,247
Inventories and other assets 3,772
Property, plant and equipment 13,500
Intangible assets acquired:
Customer relationships (7 1/2 years) 5,450
Other (2 - 10 years) 1,440
Goodwill 7,629
Accounts payable and accrued liabilities (1,560)
--------------
Net assets acquired $35,297
==============
Tapco - On September 8, 2004, Headwaters acquired 100% of the ownership
interests of Tapco and paid off all of Tapco's outstanding debt. Tapco is
F-14
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
headquartered in Wixom, Michigan and is a leading designer, manufacturer and
marketer of specialty building products used in exterior residential home
improvement and construction throughout the United States and Canada. The
Tapco acquisition further diversified Headwaters' cash flow stream away from
its historical reliance on alternative energy. Tapco brings economy of scale
and manufacturing expertise that results in some of the lowest manufacturing
costs in the siding accessory industry, which has improved the combined
margins in Headwaters' construction materials segment. Headwaters may also
be able to leverage Tapco's distribution networks to accelerate sales of
Headwaters' diverse construction materials product portfolio. Tapco's
results of operations have been included in Headwaters' consolidated
statement of income since September 8, 2004.
In order to obtain the cash necessary to acquire Tapco, retire Tapco's debt
and preferred stock, and repay Headwaters' existing senior debt, Headwaters
borrowed $790,000,000 of debt consisting of $640,000,000 of senior secured
debt under a first lien with a six and one-half-year term and a floating
interest rate, and $150,000,000 of senior secured debt under a second lien
with an eight-year term, also with a floating interest rate. Headwaters
incurred approximately $18,200,000 of debt issue costs in connection with
the issuance of the new senior debt, all of which is described in more
detail in Note 9.
The following table sets forth the total consideration paid to acquire
Tapco, as preliminarily determined and previously reflected in the 2004 Form
10-K, and as finally determined.
(in thousands) Preliminary Final
------------------------------------------------------------------------------------------
Cash paid to Tapco stockholders $388,297 $388,297
Cash paid to retire Tapco debt, preferred stock
and related accrued interest 326,703 326,703
Costs directly related to acquisition 9,000 8,700
------------------------------
$724,000 $723,700
==============================
The Tapco acquisition was accounted for using the purchase method of
accounting. The consideration Headwaters paid for Tapco was negotiated at
arms length and assets acquired and liabilities assumed were recorded at
their estimated fair values as of September 8, 2004. Tapco has a leading
market share in most of its product lines with some lines having a market
share greater than 75%. Tapco has the ability to deliver its products within
a few days of receiving the order which is appealing to architects,
contractors and end users of the product. Tapco also offers wide-ranging
product choices delivered through an extensive distribution network
throughout the United States. Tapco's products, manufacturing process and
distributors are currently substantially different than those utilized by
Headwaters' other business units and a substantial amount of sales relate to
the remodeling industry. As such, Tapco may further mitigate the cyclical
nature of Headwaters' construction materials business in the future. Tapco's
primary value, therefore, is due to its significant market presence and
manufacturing efficiencies. These values are largely the result of Tapco's
manufacturing and distribution capacities, product breadth and workforce
which are not separable and, accordingly, contribute to a significant amount
of goodwill.
Approximately $167,300,000 of the estimated purchase price was allocated to
estimated identifiable intangible assets consisting primarily of customer
relationships, trade names, and patents. The estimated intangible assets
have estimated average useful lives ranging from two to twenty years, with a
combined weighted average life of approximately 15 years. The remaining
purchase price not attributable to the tangible and identifiable intangible
assets was allocated to goodwill, which is not tax deductible. All of the
intangible assets and goodwill have been allocated to Headwaters'
construction materials segment.
F-15
The following table sets forth the preliminary and final allocations of the
total consideration paid to the tangible and intangible assets acquired and
liabilities assumed. The adjustments to the allocation of the purchase price
resulted primarily from the final determination of fair values for property,
plant and equipment and current and deferred income taxes.
(in thousands) Preliminary Final
------------------------------------------------------------------------------------------
Cash $ 10,317 $ 10,317
Trade receivables, net 41,696 41,696
Inventories 16,835 16,585
Other assets 1,232 1,263
Property, plant and equipment 61,376 67,494
Intangible assets acquired:
Customer relationships (15 years) 62,000 62,000
Trade names (20 years) 62,000 62,000
Patents (10 years) 40,000 40,000
Non-competition agreements (2 years) 3,300 3,300
Goodwill 527,248 524,979
Accounts payable and accrued liabilities (33,237) (37,584)
Net deferred income tax liabilities (68,767) (68,350)
-------------------------------
Net assets acquired $724,000 $723,700
===============================
Deferred Acquisition Costs - In 2004, Headwaters expensed approximately
$848,000 of deferred acquisition costs related to acquisition projects that
were abandoned. Write-offs of deferred acquisition costs were not material
in 2003 or 2005.
Fiscal 2006 Acquisition - Subsequent to September 30, 2005, Tapco acquired
certain assets and assumed certain liabilities of Max Manufacturing &
Roofing, LLC. Total consideration, including potential future deferred
payments, is not material.
4. Segment Reporting
Headwaters currently operates in three business segments, construction
materials, CCPs and alternative energy. These segments are managed and
evaluated separately by management due to differences in their operations,
products and services.
Prior to 2004, the businesses in the construction materials segment
manufactured and distributed value-added bagged concrete, stucco, mortar and
block products. The acquisition of SCP expanded Headwaters' concrete block
business and the acquisition of Eldorado added manufactured architectural
stone to the construction materials product line. Tapco is a leading
designer, manufacturer and marketer of building products used in exterior
residential home improvement and construction. Revenues for the construction
materials segment consist of product sales to wholesale and retail
distributors, contractors and other users of building products and
construction materials.
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-fired 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.
The alternative energy segment includes Headwaters' legacy coal-based solid
alternative fuels business and HTI's business of developing catalyst
technologies to convert coal and heavy oil into higher-value liquid fuels,
as well as nanocatalyst processes and applications. Revenues for this
segment consist primarily of sales of chemical reagents and license fees.
F-16
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 Note 2. Performance of the segments is evaluated primarily on
revenue growth, operating income and cash flow, although other factors are
used in certain situations, such as income tax credits generated by
activities of the alternative energy segment. Intersegment sales are
immaterial. Segment costs and expenses considered in deriving segment
operating income include cost of revenues, 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 CCPs for 2004 includes VFL's results for six months.
Segment information for construction materials for 2004 includes Eldorado's
results for four months, SCP's results for three months and Tapco's results
for 23 days.
2003
--------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $ 49,350 $169,938 $168,342 $ -- $ 387,630
====================================================================
Depreciation and amortization $ (624) $(11,045) $ (1,222) $ -- $ (12,891)
====================================================================
Operating income (loss) $ 4,734 $ 21,521 $ 65,002 $(14,138) $ 77,119
=======================================================
Net interest expense (15,377)
Other income (expense), net (1,661)
Income tax provision (23,450)
------------
Net income $ 36,631
============
Capital expenditures $ 912 $ 8,117 $ 166 $ 521 $ 9,716
====================================================================
Segment assets $ 22,341 $283,916 $ 34,959 $ 32,059 $ 373,275
====================================================================
2004
--------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $ 134,027 $210,155 $209,773 $ -- $ 553,955
====================================================================
Depreciation and amortization $ (6,210) $(12,510) $ (1,198) $ (271) $ (20,189)
====================================================================
Operating income (loss) $ 17,261 $ 30,386 $ 98,995 $(18,885) $ 127,757
=======================================================
Net interest expense (18,509)
Other income (expense), net (4,141)
Income tax provision (40,790)
------------
Net income $ 64,317
============
Capital expenditures $ 9,394 $ 3,679 $ 745 $ 149 $ 13,967
====================================================================
Segment assets $1,104,980 $316,982 $ 44,156 $ 74,661 $1,540,779
====================================================================
F-17
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
2005
--------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $ 519,926 $246,819 $297,894 $ -- $1,064,639
====================================================================
Depreciation and amortization $ (37,485) $(12,648) $ (5,922) $ (321) $ (56,376)
====================================================================
Operating income (loss) $ 72,878 $ 32,780 $171,164 $(39,949) $ 236,873
=======================================================
Net interest expense (57,433)
Other income (expense), net (15,632)
Income tax provision (42,530)
------------
Net income $ 121,278
============
Capital expenditures $ 44,408 $ 5,807 $ 6,019 $ 414 $ 56,648
====================================================================
Segment assets $1,142,547 $311,599 $155,458 $ 62,052 $1,671,656
====================================================================
5. Receivables
Activity in the trade receivables allowance account was as follows.
Accounts
Balance at Additions written off
beginning Charged to from and other Balance at
(in thousands) of year expense acquisitions deductions end of year
---------------------------------------------------------------------------------------------------------------
Fiscal year ended September 30, 2003 $ 412 $ 516 $ -- $ (351) $ 577
Fiscal year ended September 30, 2004 577 2,397 4,273 (1,470) 5,777
Fiscal year ended September 30, 2005 5,777 3,887 -- (4,164) 5,500
Notes receivable generally relate to nonoperating activities and
accordingly, losses are included in other expense in the consolidated
statements of income. Net losses recognized on notes receivable were
approximately $2,142,000 in 2003, $2,622,000 in 2004 and $0 in 2005.
6. Inventories
Inventories consisted of the following at September 30:
(in thousands) 2004 2005
----------------------------------------------------------------
Raw materials $ 8,517 $12,604
Finished goods 35,295 47,915
-----------------------
$43,812 $60,519
=======================
7. Property, Plant and Equipment
Property, plant and equipment consisted of the following at September 30:
Estimated useful
(in thousands) lives 2004 2005
----------------------------------------------------------------------------------------------------
Land and improvements 8 - 30 years $ 14,041 $ 14,770
Buildings and improvements 3 - 40 years 34,269 41,623
Equipment and vehicles 3 - 30 years 88,791 114,811
Dies and molds 3 - 15 years 28,986 42,126
Construction in progress 8,052 14,249
------------------------
174,139 227,579
Less accumulated depreciation (16,528) (37,129)
------------------------
Net property, plant and equipment $157,611 $190,450
========================
F-18
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
Depreciation expense was approximately $6,387,000 in 2003, $11,035,000 in
2004, and $27,553,000 in 2005.
8. Intangible Assets and Goodwill
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 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 $18,256
Customer relationships 7 1/2 - 15 years 68,331 452 68,331 5,395
Trade names 5 - 20 years 63,657 268 63,657 3,642
Patents and patented
technologies 7 1/2 - 15 years 52,464 2,969 55,359 8,060
Non-competition agreements 2 - 3 1/2 years 10,422 867 10,422 4,939
Other 9 - 10 years 2,336 1,002 2,336 1,255
-----------------------------------------------------------------
$314,900 $17,082 $317,795 $41,547
=================================================================
Total amortization expense related to intangible assets was approximately
$6,504,000 in 2003, $9,107,000 in 2004 and $24,465,000 in 2005. Total
estimated annual amortization expense for fiscal years 2006 through 2010 is
shown in the following table.
Year ending September 30: (in thousands)
----------------------------------------------
2006 $24,366
2007 22,021
2008 20,473
2009 20,260
2010 19,927
Goodwill - Changes in the carrying amount of goodwill, by segment, are as
follows for 2004 and 2005.
Alternative Construction
(in thousands) Energy CCPs Materials Total
-----------------------------------------------------------------------------------------------------
Balances as of September 30, 2003 $4,258 $107,873 $ -- $112,131
Goodwill acquired during the year -- 8,125 695,140 703,265
-----------------------------------------------------------------
Balances as of September 30, 2004 4,258 115,998 695,140 815,396
Adjustments to previously recorded
purchase price -- -- (3,851) (3,851)
-----------------------------------------------------------------
Balances as of September 30, 2005 $4,258 $115,998 $691,289 $811,545
=================================================================
In accordance with the requirements of SFAS No. 142, Headwaters does not
amortize goodwill, all of which relates to acquisitions that occurred from
2001 through 2004. SFAS No. 142 requires Headwaters to periodically perform
tests for goodwill impairment, at least annually, or sooner if evidence of
possible impairment arises. Headwaters performs its annual impairment tests
as of June 30, using a two-step process that begins with an estimation of
the fair values of the reporting units with goodwill. Currently, five
reporting units have goodwill, as follows: (i) HTI, (ii) Resources, (iii)
Eldorado, (iv) SCP, and (v) Tapco.
Step 1 of impairment testing consists of determining and comparing the fair
values of the reporting units to the carrying values of those reporting
units. If step 1 is failed for any of the reporting units, indicating a
potential impairment, Headwaters would be required to complete step 2, which
F-19
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
is a more detailed test to calculate the implied fair value of goodwill, and
compare that value to the carrying value of the goodwill. If the carrying
value of the goodwill exceeds the implied fair value of the goodwill, an
impairment loss is required to be recorded.
Headwaters has performed step 1 impairment tests of recorded goodwill as of
June 30, 2003, 2004 and 2005, all of which indicated that the fair values of
the reporting units exceeded their carrying values. Accordingly, step 2 of
the impairment tests was not required to be performed, and no impairment
charge was necessary.
9. Liabilities
Other Accrued Liabilities - Other accrued liabilities consisted of the
following at September 30:
(in thousands) 2004 2005
-----------------------------------------------------------------------------------------------
Cost of product not yet invoiced $10,763 $18,531
Acquisition-related accruals (primarily escrow accounts) 24,676 --
Other 30,186 47,660
-------------------------------
$65,625 $66,191
===============================
Long-term Debt - Long-term debt consisted of the following at September 30:
(in thousands) 2004 2005
-----------------------------------------------------------------------------------------------
Senior secured debt $790,000 $472,673
Convertible senior subordinated notes 172,500 172,500
Notes payable to a bank 9,787 8,705
Other 227 140
-------------------------------
972,514 654,018
Less: current portion (57,873) (52,207)
-------------------------------
Total long-term debt $914,641 $601,811
===============================
Senior Secured Credit Agreements - In September 2004, Headwaters entered
into two credit agreements with a syndication of lenders. The credit
agreements have since been amended, most recently in October 2005. A total
of $790,000,000 was originally borrowed under the credit facility, which
also provides for up to $60,000,000 of borrowings under a revolving credit
arrangement. The original 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 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. As of September 30,
2005, the second lien term loan has been repaid in its entirety. With
certain limited exceptions, the first lien term loan is secured by all
assets of Headwaters and is senior in priority to all other debt except for
the specific SCP assets that collateralize the notes payable to banks
discussed below. The terms of the credit facility, as amended, are 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 5.9% at September 30, 2005.
The second lien term loan bore 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
F-20
the terms of the agreement. Headwaters can lock in new LIBOR rates for the
first lien loan for one, two, three or six months. The most recent rate
change occurred in October 2005.
The first lien term loan ($442,673,000 outstanding at September 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 from November 2010 through April 2011, the
termination date. Interest is generally due on a quarterly basis.
During 2005, Headwaters repaid a total of $197,327,000 of the first lien
term loan and all of the second lien term loan ($150,000,000). As a result
of the early repayments, accelerations of amortization of the related debt
issue costs totaling approximately $7,396,000 were charged to interest
expense. Prepayment penalties totaling $4,000,000 were paid related to the
early repayments of the second lien term debt, which amount was also charged
to interest expense.
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 were restricted and required prepayment penalties
ranging up to 3% of the prepayments made in the first year and 2% in the
second year. Once repaid in full or in part, no further reborrowings under
either of the term loan arrangements can be made.
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, when 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). As of September 30, 2005,
Headwaters had $30,000,000 of borrowings outstanding under the revolving
credit arrangement. Because Headwaters' intent was to repay the outstanding
borrowings under the revolving credit arrangement within 12 months, this
amount is reflected as current in the consolidated balance sheet as of
September 30, 2005. The credit agreement also allows for the issuance of
letters of credit, provided there is capacity under the revolving credit
arrangement. As of September 30, 2005, six letters of credit totaling
$5,503,000 were outstanding, with expiration dates ranging from January 2006
to December 2006. Subsequent to September 30, 2005, an additional letter of
credit was issued in the amount of $2,705,000, expiring in October 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 2005, $72,000,000 for 2006
and $75,000,000 for 2007 through 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 4.5:1.0 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 3.5:1.0, 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 September 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 (subsequently reduced to $150,000,000) 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
September 30, 2005) of this debt for the period commencing September 8, 2005
through September 8, 2007. During 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.
F-21
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
Headwaters accounts for the agreements which limit its variable interest
rate exposure 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 September 30, 2005 of approximately $2,100,000, which, net
of $820,000 of income taxes, represents other comprehensive income for 2005.
Total comprehensive income was approximately $122,558,000 for 2005. Total
comprehensive income did not differ from net income in 2003 or 2004.
Former Senior Secured Credit Agreement - In March 2004, Headwaters entered
into a credit agreement with a group of banks under which a total of
$50,000,000 was borrowed under a term loan arrangement and which, as amended
in June 2004, provided for an additional $75,000,000 to be borrowed under a
revolving credit arrangement. The initial $50,000,000 of proceeds were used
to repay in full the remaining balance due under Headwaters' 2002 senior
secured credit agreement (see below). Debt issue costs of approximately
$1,300,000 were incurred in issuing this debt, all of which was expensed in
2004.
The term loan was secured by all assets of Headwaters, bore interest at a
variable rate linked to the Eurodollar rate or the lenders' base rate, both
as defined in the agreement, and was repayable in quarterly installments of
$1,250,000 through September 2007, with a final payment of $32,500,000 due
November 2007. In connection with the purchase of Eldorado in June 2004, a
total of $44,000,000 was borrowed under the revolving credit arrangement,
all of which was repaid in June 2004. In connection with the purchase of SCP
in July 2004, a total of $20,000,000 was borrowed, all of which was repaid
in September 2004. Also in September 2004, the remaining balance outstanding
under the term loan was repaid in full using proceeds from the new 2004
senior secured credit facility described above.
2002 Senior Secured Credit Agreement - In connection with the ISG
acquisition in 2002, Headwaters entered into a $175,000,000 senior secured
credit agreement with a syndication of lenders, under which a total of
$155,000,000 was borrowed as a term loan on the acquisition date. The credit
agreement also allowed up to $20,000,000 to be borrowed under a revolving
credit arrangement. The debt was issued at a 3% discount and Headwaters
received net cash proceeds of $150,350,000. The original issue discount was
accreted using the effective interest method and the accretion was recorded
as interest expense. The debt was secured by all assets of Headwaters, bore
interest at a variable rate linked to the Eurodollar rate or the lenders'
base rate, both as defined in the agreement, and was repayable in quarterly
installments through August 30, 2007.
During the December 2003 quarter, principal repayments totaling $39,714,000
were made, including $33,471,000 of optional prepayments. During the March
2004 quarter, the remaining balance was repaid in full using available cash
and $50,000,000 of proceeds from the former 2004 senior secured credit
facility described above. In connection with the full repayment of this
debt, non cash interest expense totaling approximately $5,023,000 was
recognized in the March 2004 quarter, representing amortization of all of
the remaining debt discount and debt issue costs related to this debt.
Convertible Senior Subordinated Notes - In connection with the Eldorado
acquisition, Headwaters issued $172,500,000 of 2.875% 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
of the common stock trading price and the number of shares of common stock
F-22
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
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 calculations on an if-converted
basis, as described in more detail in Note 13.
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 September 30, 2005, ranged
from 4.5% to 6.25%. Because the notes are callable by the bank, Headwaters
has included the outstanding balance in current portion of long-term debt in
the consolidated balance sheet. The notes are collateralized by certain
assets of SCP and contain financial covenants specific to SCP, including a
minimum fixed charge coverage ratio, a leverage ratio requirement, and
limitations on capital expenditures. Headwaters is in compliance with all
debt covenants as of September 30, 2005.
Senior Subordinated Debentures - In connection with the ISG acquisition,
Headwaters also entered into a $20,000,000 subordinated loan agreement,
under which senior subordinated debentures were issued at a 2% discount,
with Headwaters receiving net cash proceeds of $19,600,000. The original
issue discount was accreted using the effective interest method and the
accretion was recorded as interest expense. ISG management participated in
one-half, or $10,000,000, of the $20,000,000 of debt issued. The other half
was issued to a corporation. The debentures bore interest at 18% and were
due in 2007; however, in December 2003, the debentures were repaid in full,
including a 4%, or $400,000, prepayment charge paid to the corporation
holding $10,000,000 of the debentures. This charge, along with all remaining
unamortized debt discount and debt issue costs, is included in interest
expense in the consolidated statement of income.
Notes Payable to Former VFL Stockholders - In connection with the VFL
acquisition, Headwaters issued $19,000,000 of notes payable to the VFL
stockholders, all of which was repaid in 2004. The interest rate on
$16,000,000 of the notes was 9% and the interest rate on the remaining
$3,000,000 of notes was variable.
Interest Costs - During 2003, Headwaters incurred total interest costs of
approximately $15,917,000, including approximately $3,857,000 of non-cash
interest expense and approximately $230,000 of interest costs that were
capitalized. During 2004, Headwaters incurred total interest costs of
approximately $19,888,000, including approximately $6,031,000 of non-cash
interest expense and approximately $435,000 of interest costs that were
capitalized. During 2005, Headwaters incurred total interest costs of
approximately $59,677,000, including approximately $10,634,000 of non-cash
interest expense and approximately $464,000 of interest costs that were
capitalized.
F-23
Interest Rates and Debt Maturities - The weighted-average interest rate on
the face amount of outstanding long-term debt, disregarding amortization of
debt issue costs, debt discount, and the gain realized upon reduction of the
interest rate hedges in 2005, was approximately 6.3% at September 30, 2004
and 5.2% at September 30, 2005.
Future maturities of long-term debt as of September 30, 2005 were as
follows:
Year ending September 30, (in thousands)
-------------------------------------------------
2006 $ 52,207
2007 13,466
2008 13,416
2009 13,414
2010 13,414
Thereafter 548,101
-------------
Total long-term debt $654,018
=============
10. Fair Value of Financial Instruments
Headwaters' financial instruments consist primarily of cash and cash
equivalents, trade receivables, accounts payable and long-term debt. All of
these financial instruments except long-term debt are either carried at fair
value in the balance sheet or are of a short-term nature. Accordingly, the
carrying values for those financial instruments as reflected in the
consolidated balance sheets closely approximate their fair values.
With the exception of the 2.875% convertible senior subordinated notes due
2016, substantially all of Headwaters' debt outstanding as of September 30,
2004 and 2005 consisted of variable-rate debt. However, as a result of the
hedge agreements entered into for $150,000,000 of the variable-rate senior
secured debt described in Note 9, Headwaters has effectively fixed the
interest rate on that portion of debt for approximately two years, through
September 8, 2007.
Using market interest rates for the convertible senior subordinated notes of
approximately 2.3% in 2004 and 2.1% in 2005 and a market interest rate of
6.3% in 2005 for the $150,000,000 hedged portion of senior debt, the fair
value of all outstanding long-term debt as of September 30, 2004 and 2005
would be approximately $978,892,000 and $660,677,000, respectively. The
market interest rates for the convertible senior subordinated notes
decreased during the period June 2004 to September 2004 and again during
2005 due primarily to the increase in Headwaters' common stock price during
those periods.
11. Income Taxes
Headwaters recorded income tax provisions with an effective tax rate of
approximately 39% in 2003 and 2004 and 26% in 2005. The reduction in the
effective tax rate for 2005 is primarily due to Section 29 tax credits
related to Headwaters' 19% interest in an entity that owns and operates a
coal-based solid alternative fuel production facility (see Note 14), plus
two other smaller alternative fuel facilities that Headwaters owns and
operates.
The income tax provision consisted of the following for the years ended
September 30:
(in thousands) 2003 2004 2005
--------------------------------------------------------------------------------------------
Current tax provision:
Federal $20,726 $38,374 $ 67,654
State 3,602 3,699 7,405
------------------------------------------
Total current tax provision 24,328 42,073 75,059
Deferred tax provision (benefit):
Federal (774) (1,273) (29,108)
State (104) (10) (3,421)
------------------------------------------
Total deferred tax provision (benefit) (878) (1,283) (32,529)
------------------------------------------
Total income tax provision $23,450 $40,790 $ 42,530
==========================================
The provision for income taxes differs from the amount computed using the
statutory federal income tax rate due to the following.
(in thousands) 2003 2004 2005
--------------------------------------------------------------------------------------------
Tax provision at U.S. statutory rate $21,028 $36,787 $57,333
State income taxes, net of federal tax effect 2,352 2,901 3,395
Income tax credits -- (205) (20,455)
Nondeductible expenses 302 764 3,039
Other (232) 543 (782)
------------------------------------------
Income tax provision $23,450 $40,790 $42,530
==========================================
F-24
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
As of September 30, 2005, Headwaters had deferred tax assets related to
state and non-U.S. net operating loss ("NOL") carryforwards of approximately
$436,000 and $1,605,000, respectively. Headwaters has established a
valuation allowance for $1,949,000 of this amount, approximately $1,000,000
of which related to opening balance sheet adjustments for Tapco. A valuation
allowance is required when there is significant uncertainty as to the
realizability of deferred tax assets. Because the realization of the
deferred tax assets related to these NOLs is dependent upon future income
related to domestic and foreign jurisdictional operations that have
historically generated losses, management determined that it is not "more
likely than not" that these NOLs will be realized and therefore, a valuation
allowance is required. The state NOLs expire from 2011 to 2024 and
substantially all of the non-U.S. NOLs do not expire. The components of
Headwaters' deferred income tax assets and liabilities were as follows as of
September 30:
(in thousands) 2004 2005
--------------------------------------------------------------------------------------------
Deferred tax assets:
Stock-based compensation $ -- $ 11,500
Tax credit carryforwards -- 11,144
Estimated liabilities 3,604 7,058
Intangible asset basis differences -- 5,553
Reserves and allowances 3,624 4,539
Deferred license fee revenue 3,672 2,828
NOL carryforwards 40 2,041
Valuation allowance related to NOL carryforwards -- (1,949)
---------------------------
Total deferred tax assets 10,940 42,714
---------------------------
Deferred tax liabilities:
Intangible asset basis differences (100,911) (98,155)
Property, plant and equipment basis differences (21,224) (18,854)
Interest on convertible senior subordinated notes (1,081) (4,488)
Other (5,160) (1,089)
---------------------------
Total deferred tax liabilities (128,376) (122,586)
---------------------------
Net deferred tax liability $(117,436) $ (79,872)
===========================
12. Equity Securities and Stock-Based Compensation
Authorized Stock - In January 2005, Headwaters' Board of Directors ("Board")
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 in March 2005. Headwaters also has 10,000,000 shares of
authorized preferred stock, none of which was issued or outstanding as of
September 30, 2004 or 2005.
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."
Issuance of Common Stock - Headwaters has an effective universal shelf
registration statement on file with the SEC that can be used for the sale of
common stock, preferred stock, convertible debt and other securities. In
F-25
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
2004, Headwaters filed a prospectus supplement to that shelf registration
statement and issued 4,958,457 shares of common stock in an underwritten
public offering. Proceeds of $90,258,000 were received, net of commissions
and other offering costs totaling $6,432,000.
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. In February 2005, Headwaters filed a prospectus supplement
to the two 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.
Grants of Stock Incentive Awards - During 2005, the Compensation Committee
of Headwaters' Board (the "Committee") granted to certain officers and
employees stock incentive awards consisting of approximately 3,013,000 stock
appreciation rights ("SARs") and approximately 214,000 stock options.
Substantially all of these awards were granted during the quarter ended June
30, 2005, the same quarter that Headwaters early adopted SFAS No. 123R, as
explained below. Approximately 1,995,000 of the SARs vested at grant date,
and a majority 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. The grant of these immediate-vested SARs
resulted in approximately $16,190,000 of compensation expense being recorded
in 2005, which was calculated in accordance with SFAS No. 123R as described
below under "Stock-Based Compensation." The remaining SARs which were
granted during 2005 (approximately 1,019,000) vest over five years, and
approximately 910,000 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 equal to the fair
market value of Headwaters' common stock on the dates 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 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. The grants of performance
units were not made until November 2005 and could result in the payment to
employees of a maximum amount of approximately $3,550,000 if all performance
criteria are met.
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 adjusted the amounts
previously reported in its consolidated statement of income for the six
months ended March 31, 2005 in deriving the statement of income amounts
reported for 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.
F-26
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
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 2005, Headwaters recorded a total of $33,812,000 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
$12,190,000 for 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 and SARs (approximately $8,098,000
for 2005) are reflected in the consolidated statements of changes in
stockholders' equity and cash flows. The following table summarizes non-cash
stock-based compensation included in operating costs and expenses for the
years indicated.
(in thousands) 2003 2004 2005
-----------------------------------------------------------------------------------------------
Construction materials $ -- $ -- $ 1,392
Coal combustion products -- -- 572
Research and development -- -- 1,862
Selling, general and administrative 91 289 29,986
------------------------------------------
Total stock-based compensation expense $91 $289 $33,812
==========================================
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 2). 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 2005:
Under Previous SFAS No. 123R
(in thousands, except per-share data) Accounting Adjustments As Reported
---------------------------------------------------------------------------------------------------------
Income before income taxes $ 197,242 $(33,434) $163,808
Net income $ 142,659 $(21,381) $121,278
Basic earnings per share $ $3.75 $ (0.56) $ 3.19
Diluted earnings per share $ $3.26 $ (0.47) $ 2.79
Cash flows from operating activities $ 159,329 $ (8,098) $151,231
Cash flows from financing activities $(106,474) $ 8,098 $(98,376)
A significant amount of the effect of the SFAS No. 123R adjustments reported
above resulted from the expense associated with the immediate-vested SARs
granted in 2005 and from the acceleration of vesting of certain stock
options which also occurred in 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 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 EPS, as described in
more detail in Note 13.
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
F-27
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
model output. One such adjustment was used in determining the fair value of
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.
The following assumptions were used in determining the fair values of the
2005 awards granted during the quarters ended June 30 and September 30,
2005. The assumptions used in determining the fair values of awards granted
in the prior two quarters of 2005 (184,000 options) 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%
Reductions in value from B-S-M output for SAR
appreciation caps 24% - 49%
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 September 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 September 30, 2005, options, SARs and other awards for
approximately 864,000 shares of common stock could be granted under the
other three Plans. Headwaters uses newly issued shares to meet its
obligations when awards are exercised.
A committee of Headwaters' Board (the "Committee"), or in its absence, the
full Board, 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.
F-28
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
Stock Options - The following table summarizes the activity for all of
Headwaters' stock options, including options not granted under the Plans,
for 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 (1,166) 11.19
Forfeited or expired (53) 16.98
------------
Outstanding at September 30, 2005 2,793 $18.62 7.1 $52,450
============================================================
Exercisable at September 30, 2005 2,465 $18.78 7.1 $45,900
============================================================
The weighted-average grant-date fair value (using the B-S-M model) of
options granted during 2005 was $13.26. The total intrinsic value of options
exercised during 2005 was approximately $27,800,000. The total fair value of
options vested during 2005 was approximately $23,440,000.
The following table summarizes the activity for all of Headwaters' stock
options for 2003 and 2004
2003 2004
--------------------------------------------------
Weighted- Weighted-
average average
exercise exercise
(in thousands) Shares price Shares price
---------------------------------------------------------------------------------------------------------
Outstanding at beginning of year 2,990 $ 7.56 3,615 $10.88
Granted 1,188 16.45 1,162 26.07
Exercised (514) 4.05 (826) 9.70
Canceled (49) 14.48 (153) 15.80
--------------------------------------------------
Outstanding at end of year 3,615 $10.88 3,798 $15.53
==================================================
Exercisable at end of year 1,992 $ 7.51 1,821 $ 8.90
==================================================
Weighted-average fair value of options
granted during the year below market none none
Weighted-average fair value of options
granted during the year at market $ 7.16 $11.21
Weighted-average fair value of options
granted during the year above market none none
SARs - The following table summarizes the activity for all of Headwaters'
SARs for 2005. As noted previously, SARs either vested on the date of grant
(1,995,000), or will vest over a five-year period (1,019,000). 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
F-29
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
Headwaters during the five-year period. Headwaters currently expects the
performance criteria to be achieved and therefore records compensation
expense over the related service period. 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 3,013 32.12
Exercised (4) 31.97
Forfeited or expired (1) 31.97
------------
Outstanding at September 30, 2005 3,008 $32.12 9.6 $15,850
============================================================
Exercisable at September 30, 2005 1,990 $31.97 9.6 $10,800
============================================================
The weighted-average grant-date fair value of SARs granted during 2005 was
$9.65. The total intrinsic value of SARs exercised during 2005 was $50,000.
The total fair value of SARs vested during 2005 was approximately
$16,190,000.
Other Stock-Based Awards and Unrecognized Compensation Cost - In addition to
the stock options and SARs reflected in the tables above, 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. Compensation expense equal to the
value of the stock on the date of grant is being recognized over the vesting
period which is also the requisite service period. In 2005, Headwaters
agreed to issue up to 25,000 shares of common stock to the Chief Executive
Officer and Chairman of the Board, which shares will vest in March 2010 if
the market value of a share of Headwaters' common stock meets or exceeds
stipulated thresholds. The fair value of this "contingent performance stock"
was estimated by an independent valuation firm by calculating the
probabilities that Headwaters' common stock would reach the various market
value thresholds. The fair value is being recognized as expense over the
requisite service period, or through March 2010. Finally, Headwaters also
recognizes compensation expense in connection with its Employee Stock
Purchase Plan ("ESPP"). Compensation expense related to restricted stock,
contingent performance stock and the ESPP is not material.
As of September 30, 2005, there is approximately $14,120,000 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.
Stockholder Approval of Equity Compensation Plans - The following table
presents information related to stockholder approval of equity compensation
plans as of September 30, 2005.
(in thousands)
--------------------------------------------------------------------------------------------------------
Maximum shares to Weighted-average
be issued upon exercise price of Shares remaining
exercise of outstanding available for future
options and other options and other issuance under existing
Plan Category awards awards equity compensation plans
--------------------------------------------------------------------------------------------------------
Plans approved by stockholders 4,379 $26.21 358
Plans not approved by stockholders 1,447 23.39 506
--------------------------------------------------------------------
Total 5,826 $25.51 864
====================================================================
As discussed above, Headwaters has four Plans under which options and SARs
have been granted. Headwaters has also issued options not covered by any
Plan. Stockholders have approved three of the four Plans. The amounts
included in the caption "not approved by stockholders" in the above table
represent amounts applicable under the Plan not approved by stockholders
plus all stock options granted outside of any Plan.
F-30
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
13. Earnings per Share
The following table sets forth the computation of basic and diluted EPS for
the years ended September 30:
(in thousands, except per-share data) 2003 2004 2005
-------------------------------------------------------------------------------------------------------
Numerator:
Numerator for basic earnings per share - net income $36,631 $64,317 $121,278
Interest expense related to convertible senior subordinated
notes, net of taxes -- 1,191 4,307
------------------------------------
Numerator for diluted earnings per share - net income plus
interest expense related to convertible notes, net of taxes $36,631 $65,508 $125,585
====================================
Denominator:
Denominator for basic earnings per share - weighted-average
shares outstanding 27,083 31,774 37,993
Effect of dilutive securities:
Shares issuable upon exercise of options, warrants and SARs 1,112 1,245 1,340
Shares issuable upon conversion of convertible notes -- 1,917 5,750
------------------------------------
Total potential dilutive shares 1,112 3,162 7,090
------------------------------------
Denominator for diluted earnings per share - weighted-average
shares outstanding after assumed exercises and conversions 28,195 34,936 45,083
====================================
Basic earnings per share $ 1.35 $ 2.02 $ 3.19
====================================
Diluted earnings per share $ 1.30 $ 1.88 $ 2.79
====================================
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 2004 and 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 9. 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
EPS 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 EPS calculations
consisted of out-of-the money options for approximately 655,000 shares in
2003, 30,000 shares in 2004 and 139,000 shares in 2005. In addition,
approximately 323,000 SARs were not included in the diluted EPS calculation
for 2005 because they were anti-dilutive.
14. Commitments and Contingencies
Commitments and contingencies as of September 30, 2005 not disclosed
elsewhere, are as follows.
Leases - Rental expense was approximately $11,999,000 in 2003, $14,618,000
in 2004 and $24,330,000 in 2005. Headwaters has noncancellable operating
F-31
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
leases for certain facilities and equipment. Most of these leases have
renewal terms and currently are set to expire in various years through 2017.
As of September 30, 2005, minimum rental payments due under these leases are
as follows.
Year ending September 30: (in thousands)
--------------------------------------------
2006 $20,017
2007 17,050
2008 12,332
2009 8,141
2010 5,322
Thereafter 8,365
-------------
$71,227
=============
Sale and Purchase Commitments - Certain CCP segment contracts with its
customers require Headwaters to make minimum sales. Certain other CCP
contracts with suppliers require Headwaters to make minimum purchases.
Actual sales and purchases under contracts with minimum requirements were
approximately $895,000 and $11,446,000, respectively, for 2003, $1,021,000
and $12,498,000, respectively, for 2004 and $1,095,000 and $13,223,000,
respectively, for 2005. As of September 30, 2005, minimum future
requirements are as follows.
(in thousands)
---------------------------
Minimum Minimum
Year ending September 30: sales purchases
----------------------------------------------------------
2006 $ 515 $12,190
2007 375 8,981
2008 375 7,427
2009 375 7,212
2010 63 7,289
Thereafter -- 7,678
---------------------------
$1,703 $50,777
===========================
Employee Benefit Plans - Headwaters has three employee benefit plans that
were operative during 2003, 2004 and 2005: the 401(k) Profit Sharing Plan
("401(k) Plan"), the 2000 Employee Stock Purchase Plan ("ESPP"), and the
Incentive Bonus Plan ("IBP"). During 2005, Headwaters' Board approved a
Deferred Compensation Plan ("DCP") which became effective in January 2005.
Also in January 2005, Headwaters' Board adopted the Long Term Incentive
Compensation Plan ("LTIP") which was approved at the annual meeting of
stockholders in March 2005. Substantially all employees of Headwaters are
eligible to participate in the 401(k) Plan and the ESPP after meeting length
of employment requirements. Only designated employees are eligible to
participate in the IBP, DCP and LTIP.
In addition to Headwaters' benefit plans, certain of the subsidiaries
acquired by Headwaters in 2004 had employee benefit plans. Substantially all
of these acquired subsidiaries' employee benefit plans have been
discontinued except for Tapco's 401(k) Profit Sharing Plan, which will
continue to operate through 2006. Under the terms of Tapco's 401(k) Profit
Sharing Plan, Tapco has agreed to pay a certain percentage of most
employees' salaries into the Profit Sharing Plan on behalf of those
employees.
The total expense for all of Headwaters' benefit plans combined was
approximately $5,768,000 in 2003, $14,862,000 in 2004 and $22,750,000 in
2005.
401(k) Plan. Under the terms of the 401(k) Plan, eligible employees may
elect to make tax-deferred contributions of up to 50% of their compensation,
subject to statutory limitations. Headwaters matches employee contributions
up to a designated maximum rate and these matching contributions vest after
three years. Headwaters is not required to be profitable to make matching
contributions.
ESPP. The ESPP provides eligible employees with an opportunity to purchase
Headwaters common stock on favorable terms and to pay for such purchases
F-32
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
through payroll deductions. A total of 500,000 shares of common stock were
initially reserved for issuance under the Plan, and approximately 240,000
shares remain available for future issuance as of September 30, 2005. Under
the ESPP, employees purchase shares of stock directly from Headwaters, which
shares are made available from treasury shares which have been repurchased
on the open market. The ESPP is intended to comply with Section 423 of the
Internal Revenue Code, but is not subject to the requirements of ERISA.
Employees purchase stock through payroll deductions of 1% to 10% of cash
compensation, subject to certain limitations. The stock is purchased in a
series of quarterly offerings. The cost per share to the employee is 85% of
the fair market value at the end of each offering period.
IBP. The IBP, the specifics of which are approved annually by the
Compensation Committee of the Board, provides for annual cash bonuses to be
paid if Headwaters accomplishes certain financial goals and if participating
employees meet individual goals. Headwaters' financial goals are based upon
an economic value added concept ("EVA") that purports to more closely align
with a company's share price performance than other measurements of
performance.
DCP. The DCP is a nonqualified plan that allows eligible employees to make
tax-deferred contributions of up to 50% of their base compensation and 100%
of their incentive compensation. In certain instances, Headwaters matches
employee contributions up to a designated maximum rate and these matching
contributions vest after three years. Headwaters is not required to be
profitable to make matching contributions.
LTIP. Other than obligations associated with the grants of certain of the
stock-based awards described in Note 12, Headwaters has no commitments under
the LTIP as of September 30, 2005.
Self 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 September 30, 2005,
approximately $2,306,000 is accrued for claims incurred on or before
September 30, 2005 that have not been paid or reported.
Effective as of October 1, 2005, Headwaters became self insured for workers
compensation claims, limited by stop-loss coverage for amounts in excess of
$250,000 per occurrence and $6,022,000 in the aggregate annually.
Employment Agreements - Headwaters and its subsidiaries have entered into
employment agreements with its Chief Executive Officer and several other
officers and employees. The agreements have original terms ranging up to
five years, many of which are renewable by Headwaters, often for one-year
terms. They provide for annual salaries currently ranging from approximately
$69,000 to $600,000 annually per person. Assuming all agreements set to
expire in 2006 are renewed, the annual commitment under all employment
agreements combined would currently approximate $4,345,000. The aggregate
commitment as of September 30, 2005, assuming no renewals, is approximately
$6,590,000. Most agreements provide for termination benefits, which vary
widely from agreement to agreement.
Property, Plant and Equipment - As of September 30, 2005, Headwaters was
committed to spend approximately $7,424,000 on capital projects that were in
various stages of completion.
Solid Alternative Fuel Facility - In September 2004, Headwaters purchased a
9% variable interest in an entity that owns and operates a coal-based solid
alternative fuel production facility, where Headwaters is not the primary
beneficiary. In December 2004, Headwaters purchased an additional 10%
variable interest in this entity. Headwaters' 19% minority interest was
acquired in exchange for initial cash payments totaling $500,000 and an
obligation to pay $15,000,000 in monthly installments from October 2004
through December 2007. This obligation, recorded in other accrued
liabilities and other long-term liabilities in the consolidated balance
sheet (totaling $12,212,000 at September 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 and total approximately $16,054,000 for
2005.
F-33
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 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. Headwaters has the ability, under certain conditions, to
limit its liability under the fixed payment obligations currently totaling
$12,212,000; therefore, Headwaters' obligation to make all of the
above-described payments is effectively limited to the tax benefits
Headwaters receives.
Joint Venture Obligations - In 2004, Headwaters entered into an agreement
with Degussa AG, 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 in 2004, an
additional $1,000,000 in October 2005 and is further obligated to pay
$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, through September 2007, of which approximately
(euro)2,022,000 (approximately $2,435,000) remains to be paid as of
September 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 which have been incurred during the normal course of
business, including the specific matters 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 2005, Headwaters incurred approximately $4,290,000 of expense for legal
matters, exclusive of costs for outside legal counsel. This amount includes
accruals for or payments made relating to settlements achieved, plus
Headwaters' estimates of the probable liability for unresolved matters,
giving consideration in certain instances to amounts for which Headwaters is
willing to settle. Headwaters currently believes the range of potential loss
for all unresolved matters, excluding costs for outside counsel, is from
$4,000,000 up to the amounts sought by claimants and has recorded a total
liability as of September 30, 2005 of $4,000,000. Claims and damages sought
by claimants in excess of this amount are not deemed to be probable. 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 matters discussed below 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. Therefore, 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 $3,000,000 in 2003, $3,800,000 in 2004 and $5,440,000 in 2005
(exclusive of a reimbursement of legal costs in 2005 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.
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
F-34
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
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.
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 are expected to be received
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 limited to a maximum of $5,000,000 per
quarter and 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).
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.
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 February 2006. Because the resolution of the
litigation is uncertain, legal counsel cannot express an opinion as to the
ultimate amount, if any, of Headwaters' liability.
F-35
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
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 credit for synthetic
fuel produced from coal. The committee failed to approve the proposed
amendment, but the amendment or other similar legislation 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, through August 31, 2005, the average reference price is $47.85 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.
F-36
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
In an environment of high oil prices, the risk of phase-out increases.
Headwaters' customers and licensees will make their own assessments of
phase-out risk. If customers and licensees perceive a potential negative
impact from phase-out, they may reduce or stop synthetic fuel production or
require Headwaters to share in the costs associated with phase-out. These
events may materially adversely affect Headwaters' future revenue and net
income.
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 will continue the
audit process in the future. 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, the license fees owed to Headwaters, which accumulated
during a period of approximately two and a half years, were placed in escrow
for the benefit of Headwaters, pending resolution of an audit of the
licensee by the IRS.
Prior to December 31, 2003, certain accounting rules governing revenue
recognition, requiring that the seller's price to the buyer be "fixed or
determinable" as well as reasonably certain of collection, appeared to
preclude revenue recognition for the amounts placed in escrow because they
were potentially subject to adjustment based on the outcome of the IRS
audit. Accordingly, none of the escrowed amounts were recognized as revenue
in the consolidated statements of income through December 31, 2003. During
the March 2004 quarter, the fieldwork for the tax audit of the licensee was
completed and there were no proposed adjustments to the tax credits claimed
by the licensee. As a result, in March 2004 Headwaters recognized revenue,
net of the amount Headwaters was required to pay to a third party, relating
to the funds deposited in the escrow account, totaling approximately
$27,900,000. Approximately $3,000,000 of this amount related to revenue
recorded in the March 2004 quarter and approximately $25,000,000 was
recorded as revenue related to prior periods. Interest income of
approximately $164,000 was also recognized. During the June 2004 quarter,
the IRS completed its administrative review of the licensee's tax audit and
the escrowed amounts were disbursed from the escrow account and paid to
Headwaters.
In addition to the escrowed amounts, this same licensee has also set aside
substantial amounts for working capital and other operational contingencies
as provided for in the contractual agreements. These amounts 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.
F-37
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
15. Related Party Transactions
In addition to transactions disclosed elsewhere, Headwaters was involved in
the following related party transactions during 2003, 2004 and 2005. A
director of Headwaters is a principal in one of the insurance brokerage
companies Headwaters uses to purchase certain insurance benefits for its
employees. Commissions paid to that company by providers of insurance
services to Headwaters totaled approximately $120,000 in 2003, $130,000 in
2004 and $196,000 in 2005.
Eldorado purchases product from an entity located in Mexico in which an
officer of Eldorado has a minority ownership interest. Costs incurred for
materials purchased from this entity were approximately $2,712,000 in 2004
and $11,826,000 in 2005. A majority of SCP's transportation needs are
provided by a company, two of the principals of which are related to an
officer of SCP. Costs incurred were approximately $970,000 in 2004 and
$4,904,000 in 2005.
In 2003, Headwaters executed incentive agreements with three of the former
stockholders and officers of ISG, all of whom were officers of either
Headwaters or ISG following the ISG acquisition. The maximum payments would
have been required if there had been a change in control prior to October
2004, or if the officers remained employed through September 2004 and the
average stock price for any calendar quarter reached $25 per share or more.
During 2004, Headwaters recorded an expense for $1,500,000 related to this
obligation.
16. Quarterly Financial Data (unaudited)
Summarized unaudited quarterly financial data for 2004 and 2005 is as
follows.
2004 (2)
-----------------------------------------------------------------
First Second Third Fourth
(in thousands, except per-share data) quarter quarter (2) quarter (2) quarter (2) Full year
---------------------------------------------------------------------------------------------------------------
Net revenue $101,469 $119,521 $134,318 $198,647 $553,955
Gross profit 37,255 57,879 46,679 70,877 212,690
Net income 10,092 18,627 16,060 19,538 64,317
Basic earnings per share (1) 0.36 0.57 0.48 0.59 2.02
Diluted earnings per share (1) 0.35 0.55 0.45 0.51 1.88
2005 (3)
-----------------------------------------------------------------
First Second Third Fourth
(in thousands, except per-share data) quarter (3) quarter (3) quarter (3) quarter (3) Full year
---------------------------------------------------------------------------------------------------------------
Net revenue $218,416 $222,392 $308,729 $315,102 $1,064,639
Gross profit 76,105 81,592 121,699 111,616 391,012
Net income 11,137 9,974 55,290 44,877 121,278
Basic earnings per share (1) 0.33 0.28 1.35 1.09 3.19
Diluted earnings per share (1) 0.30 0.26 1.17 0.95 2.79
--------------------
(1) Because the weighted-average share number used to calculate EPS for the full
year is an average of the numbers used for the four quarters, the full year
EPS amount does not equal the sum of the EPS amounts for the four quarters
in the year.
(2) In the second quarter of 2004 Headwaters recognized revenue relating to
funds deposited in an escrow account totaling approximately $27,900,000,
most of which related to prior periods (see Note 14). In addition, revenue
and net income for the third and fourth quarters of 2004 were materially
affected by the 2004 acquisitions (see Note 3). Finally, the diluted
earnings per share amounts shown above for the third and fourth quarters of
2004 have been restated to include the effect of contingently convertible
securities as required by EITF 04-08 (see Note 13).
(3) In the third quarter of 2005, Headwaters settled its litigation with AJG and
recognized a significant non-recurring gain of $50,000,000, along with
increased recurring revenues beginning in that quarter (see Note 14). Also
in the third quarter of 2005, Headwaters adopted SFAS No. 123R (see Note 12)
F-38
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
September 30, 2005
-----------
which, combined with the grant of immediate-vested SARs and the acceleration
of vesting of certain outstanding options, resulted in the recognition of
significant non-recurring stock-based compensation expense totaling
approximately $25,510,000. Headwaters adopted SFAS No. 123R using the
"modified retrospective" method, with restatement of the interim periods in
the year of adoption. Accordingly, the amounts shown above for the first and
second quarters of 2005 have been restated to reflect stock-based
compensation expense calculated in accordance with the new stock-based
compensation accounting rules.
Finally, in the fourth quarter of 2005, Headwaters recorded income tax
expense at an effective income tax rate of approximately 18%, compared to an
effective income tax rate of approximately 30% for the first nine months of
the year. The lower rate for the fourth quarter was required to reduce the
effective income tax rate for the year to approximately 26%. This reduction
was primarily a result of Section 29 income tax credits related to
alternative fuel facilities in which Headwaters has an ownership interest
(see Notes 11 and 14).
F-39