UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 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
-----------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 87-0547337
------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
10653 South River Front Parkway, Suite 300
South Jordan, Utah 84095
---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
(801) 984-9400
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(Registrant's telephone number, including area code)
Not applicable
---------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer (as defined in Rule
12b-2 of the Exchange Act).
Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ]
The number of shares outstanding of the Registrant's common stock as of
January 31, 2006 was 42,131,354.
HEADWATERS INCORPORATED
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Page
No.
ITEM 1. FINANCIAL STATEMENTS (Unaudited):
Condensed Consolidated Balance Sheets - As of September 30,
2005 and December 31, 2005 .....................................3
Condensed Consolidated Statements of Income - For the three
months ended December 31, 2004 and 2005 ........................4
Condensed Consolidated Statement of Changes in Stockholders'
Equity - For the three months ended December 31, 2005...........5
Condensed Consolidated Statements of Cash Flows - For the three
months ended December 31, 2004 and 2005.........................6
Notes to Condensed Consolidated Financial Statements ...............7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS..........................................19
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.........28
ITEM 4. CONTROLS AND PROCEDURES............................................29
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS .................................................30
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS .......30
ITEM 3. DEFAULTS UPON SENIOR SECURITIES ...................................30
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ...............30
ITEM 5. OTHER INFORMATION..................................................30
ITEM 6. EXHIBITS ..........................................................30
SIGNATURES....................................................................31
Forward-looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995 regarding
future events and our future results that are based on current expectations,
estimates, forecasts, and projections about the industries in which we operate
and the beliefs and assumptions of our management. Actual results may vary
materially from such expectations. Words such as "expects," "anticipates,"
"targets," "goals," "projects," "believes," "seeks," "estimates," or variations
of such words and similar expressions, are intended to identify such
forward-looking statements. In addition, any statements that refer to
projections of our future financial performance, our anticipated growth and
trends in our businesses, and other characterizations of future events or
circumstances, are forward-looking. For a discussion of the factors that could
cause actual results to differ from expectations, please see the risk factors
described in Item 7 of our Annual Report on Form 10-K for the year ended
September 30, 2005 and in Item 2 of this report. There can be no assurance that
our results of operations will not be adversely affected by such factors. Unless
legally required, we undertake no obligation to revise or update any
forward-looking statements for any reason. Readers are cautioned not to place
undue reliance on these forward-looking statements, which speak only as of the
date of this report.
Our internet address is www.headwaters.com. There we make available, free of
charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K and any amendments to those reports, as soon as reasonably
practicable after we electronically file such material with, or furnish it to,
the Securities and Exchange Commission ("SEC"). Our reports can be accessed
through the investor relations section of our web site. The information found on
our web site is not part of this or any report we file with or furnish to the
SEC.
2
ITEM 1. FINANCIAL STATEMENTS
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, December 31,
(in thousands, except per-share data) 2005 2005
- -----------------------------------------------------------------------------------------------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 13,666 $ 24,501
Trade receivables, net 174,127 149,728
Other receivable 70,000 70,000
Inventories 60,519 63,954
Current and deferred income taxes 28,577 28,577
Other 8,185 14,591
---------------------------------
Total current assets 355,074 351,351
---------------------------------
Property, plant and equipment, net 190,450 196,219
---------------------------------
Other assets:
Intangible assets, net 276,248 267,619
Goodwill 811,545 822,987
Debt issue costs and other assets 38,339 41,774
---------------------------------
Total other assets 1,126,132 1,132,380
---------------------------------
Total assets $ 1,671,656 $ 1,679,950
=================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 43,957 $ 39,516
Accrued personnel costs 33,584 24,130
Accrued income taxes 14,941 9,908
Other accrued liabilities 66,191 71,437
Deferred license fee revenue 26,858 25,615
Current portion of long-term debt 52,207 51,310
---------------------------------
Total current liabilities 237,738 221,916
---------------------------------
Long-term liabilities:
Long-term debt 601,811 598,434
Deferred income taxes 108,449 108,060
Other 37,345 31,028
---------------------------------
Total long-term liabilities 747,605 737,522
---------------------------------
Total liabilities 985,343 959,438
---------------------------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.001 par value; authorized 100,000 shares; issued and
outstanding: 41,842 shares at September 30, 2005 (including 347 shares
held in treasury) and 42,045 shares at December 31, 2005 (including 316
shares held in treasury) 42 42
Capital in excess of par value 489,602 495,115
Retained earnings 197,808 226,104
Treasury stock and other (1,139) (749)
---------------------------------
Total stockholders' equity 686,313 720,512
---------------------------------
Total liabilities and stockholders' equity $ 1,671,656 $ 1,679,950
=================================
See accompanying notes.
3
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended December 31,
--------------------------------
(in thousands, except per-share data) 2004 2005
- -------------------------------------------------------------------------------------------------------------------------------
Revenue: (as restated)
Construction materials $ 113,729 $ 129,969
Coal combustion products 53,052 65,165
Alternative energy 51,635 85,414
-------------------------------
Total revenue 218,416 280,548
-------------------------------
Operating costs and expenses:
Construction materials 76,603 89,705
Coal combustion products 41,053 48,962
Alternative energy 24,655 47,658
Amortization 6,098 6,036
Research and development 2,384 2,964
Selling, general and administrative 32,323 34,958
-------------------------------
Total operating costs and expenses 183,116 230,283
-------------------------------
Operating income 35,300 50,265
-------------------------------
Other income (expense):
Net interest expense (15,805) (8,951)
Other, net (1,918) (3,068)
-------------------------------
Total other income (expense), net (17,723) (12,019)
-------------------------------
Income before income taxes 17,577 38,246
Income tax provision (6,440) (9,950)
-------------------------------
Net income $ 11,137 $ 28,296
===============================
Basic earnings per share $ 0.33 $ 0.68
===============================
Diluted earnings per share $ 0.30 $ 0.60
===============================
See accompanying notes.
4
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(Unaudited) For the Three Months Ended December 31, 2005
Common stock Capital in Total
-------------------- excess Retained Treasury stock, stockholders'
(in thousands) Shares Amount of par value earnings at cost Other equity
- ------------------------------------------------------------------------------------------------------------------------------------
Balances as of September 30, 2005 41,842 $42 $489,602 $197,808 $(2,419) $1,280 $686,313
Exercise of stock options and stock
appreciation rights 197 -- 1,002 1,002
Tax benefit from exercise of stock
options and stock appreciation rights 1,849 1,849
31 shares of treasury stock transferred
to employee stock purchase plan, at cost 880 85 965
Issuance of restricted stock 6 -- -- --
Stock-based compensation 1,782 1,782
Other comprehensive income - unrealized
gain on cash flow hedges, net of taxes 305 305
Net income for the three months ended
December 31, 2005 28,296 28,296
------------------------------------------------------------------------------------------
Balances as of December 31, 2005 42,045 $42 $495,115 $226,104 $(2,334) $1,585 $720,512
==========================================================================================
See accompanying notes.
5
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended December 31,
--------------------------------
(in thousands) 2004 2005
- -------------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities: (as restated)
Net income $ 11,137 $ 28,296
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 13,587 14,963
Non-cash stock-based compensation expense 2,514 1,782
Non-cash interest expense related to amortization of debt issue costs 1,941 630
Amortization of non-refundable license fees (295) (5,519)
Deferred income taxes -- (584)
Net loss (gain) on disposition of property, plant and equipment 139 (18)
Decrease in trade receivables 21,068 25,072
Increase in inventories (1,966) (3,165)
Decrease in accounts payable and accrued liabilities (26,026) (25,272)
Other changes in operating assets and liabilities, net 17,669 (7,966)
------------------------------
Net cash provided by operating activities 39,768 28,219
------------------------------
Cash flows from investing activities:
Purchase of property, plant and equipment (11,900) (13,279)
Payments for acquisition, net of cash acquired -- (2,432)
Net increase in other assets (1,820) (1,388)
Proceeds from disposition of property, plant and equipment -- 173
------------------------------
Net cash used in investing activities (13,720) (16,926)
------------------------------
Cash flows from financing activities:
Net proceeds from issuance of long-term debt 718 --
Payments on long-term debt (51,209) (4,274)
Proceeds from exercise of stock options 1,177 1,002
Income tax benefit from exercise of stock options and stock appreciation rights 2,020 1,849
Employee stock purchases 395 965
------------------------------
Net cash used in financing activities (46,899) (458)
------------------------------
Net increase (decrease) in cash and cash equivalents (20,851) 10,835
Cash and cash equivalents, beginning of period 20,851 13,666
------------------------------
Cash and cash equivalents, end of period $ -- $ 24,501
==============================
Supplemental schedule of non-cash investing and financing activities -
Purchase of variable interest in solid alternative fuel facility in
exchange for commitment to make future payments $ 7,500 $ --
==============================
See accompanying notes.
6
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
1. Nature of Operations and Basis of Presentation
Organization and Description of Business - Headwaters Incorporated is
incorporated in Delaware. Headwaters owns 100% of the following
subsidiaries: Headwaters Resources, Inc. and Headwaters Construction
Materials, Inc. (the two of which combined were formerly Industrial
Services Group, Inc., a Utah-based company acquired by Headwaters in
September 2002) ("ISG"); Headwaters Technology Innovation Group, Inc.
(formerly Hydrocarbon Technologies, Inc., a New Jersey company acquired in
August 2001) ("HTI"); VFL Technology Corporation, a Pennsylvania company
acquired in April 2004 ("VFL"); Eldorado Stone, LLC, a Delaware company
acquired in June 2004 ("Eldorado"); Southwest Concrete Products, L.P., a
Texas company acquired in July 2004 ("SCP"); and Tapco Holdings, Inc., a
Michigan company acquired in September 2004 ("Tapco").
Headwaters' focus is on enhancing the value of energy resources in an
environmentally responsible manner; expanding Headwaters' construction
materials business, including opportunities to utilize products from other
Headwaters operations in the production of construction materials;
promoting the expanded use of coal combustion products ("CCPs"); and
developing HTI's energy and nanocatalysis technologies. Headwaters
currently generates revenue from the sale of construction materials, from
marketing CCPs, and from licensing its chemical technologies to produce
solid alternative fuel. Headwaters intends to continue to expand its
business through growth of existing operations, commercialization of
technologies currently being developed, and strategic acquisitions of
products or entities that expand Headwaters' current operating platform.
Headwaters' construction materials segment develops, manufactures and
distributes bagged concrete, stucco, mortar and block products that utilize
fly ash, and with the acquisitions of Eldorado and SCP, manufactured stone
and an expanded array of concrete block products. Tapco is a leading
designer, manufacturer and marketer of building products used in exterior
residential home improvement and construction.
ISG's CCP operations and VFL (together referred to as Headwaters'
Resources, Inc., or "Resources") represent the nation's largest provider of
CCP management and marketing services to the electric utility industry,
serving more than 100 coal-fired electric power generation plants
nationwide. Through its distribution network of over 110 locations,
Resources is the leading provider of high quality fly ash to the building
products and ready mix concrete industries in the United States. Resources
also develops and deploys technologies for maintaining and improving fly
ash quality.
Through its proprietary Covol Fuels process, Headwaters adds value to the
production of coal-based solid alternative fuels, primarily for use in
electric power generation plants. Headwaters currently licenses its
technologies to the owners of 28 of a company-estimated 75 coal-based solid
alternative fuel facilities in the United States and sells chemical
reagents to licensees and other customers. Through its wholly-owned
subsidiary HTI, Headwaters conducts research and development activities
directed at catalysts and processes to convert coal and heavy oil into
high-value liquid fuels. In addition, HTI has developed a unique process to
custom design nanocatalysts that could be used in multiple industrial
applications.
Basis of Presentation - The accompanying unaudited condensed consolidated
financial statements have been prepared in accordance with the rules and
regulations of the Securities and Exchange Commission ("SEC") for quarterly
reports on Form 10-Q. In the opinion of management, all adjustments
considered necessary for a fair presentation have been included, and
consist of normal recurring adjustments. As described in more detail in
Note 3, 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
three months ended December 31, 2004 for the effects of applying SFAS No.
123R.
Certain information and footnote disclosures normally included in annual
financial statements prepared in accordance with U.S. generally accepted
accounting principles have been condensed or omitted. These financial
statements should be read in conjunction with the consolidated financial
statements and notes thereto included in Headwaters' Annual Report on Form
10-K for the year ended September 30, 2005 ("Form 10-K").
7
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
Headwaters' fiscal year ends on September 30. Unless otherwise noted,
future references to 2004 refer to Headwaters' fiscal quarter ended
December 31, 2004, and references to 2005 refer to Headwaters' fiscal
quarter ended December 31, 2005. The consolidated financial statements
include the accounts of Headwaters, all of its subsidiaries and other
entities in which Headwaters has a controlling interest. All significant
intercompany transactions and accounts are eliminated in consolidation. Due
to the seasonality of the operations of the construction materials and CCP
segments and other factors, Headwaters' consolidated results of operations
for 2005 are not indicative of the results to be expected for the full
fiscal 2006 year.
Recent Accounting Pronouncements - Headwaters has reviewed recently issued
accounting standards which have not yet been adopted in order to determine
their potential effect, if any, on the results of operations or financial
position of Headwaters. Based on that review, Headwaters does not currently
believe that any of these recent accounting pronouncements will have a
significant effect on its current or future financial position, results of
operations, cash flows or disclosures.
Reclassifications - Certain prior period amounts have been reclassified to
conform to the current period's presentation, including some changes
resulting from the adoption of SFAS No. 123R, as explained in Note 3. The
reclassifications had no effect on net income or total assets.
2. Segment Reporting
The following segment information has been prepared in accordance with SFAS
No. 131, "Disclosure about Segments of an Enterprise and Related
Information." The accounting policies of the segments are the same as those
described in the notes to the financial statements in Headwaters' Form
10-K. Segment performance is evaluated primarily on revenue growth and
operating income, although other factors are also used, 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.
Three Months Ended December 31, 2004
--------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
---------------------------------------------------------------------------------------------------------------
Segment revenue $ 113,729 $ 53,052 $ 51,635 $ -- $ 218,416
============= =========== =========== ========== ==========
Depreciation and amortization $ (9,406) $ (3,144) $ (964) $ (73) $ (13,587)
============= =========== =========== ========== ==========
Operating income (loss) $ 14,552 $ 5,204 $ 21,089 $ (5,545) $ 35,300
============= =========== =========== ==========
Net interest expense (15,805)
Other income (expense), net (1,918)
Income tax provision (6,440)
----------
Net income $ 11,137
==========
Capital expenditures $ 10,018 $ 1,374 $ 410 $ 98 $ 11,900
============= =========== =========== ========== ==========
Segment Assets as of December 31, 2004 $ 1,092,251 $ 307,560 $ 54,207 $ 34,424 $1,488,442
============= =========== =========== ========== ==========
8
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
Three Months Ended December 31, 2005
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
----------------------------------------------------------------------------------------------------------------
Segment revenue $ 129,969 $ 65,165 $ 85,414 $ -- $ 280,548
============= =========== =========== ========== ==========
Depreciation and amortization $ (9,934) $ (3,164) $ (1,774) $ (91) $ (14,963)
============= =========== =========== ========== ==========
Operating income (loss) $ 14,949 $ 9,421 $ 32,780 $ (6,885) $ 50,265
============= =========== =========== ==========
Net interest expense (8,951)
Other income (expense), net (3,068)
Income tax provision (9,950)
----------
Net income $ 28,296
==========
Capital expenditures $ 8,722 $ 2,123 $ 2,051 $ 383 $ 13,279
============= =========== =========== ========== ==========
Segment Assets as of December 31, 2005 $ 1,134,557 $ 304,771 $ 164,952 $ 75,670 $1,679,950
============= =========== =========== ========== ==========
3. Securities and Stock-Based Compensation
Shelf Registration Statement - Headwaters has an effective universal shelf
registration statement on file with the SEC that can be used for the sale
of common stock, preferred stock, convertible debt and other securities.
Approximately $18.0 million remains available for future offerings of
securities under this 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 - As described in detail in Note 12 to the
consolidated financial statements in the Form 10-K, during fiscal 2005 the
Compensation Committee of Headwaters' Board of Directors (the "Committee")
authorized the grant of several stock incentive awards. At that time, 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 these performance units were made in November 2005 and
could result in the payment to employees of a maximum amount of
approximately $3.6 million if all performance criteria are met.
Subsequent to December 31, 2005 and in accordance with Headwaters' practice
of granting options to directors that vest at the rate of 12,000 per year,
the Committee granted options for the purchase of a total of 108,000 shares
of common stock to three directors. These options have an exercise price of
$32.80 per share and vest over a three-year period.
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 (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 three months ended December 31, 2004. The application of
SFAS No. 123R for 2004 had the effect of reducing net income for that
period by approximately $1.9 million ($0.06 basic earnings per share and
$0.04 diluted earnings per share), the same amount as reported in the pro
forma SFAS No. 123 footnote disclosure in Headwaters' December 31, 2004
Form 10-Q.
Beginning October 1, 2004, Headwaters also reclassified certain stock-based
compensation expense 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 are reflected in the
consolidated statements of changes in stockholders' equity and 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. Finally, SFAS No. 123R
mandated certain changes in the calculation of diluted Earnings per Share
("EPS"), as explained in Note 13 to the consolidated financial statements
in the Form 10-K.
9
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
Total stock-based compensation expense was approximately $2.5 million in
2004 and $1.8 million in 2005. As of December 31, 2005, there is
approximately $12.5 million of total compensation cost related to nonvested
awards not yet recognized, which will be recognized in future periods over
applicable vesting terms.
4. Inventories
Inventories consisted of the following at:
(in thousands) September 30, 2005 December 31, 2005
--------------------------------------------------------------------------
Raw materials $ 12,604 $ 12,641
Finished goods 47,915 51,313
----------------------------------------
$ 60,519 $ 63,954
========================================
5. Intangible Assets
Intangible Assets - Headwaters has no identified intangible assets that are
not being amortized. The following table summarizes the gross carrying
amounts and the related accumulated amortization of all amortizable
intangible assets as of:
September 30, 2005 December 31, 2005
-------------------------------- --------------------------------
Gross Gross
Estimated Carrying Accumulated Carrying Accumulated
(in thousands) useful lives Amount Amortization Amount Amortization
---------------------------------------------------------------------------------------------------------------
CCP contracts 8 - 20 years $117,690 $18,256 $117,690 $19,939
Customer relationships 7 1/2 - 15 years 68,331 5,395 68,331 6,635
Trade names 5 - 20 years 63,657 3,642 63,657 4,486
Patents and patented
technologies 7 1/2 - 16 years 55,359 8,060 52,765 9,251
Non-competition agreements 2 - 3 1/2 years 10,422 4,939 10,422 5,957
Other 9 - 10 years 2,336 1,255 2,336 1,314
-----------------------------------------------------------------
$317,795 $41,547 $315,201 $47,582
=================================================================
Total amortization expense related to intangible assets was approximately
$6.1 million and $6.0 million for 2004 and 2005, respectively. Total
estimated annual amortization expense is as follows for the fiscal years
presented.
Year ending September 30, (in thousands)
----------------------------------- -------------
2006 $24,137
2007 21,859
2008 20,311
2009 20,098
2010 19,765
2011 19,585
10
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
6. Long-term Debt
Long-term debt consisted of the following at:
September 30, December 31,
(in thousands) 2005 2005
------------------------------------------------------------------------------------------------
Senior secured debt $472,673 $469,319
Convertible senior subordinated notes 172,500 172,500
Notes payable to a bank 8,705 7,808
Other 140 117
--------------------------------
654,018 649,744
Less: current portion (52,207) (51,310)
--------------------------------
Total long-term debt $601,811 $598,434
================================
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. The
second lien term loan was repaid in its entirety prior to September 30,
2005. 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 specific SCP assets that collateralize the notes payable to a
bank 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 weighted-average interest rate on
the first lien debt was approximately 6.3% at December 31, 2005, after
giving consideration to the effect of the interest rate hedge on $150.0
million of this debt, as described below. 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 January 2006.
The first lien term loan ($439.3 million outstanding at December 31, 2005)
is repayable in quarterly installments of principal and interest, with
minimum required quarterly principal repayments of approximately $3.4
million through August 2010, plus three repayments of approximately $125.2
million each in November 2010, February 2011 and April 2011, the
termination date. Interest is generally due on a quarterly basis. During
2005, Headwaters made one principal payment of $3.4 million and subsequent
to December 31, 2005 made an optional repayment of $24.0 million, which
effectively paid the required principal repayments on the senior debt until
November 2007.
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. Once repaid in full
or in part, no further reborrowings under either the first or second lien
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 $60.0 million revolver can be
11
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
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
December 31, 2005, Headwaters had $30.0 million of borrowings outstanding
under the revolving credit arrangement, all of which was repaid subsequent
to December 31, 2005. 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 December 31, 2005. The credit agreement also allows for the
issuance of letters of credit, provided there is capacity under the
revolving credit arrangement. As of December 31, 2005, seven letters of
credit totaling $8.2 million were outstanding, with expiration dates
ranging from January 2006 to December 2006.
The credit agreements contain restrictions and covenants common to such
agreements, including limitations on the incurrence of additional debt,
investments, merger and acquisition activity, asset sales and liens, annual
capital expenditures in excess of $72.0 million for fiscal 2006 and $75.0
million for fiscal 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, as
follows: 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 December 31, 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 expired on their terms prior to September 30, 2005.
The second set of agreements effectively fixes the LIBOR rate at 3.71% for
$150.0 million of this debt for the period September 8, 2005 through
September 8, 2007. Headwaters accounts for the agreements which limit its
variable interest rate exposure as cash flow hedges, with their fair market
value 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 December 31, 2005 of approximately $2.6 million, which, net
of $1.0 million of income taxes, represents other comprehensive income.
Total comprehensive income was approximately $28.6 million in 2005. Total
comprehensive income did not differ from net income in 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 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.
12
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
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 (see Note 8).
Notes Payable to a Bank - In connection with the acquisition of SCP in July
2004, Headwaters assumed SCP's obligations under its notes payable to a
bank. The notes require monthly interest and quarterly principal payments
and bear interest at variable rates, which as of December 31, 2005, ranged
from 4.8% to 7.0%. 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 December 31, 2005.
Interest Costs - During 2004 and 2005, Headwaters incurred net interest
costs of approximately $16.0 and $10.0 million, respectively, including
approximately $1.9 million and $0.6 million, respectively, of non-cash
interest expense and approximately $0.1 million and $0.1 million,
respectively, of interest costs that were capitalized. The weighted-average
interest rate on the face amount of outstanding long-term debt,
disregarding amortization of debt issue costs, was approximately 5.2% at
September 30, 2005 and 5.5% at December 31, 2005. Interest income was $0.1
million and $0.9 million during 2004 and 2005, respectively.
7. Income Taxes
Headwaters' effective income tax rate for 2005 was approximately 26%, the
estimated effective tax rate for the fiscal year ending September 30, 2006.
This compares to an effective tax rate of approximately 37% for 2004. The
reduction in the effective tax rate for 2005 is primarily due to increased
Section 45K [formerly 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 10), plus two other smaller alternative
fuel facilities that Headwaters owns and operates. The alternative fuel
produced at these three facilities through December 2007 qualifies for tax
credits pursuant to Section 45K of the Internal Revenue Code. The continued
availability of these tax credits is subject to the uncertainties of
phase-out, IRS audit and other risks associated with Section 45K tax
credits.
13
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
8. Earnings per Share
The following table sets forth the computation of basic and diluted EPS for
the three months ended December 31:
(in thousands, except per-share data) 2004 2005
------------------------------------------------------------------------------------------------------------
Numerator:
Numerator for basic earnings per share -
net income $11,137 $28,296
Interest expense related to convertible
senior subordinated notes, net of taxes 978 1,088
-------------------------------
Numerator for diluted earnings per share -
net income plus interest expense related
to convertible notes, net of taxes $12,115 $29,384
===============================
Denominator:
Denominator for basic earnings per share
- weighted-average shares outstanding 33,439 41,605
Effect of dilutive securities:
Shares issuable upon exercise of
options and SARs 1,362 1,271
Shares issuable upon conversion of
convertible notes 5,750 5,750
-------------------------------
Total potential dilutive shares 7,112 7,021
-------------------------------
Denominator for diluted earnings per
share - weighted-average shares outstanding
after assumed exercises and conversions 40,551 48,626
===============================
Basic earnings per share $ 0.33 $ 0.68
===============================
Diluted earnings per share $ 0.30 $ 0.60
===============================
Anti-dilutive securities not considered in the diluted EPS calculations
consisted of options for approximately 110,000 shares and 27,000 shares in
2004 and 2005, respectively. In addition, approximately 106,000 SARs were
not included in the diluted EPS calculation for 2005 because they were
anti-dilutive.
9. Acquisitions
As described in Note 3 to the consolidated financial statements in the Form
10-K, Headwaters agreed to pay an earn-out to the sellers of SCP if a
specified earnings target was exceeded during the 12 months ended 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. In 2005, Headwaters recorded increased goodwill
of approximately $10.0 million, representing an estimate of the earn-out
consideration which could be paid. Headwaters currently expects to finalize
the determination of the earn-out consideration by March 31, 2006.
In 2005, Tapco acquired certain assets and assumed certain liabilities of
Max Manufacturing & Roofing, LLC. Total consideration, including potential
future deferred payments, is not material.
10. Commitments and Contingencies
Commitments and contingencies as of December 31, 2005 not disclosed
elsewhere, are as follows.
Self Insurance - Headwaters has adopted self-insured medical insurance
plans that cover substantially all employees. There is stop-loss coverage
for medical insurance claims in excess of $100,000 to $175,000 per
individual per year. In addition, effective as of October 1, 2005,
Headwaters became self insured for workers compensation claims, limited by
14
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
stop-loss coverage for amounts in excess of $250,000 per occurrence and
$6.0 million in the aggregate annually. 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 December 31, 2005, approximately $3.5 million is
accrued for medical and workers compensation claims incurred on or before
December 31, 2005 that have not been paid or reported.
Property, Plant and Equipment - As of December 31, 2005, Headwaters was
committed to spend approximately $3.9 million 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 $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 approximately $11.0 million at December 31, 2005), bears
interest at an 8% rate. Headwaters also agreed to make additional payments
to the seller based on a pro-rata allocation of the tax credits generated
by the facility, also through December 2007. These additional contractual
payments, along with the amortization of the $15.5 million investment, are
recorded in other expense in the consolidated statement of income and total
approximately $2.3 million and $3.1 million for 2004 and 2005,
respectively.
The alternative fuel produced at the facility through December 2007
qualifies for tax credits pursuant to Section 45K of the Internal Revenue
Code, and Headwaters is entitled to receive its pro-rata share of such tax
credits generated. Due to the combined effect of the seasonality of
Headwaters' operations and the requirement to use an estimated effective
tax rate for the year in calculating income taxes, Headwaters is not able
to recognize the benefit of all of the tax credits earned in the December
and March quarters in its results of operations for those quarters. Tax
credits earned but not recognized in the December and March quarters are
recognized in the June and September quarters. Even though Headwaters did
not fully recognize its portion of the benefits of the tax credits
generated during 2005, Headwaters' pro-rata share of costs incurred to
generate those tax credits was recognized as other expense through December
31, 2005. Headwaters has the ability, under certain conditions, to limit
its liability under the fixed payment obligations currently totaling
approximately $11.0 million; 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 $1.2 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)1.8
million (approximately $2.1 million) remains to be paid as of December 31,
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.
Costs paid to outside legal counsel for litigation have historically
comprised a majority of Headwaters' litigation-related costs. In 2005,
Headwaters incurred approximately $1.0 million of expense for legal
matters, including costs for outside legal counsel. 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
15
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
claimants and has recorded a total liability as of December 31, 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. It is not possible to estimate what
litigation-related costs will be in future periods.
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. 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.
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 $2.8 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.
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 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
16
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
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 45K Matters - A material amount of Headwaters' consolidated
revenues and net income is derived from Headwaters Energy Services' license
fees and sales of chemical reagents, both of which depend on the ability of
licensees and other customers to manufacture and sell qualified synthetic
fuels that generate tax credits under Section 45K [formerly Section 29] of
the Internal Revenue Code. Headwaters also claims Section 45K tax credits
based upon synthetic fuel sales from facilities in which Headwaters owns an
interest. 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, including the items discussed below.
Phase-Out. Section 45K 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. Historically, the
reference price has trended somewhat lower than published market prices for
oil. 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, Headwaters estimates that the
average reference price will be approximately $50.50 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. Therefore, Headwaters does not anticipate any phase-out of tax
credits for calendar 2005. For calendar 2006, Headwaters estimates that the
phase-out range (again, computed with a 2% inflation adjustment) begins at
$53.43 and completes phase-out at $67.07 per barrel. Congress is
considering legislation to change Section 45K phase-out calculations to a
prospective rather than retrospective application of the reference price.
As of the date hereof, it is too early to estimate a reference price for
calendar 2006. However, Headwaters estimates that if January 2006 average
oil prices are maintained for all of 2006, and absent a change to a
prospective application of the reference price, partial phase-out could
result.
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.
Headwaters must make similar assessments with respect to the continued
operation of its own synthetic fuel production facilities. One of
Headwaters' licensees has decided to stop production of synthetic fuel at
least temporarily. These events may materially adversely affect both the
amounts and timing of recognition of Headwaters' future revenue and net
income.
Legislation. Under current law, Section 45K 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 45K. If Section 45K 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
17
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
(Unaudited)
close their facilities or materially reduce production activities (whether
after 2007, or upon earlier repeal or adverse modification of Section 45K,
or for any other reason), it would have a material adverse effect on the
revenues and net income of Headwaters.
IRS Audits. Licensees are subject to audit by the IRS. The IRS may
challenge whether Headwaters Energy Services' licensees satisfy the
requirements of Section 45K, or applicable Private Letter Rulings,
including placed-in-service requirements, or may attempt to disallow
Section 45K tax credits for some other reason. The IRS has initiated audits
of certain licensee-taxpayers who claimed Section 45K tax credits and will
continue the audit process in the future. In addition, the IRS may audit
Headwaters concerning tax credits claimed for synthetic fuel sold from the
facilities in which it owns an interest. The inability of a licensee to
claim Section 45K 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 [now Section 45K] 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
45K tax credits in the future. The Subcommittee investigation may have a
material adverse effect on the willingness of current owners to operate
their facilities, and may materially adversely affect Headwaters' revenues
and net income.
License Fees - Pursuant to the contractual terms of an agreement with a
certain licensee, this licensee has set aside substantial amounts for
working capital and other operational contingencies as provided for in the
contractual agreements. These amounts may eventually be paid out to various
parties having an interest in the cash flows from the licensee's
operations, including Headwaters, if they are not used for working capital
and other operational contingencies. As a result, Headwaters currently
expects to receive at some future date a portion of those reserves, the
amount of which is not currently determinable and which constitutes a gain
contingency not recognizable as revenue.
18
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with the accompanying unaudited consolidated financial statements and notes
thereto included elsewhere herein. Headwaters' fiscal year ends on September 30
and unless otherwise noted, future references to 2004 refer to Headwaters'
fiscal quarter ended December 31, 2004, and references to 2005 refer to
Headwaters' fiscal quarter ended December 31, 2005.
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 fiscal 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 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 exterior 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
since that time 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 and Segments
Consolidation. The consolidated financial statements include the
accounts of Headwaters, all of its subsidiaries and other entities in which
Headwaters has a controlling interest. Headwaters is also required to
consolidate any variable interest entities for which it is the primary
beneficiary; however, as of December 31, 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.
19
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.
The construction materials segment includes the legacy bagged concrete,
stucco, mortar and block products business, as well as Eldorado's manufactured
architectural stone products and Tapco's 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. VFL has been included
in Headwaters' CCP segment since its acquisition.
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.
Due to the seasonality of the operations of the construction materials
and CCP segments and other factors, Headwaters' consolidated results of
operations for the December 2005 quarter are not indicative of the results to be
expected for the full fiscal 2006 year.
Three Months Ended December 31, 2005 Compared to Three Months Ended December 31,
2004
The information set forth below compares Headwaters' operating results
for the three months ended December 31, 2005 ("2005") with operating results for
the three months ended December 31, 2004 ("2004").
Revenue. Total revenue for 2005 increased by $62.1 million or 28% to
$280.5 million as compared to $218.4 million for 2004. The major components of
revenue are discussed in the sections below.
Construction Materials Segment. Sales of construction materials during
2005 were $130.0 million with a corresponding direct cost of $89.7 million.
Sales of construction materials during 2004 were $113.7 million with a
corresponding direct cost of $76.6 million. The increase in sales of
construction materials during 2005 was due primarily to increases in volume,
which occurred across all major product lines. The primary reasons for the
decline in gross margin percentage were higher raw material costs and
manufacturing inefficiencies related to expansion of capacity and product lines
and restructuring of operations at certain manufacturing facilities. Headwaters
currently expects the gross margin percentage for the quarter ending March 31,
2006 to approximate the December 2005 quarter levels, with the potential for
some improvement in gross margin percentage in the last half of the 2006 fiscal
year.
CCP Segment. CCP revenues for 2005 were $65.2 million with a
corresponding direct cost of $49.0 million. CCP revenues for 2004 were $53.1
million with a corresponding direct cost of $41.1 million. The increases in CCP
revenues and in the gross margin percentage during 2005 were due primarily to a
combination of continued strong demand for CCPs, upward pricing trends in most
concrete markets, and increased project revenues. In addition, weather
conditions in the south central region of the United States were favorable. The
growth in demand for CCPs is due in part to certain regional shortages in the
availability of portland cement for which CCPs are a substitute, which can
result in an increased percentage of CCPs being used in concrete. The cement
shortages also resulted in increased prices for CCPs in several markets.
Alternative Energy Segment. Headwaters' alternative energy segment
revenue consists primarily of chemical reagent sales, license fee revenue
related to its solid alternative fuel technologies, and to a lesser extent,
sales of synthetic fuel from two solid alternative fuel production facilities
that Headwaters owns that began operating in fiscal 2005. The major components
of revenue for the alternative energy segment are discussed in the sections
below.
A material amount of Headwaters' consolidated revenues and net income
is derived from Headwaters Energy Services' license fees and sales of chemical
reagents, both of which depend on the ability of licensees and other customers
to manufacture and sell qualified synthetic fuels that generate tax credits
under Section 45K [formerly 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 45K
Matters" below. Due to the potential significance of these issues, it is not
possible to predict the trend of alternative energy revenue in future periods.
Sales of Chemical Reagents. Chemical reagent sales during 2005 were
$44.5 million with a corresponding direct cost of $33.3 million. Chemical
reagent sales during 2004 were $36.8 million with a corresponding direct cost of
$24.6 million. The increase in chemical reagent sales during 2005 was due almost
20
exclusively to increased synthetic fuel production by Headwaters' licensees
(resulting in increased sales of $7.7 million) with little change in the sales
of chemical reagents to other customers. It is not possible to predict the trend
of sales of chemical reagents. The gross margin percentage for 2005 of 25% was
8% lower than for 2004, due primarily to increases in the cost of product, which
in turn is related to increases in the costs of petroleum-based materials.
Headwaters currently expects reagent margins to stabilize in the 25% range
during fiscal 2006, depending upon crude oil prices and the availability of raw
material feedstocks.
License Fees. During 2005, Headwaters recognized license fee revenue
totaling $28.1 million, an increase of $13.5 million or 92% from $14.6 million
of license fee revenue recognized during 2004. The primary reason for the
increase in license fee revenue in 2005 compared to 2004 relates to ongoing
revenues stemming from the settlement of the AJG litigation in fiscal 2005,
which is described in more detail in Note 14 to the consolidated financial
statements in the Form 10-K ($11.1 million of the increase). License fee revenue
from licensees not associated with the litigation increased $2.4 million from
2004 to 2005 as a result of increased production and sales of alternative fuel
by these licensees.
Pursuant to the contractual terms of an agreement with a certain
licensee, this licensee has set aside substantial amounts for working capital
and other operational contingencies as provided for in the contractual
agreements. These amounts may eventually be paid out to various parties having
an interest in the cash flows from the licensee's operations, including
Headwaters, if they are not used for working capital and other operational
contingencies. As a result, Headwaters currently expects to receive at some
future date a portion of those reserves, the amount of which is not currently
determinable and which constitutes a gain contingency not recognizable as
revenue.
Other Alternative Energy Segment Revenues. Sales of synthetic fuel
during 2005 were $11.5 million with a corresponding direct cost of $13.3
million. There were no sales of synthetic fuel during 2004 since the two
alternative fuel facilities were not operating in 2004. Revenue from the sale of
synthetic fuel has a negative gross margin, which is more than compensated for
by 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.
Research and Development. Research and development expenses increased
by $0.6 million to $3.0 million in 2005 from $2.4 million in 2004. The increase
was primarily attributable to increased HTI research and development activities,
which are likely to continue at or above 2005 levels in future periods.
Selling, General and Administrative Expenses. These expenses increased
$2.7 million, or 8% to $35.0 million for 2005 from $32.3 million for 2004. The
increase in 2005 was due to the general growth of Headwaters' operations. The
increase in selling, general and administrative expenses of 8% was significantly
less than the revenue growth rate of 28% due to the relationship of fixed and
variable costs, and the significant portion of revenue growth attributable to
the alternative energy segment, for which license fees and chemical reagent
sales comprise the majority of revenues.
Other Income and Expense. During 2005, Headwaters reported net other
expense of $12.0 million compared to net other expense of $17.7 million during
2004. The change of $5.7 million was attributable to a decrease in net interest
expense of $6.8 million partially offset by an increase in other expenses of
approximately $1.1 million. Net interest expense decreased from $15.8 million in
2004 to $9.0 million in 2005, due primarily to significantly lower average
levels of long-term debt in 2005 compared to 2004.
The increase in other expenses of $1.1 million consisted primarily of a
$0.8 million increase in costs related to Headwaters' investment in the
coal-based solid alternative fuel production facility described in Note 10 to
the consolidated financial statements, which investment increased from 9% to 19%
in December 2004. The alternative fuel produced at the facility through December
2007 qualifies for tax credits pursuant to Section 45K of the Internal Revenue
Code, and Headwaters is entitled to receive its pro-rata share of such tax
credits generated. Due to the combined effect of the seasonality of Headwaters'
operations and the requirement to use an estimated effective tax rate for the
year in calculating income taxes, Headwaters is not able to recognize the
benefit of all of the tax credits earned in the December and March quarters in
its results of operations for those quarters. Tax credits earned but not
recognized in the December and March quarters are recognized in the June and
September quarters. Even though Headwaters did not fully recognize its portion
of the benefits of the tax credits generated during 2005, Headwaters' pro-rata
share of costs incurred to generate those tax credits was recognized as other
expense through December 31, 2005.
Income Tax Provision. Headwaters' effective income tax rate for 2005
was approximately 26%, the estimated effective tax rate for the fiscal year
ending September 30, 2006. This compares to an effective tax rate of
approximately 37% for 2004. The reduction in the effective tax rate for 2005 is
primarily due to increased Section 45K tax credits related to Headwaters' 19%
interest in an entity that owns and operates a coal-based solid alternative fuel
production facility (see Note 10 to the consolidated financial statements), plus
two other smaller alternative fuel facilities that Headwaters owns and operates.
The alternative fuel produced at these three facilities through December 2007
21
qualifies for tax credits pursuant to Section 45K of the Internal Revenue Code.
The continued availability of these tax credits is subject to the uncertainties
of phase-out, IRS audit and other risks associated with Section 45K tax credits.
Excluding the effect of the tax credits, Headwaters' effective tax rate in 2005
would have been approximately 39%.
Headwaters adjusts its income tax provision each quarter to yield the
estimated effective tax rate for the fiscal year on a cumulative basis, causing
each quarter's effective tax rate to vary somewhat. It is possible that
Headwaters' estimate of its effective tax rate for fiscal 2006 will change in
the future, necessitating an adjustment in future periods to reflect the impact
of the rate change on results for prior fiscal 2006 quarters.
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 natural gas, 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 $28.2 million compared to $39.8 million during 2004.
In both periods, the primary investing activity consisted of the purchase of
property, plant and equipment and the primary financing activity consisted of
repayments of long-term debt. More details about Headwaters' investing and
financing activities are provided in the following paragraphs.
Investing Activities. Expenditures for property, plant and equipment
increased $1.4 million from 2004 ($11.9 million) to 2005 ($13.3 million). Most
of these capital expenditures were incurred by the construction materials
segment. Capital expenditures for fiscal 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' planned 2006 capital
expenditures represent expansion of operations, rather than "maintenance" of
operating capacity, and a significant portion of the anticipated increase in
capital expenditures from fiscal 2005 to fiscal 2006 is expected to be in the
CCP and alternative energy segments. The "unused" amounts of Headwaters' annual
capital expenditures limits in the senior debt agreements can generally be
"carried over" from year to year. As of December 31, 2005, Headwaters was
committed to spend approximately $3.9 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.
22
As described in Note 3 to the consolidated financial statements in the
Form 10-K, Headwaters agreed to pay an earn-out to the sellers of SCP if a
specified earnings target was exceeded during the 12 months ended 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. In 2005, Headwaters recorded increased goodwill of
approximately $10.0 million, representing an estimate of the earn-out
consideration which could be paid. Headwaters currently expects to finalize the
determination of the earn-out consideration by March 31, 2006.
In 2005, Tapco acquired certain assets and assumed certain liabilities
of Max Manufacturing & Roofing, LLC. Total consideration, including potential
future deferred payments, is not material.
As described in more detail in Note 10 to the consolidated financial
statements, in September 2004 Headwaters purchased a 9% variable interest in an
entity that owns and operates a coal-based solid alternative fuel production
facility, where Headwaters is not the primary beneficiary. In December 2004,
Headwaters purchased an additional 10% variable interest in this entity.
Headwaters' 19% minority interest was acquired in exchange for initial cash
payments totaling $0.5 million and an obligation to pay $15.0 million in monthly
installments from October 2004 through December 2007. This obligation, recorded
in other accrued liabilities and other long-term liabilities in the consolidated
balance sheet (totaling $11.0 million at December 31, 2005), bears interest at
an 8% rate. Headwaters also agreed to make additional payments to the seller
based on a pro-rata allocation of the tax credits generated by the facility,
also through December 2007. These additional contractual payments, along with
the amortization of the $15.5 million investment, are recorded in other expense
in the consolidated statement of income and total approximately $2.3 million and
$3.1 million for 2004 and 2005, respectively.
The alternative fuel produced at the facility through December 2007
qualifies for tax credits pursuant to Section 45K 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 $11.0 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)1.8 million (approximately $2.1 million) remains to be
paid as of December 31, 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 in fiscal 2005 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 positive cash flow to continue
in the future and also has the ability to access the equity markets.
Headwaters has an effective universal shelf registration statement on
file with the SEC that can be used for the sale of common stock, preferred
stock, convertible debt and other securities. Approximately $18.0 million
remains available for future offerings of securities under this 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.
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. The second lien term loan was repaid in
its entirety prior to September 30, 2005. 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 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
23
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 weighted-average interest rate on the first lien debt was approximately 6.3%
at December 31, 2005, after giving consideration to the effect of the interest
rate hedge on $150.0 million of this debt, as described below. 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 January 2006.
The first lien term loan ($439.3 million outstanding at December 31,
2005) is repayable in quarterly installments of principal and interest, with
minimum required quarterly principal repayments of approximately $3.4 million
through August 2010, plus three repayments of approximately $125.2 million each
in November 2010, February 2011 and April 2011, the termination date. Interest
is generally due on a quarterly basis. During 2005, Headwaters made one
principal payment of $3.4 million and subsequent to December 31, 2005 made an
optional repayment of $24.0 million, which effectively paid the required
principal repayments on the senior debt until November 2007. This early debt
repayment, along with the full repayment of the outstanding amount under the
revolving credit arrangement of $30.0 million, were repaid with funds received
from the final $70.0 million payment due from the litigation settlement reached
with AJG in fiscal 2005.
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. Once repaid in full or in part, no
further reborrowings under either the first or second lien 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 expired on their terms prior to September 30, 2005. The
second set of agreements effectively fixes the LIBOR rate at 3.71% for $150.0
million of this debt for the period September 8, 2005 through September 8, 2007.
Headwaters accounts for the agreements which limit its variable interest rate
exposure as cash flow hedges, with their fair market value 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 December 31, 2005 of
approximately $2.6 million, which, net of $1.0 million of income taxes,
represents other comprehensive income. Total comprehensive income was
approximately $28.6 million in 2005. Total comprehensive income did not differ
from net income in 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
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.
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 December 31, 2005, ranged from 4.8%
to 7.0%. Because the notes are callable by the bank, Headwaters has included the
outstanding balance of $7.8 million in current portion of long-term debt in the
24
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 December
31, 2005.
Options and Employee Stock Purchases - In 2005, cash proceeds from the
exercise of options and employee stock purchases totaled $2.0 million, compared
to $1.6 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 financing
activities in the consolidated statements of cash flows, were $2.0 million in
2004 and $1.8 million in 2005. These income tax deductions do not affect income
tax expense or the effective income tax rate; rather they are reflected as
increases in capital in excess of par value in the consolidated balance sheet.
Working Capital. In 2005, Headwaters' working capital increased by
$12.1 million, to $129.4 million as of December 31, 2005. Headwaters expects
operations to produce positive cash flows in future periods. 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 December 31, 2005, Headwaters had $30.0 million of borrowings
outstanding under the revolving credit arrangement, all of which was repaid
subsequent to December 31, 2005. 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
December 31, 2005. The credit agreement also allows for the issuance of letters
of credit, provided there is capacity under the revolving credit arrangement. As
of December 31, 2005, seven letters of credit totaling $8.2 million were
outstanding, with expiration dates ranging from January 2006 to December 2006.
Headwaters may, in the future, make optional prepayments of the senior
debt depending on actual cash flows, Headwaters' current and expected cash
requirements and other applicable factors deemed significant by management.
The 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 $72.0 million for fiscal 2006 and $75.0
million for fiscal 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, as follows: 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 December 31, 2005.
As described above, Headwaters has approximately $477.1 million of
variable-rate long-term debt outstanding as of December 31, 2005, consisting of
$469.3 million of senior debt and $7.8 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), required principal repayments, plus the January 2006
payments of $54.0 million on the senior debt, a change in the interest rate of
1% would change Headwaters' interest expense by approximately $2.7 million
during the 12 months ending December 31, 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 $1.8 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.
25
Headwaters' effective income tax rate for 2005 was approximately 26%,
the estimated effective tax rate for the fiscal year ending September 30, 2006.
This compares to an effective tax rate of approximately 37% for 2004. The
reduction in the effective tax rate for 2005 is primarily due to increased
Section 45K tax credits related to Headwaters' 19% interest in an entity that
owns and operates a coal-based solid alternative fuel production facility (see
Note 10 to the consolidated financial statements), plus two other smaller
alternative fuel facilities that Headwaters owns and operates. The alternative
fuel produced at these three facilities through December 2007 qualifies for tax
credits pursuant to Section 45K of the Internal Revenue Code. The continued
availability of these tax credits is subject to the uncertainties of phase-out,
IRS audit and other risks associated with Section 45K tax credits. Excluding the
effect of the tax credits, Headwaters' effective tax rate in 2005 would have
been approximately 39%.
Summary of Future Cash Requirements. Significant future cash uses, in
addition to operational working capital requirements, including income tax
payments, are currently expected to consist primarily of capital expenditures
and debt service payments on outstanding long-term debt.
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 in Note 10 to the consolidated financial statements. Headwaters
intends to vigorously defend or resolve these matters by settlement, as
appropriate. Management does not currently believe that the outcome of these
matters will have a material adverse effect on Headwaters' operations, cash
flows or financial position.
Costs paid to outside legal counsel for litigation have historically
comprised a majority of Headwaters' litigation-related costs. In 2005,
Headwaters incurred approximately $1.0 million of expense for legal matters,
including costs for outside legal counsel. 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 December 31, 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. It is not
possible to estimate what litigation-related costs will be in future periods.
The matters discussed in Note 10 to the consolidated financial
statements 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.
As described in detail in Note 12 to the consolidated financial
statements in the Form 10-K, during fiscal 2005 the Compensation Committee of
Headwaters' Board of Directors (the "Committee") authorized the grant of several
stock incentive awards. At that time, 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 these performance units were made in
November 2005 and could result in the payment to employees of a maximum amount
of approximately $3.6 million if all performance criteria are met.
Section 45K Matters
A material amount of Headwaters' consolidated revenues and net income
is derived from Headwaters Energy Services' license fees and sales of chemical
reagents, both of which depend on the ability of licensees and other customers
to manufacture and sell qualified synthetic fuels that generate tax credits
under Section 45K [formerly Section 29] of the Internal Revenue Code. Headwaters
also claims Section 45K tax credits based upon synthetic fuel sales from
facilities in which Headwaters owns an interest. 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, including the items discussed below.
Phase-Out. Section 45K 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. Historically, the reference
price has trended somewhat lower than published market prices for oil. 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, Headwaters estimates that the average reference price
will be approximately $50.50 per barrel, and an estimate of the phase-out range
26
(computed by increasing the 2004 inflation adjustment factor by 2%) begins at
$52.38 and completes phase-out at $65.76 per barrel. Therefore, Headwaters does
not anticipate any phase-out of tax credits for calendar 2005. For calendar
2006, Headwaters estimates that the phase-out range (again, computed with a 2%
inflation adjustment) begins at $53.43 and completes phase-out at $67.07 per
barrel. Congress is considering legislation to change Section 45K phase-out
calculations to a prospective rather than retrospective application of the
reference price. As of the date hereof, it is too early to estimate a reference
price for calendar 2006. However, Headwaters estimates that if January 2006
average oil prices are maintained for all of 2006, and absent a change to a
prospective application of the reference price, partial phase-out could result.
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. Headwaters must make
similar assessments with respect to the continued operation of its own synthetic
fuel production facilities. One of Headwaters' licensees has decided to stop
production of synthetic fuel at least temporarily. These events may materially
adversely affect both the amounts and timing of recognition of Headwaters'
future revenue and net income.
Legislation. Under current law, Section 45K 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 45K. If Section 45K 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 45K, or for any other reason), it would have a material adverse
effect on the revenues and net income of Headwaters.
IRS Audits. Licensees are subject to audit by the IRS. The IRS may
challenge whether Headwaters Energy Services' licensees satisfy the requirements
of Section 45K, or applicable Private Letter Rulings, including
placed-in-service requirements, or may attempt to disallow Section 45K tax
credits for some other reason. The IRS has initiated audits of certain
licensee-taxpayers who claimed Section 45K tax credits and will continue the
audit process in the future. In addition, the IRS may audit Headwaters
concerning tax credits claimed for synthetic fuel sold from the facilities in
which it owns an interest. The inability of a licensee to claim Section 45K 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 [now
Section 45K] 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 45K tax
credits in the future. The Subcommittee investigation may have a material
adverse effect on the willingness of current owners to operate their facilities,
and may materially adversely affect Headwaters' revenues and net income.
Recent Accounting Pronouncements
Headwaters has reviewed recently issued accounting standards which have
not yet been adopted in order to determine their potential effect, if any, on
the results of operations or financial position of Headwaters. Based on that
review, Headwaters does not currently believe that any of these recent
accounting pronouncements will have a significant effect on its current or
future financial position, results of operations, cash flows or disclosures.
Risks Factors
Risks relating to Headwaters' business and common stock are described
in detail in Item 7 of the Form 10-K. The following information supplements the
information described therein as it relates to Section 45K phase-out.
27
Section 45K [formerly Section 29] of the Internal Revenue Code
("Section 45K") tax credits are subject to phase-out if the unregulated average
annual oil price reaches the IRS established phase-out range.
Tax credits claimed by an alternative fuel facility operator are
reduced prior to their scheduled expiration on December 31, 2007 if the
"reference price" of oil exceeds the lower end of a phase-out range and are
eliminated entirely if the reference price exceeds the higher end of that range,
with the beginning and end of the range being adjusted annually for inflation.
In April of each year, the Internal Revenue Service ("IRS") announces the
reference price and the phase-out range of oil prices for the prior calendar
year. For example, in April 2005, the IRS announced that the reference price for
calendar 2004 was $36.75 per barrel and 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 reference price did not fall within the range,
there was not a phase-out of the credit for qualified fuel sold in 2004. For
calendar 2005, Headwaters estimates that the reference price will be
approximately $50.50 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. Therefore, Headwaters does
not anticipate that there will be any phase-out of Section 45K 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. For
calendar 2006, Headwaters estimates that the phase-out range (again, computed
with a 2% inflation adjustment) begins at $53.43 and completes phase-out at
$67.07 per barrel. Congress is considering legislation to change Section 45K
phase-out calculations to a prospective rather than retrospective application of
the reference price. As of the date hereof, it is too early to estimate a
reference price for calendar 2006. However, Headwaters estimates that if January
2006 average oil prices are maintained for all of 2006, and absent a change to a
prospective application of the reference price, partial phase-out could result.
If the Section 45K tax credits are phased out in whole or in material part, the
amounts and timing of recognition of Headwaters Energy Services' future revenue
and profitability will be severely affected.
The reference price of oil and the inflation adjustment factor 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 U.S. Energy
Information Agency's estimate of 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. The government updates phase-out criteria each April for
alternative fuel produced during the previous calendar year. The price of oil
has impacted the decisions of facility owners concerning alternative fuel
production beginning with the first quarter of calendar year 2006.
During calendar 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 and its
licensees and customers continue to closely watch oil price trends and will
consider whether or not to operate their facilities in calendar 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. Headwaters must
also make assessments with respect to the continued operation of its own
synthetic fuel production facilities. One of Headwaters' licensees has decided
to stop production of synthetic fuel at least temporarily. Decisions by
Headwaters to stop operation of its own synthetic fuel production facilities
will increase Headwaters' tax rate for the year in which production is
curtailed. Decisions by Headwaters or its licensees or customers to curtail or
eliminate production will severely affect our profitability, including the
timing of recognition of revenue.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Headwaters is exposed to financial market risks, primarily related to
changes in interest rates. Headwaters does not use derivative financial
instruments for speculative or trading purposes, but has entered into hedge
transactions to limit its variable interest rate exposure, as explained below.
As described in more detail in Note 6 to the consolidated financial
statements, Headwaters has approximately $477.1 million of variable-rate
long-term debt outstanding as of December 31, 2005, consisting of $469.3 million
of senior debt and $7.8 million of notes payable to a bank. There was
approximately $481.4 million of variable-rate long-term debt outstanding as of
September 30, 2005.
The $469.3 million of borrowings under the senior debt agreement
consisted of a first lien term loan in the amount of $439.3 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
28
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
weighted-average interest rate on the first lien debt was approximately 6.3% at
December 31, 2005, after giving consideration to the effect of the interest rate
hedge on $150.0 million of this debt, as described below. 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 January 2006. 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%.
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 expired on their terms prior to September 30, 2005. The
second set of agreements effectively fixes the LIBOR rate at 3.71% for $150.0
million of this debt for the period September 8, 2005 through September 8, 2007.
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
December 31, 2005 of approximately $2.6 million, which, net of $1.0 million of
income taxes, represents other comprehensive income. Total comprehensive income
was approximately $28.6 million in 2005. Total comprehensive income did not
differ from net income in 2004.
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 December 31, 2005, ranged from 4.8% to 7.0%.
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), required principal repayments, plus the January 2006
payments of $54.0 million on the senior debt, a change in the interest rate of
1% would change Headwaters' interest expense by approximately $2.7 million
during the 12 months ending December 31, 2006.
ITEM 4. 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 Quarterly
Report on Form 10-Q, 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
December 31, 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 Quarterly Report. Headwaters' management,
including the CEO and CFO, does not expect that disclosure controls can or will
prevent or detect all errors and all fraud, if any. A control system, no matter
how well designed and operated, can provide only reasonable, not absolute,
assurance that the objectives of the control system are met. Also, 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 December 31, 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
29
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
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 December 31, 2005 that has materially
affected, or is reasonably likely to materially affect, Headwaters' internal
control over financial reporting.
.
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See "Legal or Contractual Matters" in Note 10 to the consolidated
financial statements for a description of current legal proceedings.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
The following exhibits are included herein:
12 Computation of ratio of earnings to combined fixed *
charges and preferred stock dividends
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief *
Executive Officer
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief *
Financial Officer
32 Section 1350 Certifications of Chief Executive *
Officer and Chief Financial Officer
-----------------------
* Filed herewith.
30
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HEADWATERS INCORPORATED
Date: February 3, 2006 By: /s/ Kirk A. Benson
------------------------------------------
Kirk A. Benson, Chief Executive Officer
(Principal Executive Officer)
Date: February 3, 2006 By: /s/ Scott K. Sorensen
------------------------------------------
Scott K. Sorensen, Chief Financial Officer
(Principal Financial Officer)
31