UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2006
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
---------------------------------------------------
(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
April 28, 2006 was 42,277,578.
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 March 31, 2006 ................................................3
Condensed Consolidated Statements of Income - For the three and
six months ended March 31, 2005 and 2006 ..........................4
Condensed Consolidated Statement of Changes in Stockholders'
Equity - For the six months ended March 31, 2006...................5
Condensed Consolidated Statements of Cash Flows - For the six
months ended March 31, 2005 and 2006...............................6
Notes to Condensed Consolidated Financial Statements ................7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.........................................21
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..........33
ITEM 4. CONTROLS AND PROCEDURES.............................................34
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS ..................................................34
ITEM 1A.RISK FACTORS .......................................................34
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS ........35
ITEM 3. DEFAULTS UPON SENIOR SECURITIES ....................................35
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ................35
ITEM 5. OTHER INFORMATION...................................................36
ITEM 6. EXHIBITS ...........................................................36
SIGNATURES....................................................................37
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 1A 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, March 31,
(in thousands, except per-share data) 2005 2006
- ------------------------------------------------------------------------------------------ --------------- ---------------
ASSETS
Current assets:
Cash and cash equivalents $ 13,666 $ 56,775
Trade receivables, net 174,127 127,494
Other receivable 70,000 --
Inventories 60,519 68,202
Current and deferred income taxes 28,577 20,425
Other 8,185 10,742
--------------- ---------------
Total current assets 355,074 283,638
--------------- ---------------
Property, plant and equipment, net 190,450 198,904
--------------- ---------------
Other assets:
Intangible assets, net 276,248 261,685
Goodwill 811,545 826,258
Debt issue costs and other assets 38,339 45,616
--------------- ---------------
Total other assets 1,126,132 1,133,559
--------------- ---------------
Total assets $ 1,671,656 $ $1,616,101
=============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 43,957 $ 32,009
Accrued personnel costs 33,584 26,758
Accrued income taxes 14,941 --
Other accrued liabilities 66,191 67,401
Deferred license fee revenue 26,858 22,925
Current portion of long-term debt 52,207 7,682
--------------- ---------------
Total current liabilities 237,738 156,775
--------------- ---------------
Long-term liabilities:
Long-term debt 601,811 587,842
Deferred income taxes 108,449 106,577
Other 37,345 24,192
--------------- ---------------
Total long-term liabilities 747,605 718,611
--------------- ---------------
Total liabilities 985,343 875,386
--------------- ---------------
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 42,212 shares at March 31, 2006 (including 300
shares held in treasury) 42 42
Capital in excess of par value 489,602 496,569
Retained earnings 197,808 244,504
Treasury stock and other (1,139) (400)
--------------- ---------------
Total stockholders' equity 686,313 740,715
--------------- ---------------
Total liabilities and stockholders' equity $ 1,671,656 $ 1,616,101
=============== ===============
See accompanying notes.
3
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended March 31, Six Months Ended March 31,
------------------------------------ --------------------------------
(in thousands, except per-share data) 2005 2006 2005 2006
- --------------------------------------------------------- ----------------- ------------------ --------------- ----------------
Revenue: (as restated) (as restated)
Construction materials $ 109,157 $ 131,709 $ 222,885 $ 261,678
Coal combustion products 48,467 58,491 101,519 123,656
Alternative energy 64,768 79,483 116,404 164,897
----------------- ------------------ --------------- ----------------
Total revenue 222,392 269,683 440,808 550,231
----------------- ------------------ --------------- ----------------
Operating costs and expenses:
Construction materials 73,817 91,231 150,420 180,936
Coal combustion products 38,393 46,347 79,446 95,309
Alternative energy 28,590 52,590 53,245 100,247
Amortization 6,098 6,105 12,196 12,141
Research and development 2,967 3,355 5,351 6,319
Selling, general and administrative 36,663 32,313 68,986 67,272
----------------- ------------------ --------------- ----------------
Total operating costs and expenses 186,528 231,941 369,644 462,224
----------------- ------------------ --------------- ----------------
Operating income 35,864 37,742 71,164 88,007
----------------- ------------------ --------------- ----------------
Other income (expense):
Net interest expense (18,798) (8,709) (34,603) (17,660)
Other, net (3,222) (2,432) (5,140) (5,501)
----------------- ------------------ --------------- ----------------
Total other income (expense), net (22,020) (11,141) (39,743) (23,161)
----------------- ------------------ --------------- ----------------
Income before income taxes 13,844 26,601 31,421 64,846
Income tax provision (3,870) (8,200) (10,310) (18,150)
----------------- ------------------ --------------- ----------------
Net income $ 9,974 $ 18,401 $ 21,111 $ 46,696
================= ================== =============== ================
Basic earnings per share $ 0.28 $ 0.44 $ 0.61 $ 1.12
================= ================== =============== ================
Diluted earnings per share $ 0.26 $ 0.40 $ 0.55 $ 1.00
================= ================== =============== ================
See accompanying notes.
4
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
For the Six Months Ended March 31, 2006
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 368 -- 4,946 4,946
Tax benefit from exercise of stock
options and stock appreciation
rights, net of reversals pertaining
to prior periods (2,920) (2,920)
47 shares of treasury stock
transferred to employee
stock purchase plan, at cost 1,316 129 1,445
Issuance of restricted stock, net
of cancellations 2 -- -- --
Stock-based compensation 3,625 3,625
Other comprehensive income -
unrealized gain on cash flow
hedges, net of taxes 610 610
Net income for the six months ended
March 31, 2006 46,696 46,696
--------- ---------- -------------- ------------ ------------------ --------- --------------
Balances as of March 31, 2006 42,212 $42 $496,569 $244,504 $(2,290) $1,890 $740,715
========= ========== ============== ============ ================== ========= ==============
See accompanying notes.
5
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended March 31,
------------------------------
(in thousands) 2005 2006
- ---------------------------------------------------------------------------------------------- -------------- --------------
(as restated)
Cash flows from operating activities:
Net income $ 21,111 $ 46,696
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 27,683 30,780
Non-cash stock-based compensation expense 5,246 3,625
Non-cash interest expense related to amortization of debt issue costs 6,741 1,627
Amortization of non-refundable license fees (589) (11,034)
Deferred income taxes (4,945) 6,512
Net loss (gain) on disposition of property, plant and equipment 97 (77)
Decrease in trade receivables 6,999 47,296
Increase in inventories (12,717) (8,098)
Decrease in accounts payable and accrued liabilities (13,437) (47,347)
Other changes in operating assets and liabilities, net 5,971 65,254
-------------- --------------
Net cash provided by operating activities 42,160 135,234
-------------- --------------
Cash flows from investing activities:
Purchase of property, plant and equipment (23,509) (24,604)
Payments for acquisitions, net of cash acquired -- (4,613)
Investments in joint ventures and net increase in other assets (4,289) (8,672)
Proceeds from disposition of property, plant and equipment 182 787
-------------- --------------
Net cash used in investing activities (27,616) (37,102)
-------------- --------------
Cash flows from financing activities:
Net proceeds from issuance of long-term debt 14,953 --
Payments on long-term debt (253,852) (58,494)
Net proceeds from issuance of common stock 199,261 --
Proceeds from exercise of stock options 4,120 4,946
Income tax benefit from exercise of stock options and stock appreciation
rights (net of reversals pertaining to prior periods) 5,295 (2,920)
Employee stock purchases 771 1,445
-------------- --------------
Net cash used in financing activities (29,452) (55,023)
-------------- --------------
Net increase (decrease) in cash and cash equivalents (14,908) 43,109
Cash and cash equivalents, beginning of period 20,851 13,666
-------------- --------------
Cash and cash equivalents, end of period $ 5,943 $ 56,775
============== ==============
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 $ --
Increase in accrued liabilities for earn-out and other acquisition-related
commitments -- 11,000
See accompanying notes.
6
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(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, during 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 statements of income for the
three and six months ended March 31, 2005 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
7
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
statements and notes thereto included in Headwaters' Annual Report on Form
10-K for the year ended September 30, 2005 ("Form 10-K") and in Headwaters'
Quarterly Report on Form 10-Q for the quarter ended December 31, 2005.
Headwaters' fiscal year ends on September 30. Unless otherwise noted,
future references to 2005 refer to Headwaters' fiscal quarter and/or
six-month period ended March 31, 2005, and references to 2006 refer to
Headwaters' fiscal quarter and/or six-month period ended March 31, 2006.
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 2006 are not
indicative of the results to be expected for the full fiscal 2006 year.
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 March 31, 2005
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
------------------------------------------ -------------- ------------ ------------- ------------- -------------
Segment revenue $ 109,157 $ 48,467 $ 64,768 $ -- $ 222,392
============== ============ ============= ============= =============
Depreciation and amortization $ (9,339) $ (3,151) $ (1,528) $ (78) $ (14,096)
============== ============ ============= ============= =============
Operating income (loss) $ 12,122 $ 3,588 $ 29,825 $ (9,671) $ 35,864
============== ============ ============= =============
Net interest expense (18,798)
Other income (expense), net (3,222)
Income tax provision (3,870)
-------------
Net income $ 9,974
=============
Capital expenditures $ 8,971 $ 2,025 $ 521 $ 92 $ 11,609
============== ============ ============= ============= =============
8
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
Three Months Ended March 31, 2006
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
------------------------------------------ -------------- ------------ ------------- ------------- -------------
Segment revenue $ 131,709 $ 58,491 $ 79,483 $ -- $ 269,683
============== ============ ============= ============= =============
Depreciation and amortization $ (10,795) $ (3,162) $ (1,763) $ (97) $ (15,817)
============== ============ ============= ============= =============
Operating income (loss) $ 13,309 $ 5,320 $ 20,315 $ (1,202) $ 37,742
============== ============ ============= =============
Net interest expense (8,709)
Other income (expense), net (2,432)
Income tax provision (8,200)
-------------
Net income $ 18,401
=============
Capital expenditures $ 6,856 $ 2,634 $ 1,774 $ 62 $ 11,326
============== ============ ============= ============= =============
Six Months Ended March 31, 2005
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
------------------------------------------ -------------- ------------ ------------- ------------- -------------
Segment revenue $ 222,885 $101,519 $116,404 $ -- $ 440,808
============== ============ ============= ============= =============
Depreciation and amortization $ (18,745) $ (6,295) $ (2,492) $ (151) $ (27,683)
============== ============ ============= ============= =============
Operating income (loss) $ 26,674 $ 8,792 $ 50,914 $(15,216) $ 71,164
============== ============ ============= =============
Net interest expense (34,603)
Other income (expense), net (5,140)
Income tax provision (10,310)
-------------
Net income $ 21,111
=============
Capital expenditures $ 18,989 $ 3,399 $ 931 $ 190 $ 23,509
============== ============ ============= ============= =============
Segment Assets as of March 31, 2005 $1,106,743 $308,359 $ 63,274 $ 54,018 $1,532,394
============== ============ ============= ============= =============
Six Months Ended March 31, 2006
---------------------------------------------------------------------
Construction Alternative
(in thousands) Materials CCPs Energy Corporate Totals
------------------------------------------ -------------- ------------ ------------- ------------- -------------
Segment revenue $ 261,678 $123,656 $164,897 $ -- $ 550,231
============== ============ ============= ============= =============
Depreciation and amortization $ (20,729) $ (6,326) $ (3,537) $ (188) $ (30,780)
============== ============ ============= ============= =============
Operating income (loss) $ 28,258 $ 14,741 $ 53,095 $ (8,087) $ 88,007
============== ============ ============= =============
Net interest expense (17,660)
Other income (expense), net (5,501)
Income tax provision (18,150)
-------------
Net income $ 46,696
=============
Capital expenditures $ 15,577 $ 4,757 $ 3,825 $ 445 $ 24,604
============== ============ ============= ============= =============
Segment Assets as of March 31, 2006 $1,143,684 $302,925 $ 70,815 $ 98,677 $1,616,101
============== ============ ============= ============= =============
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
9
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
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.
Stock Option Grants - In accordance with Headwaters' practice of granting
options to directors that vest at the rate of 12,000 per year, during the
quarter ended March 31, 2006, the Compensation Committee of Headwaters'
Board of Directors 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 statements of
income for the three and six months ended March 31, 2005. The application
of SFAS No. 123R for 2005 had the effect of reducing net income for the
three and six months ended March 31, 2005 by approximately $2.0 million
($0.05 basic earnings per share and $0.04 diluted earnings per share) and
$3.9 million ($0.11 basic earnings per share and $0.10 diluted earnings per
share), respectively, the same amounts as reported in the pro forma SFAS
No. 123 footnote disclosure in Headwaters' March 31, 2005 Form 10-Q.
Retroactive to 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.
Total stock-based compensation expense was approximately $2.7 million and
$1.8 million for the three months ended March 31, 2005 and 2006,
respectively, and $5.2 million and $3.6 million for the six months ended
March 31, 2005 and 2006, respectively. As of March 31, 2006, there is
approximately $12.0 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 March 31, 2006
-------------------------- -------------------- -------------------
Raw materials $12,604 $11,145
Finished goods 47,915 57,057
-------------------- -------------------
$60,519 $68,202
==================== ===================
10
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
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 March 31, 2006
-------------------------------- --------------------------------
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 $21,621
Customer relationships 7 1/2 - 15 years 68,331 5,395 68,331 7,873
Trade names 5 - 20 years 63,657 3,642 63,657 5,330
Patents and patented
technologies 7 1/2 - 16 years 55,359 8,060 52,937 10,513
Non-competition agreements 2 - 3 1/2 years 10,422 4,939 10,422 6,974
Other 9 - 10 years 2,336 1,255 2,336 1,377
--------------- ---------------- --------------- ----------------
$317,795 $41,547 $315,373 $53,688
=============== ================ =============== ================
Total amortization expense related to intangible assets was approximately
$6.1 million for both the three months ended March 31, 2005 and 2006, and
$12.2 million and $12.1 million for the six months ended March 31, 2005 and
2006, respectively. Total estimated annual amortization expense is as
follows for the fiscal years presented.
Year ending September 30, (in thousands)
------------------------- --------------
2006 $24,140
2007 21,868
2008 20,320
2009 20,107
2010 19,774
2011 19,594
6. Long-term Debt
Long-term debt consisted of the following at:
September 30, March 31,
(in thousands) 2005 2006
---------------------------------------- -------------- --------------
Senior secured debt $ 472,673 $ 415,319
Convertible senior subordinated notes 172,500 172,500
Notes payable to a bank 8,705 7,610
Other 140 95
--------------- --------------
654,018 595,524
Less: current portion (52,207) (7,682)
--------------- --------------
Total long-term debt $ 601,811 $ 587,842
=============== ==============
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. Headwaters is in
compliance with all debt covenants as of March 31, 2006.
11
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
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%. Headwaters' current rate is LIBOR plus
2.0%. The weighted-average interest rate on the first lien debt was
approximately 6.3% at March 31, 2006, 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 April 2006.
The first lien term loan ($415.3 million outstanding at March 31, 2006) 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 2006, Headwaters
made one required principal repayment of $3.4 million and one 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
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 during the
quarter ended March 31, 2006. There were no borrowings outstanding under
the revolving credit arrangement as of March 31, 2006, or subsequent
thereto. The credit agreement also allows for the issuance of letters of
credit, provided there is capacity under the revolving credit arrangement.
As of March 31, 2006, eight letters of credit totaling $6.9 million were
outstanding, with expiration dates ranging from June 2006 to December 2008.
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 4.25:1.0 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 3.25:1.0,
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.
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
12
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
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 March 31, 2006 of approximately $3.1 million, which, net of
$1.2 million of income taxes, represents other comprehensive income. Total
comprehensive income was approximately $12.5 million and $18.7 million for
the three months ended March 31, 2005 and 2006, respectively, and $23.6
million and $47.3 million for the six months ended March 31, 2006,
respectively.
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 (see Note 8).
Notes Payable to a Bank - In connection with the acquisition of SCP in July
2004, Headwaters assumed SCP's obligations under its notes payable to a
bank. The notes require monthly interest and quarterly principal payments
and bear interest at variable rates, which as of March 31, 2006, ranged
from 5.1% to 7.3%. 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 March 31, 2006.
Interest - During the three months ended March 31, 2005 and 2006,
Headwaters incurred total interest costs of approximately $18.9 and $9.4
million, respectively, including approximately $4.8 million and $1.0
million, respectively, of non-cash interest expense and approximately $0.1
million and $0.2 million, respectively, of interest costs that were
13
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
capitalized. During the six months ended March 31, 2005 and 2006,
Headwaters incurred total interest costs of approximately $34.9 and $19.4
million, respectively, including approximately $6.7 million and $1.6
million, respectively, of non-cash interest expense and approximately $0.2
million and $0.3 million, respectively, of interest costs that were
capitalized.
Interest income was approximately $0 and $0.5 million during the three
months ended March 31, 2005 and 2006, respectively, and $0.1 million and
$1.4 million during the six months ended March 31, 2005 and 2006,
respectively. 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 5.3% at March 31, 2006.
7. Income Taxes
Headwaters' estimated effective income tax rate for the fiscal year ending
September 30, 2006 is 27.2%, the rate applied to the six month period ended
March 31, 2006. Headwaters also incurred an additional $0.5 million of
income tax expense in the quarter ended March 31, 2006 for amounts related
to adjustments from an ongoing IRS audit. Using a 27.2% rate for the six
month period yielded an effective income tax rate of approximately 29.1%
for the three months ended March 31, 2006, exclusive of the additional
provision of $0.5 million. These rates for the 2006 periods compare to
effective tax rates of approximately 32.8% for the six months ended March
31, 2005 and 28.0% for the three months ended March 31, 2005.
The reduction in the effective tax rate for fiscal 2006 as compared to
fiscal 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 ability to generate these tax
credits is subject to the uncertainties of phase-out, IRS audit and other
risks associated with Section 45K tax credits, as more fully described in
Note 10.
For purposes of calculating an estimated effective tax rate for fiscal
2006, Headwaters assumed a phase-out percentage for Section 45K tax credits
for calendar 2006 of approximately 37%. This estimated phase-out percentage
was derived by estimating what the calendar 2006 reference price for oil
would be using actual NYMEX oil prices for the months January through March
2006 and forward NYMEX oil prices for the months April through December
2006. These monthly NYMEX oil prices were then reduced by approximately
12%, which percentage reduction represents Headwaters' estimate of the
relationship between NYMEX prices and the average U.S. wellhead oil prices
actually used to calculate the annual reference price. The estimated
reference price for calendar 2006 was calculated by averaging the 12
months' estimated oil prices, which was then compared to the estimated
phase-out range for calendar 2006 ($54.27 to $68.12) in order to derive an
estimated phase-out percentage.
While it is not possible to accurately estimate the entire calendar year
2006 phase-out percentage at the current time, and it is certain that
Headwaters' estimate of the phase-out percentage will change during the
year, as of March 31, 2006, an estimated phase-out percentage of 37% is
Headwaters' best estimate of what the phase-out percentage for calendar
2006 would be, using available information as of that date. (As of April
30, 2006, the estimated phase-out percentage for calendar 2006 would be
approximately 66%.)
14
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
8. Earnings per Share
The following table sets forth the computation of basic and diluted EPS for
the periods indicated.
Three Months Ended March 31, Six Months Ended March 31,
-------------------------------- -------------------------------
(in thousands, except per-share data) 2005 2006 2005 2006
------------------------------------------- --------------- ---------------- --------------- ---------------
Numerator:
Numerator for basic earnings per share -
net income $ 9,974 $ 18,401 $ 21,111 $ 46,696
Interest expense related to convertible
senior subordinated notes, net of taxes 1,070 1,042 2,048 2,130
--------------- ---------------- --------------- ---------------
Numerator for diluted earnings per share -
net income plus interest expense related
to convertible notes, net of taxes $ 11,044 $ 19,443 $ 23,159 $ 48,826
=============== ================ =============== ===============
Denominator:
Denominator for basic earnings per share
- weighted-average shares outstanding 36,172 41,830 34,806 41,717
Effect of dilutive securities:
Shares issuable upon exercise of options
and SARs 1,146 1,354 1,254 1,313
Shares issuable upon conversion of
convertible notes 5,750 5,750 5,750 5,750
--------------- ---------------- --------------- ---------------
Total potential dilutive shares 6,896 7,104 7,004 7,063
--------------- ---------------- --------------- ---------------
Denominator for diluted earnings per
share - weighted-average shares
outstanding after assumed exercises
and conversions 43,068 48,934 41,810 48,780
=============== ================ =============== ===============
Basic earnings per share $ 0.28 $ 0.44 $ 0.61 $ 1.12
=============== ================ =============== ===============
Diluted earnings per share $ 0.26 $ 0.40 $ 0.55 $ 1.00
=============== ================ =============== ===============
Anti-dilutive securities not considered in the diluted EPS calculations
consisted of options for approximately 180,000 shares and 108,000 shares
for the three months ended March 31, 2005 and 2006, respectively, and
150,000 shares and 68,000 shares for the six months ended March 31, 2005
and 2006, respectively. In addition, approximately 106,000 and 64,000 SARs
were not included in the diluted EPS calculations for the three and six
months ended March 31, 2006, respectively, 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 earn-out consideration totaled $9.5
million and was recorded as additional goodwill. The earn-out consideration
was paid to the former owners of SCP, one of whom is a current officer of
Headwaters, in April 2006.
During the quarter ended December 31, 2005, Tapco acquired certain assets
and assumed certain liabilities of a privately-held company, and during the
quarter ended March 31, 2006, Eldorado acquired certain assets and assumed
certain liabilities of another privately-held company. In addition,
subsequent to March 31, 2006, Headwaters acquired certain assets of a third
company. Total consideration paid or accrued for these three acquisitions
was approximately $15.0 million. Pursuant to the terms of the three
acquisition agreements, additional amounts are payable in the future, based
on certain net revenues or the achievement of stipulated revenue or
earnings targets in future periods.
15
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
10. Commitments and Contingencies
Commitments and contingencies as of March 31, 2006 not disclosed elsewhere,
are as follows.
Performance Unit 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.
Property, Plant and Equipment - As of March 31, 2006, Headwaters was
committed to spend approximately $6.2 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 $9.7 million at March 31, 2006), 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 statements of income and
total approximately $4.8 million and $2.5 million for the three months
ended March 31, 2005 and 2006, respectively, and $7.2 million and $5.6
million for the six months ended March 31, 2005 and 2006, 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 based upon its percentage of ownership of the facility.
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 in the December and
March quarters, Headwaters' pro-rata share of costs incurred to generate
those tax credits is recognized as other expense as those costs are
incurred. Headwaters has the ability, under certain conditions, to limit
its liability under the fixed payment obligations currently totaling
approximately $9.7 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 fiscal 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)1.4 million (approximately $1.7 million) remains to be
paid as of March 31, 2006. 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.
Headwaters has also agreed to a joint venture project with Great River
Energy, a Minnesota-based power generation and supply cooperative ("GRE"),
to construct, own and operate an ethanol plant located in North Dakota
16
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
("Blue Flint"). The Blue Flint joint venture, in which a Headwaters
subsidiary will own a 51% interest, is currently in the final stages of
formation. The plant is currently expected to begin operating in early
calendar 2007 with estimated ethanol production of 50 million gallons
annually.
Estimated costs to construct the ethanol plant are approximately $87.5
million with an additional $7.5 million to be used for working capital and
start-up costs. As of March 31, 2006, Blue Flint was committed to spend
approximately $54.7 million in construction costs. Blue Flint expects to
fund plant construction and start-up costs with approximately $76.0 million
of debt secured by all the assets of Blue Flint, along with capital
contributions of $9.7 million and $9.3 million from Headwaters and GRE,
respectively. Capital contributions made by Headwaters as of March 31, 2006
totaled $6.9 million. The Blue Flint joint venture is being accounted for
using the equity method of accounting because both partners have equal
voting rights and control over the joint venture.
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. During the
six months ended March 31, 2006, Headwaters recorded a net credit of
approximately $(1.0) million for legal matters, including costs for outside
legal counsel. The credit in costs for legal matters was due to positive
developments in certain legal matters Headwaters is defending, leading to
reduced likelihood of ultimate legal liability. Headwaters currently
believes the range of potential loss for all unresolved matters, excluding
costs for outside counsel, is from $1.0 million up to the amounts sought by
claimants and has recorded a total liability as of March 31, 2006 of $1.0
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
17
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
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. In February 2006, the District Court
dismissed all claims against Headwaters. Also in February 2006, plaintiffs
filed their notice of appeal to the United States Court of Appeals for the
Sixth Circuit. 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 Insulating and Finish System
("EIFS") which was produced for a limited time (through 1997) by Best
Masonry & Tool Supply and Don's Building Supply. There is a 10-year
projected claim period following discontinuation of the product.
Typically, the claims cite damages for alleged personal injuries and
punitive damages for alleged unfair business practices in addition to
asserting more conventional damage claims for alleged economic loss and
damage to property. To date, claims made against such subsidiaries have
been paid by their insurers, with the exception of minor deductibles,
although such insurance carriers typically have issued "reservation of
rights" letters. None of the cases has gone to trial. While, to date, none
of these proceedings have required that HCM incur substantial costs, there
is no guarantee of insurance coverage or continuing coverage. These and
future proceedings may result in substantial costs to HCM, including
attorneys' fees, managerial time and other personnel resources and costs.
Adverse resolution of these proceedings could have a materially negative
effect on HCM's business, financial condition, and results of operation,
and its ability to meet its financial obligations. Although HCM carries
general and product liability insurance, HCM cannot assure that such
insurance coverage will remain available, that HCM's insurance carrier will
remain viable, or that the insured amounts will cover all future claims in
excess of HCM's uninsured retention. Future rate increases may also make
such insurance uneconomical for HCM to maintain. In addition, the insurance
policies maintained by HCM exclude claims for damages resulting from
exterior insulating finish systems, or EIFS, that have manifested after
March 2003. Because resolution of the litigation and claims is uncertain,
legal counsel cannot express an opinion as to the ultimate amount, if any,
of HCM's liability.
Other. Headwaters and its subsidiaries are also involved in other legal
proceedings that have arisen in the normal course of business.
Section 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 domestic wellhead 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 2005, the reference price was $50.26 per barrel and the
18
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
phase-out range began at $53.20 and would have fully phased out tax credits
at $66.78 per barrel. Therefore, there was no phase-out of tax credits for
calendar 2005.
For calendar 2006, Headwaters estimates that the phase-out range (computed
by increasing the 2005 inflation adjustment factor by 2%) begins at $54.27
and completes phase-out at $68.12 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 accurately estimate a reference price for
calendar 2006. However, Headwaters estimates that if average oil prices for
the calendar 2006 period to date are maintained for all of calendar 2006,
and absent a legislative change to a prospective application of the
reference price, partial phase-out would occur.
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
financial 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.
Several of Headwaters' licensees have 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. The inability of a licensee to
claim Section 45K tax credits would reduce Headwaters' future income from
the licensee. In addition, the IRS may audit Headwaters concerning tax
credits claimed for synthetic fuel sold from the facilities in which it
owns an interest.
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 February 2006, 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. Renewed activity in the Subcommittee
investigation, if it occurs, 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.
19
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2006
(Unaudited)
License Fees - Pursuant to the 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
agreement. 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.
20
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 2005 refer to Headwaters'
fiscal quarter and/or six-month period ended March 31, 2005, and references to
2006 refer to Headwaters' fiscal quarter and/or six-month period ended March 31,
2006.
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 Section
45K [formerly Section 29] business. 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.
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 hereafter.
Under current law, Section 45K tax credits for synthetic fuel produced
from coal expire on December 31, 2007. In addition, Section 45K tax credits are
subject to phase-out after the average annual domestic wellhead 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.
There was no phase-out of Section 45K tax credits for calendar 2005; however,
during 2006, higher oil prices have increased the possibility of a phase-out of
tax credits for calendar 2006. As a result, Headwaters' revenues, operating
income and income tax provision have all been materially negatively affected for
the fiscal quarter ended March 31, 2006. Furthermore, Headwaters' entire fiscal
2006 results could be negatively affected by phase-out.
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. In addition, in 2006, Headwaters has begun to
acquire small companies with innovative products that can be marketed using
Headwaters' existing distribution channels. 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 addition,
Headwaters has agreed to a joint venture project to construct, own and operate
an ethanol plant located in North Dakota which is currently expected to begin
operating in early calendar 2007 and is also beginning to invest in 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' strong 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 fiscal 2005 and continuing into 2006, Headwaters has focused on
integration of its recent acquisitions, including the marketing of diverse
construction materials products through its national distribution network, and
21
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.
Section 45K Matters
Phase-Out. Section 45K tax credits are subject to phase-out after the
average annual domestic wellhead 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 2005, the reference price was $50.26 per barrel and the phase-out range
began at $53.20 and would have fully phased out tax credits at $66.78 per
barrel. Therefore, there was no phase-out of tax credits for calendar 2005.
For calendar 2006, Headwaters estimates that the phase-out range
(computed by increasing the 2005 inflation adjustment factor by 2%) begins at
$54.27 and completes phase-out at $68.12 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 accurately estimate a reference price for calendar 2006.
However, Headwaters estimates that if average oil prices for the calendar 2006
period to date are maintained for all of calendar 2006, and absent a legislative
change to a prospective application of the reference price, partial phase-out
would occur.
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 financial 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. Several of Headwaters' licensees have 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.
Phase-out Sensitivity Analysis. The amount of license fee revenue
recognized by Headwaters for the March 2006 quarter was materially negatively
affected by no revenues being recognized for several licensees whose license
agreements call for Headwaters to be paid a portion of the tax credits earned by
the licensee. Because of the current uncertainty related to phase-out of tax
credits for calendar 2006, certain accounting rules governing revenue
recognition, requiring that the seller's price to the buyer be "fixed or
determinable," at this time preclude revenue recognition for these licensees.
Accordingly, revenues for these licensees, totaling approximately $10.5 million,
will not be recognized until such time as they become more certain as to
reasonable estimation.
As described in detail in Note 7 to the consolidated financial
statements, using available information as of March 31, 2006, Headwaters
calculated an estimated phase-out percentage for Section 45K tax credits for
calendar 2006 of 37%. Headwaters used this estimated phase-out percentage in
calculating an estimated effective tax rate for fiscal 2006. (As of April 30,
2006, the estimated phase-out percentage for calendar 2006 would be
approximately 66%.) The following table summarizes results of operations that
would have been reported for the three months ended March 31, 2006, assuming a
0% phase-out percentage were to be used to recognize revenues for all licensees
whose license agreements call for Headwaters to be paid a portion of the tax
credits earned by the licensee.
As Adjusted ,
Using a Phase-out
(in thousands, except per-share data) As Reported Percentage of 0%*
-------------------------------------- -------------- -----------------
Revenue $269,683 $280,140
Operating income $37,742 $46,500
Income before income taxes $26,601 $33,859
Income tax provision $(8,200) $(8,170)
Net income $18,401 $25,689
Diluted earnings per share $0.40 $0.55
- --------------------
* For licensees with tax credit-based contracts.
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
22
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. The inability of a licensee to claim Section 45K
tax credits would reduce Headwaters' future income from the licensee. In
addition, the IRS may audit Headwaters concerning tax credits claimed for
synthetic fuel sold from the facilities in which it owns an interest.
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 February
2006, 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.
Renewed activity in the Subcommittee investigation, if it occurs, 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.
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 March 31, 2006, 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.
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 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 almost exclusively 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 2006 periods are not indicative of the results to be expected
for the full fiscal 2006 year.
23
Three Months Ended March 31, 2006 Compared to Three Months Ended March 31, 2005
The information set forth below compares Headwaters' operating results
for the three months ended March 31, 2006 ("2006") with operating results for
the three months ended March 31, 2005 ("2005").
Revenue. Total revenue for 2006 increased by $47.3 million or 21% to
$269.7 million as compared to $222.4 million for 2005. The major components of
revenue are discussed in the sections below.
Construction Materials Segment. Sales of construction materials during
2006 were $131.7 million with a corresponding direct cost of $91.2 million.
Sales of construction materials during 2005 were $109.2 million with a
corresponding direct cost of $73.8 million. The increase in sales of
construction materials during 2006 was due primarily to increases in volume,
which occurred across all major product lines, with a lesser impact from price
increases related to passing on to customers a portion of raw material cost
increases. The primary reasons for the decline in gross margin percentage from
2005 to 2006 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
improvement in gross margin percentage in the last half of the 2006 fiscal year
due to recently implemented and planned price increases, improved operations and
better fixed cost absorption.
CCP Segment. CCP revenues for 2006 were $58.5 million with a
corresponding direct cost of $46.3 million. CCP revenues for 2005 were $48.5
million with a corresponding direct cost of $38.4 million. The increase in CCP
revenues during 2006 was 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 in 2006. 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" above. 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 2006 were
$49.9 million with a corresponding direct cost of $37.7 million. Chemical
reagent sales during 2005 were $39.9 million with a corresponding direct cost of
$28.4 million. The increase in chemical reagent sales during 2006 was due
primarily to increased synthetic fuel production by Headwaters' licensees
(resulting in increased sales of $7.5 million) and by customers with whom
Headwaters does not have a license agreement (resulting in increased sales of
$2.5 million). Despite the threat of phase-out, overall sales of chemical
reagents for 2006 have increased over 2005; however, it is not possible to
predict the trend for sales of chemical reagents in future periods. The gross
margin percentage for 2006 of 24% was 500 basis points lower than for 2005, 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 near the current level during fiscal 2006,
depending upon crude oil prices and the availability of raw material feedstocks.
License Fees. During 2006, Headwaters recognized license fee revenue
totaling $16.3 million, a decrease of $8.3 million or 34% from $24.6 million of
license fee revenue recognized during 2005. The primary reason for the decrease
in license fee revenue in 2006 compared to 2005 relates to no revenues being
recognized for several licensees whose license agreements call for Headwaters to
be paid a portion of the value of the tax credits earned by the licensee.
Because of the current uncertainty related to phase-out of tax credits for
calendar 2006, certain accounting rules governing revenue recognition, requiring
that the seller's price to the buyer be "fixed or determinable," at this time
preclude revenue recognition for these licensees. Accordingly, revenues for
these licensees, totaling approximately $10.5 million (calculated based on
licensee-reported data), will not be recognized until such time as they become
more certain as to reasonable estimation. Reference is also made to the policy
disclosures in Headwaters' Form 10-K, Item 7: Management's Discussion and
Analysis of Financial Condition and Results of Operations, Critical Accounting
Policies and Estimates - License Fee Revenue Recognition. The decrease in
24
license fee revenue for 2006 was partially offset by ongoing revenues ($4.0
million) 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.
Pursuant to the 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 agreement. 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 2006 were $11.8 million with a corresponding direct cost of $13.8
million. There were no sales of synthetic fuel during 2005 since Headwaters' two
alternative fuel facilities were not operating in 2005. Revenue from the sale of
synthetic fuel has a negative gross margin, which is more than compensated for
by the income tax credits expected to be 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 $0.4 million to $3.4 million in 2006 from $3.0 million in 2005. The increase
was primarily attributable to increased HTI research and development activities,
which are likely to continue near 2006 levels in future periods.
Selling, General and Administrative Expenses. These expenses decreased
$4.4 million, or 12% to $32.3 million for 2006 from $36.7 million for 2005. The
decrease in 2006 was due primarily to a $5.5 million reduction in expense for
legal matters, partially offset by a $1.7 million increase in marketing
expenses. The reduction in costs for legal matters was due to positive
developments in certain legal matters Headwaters is defending, leading to
reduced likelihood of ultimate legal liability. The increase in marketing
expenses relates to an effort in the construction materials segment to increase
awareness and sales of new products, primarily by Eldorado and Tapco.
Other Income and Expense. During 2006, Headwaters reported net other
expense of $11.1 million compared to net other expense of $22.0 million during
2005. The change of $10.9 million was attributable to a decrease in net interest
expense of $10.1 million and a decrease in other expenses of $0.8 million. Net
interest expense decreased from $18.8 million in 2005 to $8.7 million in 2006,
due primarily to significantly lower average levels of long-term debt in 2006
compared to 2005.
The decrease in other expenses of $0.8 million consisted primarily of a
decrease in costs related to Headwaters' investment in the coal-based solid
alternative fuel production facility described in Note 10 to the consolidated
financial statements. The primary reason for decreased costs for this facility
is related to using an estimated phase-out percentage for Section 45K tax
credits for calendar 2006 of approximately 37%, all as explained in Note 7 to
the consolidated financial statements.
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 based upon its percentage of ownership of the facility. 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 and 2006, Headwaters' pro-rata share of costs
incurred to generate the tax credits reflected in the effective tax rate was
recognized as other expense through March 31, 2005 and 2006.
Income Tax Provision. Headwaters' estimated effective income tax rate
for the fiscal year ending September 30, 2006 is 27.2%, the rate applied to the
six month period ended March 31, 2006. Headwaters also incurred an additional
$0.5 million of income tax expense in the quarter ended March 31, 2006 for
amounts related to adjustments from an ongoing IRS audit. Using a 27.2% rate for
the six month period yielded an effective income tax rate of approximately 29.1%
for the three months ended March 31, 2006, exclusive of the additional provision
of $0.5 million. These rates for the 2006 periods compare to effective tax rates
of approximately 32.8% for the six months ended March 31, 2005 and 28.0% for the
three months ended March 31, 2005. The reduction in the effective tax rate for
fiscal 2006 as compared to fiscal 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 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 ability to generate these tax credits is subject to the
uncertainties of phase-out, IRS audit and other risks associated with Section
25
45K tax credits, as more fully described hereafter in "Section 45K Matters."
Excluding the effect of the tax credits, Headwaters' estimated effective tax
rate for fiscal 2006 would be approximately 39%.
For purposes of calculating an estimated effective tax rate for fiscal
2006, Headwaters assumed a phase-out percentage for Section 45K tax credits for
calendar 2006 of approximately 37%. This estimated phase-out percentage was
derived by estimating what the calendar 2006 reference price for oil would be
using actual NYMEX oil prices for the months January through March 2006 and
forward NYMEX oil prices for the months April through December 2006. These
monthly NYMEX oil prices were then reduced by approximately 12%, which
percentage reduction represents Headwaters' estimate of the relationship between
NYMEX prices and the average U.S. wellhead oil prices actually used to calculate
the annual reference price. The estimated reference price for calendar 2006 was
calculated by averaging the 12 months' estimated oil prices, which was then
compared to the estimated phase-out range for calendar 2006 ($54.27 to $68.12)
in order to derive an estimated phase-out percentage.
While it is not possible to accurately estimate the entire calendar
year 2006 phase-out percentage at the current time, and it is certain that
Headwaters' estimate of the phase-out percentage will change during the year, as
of March 31, 2006, an estimated phase-out percentage of 37% is Headwaters' best
estimate of what the phase-out percentage for calendar 2006 would be, using
available information as of that date. (As of April 30, 2006, the estimated
phase-out percentage for calendar 2006 would be approximately 66%.)
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 probable 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.
Six Months Ended March 31, 2006 Compared to Six Months Ended March 31, 2005
The information set forth below compares Headwaters' operating results
for the six months ended March 31, 2006 ("2006") with operating results for the
six months ended March 31, 2005 ("2005").
Revenue. Total revenue for 2006 increased by $109.4 million or 25% to
$550.2 million as compared to $440.8 million for 2005. The major components of
revenue are discussed in the sections below.
Construction Materials Segment. Sales of construction materials during
2006 were $261.7 million with a corresponding direct cost of $180.9 million.
Sales of construction materials during 2005 were $222.9 million with a
corresponding direct cost of $150.4 million. The increase in sales of
construction materials during 2006 was due primarily to increases in volume,
which occurred across all major product lines, with a lesser impact from price
increases related to passing on to customers a portion of raw material cost
increases. The primary reasons for the decline in gross margin percentage from
2005 to 2006 were higher raw material costs and manufacturing inefficiencies
related to expansion of capacity and product lines and restructuring of
operations at certain manufacturing facilities.
CCP Segment. CCP revenues for 2006 were $123.7 million with a
corresponding direct cost of $95.3 million. CCP revenues for 2005 were $101.5
million with a corresponding direct cost of $79.4 million. The increase in CCP
revenues and in the gross margin during 2006 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 in 2006. 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.
Sales of Chemical Reagents. Chemical reagent sales during 2006 were
$94.4 million with a corresponding direct cost of $71.1 million. Chemical
reagent sales during 2005 were $76.7 million with a corresponding direct cost of
$53.0 million. The increase in chemical reagent sales during 2006 was due
primarily to increased synthetic fuel production by Headwaters' licensees
(resulting in increased sales of $15.2 million) and by customers with whom
Headwaters does not have a license agreement (resulting in increased sales of
$2.5 million). Despite the threat of phase-out, overall sales of chemical
reagents for 2006 have increased over 2005; however, it is not possible to
predict the trend for sales of chemical reagents in future periods. The gross
margin percentage for 2006 of 25% was 600 basis points lower than for 2005, due
primarily to increases in the cost of product, which in turn is related to
increases in the costs of petroleum-based materials.
26
License Fees. During 2006, Headwaters recognized license fee revenue
totaling $44.5 million, an increase of $5.3 million or 14% from $39.2 million of
license fee revenue recognized during 2005. The primary reason for the increase
in license fee revenue for 2006 was ongoing revenues ($20.8 million) 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. This increase was largely offset by decreases in license fee revenue in
2006 compared to 2005 related to no revenues being recognized for several
licensees whose license agreements call for Headwaters to be paid a portion of
the value of the tax credits earned by the licensee. Because of the current
uncertainty related to phase-out of tax credits for calendar 2006, certain
accounting rules governing revenue recognition, requiring that the seller's
price to the buyer be "fixed or determinable," at this time preclude revenue
recognition for these licensees. Accordingly, calendar 2006 revenues for these
licensees will not be recognized until such time as they become more certain as
to reasonable estimation.
Other Alternative Energy Segment Revenues. Sales of synthetic fuel
during 2006 were $23.3 million with a corresponding direct cost of $27.0
million. There were no sales of synthetic fuel during 2005 since Headwaters' two
alternative fuel facilities were not operating in 2005. Revenue from the sale of
synthetic fuel has a negative gross margin, which is more than compensated for
by the income tax credits expected to be 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 $0.9 million to $6.3 million in 2006 from $5.4 million in 2005. The increase
was primarily attributable to increased HTI research and development activities.
Selling, General and Administrative Expenses. These expenses decreased
$1.7 million, or 2% to $67.3 million for 2006 from $69.0 million for 2005. The
decrease in 2006 was due primarily to a $4.8 million reduction in expense for
legal matters, partially offset by a $2.3 million increase in marketing
expenses. The reduction in costs for legal matters was due to positive
developments in certain legal matters Headwaters is defending, leading to
reduced likelihood of ultimate legal liability. The increase in marketing
expenses relates to an effort in the construction materials segment to increase
awareness and sales of new products, primarily by Eldorado and Tapco.
Other Income and Expense. During 2006, Headwaters reported net other
expense of $23.2 million compared to net other expense of $39.7 million during
2005. The change of $16.5 million was attributable to a decrease in net interest
expense of $16.9 million and an increase in other expenses of $0.4 million. Net
interest expense decreased from $34.6 million in 2005 to $17.7 million in 2006,
due primarily to significantly lower average levels of long-term debt in 2006
compared to 2005.
Income Tax Provision. Headwaters' estimated effective income tax rate
for the fiscal year ending September 30, 2006 is 27.2%, the rate applied to the
six month period ended March 31, 2006. Headwaters also incurred an additional
$0.5 million of income tax expense for amounts related to adjustments from an
ongoing IRS audit. This rate for 2006 compares to an effective tax rate of
approximately 32.8% for the six months ended March 31, 2005. The reduction in
the effective tax rate for fiscal 2006 as compared to fiscal 2005 is primarily
due to increased Section 45K [formerly Section 29] tax credits related to
Headwaters' investment in an entity that owns and operates a coal-based solid
alternative fuel production facility (which investment increased from 9% to 19%
in December 2004, as described in 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 ability to generate these tax credits is
subject to the uncertainties of phase-out, IRS audit and other risks associated
with Section 45K tax credits, as more fully described hereafter in "Section 45K
Matters." Excluding the effect of the tax credits, Headwaters' estimated
effective tax rate for fiscal 2006 would be approximately 39%.
While it is not possible to accurately estimate the entire calendar
year 2006 phase-out percentage at the current time, and it is certain that
Headwaters' estimate of the phase-out percentage will change during the year, as
of March 31, 2006, an estimated phase-out percentage of 37% is Headwaters' best
estimate of what the phase-out percentage for calendar 2006 would be, using
available information as of that date. (As of April 30, 2006, the estimated
phase-out percentage for calendar 2006 would be approximately 66%.)
Impact of Inflation and Related Matters
Headwaters' operations have been impacted in 2006 by i) rising costs
for chemical reagents in the alternative energy segment; ii) increased cement,
polypropylene and poly-vinyl chloride costs in the construction materials
segment; iii) increased fuel costs that have affected transportation costs in
most of Headwaters' business units; and iv) certain regional shortages of cement
and aggregate materials. 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.
27
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 the six months ended March 31, 2006 ("2006") was $135.2
million compared to $42.2 million during the six months ended March 31, 2005
("2005"). The primary reason for the increase in cash provided from operations
in 2006 was the receipt of the final $70.0 million payment due from the
litigation settlement reached with AJG in fiscal 2005. In both periods, the
primary investing activity consisted of the purchase of property, plant and
equipment. The primary financing activity consisted of repayments of long-term
debt, and in 2005, proceeds from the issuance of common stock. More details
about Headwaters' investing and financing activities are provided in the
following paragraphs.
Investing Activities. Expenditures for property, plant and equipment
increased $1.1 million from 2005 ($23.5 million) to 2006 ($24.6 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 March 31, 2006, Headwaters was committed
to spend approximately $6.2 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.
During 2006, Tapco acquired certain assets and assumed certain
liabilities of a privately-held company, and Eldorado acquired certain assets
and assumed certain liabilities of another privately-held company. In addition,
subsequent to March 31, 2006, Headwaters acquired certain assets of a third
company. Total consideration paid or accrued for these three acquisitions was
approximately $15.0 million, of which $4.6 million was paid prior to March 31,
2006. Pursuant to the terms of the three acquisition agreements, additional
amounts are payable in the future, based on certain net revenues or the
achievement of stipulated revenue or earnings targets in future periods.
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 earn-out consideration totaled $9.5 million
and was recorded as additional goodwill. The earn-out consideration was paid to
the former owners of SCP, one of whom is a current officer of Headwaters, in
April 2006.
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 $9.7 million at March 31, 2006), 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 $7.2 million and
$5.6 million for 2005 and 2006, respectively.
28
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 based upon its percentage of ownership of the facility. 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 approximately $9.7 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 fiscal 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)1.4 million (approximately $1.7 million) remains to be
paid as of March 31, 2006. 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.
Headwaters has also agreed to a joint venture project with Great River
Energy, a Minnesota-based power generation and supply cooperative ("GRE"), to
construct, own and operate an ethanol plant located in North Dakota ("Blue
Flint"). The Blue Flint joint venture, in which a Headwaters subsidiary will own
a 51% interest, is currently in the final stages of formation. The plant is
currently expected to begin operating in early calendar 2007 with estimated
ethanol production of 50 million gallons annually.
Estimated costs to construct the ethanol plant are approximately $87.5
million with an additional $7.5 million to be used for working capital and
start-up costs. As of March 31, 2006, Blue Flint was committed to spend
approximately $54.7 million in construction costs. Blue Flint expects to fund
plant construction and start-up costs with approximately $76.0 million of debt
secured by all the assets of Blue Flint, along with capital contributions of
$9.7 million and $9.3 million from Headwaters and GRE, respectively. Capital
contributions made by Headwaters as of March 31, 2006 totaled $6.9 million. The
Blue Flint joint venture is being accounted for using the equity method of
accounting.
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 limitations on its 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. Headwaters is
in compliance with all debt covenants as of March 31, 2006.
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%.
Headwaters' current rate is LIBOR plus 2.0%. The weighted-average interest rate
on the first lien debt was approximately 6.3% at March 31, 2006, after giving
29
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 April 2006.
The first lien term loan ($415.3 million outstanding at March 31, 2006)
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 2006, Headwaters made one required
principal repayment of $3.4 million and one 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 March 31, 2006 of approximately
$3.1 million, which, net of $1.2 million of income taxes, represents other
comprehensive income. Total comprehensive income was approximately $12.5 million
and $18.7 million for the three months ended March 31, 2005 and 2006,
respectively, and $23.6 million and $47.3 million for the six months ended March
31, 2006, respectively.
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.
30
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 March 31, 2006, ranged from 5.1% to
7.3%. Because the notes are callable by the bank, Headwaters has included the
outstanding balance of $7.6 million 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 March
31, 2006.
Options and Employee Stock Purchases - In 2006, cash proceeds from the
exercise of options and employee stock purchases totaled $6.4 million, compared
to $4.9 million of proceeds in 2005. 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 negative $2.9
million in 2006 and $5.3 million in 2005. The negative amount in 2006 was caused
by a reversal of amounts pertaining to prior periods, stemming from adjustments
related to an ongoing IRS audit.
Working Capital. During 2006, Headwaters' working capital increased by
$9.5 million, to $126.9 million as of March 31, 2006. Headwaters expects
operations to produce positive cash flows in future periods and believes working
capital, along with available borrowings under the revolving credit arrangement,
will be sufficient for operating needs for the next 12 months.
Long-term Debt and Revolving Credit Arrangement. 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 during the quarter ended March 31, 2006. There were no
borrowings outstanding under the revolving credit arrangement as of March 31,
2006, or subsequent thereto. The credit agreement also allows for the issuance
of letters of credit, provided there is capacity under the revolving credit
arrangement. As of March 31, 2006, eight letters of credit totaling $6.9 million
were outstanding, with expiration dates ranging from June 2006 to December 2008.
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 4.25:1.0 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 3.25:1.0, 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.
As described above, Headwaters has approximately $422.9 million of
variable-rate long-term debt outstanding as of March 31, 2006, consisting of
$415.3 million of senior debt and $7.6 million of notes payable to a bank.
Considering all outstanding balances of variable-rate debt (reduced by the
$150.0 million of senior debt that effectively has a fixed interest rate until
September 8, 2007) and required principal repayments, a change in the interest
rate of 1% would change Headwaters' interest expense by approximately $2.7
million during the 12 months ending March 31, 2007.
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 cash amounts were a negative $2.9 million in 2006. Headwaters' cash
requirements for income taxes are expected to generally approximate the income
tax provision. There is generally some lag in paying estimated taxes during a
31
fiscal year due to the seasonality of operations and because estimated income
tax payments are typically based on annualizing the fiscal year's income based
on year-to-date results. There is also some lag in realizing the cash benefits
from the utilization of tax credits due to the interaction of Headwaters'
September 30 fiscal year end and the different fiscal year ends of the entities
through which Headwaters receives the tax credits.
Headwaters' estimated effective income tax rate for the fiscal year
ending September 30, 2006 is 27.2%, the rate applied to the six month period
ended March 31, 2006. Headwaters also incurred an additional $0.5 million of
income tax expense in the quarter ended March 31, 2006 for amounts related to
adjustments from an ongoing IRS audit. Using a 27.2% rate for the six month
period yielded an effective income tax rate of approximately 29.1% for the three
months ended March 31, 2006, exclusive of the additional provision of $0.5
million. These rates for the 2006 periods compare to effective tax rates of
approximately 32.8% for the six months ended March 31, 2005 and 28.0% for the
three months ended March 31, 2005.
The reduction in the effective tax rate for fiscal 2006 as compared to
fiscal 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 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 ability to generate
these tax credits is subject to the uncertainties of phase-out, IRS audit and
other risks associated with Section 45K tax credits, as more fully described in
Note 10. Excluding the effect of the tax credits, Headwaters' effective tax rate
in 2005 would have been approximately 39%.
For purposes of calculating an estimated effective tax rate for fiscal
2006, Headwaters assumed a phase-out percentage for Section 45K tax credits for
calendar 2006 of approximately 37%. This estimated phase-out percentage was
derived by estimating what the calendar 2006 reference price for oil would be
using actual NYMEX oil prices for the months January through March 2006 and
forward NYMEX oil prices for the months April through December 2006. These
monthly NYMEX oil prices were then reduced by approximately 12%, which
percentage reduction represents Headwaters' estimate of the relationship between
NYMEX prices and the average U.S. wellhead oil prices actually used to calculate
the annual reference price. The estimated reference price for calendar 2006 was
calculated by averaging the 12 months' estimated oil prices, which was then
compared to the estimated phase-out range for calendar 2006 ($54.27 to $68.12)
in order to derive an estimated phase-out percentage.
While it is not possible to accurately estimate the entire calendar
year 2006 phase-out percentage at the current time, and it is certain that
Headwaters' estimate of the phase-out percentage will change during the year, as
of March 31, 2006, an estimated phase-out percentage of 37% is Headwaters' best
estimate of what the phase-out percentage for calendar 2006 would be, using
available information as of that date. (As of April 30, 2006, the estimated
phase-out percentage for calendar 2006 would be approximately 66%.)
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. During the six
months ended March 31, 2006, Headwaters recorded a net credit of approximately
$(1.0) million 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 $1.0 million up to the
amounts sought by claimants and has recorded a total liability as of March 31,
2006 of $1.0 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
32
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.
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 $422.9 million of variable-rate
long-term debt outstanding as of March 31, 2006, consisting of $415.3 million of
senior debt and $7.6 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 $415.3 million of borrowings under the senior debt agreement
consisted of a first lien term loan which 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 March 31, 2006, 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 April 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 March
31, 2006 of approximately $3.1 million, which, net of $1.2 million of income
taxes, represents other comprehensive income. Total comprehensive income was
approximately $12.5 million and $18.7 million for the three months ended March
31, 2005 and 2006, respectively, and $23.6 million and $47.3 million for the six
months ended March 31, 2006, respectively.
In connection with the acquisition of SCP in July 2004, Headwaters
assumed SCP's obligations under its notes payable to a bank. The notes require
monthly interest and quarterly principal payments and bear interest at variable
rates, which as of March 31, 2006, ranged from 5.1% to 7.3%.
Considering all outstanding balances of variable-rate debt (reduced by
the $150.0 million of senior debt that effectively has a fixed interest rate
until September 8, 2007) and required principal repayments, a change in the
interest rate of 1% would change Headwaters' interest expense by approximately
$2.7 million during the 12 months ending March 31, 2007.
33
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
March 31, 2006, 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 March 31, 2006.
Internal Control over Financial Reporting - Management is responsible
for establishing and maintaining adequate internal control over financial
reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act.
Headwaters' internal control over financial reporting is designed to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
accounting principles generally accepted in the United States of America.
Because of inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Therefore, even internal
controls determined to be effective can provide only reasonable assurance with
respect to financial statement preparation and presentation. The effectiveness
of Headwaters' internal control over financial reporting is subject to various
inherent limitations, including cost limitations, judgments used in decision
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 March 31, 2006 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 1A. RISK 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.
34
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 owner 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 IRS announces the reference price and the phase-out range of
oil prices for the prior calendar year. For example, in April 2006, the IRS
announced that the reference price for calendar 2005 was $50.26 per barrel and
that the phase-out range for 2005 began at $53.20 per barrel and ended with a $0
tax credit at $66.78 per barrel. Because the calendar year 2005 reference price
did not fall within the range, there was not a phase-out of the credit for
qualified fuel sold in 2005. For calendar 2006, Headwaters estimates that the
phase-out range (computed by increasing the 2005 inflation adjustment factor by
2%) begins at $54.27 and completes phase-out at $68.12 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 accurately estimate a reference price for
calendar 2006. However, Headwaters estimates that based on actual oil prices for
January through March 2006 and future oil prices for April through December
2006, and absent a legislative change to a prospective application of the
reference price, a 37% phase-out will result. (As of April 30, 2006, the
estimated phase-out percentage for calendar 2006 would be approximately 66%.) 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 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.
Headwaters and its licensees and customers closely watch oil price
trends and will continue to 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 have elected to
simply curtail or eliminate production based upon an assessment that 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. Several of Headwaters' licensees have 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 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On February 28, 2006, Headwaters held its 2006 Annual Meeting of
Stockholders for the following purposes:
1. To elect two Class III directors to serve until the 2009
annual meeting, or until their successors are duly elected and
qualified; and
2. To ratify the selection by the Board of Directors of Ernst &
Young LLP as independent auditors of Headwaters for the fiscal
year ending September 30, 2006.
35
A total of 37,632,233 shares were voted. Both proposals were approved by
the stockholders. The results of voting were as follows:
1. To elect Mr. James A. Herickhoff as a Class III director: for
- 37,402,733; withheld authority - 229,500. To elect Mr. Blake
O. Fisher, Jr. as a Class III director: for - 37,406,327;
withheld authority - 225,906.
2. To ratify the selection of Ernst & Young LLP as independent
auditors for the fiscal year ending September 30, 2006: for -
37,367,365; against - 231,152; abstain - 33,715.
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.
36
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HEADWATERS INCORPORATED
Date: May 8, 2006 By: /s/ Kirk A. Benson
-----------------------------------------
Kirk A. Benson, Chief Executive Officer
(Principal Executive Officer)
Date: May 8, 2006 By: /s/ Scott K. Sorensen
-----------------------------------------
Scott K. Sorensen, Chief Financial Officer
(Principal Financial Officer)
37