Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended September 30, 2002,
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission file number 0-27808
HEADWATERS INCORPORATED
----------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 87-0547337
- ------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
11778 South Election Road, Suite 210
Draper, Utah 84020
---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
(801) 984-9400
--------------------------------------------------
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
------------------------------------------------------------
None
Securities registered pursuant to Section 12(g) of the Act:
-----------------------------------------------------------
Common Stock, $.001 par value
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes [X] No [ ]
The aggregate market value of the voting stock held by non-affiliates
of the registrant as of March 31, 2002 was $358,682,169 based upon the closing
price on the Nasdaq National Market reported for such date. This calculation
does not reflect a determination that persons whose shares are excluded from the
computation are affiliates for any other purpose.
The number of shares outstanding of the registrant's common stock as of
November 30, 2002 was 27,377,539.
___________________________
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the following document are incorporated herein by
reference: Portions of the registrant's definitive proxy statement to be issued
in connection with registrant's annual stockholders' meeting to be held in 2003.
TABLE OF CONTENTS
Page
PART I
ITEM 1. BUSINESS...........................................................3
ITEM 2. PROPERTIES.........................................................9
ITEM 3. LEGAL PROCEEDINGS.................................................10
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............11
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS.............................................11
ITEM 6. SELECTED FINANCIAL DATA...........................................13
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.......................................14
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........33
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.......................34
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE.............................34
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................35
ITEM 11. EXECUTIVE COMPENSATION............................................35
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT....35
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................35
PART IV
ITEM 14. CONTROLS AND PROCEDURES...........................................35
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
ON FORM 8-K.....................................................36
SIGNATURES.................................................................[TBA]
Forward-looking Statements
Statements in this Form 10-K, including those concerning the Registrant's
expectations regarding its business, and certain of the information presented in
this report, constitute forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. As such, actual results may
vary materially from such expectations. For a discussion of the factors that
could cause actual results to differ from expectations, please see the captions
entitled "Forward-looking Statements" and "Risk Factors Affecting Future Results
of Operations" in Item 7 hereof. There can be no assurance that the Registrant's
results of operations will not be adversely affected by such factors. Registrant
undertakes no obligation to revise or publicly release the results of any
revision to these forward-looking statements. Readers are cautioned not to place
undue reliance on these forward-looking statements, which reflect management's
opinion only as of the date hereof.
Availability of SEC Filings
Headwaters makes available, free of charge, through its website (www.hdwtrs.com)
its Forms 10-K, 10-Q and 8-K, as well as its registration statements, as soon as
reasonably practicable after those reports are electronically filed with the
SEC.
2
PART I
ITEM 1. BUSINESS
General Development of Business
Introduction. Headwaters Incorporated is a world leader in developing
and deploying energy related technologies to the marketplace. Headwaters is
focused on converting fossil fuels such as gas, coal and heavy oils into
alternative energy products. As part of its long-term growth strategy,
Headwaters acquired Hydrocarbon Technologies, Inc. ("HTI") on August 28, 2001
and Industrial Services Group, Inc. ("ISG") on September 19, 2002 and these
entities are now wholly-owned subsidiaries of Headwaters. ISG, through its own
wholly-owned operating subsidiary, ISG Resources, Inc., is the nation's largest
manager and marketer of coal combustion products. With the ISG acquisition,
Headwaters is in a unique position to provide a full range of value-added
services to the coal-fired electric generating industry, as well as capitalize
on opportunities to develop related energy technologies.
Headwaters' Company History. Headwaters was incorporated in Delaware in
1995 under the name Covol Technologies, Inc. In September 2000, Covol's name was
changed to Headwaters Incorporated. Headwaters' stock trades under the Nasdaq
symbol HDWR.
Unless the context otherwise requires, "ISG" refers to Industrial
Services Group, Inc. and its operating subsidiary ISG Resources, Inc., together
with their consolidated subsidiaries. References to "Headwaters," "combined
company," "company," "we," "our," and "us," refer to Headwaters Incorporated and
its division Covol Fuels, together with its consolidated subsidiaries ISG and
HTI.
Headwaters operates its business through two wholly-owned subsidiaries
and one division: ISG focuses on utilizing, marketing, and disposing of large
volumes of coal combustion products. HTI develops and markets innovative energy
and catalyst technologies. Covol Fuels licenses technology and sells chemical
reagents to produce solid alternative fuel.
ISG
ISG's Company History. ISG was incorporated in Delaware in 1997.
Beginning in October 1997, ISG acquired through a series of transactions a
number of companies to form a national coal combustion products business. ISG
Resources, Inc., which was incorporated in Utah in August 1998, and its
subsidiaries, operate this business.
Principal Products and their Markets by Division. ISG's coal combustion
products ("CCPs") division is a supplier of post-combustion services and
technologies to the coal-fired electric utility industry. ISG manages
approximately 20 million tons annually of CCPs for a majority of the nation's
largest coal-fired utilities, as well as for other industrial clients. ISG
markets CCPs (primarily fly ash and bottom ash) to replace manufactured or mined
materials, such as Portland cement, lime, agricultural gypsum, fired lightweight
aggregate, granite aggregate and limestone. Based upon available information,
ISG believes it is the largest manager and marketer of CCPs in North America.
Fly ash is a pozzolan that, in the presence of water, will combine with
an activator (lime, Portland cement or kiln dust) to produce a cement-like
material. This characteristic makes fly ash a cost-competitive substitute for
other more expensive cementitious building materials. Concrete manufacturers can
typically use fly ash as a substitute for 15% - 30% of their cement
requirements, depending on the quality of the fly ash and the end-use of the
concrete. In addition to its cost-benefit, fly ash provides greater structural
strength and durability in applications such as road and dam construction.
Bottom ash is utilized as an aggregate in concrete block construction and for
road base construction.
ISG's manufactured products division manages the production and sale of
masonry mortars, block and stucco materials, as well as some of ISG's
value-added technology products for the construction market. Key geographic
areas of production and sales are Texas, California, Georgia, Florida and
Louisiana. ISG utilizes high volumes of CCPs as ingredients in the mortars,
blocks and stuccos that ISG produces.
3
ISG has developed and continues to develop new technologies to promote
the use of CCPs. Projects currently in development and/or use include (i) rapid
setting, high strength concretes for road repairs and other uses; (ii) fiber
reinforced, non-autoclaved aerated concrete panels and block for residential and
commercial construction; (iii) carbon fixation technology which utilizes
chemical additives to increase the marketability of fly ash with high or
unpredictable levels of residual carbon; and (iv) ammonia removal technology to
remove ammonia from fly ash that has been contaminated by pollution control
devices or natural operating conditions.
Sources of Available Raw Materials and Inventory Requirements. Coal is
the largest indigenous fossil fuel resource in the United States, with current
U.S. annual coal production in excess of one billion tons. The use of coal to
generate electricity has nearly tripled in the last 30 years. Today, coal
generates over half of all electricity consumed in the U.S., more than all other
fuel sources combined. The government estimates that electricity generated from
coal will increase 25% by 2020. The combustion of coal results in a high
percentage of residual materials which serve as the "raw material" for the CCP
industry. According to the American Coal Ash Association, more than two-thirds
of CCPs produced in 2000 were disposed of in landfills, providing ample
opportunities for continuing increases in CCP utilization. As long as the
majority of electricity in this country comes from the use of coal-fired
generation, ISG believes it will have an adequate supply of raw materials.
Competitive Business Conditions. Although ISG is the nation's leading
manager and marketer of CCPs, ISG still faces significant competition. Such
competitors include LaFarge North America, Boral, Holcim, Inc. and Mineral
Resource Technologies. Although CCPs have been utilized since the mid-1960's, in
recent years fly ash has seen greater acceptance in the construction industry.
Fly ash is now widely used for its superior strength, durability, alkali
resistance and environmental friendliness. ISG expects to continue to be a
leader in this industry with its nation-wide infrastructure, long-term
contractual relationships with existing utilities, and aggressive growth
strategies.
ISG's manufactured products division faces challenges from its many
larger competitors in the mortar, stucco and construction materials industries.
ISG intends to maintain its competitiveness and expand its operations through
the development of unique proprietary formulas and by implementing aggressive
marketing and distribution strategies.
Electric Utility Deregulation. The process of electric utility
deregulation has slowed substantially compared to predictions from previous
years. The impact that full deregulation of the industry will have on ISG is
something that cannot be accurately projected. The major area of impact concerns
the individual sources of CCPs that ISG manages and markets. Deregulation could
result in some sources being put out of service because they are not
economically competitive. Alternatively, deregulation efforts have spurred
renewed interest in the construction of new coal-fired electric generating
facilities. ISG believes that no significant changes to the availability of CCPs
will occur. However, since this change to the industry continues to evolve, ISG
could be materially adversely affected if major changes occur.
Covol Fuels
Principal Products. Covol Fuels develops and applies proprietary
technologies used to produce coal-based solid alternative fuel. As an operating
division of Headwaters, Covol Fuels has developed, patented and commercialized a
chemical technology that converts carbon-based feedstock, such as coal, to a
qualified solid alternative fuel that is eligible for federal tax credits under
Section 29 of the Internal Revenue Code. Covol Fuels licenses this technology to
owners of solid alternative fuel facilities for which it receives royalty
revenues. The owners of the solid alternative fuel facilities are eligible to
receive federal tax credits based on the amount of qualified solid alternative
fuel produced using Covol Fuels' technology. Covol Fuels has pioneered work with
the IRS relating to Section 29 credits and obtained one of the first Private
Letter Rulings from the IRS for a coal-based synthetic fuel process. Covol
Fuels' in-house personnel work closely with customers to achieve compliance with
IRS guidelines and to improve alternative fuel production. In addition to
royalty revenues, Covol Fuels also sells its proprietary chemical reagents
essential to the production of solid alternative fuels both to its licensee
plants and to other customers' plants.
In fiscal 2002, prior to its acquisition of ISG, Headwaters generated
over 90% of its revenues through license fees from its technology and sale of
chemical reagents to owners of solid alternative fuel facilities whose
facilities were placed into service prior to July 1, 1998, qualifying them for
Section 29 tax credits. Covol Fuels currently has technology licensing
agreements with 28 alternative fuel facilities. Under the terms of the
contracts,
4
Covol Fuels is generally paid a quarterly royalty fee based on either facility
production or tax credits generated by the facilities. In certain instances,
Covol Fuels was also paid initial license fees when certain events occurred or
when certain production levels were reached.
Sources of Available Raw Materials and Inventory Requirements. Covol
Fuels' chemical reagents are manufactured by Dow Reichhold Specialty Latex LLC
("Dow") under a long-term, fixed-price supply contract. Covol Fuels relies on
Dow through its several regional distribution centers to supply its licensees
and customers with timely and adequate supplies of chemicals. Separately, the
alternative fuel facility owners have unrelated feedstock agreements that
provide a supply of raw coal for processing at their facilities. These licensees
and customers in turn have production agreements to supply alternative fuel to
end users (usually coal-fired electric generating facilities).
Competitive Business Conditions. Covol Fuels' alternative fuel
technologies compete with other alternative fuel products as well as traditional
fuels. Competitive factors include price, quality, delivery cost, and handling
costs. Covol Fuels may experience competition from other alternative fuel
technology companies and their licensees, particularly those companies with
technologies to produce coal-based solid alternative fuels. Competition may come
in the form of the licensing of the competing technologies to process coal
derivatives, the marketing of competitive chemical reagents, the marketing of
end products qualifying as synthetic fuel, and the development of alternative
fuel projects. Competition includes, for example, Nalco Chemical Company in the
chemical reagent sales business. Headwaters also experiences competition from
traditional coal and fuel suppliers and natural resource producers, in addition
to those companies that specialize in the recycling and upgrading of industrial
waste products. Many of these companies have greater financial, management, and
other resources than Headwaters. Covol Fuels believes that it will be able to
compete effectively, but there can be no assurance that it will be able to do so
successfully.
Major Customers. The following table presents revenues for all
customers that accounted for over 10% of total revenue during 2000, 2001 or
2002. Most of the named customers are energy companies.
(thousands of dollars) 2000 2001 2002
---------------------------------------- ----------------- ---------------- -----------------
TECO Coal Corporation affiliates Less than 10% $16,044 $20,292
DTE Energy Services, Inc. affiliates Less than 10% 5,111 19,660
Marriott International, Inc. affiliates Less than 10% Less than 10% 19,105
AIG Financial Products Corp. affiliates Less than 10% Less than 10% 16,900
PacifiCorp affiliates $15,511 4,978 Less than 10%
Pace Carbon Fuels, L.L.C. affiliates Less than 10% 4,675 Less than 10%
Fluor Corporation affiliate 3,138 Less than 10% Less than 10%
HTI
HTI has developed catalyst and nano-catalyst technologies to convert
coal, gas and heavy/waste oils to liquid fuels. The conversion from low to high
value products also allows HTI to extract troublesome elements such as sulfur,
nitrogen and heavy metals out of the fuel, resulting in ultra clean fuels. The
development of nano-catalyst technology places HTI at the forefront of applying
advanced molecular science to multiple energy and chemical processes. HTI
maintains a staff of engineers, scientists, and technicians at its pilot plant
and laboratory facilities with experience in the design and operation of
high-pressure and temperature process plants. These facilities are used to
further technology development efforts as well as for outside services provided
to other companies and government agencies.
Initially formed in 1943 as Hydrocarbon Research, Inc., HTI and its
predecessor have a long history of developing and commercializing chemical and
energy technologies. One of the core competencies developed by HTI is working at
the molecular level to control how atoms of precious metals catalysts are fixed
on substrate materials. Nanotechnology is one of the most significant
advancements in catalysis technology during the past 20 years, and HTI is
currently positioning to participate within this market through its research
expertise and increasing portfolio of patents.
5
HTI offers technology for producing ultra-clean liquid fuels directly
from coal. In this process, coal molecules are changed into diesel, gasoline and
other fuel molecules, and sulfur, nitrogen, ash and other impurities are
removed, leaving a very high grade liquid fuel.
HTI has developed a patented technology to change complex heavy oil
molecules into lighter molecules. The HTI process is a novel hydrocracking
process using HTI's proprietary slurry catalyst and close-coupled hydrotreating
to produce ultra-clean diesel fuel, jet fuel, gasoline or fuel oil. The
technology can be applied in new or existing hydrocrackers.
Commercialization of slurry-phase Fischer-Tropsch (F-T) technology is a
major objective of both government and industry to provide the nation with
adequate clean diesel fuels from indigenous fossil fuel resources. HTI has
developed a novel skeletal-iron F-T catalyst specifically designed for
slurry-phase reactors. It is stronger than conventional F-T catalysts and
delivers improved economics, making F-T technology more competitive in the
marketplace.
Research and Development
In 2001, research and development expenses consisted of $2,400,000 of
acquired in-process research and development related to the HTI acquisition. The
acquired in-process research and development consisted primarily of efforts
focused on developing catalysts and catalytic processes to lower the cost of
producing alternative fuels and chemicals while improving energy efficiency and
reducing environmental risks. In 2002, research and development expenses of
$2,322,000 consisted primarily of ongoing activities at HTI. In 2003, research
and development expenses are expected to increase as a result of the ISG
acquisition in late 2002.
Headwaters' Business Strategy
Headwaters' competitive strengths include: (i) pre- and post-combustion
coal market leadership; (ii) strong cash flows; (iii) ability to provide
comprehensive services along the coal value chain; (iv) nationwide capabilities
and infrastructure; (v) development of leading energy technologies; (vi) strong
growth profile driven by increasing market acceptance; (vii) responsiveness to
industry demands; and (viii) the ability to provide products and services that
address environmental concerns. Headwaters intends to capitalize on these
strengths in pursuing the following strategic initiatives:
Expand and Enhance Core Businesses. Headwaters intends to expand its
coal-based alternative fuel business by expanding royalty and chemical reagent
revenues by assisting customers to increase production and offering value-added
services, such as technical and plant support, that drive increased production
at facilities using its technology and chemical reagents. Headwaters believes
ISG can increase the market penetration of fly ash and other CCPs in the
concrete and other construction products industries through established and
historically successful customer training programs. In addition, ISG intends to
continue to provide CCP management services to current coal-fired utility
customers and seek new service opportunities with other utilities.
Leverage Complementary Relationships and Capabilities. Covol Fuels and
ISG each maintains long-standing relationships with many of the nation's largest
producers of electricity derived from coal. Most of these relationships are
complementary, which Headwaters believes will provide significant opportunities
to expand and strengthen its position among coal-fired power generation
utilities. By leveraging these complementary relationships Headwaters intends to
increase ISG's penetration with coal-fired power generation companies that are
Covol Fuels' customers and to capitalize on ISG's numerous nationwide
relationships with coal-fired power generation facilities to increase awareness
and acceptance of Covol Fuels' coal-based solid alternative fuel technology.
Develop and License New Energy Technologies. Headwaters intends to
develop technologies that address various needs along the coal value chain, in
particular in the pre-combustion and post-combustion stages, primarily for
licensing, rather than building and owning manufacturing assets. As part of its
pre-combustion strategy, Covol Fuels intends to continue to develop technologies
that improve coal handling, enhance coal combustion characteristics and reduce
air emissions. ISG is developing new technologies such as ammonia removal and
carbon fixation, as well as proprietary chemical surfactant technology that
increases both the quality and usefulness of fly ash from coal combustion. In
addition to developing coal-based technologies, HTI is developing other
technologies
6
that add value to other fossil fuels and chemicals. These efforts focus on
upgrading heavy oil to lighter fuels, changing gas into liquid fuels, turning
otherwise unusable products into fuels and other energy-related
nanotechnologies.
Pursue Complementary and Expansionary Acquisitions. Headwaters intends
to identify and analyze additional acquisition opportunities to strengthen and
fortify its position as a leading value enhancer to fuels. Specifically,
Headwaters will evaluate possible acquisitions of complementary businesses
aligned to the chemical, mineral, or energy industries in which Headwaters does
business. If suitable candidates are not found in these industries, Headwaters
may pursue possible acquisition candidates in other growing industries where
promising financial returns exist.
Intellectual Property
ISG has 14 U.S. patents that expire between 2009 and 2018 and nine U.S.
patent applications pending. ISG has 14 registered trademarks and two pending
trademark applications. While these collective patents and trademarks are
important to ISG's competitive position, no single patent or trademark is
material to ISG.
Covol Fuels has nine U.S. patents that expire between 2011 and 2014.
Covol Fuels has one registered trademark and one pending trademark application.
HTI has 16 U.S. patents that expire between 2011 and 2020 and 17 U.S.
patent applications pending. HTI has two registered trademarks and one pending
trademark application.
There can be no assurance as to the scope of protection afforded by the
patents. In addition, there are other technologies in use and others may
subsequently be developed, which do not, or will not, utilize processes covered
by the patents. There can be no assurance that Headwaters' patents will not be
infringed or challenged by other parties or that Headwaters will not infringe on
patents held by other parties. Because many of these patents represent new
technology, the importance of the patents to Headwaters' business will depend on
its ability to commercialize these technologies successfully, as well as its
ability to protect its technology from infringement or challenge by other
parties.
In addition to patent protection, Headwaters also relies on trade
secrets, know-how, and confidentiality agreements to protect these technologies.
However, such methods may not afford complete protection and there can be no
assurance that others will not independently develop such know-how or obtain
access to Headwaters' know-how, concepts, ideas, and documentation.
Since Headwaters' proprietary information is important to its business,
failure to protect ownership of its proprietary information would likely have a
material adverse effect on Headwaters. Headwaters' current revenues are
dependent upon license fees and chemical sales. Headwaters believes that its
patents, trade secrets, know-how and confidential information are the basis upon
which it obtains and secures licensing agreements.
Effect of Federal, State and Local Laws
Headwaters and its subsidiaries are subject to federal, state, and
local environmental regulations. Headwaters believes that it has obtained all
required permits pertaining to its business and operations, and that it is in
substantial compliance with all applicable laws.
ISG. The Federal Clean Air Act of 1970 ("Clean Air Act"), Amendments to
the Clean Air Act, and corresponding state laws regulating air emissions, affect
the coal industry directly and indirectly. The coal industry may be directly
affected by permitting requirements of the Clean Air Act and/or emissions
control requirements relating to particulate matter (e.g., "fugitive dust"). The
coal industry may also be impacted by future regulation of fine particulate
matter. In July 1997, the United States Environmental Protection Agency ("EPA")
adopted new, more stringent National Ambient Air Quality Standards ("NAAQS") for
particulate matter and ozone. Because electric utilities emit nitrogen oxides,
which are precursors to ozone, ISG's utility customers and suppliers are likely
to be affected when the revisions to the NAAQS are implemented by the states.
State and federal regulations, including the new NAAQS, may reduce the available
quantities of CCPs. The extent of the potential impact of the NAAQS on the coal
industry will depend on the policies and control strategies associated with the
7
state implementation process under the Clean Air Act. Nonetheless, the NAAQS
could have a material adverse effect on ISG's financial condition and
operations.
The Clean Air Act indirectly affects ISG's operations by limiting the
air emissions of sulfur dioxides, nitrous oxides, and other compounds emitted by
coal-fired utility power plants. The affected utilities have been (or may be)
able to meet these requirements by switching to lower sulfur fuels, installing
new more efficient equipment and pollution control devices such as scrubbers,
reducing electricity generating levels, or purchasing or trading "pollution
credits." Specific emission sources will receive these credits, which utilities
and other industrial concerns can trade or sell to allow other units to emit
higher levels of sulfur dioxide.
The Clean Air Act Amendments also require utilities that are currently
major sources of nitrogen oxides in moderate or higher ozone nonattainment
areas, to install reasonably available control technology for nitrogen oxides.
In addition, the EPA currently plans to implement stricter ozone standards
(discussed above) by 2004. EPA promulgated a rule (the "SIP call") in 1998
requiring 22 eastern states to make substantial reductions in nitrogen oxide
emissions. Under this proposal, the EPA expects that states will achieve these
reductions by requiring power plants to make substantial reductions in their
nitrogen oxide emissions. Installation of reasonably available control
technology and additional control measures required under the SIP call will make
it more costly to operate coal-fired utility power plants and could make coal a
less attractive fuel alternative in the planning and building of future utility
power plants. Any reduction in coal-fired power generation could have a material
adverse effect on ISG's financial condition and operations. ISG cannot predict
the effect of these regulations on the coal industry with any certainty. No
assurance can be given that the implementation of the Clean Air Act Amendments
or any future regulatory provisions will not materially adversely affect ISG.
As utilities take steps to meet more stringent emissions control
guidelines, residual carbon in fly ash becomes a growing problem for ISG. ISG
cannot fully utilize this lower quality fly ash in some products and
applications. Therefore, ISG has pursued research and development technologies
to develop a carbon fixation process to treat fly ash that could not otherwise
be used due to its quality. This technology renders some ash products usable for
the first time without having any negative impact on the quality of the finished
concrete product. ISG is successfully working with several utilities utilizing
this technology.
ISG has also filed a provisional patent application for a technology to
control ammonia in fly ash. Ammonia is another emerging challenge in the ash
industry. As utilities implement more stringent air pollution controls, many are
treating boiler exhaust gases with ammonia to remove nitrous oxides. Some of the
unreacted ammonia is deposited on fly ash particles. To address this challenge,
ISG's technology uses a chemical reagent to convert ammonia into harmless
compounds. ISG is currently working with two utilities to implement the
technology.
Covol Fuels. Covol Fuels and the alternative fuel operations of its
licensees are subject to federal, state and local environmental regulations that
impose limitations on the discharge of pollutants and establish standards for
the treatment, storage and disposal of waste materials. In order to establish
and operate alternative fuel plants, Covol Fuels and its licensees have obtained
various state and local permits.
In processing alternative fuel from coal, acid is the only hazardous
material which is used and stored. Despite safeguards, the possibility exists
that regulatory noncompliance or accidental discharges could create an
environmental liability. Therefore, alternative fuel operations owned or
operated by Covol Fuels and its licensees could incur future liabilities arising
from the discharge of pollutants into the environment or from improper waste
disposal practices. In addition, the enactment of more stringent environmental
regulations, or failure to maintain or comply with such regulations, could have
a material adverse effect on Covol Fuels or its licensees.
HTI. HTI and its subsidiaries are also subject to federal, state, and
local environmental regulations. HTI and its subsidiaries use their facilities
in the ordinary course of business to research, develop, process and/or recycle
waste coal, oil and chemicals. As a result, petroleum and other hazardous
materials have been and continue to be present on these properties. HTI and its
subsidiaries hire independent contractors to transport and dispose of hazardous
materials and to send hazardous wastes to federally approved off-site waste
facilities. HTI and its subsidiaries believe that appropriate handling and
training procedures are in effect for all properties and operations. Despite
safeguards, the possibility exists that regulatory noncompliance or accidental
discharges could create an environmental liability. Therefore, operations owned
or operated by HTI and its subsidiaries could incur future
8
liabilities arising from the discharge of pollutants into the environment or
from improper waste disposal practices. In addition, the enactment of more
stringent environmental regulations, or failure to maintain or comply with such
regulations, could have a material adverse effect on HTI and its subsidiaries.
Headwaters is also subject to federal and state safety and health
standards. Therefore, Headwaters is committed to providing effective management
of worker safety and health protection. In addition, Headwaters has developed
safety policies designed to raise and maintain safety awareness by management
and employees. Headwaters has a positive working relationship with MSHA. Failure
by Headwaters and its customers and licensees to comply with safety and health
standards could have a material adverse affect on business operations. For
example, a regulatory inspector could close an alternative fuel facility until
the licensee meets the required standards.
Number of Employees
Headwaters currently employs approximately 840 employees full-time. Of
these employees, approximately 60 are in corporate administration, 50 are
employed by Headwaters' Covol Fuels division, 40 are employed by HTI, 500 are
employed by ISG's CCP division, and 190 are employed by ISG's manufactured
products division. Approximately 20 employees work under collective bargaining
agreements (primarily laborers, equipment operators and truck drivers in Iowa).
ITEM 2. PROPERTIES
Headwaters
Headwaters' principal office is located at 11778 South Election Road,
Suite 210, Draper, Utah 84020, and its telephone number is (801) 984-9400.
Headwaters' web site is www.hdwtrs.com. The information on Headwaters' website
does not constitute a part of this document.
In October 2000, Headwaters leased for a five-year term approximately
7,000 square feet of office space in Draper, Utah, which houses Headwaters'
executive offices. The lease provides for a monthly rent of approximately
$8,000, with certain adjustments for inflation plus expenses.
By February 2003, Headwaters will have consolidated corporate and other
business functions in a new location at 10653 South River Front Parkway, Suite
300, South Jordan, Utah 84095. This new lease for approximately 26,500 square
feet provides for a six-year term. The monthly rent will be approximately
$40,000, with certain adjustments for inflation plus expenses.
ISG
ISG's principal office is located at 136 East South Temple, Suite 1300,
Salt Lake City, Utah 84111, and its telephone number is (801) 236-9700. ISG's
website is www.isgresources.com. The information on ISG's website does not
constitute a part of this document.
ISG currently leases approximately 13,400 square feet on a
month-to-month basis for its executive offices in Salt Lake City, Utah. The
lease provides for a monthly rent of approximately $18,000, with certain
adjustments for inflation plus expenses. It is expected that ISG will terminate
this lease in early 2003. ISG also leases property in three states for regional
offices and laboratory facilities.
In addition, ISG owns or leases approximately 20 parcels in 17 states
for its fly ash storage and distribution operations. ISG also owns or leases
nine properties in three states for its building products manufacturing and
sales operations.
HTI
In 1995, HTI purchased approximately six acres in Lawrenceville, New
Jersey, where its headquarters and research facilities are now located.
9
ITEM 3. LEGAL PROCEEDINGS
Headwaters has some significant ongoing litigation discussed below.
Headwaters intends to vigorously defend and pursue its rights in these actions.
Adtech. 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 an alternative fuel
technology invented by Davidson. (This technology is distinct from the
technology developed by Headwaters.) In September 2000, Headwaters received a
summons and complaint from the United States District Court for the Western
District of Tennessee filed by Adtech, Inc. against Davidson and Headwaters. In
the action, certain purported officers and directors of Adtech alleged that the
technology purchase transaction was an unauthorized corporate action and that
Davidson and Headwaters conspired together to effect the transfer. The complaint
asserted related causes of action and sought unspecified money damages and other
relief. In August 2001, the trial court granted Headwaters' motion to dismiss
the complaint. Plaintiffs appealed the case to the Sixth Circuit Court of
Appeals. In June 2002, the Sixth Circuit Court of Appeals issued an order i)
affirming the District Court's judgment and order of dismissal, and ii)
transferring to the Federal Circuit Court of Appeals plaintiff's appeal of the
District Court's order denying the motion for relief from judgment. Because
resolution of the appeal is uncertain, legal counsel cannot express an opinion
as to the ultimate amount, if any, of Headwaters' liability.
Boynton. This action is factually related to the Adtech matter. In the
Adtech case, the alleged claims are asserted by certain purported officers and
directors of Adtech, Inc. In the Boynton 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,
inter alia, 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 complaint seeks declaratory relief and compensatory
and punitive damages. Because the litigation is at an early stage and resolution
is uncertain, legal counsel cannot express an opinion as to the ultimate amount,
if any, of Headwaters' liability.
AGTC. In March 1996, Headwaters entered into an agreement with AGTC and
its associates for certain services related to the identification and selection
of alternative fuel projects. In March 2002, AGTC filed an arbitration demand
claiming that it is owed a commission under the 1996 agreement for eight percent
of the monetized price of the Port Hodder project. Headwaters asserts that AGTC
did not perform under the agreement and that the agreement was terminated and
the disputes were settled in July 1996. Headwaters has filed an answer in the
arbitration, denying AGTC's claims and has asserted counterclaims against AGTC.
Because the arbitration is at an early stage and resolution is uncertain, legal
counsel cannot express an opinion as to the ultimate amount of recovery or
liability.
AJG. In December 1996, Headwaters entered into a technology license and
proprietary chemical reagent sale agreement with AJG Financial Services, Inc.
The agreement called for AJG to pay royalties and to purchase proprietary
chemical reagent material from Headwaters. In October 2000, Headwaters filed a
complaint in the Fourth District Court for the State of Utah against AJG
alleging that it had failed to make payments and to perform other obligations
under the agreement. Headwaters asserts claims including breach of contract,
declaratory judgment, unjust enrichment, and accounting and seeks money damages
as well as other relief. AJG's answer to the complaint denied Headwaters' claims
and asserted counter-claims based upon allegations of misrepresentation and
breach of contract. AJG seeks unspecified compensatory damages as well as
punitive damages. Headwaters has denied the allegations of AJG's counter-claims.
Because the litigation is at an early stage and resolution is uncertain, legal
counsel cannot express an opinion as to the ultimate amount of recovery or
liability.
Nalco. In October 2000, Headwaters filed a complaint in the United
States District Court for the District of Utah against Nalco Chemical Company
("Nalco"). Headwaters alleges that Nalco, by its sale and marketing of materials
for use in creating alternative fuel, breached a non-disclosure agreement,
misappropriated trade secrets, and violated patent rights of Headwaters.
Headwaters seeks by its complaint injunctive relief and damages to be proven at
trial. Nalco filed an answer denying the allegations in the complaint and
asserting counter-claims alleging patent invalidity, antitrust violations, and
interference with economic relations. Headwaters denies the counter-claims;
however, if Nalco prevails on its counter-claims, the result could have a
material adverse effect on
10
Headwaters' business. Because the litigation is at an early stage and resolution
is uncertain, legal counsel cannot express an opinion as to the ultimate amount,
if any, that might be recovered.
Other. Headwaters and its subsidiaries are also involved in other legal
proceedings that have arisen in the normal course of business. For example,
certain subsidiaries of ISG are involved in legal proceedings involving
allegations of breach of warranty and sales of defective building products
applied by third parties to building exteriors. Generally, ISG denies and
defends such allegations or resolves such matters as appropriate. Management
does not believe that the outcome of these matters will have a significant
adverse effect upon the operations or the financial position of Headwaters;
however, it is possible that a change in management's estimates of probable
liability could occur and the change could be significant.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The shares of Headwaters' common stock trade on the Nasdaq National
Market under the symbol "HDWR." Options on Headwaters' common stock are traded
on the Chicago Board Options Exchange under the symbol "HQK." The following
table sets forth, for the periods presented, the high and low trading prices of
Headwaters' common stock as reported by Nasdaq.
Fiscal 2001 Low High
----------- --- ----
Quarter ended December 31, 2000 $2.13 $ 3.25
Quarter ended March 31, 2001 2.25 6.53
Quarter ended June 30, 2001 6.44 16.00
Quarter ended September 30, 2001 7.11 14.19
Fiscal 2002
-----------
Quarter ended December 31, 2001 $ 9.00 $13.10
Quarter ended March 31, 2002 11.16 15.55
Quarter ended June 30, 2002 11.37 19.15
Quarter ended September 30, 2002 11.87 16.74
As of November 30, 2002, there were approximately 410 stockholders of
record of Headwaters' common stock. Headwaters has not paid dividends on its
common stock to date and does not intend to pay dividends on its common stock in
the foreseeable future. Pursuant to debt agreements Headwaters entered into in
September 2002, Headwaters is prohibited from paying cash dividends so long as
any of the long-term debt is outstanding. Headwaters intends to retain earnings
to finance the development and expansion of its business. Payment of common
stock dividends in the future will depend, among other things, upon Headwaters'
debt covenants, its ability to generate earnings, its need for capital, its
investment opportunities and its overall financial condition.
Recent Sales of Unregistered Securities
The following sets forth all securities issued by Headwaters within the
past three years without registration under the Securities Act of 1933, as
amended. No underwriters were involved in any stock issuances nor were any
commissions paid in connection therewith. However, Headwaters did pay finders
fees in the form of cash, stock or warrants in connection with various
securities issuances.
11
Headwaters believes that the following issuances of securities were
exempt from the registration requirements of the Securities Act of 1933, as
amended, pursuant to the exemption set forth in Section 4(2) thereof. Each
security was issued subject to transfer restrictions. Each certificate for each
security bears a restricted legend. Each investor made representations to
Headwaters that it was accredited as that term is defined in Regulation D and
that the security was acquired for investment purposes. However, Headwaters has
several effective registration statements filed on Form S-3 or Form S-8. These
registration statements have registered many of the securities described in this
section.
During November 1998, Headwaters completed a financing transaction that
consisted of debt and equity including warrants to purchase shares of restricted
common stock at an exercise price of $7.50 per share. The warrants' original
term was set to expire on June 30, 2000. During 2000 the exercise period for the
purchase of approximately 183,000 of these warrant shares was extended for
approximately seven months.
During January 1999, Headwaters completed a financing transaction with
a major shareholder and lender to Headwaters, that consisted of the sale of
1,000 shares of a new series of non-voting, 7% dividend, convertible preferred
stock, designated as Series C. Headwaters received approximately $900,000 in net
proceeds from the issuance of this preferred stock. During January 2000, all of
the remaining shares of Series C preferred stock were converted. Approximately
237,000 shares of common stock were issued on conversion of the preferred stock
and related accrued but unpaid dividends. There are no outstanding shares of
Series C preferred stock.
On March 17, 1999, Headwaters completed a financing transaction with a
large investment fund. The financing consisted of the issuance of $20,000,000
face value of convertible secured debt, issued at a 50% discount, and the
issuance of 60,000 shares of cumulative convertible preferred stock (Series D)
for $6,000,000, for total gross proceeds of $16,000,000. Warrants for the
purchase of common stock were also issued as part of the financing and were
valued at approximately $3,000,000. Net cash proceeds were used to retire
maturing short-term debt and related accrued interest, for working capital and
other general corporate purposes. This transaction is described in detail in the
Form 8-K filed March 24, 1999 and in the Form 10-Q/A for the quarterly period
ended March 31, 1999. Beginning in November 1999 and through March 2000,
Headwaters issued approximately 2,632,000 shares of common stock on conversion
of 24,369 shares of Series D preferred stock. The preferred stock was
convertible at $5.00 or 90% of market, whichever was less. By May 2000,
Headwaters had redeemed all of the investment fund's $20,000,000 face value
convertible debt and incurred early prepayment costs of approximately
$6,037,000. By March 2000, Headwaters had redeemed the investment fund's 35,631
remaining Series D preferred shares for $4,454,000 including a redemption
premium of approximately $1,882,000. There are no outstanding shares of Series D
preferred stock.
In December 1999, Headwaters placed $1,500,000 of financing less a 10%
placement fee with an investor. The debt was convertible at $0.73 per share, the
market price at closing, or market price on the conversion date, whichever was
less. In January 2000, Headwaters redeemed all of this convertible debt for
redemption consideration of approximately $1,900,000 plus 205,435 shares of
common stock. The agreement required the issuance of warrants to purchase
Headwaters shares equal to 40% of the shares issuable under the debt agreement.
Warrants for the purchase of approximately 923,000 shares were issued. The
warrants had a three-year exercise period and an exercise price of $0.88 per
share.
In March 2000, Headwaters completed a private placement financing
transaction by selling to 49 investors approximately 3,629,000 shares of
restricted Headwaters common stock, $0.001 par value, at a price of $1.36 per
share, yielding to Headwaters $4,666,000, net of $270,000 in placement costs.
The investors received registration rights for the stock purchased.
In April 2000, Headwaters completed a private placement financing
transaction by selling to one of its directors and three officers a total of
approximately 379,000 shares of restricted Headwaters common stock, $0.001 par
value, at a price of $1.56 per share and warrants for the purchase of
approximately 133,000 shares of common stock, for net cash proceeds to
Headwaters of approximately $588,000. The warrants are exercisable through March
2005 at a price of $1.56 per share. The investors received registration rights
for the stock purchased and the warrant shares.
In April 2000, an investor acquired from a third party a Headwaters'
14% note due in April 2000 with an approximate $3,000,000 balance and at the
same time also acquired from the third party warrants to purchase
12
100,000 shares of Headwaters' common stock. Headwaters and the investor agreed
to extend for one year the repayment date for $1,000,000 of the principal amount
of the note. Headwaters and the investor further agreed to the satisfaction of
$2,000,000 of the note in exchange for 1,185,818 shares of Headwaters restricted
common stock, $0.001 par value, and warrants to purchase 296,000 shares of
Headwaters' common stock. The warrants were exercised in fiscal 2002 at a price
of $2.10 per share. In July 2000, Headwaters repaid the $1,000,000 note balance
which was accruing interest at 14%. A former director of Headwaters was also a
manager and 2.5% owner of the investor. The director disclaims any beneficial
interest in the investor's securities in Headwaters.
During the fiscal year ended September 30, 2001, pursuant to the
exercise of options, approximately 116,000 shares of Headwaters restricted
common stock were issued.
In August 2001, Headwaters acquired 100% of the common stock of HTI for
total costs at closing of approximately $11,774,000, including the issuance of
approximately 593,000 shares of Headwaters restricted common stock, valued at
$5,485,000. In April 2002, Headwaters and the former HTI stockholders reached a
final settlement of all outstanding contingent payments and Headwaters paid the
former HTI stockholders additional consideration with a value totaling
$3,242,000. This consideration included the issuance of approximately 178,000
shares of Headwaters restricted common stock valued at $2,823,000. Headwaters
filed a registration statement on Form S-3 to register all of the restricted
stock issued to the former HTI stockholders.
In September 2002, Headwaters acquired 100% of the common stock of ISG.
Total consideration at closing was approximately $257,856,000 and included the
issuance of 2,100,000 shares of Headwaters restricted common stock valued at
$32,718,000. Headwaters filed a registration statement on Form S-3 to register
all of the restricted common stock issued to the former ISG stockholders. In
order to obtain the cash necessary to acquire ISG and retire the ISG debt,
Headwaters issued $175,000,000 of new debt consisting of $155,000,000 of senior
secured debt with a five-year term and a variable interest rate and $20,000,000
of subordinated debt with an approximate five-year term and a fixed interest
rate. ISG management participated in one-half, or $10,000,000, of the
subordinated debt. Total cash proceeds from the issuance of new debt, net of
debt discounts, was $169,950,000. Headwaters incurred approximately $6,200,000
of debt issuance costs to place the new debt, which had an initial combined
effective weighted-average interest rate of approximately 9.0%.
During the fiscal year ended September 30, 2002, pursuant to the
exercise of options and warrants, approximately 646,000 shares of Headwaters
restricted common stock were issued. Headwaters has several outstanding
effective registration statements filed on Form S-3 and Form S-8. All but
approximately 6,000 shares of restricted common stock issued during fiscal 2002
have been registered on one or more of these registration statements.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from the consolidated
financial statements of Headwaters. This information should be read in
conjunction with the consolidated financial statements, related notes and other
financial information included herein. As more fully described in Note 14 to the
consolidated financial statements, in 2000 Headwaters recorded approximately
$16.9 million of net gains on sale of facilities and approximately $17.8 million
of asset write-offs and other charges. Headwaters believes these items are not
directly related to its core business and does not expect similar items in the
future. As more fully described in Note 14 to the consolidated financial
statements, in 2000 Headwaters recorded an extraordinary loss on early
extinguishment of debt of $7.9 million. As more fully described in Note 12 to
the consolidated financial statements, in 2000 and 2001, Headwaters recorded
approximately $3.0 million and $7.5 million, respectively, of income tax benefit
primarily related to the reduction of its deferred tax asset valuation
allowance.
Also, as more fully described in Note 3 to the consolidated financial
statements, in August 2001, Headwaters acquired HTI, the financial statements of
which are consolidated with Headwaters' financial statements using a one-month
lag. Accordingly, HTI's August 2001 acquisition date balance sheet was
consolidated with Headwaters' September 30, 2001 balance sheet, but no results
of operations of HTI were included in Headwaters' consolidated results for
fiscal 2001. HTI's August 31, 2002 balance sheet was consolidated with
Headwaters' September 30, 2002 balance sheet and HTI's results of operations for
the year ended August 31, 2002 were consolidated with Headwaters' 2002 results.
As more fully described in Note 3 to the consolidated financial
13
statements, in September 2002, Headwaters acquired ISG. The results of ISG from
September 19, 2002 (date of acquisition) through September 30, 2002 are included
in Headwaters' consolidated results for fiscal 2002, but ISG's results of
operations up to September 18, 2002 have not been included in Headwaters'
consolidated results for any period.
The selected financial data as of and for the years ended September 30,
1998 and 1999 and as of September 30, 2000 are derived from audited financial
statements not included herein. The selected financial data as of September 30,
2001 and 2002 and for the years ended September 30, 2000, 2001, and 2002 were
derived from the audited financial statements of Headwaters included elsewhere
herein.
Year Ended September 30,
-----------------------------------------------------------------
(thousands of dollars, except per-share data) 1998 1999 2000 2001 2002
- ------------------------------------------------- ------------ ------------ ------------ ------------ -------------
OPERATING DATA:
Total revenue $ 2,186 $ 6,719 $27,886 $45,464 $119,345
Net income (loss) (11,308) (28,393) 3,682 21,517 24,286
Diluted net income (loss) per common share (1.17) (2.39) 0.07 0.87 0.94
As of September 30,
-----------------------------------------------------------------
(thousands of dollars) 1998 1999 2000 2001 2002
- ------------------------------------------------- ------------ ------------ ------------ ------------ -------------
BALANCE SHEET DATA:
Working capital (deficit) $ 6,575 $ (2,721) $ 8,393 $ 8,619 $ 15,023
Net property, plant and equipment 15,809 14,182 552 2,680 50,549
Total assets 68,061 58,095 33,441 55,375 372,857
Long-term obligations:
Long-term debt and other liabilities 14,879 18,422 5,235 3,055 154,984
Unamortized portion of non-refundable
license fees 7,455 6,579 7,681 5,805 5,010
Redeemable convertible preferred
stock -- 4,332 -- -- --
Deferred income taxes -- -- -- -- 51,357
Total long-term obligations 23,256 30,255 12,916 8,860 211,351
Total stockholders' equity (deficit) 14,746 (1,028) 10,747 31,086 98,596
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with the information set forth under the caption entitled "ITEM 6. SELECTED
FINANCIAL DATA" and the consolidated financial statements and notes thereto
included elsewhere herein. Headwaters' fiscal year ends on September 30 and
unless otherwise noted, all future references to years shall mean Headwaters'
fiscal year rather than a calendar year.
Acquisitions of ISG and HTI
The consolidated financial statements include the accounts of
Headwaters and all of its subsidiaries, only two of which have significant
operations, ISG and HTI. As more fully described in Note 3 to the consolidated
financial statements, ISG was acquired on September 19, 2002 and HTI was
acquired in August 2001. Accordingly, ISG's results of operations for the period
from September 19, 2002 through September 30, 2002 have been consolidated with
Headwaters' 2002 results and ISG's balance sheet has been consolidated with
Headwaters' balance sheet as of September 30, 2002. Due to the time required to
obtain accurate financial information related to HTI's foreign contracts, for
financial reporting purposes HTI's financial statements are consolidated with
Headwaters' financial statements using a one-month lag. Accordingly, HTI's
August 2001 acquisition date balance sheet was consolidated with Headwaters'
September 30, 2001 balance sheet, but no results of operations of HTI were
included in the consolidated statement of income for 2001. HTI's August 31,
14
2002 balance sheet was consolidated with Headwaters' September 30, 2002 balance
sheet and HTI's results of operations for the year ended August 31, 2002 were
consolidated with Headwaters' 2002 results.
ISG Acquisition. On September 19, 2002, Headwaters acquired 100% of the
common stock of ISG, assumed or paid off all of ISG's outstanding debt and
redeemed all of ISG's outstanding preferred stock. ISG is headquartered in Salt
Lake City, Utah and is engaged primarily in the management of long-term
contracts for coal combustion products and the distribution of related building
materials and construction products throughout the United States, all through
its wholly-owned subsidiary, ISG Resources, Inc. Headwaters has focused on using
technology to add value to fossil fuels, particularly coal. The acquisition of
ISG provides Headwaters with a significant position in the last step of the coal
value chain due to its competencies in managing the products resulting from the
combustion of coal. The acquisition of ISG also brings to Headwaters substantial
management depth, comprehensive corporate infrastructure and critical mass in
revenues and operating profit.
In order to obtain the cash necessary to acquire ISG and retire ISG's
outstanding debt, Headwaters issued $175.0 million of new debt consisting of
$155.0 million of senior secured debt with a five-year term and a variable
interest rate and $20.0 million of subordinated debt with an approximate
five-year term and a fixed interest rate (see Note 8 to the consolidated
financial statements). ISG management participated in one-half, or $10.0
million, of the subordinated debt. Total cash proceeds from the issuance of new
debt, net of debt discounts, was $169.9 million. Headwaters incurred
approximately $6.2 million of debt issuance costs to place the new debt, which
had an initial combined effective weighted-average interest rate of
approximately 9.0%. Total consideration paid for ISG was approximately $257.9
million, which consisted of the issuance of Headwaters' common stock, cash
payments to the former ISG stockholders, cash paid to retire ISG debt, and costs
directly related to the acquisition.
The ISG acquisition was accounted for using the purchase method of
accounting as required by Statement of Financial Accounting Standards ("SFAS")
No.141, "Business Combinations." Assets acquired and liabilities assumed were
recorded at their estimated fair values as of September 19, 2002. Approximately
$109.2 million of the purchase price was allocated to identifiable intangible
assets consisting primarily of contracts with coal-fired power generation
plants. This amount is being amortized over the estimated combined useful life
of 20 years. The remaining purchase price not attributable to the tangible and
identifiable intangible assets (approximating $109.1 million) was allocated to
goodwill. The final allocation of the purchase price, in particular the
estimated fair values for certain acquired property, will likely differ from the
preliminary allocation after final valuations and other procedures have been
completed.
HTI Acquisition. In August 2001, Headwaters completed the acquisition
of 100% of the common stock of HTI, a New Jersey-based company. HTI develops and
commercializes catalysts and catalytic processes for producing chemicals and
converting low-value fossil fuels into high-value alternative fuels. Total
consideration at closing, including the direct costs incurred by Headwaters to
consummate the acquisition, was approximately $11.8 million. In accordance with
the original HTI acquisition agreements, additional contingent consideration
could be earned by the former HTI stockholders during calendar 2002 based on the
attainment of certain operating targets and other milestones. In April 2002,
Headwaters and the former HTI stockholders agreed to an amendment of the
acquisition agreements and reached a final settlement of all outstanding
contingent payments. Headwaters paid the former HTI stockholders additional
consideration with a value totaling approximately $3.2 million. Total
consideration paid for HTI was therefore approximately $15.0 million, which
consisted of the issuance of Headwaters' common stock and options to acquire
Headwaters common stock, cash payments to the former HTI stockholders, cash paid
to retire HTI debt, and costs directly related to the acquisition.
The HTI acquisition was accounted for using the purchase method of
accounting. Assets acquired and liabilities assumed were recorded at their
estimated fair values as of the acquisition date. Approximately $9.7 million of
the purchase price was allocated to identifiable intangible assets consisting of
existing patented technology with an estimated useful life of 15 years.
Approximately $2.4 million of the purchase price was allocated to purchased
in-process research and development, consisting primarily of efforts focused on
developing catalysts and catalytic processes to lower the cost of producing
alternative fuels and chemicals while improving energy efficiency and reducing
environmental risks. This amount represented the estimated purchased in-process
technology for projects that had not reached technological feasibility and had
no alternative use as of the acquisition date, and was expensed in 2001.
Approximately $4.3 million of the purchase price was allocated to goodwill.
Segments. Until Headwaters acquired ISG in September 2002, Headwaters
operated in and reported as a single industry segment, alternative energy. With
the acquisition of ISG in September 2002, Headwaters now operates
15
in three business segments, alternative energy, CCPs, and manufactured products.
These segments are managed and evaluated separately by management based on
fundamental differences in their operations, products and services.
The alternative energy segment includes Headwaters' traditional
coal-based solid alternative fuel business and HTI's business of developing and
commercializing catalysts and catalytic processes for producing chemicals and
converting low-value fossil fuels into high-value alternative fuels. Revenues
for this segment include primarily sales of chemical reagents and license fees.
The CCP segment includes ISG's business of supplying post-combustion
services and technologies to the coal-fired electric utility industry. This
segment markets and manages coal combustion products such as fly ash and bottom
ash, known as CCPs. ISG has long-term contracts, primarily with coal-fired
electric generating utilities, pursuant to which it manages the post-combustion
operations for the utilities. ISG markets these CCPs to replace manufactured or
mined materials, such as portland cement, lime, agricultural gypsum, fired
lightweight aggregate, granite aggregate and limestone. CCP revenues consist
primarily of the sale of products, along with a small percentage of service
revenue.
The manufactured products segment produces and sells standard masonry
and stucco construction materials and supplies, packaged products and blocks, as
well as some of ISG's value-added technology products. ISG has introduced high
volumes of CCPs as ingredients in the mortars, stuccos and blocks that the
manufactured products segment produces.
Critical Accounting Policies and Estimates
Headwaters' significant accounting policies are identified and
described in Note 2 to the consolidated financial statements. The preparation of
financial statements in conformity with accounting principles generally accepted
in the United States requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements, and
the reported amounts of revenue and expenses during the reporting period.
Headwaters continually evaluates its policies and estimation
procedures. Estimates are often based on historical experience and on
assumptions that are believed to be reasonable under the circumstances, but
which could change in the future. Some of Headwaters' accounting policies and
estimation procedures require the use of substantial judgment and actual results
could differ materially from the estimates underlying the amounts reported in
the consolidated financial statements. The following is a discussion of these
critical accounting policies and estimates.
License Fee Revenue Recognition. There are 28 alternative fuel
facilities that are currently licensed to use Headwaters' patented technology
and from which Headwaters earns license fees. These recurring license fees or
royalty payments are recognized in the period when earned, which generally
coincides with the sale of alternative fuel by Headwaters' licensees. In certain
instances, Headwaters receives timely regular written reports from licensees
notifying Headwaters of the amount of solid alternative fuel sold and the
royalty due Headwaters under the terms of the respective license fee agreements.
Moreover, in most instances, Headwaters has experienced a regular pattern of
payment by the licensees of these reported amounts due.
Generally, estimates of license fee revenue earned, where required, can
be reliably made based upon historical experience and / or communications from
licensees for whom an established pattern exists. In some cases, however, such
as when a licensee is beginning to produce and sell alternative fuel or when an
alternative fuel facility is sold by a licensee to another entity, and for which
there is no pattern or knowledge of past or current production and sales
activity, there may be more limited information upon which to determine an
estimate of license fee revenue earned. In these situations, Headwaters uses
such information as is available and where possible, attempts are made to
substantiate the information, such as observing the levels of chemical reagents
purchased by the licensee and used in the production of the solid alternative
fuel. In certain limited situations, Headwaters is unable to reliably estimate
the license fee revenues earned during a period, and therefore revenue
recognition is delayed until a future date when sufficient information is known
from which to make a reasonable estimation.
Realizability of Receivables. Allowances are provided for uncollectible
accounts and notes receivable when deemed necessary. Such allowances are based
on an account-by-account analysis of collectibility or impairment and totaled
approximately $0 at September 30, 2001 and approximately $0.4 million at
September 30, 2002 for trade receivables and $0 at September 30, 2001 and 2002
for notes receivable. Headwaters performs periodic credit evaluations of its
customers, but collateral is not required for trade receivables. Collateral,
generally consisting of most or all assets of the debtor, is required for notes
receivable.
16
With regard to Headwaters' trade receivables from the alternative
energy segment, past allowances have been minimal as have any required
write-offs. Trade receivables from the CCP and manufactured products segments
involve substantially more customers and receivable allowances are required.
Headwaters reviews the collectibility of its trade receivables as of the end of
each reporting period.
Losses recognized on notes receivable were $0 in 2000, approximately
$3.7 million in 2001 and approximately $0.7 million in 2002. Because the notes
generally relate to nonoperating activities, these losses are included in other
expense in the consolidated statements of income. The losses on receivables in
2001 consisted entirely of write-offs or impairments of notes receivable from
unrelated high-risk entities which Headwaters loaned funds to in late fiscal
2000 and early fiscal 2001, which amounts were determined to be uncollectible or
worthless. Headwaters no longer makes these loans, and in September 2001,
Headwaters sold all its remaining loans and equity investments in these entities
to a limited liability corporation, in exchange for a $4,000,000 note
receivable, due no later than September 2004. This note is being accounted for
on the cost recovery basis. Headwaters reviews collectibility of this note
receivable at the end of each reporting period. This collectibility review
consists of consideration of payments of required interest and principal and the
sufficiency of the collateral to support the outstanding note receivable
balance. To the extent impairment is indicated, Headwaters writes down the note
receivable to its estimated net realizable value at that time. An impairment
loss of approximately $1.0 million was recorded in 2002 due to a decline in the
value of the underlying collateral.
Headwaters considers its receivable allowances adequate as of September
30, 2002; however, changes in economic conditions generally or in specific
markets in which Headwaters operates could have a material effect on required
reserve balances.
Valuation of Long-Lived Assets, including Intangible Assets and
Goodwill. Headwaters periodically evaluates the carrying value of long-lived
assets, including intangible assets and goodwill, as well as the related
amortization periods, to determine whether adjustments to these amounts or to
the useful lives are required based on current events and circumstances. Changes
in circumstances such as technological advances, changes to Headwaters' business
model or changes in Headwaters capital strategy could result in the actual
useful lives differing from Headwaters' current estimates. In those cases where
Headwaters determines that the useful life of property, plant and equipment or
intangible assets should be shortened, Headwaters would amortize the net book
value in excess of salvage value over its revised remaining useful life, thereby
increasing depreciation or amortization expense.
The carrying value of a long-lived asset is considered impaired when
the anticipated cumulative undiscounted cash flow from that asset is less than
its carrying value. In that event, a loss is recognized based on the amount by
which the carrying value exceeds the fair market value of the long-lived asset.
Impairment-related losses recognized in Headwaters' consolidated statement of
income for 2000 are more fully described in Note 14 to the consolidated
financial statements. There were no losses recorded in 2001 or 2002. Indicators
of impairment include such things as a significant adverse change in legal
factors or in the general business climate or an expectation that significant
assets will be sold or otherwise disposed of.
Beginning in 2003, Headwaters will perform periodic impairment tests of
its intangible assets, most of which were acquired in connection with the
acquisitions of ISG and HTI, in accordance with the requirements of SFAS No.
142, "Accounting for Goodwill and Intangible Assets." The new rules require,
among other things, that goodwill be tested for impairment at least annually
using a two-step process that begins with an estimation of the fair value of the
reporting unit giving rise to the goodwill. Headwaters currently believes that
neither the ISG- nor HTI-related identifiable intangible assets and goodwill are
impaired under either the existing rules for testing impairment, or under the
new rules required by SFAS No. 142.
Identified intangible assets consist primarily of ISG long-term
contracts and HTI patented technology. It is possible that some of Headwaters'
tangible or intangible long-lived assets or goodwill could be impaired in the
future and that the resulting write-downs could be material.
Legal Matters. Headwaters is involved in several legal proceedings that
have arisen out of the normal course of business, all as explained in more
detail in "ITEM 3. LEGAL PROCEEDINGS" and Note 15 to the consolidated financial
statements. Of the five primary legal matters described in Note 15, Headwaters
is a defendant in three cases, and both a plaintiff and defendant in two cases.
Management in all cases intends to vigorously defend its position. Management
does not currently believe that the outcome of these activities will have a
significant effect upon the operations or the financial position of Headwaters;
however, it is possible that a change in management's estimates of probable
liability could occur and the change could be significant. In regards to all of
these legal matters, legal counsel cannot express an opinion as to the ultimate
amounts of recovery or liability.
17
Year Ended September 30, 2002 Compared to Year Ended September 30, 2001
The information set forth below compares Headwaters' operating results
for fiscal 2002 with its operating results for fiscal 2001.
Revenue. Total revenue for 2002 increased by $73.8 million or 162% to
$119.3 million as compared to $45.5 million for 2001. The major components of
revenue are discussed in the sections below.
Chemical Reagent Sales. Chemical reagent sales during 2002 were $74.4
million with a corresponding direct cost of $50.1 million. Chemical reagent
sales during 2001 were $22.4 million with a corresponding direct cost of $14.5
million. The increase in chemical reagent sales in 2002 over 2001 was due to
increased alternative fuel production by Headwaters' licensees, as well as sales
of chemical reagents to new customers. Currently, Headwaters expects its future
chemical reagent sales revenue from all licensees and other customers to be
higher than the amounts reported for 2002 due to anticipated increases in
alternative fuel production by licensees and increased sales of chemical
reagents to new customers. However, Headwaters does not expect the rate of
growth in 2003 to be as high as it was for 2002.
License Fees. During 2002, Headwaters recognized license fee revenue
totaling $30.5 million, an increase of $9.7 million or 47% over $20.8 million of
license fee revenue recognized during 2001. License fees in 2002 consisted of
recurring license fees or royalty payments of $29.0 million and deferred revenue
amortization of $1.5 million. License fees in 2001 consisted of recurring
license fees of $18.8 million and deferred revenue amortization of $2.0 million.
A major licensee significantly reduced its production and sale of
alternative fuel in early 2001 and did not operate its four facilities for most
of 2001. This licensee sold the facilities in October 2001, and Headwaters
earned approximately $3.7 million more in license fees from these facilities in
2002 than in 2001. This factor, combined with increased alternative fuel sales
by most other licensees, caused the increase in license fee revenue for 2002
over 2001. Headwaters currently expects license fee revenue to increase in 2003
by an amount comparable to the 2002 increase. However, these increases are
expected to decline in the future as this business segment continues to mature
and it is possible that unforeseen adverse events could occur in the future that
would cause license fee revenue to decrease.
Pursuant to the contractual terms of an agreement with a certain
licensee, the cumulative net license fees generated by Headwaters, totaling
approximately $6.0 million as of September 30, 2002, have been placed in escrow
for the benefit of Headwaters. Headwaters currently expects the escrowed amounts
to increase as additional license fees are generated and that most, if not all,
of such amounts will be recognized as revenue at some future date. Certain
accounting rules governing revenue recognition require that the seller's price
to the buyer be "fixed or determinable" as well as reasonably certain of
collection. In this situation, those rules appear to currently preclude revenue
recognition. Accordingly, none of the escrowed amounts have been recognized as
revenue in the consolidated statements of income.
Other Revenues and Cost of Revenues. Coal combustion product sales and
services and manufactured product sales and the related cost of revenue captions
represent ISG's revenues and cost of revenues for the period from September 19,
2002 through September 30, 2002. Approximately $2.9 million of other revenues
and $5.2 million of cost of other revenues represent HTI's revenues and cost of
revenues for 2002. There were no comparable revenues and cost of revenues for
ISG and HTI in 2001.
Depreciation and Amortization. These costs increased by $1.4 million to
$1.8 million in 2002 from $0.4 million in 2001. The increase was primarily
attributable to the depreciation and amortization of the tangible and intangible
assets acquired in the HTI acquisition in August 2001 ($1.0 million) and the
depreciation and amortization of the tangible and intangible assets acquired in
the ISG acquisition in September 2002 ($0.4 million). Depreciation and
amortization expense will increase substantially in 2003 as a result of the ISG
acquisition.
Research and Development. Approximately $2.4 million of the HTI
purchase price was allocated to purchased in-process research and development,
all of which was expensed in 2001. In 2002, research and development expenses of
$2.3 million represent primarily $2.1 million of costs related to HTI
activities.
Selling, General and Administrative Expenses. These expenses increased
$5.1 million or 59% to $13.7 million for 2002 from $8.6 million for 2001. The
increase in 2002 was due primarily to ISG costs of approximately $1.6 million,
an increase in compensation-related costs of approximately $1.2 million, an
increase in professional services expenses of approximately $1.1 million and
smaller increases in most of the other expense categories. The increase in
compensation-related costs related primarily to an increase in incentive-based
pay as a result of
18
improved operating results. The increase in professional services expenses was
due primarily to legal costs associated with legal actions Headwaters is
currently pursuing. The increases in other expense categories were due primarily
to the growth of Headwaters' business during 2002.
Other Income and Expense. During 2002, Headwaters reported net other
expenses of $0.8 million compared to net other expenses of $5.2 million during
2001. The change of $4.4 million or 85% is primarily attributable to i) an
increase in interest and net investment income of $0.3 million, ii) a decrease
in equity and debt investment-related losses of approximately $5.5 million, and
iii) a gain on the sale of assets of approximately $1.3 million; partially
offset by the write-off of deferred project / financing costs of approximately
$2.6 million and an increase in interest expense of approximately $0.3 million.
The increase in interest income from 2001 to 2002 primarily related to
an increase in the average balance of short-term investments in 2002 over 2001,
partially offset by a decrease in interest income from a $6.5 million note
receivable from a licensee which was collected in October 2001.
During 2000, Headwaters made several equity investments in and loans to
unrelated high-risk entities and in 2001, Headwaters recorded losses totaling
approximately $6.3 million related to write-offs of these investments and loans.
In September 2001, Headwaters sold all of its remaining high-risk investments in
exchange for a $4.0 million note receivable from a limited liability
corporation. Headwaters wrote down this note receivable as of September 30, 2002
and recorded an impairment loss of approximately $1.0 million in 2002 due to a
decline in the value of the underlying collateral.
The $1.3 million gain on sale of assets resulted from the sale of a 50%
interest in one of Headwaters' original alternative fuel facilities. Headwaters
recorded approximately $2.6 million of losses related to the write-off of
deferred project / financing costs in 2002 resulting from the abandonment of
certain projects or the postponement or redirection of activities for which
costs had previously been deferred pending the ultimate outcome of the projects
and activities. Interest expense increased in 2002 due to the substantial
increase in outstanding debt incurred in September 2002 to finance the
acquisition of ISG. Interest expense will increase substantially in 2003 as a
result of the debt incurred to facilitate the ISG acquisition.
Income Taxes. In 2001, Headwaters reported a net income tax benefit of
$7,049,000, consisting of the recognition of $7,470,000 of its deferred tax
asset, reduced by $100,000 of federal alternative minimum tax and $321,000 of
current state income tax expense. In 2002, as a result of recording the full
value of its deferred tax asset in 2001, Headwaters recorded an income tax
provision with an effective tax rate of approximately 40%.
Year Ended September 30, 2001 Compared to Year Ended September 30, 2000
The information set forth below compares Headwaters' operating results
for fiscal 2001 with its operating results for fiscal 2000.
Revenue. Total revenue for 2001 increased by $17.6 million or 63% to
$45.5 million as compared to $27.9 million for 2000. The major components of
revenue are discussed in the sections below.
Chemical Reagent Sales. Chemical reagent sales during 2001 were $22.4
million with a corresponding direct cost of $14.5 million. Chemical reagent
sales during 2000 were $9.8 million with a corresponding direct cost of $6.6
million. The increase in chemical reagent sales in 2001 over 2000 was due to
increased alternative fuel production by Headwaters' licensees, as well as sales
of chemical reagents to new customers. There were no similar sales of chemical
reagents to new customers in 2000.
License Fees. During 2001, Headwaters recognized license fee revenue
totaling $20.8 million, an increase of $3.5 million or 20% over $17.3 million of
license fee revenue recognized during 2000. License fees in 2001 consisted of
recurring license fees or royalty payments of $18.8 million and deferred revenue
amortization of $2.0 million. License fees in 2000 consisted of recurring
license fees of $16.5 million and deferred revenue amortization of $0.8 million.
Recurring license fees in 2000 included $11.7 million related to a
single licensee that owned four facilities. This licensee did not report and pay
certain prior period royalty obligations to Headwaters timely, resulting in some
"catch-up" revenue recognition in 2000 for royalties related to periods other
than the year ended September 30, 2000. Moreover, this licensee significantly
reduced its production and sale of alternative fuel in early 2001 and did not
operate the four facilities for most of 2001. These two factors combined
resulted in a decline in recurring license fees from the licensee of
approximately $8.0 million in 2001 as compared to 2000. Due to increased
alternative fuel
19
sales, there was an increase of approximately $10.2 million in recurring license
fees from all other licensees in 2001 over 2000. In 2001, the largest single
licensee accounted for $6.2 million of earned license fees.
Depreciation and Amortization. These costs decreased by $0.8 million to
$0.4 million in 2001 from $1.2 million in 2000. The decrease was primarily
attributable to elimination of depreciation associated with the three facilities
owned by Headwaters which were sold in 2000.
Research and Development. Approximately $2.4 million of the HTI
purchase price was allocated to purchased in-process research and development,
all of which was expensed in 2001.
Selling, General and Administrative Expenses. These expenses increased
$0.6 million or 7% to $8.6 million for 2001 from $8.0 million for 2000. The
increase in 2001 was due primarily to an increase in professional services
expenses of approximately $1.3 million and an increase in compensation-related
costs of approximately $0.5 million. These increases were partially offset by
the elimination of approximately $1.1 million of costs associated with the
facilities owned by Headwaters which were sold in 2000 and the wash plant
located in Utah, as well as the resolution in 2001 of certain liabilities for
$0.2 million less than previously recorded. The increase in professional
services expenses was due primarily to legal costs associated with legal actions
Headwaters is pursuing. The increase in compensation-related costs related
primarily to an increase in marketing department headcount.
Asset Write-offs and Other Charges. In 2000, Headwaters recorded an
impairment charge of approximately $14.8 million related to assets located in
Utah and Alabama. This impairment charge consisted of an approximate $12.6
million write-down to net realizable value of certain ancillary plant equipment
which remained on the sites when the facilities were sold and was idled, plus an
approximate $2.2 million write-off of an intangible asset which was no longer
considered recoverable due to the relocation of a licensee facility. Headwaters
also recorded employee severance and other non-cash charges from incremental
amortization of deferred compensation from stock options (resulting from the
termination of employees whose stock options became fully vested upon
termination) totaling approximately $1.5 million. Other settlement charges ($1.0
million) and asset write-downs ($0.5 million) were recorded in 2000. All of
these asset write-offs and other charges totaled approximately $17.8 million.
There were no similar charges recorded in 2001.
Other Income and Expense. During 2001, Headwaters reported net other
expenses of $5.2 million compared to net other income of $14.3 million during
2000. The change of $19.5 million or 136% is primarily attributable to i) a
decrease in gains on sale of facilities of $16.9 million, ii) a decrease in
interest and investment income of approximately $1.1 million, iii) an increase
in equity and debt investment-related losses of approximately $5.5 million, and
iv) a decrease of $1.1 million from gains on other transactions, related to the
satisfaction of a $0.8 million contingent contract liability and a $0.3 million
gain recognized on a note receivable transaction in 2000. These changes were
partially offset by a decrease of approximately $4.6 million in interest expense
and an increase in the mark-to-market adjustment of the carrying value of a
related party note receivable of approximately $0.5 million.
In 1999, Headwaters sold a facility located in Pennsylvania on which a
loss of approximately $1.8 million was recognized. Headwaters also entered into
an agreement under which it operates this facility on behalf of the owner. In
2000, upon achieving specified operating performance milestones, Headwaters
received additional cash payments related to the sale of this facility. These
payments, net of obligations to third parties, approximated $7.4 million. Of the
net amount received, Headwaters recognized $4.4 million as a gain in 2000
because there were no ongoing obligations associated with those payments.
Headwaters deferred the recognition of $3.0 million, which amount was
characterized in the sales agreement as prepaid royalties. This amount is being
recognized as revenue on a straight-line basis through December 2007.
In 2000, Headwaters sold the three remaining alternative fuel
facilities it owned plus an option to acquire a licensee facility. One of these
sold facilities was located in Utah, two of these facilities were located in
West Virginia, and the facility under option was located in Nevada. Headwaters
reported net gains on these transactions totaling approximately $12.5 million.
Headwaters also entered into its standard supply agreements with the new owners
of the facilities to sell proprietary chemical material used at the facilities
and receives ongoing royalties based upon the sale of alternative fuel from the
facilities.
The decrease in interest income from 2000 to 2001 primarily related to
a decrease in interest from the related party note receivable discussed below
from $0.5 million in 2000 to $0 in 2001 and a decrease in the interest rate on a
$6.5 million note receivable from a licensee. During 2000, Headwaters made
several equity investments in and loans to unrelated high-risk entities and in
2000, Headwaters recognized approximately $0.8 million of losses related to its
equity investments. During 2001, Headwaters recorded additional losses totaling
approximately $6.3
20
million related to write-offs of notes receivable and losses on equity
investments, for an increase of $5.5 million in the 2001 losses compared to
2000.
Interest expense decreased in 2001 primarily due to the significantly
lower average levels of outstanding borrowings that existed in 2001 as compared
to 2000. During 1996, Headwaters sold certain construction companies and
received as consideration a $5.0 million note receivable. The note was "marked
to market" each period based upon the market value of Headwaters' common stock
held as collateral and was reflected in the consolidated balance sheet at the
underlying value of this collateral, $0.5 million at September 30, 2000. In
2001, Headwaters accepted as full satisfaction of the note receivable the shares
of Headwaters' stock collateralizing the note and a new note receivable which
was recorded at $0 due to substantial uncertainty of both the collectibility of
the new note and the value of the new collateral. This transaction resulted in
recognition of a gain in 2001 of approximately $0.6 million, representing the
increase in value of the collateral from September 30, 2000 to the date the
collateral was surrendered in payment of the note. The corresponding adjustment
in 2000 resulted in a write-up of $0.1 million for a net increase in the
adjustment of $0.5 million in 2001 compared to 2000.
Income Taxes. In 2000, Headwaters reported a net income tax benefit of
$2.9 million, consisting of the recognition of $3.0 million of its deferred tax
asset, reduced by $0.1 million of federal alternative minimum tax. In 2001,
Headwaters reported a net income tax benefit of $7.0 million, consisting of the
recognition of $7.4 million of its deferred tax asset, reduced by $0.1 million
of federal alternative minimum tax and $0.3 million of current state income tax
expense.
Headwaters' valuation allowance decreased by $14.2 million during 2001.
A valuation allowance is provided if it is more likely than not that some
portion or all of a deferred tax asset will not be realized. Based primarily on
results of operations in 2001 and expected future results of operations,
Headwaters determined that as of September 30, 2001, it was more likely than not
that its deferred tax assets would be realized and the valuation allowance was
eliminated.
Extraordinary Item. In 2000, Headwaters redeemed all of its remaining
convertible debt. The redemption consideration and early prepayment costs
included approximately $7.0 million in cash plus the issuance of approximately
0.2 million shares of common stock. The loss recognized as a result of the total
redemption consideration paid plus the acceleration of amortization of the
unamortized debt discount and debt issuance costs in excess of the debt carrying
value totaled approximately $7.9 million.
Liquidity and Capital Resources
Net cash provided by operating activities during 2002 was $42.8 million
compared to $19.8 million during 2001. Most of the cash flow from operating
activities in both periods was attributable to net income. During 2002,
investing activities consisted primarily of payments for the acquisition of ISG.
Financing activities in 2002 consisted primarily of net proceeds from the
issuance of long-term debt used to finance the acquisition of ISG.
Operating Activities. Headwaters reported net income for 2002 of $24.3
million. Moreover, most of Headwaters' reported income tax expense of $15.9
million consisted of deferred income taxes, largely as a result of using
Headwaters' net operating loss carryforwards which did not require the use of
cash. For 2002, cash provided from operations was reduced by a significant
increase in trade receivables approximating $7.7 million, net of ISG's trade
receivables as of the date of acquisition. This increase in trade receivables is
due to the significant increase in revenues.
Investing and Financing Activities. Headwaters acquired ISG in
September 2002. Payments to acquire ISG, net of cash acquired, were
approximately $205.9 million. In order to obtain the cash necessary to acquire
ISG and retire the ISG debt, Headwaters issued $175.0 million of new debt
consisting of $155.0 million of senior secured debt with a five-year term and a
variable interest rate and $20.0 million of subordinated debt with an
approximate five-year term and a fixed interest rate (see Note 8 to the
consolidated financial statements). Total cash proceeds from the issuance of new
debt, net of debt discounts, was $169.9 million. Headwaters incurred
approximately $6.2 million of debt issuance costs to place the new debt, which
had an initial combined effective weighted-average interest rate of
approximately 9.0%.
In September 2001, Headwaters sold all of its remaining high-risk
investments in exchange for a $4.0 million note receivable from a limited
liability corporation. This note is due no later than September 2004, is
collateralized by the bridge loans and equity investments sold and is being
accounted for on the cost recovery method. Following an impairment loss of
approximately $1.0 million recorded in 2002, this note has a carrying value of
$2.7 million as of September 30, 2002. Headwaters could incur additional losses
if the remaining balance
21
on the note is not repaid. At September 30, 2001, in addition to the $4.0
million note receivable, Headwaters had outstanding one other note receivable in
the amount of $6.5 million. This note and the related accrued interest were
collected in October 2001.
Financing activities during 2002 also included proceeds from the
exercise of stock options and warrants of approximately $5.4 million.
Headwaters intends to expand its business through growth of existing
operations and strategic acquisitions of entities that operate in adjacent
industries. Any acquisitions, however, would require the approval of current
debt holders.
In July 2002, Headwaters filed a $250.0 million universal shelf
registration statement with the SEC that can be used for the sale of common
stock, preferred stock, convertible debt and other securities, should Headwaters
so choose. This registration statement was declared effective by the SEC in
August 2002; however, a prospectus supplement describing the terms of any
securities to be issued is required to be filed before any offering would
commence under the registration statement. Headwaters could use the proceeds
from securities offered under the shelf registration to reduce long-term debt,
or for working capital and other general corporate purposes. Headwaters
currently has no plans to utilize the shelf registration.
Working Capital. Headwaters' working capital increased from $8.6
million at September 30, 2001, to $15.0 million at September 30, 2002. This
increase in working capital resulted primarily from increased revenue and
profitability and was partially offset by the cash used to acquire ISG and an
increase in the current portion of long-term debt. Headwaters expects operations
to produce positive cash flows in future periods, which, combined with current
working capital and the $20.0 million revolving line of credit described below,
is expected to be sufficient for Headwaters' operating needs for the next 12
months.
Long-term Debt. In connection with the ISG acquisition, Headwaters
entered into a $175.0 million senior secured credit agreement with a syndication
of lenders, under which a total of $155.0 million was borrowed on the
acquisition date. The remaining $20.0 million is available for borrowing under
the terms of this credit agreement. This debt was issued at a 3% discount and
Headwaters received net cash proceeds of $150.3 million. The debt is secured by
all assets of Headwaters, bears interest at a variable rate (approximately 5.9%
at September 30, 2002), and is repayable quarterly beginning December 2002
through August 2007. Required principal repayments total $15.5 million in 2003,
$31.0 million in 2004, 2005 and 2006, and $46.5 million in 2007. In certain
situations, for example when Headwaters receives "excess cash flow," as defined,
mandatory prepayments are required. Mandatory prepayments are calculated as a
percentage ranging up to 100% of "excess cash flow," which percentage is based
on Headwaters' "leverage ratio." The debt agreement also allows optional
prepayments. Headwaters currently expects to make prepayments that will retire
the debt prior to its scheduled maturity.
The debt agreement contains restrictions and covenants common to such
agreements, including limitations on the incurrence of additional debt,
investments, merger and acquisition activity, asset liens, capital expenditures
in excess of $15.0 million in any fiscal year, and the payment of dividends,
among others. In addition, Headwaters must maintain certain financial ratios,
including leverage ratios and interest coverage, as those terms are defined in
the credit agreement. As of September 30, 2002, Headwaters must maintain a total
leverage ratio of 3.0:1.0 or less. The maximum ratio declines over time until
June 2004, at which time the ratio must remain at 2.0:1.0 or less. There is a
similar leverage ratio requirement for the senior debt alone, which at September
30, 2002 must be 2.5:1.0 or less, declining over time through June 2004, at
which time it must be maintained at 1.5:1.0 or less. The interest coverage
requirement at September 30, 2002 was 3.75:1.0 or more. This ratio requirement
increases over time, until December 2003, at which time the ratio must be
maintained at a level of 5.0:1.0 or more. Headwaters was in compliance with all
debt covenants as of September 30, 2002.
Under the terms of the senior secured credit agreement, Headwaters may
borrow up to a total $175.0 million; provided, however, that, except for the
initial $20.0 million of available revolving credit, the maximum borrowing limit
is permanently reduced by the amount of any repayments of the initial $155.0
million borrowed in September 2002. Terms of any additional borrowings under the
credit agreement are generally the same as described in the preceding
paragraphs. Finally, the credit agreement allows for the issuance of letters of
credit, provided there is capacity available under the total credit line. As of
November 15, 2002, two letters of credit for a total of approximately $3.0
million have been issued with expiration dates of March 2003 and November 2003.
No other borrowings have been drawn or letters of credit issued through November
15, 2002. Headwaters pays a fee of 5/8% on the unused portion of the revolving
credit agreement.
22
Also in connection with the ISG acquisition, Headwaters entered into a
$20.0 million subordinated loan agreement, under which senior subordinated
debentures were issued at a 2% discount, with Headwaters receiving net cash
proceeds of $19.6 million. ISG management participated in one-half, or $10.0
million, of the $20.0 million of debt issued. The other half was issued to a
corporation. The debt is not secured, bears interest at an 18% rate, and is
repayable in September 2007. It is senior to all other debt except the senior
secured debt described above. The debt agreement allows for optional
prepayments. Any prepayments paid to the corporation are subject to a prepayment
charge which ranges from 5% of the principal prepaid in the first year to 1% of
the principal prepaid in the last year of the five-year term of the debt
agreement. Interest is payable quarterly, beginning October 2002 and is payable
in cash at a 12% rate. At Headwaters' option, interest calculated at an
additional 6% rate may be added to the principal balance in lieu of payment in
cash. Headwaters currently intends to pay in cash the entire amount of interest
which accrues.
The loan agreement contains restrictions and covenants common to such
agreements, and these are generally consistent with those described above for
the senior secured debt. As of September 30, 2002, Headwaters must maintain a
total leverage ratio of 3.25:1.0 or less. The maximum ratio declines over time
until June 2004, at which time the ratio must remain at 2.25:1.0 or less. The
interest coverage requirement at September 30, 2002 was 3.50:1.0 or more. This
ratio requirement increases over time, until December 2003, at which time the
ratio must be maintained at a level of 4.75:1.0 or more. Headwaters was in
compliance with all debt covenants as of September 30, 2002.
Income Taxes. As of September 30, 2001, Headwaters had net operating
loss carryforwards ("NOLs") of approximately $24.0 million and research and
development tax credit carryforwards of approximately $0.2 million for federal
tax purposes. During 2002, Headwaters utilized all of these NOLs and tax credit
carryforwards except for approximately $0.9 million of HTI's acquisition date
NOLs that are subject to an annual limitation of approximately $0.8 million due
to the change in ownership of HTI. Headwaters expects to utilize HTI's remaining
NOLs in 2003 and 2004.
During 2002, Headwaters made estimated payments for alternative minimum
taxes and for certain state income taxes in states where NOLs are not available.
Due to the passage in March 2002 of the Job Creation and Worker Assistance Act
of 2002 (the "Act"), Headwaters filed for a refund of the alternative minimum
taxes paid in fiscal 2001 and filed for refunds related to the carryback of
HTI's 2000 and 2001 losses, which pursuant to the Act can be carried back for
five years instead of the statutory two-year period. Due to NOLs for regular
federal tax purposes and in many states where Headwaters had operations, the
provisions of the Act allowing Headwaters' NOLs to offset 100% of the
alternative minimum tax liability for fiscal 2002, and due to tax benefits from
the exercise of stock options, Headwaters did not pay significant amounts of
income taxes in 2002.
Significant future cash needs, in addition to operational working
capital requirements, are currently expected to consist primarily of (i) debt
service payments on outstanding long-term debt, (ii) income taxes, and (iii)
capital expenditures. Capital expenditures are currently expected to be
approximately $10.0 million in 2003, with somewhat higher requirements in
succeeding years.
Contractual Obligations and Contingent Liabilities and Commitments
Other than operating leases for certain equipment and real estate,
Headwaters has no significant off-balance sheet transactions, derivatives, or
similar instruments and is not a guarantor of any other entities' debt or other
financial obligations. The following table presents a summary of Headwaters'
contractual obligations and payments, by period as of September 30, 2002.
Cash Payments Due by Period
----------------------------------------- -----------------------------------------------------------------
(millions of dollars) Total 1 Year 2 -3 Years 4 -5 Years After 5 Years
----------------------------------------- ---------- ------------ ------------ ------------ ---------------
Senior secured debt $155.0 $15.5 $62.0 $ 77.5 $ --
Senior subordinated debt 20.0 -- -- 20.0 --
Other long-term debt 0.1 0.1 -- -- --
---------- ------------ ------------ ------------ ---------------
Total long-term debt 175.1 15.6 62.0 97.5 --
Operating leases 30.7 8.9 11.7 5.8 4.3
Unconditional purchase obligations 35.7 8.1 11.0 5.9 10.7
Employment contracts, minimum royalties,
and other long-term obligations 5.7 3.9 1.8 -- --
---------- ------------ ------------ ------------ ---------------
Total contractual cash obligations $247.2 $36.5 $86.5 $109.2 $15.0
========== ============ ============ ============ ===============
23
Subsequent to September 30, 2002, Headwaters entered into a new
headquarters office lease arrangement which expires in 2008. Total minimum
rental payments under the new lease agreement, which are not included above,
total approximately $2.6 million.
Under the terms of the senior secured credit agreement, Headwaters may
borrow up to a total $175.0 million; provided, however, that, except for the
initial $20.0 million of available revolving credit, the maximum borrowing limit
is permanently reduced by the amount of any repayments of the initial $155.0
million borrowed in September 2002. The credit agreement allows for the issuance
of letters of credit, provided there is capacity available under the total
credit line. As of November 15, 2002, two letters of credit for a total of
approximately $3.0 million have been issued with expiration dates of March 2003
and November 2003. No other borrowings have been drawn or letters of credit
issued through November 15, 2002.
Headwaters is involved in several legal proceedings that have arisen
out of the normal course of business, all as explained in more detail in "ITEM
3. LEGAL PROCEEDINGS" and Note 15 to the consolidated financial statements. Of
the five primary legal matters described in Note 15, Headwaters is a defendant
in three cases, and both a plaintiff and defendant in two cases. Management in
all cases intends to vigorously defend its position. Management does not
currently believe that the outcome of these activities will have a significant
effect upon the operations or the financial position of Headwaters; however, it
is possible that a change in management's estimates of probable liability could
occur and the change could be significant. In regards to all of these legal
matters, legal counsel cannot express an opinion as to the ultimate amounts of
recovery or liability.
Recent Accounting Pronouncements
Headwaters has implemented SFAS No. 142, "Accounting for Goodwill and
Intangible Assets," with the exception of certain additional disclosures which
may not be early implemented. Full implementation of SFAS No. 142 will require
certain additional disclosures regarding ISG's and HTI's identified intangible
assets and goodwill beginning October 1, 2002. In addition, SFAS No. 142, when
fully implemented in fiscal 2003, will require Headwaters to review for
impairment those intangible assets and goodwill in accordance with the
requirements of SFAS No. 142, instead of following the existing rules for
impairment testing. The new rules require, among other things, that goodwill be
tested for impairment at least annually using a two-step process that begins
with an estimation of the fair value of the reporting unit giving rise to the
goodwill. Headwaters currently believes that neither the ISG- nor HTI-related
identifiable assets and goodwill are impaired under either the existing rules
for testing impairment, or under the new rules required by SFAS No. 142.
In April 2002, SFAS No. 145, "Rescission of FASB Statements No. 4, 44,
and 64, Amendment of FASB Statement No. 13, and Technical Corrections," was
issued. SFAS No. 145, in rescinding SFAS No. 4, will require that the loss on
early extinguishment of debt, classified as an extraordinary item in 2000, no
longer be classified as extraordinary, but rather as other expense. SFAS No. 145
is required to be implemented by Headwaters in 2003 and management does not
expect it to have a material effect on Headwaters' future financial position or
results of operations.
In August 2001, SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets," was issued, and in July 2002, SFAS No. 146,
"Accounting for Costs Associated with Exit or Disposal Activities," was issued.
These pronouncements must be implemented by Headwaters as of October 1, 2002 and
January 1, 2003, respectively. Headwaters has reviewed these standards and all
other recently issued, but not yet adopted, accounting standards in order to
determine their potential effect, if any, on the future results of operations or
financial position of Headwaters. Based on that review, Headwaters does not
currently believe that any of these recent accounting pronouncements will have a
significant effect on its current or future financial position or results of
operations.
Impact of Inflation
During 2002, Headwaters' operations were not materially impacted by
inflation.
Forward-looking Statements
Statements in this Annual Report on Form 10-K regarding Headwaters'
expectations as to the managing and marketing of coal combustion products,
operation of facilities utilizing alternative fuel technologies, the marketing
of alternative fuels, the receipt of licensing fees, royalties, and product
sales revenues, the development, commercialization and financing of new
technologies and other strategic business opportunities and acquisitions and
other information about Headwaters that is not purely historical by nature,
including those statements regarding Headwaters' future business plans, the
operation of facilities, the availability of tax credits, the
24
availability of feedstocks, and the marketability of the coal combustion
products and alternative fuel, constitute forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995. Although
Headwaters believes that its expectations are based on reasonable assumptions
within the bounds of its knowledge of its business and operations, there can be
no assurance that actual results will not differ materially from its
expectations. In addition to matters affecting the coal combustion products and
alternative fuel industries or the economy generally, factors which could cause
actual results to differ from expectations stated in these forward-looking
statements include, among others, the following:
(1) Ability to repay our substantial debt obligations, including significant
interest payments, under our senior secured credit facility and senior
subordinated debentures.
(2) Restrictions on our ability to operate the businesses because of covenants
in the senior secured credit facility and senior subordinated debentures.
(3) Satisfactory resolution of several significant disputes in litigation.
(4) Increased use and market acceptance of fly ash.
(5) Fluctuations in the price and sales of cement and concrete products markets
in which ISG competes.
(6) Clean Air Act Amendments and regulations that could adversely impact coal
consumption or the quality and quantity of coal combustion products.
(7) Potential property damage claims and the availability of insurance coverage
for claims related to ISG's stucco and other building products.
(8) Operating issues for licensed alternative fuel facilities including
feedstock availability, moisture content, Btu content, correct application
of chemical reagent, achieving significant chemical change, operability of
equipment, production capacity, product durability, resistance to water
absorption, overall costs of operations and other commercial factors
surrounding the use of Covol Fuels' technologies.
(9) Marketing issues relating to acceptance and regulatory permitting of
alternative fuels manufactured using Covol Fuels' technologies.
(10) Securing of suitable alternative fuel facility sites, including permits and
raw materials, for relocation and operation of alternative fuel facilities
and product sales.
(11) The market acceptance of products manufactured with Headwaters'
technologies in the face of competition from traditional products.
(12) Dependence on licensees to successfully implement Covol Fuels' technologies
and to make license and other payments to Covol Fuels.
(13) Maintenance of placed-in-service and other requirements under Section 29 of
the tax code by alternative fuel manufacturing facilities.
(14) Changes in governmental regulations or failure to comply with existing
regulations that could result in reduction or shutdown of operations of
licensee alternative fuel facilities.
(15) The continued availability of tax credits to licensees under the tax code
and each licensee's ability to use tax credits.
(16) The commercial feasibility of Covol Fuels' alternative fuel technologies
upon the expiration of tax credits.
(17) Ability to commercialize new technologies which have only been tested in
the laboratory and not in full-scale operations.
(18) Ability to commercialize the technology of HTI and to implement new
business plans which are at an early stage of investigation and investment
and which will require significant time, management, and capital
investment.
(19) Success of HTI in conducting business in China.
(20) Success in the face of competition by others producing coal combustion
products or alternative chemical reagent products.
(21) Sufficiency of intellectual property protections.
(22) Successful integration of recent acquisitions and retention of key
management personnel.
Risk Factors Affecting Future Results of Operations
Leverage Risks
We have substantial debt and have significant interest payment requirements
under our senior secured credit facility and senior subordinated debentures.
As of the closing of the acquisition of ISG and the related bank
financing, we have approximately $175 million in debt outstanding. Subject to
restrictions in our senior secured credit facility and senior
25
subordinated debentures, we may also incur significant amounts of additional
debt for working capital, capital expenditures and other purposes. Our high
level of combined debt could have important consequences for our company,
including the following:
o we may have difficulty borrowing money for working capital,
capital expenditures, acquisitions or other purposes;
o we will need to use a large portion of our cash flow to pay
interest and the required principal payments on borrowings
under our senior secured credit facility and senior
subordinated debentures, which will reduce the amount of
money available to finance our operations, capital
expenditures and other activities; o our senior debt has a
variable rate of interest, which exposes us to the risk of
increased interest rates;
o borrowings under our senior secured credit facility is
secured by all our assets;
o we may be more vulnerable to economic downturns and adverse
developments in our business;
o we may be less flexible in responding to changing business
and economic conditions, including increased competition and
demand for new products and services; and
o we may not be able to implement our business plans.
Our ability to make scheduled payments of the principal of, to pay
interest on or to refinance our indebtedness depends on our future performance,
which to a certain extent is subject to economic, financial, competitive and
other factors beyond our control. There can be no assurance that our business
will continue to generate cash flow from operations in the future sufficient to
service our debt and make necessary capital expenditures. If unable to generate
such cash flow, we may be required to adopt one or more alternatives, such as
selling assets, restructuring debt or obtaining additional equity capital. There
can be no assurance that any of these strategies could be effected on
satisfactory terms or without substantial additional expense to us. These and
other factors could have a material adverse effect on our results of operations,
liquidity and financial condition.
Covenant restrictions under our senior secured credit facility and senior
subordinated debentures may limit our ability to operate our business.
Our senior secured credit facility and senior subordinated debentures
contain, among other things, covenants that may restrict our ability to finance
future operations or capital needs, to acquire additional businesses or to
engage in other business activities. Our senior secured credit facility and
senior subordinated debentures restrict, among other things, our ability and the
ability of our subsidiaries to:
o borrow money;
o pay dividends or make distributions;
o purchase or redeem stock;
o make investments and extend credit;
o engage in transactions with affiliates;
o engage in sale leaseback transactions;
o consummate certain asset sales;
o effect a consolidation or merger or sell, transfer, lease or
otherwise dispose of all or substantially all of our assets;
and
o create liens on our assets.
In addition, our senior secured credit facility and senior subordinated
debentures and other material agreements require us to maintain specified
financial ratios and satisfy certain financial condition tests which may require
that we take action to reduce our debt or to act in a manner contrary to our
business objectives. Events beyond our control, including changes in general
economic and business conditions, may affect our ability to meet those financial
ratios and financial condition tests. We cannot assure you that we will meet
those tests or that our senior lenders will waive any failure to meet those
tests. A breach of any of these covenants would result in a default under our
senior secured credit facility and senior subordinated debentures and other
material agreements. If an event of default under our senior secured credit
facility and senior subordinated debentures occurs, our lenders could elect to
declare all amounts outstanding under the credit facilities, together with
accrued interest, to be immediately due and payable. Such a default may, in
turn, cause a default under or an acceleration of our other outstanding
indebtedness and some of our material agreements. In such a case, there can be
no assurance that we would be able to refinance or otherwise repay such
indebtedness.
26
Litigation Risk
We are involved in significant litigation.
We are a party to some significant legal proceedings. These proceedings
will require that we incur substantial costs, including attorneys' fees,
managerial time, and other personnel resources and costs. Adverse resolution of
these proceedings could have a materially negative effect on such things as (i)
potential future revenues from licensees, (ii) our financial liabilities, and
(iii) the strength of some aspects of our intellectual property in the
alternative fuels industry. See "ITEM 3. LEGAL PROCEEDINGS" for a description of
the material pending legal proceedings.
Covol Fuels Risks
Commercial viability of alternative fuel facilities depends on the continued
existence of tax credits under Section 29 of the Internal Revenue Code.
Because to date the profitability of the alternative fuel facilities
that qualify for tax credits under Section 29 depends upon the economic benefits
from the tax credits in addition to the profits, if any, from operations, our
profits currently depend upon the existence of the tax credits under Section 29
of the Internal Revenue Code. Moreover, royalty payments under our license
agreements are typically based on a percentage of tax credits or profits earned.
Under current law, Section 29 expires on December 31, 2007, after which tax
credits will not apply to the alternative fuel facilities. In addition, there
have been legislative initiatives from time to time to consider the early repeal
or modification of Section 29, although they have not been successful. To date,
coal-based solid alternative fuel facilities that are not eligible for tax
credits have not been built, and we believe they could not presently be operated
profitably. If the tax credits are not extended, or Section 29 is repealed or
adversely modified prior to the end of 2007, licensees, in order to remain
competitive and commercially viable after 2007, will have to manage their costs
of production and feedstock and develop the market for coal-based solid
alternative fuel with adequate prices to cover the costs. Following 2007, absent
an extension of tax credits, or any earlier repeal of Section 29, we will need
to renegotiate our license agreements with licensees to take into account the
absence of tax credits. If our licensees close their facilities after 2007, it
would have a material adverse effect on our business.
Ongoing financial profitability of Covol Fuels depends on operational success of
licensees.
Covol Fuels has licensed its coal-based solid alternative fuel
technology to a limited number of licensees. Covol Fuels' profitability depends
on the ability of its licensees to produce and sell alternative fuel that will
generate license fees. There are 28 alternative fuel facilities that license
Covol Fuels' technologies. To date, Covol Fuels has earned license fees from the
owners of 18 facilities, but most of the ongoing royalties earned to date have
been generated by eight facilities owned by three licensees. If any one of these
licensees shuts down its facilities, operates its facilities at low production
levels, or sells its facilities resulting in short-term or long-term disruption
of operations, our revenues could be materially adversely affected. To
successfully operate a facility, the plant owner must produce and market a
high-quality coal-based solid alternative fuel. In order to do so, Covol Fuels'
licensees must address all operational issues including, but not limited to,
feedstock availability, cost, moisture content, Btu content, correct chemical
reagent formulation and application, operability of equipment, product
durability, resistance to water absorption and overall costs of operations. In
some cases, licensees may be forced to relocate plants and enter into new
strategic contracts to address marketing and operational issues. For example,
some of the owners of facilities are moving the facilities to new sites with
better sources of raw materials for operation. Licensee plant relocations
disrupt production and delay generation of license fees for us. It is not
certain how much time our licensees will require for the full resolution of all
of these marketing and operational issues.
Covol Fuels' profitable financial results have depended in part on
increased production over time of coal-based solid alternative fuel by its
licensees. While to date efficiencies in production and improvements in
facilities equipment and processes have allowed increased production, and we
believe that capacity of the facilities can continue to be increased, capacity
is ultimately finite for the specific facilities and could limit growth in the
future.
Covol Fuels' licensees may not qualify for tax credits granted by Congress to
encourage production of alternative fuels.
Section 29 of the Internal Revenue Code provides a tax credit for the
production and sale of qualified alternative fuel, including coal-based solid
alternative fuel produced by using Covol Fuels' technologies. Covol Fuels'
royalties and chemical sales revenues are ultimately derived from its licensees'
ability to manufacture and
27
sell qualified fuels that generate tax credits for the facility owners. The IRS
has issued at least 14 private letter rulings to licensees of Covol Fuels'
technologies covering 19 alternative fuel facilities. These rulings may be
modified or revoked by the Internal Revenue Service ("IRS") if the IRS adopts
regulations that are different from these rulings. Also, a private letter ruling
may not apply if the actual operating practice differs from the information
given to the IRS for the ruling. The IRS from time to time reviews taxpayer use
of the Section 29 tax credit, including whether there should be restrictions on
the availability of such credits. As discussed above, ultimately it is within
the power of Congress to repeal or extend Section 29. Therefore, tax credits may
not be available in the future, which would materially adversely impact us.
Based upon the language of Section 29 and private letter rulings issued
by the IRS to Covol Fuels and its licensees, Covol Fuels and its licensees
believe the coal-based solid alternative fuel facilities built and completed
prior to July 1, 1998, are eligible for Section 29 tax credits. However, the
ability to claim tax credits is dependent upon a number of conditions including,
but not limited to, the following:
o The facilities were constructed pursuant to a binding
contract entered into before January 1, 1997;
o All steps were taken for the facility to be considered
placed in service prior to July 1, 1998;
o Manufacturing procedures are applied to produce a
significant chemical change and hence a "qualified fuel";
o The alternative fuel is sold to an unrelated party; and
o The owner of the facility is in a tax-paying position and
can therefore use the tax credits.
Licensees are subject to audit by the IRS. The IRS may challenge Covol
Fuels' licensees on any one of these or other conditions. Also, Covol Fuels'
licensees may not be in a financial position to claim the tax credits if they
are not profitable and therefore reduce the alternative fuel produced at their
facility. In addition, the Section 29 credit is subject to phase-out after the
unregulated oil price reaches a certain level, adjusted annually for inflation.
The inability of a licensee to claim tax credits could potentially reduce our
income from the licensee.
Covol Fuels must be able to develop and improve our alternative fuel
technologies.
Covol Fuels' current business is dependent upon alternative fuel
technologies. To remain competitive, we must be able to develop or refine our
technologies to keep up with future alternative fuel requirements. As licensees
develop and modify their operations and choices of coal feedstocks, we will need
to find new methods, know-how, chemicals, and other techniques to meet licensee
and customer demands, such as demands for improved efficiencies, lower costs,
and improvements in alternative fuel products, including chemical change and
improved physical characteristics. If we are unable to develop or refine our
technologies, our revenues and business could be materially harmed.
HTI Risks
HTI's technologies may not be commercially developed and marketed profitably.
Headwaters acquired HTI, in August 2001. As an early stage company, HTI
focuses on developing and commercializing catalysts and catalytic processes for
producing chemicals and converting low-value fossil fuels into high-value
alternative fuels. Although HTI has developed and patented several potential
processes, these processes are still in the developmental stage. Market
acceptance of these processes, if at all, will depend on our ability to enter
into agreements with licensees to further develop and provide adequate funding
to commercialize the processes. We can give no assurances that we will be able
to enter into any of these agreements or that adequate funding will be available
to fully develop and successfully commercialize those processes or that they can
be marketed profitably.
HTI will conduct business in China.
HTI has recently entered into agreements with Shenhua Group, China's
largest coal company, which will license its direct coal liquefaction coal
technology for use in plants in China. In addition, other HTI activities are
likely to involve licensing of other technologies in China. There is the risk
that foreign intellectual property laws will not protect our intellectual
property rights to the same extent as under United States laws, leaving us
vulnerable to competitors who may attempt to copy our products, processes or
technologies. Further, the legal system of China is based on statutory law.
Under this system, prior court decisions may be cited as persuasive authority
but do not have binding precedential effect. Since 1979, the Chinese government
has been developing a comprehensive system of commercial laws and considerable
progress has been made in the promulgation of laws
28
and regulations dealing with economic matters, such as corporate organization
and governance, foreign investment, commerce, taxation and trade. As these laws,
regulations and legal requirements are relatively new and because of the limited
volume of published case law and judicial interpretations and the non-binding
nature of prior court decisions, the interpretation and enforcement of these
laws, regulations and legal requirements involve some uncertainty. These
uncertainties could limit the legal protection or recourse available to us. In
addition, dependence on foreign licenses and conducting foreign operations may
subject us to increased risk to political change, ownership issues, or
repatriation or currency exchange concerns.
ISG Risks
ISG's business is dependent upon increased use and market acceptance of fly ash.
ISG's business strategy is to increase the use of fly ash in cement and
concrete through its marketing initiatives, which emphasize the environmental,
cost, and performance advantages of fly ash. If ISG's marketing initiatives are
not successful in the construction industry, or if environmental regulation does
not continue to emphasize the use and recycling of coal combustion products or
CCPs and therefore the use of the fly ash, ISG may not be able to sustain its
operations and future growth.
ISG's business is dependent upon the price and sales of cement and concrete.
A significant portion of ISG's business is based on the sale of cement
and concrete products containing fly ash. There is currently an overcapacity of
cement and concrete in the world market, causing potential price decreases.
Although the markets for ISG's products are regional, ISG's business is affected
by the availability of competing products. In addition, any slowing of the
construction business in ISG's markets, particularly highway construction, could
adversely affect ISG's sales.
Clean Air Act Amendments could adversely impact coal consumption.
The federal Clean Air Act of 1970 and subsequent amendments
(particularly the Clean Air Act Amendments of 1990), and corresponding state
laws, which regulate the emissions of materials into the air, affect the coal
industry both directly and indirectly. The coal industry is directly affected by
Clean Air Act permitting requirements and/or emissions control requirements,
including requirements relating to particulate matter (such as, "fugitive
dust"). The coal industry may also be impacted by future regulation of fine
particulate matter. In July 1997, the United States Environmental Protection
Agency, or EPA, adopted new, more stringent National Ambient Air Quality
Standards, or NAAQS, for particulate matter and ozone. Because electric
utilities emit nitrogen oxides, which are precursors to ozone, ISG's utility
customers are likely to be affected when the new NAAQS are implemented by the
states. State and federal regulations relating to fugitive dust and the
implementation of the new NAAQS may reduce ISG's sources for its products. The
extent of the potential impact of the new NAAQS on the coal industry will depend
on the policies and control strategies associated with the state implementation
process under the Clean Air Act. Nonetheless, the new NAAQS could have a
material adverse effect on ISG's financial condition and results of operations.
The Clean Air Act indirectly affects ISG's operations by limiting the
air emissions of sulfur dioxide and other compounds emitted by coal-fired
utility power plants. The affected utilities have been and may be able to meet
these requirements by, among other things, switching to lower sulfur fuels,
installing pollution control devices such as scrubbers, reducing electricity
generating levels or purchasing or trading "pollution credits." The affect on
ISG, of the Clean Air Act regulation of emissions cannot be completely
ascertained at this time.
The 1990 Clean Air Act Amendments require utilities that are currently
major sources of nitrogen oxides in moderate or higher ozone non-attainment
areas to install reasonably available control technology for nitrogen oxides.
EPA currently plans to finalize stricter ozone NAAQS (discussed above) by 2004.
EPA promulgated a rule (the "SIP call") in 1998 requiring eastern states to
make substantial reductions in nitrogen oxide emissions. Under this rule, EPA
expects that states will achieve these reductions by requiring power plants to
make substantial reductions in their nitrogen oxide emissions. Installation of
reasonably available control technology and additional control measures required
under the SIP call will make it more costly to operate coal-fired utility power
plants and could make coal a less attractive fuel alternative in the planning
and building of utility power plants in the future. Any material reduction in
coal's share of the capacity for power generation could have a material adverse
effect on ISG's financial condition and results of operations. The effect that
such regulation or other requirements may have on the coal industry in general
and on ISG in particular cannot be predicted with certainty. No assurance can be
given that the implementation of the 1990 Clean Air Act Amendments or any future
regulatory provisions will not materially adversely affect ISG.
29
In addition, the 1990 Clean Air Act Amendments require a study of
utility power plant emissions of certain toxic substances, including mercury,
and direct EPA to regulate these substances, if warranted. EPA has submitted
reports to Congress on Mercury (1997) and Utility Air Toxics (1998). On December
14, 2000, EPA announced its finding that regulation of hazardous air pollutant
emissions from oil- and coal-fired electric utility steam generating units is
necessary and appropriate. EPA expects to propose emission standards by December
15, 2003 and to finalize them by December 15, 2004. These regulations are likely
to require reductions in mercury emissions, and such requirements, if
promulgated, could result in reduced use of coal if utilities switch to other
sources of fuel.
The Clear Skies Initiative, announced by the Bush Administration in
February 2002, seeks to develop strategies for reducing emissions of sulfur
dioxide, nitrogen oxides and mercury from power plants. Because the Initiative
is still in its early stages, its effect on ISG cannot be determined at this
time.
ISG's business is dependent upon the quality and quantity of the CCPs it uses in
its products.
Coal-fired boilers have been impacted by regulations under the Clean
Air Act and the 1990 Clean Air Act Amendments, which established specific
emissions levels for sulfur dioxide, or SOx, and nitrogen oxides, or NOx. These
emissions levels have required utilities to undertake many of the following
changes: change their fuel source(s), add scrubbers to capture sulfur dioxide,
add new boiler burner systems to control NOx, add or modify fuel pulverizers/air
handling systems to control NOx, introduce flue gas conditioning materials to
control particulate emissions in conjunction with meeting sulfur dioxide
emissions targets and in some very isolated cases shut down a plant. All of
these changes can impact the quantity and quality of CCPs produced at a power
plant. Furthermore, proposed regulations to control mercury emissions could
result in implementation of additional technologies at power plants that could
negatively affect fly ash quality. Inappropriate use of CCPs can result in
faulty end products.
Property damage claims against ISG; uncertainty of insurance coverage;
litigation.
ISG and its subsidiaries are involved in numerous legal proceedings,
including property damage actions related to its stucco and mortar manufactured
products. Currently, each of the proceedings is being defended by attorneys
retained by various insurance carriers pursuant to "reservation of rights"
letters. While, to date, none of these proceedings have required that ISG incur
substantial costs, there is no guarantee of coverage or continuing coverage, and
these and future proceedings may result in substantial costs to ISG, including
attorneys' fees, managerial time, and other personnel resources and costs.
Adverse resolution of these proceedings could have a materially negative effect
on ISG's business, financial condition and results of operation, and its ability
to meet its financial obligations. Although ISG carries general and product
liability insurance, ISG cannot assure that such insurance coverage will remain
available, that ISG's insurance carrier will remain viable or that the insured
amounts will cover all future claims in excess of ISG's uninsured retention.
Furthermore, future rate increases may make such insurance uneconomical for ISG
to maintain.
ISG's business could be adversely affected by fluctuations in seasonality and
cyclicality.
ISG's business consists of managing CCPs and other materials for
utilities and other industrial facilities and marketing these materials to end
users. Materials management services often include disposal operations and
landfill services that are directly tied to year-round plant operations,
providing relatively evenly distributed revenue generation. However, CCP sales
are keyed to construction market demands that tend to generally follow national
trends in construction with predictable responses to seasonal peaks. ISG's CCP
sales have historically reflected these seasonal trends, with the largest
percentage of total annual revenues being realized in the quarters ended June 30
and September 30. Low seasonal demand normally results in reduced shipments and
revenues in the quarter ended March 31.
The CCP industry is cyclical and is affected by changes in general and
local economic conditions, such as building construction and highway
(infrastructure repair) construction. A downturn in the economy in one or more
markets served by ISG could have a material adverse effect on ISG's sales.
If ISG's coal-fired electric utility industry suppliers fail to provide ISG with
CCPs on a timely basis, ISG's costs could increase and our growth could be
hindered.
ISG currently relies on the production of CCPs by coal-fired electric
utilities. ISG has occasionally experienced delays and other problems in
receiving CCPs from its coal-fired electric utility suppliers and may, in the
future be unable to obtain CCPs on the scale and within the time frames required
by ISG to meet its customers' needs. If ISG is unable to obtain, or if it
experiences a delay in the delivery of CCPs, ISG may be
30
forced to incur significant unanticipated expenses to secure alternative sources
of CCPs or to otherwise maintain supply to its customers.
Operational Risks
We have significant competition.
Coal-based solid alternative fuels made using Covol Fuels' technologies
compete with other alternative fuel products, as well as traditional fuels.
Competition may come in the form of the licensing of competing technologies to
process coal derivatives, the marketing of competitive chemical reagents, the
marketing of end products qualifying as synthetic fuel, and the development of
alternative fuel projects. Covol Fuels also experiences competition from
traditional coal and fuel suppliers and natural resource producers, in addition
to those companies that specialize in the recycling and upgrading of industrial
waste products. These companies may have greater financial, management and other
resources than Covol Fuels has. Further, many industrial coal users are limited
in the amount of alternative fuel product they can purchase from Covol Fuels'
licensees because they have committed to purchase a substantial portion of their
coal requirements through long-term contracts for standard coal. Covol Fuels may
not be able to compete successfully in the future.
Alternative fuel sources and the recycling of waste products are the
subject of extensive research and development by our competitors. If a
competitive technology is developed that greatly increases the demand for waste
products or reduces the costs of alternative fuels or other resources, the
economic viability of our technologies and business could be adversely affected.
Generally, the markets for ISG's traditional CCPs and manufactured
products are highly competitive, with many local, regional and national
companies that compete for market share in these areas with similar products and
with numerous other products which are substitutable. ISG competes with respect
to obtaining materials management contracts with utility and other industrial
companies, the marketing of CCPs and related industrial materials, and the
marketing of its manufactured products. The markets for the management of CCPs,
related industrial materials and manufactured products are highly fragmented.
Although ISG believes it is the largest manager of CCPs in North America and the
only company providing such management services on a national basis, due to the
high cost of transportation relative to sales price, competition is generally
regional. ISG has a presence in every region in the United States. Although ISG
typically has long-term contracts with its clients, some of such contracts
provide for the termination of such contract at the convenience of the utility
company upon a minimum 90-day notice. Moreover, some of ISG's most significant
competitors on a regional basis appear to be seeking a broader national
presence. Some of these competitors have substantially greater resources than
ISG, and there can be no assurance that if they were to begin to compete in the
national market, or in regions where they currently do not have operations, ISG
would not be adversely affected.
If we fail to successfully manage or integrate acquisitions of companies or
technologies, such as the acquisition of ISG, our business may be disrupted and
harmed.
Successful management and integration of acquisitions, such as the
acquisition of ISG, are subject to a number of risks, including:
o difficulties in assimilating acquired operations,
technologies or products including loss of key employees;
o diversion of management's attention from core business
operations;
o adverse effects on business relationships with suppliers and
customers or those of the acquired business;
o assumption of contingent liabilities; and
o incurrence of potential significant write-offs.
There can be no assurance that we will be successful in implementing
our acquisition of ISG. Further, as part of our general business strategy, we
may seek to acquire or invest in other businesses, products or technologies that
we believe could complement or expand our business, augment our market coverage,
enhance our technical capabilities or otherwise offer growth opportunities. In
addition to the risks outlined above, our ability to successfully implement our
strategy is subject to a number of risks, including difficulties in identifying
acceptable acquisition candidates, consummating acquisitions on favorable terms
and obtaining adequate financing, which may adversely affect our ability to
develop new products and services and to compete in our rapidly changing
marketplace. In addition, if we consummate acquisitions through an exchange of
our securities, our existing stockholders could suffer significant dilution.
There can be no assurance that we will be successful in
31
implementing our acquisition strategy, that such strategy will improve our
operating results, or that these activities will not have a significant dilutive
effect on existing shareholders.
Our business could be harmed if we are unable to protect our proprietary
technology.
We rely primarily on a combination of trade secrets, patents, copyright
and trademark laws and confidentiality procedures to protect our technology.
Despite these precautions, unauthorized third parties may infringe upon, copy or
reverse engineer portions of our technology. We do not know if current or future
patent applications will be issued with the scope of the claims sought, if at
all, or whether any patents issued will be challenged or invalidated. Our
business could be harmed if we infringe upon the intellectual property rights of
others. We have been, and may be in the future, notified that we may be
infringing intellectual property rights possessed by third parties. If any such
claims are asserted against us, we may seek to enter into royalty or licensing
arrangements. There is a risk in these situations that no license will be
available or that a license will not be available on reasonable terms,
precluding our use of the applicable technology. Alternatively, we may decide to
litigate such claims or to design around the patented technology. These actions
could be costly and would divert the efforts and attention of our management and
technical personnel. As a result, any infringement claims by third parties or
claims for indemnification by customers resulting from infringement claims,
whether or not proven to be true, may materially harm our business and
prospects.
Headwaters' and its subsidiaries' operations must comply with government
environmental regulations.
Our operations are subject to federal, state and local environmental
regulation. HTI's ordinary course of business involves using its facilities to
perform R&D activities, process and recycle oil and to research and develop
technologies involving waste coal, oil chemicals and energy technologies,
including liquefaction of coal. As a result, petroleum and other hazardous
materials have been and are present on HTI's properties. Regulatory
noncompliance or accidental discharges, in spite of safeguards, could create an
environmental liability. Therefore operations entail risk of environmental
damage and we could incur liabilities in the future arising from the discharge
of pollutants into the environment or from waste disposal practices.
Materials sold by ISG vary in chemical composition. Although fossil
fuel combustion wastes have been excluded from regulation as "hazardous wastes"
under the Resource Conservation and Recovery Act ("RCRA"), the EPA has
determined that regulations are warranted for coal combustion wastes disposed of
in landfills or surface impoundments, or used to fill surface or underground
mines. EPA is planning to publish a proposed rulemaking in March 2003. ISG
manages a number of landfill and pond operations that may be affected by EPA's
proposed regulations. In most of these operations permits are contractually
retained by the client and the client would be liable for any costs associated
with new permitting requirements. However, the effect of such regulations on ISG
cannot be completely ascertained at this time.
While CCPs are not "hazardous wastes" under RCRA, they may contain
small concentrations of metals that are considered as "hazardous substances"
under the Comprehensive Environmental Response Compensation and Liability Act
("CERCLA"). Land application of CCPs is regulated by a variety of federal and
state statutes, which impose testing and management requirements to ensure
environmental protection. Under limited circumstances, mismanagement of CCPs can
give rise to CERCLA liability.
ISG is engaged in providing services at one landfill operation that is
permitted and managed as a hazardous waste landfill. The client process is
intended to convert aluminum potliner, a hazardous waste, into a "non-hazardous
condition" through the use of its patented treatment process. ISG provides the
services necessary to landfill the residues of this treatment process and
operates certain in-plant equipment and systems for the client. Although
environmental liabilities related to the project are assumed by the client,
there can be no assurance that ISG will not be named in third party claims
relating to the project.
Risks Relating to Our Securities
Our stock price has been and could remain volatile.
The market price for Headwaters' common stock has been and may continue
to be volatile and subject to significant price and volume fluctuations in
response to market and other factors, including the following, some of which are
beyond our control:
o variations in our quarterly operating results from the
expectations of securities analysts or investors;
o downward revisions in securities analysts' estimates or
changes in general market conditions;
o announcements of technological innovations or new products
or services by us or our competitors;
32
o announcement by us or our competitors of significant
acquisitions, strategic partnerships, joint ventures or
capital commitments;
o additions or departures of key personnel;
o investor perception of our industry or our prospects;
o insider selling or buying;
o regulatory developments affecting our industry; and
o general technological or economic trends.
In the past, following periods of volatility in the market price of
their stock, many companies have been the subject of securities class action
litigation. If we became involved in securities class action litigation in the
future, it could result in substantial costs and diversion of our management's
attention and resources and could harm our stock price, business, prospects,
results of operations, and financial condition.
Future sales of our common stock could adversely affect our stock price.
Substantial sales of our common stock in the public market, or the
perception by the market that such sales could occur, could lower our stock
price or make it difficult for us to raise additional equity capital in the
future. As of November 30, 2002, we had 27,377,539 shares of common stock
outstanding, including the 2,100,000 shares issued to ISG's stockholders in the
acquisition.
In addition, as of November 30, 2002, 3,925,667 shares of Headwaters'
common stock were required to be reserved for issuance under Headwaters' stock
option and other benefit plans and 92,306 shares of our common stock were
required to be reserved for issuance pursuant to outstanding warrants. As of
November 30, 2002, options to purchase 3,456,871 shares of Headwaters' common
stock were issued and outstanding under Headwaters' stock option plans at a
weighted average exercise price of $9.04 per share, of which options to purchase
1,938,318 shares had vested. Warrants to purchase 92,306 shares of Headwaters
common stock are outstanding and are vested.
We cannot predict if future sales of our common stock, or the
availability of our common stock for sale, will harm the market price for our
common stock or our ability to raise capital by offering equity securities.
We do not pay dividends and do not anticipate paying any dividends in the
future, so any short-term return on your investment will depend on the market
price of our capital stock and/or our ability to make payments on our debt
securities.
Headwaters has never declared or paid cash dividends on its common
stock. We currently intend to retain any earnings to finance our operations and
growth. The terms and conditions of our senior secured credit facility and
senior subordinated debentures each restrict and limit payments or distributions
in respect of our capital stock. Therefore, we do not expect to pay any
dividends. Any short-term return on our investment will depend on the market
price for our shares and/or our ability to make payments on our debt securities.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Headwaters is exposed to financial market risks, primarily related to
changes in interest rates. Headwaters does not use derivative financial
instruments for speculative or trading purposes, and no significant derivative
financial instruments were outstanding as of September 30, 2002 or subsequent
thereto.
The majority of Headwaters' short-term investments, all of which are
classified as trading securities, consist of fixed-rate U.S. government
securities or securities backed by the U.S. government. Changes in interest
rates can affect the market value of these investments, which are carried at
market value in the consolidated balance sheets. The periodic adjustments to
reflect changes in market value are included in interest and net investment
income in the consolidated statements of operations. Based on the current amount
of short-term investments and expected near-term changes in the amount of
short-term investments, Headwaters does not expect any material near-term
investment losses to result from changes in interest rates.
As described in more detail in Note 8 to the consolidated financial
statements, Headwaters has outstanding $155.0 million of variable-rate long-term
debt as of September 30, 2002. The interest rate of this debt as of September
30, 2002 is approximately 5.9%, which rate is first subject to change in April
2003. At that time, Headwaters can lock in a rate for one, two, three, or six
months. A change in the interest rate of 1% would change
33
interest expense by less than $1.5 million per year, considering principal
repayments that are required beginning December 2002.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary financial data required by
this Item 8 are set forth in Item 15 of this Form 10-K. All information that has
been omitted is either inapplicable or not required.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
As described in more detail in the following paragraphs, Headwaters
dismissed Arthur Andersen LLP ("AA") as its independent accountants on May 10,
2002 and appointed PricewaterhouseCoopers LLP ("PwC"). On October 14, 2002,
Headwaters dismissed PwC and appointed Ernst & Young LLP ("E&Y").
On September 19, 2002, Headwaters acquired 100% of the common stock of
ISG. E&Y has audited ISG since its inception. ISG's revenues currently comprise
approximately 65% of the consolidated revenues of the combined entity and ISG
operates in 35 states and Canada. In addition, approximately 85% of Headwaters'
current employees came from the ISG acquisition. On October 14, 2002, Headwaters
decided to retain E&Y as its independent accountants for the new combined
company and accordingly dismissed PwC. The Registrant's Audit Committee
participated in and approved the decision to change independent accountants.
Headwaters has not consulted with E&Y on any application of accounting
principles or any other matter during the two fiscal years ended September 30,
2001 or subsequent thereto.
The reports of PwC on the financial statements for the past two fiscal
years contained no adverse opinion or disclaimer of opinion and were not
qualified or modified as to uncertainty, audit scope or accounting principle.
In connection with its audits for the two most recent fiscal years and
through October 14, 2002, there have been no disagreements with PwC on any
matter of accounting principles or practices, financial statement disclosure, or
auditing scope or procedure, which disagreements if not resolved to the
satisfaction of PwC would have caused them to make reference thereto in their
reports on the financial statements for such years.
During the two most recent fiscal years and through October 14, 2002,
there have been no reportable events (as defined in Regulation S-K Item
304(a)(1)(v)).
The Registrant requested that PwC furnish it with a letter addressed to
the Securities and Exchange Commission stating whether or not it agrees with the
above statements. A copy of such letter is filed as Exhibit 16 to this Form
10-K.
Due to events involving Headwaters' former auditors, AA, on May 10,
2002 Headwaters Incorporated dismissed AA as its independent accountants. The
Registrant's Audit Committee participated in and approved the decision to change
independent accountants.
The reports of AA on the financial statements for the two fiscal years
audited by them (fiscal 2000 and fiscal 2001) contained no adverse opinion or
disclaimer of opinion and were not qualified or modified as to uncertainty,
audit scope or accounting principle.
In connection with its audits for those two fiscal years and through
May 10, 2002, there were no disagreements with AA on any matter of accounting
principles or practices, financial statement disclosure, or auditing scope or
procedure, which disagreements if not resolved to the satisfaction of AA would
have caused them to make reference thereto in their reports on the financial
statements for such years.
During fiscal 2000 and fiscal 2001 and through May 10, 2002, there were
no reportable events (as defined in Regulation S-K Item 304(a)(1)(v)).
The Registrant requested that AA furnish it with a letter addressed to
the Securities and Exchange Commission stating whether or not it agrees with the
above statements. A copy of such letter is filed as Exhibit 16.1 to this Form
10-K.
34
On May 10, 2002, the audit committee appointed PwC as Headwaters'
independent accountants. Headwaters has not consulted with PwC on any
application of accounting principles or any other matter during the two fiscal
years ended September 30, 2001 or subsequent thereto, except for consultations
in the capacity as Headwaters' independent accountants up to July 19, 2000.
There were no disagreements with accountants on accounting or financial
statement disclosure subsequent to the appointment of AA on July 19, 2000.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information to be set forth under the captions "Executive Officers"
and "Proposal No. 1: Election of Directors" in Headwaters' Proxy Statement to be
filed in January 2003 for the Annual Meeting of Stockholders to be held in 2003
(the "Proxy Statement"), is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information to be set forth under the caption "Executive
Compensation and Related Information" in the Proxy Statement is incorporated
herein by reference; provided, however, that Headwaters specifically excludes
from such incorporation by reference any information set forth under the
captions "Compensation Committee Report on Executive Compensation" and
"Stockholder Return Performance Graph" in the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Security ownership of certain beneficial owners and management to be
set forth under the caption "Security Ownership of Directors, Nominees and
Principal Stockholders" in the Proxy Statement is incorporated herein by
reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information to be set forth under the caption "Transactions with
Related Parties" in the Proxy Statement is incorporated herein by reference.
PART IV
ITEM 14. CONTROLS AND PROCEDURES
Disclosure controls are procedures that are designed with an objective
of ensuring that information required to be disclosed in Headwaters' periodic
reports filed with the SEC, such as this Annual Report on Form 10-K, is
recorded, processed, summarized and reported within the time periods specified
by the SEC. Disclosure controls are also designed with an objective of ensuring
that such information is accumulated and communicated to Headwaters' management,
including the CEO and CFO, in order to allow timely consideration regarding
required disclosures.
The evaluation of Headwaters' disclosure controls by the CEO and CFO
included a review of the controls' objectives and design, the operation of the
controls, and the effect of the controls on the information presented in this
Annual Report. Headwaters' management, including the CEO and CFO, does not
expect that disclosure controls can or will prevent or detect all errors and all
fraud, if any. A control system, no matter how well designed and operated, can
provide only reasonable, not absolute, assurance that the objectives of the
control system are met. Also, projections of any evaluation of the disclosure
controls and procedures to future periods are subject to the risk
35
that the disclosure controls and procedures may become inadequate because of
changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.
Based on their review and evaluation as of a date within 90 days of the
filing of this Form 10-K, and subject to the inherent limitations all as
described above, Headwaters' Chief Executive Officer and Chief Financial Officer
have concluded that Headwaters' disclosure controls and procedures (as defined
in Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934) are
effective. They are not aware of any significant changes in Headwaters'
disclosure controls or in other factors that could significantly affect these
controls subsequent to the date of their evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
Consolidated Financial Statements of Headwaters Incorporated Page
Report of Independent Auditors for 2002 F-1
Report of Independent Accountants for 2000 and 2001 F-2
Consolidated Balance Sheets as of September 30, 2001 and 2002 F-3
Consolidated Statements of Income
for the years ended September 30, 2000, 2001 and 2002 F-5
Consolidated Statements of Changes in Stockholders' Equity
for the years ended September 30, 2000 and 2001 F-6
Consolidated Statement of Changes in Stockholders' Equity and
Comprehensive Income for the year ended September 30, 2002 F-8
Consolidated Statements of Cash Flows
for the years ended September 30, 2000, 2001 and 2002 F-9
Notes to Consolidated Financial Statements F-11
2. Financial Statement Schedules
All financial statement schedules for which provision is made in the
applicable accounting regulations of the Securities and Exchange Commission are
not required under the related instructions or are inapplicable, and therefore
have been omitted.
3. Listing of Exhibits
Certain other instruments which would otherwise be required to be
listed below have not been so listed because such instruments do not authorize
securities in an amount which exceeds 10% of the total assets of Headwaters and
its subsidiaries on a consolidated basis and Headwaters agrees to furnish a copy
of any such instrument to the Commission upon request.
For convenience, the name Headwaters is used throughout this listing
although in some cases the name Covol was used in the original instrument.
Exhibit No. Description Location
- ----------- ----------- --------
3.1.9 Restated Certificate of Incorporation of Headwaters dated August 14, 2001 (8)
3.2.4 Restated By-Laws of Headwaters *
10.11.3 Second Amended and Restated Sublicense and Binder Purchase and Sale Agreement *
dated December 4, 2001, among Central City Synfuel, LLC, Cobon Energy, LLC, and
Headwaters
10.45** License and Binder Purchase Agreement, dated December 14, 1997, between (2)
Appalachian Synfuel, LLC and Headwaters
10.50.1** Form of Amended and Restated License and Binder Purchase Agreement dated February (3)
3, 1998, between PC Virginia Synthetic Fuel #1, PC West Virginia Synthetic Fuel
#1, PC West Virginia Synthetic Fuel #2, PC West Virginia Synthetic Fuel #3 and
Headwaters
36
10.50.1.1*** Form of First Amendment to Amended and Restated License and Binder Purchase (6)
Agreement, dated March 31, 1999, between PC Virginia Synthetic Fuel #1; PC West
Virginia Synthetic Fuel #1; PC West Virginia Synthetic Fuel #2; PC West Virginia
Synthetic Fuel #3 and Headwaters
10.54 Employment Agreement effective May 1, 1998 with Steven G. Stewart (4)
10.60 Employment Agreement dated October 25, 2002 with Kirk A. Benson *
10.60.1 ISG Employment Agreement dated October 1, 2001 with R. Steve Creamer *
10.60.2 ISG Employment Agreement dated October 1, 2001 with J.I. Everest, II *
10.60.3 ISG Employment Agreement dated October 1, 2001 with Raul Deju *
10.65.3*** Amended and Restated License and Binder Purchase Agreement dated July 1, 2002 *
between Headwaters and Premier Elkhorn Coal Company
10.65.4*** Amended and Restated License and Binder Purchase Agreement dated July 1, 2002 *
between Headwaters and Clintwood Elkhorn Mining Company
10.67.2*** Amended and Restated Proprietary Reagent Supply and License Agreement dated June *
6, 2002 between DTE Smith Branch, LLC and Headwaters
10.69*** Settlement Agreement and Mutual Release dated May 25, 2000 among Headwaters and (5)
Birmingham Syn Fuel, L.L.C., PacifiCorp Syn Fuel, L.L.C., and PacifiCorp
Financial Services, Inc.
10.69.3*** License and Binder Purchase Agreement dated May 25, 2000 between Birmingham Syn (5)
Fuel, L.L.C. and Headwaters
10.69.4*** License and Binder Purchase Agreement dated May 25, 2000 between PacifiCorp Syn (5)
Fuel, L.L.C. and Headwaters (related to the Brookwood facility)
10.69.5*** License and Binder Purchase Agreement dated May 25, 2000 between PacifiCorp Syn (5)
Fuel, L.L.C. and Headwaters (related to the Pumpkin Center #1 facility)
10.69.6*** License and Binder Purchase Agreement dated May 25, 2000 between PacifiCorp Syn (5)
Fuel, L.L.C. and Headwaters (related to the Pumpkin Center #2 facility)
10.70*** Settlement Agreement and Release dated June 26, 2000 among Headwaters, Utah (5)
Synfuel #1, Ltd., Coaltech No. 1, L.P., AJG Financial Services, Inc. and Square D
Company
10.72 Agreement and Plan of Reorganization between Headwaters and Hydrocarbon (7)
Technologies, Inc. dated May 2, 2001
10.72.1 Share Exchange Agreement between Headwaters and Hydrocarbon Technologies, Inc. (7)
dated May 2, 2001
10.72.2 Amendment No. 1 to Agreement and Plan of Reorganization between Headwaters and (8)
Hydrocarbon Technologies, Inc. dated August 21, 2001
10.72.3 Amendment No. 1 to Share Exchange Agreement between Headwaters and Hydrocarbon (8)
Technologies, Inc. dated August 21, 2001
10.73 Contribution and Subscription Agreement among Headwaters and Avintaquin Capital, (9)
LLC dated September 24, 2001
10.73.1 Promissory Note from Avintaquin Capital, LLC in favor of Headwaters dated (9)
September 24, 2001
10.74 Asset Purchase Agreement between Headwaters and Red Hawk Energy, LLC dated (11)
December 28, 2001
10.75 Agreement and Plan of Merger between Headwaters and Industrial Services Group, (13)
Inc. dated July 15, 2002
10.75.1 Form of Registration Rights Agreement between Headwaters and the Stockholders of (13)
Industrial Services Group, dated as of September 19, 2002
10.75.2 First Amendment to Agreement and Plan of Merger and Equityholder Agreements among (14)
Headwaters, Industrial Services Group, Inc. and Equityholders of Industrial
Services Group, Inc. dated September 19, 2002
10.76 Senior Credit Agreement for $175,000,000 among Headwaters and various lenders (14)
dated September 19, 2002
10.77 Loan Agreement for $20,000,000 between Headwaters and Allied Capital Corporation (14)
dated September 19, 2002
10.77.1 Participation Agreement among Allied Capital Corporation, Headwaters and other (14)
Participants dated September 19, 2002
10.78*** ISG Replacement Agreement for Management of Ash and Other Byproducts dated *
September 2002
10.79*** ISG Agreement for Fly Ash dated May 22, 2001 *
12 Computation of ratio of earnings to fixed charges *
16 Letter regarding change in certifying accountant (15)
16.1 Letter regarding change in certifying accountant (Originally designated as (12)
Exhibit No. 16)
21.1 List of Subsidiaries of Headwaters *
23 Consent of Ernst & Young LLP *
37
23.1 Consent of PricewaterhouseCoopers LLP *
99.1 Amended 2000 Employee Stock Purchase Plan (originally designated as Exhibit No. (10)
99.2)
99.2 1995 Stock Option Plan (originally designated as Exhibit No. 10.5) (1)
99.2.1 First Amendment to the 1995 Stock Option Plan (originally designated as Exhibit (1)
10.5.1)
99.2.2 1996 Stock Option Agreement *
99.2.3 1998 Stock Option Agreement *
99.2.4 2001 Stock Option Agreement *
99.2.5 2002 Stock Option Agreement *
99.3 Headwaters Incentive Bonus Plan dated May 25, 2000 (6)
99.4 Amended Headwaters 2002 Stock Incentive Plan *
99.5 Section 906 Certification of Chief Executive Officer *
99.6 Section 906 Certification of Chief Financial Officer *
_______________________
* Filed herewith.
** Confidential treatment has been granted to certain portions of this exhibit, which portions have been
deleted and filed separately with the Securities and Exchange Commission.
*** This exhibit contains confidential material that has been omitted pursuant to a Confidential Treatment
Request. The omitted information has been filed separately with the Securities and Exchange Commission.
Unless another exhibit number is indicated as the exhibit number for the exhibit as "originally filed," the
exhibit number in the filing in which any exhibit was originally filed and to which reference is made hereby is
the same as the exhibit number assigned herein to the exhibit.
(1) Incorporated by reference to the indicated exhibit filed with Headwaters' Registration Statement on Form
10, filed February 26, 1996.
(2) Incorporated by reference to the indicated exhibit filed with Headwaters' Annual Report on Form 10-K for
the fiscal year ended September 30, 1997.
(3) Incorporated by reference to the indicated exhibit filed with Headwaters' Quarterly Report on Form 10-Q,
for the quarterly period ended March 31, 1998.
(4) Incorporated by reference to the indicated exhibit filed with Headwaters' Annual Report on Form 10-K,
for the fiscal year ended September 30, 1998.
(5) Incorporated by reference to the indicated exhibit filed with Headwaters' Quarterly Report on Form 10-Q
for the quarter ended June 30, 2000.
(6) Incorporated by reference to the indicated exhibit filed with Headwaters' Annual Report on Form 10-K for
the fiscal year ended September 30, 2000.
(7) Incorporated by reference to the indicated exhibit filed with Headwaters' Quarterly Report on Form 10-Q,
for the quarter ended June 30, 2001.
(8) Incorporated by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for events dated August 14, 2001 and August 28, 2001, filed September 12, 2001.
(9) Incorporated by reference to the indicated exhibit filed with Headwaters' Annual Report on Form 10-K,
for the fiscal year ended September 30, 2001.
(10) Incorporated by reference to the indicated exhibit filed with Headwaters' Quarterly Report on Form 10-Q,
for the quarter ended December 31, 2001.
(11) Incorporated by reference to the indicated exhibit filed with Headwaters' Quarterly Report on Form 10-Q,
for the quarter ended March 31, 2002.
(12) Incorporated by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated May 10, 2002, filed May 10, 2002.
(13) Incorporated by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated July 15, 2002, filed July 18, 2002.
(14) Incorporated by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated September 19, 2002, filed October 4, 2002.
(15) Incorporated by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated October 14, 2002, filed October 18, 2002.
38
Reports on Form 8-K
The following reports on Form 8-K were filed during the quarter ended
September 30, 2002:
o Form 8-K filed on July 18, 2002 for event dated July 15, 2002 (Probable
Acquisition of Industrial Services Group, Inc. ("ISG")). The following
financial statements of ISG and unaudited pro forma financial
information were filed with this Form 8-K:
Audited Financial Statements of ISG:
------------------------------------
Report of Independent Auditors
Consolidated Balance Sheets as of December 31, 2001 and 2000
Consolidated Statements of Operations for the Years Ended
December 31, 2001, 2000 and 1999
Consolidated Statements of Comprehensive Loss for the Years
Ended December 31, 2001, 2000 and 1999
Consolidated Statements of Shareholders' Equity (Deficit) for the
Years Ended December 31, 2001, 2000 and 1999
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2001, 2000 and 1999
Notes to Consolidated Financial Statements
Unaudited Financial Statements of ISG:
--------------------------------------
Condensed Consolidated Balance Sheets as of March 31, 2002 and
December 31, 2001
Condensed Consolidated Statements of Operations for the
Three Months Ended March 31, 2002 and 2001
Condensed Consolidated Statements of Comprehensive Loss for
the Three Months Ended March 31, 2002 and 2001
Condensed Consolidated Statements of Cash Flows for the Three
Months Ended March 31, 2002 and 2001
Notes to Condensed Consolidated Financial Statements
Unaudited Pro Forma Financial Information for Headwaters Incorporated:
----------------------------------------------------------------------
Introduction to Pro Forma Financial Information
Pro Forma Condensed Combined Balance Sheet as of March 31, 2002
Pro Forma Condensed Combined Statement of Income for the Year Ended
September 30, 2001
Pro Forma Condensed Combined Statement of Income for the Six Months
Ended March 31, 2002
Notes to Pro Forma Condensed Combined Financial Information
o Form 8-K filed on July 22, 2002 for events dated August 28, 2001 and
July 15, 2002 (Probable Acquisition of ISG and Acquisition of
Hydrocarbon Technologies, Inc.). The following unaudited pro forma
financial information was filed with this Form 8-K:
Introduction to Pro Forma Financial Information
Pro Forma Condensed Combined Statement of Income for the Year
Ended September 30, 2001
Notes to Pro Forma Condensed Combined Statement of Income
In addition to the Forms 8-K filed during the quarter ended September
30, 2002, Headwaters filed the following Forms 8-K subsequent to
September 30, 2002:
o Form 8-K filed on October 4, 2002 for event dated September 19, 2002
(Acquisition of ISG). The following financial statements of ISG and
unaudited pro forma financial information were filed with this Form
8-K:
Unaudited Financial Statements of ISG:
--------------------------------------
Condensed Consolidated Balance Sheets as of June 30, 2002 and
December 31, 2001
Condensed Consolidated Statements of Operations for the Three
and Six Months Ended June 30, 2002 and 2001
Condensed Consolidated Statements of Comprehensive Income (Loss)
for the Three and Six Months Ended June 30, 2002 and 2001
39
Condensed Consolidated Statements of Cash Flows for the Six Months
Ended June 30, 2002 and 2001
Notes to Condensed Consolidated Financial Statements
Unaudited Pro Forma Financial Information for Headwaters
Incorporated:
--------------------------------------------------------
Introduction to Pro Forma Financial Information
Pro Forma Condensed Combined Balance Sheet as of June 30, 2002
Pro Forma Condensed Combined Statement of Income for the Year Ended
September 30, 2001
Pro Forma Condensed Combined Statement of Income for the Nine
Months Ended June 30, 2002
Notes to Pro Forma Condensed Combined Financial Information
o Form 8-K filed on October 18, 2002 for event dated October 14, 2002
(Change in Registrant's Certifying Accountant).
o Form 8-K filed on October 22, 2002 for event dated October 22, 2002
(Updated List of Risk Factors for Outstanding Effective Forms S-3
and S-8).
Exhibits
The response to this portion of Item 15 is submitted as a separate
section of this report. See Item 15 (a) 3 above.
Financial Statement Schedules
The response to this portion of Item 15 is submitted as a separate
section of this report. See Item 15 (a) 2 above.
40
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
HEADWATERS INCORPORATED
By: /s/ Kirk A. Benson
------------------------------
Kirk A. Benson
Chief Executive Officer and
Principal Executive Officer
By: /s/ Steven G. Stewart
------------------------------
Steven G. Stewart
Chief Financial Officer and
Principal Financial Officer
Date: December 23, 2002
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
/s/ Kirk A. Benson Chief Executive Officer December 23, 2002
- ------------------------- (Principal Executive Officer)
Kirk A. Benson and Director
/s/ Steven G. Stewart Chief Financial Officer December 23, 2002
- ------------------------- (Principal Financial and
Steven G. Stewart Accounting Officer)
/s/ James A. Herickhoff Director December 23, 2002
- -------------------------
James A. Herickhoff
/s/ Raymond J. Weller Director December 23, 2002
- -------------------------
Raymond J. Weller
/s/ Ronald S. Tanner Director December 23, 2002
- -------------------------
Ronald S. Tanner
/s/ E. J. "Jake" Garn Director December 23, 2002
- -------------------------
E. J. "Jake" Garn
/s/ Alfred G. Comolli Director December 23, 2002
- --------------------------
Alfred G. Comolli
/s/ L.K. (Theo) Lee Director December 23, 2002
- --------------------------
L.K. (Theo) Lee
41
CERTIFICATION PURSUANT TO SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
I, Kirk A. Benson, certify that:
1. I have reviewed this Annual Report on Form 10-K of Headwaters
Incorporated;
2. Based on my knowledge, this Annual Report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this Annual Report;
3. Based on my knowledge, the financial statements, and other financial
information included in this Annual Report, fairly present in all
material respects the financial condition, results of operations and
cash flows of Headwaters as of, and for, the periods presented in this
Annual Report;
4. Headwaters' other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for Headwaters and
have:
a) designed such disclosure controls and procedures to ensure
that material information relating to Headwaters, including
its consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
this Annual Report is being prepared;
b) evaluated the effectiveness of Headwaters' disclosure controls
and procedures as of a date within 90 days prior to the filing
date of this Annual Report (the "Evaluation Date"); and
c) presented in this Annual Report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. Headwaters' other certifying officer and I have disclosed, based on our
most recent evaluation, to Headwaters' auditors and the audit committee
of Headwaters' board of directors:
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect Headwaters'
ability to record, process, summarize and report financial
data and have identified for Headwaters' auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in Headwaters'
internal controls; and
6. Headwaters' other certifying officer and I have indicated in this
Annual Report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: December 23, 2002
/s/ Kirk A. Benson
----------------------------
Kirk A. Benson
Chief Executive Officer
42
CERTIFICATION PURSUANT TO SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
I, Steven G. Stewart, certify that:
1. I have reviewed this Annual Report on Form 10-K of Headwaters
Incorporated;
2. Based on my knowledge, this Annual Report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this Annual Report;
3. Based on my knowledge, the financial statements, and other financial
information included in this Annual Report, fairly present in all
material respects the financial condition, results of operations and
cash flows of Headwaters as of, and for, the periods presented in this
Annual Report;
4. Headwaters' other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for Headwaters and
have:
(a) designed such disclosure controls and procedures to ensure
that material information relating to Headwaters, including
its consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
this Annual Report is being prepared;
(b) evaluated the effectiveness of Headwaters' disclosure controls
and procedures as of a date within 90 days prior to the filing
date of this Annual Report (the "Evaluation Date"); and
(c) presented in this Annual Report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. Headwaters' other certifying officer and I have disclosed, based on our
most recent evaluation, to Headwaters' auditors and the audit committee
of Headwaters' board of directors:
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect Headwaters'
ability to record, process, summarize and report financial
data and have identified for Headwaters' auditors any material
weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management
or other employees who have a significant role in Headwaters'
internal controls; and
6. Headwaters' other certifying officer and I have indicated in this
Annual Report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: December 23, 2002
/s/ Steven G. Stewart
----------------------------
Steven G. Stewart
Chief Financial Officer
43
Report of Independent Auditors for 2002
The Board of Directors and Stockholders
Headwaters Incorporated
We have audited the accompanying consolidated balance sheet of Headwaters
Incorporated as of September 30, 2002, and the related consolidated statements
of income, changes in stockholders' equity and comprehensive income, and cash
flows for the year then ended. These financial statements are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Headwaters
Incorporated at September 30, 2002, and the consolidated results of its
operations and its cash flows for the year then ended, in conformity with
accounting principles generally accepted in the United States.
/s/ Ernst & Young LLP
Salt Lake City, Utah
November 15, 2002
F-1
Report of Independent Accountants
To the Board of Directors and Stockholders
of Headwaters Incorporated:
In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of income, changes in stockholders' equity, and cash
flows present fairly, in all material respects, the financial position of
Headwaters Incorporated and its subsidiaries at September 30, 2001, and the
results of their operations and their cash flows for each of the two years in
the period ended September 30, 2001 in conformity with accounting principles
generally accepted in the United States of America. These financial statements
are the responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Salt Lake City, Utah
July 15, 2002
F-2
HEADWATERS INCORPORATED
CONSOLIDATED BALANCE SHEETS
As of September 30,
(thousands of dollars) 2001 2002
- -------------------------------------------------------------------------------------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 999 $ 7,284
Short-term investments 6,048 5,907
Trade receivables, net 8,887 50,331
Inventories 592 8,442
Short-term notes and accrued interest receivable 6,857 377
Deferred income taxes 120 1,814
Other current assets 545 3,778
-------------------------------
Total current assets 24,048 77,933
-------------------------------
Property, plant and equipment, net 2,680 50,549
-------------------------------
Other assets:
Notes and accrued interest receivable 4,000 4,593
Intangible assets, net 10,752 118,918
Goodwill -- 113,367
Debt issue costs and other assets 805 7,497
Deferred income taxes 13,090 --
-------------------------------
Total other assets 28,647 244,375
-------------------------------
Total assets $ 55,375 $ 372,857
==============================
See accompanying notes.
F-3
HEADWATERS INCORPORATED
CONSOLIDATED BALANCE SHEETS, continued
As of September 30,
(thousands of dollars and shares) 2001 2002
- -------------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 2,203 $ 20,773
Accrued personnel costs 2,777 7,293
Other accrued liabilities 4,987 14,888
Current portion of long-term debt 4,356 15,578
Current portion of unamortized non-refundable license fees 1,106 4,378
-------------------------------
Total current liabilities 15,429 62,910
-------------------------------
Long-term liabilities:
Long-term debt 149 154,552
Deferred income taxes -- 51,357
Unamortized non-refundable license fees 5,805 5,010
Other long-term liabilities 2,906 432
-------------------------------
Total long-term liabilities 8,860 211,351
-------------------------------
Total liabilities 24,289 274,261
-------------------------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.001 par value; authorized 50,000 shares; issued
and outstanding: 23,807 shares at September 30, 2001 (including
548 shares held in treasury) and 27,327 shares at September 30, 2002
(including 526 shares held in treasury) 24 27
Capital in excess of par value 83,226 126,265
Accumulated deficit (48,704) (24,418)
Treasury stock, at cost (3,038) (3,013)
Other (422) (265)
-------------------------------
Total stockholders' equity 31,086 98,596
-------------------------------
Total liabilities and stockholders' equity $ 55,375 $ 372,857
===============================
See accompanying notes.
F-4
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF INCOME
Year ended September 30,
(thousands of dollars, except per-share data) 2000 2001 2002
- -----------------------------------------------------------------------------------------------------------------------------
Revenue:
Chemical reagent sales $ 9,757 $ 22,407 $ 74,419
License fees 17,315 20,765 30,456
Coal combustion product sales and services -- -- 6,818
Manufactured product sales -- -- 1,774
Other revenues 814 2,292 5,878
-------------------------------------------------------
Total revenue 27,886 45,464 119,345
-------------------------------------------------------
Operating costs and expenses:
Cost of chemical reagents 6,617 14,524 50,134
Cost of coal combustion products and services -- -- 3,764
Cost of manufactured products -- -- 1,388
Cost of other revenues -- -- 5,244
Depreciation and amortization 1,176 355 1,760
Research and development -- 2,400 2,322
Selling, general and administrative 8,006 8,554 13,699
Asset write-offs and other charges 17,758 -- --
-------------------------------------------------------
Total operating costs and expenses 33,557 25,833 78,311
-------------------------------------------------------
Operating income (loss) (5,671) 19,631 41,034
-------------------------------------------------------
Other income (expense):
Interest and net investment income 1,775 726 1,000
Interest expense (4,814) (224) (553)
Losses on notes receivable and equity investments (746) (6,265) (743)
Net gains on sale of facilities 16,870 -- --
Other, net 1,228 600 (502)
-------------------------------------------------------
Total other income (expense), net 14,313 (5,163) (798)
-------------------------------------------------------
Income before income taxes and extraordinary item 8,642 14,468 40,236
Income tax benefit (provision) 2,900 7,049 (15,950)
-------------------------------------------------------
Income before extraordinary item 11,542 21,517 24,286
Extraordinary loss on early extinguishment of debt (7,860) -- --
-------------------------------------------------------
Net income $ 3,682 $ 21,517 $ 24,286
=======================================================
Basic net income per common share $ 0.07 $ 0.94 $ 1.00
=======================================================
Diluted net income per common share $ 0.07 $ 0.87 $ 0.94
=======================================================
See accompanying notes.
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Other
-----------------------------
Notes and
interest
receivable
-related
parties, from
issuance of,
Convertible Common Deferred or
Preferred Stock Common Stock Capital in stock compensation collateralized
(thousands of --------------- ---------------- excess of par Accumulated held in from stock by, common
dollars and shares) Shares Amount Shares Amount value deficit treasury options stock
- ------------------------------- ------- ------ ------ ------ ------------- ------------ ----------- ------------- --------------
Balances as of
September 30, 1999 17 $1 12,766 $13 $78,457 $(71,713) $ -- $(1,222) $(6,564)
Preferred stock cash dividends (297)
Reclassification of redeemable
convertible preferred stock to
convertible preferred stock 38 -- 2,710
Common stock issued on
conversion of convertible
preferred stock and in payment
of dividends (2) -- 2,812 3 1,631 (11)
Redemption of convertible
preferred stock (36) -- (2,572) (1,882)
Common stock issued for cash 4,008 4 5,250
Common stock issued on
conversion of debt 3,726 3 2,961
Common stock issued in connection
with redemption of debt 214 -- 256
Common stock issued in connection
with cash and cashless exercises
of warrants and options 985 1 658
Value of common stock warrants
and options issued in connection
with convertible debt financing
and debt extension -- -- 538
Purchase and cancellation
of warrants (149)
Cancellation of related party
notes receivable and common
stock collateralizing the notes (812) (1) (5,944) 6,164
Write-up of related party
note receivable (66)
Purchase of 586 shares of
treasury stock, at cost (1,897)
14 shares of treasury stock
transferred to employee stock
purchase plan, at cost 26
Cancellation of 358 shares of
treasury stock (358) -- (1,137) 1,137
Amortization of deferred
compensation from stock options 707
Net income for the year ended
September 30, 2000 3,682
-- -- ------ --- ------- -------- -------- ------- -------
Balances as of
September 30, 2000 17 $1 23,341 $23 $82,659 $(70,221) $ (734) $ (515) $ (466)
-- -- ------ --- ------- -------- -------- ------- -------
See accompanying notes.
F-6
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY, continued
Other
-----------------------------
Notes and
interest
receivable
-related
parties, from
issuance of,
Convertible Common Deferred or
Preferred Stock Common Stock Capital in stock compensation collateralized
(thousands of --------------- ---------------- excess of par Accumulated held in from stock by, common
dollars and shares) Shares Amount Shares Amount value deficit treasury options stock
- ------------------------------- ------- ------ ------ ------ ------------- ------------ ----------- ------------- --------------
Balances as of
September 30, 2000 17 $1 23,341 $23 $82,659 $(70,221) $ (734) $(515) $ (466)
Common stock issued on
conversion of convertible
preferred stock (17) (1) 443 -- --
Preferred stock cash dividends (695)
Exercise of stock options
and warrants 860 1 1,925
Common stock issued in
connection with purchase of
Hydrocarbon Technologies, Inc.,
net of estimated registration
costs 593 1 5,434
Common stock options issued in
connection with purchase of
Hydrocarbon Technologies, Inc. 1,325
Tax benefit from exercise of
stock options 1,690
Write-up of related party note
receivable to collateral value (541)
Cancellation of related party
note receivable and transfer of
collateral shares to treasury
stock (1,007) 1,007
Purchase of 1,648 shares of
treasury stock, at cost (10,510)
34 shares of treasury stock
transferred to employee stock
purchase plan, at cost 101
Cancellation of 1,430 shares
of treasury stock (1,430) (1) (9,112) 9,112
Amortization of deferred
compensation from stock options 93
Net income for the year ended
September 30, 2001 21,517
--------------------------------------------------------------------------------------------------
Balances as of
September 30, 2001 -- $-- 23,807 $24 $83,226 $(48,704) $(3,038) $(422) $ --
--------------------------------------------------------------------------------------------------
See accompanying notes.
F-7
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
AND COMPREHENSIVE INCOME
Other
------------------------------
Convertible Common Deferred Accumulated
Preferred Stock Common Stock Capital in stock compensation foreign currency
(thousands of --------------- ---------------- excess of par Accumulated held in from stock translation
dollars and shares) Shares Amount Shares Amount value deficit treasury options adjustment
- ------------------------------- ------- ------ ------ ------ ------------- ------------ ----------- ------------- --------------
Balances as of
September 30, 2001 -- $-- 23,807 $24 $ 83,226 $(48,704) $(3,038) $(422) $ --
Exercise of stock options
and warrants 1,315 1 5,383
Tax benefit from exercise
of stock options 2,990
Common stock issued in connection
with acquisition of
Hydrocarbon Technologies, Inc. 178 -- 2,823
Common stock issued in
connection with acquisition of
Industrial Services Group, Inc. 2,100 2 32,716
Purchase of 83 shares of
treasury stock, at cost (1,188)
32 shares of treasury stock
transferred to employee stock
purchase plan, at cost 214 126
Cancellation of 73 shares
of treasury stock (73) -- (1,087) 1,087
Amortization of deferred
compensation from stock options 93
Net income for the year
ended September 30, 2002 24,286
Other comprehensive income -
foreign currency translation
adjustment (total comprehensive
income is $24,350) 64
-----------------------------------------------------------------------------------------------
Balances as of
September 30, 2002 -- $-- 27,327 $27 $126,265 $(24,418) $(3,013) $(329) $ 64
===============================================================================================
See accompanying notes.
F-8
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year ended September 30,
(thousands of dollars) 2000 2001 2002
- --------------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ 3,682 $ 21,517 $ 24,286
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Deferred income taxes (3,000) (9,160) 11,540
Income tax benefit from exercise of stock options -- 1,690 2,990
Depreciation and amortization 1,176 355 1,760
Amortization of non-refundable license fees (802) (2,015) (1,471)
Interest expense related to amortization of debt discount and debt issuance costs 3,034 79 136
Net gain on sale of facilities, property, plant and equipment (16,894) (42) (1,249)
Write-down of notes receivable and related accrued interest -- 3,200 986
Losses on equity investments, write-offs and provisions for unrealizable investments 746 3,018 --
Acquired in-process research and development -- 2,400 --
Write-up of related party note receivable (66) (541) --
Gains on other transactions (1,079) -- --
Non-cash portion of asset write-offs and other charges 16,037 -- --
Extraordinary loss on early extinguishment of debt 7,860 -- --
Other changes in operating assets and liabilities, net of effect of acquisitions
of Industrial Services Group, Inc. and Hydrocarbon Technologies, Inc.:
Short-term trading investments (6,973) 925 141
Receivables (3,968) (987) (7,742)
Other current assets 161 26 351
Accounts payable and accrued liabilities (1,804) 958 7,193
Unamortized non-refundable license fees 1,587 (1,587) 3,982
Other, net (62) (27) (126)
------------------------------------------
Net cash provided by (used in) operating activities (365) 19,809 42,777
------------------------------------------
Cash flows from investing activities:
Payments for acquisition of Industrial Services Group, Inc.,
net of cash acquired -- -- (205,900)
Payments for acquisition of Hydrocarbon Technologies, Inc.,
net of cash acquired -- (4,845) (419)
Collections on notes receivable -- -- 6,912
Purchase of property, plant and equipment (403) (170) (796)
Net proceeds from disposition of facilities, property, plant and equipment 42,334 168 115
Investments in and loans to non-affiliated companies (4,005) (4,636) (294)
Net decrease (increase) in other assets 834 (180) (40)
------------------------------------------
Net cash provided by (used in) investing activities 38,760 (9,663) (200,422)
------------------------------------------
Cash flows from financing activities:
Net proceeds from issuance of long-term debt and warrants 6,980 8,991 165,806
Payments on long-term debt, including redemption premiums (43,995) (9,941) (6,412)
Proceeds from exercise of options and warrants 659 1,926 5,384
Purchase of common stock for the treasury, net of employee stock purchases (1,871) (10,409) (848)
Preferred stock dividends (297) (695) --
Preferred stock redemptions (4,454) -- --
Net proceeds from issuance of common stock and warrants 5,254 -- --
Other, net (149) (2) --
------------------------------------------
Net cash provided by (used in) financing activities (37,873) (10,130) 163,930
------------------------------------------
Net increase in cash and cash equivalents 522 16 6,285
Cash and cash equivalents, beginning of year 461 983 999
------------------------------------------
Cash and cash equivalents, end of year $ 983 $ 999 $ 7,284
========================================
See accompanying notes.
F-9
HEADWATERS INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
Year ended September 30,
(thousands of dollars) 2000 2001 2002
- --------------------------------------------------------------------------------------------------------------------------------
Supplemental schedule of non-cash investing and financing activities:
Common stock issued in connection with acquisition of
Industrial Services Group, Inc. $ -- $ -- $ 32,718
Common stock issued in connection with acquisition of
Hydrocarbon Technologies, Inc. -- 5,435 2,823
Common stock options issued in connection with acquisition of
Hydrocarbon Technologies, Inc. -- 1,325 --
Cancellation of treasury stock (1,137) (9,112) (1,087)
Exchange of equity investments in and loans to non-affiliated companies for
long-term note receivable from non-affiliate -- 4,000 --
Common stock issued on conversion of convertible preferred stock and in
payment of dividends 1,634 3,100 --
Cancellation of related party note receivable and transfer of collateral shares
to treasury stock -- 1,007 --
Cancellation of notes receivable - related parties and common stock
collateralizing the notes 6,164 -- --
Common stock issued on conversion of convertible debt, debt and related
accrued interest 2,964 -- --
Reclassification of redeemable convertible preferred stock to convertible
preferred stock 2,710 -- --
Supplemental disclosure of cash flow information:
Cash paid for interest $ 10,458 $ 269 $ 39
Cash paid for income taxes -- 283 322
See accompanying notes.
F-10
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
___________
1. Organization and Description of Business
Headwaters Incorporated was incorporated in Delaware. Headwaters owns 100%
of Industrial Services Group, Inc. ("ISG"), a Utah-based company formed in
1997 and acquired by Headwaters in September 2002 (see Note 3). Headwaters
also owns 100% of Hydrocarbon Technologies, Inc. ("HTI"), a New Jersey
company formed in 1995 and acquired by Headwaters in August 2001.
Headwaters' fiscal year ends on September 30 and unless otherwise noted, all
future references to years refer to Headwaters' fiscal year rather than a
calendar year.
Headwaters develops and deploys alternative fuel- and energy-related
technologies and services that maximize the value of fossil fuels while
creating new energy technologies for the future. 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. Currently, Headwaters has licensed its technology to the owners of
28 alternative fuel facilities which are operating at various levels of
production in ten states. ISG is the nation's largest provider of coal
combustion products ("CCPs") management and marketing services to the
electric power industry, serving more than 100 coal-fired electric power
generation plants nationwide. Through its distribution network of over 130
locations, ISG is the leading provider of high quality fly ash to the
building products and ready mixed concrete industries in the United States.
ISG's manufactured products division develops, manufactures and distributes
value-added fly ash-based concrete, stucco, mortar and block products. ISG
also develops and deploys technologies for maintaining and improving fly ash
quality. HTI develops and commercializes catalyst and nano-catalyst
technologies to convert coal and heavy oils into environment-friendly,
higher-value liquid fuels. Headwaters intends to expand its business through
growth of existing operations and strategic acquisitions of entities that
operate in adjacent industries.
2. Summary of Significant Accounting Policies
Principles of Consolidation - The consolidated financial statements include
the accounts of Headwaters and all of its subsidiaries, only two of which
have significant operations, ISG and HTI. All significant intercompany
transactions and accounts are eliminated in consolidation. ISG was acquired
on September 19, 2002 and accordingly, ISG's results of operations for the
period from September 19, 2002 through September 30, 2002 have been
consolidated with Headwaters' 2002 results. Due to the time required to
obtain accurate financial information related to HTI's foreign contracts,
for financial reporting purposes HTI's financial statements are consolidated
with Headwaters' financial statements using a one-month lag. Accordingly,
HTI's August 2001 acquisition date balance sheet was consolidated with
Headwaters' September 30, 2001 balance sheet, but no results of operations
of HTI were included in the consolidated statement of income for 2001. HTI's
August 31, 2002 balance sheet was consolidated with Headwaters' September
30, 2002 balance sheet and HTI's results of operations for the year ended
August 31, 2002 were consolidated with Headwaters' 2002 results.
Segment Reporting, Major Customers and Concentrations of Risk - Until
Headwaters acquired ISG in September 2002, Headwaters operated in and
reported as a single industry segment, alternative energy. With the
acquisition of ISG in September 2002, Headwaters now operates in three
business segments, alternative energy, CCPs, and manufactured products.
Additional information about these segments is presented in Note 4. The
following table presents revenues for all customers that accounted for over
10% of total revenue during 2000, 2001 or 2002. All of these revenues are
attributable to the alternative energy segment, and most of the named
customers are energy companies.
(thousands of dollars) 2000 2001 2002
--------------------------------------------------------------------------------------------
TECO Coal Corporation affiliates Less than 10% $16,044 $20,292
DTE Energy Services, Inc. affiliates Less than 10% 5,111 19,660
Marriott International, Inc. affiliates Less than 10% Less than 10% 19,105
AIG Financial Products Corp. affiliates Less than 10% Less than 10% 16,900
PacifiCorp affiliates $15,511 4,978 Less than 10%
Pace Carbon Fuels, L.L.C. affiliates Less than 10% 4,675 Less than 10%
Fluor Corporation affiliate 3,138 Less than 10% Less than 10%
F-11
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
At September 30, 2002, Headwaters had trade receivable balances totaling
approximately $8,584,000 from the four most significant customers.
Substantially all of Headwaters' revenues were generated from sales in the
United States. Headwaters purchases all of the chemical reagent that is sold
to licensees and other customers from a single large international chemical
company. Management believes that if necessary, the chemical reagent could
be obtained from other suppliers. Headwaters has no other significant
unusual credit risks or concentrations.
Revenue Recognition - Alternative Energy Segment. There are 28 alternative
fuel facilities that currently utilize Headwaters' patented technology and
from which Headwaters earns license fees and/or profits from the sale of
chemical reagents. Non-refundable advance license fees and royalty payments
have been received from certain licensees under various terms and
conditions. These non-refundable license fees and royalties have been
deferred and are being recognized on a straight-line basis over the period
covered by the related license and royalty agreements, generally through
calendar 2007. Recurring license fees or royalty payments are recognized in
the period when earned, which generally coincides with the sale of
alternative fuel by Headwaters' licensees. In certain instances, Headwaters
is required to pay to third parties a portion of license fees received or
cash proceeds from the sale of chemical reagents. In such cases, Headwaters
records the net proceeds as revenue. Revenues from the sale of chemical
reagents are recognized upon delivery of product to the licensee or
non-licensee customer.
HTI's revenue consists primarily of contract services for businesses and
U.S. government agencies and is included in the caption "Other revenues" in
the consolidated statements of income. HTI's costs related to service
revenue are included in "Cost of other revenues." In accounting for
long-term contracts, HTI primarily uses the percentage of completion method
of accounting, on the basis of the relationship between effort expended and
total estimated effort for the contract. If estimates of costs to complete a
contract indicate a loss, a provision is made for the total anticipated
loss.
CCP and Manufactured Products Segments. Revenue from the sale of CCPs and
manufactured products is recognized upon passage of title to the customer,
which generally coincides with physical delivery and acceptance. CCP
revenues generally include transportation charges associated with delivering
the material. Service revenues include revenues earned under long-term
contracts to dispose of residual materials created by coal-fired power
generation and revenues earned in connection with certain
construction-related projects that are incidental to ISG's primary business.
Service revenues under long-term contracts are recognized concurrently with
the removal of the material and are typically based on the number of tons of
material removed at an established price per ton. Contracts generally range
from five to fifteen years, with most contracts being renewed upon
expiration. Construction-related projects are generally billed on a time and
materials basis; therefore, the revenues and related costs are recognized
when the time is incurred and the materials are used.
The cost of CCPs sold primarily represents amounts paid to utility companies
to purchase product together with storage and transportation costs to
deliver the product to the customer. Cost of services sold includes landfill
fees and transportation charges to deliver the product to the landfill.
Cash and Cash Equivalents - Headwaters considers all highly liquid debt
instruments with an original maturity of three months or less to be cash
equivalents. Certain cash and cash equivalents are deposited with financial
institutions and at times such amounts may exceed insured depository limits.
Short-term Investments - Short-term investments consist primarily of
mortgage- and other asset-backed securities, corporate bonds, U.S.
government securities, and equity securities. By policy, Headwaters invests
primarily in U.S. government securities or securities backed by the U.S.
government. All investments are defined as trading securities and are stated
at market value as determined by the most recently traded price of each
security at the balance sheet date. Unrealized gains and losses are included
in earnings. Approximately $16,000 of investment losses in 2001 and
approximately $285,000 of investment gains in 2002 related to securities
held at September 30, 2001 and 2002, respectively.
Receivables - Allowances are provided for uncollectible accounts when deemed
necessary. Such allowances are based on an account-by-account analysis of
collectibility or impairment and totaled $0 at September 30, 2001 and
approximately $412,000 at September 30, 2002 for trade receivables and $0 at
September 30, 2001 and 2002 for notes receivable.
F-12
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
Headwaters performs periodic credit evaluations of its customers, but
collateral is not required for trade receivables. Collateral, generally
consisting of most or all assets of the debtor, is required for notes
receivable. Losses recognized on notes receivable were $0 in 2000,
approximately $3,658,000 in 2001 and approximately $743,000 in 2002. Because
the notes generally relate to nonoperating activities, these losses are
included in other expense in the consolidated statements of income.
Inventories - Inventories are stated at the lower of cost (first-in,
first-out) or market (net realizable value). Inventories consisted of the
following at September 30:
(thousands of dollars) 2001 2002
----------------------------------------------------------------------
Raw materials $ -- $1,198
Finished goods 592 7,244
----------------------
$592 $8,442
======================
Property, Plant and Equipment - Property, plant and equipment are recorded
at cost. Major improvements are capitalized; maintenance, repairs and minor
improvements are charged to expense as incurred. Assets are depreciated
using the straight-line method over their estimated useful lives, limited to
the lease terms for improvements to leased assets. Upon the sale or
retirement of property, plant and equipment, any gain or loss on disposition
is reflected in results of operations, and the related asset cost and
accumulated depreciation are removed from the respective accounts.
Intangible Assets and Goodwill - Intangible assets consist primarily of
identifiable intangible assets obtained in connection with the acquisitions
of ISG (long-term contracts and patents) and HTI (existing patented
technology). These intangible assets are being amortized on the
straight-line method over their remaining estimated useful lives as of the
respective acquisition dates. Goodwill consists of the excess of the
purchase price for ISG and HTI over the fair value of identified assets
acquired, net of liabilities assumed. Goodwill is not amortized, but is
periodically tested for impairment.
Headwaters has implemented Statement of Financial Accounting Standards
("SFAS") No. 142, "Accounting for Goodwill and Intangible Assets," with the
exception of certain additional disclosures which may not be early
implemented. Full implementation of SFAS No. 142 will require certain
additional disclosures regarding ISG's and HTI's identified intangible
assets and goodwill beginning October 1, 2002. In addition, SFAS No. 142,
when fully implemented in fiscal 2003, will require Headwaters to review for
impairment those intangible assets and goodwill in accordance with the
requirements of SFAS No. 142, instead of following the existing rules for
impairment testing. The new rules require, among other things, that goodwill
be tested for impairment at least annually using a two-step process that
begins with an estimation of the fair value of the reporting unit giving
rise to the goodwill. Headwaters currently believes that neither the ISG-
nor HTI-related identifiable assets and goodwill are impaired under either
the existing rules for testing impairment, or under the new rules required
by SFAS No. 142.
Valuation of Long-Lived Assets - Headwaters periodically evaluates the
carrying value of long-lived assets, including intangible assets and
goodwill, as well as the related amortization periods, to determine whether
adjustments to these amounts or to the useful lives are required based on
current events and circumstances. The carrying value of a long-lived asset
is considered impaired when the anticipated cumulative undiscounted cash
flow from that asset is less than its carrying value. In that event, a loss
is recognized based on the amount by which the carrying value exceeds the
fair market value of the long-lived asset. Impairment-related losses
recognized in Headwaters' consolidated statement of income for 2000 are more
fully described in Note 14. There were no losses recorded in 2001 or 2002.
Debt Issue Costs - Debt issue costs represent direct costs incurred related
to the issuance of the long-term debt used to acquire ISG. These costs are
amortized to interest expense over the lives of the respective debt issues
using the effective interest method.
Equity Investments - In 2000 and 2001, Headwaters recognized approximately
$100,000 and $2,607,000, respectively, of losses related to its equity in
investments accounted for using the equity method. These losses are included
in other expense in the consolidated statements of income. Headwaters had no
equity investments at September 30, 2001 or 2002.
F-13
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
Research and Product Development Costs - Research and product development
costs are expensed as incurred.
Income Taxes - Headwaters accounts for income taxes using the asset and
liability approach. Headwaters recognizes deferred income tax assets or
liabilities for the expected future tax consequences of events that have
been recognized in the financial statements or income tax returns. Deferred
income tax assets or liabilities are determined based upon the differences
between the financial statement and tax bases of assets and liabilities
using enacted tax rates expected to apply when the differences are expected
to be settled or realized. Deferred income tax assets are reviewed
periodically for recoverability and valuation allowances are provided as
necessary. Headwaters files a consolidated tax return with its subsidiaries.
Common Stock, Options and Warrants - Common stock issued for services is
accounted for using the fair value of the shares of common stock, determined
at the time the services are provided and the liability is incurred. As
described in Note 11, Headwaters continues to apply Accounting Principles
Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25")
and related interpretations in accounting for options granted to employees
and directors. The measurement date used to value non-employee option grants
is generally the date at which the recipient's performance is complete. Such
options, as well as warrants issued in connection with debt and equity
financings, including repricings and extensions of option and warrant
expiration dates, are valued using the Black-Scholes model. If modifications
to existing options or warrants relating to debt securities occur, the
incremental value of the modified options or warrants is capitalized and
amortized to interest expense over the remaining life of the related debt.
Income Per Share Calculation - Income per share has been computed based on
the weighted-average number of common shares outstanding. Diluted income per
share computations reflect the increase in weighted-average common shares
outstanding that would result from the assumed exercise of outstanding stock
options and warrants, calculated using the treasury stock method, and the
assumed conversion of convertible securities, using the if-converted method,
where such options, warrants, and convertible securities are dilutive.
Use of Estimates - The preparation of financial statements in conformity
with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements, and the reported
amounts of revenue and expenses during the reporting period. Actual results
could differ materially from those estimates.
Reclassifications - Certain prior year amounts have been reclassified to
conform with the current year's presentation. The reclassifications had no
effect on net income or total assets.
Recent Accounting Pronouncements - The implications of full implementation
of SFAS No. 142, "Accounting for Goodwill and Intangible Assets," is
described above. In April 2002, SFAS No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections," was issued. SFAS No. 145, in rescinding SFAS No. 4, will
require that the loss on early extinguishment of debt, classified as an
extraordinary item in 2000, no longer be classified as extraordinary, but
rather as other expense. SFAS No. 145 is required to be implemented by
Headwaters in 2003 and management does not expect it to have a material
effect on Headwaters' future financial position or results of operations.
In August 2001, SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," was issued, and in July 2002, SFAS No. 146, "Accounting
for Costs Associated with Exit or Disposal Activities," was issued. These
pronouncements must be implemented by Headwaters as of October 1, 2002 and
January 1, 2003, respectively. Headwaters has reviewed these standards and
all other recently issued, but not yet adopted, accounting standards in
order to determine their potential effect, if any, on the future results of
operations or financial position of Headwaters. Based on that review,
Headwaters does not currently believe that any of these recent accounting
pronouncements will have a significant effect on its current or future
financial position or results of operations.
F-14
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
3. Acquisitions of ISG and HTI
ISG Acquisition - On September 19, 2002, Headwaters acquired 100% of the
common stock of ISG, assumed or paid off all of ISG's outstanding debt and
redeemed all of ISG's outstanding preferred stock. ISG is headquartered in
Salt Lake City, Utah and is engaged primarily in the management of long-term
contracts for coal combustion products and the distribution of related
building materials and construction products throughout the United States,
all through its wholly-owned subsidiary, ISG Resources, Inc. Headwaters has
focused on using technology to add value to fossil fuels, particularly coal.
The acquisition of ISG provides Headwaters with a significant position in
the last step of the coal value chain due to its competencies in managing
the products resulting from the combustion of coal. The acquisition of ISG
also brings to Headwaters substantial management depth, comprehensive
corporate infrastucture and critical mass in revenues and operating profit.
In order to obtain the cash necessary to acquire ISG and retire the ISG
debt, Headwaters issued $175,000,000 of new debt consisting of $155,000,000
of senior secured debt with a five-year term and a variable interest rate
and $20,000,000 of subordinated debt with an approximate five-year term and
a fixed interest rate (see Note 8). ISG management participated in one-half,
or $10,000,000, of the subordinated debt. Total cash proceeds from the
issuance of new debt, net of debt discounts, was $169,950,000. Headwaters
incurred approximately $6,200,000 of debt issuance costs to place the new
debt, which had an initial combined effective weighted-average interest rate
of approximately 9.0%.
The following table sets forth the total consideration paid for ISG:
(thousands of dollars and shares, except per-share amount)
----------------------------------------------------------------------------------------
Fair value of Headwaters stock (2,100 shares at $15.58 per share) $ 32,718
Cash paid to ISG stockholders 32,700
Cash paid to retire ISG debt and related accrued interest 184,638
Costs directly related to acquisition 7,800
------------
Total consideration $257,856
============
The value of Headwaters' 2,100,000 shares of common stock issued was
determined using the average market price of Headwaters' stock over a
five-day period, consisting of the day the terms of acquisition were agreed
to and announced and two days prior to and two days subsequent to that day.
This average price was $15.58 per share.
The following table sets forth a preliminary allocation of the total
estimated consideration to the tangible and intangible assets acquired and
liabilities assumed:
(thousands of dollars)
----------------------------------------------------------------------------------------
Cash $ 19,238
Trade receivables 33,820
Inventory and other assets 11,794
Net property, plant and equipment 47,682
Intangible assets acquired:
Contracts 106,400
Patents 2,764
Goodwill 109,109
Accounts payable and accrued liabilities (25,518)
Net deferred income tax liabilities (47,433)
------------
Net assets acquired $257,856
============
The ISG acquisition was accounted for using the purchase method of
accounting as required by SFAS No.141, "Business Combinations." Assets
acquired and liabilities assumed were recorded at their estimated fair
values as of September 19, 2002. Approximately $109,164,000 of the purchase
price was allocated to identifiable intangible assets consisting primarily
of contracts with coal-fired power generation plants. This amount is being
amortized over the
F-15
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
estimated combined useful life of 20 years. The remaining purchase price not
attributable to the tangible and identifiable intangible assets was
allocated to goodwill, none of which is expected to be tax deductible. All
of the intangible assets and all of the goodwill were preliminarily
allocated to the CCP segment. The final allocation of the purchase price,
including the estimated fair values for certain acquired property, will
likely differ from that reflected above after final valuations and other
procedures have been completed.
The following unaudited pro forma financial information for 2001 and 2002
assumes the ISG acquisition occurred as of the beginning of the respective
years. The pro forma combined results for 2001 combine Headwaters'
historical results for the year ended September 30, 2001 with ISG's
historical results for the year ended December 31, 2001, after giving effect
to certain adjustments, including interest expense and the amortization of
intangible assets. The pro forma combined results for 2002 combine
Headwaters' historical results for the year ended September 30, 2002 with
ISG's historical results for the twelve months ended September 30, 2002,
after giving effect to necessary adjustments. Accordingly, ISG's historical
results for the three-month period from October 1, 2001 to December 31, 2001
are included in both the pro forma combined results for the year ended
September 30, 2001 and the pro forma combined results for the year ended
September 30, 2002. ISG's revenues and net loss for the three-month period
ended December 31, 2001 which were included in both of these periods were
$51,221,000 and $(2,208,000), respectively.
Due to the provisions of SFAS No. 142 which require that amortization of
goodwill be discontinued, amortization of the new goodwill has not been
reflected in the pro forma information for any period presented. Also, the
goodwill amortization recorded in ISG's historical results of operations has
been eliminated. Accordingly, there is no goodwill amortization reflected in
the pro forma information for any period presented. In early calendar 2002,
ISG recorded a non-recurring extraordinary gain on extinguishment of debt in
the amount of approximately $22,558,000. This amount is not included in the
pro forma information below.
Unaudited Pro Forma
Results
---------------------------
(thousands of dollars, except per-share data) 2001 2002
--------------------------------------------------------------------------------------------
Total revenue $261,695 $335,515
Net income (excluding ISG's extraordinary gain in 2002) 22,094 26,679
Basic net income per common share 0.88 1.01
Diluted net income per common share 0.83 0.96
The pro forma results have been prepared for illustrative purposes only.
Such information does not purport to be indicative of the results of
operations which actually would have resulted had the acquisition occurred
on the dates indicated, nor is it indicative of the results that may be
expected in future periods.
HTI Acquisition - In August 2001, Headwaters completed the acquisition of
100% of the common stock of HTI, a New Jersey-based company. HTI develops
and commercializes catalysts and catalytic processes for producing chemicals
and converting low-value fossil fuels into high-value alternative fuels.
Total consideration at closing, including the direct costs incurred by
Headwaters to consummate the acquisition, was approximately $11,774,000. In
accordance with the original HTI acquisition agreements, additional
contingent consideration could be earned by the former HTI stockholders
during calendar 2002 based on the attainment of certain operating targets
and other milestones. In April 2002, Headwaters and the former HTI
stockholders agreed to an amendment of the acquisition agreements and
reached a final settlement of all outstanding contingent payments.
Headwaters paid the former HTI stockholders additional consideration with a
value totaling approximately $3,242,000.
F-16
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
The following table sets forth the total consideration paid in 2001 and
2002:
(thousands of dollars and shares, except per-share amounts)
-----------------------------------------------------------------------------------------------------
Fair value of Headwaters stock issued in 2001 (593 shares at $9.25 per share) $ 5,485
Fair value of Headwaters stock issued in 2002 (178 shares at $15.87 per share) 2,823
Fair value of options to purchase 144 shares of Headwaters' common stock issued in
exchange for 152 outstanding vested HTI options 1,325
Cash paid to HTI stockholders 1,814
Cash paid to retire HTI note payable to a bank, plus
pre-acquisition loans by Headwaters to HTI 2,560
Costs directly related to acquisition 1,009
------------
Total consideration $15,016
============
The value of the 593,000 shares of Headwaters common stock issued to the
former HTI stockholders was determined using the average market price of
Headwaters' stock over a three-day period, consisting of the day the terms
of acquisition were agreed to and one day prior to and one day subsequent to
that day ($9.25). The value of the 178,000 shares of common stock issued to
the former HTI stockholders was determined using the average market price of
Headwaters' stock over a three-day period, consisting of the day the
settlement was reached and one day prior to and one day subsequent to that
day ($15.87). For purposes of computing the estimated fair value of the
Headwaters stock options issued in exchange for outstanding HTI options, the
Black-Scholes model was used with the following assumptions: expected stock
price volatility of 90%, risk free interest rates of 3.5% to 4.0%, weighted
average expected option lives of one to three years, no dividend yield, and
a fair value of Headwaters' stock of $9.25 per share.
In March 2002, in connection with the preparation of Headwaters' and HTI's
consolidated income tax returns for the year ended September 30, 2001,
Headwaters finalized its analysis of HTI's differences between book and tax
reporting and HTI's net operating loss carryforwards as of the acquisition
date. Based on this analysis, Headwaters finalized the HTI purchase price
allocation. The following table sets forth the final allocation to the
tangible and intangible assets acquired and liabilities assumed, of the
total consideration paid.
(thousands of dollars)
---------------------------------------------------------- ------------
Tangible assets acquired, net of liabilities assumed $ 1,388
Intangible assets acquired:
Existing patented technology 9,700
Acquired in-process research and development 2,400
Goodwill 4,258
Net deferred income tax liabilities (2,730)
------------
Net assets acquired $15,016
============
The HTI acquisition was accounted for using the purchase method of
accounting. Assets acquired and liabilities assumed were recorded at their
estimated fair values as of the acquisition date. Approximately $9,700,000
of the purchase price was allocated to identifiable intangible assets
consisting of existing patented technology with an estimated useful life of
15 years.
Approximately $2,400,000 of the purchase price was allocated to purchased
in-process research and development, consisting primarily of efforts focused
on developing catalysts and catalytic processes to lower the cost of
producing alternative fuels and chemicals while improving energy efficiency
and reducing environmental risks. This amount represented the estimated
purchased in-process technology for projects that had not reached
technological feasibility and had no alternative use as of the acquisition
date, and was expensed in 2001.
4. Segment Reporting
Until Headwaters acquired ISG in September 2002, Headwaters operated in and
reported as a single industry segment, alternative energy. With the
acquisition of ISG in September 2002, Headwaters now operates in three
business segments,
F-17
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
alternative energy, CCPs, and manufactured products. These segments are
managed and evaluated separately by management based on fundamental
differences in their operations, products and services.
The alternative energy segment includes Headwaters' traditional coal-based
solid alternative fuel business and HTI's business of developing and
commercializing catalysts and catalytic processes for producing chemicals
and converting low-value fossil fuels into high-value alternative fuels.
Revenues for this segment include primarily sales of chemical reagents and
license fees.
The CCP segment includes ISG's business of supplying post-combustion
services and technologies to the coal-fired electric utility industry. This
segment markets and manages coal combustion products such as fly ash and
bottom ash, known as CCPs. ISG has long-term contracts, primarily with
coal-fired electric generating utilities, pursuant to which it manages the
post-combustion operations for the utilities. ISG markets these CCPs to
replace manufactured or mined materials, such as portland cement, lime,
agricultural gypsum, fired lightweight aggregate, granite aggregate and
limestone. CCP revenues consist primarily of the sale of products, along
with a small percentage of service revenue.
The manufactured products segment produces and sells standard masonry and
stucco construction materials and supplies, packaged products and blocks, as
well as some of ISG's value-added technology products. ISG has introduced
high volumes of CCPs as ingredients in the mortars, stuccos and blocks that
the manufactured products segment produces.
The following segment information for 2002 has been prepared in accordance
with SFAS No. 131, "Disclosure about Segments of an Enterprise and Related
Information." The accounting policies of the segments are the same as those
described in Note 2. Performance of the segments is evaluated based on i)
operating profit, and ii) operating profit before interest, taxes,
depreciation and amortization, and other income/expense items ("EBITDA").
Intersegment sales are immaterial. Amounts included in the "Corporate"
column represent costs not specifically attributable to any segment and
include general corporate overheads, research and development expenses and
other administrative departmental costs. Segment assets reflect those
specifically attributable to individual segments and primarily include
accounts receivable, inventory, property, plant and equipment, intangible
assets and goodwill. Other assets are included in the "Corporate" column.
(thousands of dollars) Alternative Manufactured
Energy CCP Products Corporate Totals
------------------------------------------- ------------ ------------ -------------- ------------- ------------
Segment revenue $110,753 $6,818 $1,774 $ -- $119,345
============ ============ ============== ============= ============
EBITDA $51,877 $1,952 $150 $(11,185) $42,794
Depreciation and amortization (1,132) (380) (32) (216) (1,760)
------------ ------------ -------------- ------------- ------------
Operating income $50,745 $1,572 $118 $(11,401) 41,034
============ ============ ============== =============
Net interest income 447
Other income (expense), net (1,245)
Income tax provision (15,950)
------------
Net income $24,286
============
Capital expenditures $546 $236 $-- $14 $796
============ ============ ============== ============= ============
Segment assets $33,413 $286,002 $21,869 $31,573 $372,857
============ ============ ============== ============= ============
F-18
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
5. Notes Receivable
Notes receivable consisted of the following at September 30:
(thousands of dollars) 2001 2002
----------------------------------------------------------------------------------------------------------
Short-term Notes and Accrued Interest Receivable:
Facility-dependent note receivable from a corporation and related accrued
interest, collected in October 2001 $6,598 $ --
Other 259 377
-------------------------
Total short-term notes and accrued interest receivable $6,857 $377
=========================
Long-term Notes and Accrued Interest Receivable:
Note receivable from a limited liability corporation, bearing interest
at LIBOR plus 0.9% (2.7% at September 30, 2002) payable quarterly, with
principal due no later than September 2004. This note is collateralized
by certain bridge loans and equity investments sold by Headwaters to
this entity in September 2001. Following payment of the note principal,
Headwaters has the right to receive the first $1,000 plus 20% of any
additional cash received by the limited liability corporation related to
the assets sold by Headwaters. This note is being accounted for on the
cost recovery basis. An impairment loss of approximately $986 was
recorded in 2002 due to a decline in the value of the underlying
collateral. $4,000 $2,700
Unsecured note receivable arising from the sale of assets to a limited
liability corporation with an effective 6.35% interest rate (which
exceeds the stated rate). Principal, along with accrued interest, is due
in four $500 installments from December 2003 through December 2006.
Headwaters recorded a gain of approximately $1,342 on this sale. -- 1,893
-------------------------
Total long-term notes and accrued interest receivable $4,000 $4,593
=========================
6. Property, Plant and Equipment
Property, plant and equipment consisted of the following at September 30:
(thousands of dollars) Estimated useful lives 2001 2002
----------------------------------------------------------------------------------------------------
Land and improvements 30 years $ 379 $ 9,227
Buildings and improvements 5 - 40 years 624 10,488
Equipment and vehicles 3 - 30 years 1,885 28,171
Construction in progress -- 3,523
-------------------------
2,888 51,409
Less accumulated depreciation (208) (860)
-------------------------
Net property, plant and equipment $2,680 $50,549
=========================
Depreciation expense was approximately $784,000 in 2000, $93,000 in 2001 and
$669,000 in 2002. As described in more detail in Note 14, Headwaters
recorded approximately $12,615,000 of expense related to impaired assets
during 2000.
F-19
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
7. Intangible Assets
Intangible assets consisted of the following at September 30:
(thousands of dollars) Estimated useful lives 2001 2002
-----------------------------------------------------------------------------------------------------
ISG contracts 20 years $ -- $106,400
HTI patented technology 15 years 9,700 9,700
ISG patents 71/2years -- 2,764
Other 9 - 10 years 1,522 1,522
-------------------------
11,222 120,386
Less accumulated amortization (470) (1,468)
-------------------------
$10,752 $118,918
=========================
Amortization expense was approximately $237,000 in 2000, $168,000 in 2001
and $998,000 in 2002. As described in more detail in Note 14, Headwaters
wrote off approximately $2,189,000 of intangible assets during 2000.
8. Liabilities
Other Accrued Liabilities - Other accrued liabilities consisted of the
following at September 30:
(thousands of dollars) 2001 2002
----------------------------------------------------------------------------- ------------- -----------
Chemical reagent costs not yet invoiced $ 877 $ 2,957
Royalties due to third parties 725 1,608
Health insurance -- 1,481
Income taxes 239 1,244
Costs related to ISG acquisition -- 1,201
Commitment to a feedstock supplier for a licensee's alternative fuel
facility 576 576
Costs related to HTI acquisition 777 --
Other 1,793 5,821
-------------------------
$4,987 $14,888
=========================
Long-term Debt - Long-term debt consisted of the following at September 30:
(thousands of dollars) 2001 2002
-------------------------------------------------------------------------------------------------------
Senior secured debt with a face amount totaling $155,000 $ -- $150,378
Senior subordinated debentures with a face amount totaling $20,000 -- 19,603
Short-term borrowings from an investment company, repaid in 2002
(see Note 9) 4,095 --
Other 410 149
-------------------------
4,505 170,130
Less: current portion (4,356) (15,578)
-------------------------
Total long-term debt $ 149 $154,552
=========================
Senior Secured Credit Agreement - In connection with the ISG acquisition,
Headwaters entered into a $175,000,000 senior secured credit agreement with
a syndication of lenders, under which a total of $155,000,000 was borrowed
on the acquisition date. The remaining $20,000,000 is available for
borrowing under the terms of this credit agreement. This debt was issued at
a 3% discount and Headwaters received net cash proceeds of $150,350,000. The
original issue discount is being accreted using the effective interest
method and the accretion is recorded as interest expense. The debt is
secured by all assets of Headwaters, bears interest at a variable rate
(approximately 5.9% at September 30, 2002), and is repayable quarterly
beginning December 2002 through August 2007. Required principal repayments
total $15,500,000 in 2003, $31,000,000 in 2004, 2005 and 2006, and
$46,500,000 in 2007. In certain situations, for example when Headwaters
F-20
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
receives "excess cash flow," as defined, mandatory prepayments are required.
Mandatory prepayments are calculated as a percentage ranging up to 100% of
"excess cash flow," which percentage is based on Headwaters' "leverage
ratio." The debt agreement also allows optional prepayments.
The debt agreement contains restrictions and covenants common to such
agreements, including limitations on the incurrence of additional debt,
investments, merger and acquisition activity, asset liens, capital
expenditures in excess of $15,000,000 in any fiscal year, and the payment of
dividends, among others. In addition, Headwaters must maintain certain
financial ratios, including leverage ratios and interest coverage, as those
terms are defined in the credit agreement. As of September 30, 2002,
Headwaters must maintain a total leverage ratio of 3.0:1.0 or less. The
maximum ratio declines over time until June 2004, at which time the ratio
must remain at 2.0:1.0 or less. There is a similar leverage ratio
requirement for the senior debt alone, which at September 30, 2002 must be
2.5:1.0 or less, declining over time through June 2004, at which time it
must be maintained at 1.5:1.0 or less. The interest coverage requirement at
September 30, 2002 was 3.75:1.0 or more. This ratio requirement increases
over time, until December 2003, at which time the ratio must be maintained
at a level of 5.0:1.0 or more. Headwaters was in compliance with all debt
covenants as of September 30, 2002.
Under the terms of the senior secured credit agreement, Headwaters may
borrow up to a total $175,000,000; provided, however, that, except for the
initial $20,000,000 of available revolving credit, the maximum borrowing
limit is permanently reduced by the amount of any repayments of the initial
$155,000,000 borrowed in September 2002. Terms of any additional borrowings
under the credit agreement are generally the same as described in the
preceding paragraphs. Finally, the credit agreement allows for the issuance
of letters of credit, provided there is capacity available under the total
credit line. As of November 15, 2002, two letters of credit for a total of
$2,970,000 have been issued with expiration dates of March 2003 and November
2003. No other borrowings have been drawn or letters of credit issued
through November 15, 2002. Headwaters pays a fee of 5/8% on the unused
portion of the revolving credit agreement.
Senior Subordinated Debentures - Also in connection with the ISG
acquisition, Headwaters entered into a $20,000,000 subordinated loan
agreement, under which senior subordinated debentures were issued at a 2%
discount, with Headwaters receiving net cash proceeds of $19,600,000. The
original issue discount is being accreted using the effective interest
method and the accretion is recorded as interest expense. ISG management
participated in one-half, or $10,000,000, of the $20,000,000 of debt issued.
The other half was issued to a corporation. The debt is not secured, bears
interest at an 18% rate, and is repayable in September 2007. It is senior to
all other debt except the senior secured debt described above. The debt
agreement allows for optional prepayments. Any prepayments paid to the
corporation are subject to a prepayment charge which ranges from 5% of the
principal prepaid in the first year to 1% of the principal prepaid in the
last year of the five-year term of the debt agreement. Interest is payable
quarterly, beginning October 2002 and is payable in cash at a 12% rate. At
Headwaters' option, interest calculated at an additional 6% rate may be
added to the principal balance in lieu of payment in cash. Headwaters
currently intends to pay in cash the entire amount of interest which
accrues.
The loan agreement contains restrictions and covenants common to such
agreements, and these are generally consistent with those described above
for the senior secured debt. As of September 30, 2002, Headwaters must
maintain a total leverage ratio of 3.25:1.0 or less. The maximum ratio
declines over time until June 2004, at which time the ratio must remain at
2.25:1.0 or less. The interest coverage requirement at September 30, 2002
was 3.50:1.0 or more. This ratio requirement increases over time, until
December 2003, at which time the ratio must be maintained at a level of
4.75:1.0 or more. Headwaters was in compliance with all debt covenants as of
September 30, 2002.
F-21
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
Interest Rates and Debt Maturities - The weighted-average interest rate on
long-term debt was approximately 4.7% at September 30, 2001 and
approximately 7.3% at September 30, 2002. Future maturities of long-term
debt as of September 30, 2002 are as follows:
(thousands
Year ending September 30, of dollars)
----------------------------------- -------------
2003 $ 15,578
2004 31,030
2005 31,012
2006 31,013
2007 66,516
-------------
Total cash payments 175,149
Unamortized debt discount (5,019)
-------------
Net carrying value $170,130
=============
Interest Costs - During 2000, Headwaters incurred total interest costs of
approximately $4,814,000, including approximately $3,034,000 of non-cash
interest expense resulting from amortization of debt discount and debt
issuance costs. During 2001, Headwaters incurred total interest costs of
approximately $224,000, including approximately $79,000 of non-cash interest
expense. During 2002, Headwaters incurred total interest costs of
approximately $553,000, including approximately $136,000 of non-cash
interest expense. No interest costs were capitalized in any of these years.
9. Financing and Other Equity Transactions
In addition to the financing transactions related to the ISG and HTI
acquisitions described in Notes 3 and 8, Headwaters entered into the
following transactions from 2000 through 2002.
Short-term Borrowings with an Investment Company - Headwaters has an
arrangement with an investment company under which Headwaters could borrow
up to 90% of the value of the portfolio of Headwaters' short-term
investments with the investment company (see Note 8). Maximum borrowings
under this arrangement during 2001 were approximately $4,095,000, which
amount was outstanding at September 30, 2001. Maximum borrowings under this
arrangement during 2002 were approximately $5,095,000, but there have been
no borrowings since the quarter ended December 31, 2001. In connection with
the issuance of long-term debt in September 2002, Headwaters agreed not to
borrow under this arrangement.
Convertible Debt - In 2000, Headwaters issued convertible secured debt and
warrants to purchase approximately 1,172,000 shares of common stock, in two
unrelated transactions, for total net proceeds of approximately $2,800,000.
The warrants had exercise prices ranging from $0.88 to $3.60 per share, with
expiration dates ranging from September 2002 to December 2002 and were
assigned a value of approximately $562,000. This debt, along with the
convertible debt issued to one of the same debt holders in September 1999,
was convertible into common stock at market rates. During 2000, convertible
debt with a face amount of approximately $1,280,000 and a carrying value of
approximately $970,000 was converted into approximately 2,540,000 shares of
common stock. In January 2000, Headwaters redeemed all of its remaining
convertible debt.
In 2000, the holder of a $4,000,000 note payable converted $2,000,000 of
principal into approximately 1,186,000 shares of common stock and warrants
for the purchase of approximately 296,000 shares of common stock. The
warrants were exercisable through April 2005 at a price of $2.10 per share
and were exercised in 2002. Headwaters repaid the remaining $2,000,000 of
principal in 2000.
Convertible Preferred Stock - During 2000, 200 shares of Series C preferred
stock, along with related accumulated but undeclared dividends, were
converted into approximately 180,000 shares of common stock; and 24,369
shares of Series D convertible preferred stock were converted into
approximately 2,632,000 shares of common stock. Also in 2000, Headwaters
redeemed the remaining outstanding 35,631 shares of Series D preferred
stock. The total amount paid to redeem the preferred stock was approximately
$4,454,000, including a redemption premium of approximately
F-22
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
$1,882,000, which was charged directly to stockholders' equity. In 2001, all
of the outstanding shares of preferred stock, consisting of 3,000 shares of
Series A and 14,310 shares of Series B, were converted into a total of
approximately 443,000 shares of common stock, representing a conversion
price of $7.00 per common share. Headwaters paid the accrued but undeclared
dividends of approximately $695,000 in cash rather than allowing conversion
into common stock at a price below market.
Common Stock - In 2000, Headwaters issued approximately 3,629,000 shares of
common stock in a private placement for cash proceeds of approximately
$4,666,000, net of costs of approximately $270,000. In another transaction,
Headwaters issued approximately 379,000 shares of common stock and warrants
for the purchase of approximately 133,000 shares of common stock to certain
officers and directors for net cash proceeds of approximately $588,000. The
warrants are exercisable through March 2005 at a price of $1.56 per share.
Treasury Stock - Beginning in 2000, Headwaters acquired shares of its common
stock in connection with the stock repurchase program announced in May 2000
and expanded in June 2001. The program, as revised, authorizes Headwaters to
purchase stock in the open market or through negotiated block transactions
up to an aggregate of 20% of the outstanding common stock, or $15,000,000,
whichever is greater. All treasury stock transactions are disclosed in the
statements of changes in stockholders' equity.
Notes and Interest Receivable - Related Parties, Collateralized by Common
Stock - In January 2001, Headwaters accepted from a stockholder as full
satisfaction of a 6%, collateral-based $5,000,000 note receivable, i)
150,000 shares of Headwaters stock and options to acquire 25,000 shares of
Headwaters common stock for $1.50 per share that collateralized the note,
both of which were cancelled, and ii) a new 6% collateralized promissory
note receivable in the principal amount of $1,750,000. Prior to this
transaction, the original note receivable was being carried at the value of
the underlying collateral ($466,000 at September 30, 2000). Headwaters
recognized a gain of approximately $541,000 representing the increase in
value of that collateral from September 30, 2000 to the date the collateral
was surrendered by the stockholder in payment of the note. Headwaters
recorded the new note receivable at $0 due to substantial uncertainty of
both the collectibility of the new note and the value of the new collateral.
In October 2001, a $750,000 payment was received on the new promissory note,
which amount, along with certain other assets, was accepted as full
satisfaction of the new promissory note. The $750,000 gain on this
transaction was recognized in 2002 and recorded as other income. Due to
substantial uncertainty regarding both value and realization, Headwaters
recorded the other assets obtained in that transaction at $0. Interest
income of $515,000 was recognized in 2000 based on cash payments received on
the note. No interest income was recognized in 2001.
In 2000, Headwaters entered into termination agreements with certain then
current and former officers and employees having notes and interest payable
to Headwaters totaling approximately $6,164,000. The agreements called for
the cancellation of the outstanding balances under the notes, including
interest, in exchange for the surrender and cancellation of the outstanding
shares of common stock collateralizing the notes. These transactions
resulted in the cancellation of approximately 812,000 shares of common stock
and the recognition of a loss of approximately $219,000, which amount
represents the interest recognized on the notes in prior periods.
SEC Registration Statement - In July 2002, Headwaters filed a $250,000,000
universal shelf registration statement with the SEC that can be used for the
sale of common stock, preferred stock, convertible debt and other
securities, should Headwaters so choose. This registration statement was
declared effective by the SEC in August 2002; however, a prospectus
supplement describing the terms of any securities to be issued is required
to be filed before any offering would commence under the registration
statement. Headwaters could use the proceeds from securities offered under
the shelf registration to reduce long-term debt, or for working capital and
other general corporate purposes.
10. Fair Value of Financial Instruments
Headwaters' financial instruments consist primarily of cash and cash
equivalents, short-term investments, trade and notes receivable, accounts
payable and long-term debt. All of these financial instruments except
certain long-term debt as of September 30, 2002 are either carried at fair
value as of the balance sheet date or are of a short-term nature.
Accordingly,
F-23
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
the carrying values for these financial instruments as reflected in the
consolidated balance sheets for 2001 and 2002 closely approximated their
fair values.
Substantially all of Headwaters' long-term debt as of September 30, 2002
consists of debt issued in connection with the ISG acquisition in September
2002. As described in Note 8, approximately 90% of the outstanding debt
balance carries a variable interest rate and approximately 10% of the
outstanding debt balance carries a fixed rate. Due to the short period of
time which has elapsed between issuance of this debt and Headwaters' fiscal
year end, the face amount of all outstanding debt is deemed to approximate
fair value as of September 30, 2002. As reflected in Note 8, the total
carrying amount of the debt issued in September 2002 was approximately
$169,981,000 as of September 30, 2002. The combined face amount, and
therefore the approximate fair value as of September 30, 2002, of this debt
totaled $175,000,000.
11. Stockholders' Equity
Preferred Stock - Headwaters has 10,000,000 shares of authorized preferred
stock, none of which was issued or outstanding as of September 30, 2001 or
2002.
Stock Options - As of September 30, 2002, Headwaters had two stock option
plans (the "Option Plans") under which 2,900,000 shares of common stock were
reserved for ultimate issuance. As of September 30, 2002, options for
approximately 214,000 shares of common stock could be granted under the
Plans. A committee of Headwaters' Board of Directors (the "Committee"), or
in its absence the Board, administers and interprets the Option Plans. This
Committee is authorized to grant options and other awards both under the
Option Plans and outside the Option Plans to eligible employees, officers,
directors, and consultants of Headwaters. One of the Option Plans provides
for the granting of both incentive stock options and non-statutory stock
options; the other Option Plan provides only for the granting of
non-statutory stock options. Terms of options granted under the Option
Plans, including vesting requirements, are determined by the Committee.
Options granted under the Option Plans vest over periods ranging up to ten
years, expire ten years from the date of grant and are not transferable
other than by will or by the laws of descent and distribution. Incentive
stock option grants must meet the requirements of the Internal Revenue Code.
Headwaters has elected to continue to apply APB 25 in accounting for options
granted to employees and directors and does not currently plan to change to
the fair value method. The alternative fair value method of accounting
prescribed by SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS
123"), requires the use of option valuation models that were not developed
for use in valuing employee stock options, as discussed below. Under APB 25,
no compensation expense is recognized for stock option grants to employees,
officers and directors when the exercise price of stock options equals or
exceeds the market price of Headwaters' common stock on the date of grant.
In years prior to 1998, certain options were granted with terms considered
compensatory. In such instances, the related compensation cost is amortized
to expense over the applicable vesting period on a straight-line basis.
Amortized compensation expense related to compensatory options granted in
prior years was approximately $707,000, $93,000 and $93,000 for 2000, 2001
and 2002, respectively.
If Headwaters had elected to account for options granted based on their fair
value, as prescribed by SFAS 123, net income and income per share would have
been changed to the pro forma amounts shown in the table below:
(thousands of dollars, except per-share data) 2000 2001 2002
---------------------------------------------------------------- ------------ ------------- ------------
Net income (loss) attributable to common stockholders - reported $1,364 $21,404 $24,286
- pro forma (350) 18,944 20,692
Basic income (loss) per share - reported 0.07 0.94 1.00
- pro forma (0.02) 0.83 0.85
Diluted income (loss) per share - reported 0.07 0.87 0.94
- pro forma (0.02) 0.77 0.80
F-24
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
The fair value of each stock option grant was determined using the
Black-Scholes option pricing model and the following assumptions: expected
stock price volatility of 50% to 90%, risk-free interest rates ranging from
1.7% to 6.3%, weighted average expected option lives of 4 to 5 years, and no
dividend yield. The Black-Scholes option valuation model was developed for
use in estimating the fair value of traded options that have no vesting
restrictions and are fully transferable. In addition, option valuation
models require the input of highly subjective assumptions including expected
stock price volatility. Because Headwaters' stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect
the fair value, in management's opinion, the existing models do not
necessarily provide a reliable measure of the fair value of stock options.
The following table is a summary of activity for all of Headwaters' stock
options, including options not granted under the Option Plans, for the years
ended September 30:
2000 2001 2002
----------------------- ---------------------- -----------------------
Weighted- Weighted- Weighted-
average average average
Exercise Exercise Exercise
(thousands of shares) Shares Price Shares Price Shares Price
---------------------------------------- ----------- ----------- ---------- ----------- ----------- -----------
Outstanding at beginning of year 2,971 $ 6.18 3,822 $5.16 3,283 $ 5.80
Granted 1,112 3.31 251 9.15 611 13.38
Granted in exchange for HTI options -- -- 144 0.07 -- --
Exercised (42) 1.50 (822) 2.42 (852) 5.02
Canceled (219) 10.37 (112) 8.42 (52) 6.60
----------- ----------- ---------- ----------- ----------- -----------
Outstanding at end of the year 3,822 $ 5.16 3,283 $5.80 2,990 $ 7.56
=========== =========== ========== =========== =========== ===========
Exercisable at end of year 2,201 $5.29 2,171 $5.70 1,898 $6.08
=========== =========== ========== =========== =========== ===========
Weighted-average fair value of
options granted during the year
below market none $9.18 none
Weighted-average fair value of options
granted during the year at market $1.09 $5.20 $7.35
Weighted-average fair value of options
granted during the year above market $1.19 none none
The following table summarizes information about all stock options outstanding at September 30, 2002:
(thousands of shares) Outstanding Options Exercisable Options
--------------------- ------------------------------------------------- ---------------------------
Number
Number Weighted-average Weighted- Exercisable Weighted-
Outstanding at Remaining average at average
Range of Exercise September 30, Contractual Life Exercise September 30, Exercise
Prices 2002 in Years Price 2002 Price
--------------------- ----------------- ----------------- ------------- -------------- ------------
$0.01 to $3.00 752 3.4 $ 1.75 589 $ 1.69
$4.00 to $5.88 831 4.9 4.74 719 4.75
$8.25 to $12.97 986 7.0 11.73 551 11.98
$13.56 to $13.85 421 9.3 13.73 39 13.56
----------------- --------------
2,990 1,898
================= ==============
In October 2002, the number of shares that can be granted under one of the
Option Plans was increased by 350,000 shares. Subsequently, in November
2002, Headwaters granted to employees non-statutory options to purchase
approximately 500,000 shares of common stock. These options have an exercise
price of $16.97, which was equal to the fair market value of Headwaters'
common stock on the date of grant.
F-25
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
Common Stock Warrants - As of September 30, 2002, there were warrants
outstanding for the purchase of approximately 179,000 shares of common stock
at prices ranging from $1.32 to $1.56 per share and with expiration dates
ranging from October 2002 to March 2005. All of these warrants were issued
in connection with private placements of common and preferred stock or debt
during 1999 and 2000.
Stockholder Approval of Options and Warrants - The following table presents
information related to stockholder approval of options and warrants, as of
September 30, 2002.
(thousands of shares)
--------------------------------------------------------------------------------------------------------------------
Weighted-average Shares remaining available
Shares to be issued exercise price of for future issuance under
upon exercise of outstanding options and existing equity
Plan Category options and warrants warrants compensation plans
--------------------------------------------------------------------------------------------------------------------
Option plan approved by
stockholders 1,981 $7.58 46
Option plans and warrants
not approved by stockholders 1,188 6.59 168
---------------------------------------------------------------------------------
Total 3,169 $7.21 214
=================================================================================
As discussed above, Headwaters has two primary stock option plans under
which options have been granted. Headwaters has also issued several options
outside of any plan, as well as warrants, in connection with various debt
and equity financing transactions. One of the two primary stock option plans
has been approved by stockholders; the other stock option plan has not been
approved by stockholders. The amounts included in the caption "not approved
by stockholders" in the above table represent amounts applicable under i)
the stock option plan not approved by stockholders, ii) all stock options
granted outside of any stock option plan, and iii) all outstanding warrants.
12. Income Taxes
In 2000, Headwaters reported a net income tax benefit of $2,900,000,
consisting of the recognition of $3,000,000 of its deferred tax asset,
reduced by $100,000 of federal alternative minimum tax. In 2001, Headwaters
reported a net income tax benefit of $7,049,000, consisting of the
recognition of $7,470,000 of its deferred tax asset, reduced by $100,000 of
federal alternative minimum tax and $321,000 of current state income tax
expense. In 2002, as a result of recording the full value of its deferred
tax asset in 2001, Headwaters recorded an income tax provision with an
effective tax rate of approximately 40%. The income tax provision (benefit)
consisted of the following at September 30:
(thousands of dollars) 2000 2001 2002
---------------------------------------------------------------------------------------------------
Current tax provision:
Federal $ 100 $ 100 $ 3,490
State -- 321 920
-----------------------------------------
Total current tax provision 100 421 4,410
Deferred tax provision (benefit):
Federal (3,040) (7,870) 9,720
State 40 400 1,820
-----------------------------------------
Total deferred tax provision (benefit) (3,000) (7,470) 11,540
-----------------------------------------
Total income tax provision (benefit) $(2,900) $(7,049) $15,950
=========================================
As of September 30, 2001, Headwaters had net operating loss carryforwards
("NOLs") of approximately $24,000,000 and research and development tax
credit carryforwards of approximately $220,000 for federal tax purposes.
During 2002, Headwaters utilized all of these NOLs and tax credit
carryforwards except for approximately $935,000 of HTI's acquisition date
NOLs that are subject to an annual limitation of approximately $800,000 due
to the change in ownership of HTI. Headwaters expects to utilize HTI's
remaining NOLs in 2003 and 2004.
F-26
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
The provision (benefit) for income taxes differs from the statutory federal
income tax rate due to the following:
(thousands of dollars) 2000 2001 2002
---------------------------------------------------------------------------------------------------
Tax provision at 35% statutory rate $ 274 $ 5,064 $14,083
State income taxes, net of federal tax effect 25 470 1,780
Change in valuation allowance (10,400) (14,200) --
Alternative minimum tax 100 100 --
Acquired in-process research and development -- 918 --
Other, primarily redetermination of prior years' tax
estimates 7,101 599 87
-----------------------------------------
Income tax provision (benefit) $ (2,900) $ (7,049) $15,950
=========================================
The components of Headwaters' deferred income tax assets and liabilities
were as follows as of September 30:
(thousands of dollars ) 2001 2002
---------------------------------------------------------------------------------------------------
Deferred tax assets:
Unamortized non-refundable license fees $ 2,640 $ 2,491
Estimated liabilities 410 2,103
Net operating loss carryforwards 9,120 411
Write-down of related party note receivable 720 383
Research and development tax credit carryforwards 220 --
Other, net 100 --
---------------------------
Total deferred tax assets 13,210 5,388
---------------------------
Deferred tax liabilities:
Intangible assets -- (45,128)
Property, plant and equipment -- (7,401)
Other, net (50) (2,402)
---------------------------
Total deferred tax liabilities (50) (54,931)
---------------------------
Net deferred tax asset (liability) $13,160 $(49,543)
===========================
The valuation allowance decreased by $10,400,000 and $14,200,000 during 2000
and 2001, respectively. A valuation allowance is provided if it is more
likely than not that some portion or all of a deferred tax asset will not be
realized. Based primarily on results of operations in 2001 and expected
future results of operations, Headwaters determined that as of September 30,
2001, it was more likely than not that its deferred tax assets would be
fully realized and accordingly, the remaining valuation allowance was
eliminated.
13. Basic and Diluted Income Per Share
The following table sets forth the computation of basic and diluted income
per share.
(thousands of dollars and shares, except per-share data) 2000 2001 2002
-------------------------------------------------------------------------------------------------------
Numerator:
Income before extraordinary item $11,542 $21,517 $24,286
Extraordinary item (7,860) -- --
---------------------------------------
Net income 3,682 21,517 24,286
Undeclared preferred stock dividends and
redemption premium (2,260) (113) --
Imputed preferred stock dividends (58) -- --
---------------------------------------
Numerator for basic earnings per share -- net income
attributable to common stockholders 1,364 21,404 24,286
Effect of dilutive securities - preferred stock dividends 119 113 --
---------------------------------------
Numerator for diluted earnings per share - net income
attributable to common stockholders after assumed conversions $ 1,483 $21,517 $24,286
=======================================
F-27
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
Denominator:
Denominator for basic earnings per share - weighted-average
shares outstanding 19,468 22,787 24,234
Effect of dilutive securities:
Shares issuable upon exercise of options and warrants 391 1,582 1,491
Shares issuable upon conversion of preferred stock 2,113 268 --
---------------------------------------
Total dilutive potential shares 2,504 1,850 1,491
---------------------------------------
Denominator for diluted earnings per share - weighted-average
shares outstanding after assumed exercises and conversions 21,972 24,637 25,725
=======================================
Basic earnings per share:
Income before extraordinary item $0.47 $0.94 $1.00
Extraordinary item (0.40) -- --
---------------------------------------
Net income per common share $0.07 $0.94 $1.00
=======================================
Diluted earnings per share:
Income before extraordinary item $0.43 $0.87 $0.94
Extraordinary item (0.36) -- --
---------------------------------------
Net income per common share $0.07 $0.87 $0.94
=======================================
During the periods presented, Headwaters' potentially dilutive securities
consisted of options and warrants for the purchase of common stock,
convertible debt and convertible preferred stock. For 2000, some options and
warrants and certain convertible preferred stock were dilutive, but all
other potentially dilutive securities were anti-dilutive and were not
considered in the calculation. For 2001, most options and warrants and all
of the then outstanding preferred stock were dilutive and were considered in
the calculation. For 2002, most options and warrants were dilutive and were
considered in the calculation.
Anti-dilutive securities not considered in the diluted earnings per share
calculation totaled approximately 7,000,000 shares in 2000, approximately
1,375,000 shares in 2001, and approximately 210,000 shares in 2002. Imputed
preferred stock dividends were calculated based upon the amount by which the
price of Headwaters' common stock exceeded the conversion price at the date
convertible preferred shares were issued.
14. Unusual and Extraordinary Items
Sale of Facilities - Headwaters' business plan through 2000 called for the
construction and sale of alternative fuel manufacturing facilities and the
licensing of Headwaters' technology to facility purchasers to generate
ongoing royalties. In 1999, Headwaters sold a facility and remained
contingently liable for $800,000 of the facility debt. This amount was
recognized as income in 2001 due to the elimination of the contingency. In
2000, upon achieving specified operating performance milestones, Headwaters
received additional cash payments related to the sale of this facility. The
cash proceeds from these payments, net of obligations to third parties,
approximated $7,377,000. Of the net amount received, Headwaters recognized
$4,400,000 as a gain because there were no ongoing obligations associated
with those payments. Headwaters deferred the recognition of $2,977,000,
which amount was characterized as prepaid royalties in the agreement. This
amount is being recognized as revenue on a straight-line basis through
December 2007.
Also, in 2000, Headwaters sold the three remaining alternative fuel
facilities it owned plus an option to acquire a licensee facility.
Headwaters reported net gains on these transactions totaling approximately
$12,470,000. All of the gains on sale of facilities are included in other
income in the consolidated statement of income.
Gains on Other Transactions - During 2000, Headwaters recorded other income
of approximately $1,079,000 related to the satisfaction of a contingent
contract liability ($755,000) and the gain recognized on a note receivable
transaction.
2000 Asset Write-offs and Other Charges - In 2000, Headwaters recorded an
impairment charge of approximately $14,804,000 related to assets located in
Utah and Alabama. This impairment charge consisted of an approximate
F-28
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
$12,615,000 write-down to net realizable value of certain plant and
equipment which remained on the sites and was idled when alternative fuel
facilities were sold, plus an approximate $2,189,000 write-off of an
intangible asset which was no longer considered recoverable due to the
relocation of a licensee facility. Headwaters also recorded employee
severance and other non-cash charges from incremental amortization of
deferred compensation from stock options (resulting from the termination of
employees whose stock options became fully vested upon termination) totaling
approximately $1,443,000. Other settlement charges ($979,000) and asset
write-downs ($532,000) were recorded in 2000. All of these asset write-offs
and other charges totaled approximately $17,758,000. Of this amount,
approximately $16,037,000 represented non-cash expenses.
Extraordinary Loss - In 2000, Headwaters redeemed all of its remaining
convertible debt. The redemption consideration and early prepayment costs
included approximately $7,037,000 in cash plus the issuance of approximately
214,000 shares of common stock. The loss recognized as a result of the total
redemption consideration paid plus the acceleration of amortization of the
unamortized debt discount and debt issuance costs in excess of the debt
carrying value totaled approximately $7,860,000. This loss is reflected as
an extraordinary item in the consolidated statement of income.
15. Commitments and Contingencies
Commitments and contingencies as of September 30, 2002 not disclosed
elsewhere are as follows:
Leases - Rental expense was approximately $255,000 in 2000, $204,000 in 2001
and $720,000 in 2002. Headwaters has noncancellable operating leases for
certain facilities and equipment. Most of these leases have renewal terms
and expire in various years through 2016. As of September 30, 2002, minimum
rental payments due under these leases are as follows:
Year ending September 30: (thousands of dollars)
---------------------------- --------------------
2003 $ 8,927
2004 6,900
2005 4,777
2006 3,229
2007 2,589
Thereafter 4,337
--------------------
$30,759
====================
Subsequent to September 30, 2002, Headwaters entered into a new headquarters
office lease arrangement which expires in 2008. Total minimum rental
payments under the new lease agreement, which are not included above, total
approximately $2,572,000.
Sale, Purchase and Royalty Commitments - Certain of ISG's contracts with its
customers and suppliers require ISG to make minimum sales and purchases. At
September 30, 2002, these minimum requirements are as follows:
(thousands of dollars)
--------------------------------
Minimum
Year ending September 30: Minimum Sales Purchases
---------------------------- ---------------- ---------------
2003 $ 521 $ 8,116
2004 599 7,033
2005 615 3,960
2006 515 2,998
2007 375 2,930
Thereafter 813 10,656
---------------- ---------------
$3,438 $35,693
================ ===============
F-29
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
ISG also has minimum royalty commitments on certain net sales for calendar
2002 and 2003. Remaining minimum royalty commitments through December 31,
2003 total approximately $832,000.
Employee Benefit Plans - In 2000, Headwaters' Board of Directors approved
three employee benefit plans, the Headwaters Incorporated 401(k) Profit
Sharing Plan, the 2000 Employee Stock Purchase Plan, and the Headwaters
Incorporated Incentive Bonus Plan. Substantially all employees of Headwaters
are eligible to participate in the 401(k) and Stock Purchase Plans after
meeting certain age and length of employment requirements. All employees,
except those directly involved in the operations of alternative fuel
facilities owned by a licensee, are eligible to participate in the Incentive
Bonus Plan. As of September 30, 2002, these plans were not effective for ISG
employees; however, it is expected that during 2003, ISG's employees will
begin to be covered under these plans.
401(k) Plan. Under the terms of the 401(k) Plan, eligible employees may
elect to make tax-deferred contributions of up to 15% of their compensation,
subject to statutory limitations. Headwaters matches employee contributions
up to a specified maximum rate and these matching contributions vest over a
three-year period. Headwaters is not required to be profitable in order to
make matching contributions.
Stock Purchase Plan. The 2000 Employee Stock Purchase Plan provides eligible
employees with an opportunity to increase their proprietary interest in the
success of Headwaters by purchasing stock in Headwaters on favorable terms
and to pay for such purchases through payroll deductions. A total of 500,000
shares of common stock are reserved for issuance under the Plan, with
approximately 420,000 shares available for future issuance as of September
30, 2002. Under the Plan, employees purchase shares of stock directly from
Headwaters, which shares are made available primarily from treasury shares
repurchased on the open market or from authorized but unissued shares, if
necessary. The Plan is intended to comply with Section 423 of the Internal
Revenue Code, but is not subject to the requirements of ERISA. Employees
purchase stock through payroll deductions of 1% to 10% of cash compensation,
subject to certain limitations. The stock is purchased in a series of
quarterly offerings. The cost per share to the employee is 85% of the lesser
of the fair market value at the beginning of the offering period or the end
of the offering period.
Incentive Bonus Plan. The Incentive Bonus Plan, approved annually by the
Compensation Committee of the Board of Directors, provides for annual cash
bonuses to be paid if Headwaters accomplishes certain financial goals and if
employees meet individual goals. A participant's cash bonus is based on
Headwaters' success in meeting or exceeding specified financial performance
targets established by the Compensation Committee of the Board of Directors,
the employee's base pay, and individual performance during the year.
Headwaters' financial goals are based upon an economic value added concept
("EVA") which purports to more closely align with a company's share price
performance than other measurements of performance.
ISG Benefit Plans. Eligible employees of ISG may participate in ISG's 401(k)
Plan. ISG matches employee contributions up to a specified maximum rate and
these matching contributions vest after three years. ISG is not required to
be profitable in order to make matching contributions. ISG also has certain
incentive bonus plans and sales commission plans that cover certain
management and sales personnel that are generally effective for calendar
2002. Payments under the incentive bonus plans are generally dependent on
exceeding specified EBITDA targets, and payments under the sales commission
plans are generally based on a percentage of revenues billed.
Total expense for all benefit plans of Headwaters and ISG was approximately
$1,768,000 in 2000, $2,082,000 in 2001 and $3,300,000 in 2002.
Medical Insurance - ISG has established a self-insured medical insurance
plan for its employees with stop-loss coverage for amounts in excess of
$75,000 per individual and approximately $5,100,000 in the aggregate for the
current plan year ending December 31, 2002. ISG has contracted with a
third-party administrator to assist in the payment and administration of
claims. Insurance claims are recognized as expenses when incurred, including
an estimate of costs incurred but not reported at the balance sheet date. As
of September 30, 2002, approximately $1,481,000 has been accrued for this
liability.
F-30
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
Legal or Contractual Matters - Adtech. 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 an alternative fuel technology invented by Davidson. (This
technology is distinct from the technology developed by Headwaters.) In
September 2000, Headwaters received a summons and complaint from the United
States District Court for the Western District of Tennessee filed by Adtech,
Inc. against Davidson and Headwaters. In the action, certain purported
officers and directors of Adtech alleged that the technology purchase
transaction was an unauthorized corporate action and that Davidson and
Headwaters conspired together to effect the transfer. The complaint asserted
related causes of action and sought unspecified money damages and other
relief. In August 2001, the trial court granted Headwaters' motion to
dismiss the complaint. Plaintiffs appealed the case to the Sixth Circuit
Court of Appeals. In June 2002, the Sixth Circuit Court of Appeals issued an
order i) affirming the District Court's judgment and order of dismissal, and
ii) transferring to the Federal Circuit Court of Appeals plaintiff's appeal
of the District Court's order denying the motion for relief from judgment.
Because resolution of the appeal is uncertain, legal counsel cannot express
an opinion as to the ultimate amount, if any, of Headwaters' liability.
Boynton. This action is factually related to the Adtech matter. In the
Adtech case, the alleged claims are asserted by certain purported officers
and directors of Adtech, Inc. In the Boynton 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, inter alia, 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 complaint seeks
declaratory relief and compensatory and punitive damages. Because the
litigation is at an early stage and resolution is uncertain, legal counsel
cannot express an opinion as to the ultimate amount, if any, of Headwaters'
liability.
AGTC. In March 1996, Headwaters entered into an agreement with AGTC and its
associates for certain services related to the identification and selection
of alternative fuel projects. In March 2002, AGTC filed an arbitration
demand claiming that it is owed a commission under the 1996 agreement for
eight percent of the monetized price of the Port Hodder project. Headwaters
asserts that AGTC did not perform under the agreement and that the agreement
was terminated and the disputes were settled in July 1996. Headwaters has
filed an answer in the arbitration, denying AGTC's claims and has asserted
counterclaims against AGTC. Because the arbitration is at an early stage and
resolution is uncertain, legal counsel cannot express an opinion as to the
ultimate amount of recovery or liability.
AJG. In December 1996, Headwaters entered into a technology license and
proprietary chemical reagent sale agreement with AJG Financial Services,
Inc. The agreement called for AJG to pay royalties and to purchase
proprietary chemical reagent material from Headwaters. In October 2000,
Headwaters filed a complaint in the Fourth District Court for the State of
Utah against AJG alleging that it had failed to make payments and to perform
other obligations under the agreement. Headwaters asserts claims including
breach of contract, declaratory judgment, unjust enrichment, and accounting
and seeks money damages as well as other relief. AJG's answer to the
complaint denied Headwaters' claims and asserted counter-claims based upon
allegations of misrepresentation and breach of contract. AJG seeks
unspecified compensatory damages as well as punitive damages. Headwaters has
denied the allegations of AJG's counter-claims. Because the litigation is at
an early stage and resolution is uncertain, legal counsel cannot express an
opinion as to the ultimate amount of recovery or liability.
Nalco. In October 2000, Headwaters filed a complaint in the United States
District Court for the District of Utah against Nalco Chemical Company
("Nalco"). Headwaters alleges that Nalco, by its sale and marketing of
materials for use in creating alternative fuel, breached a non-disclosure
agreement, misappropriated trade secrets, and violated patent rights of
Headwaters. Headwaters seeks by its complaint injunctive relief and damages
to be proven at trial. Nalco filed an answer denying the allegations in the
complaint and asserting counter-claims alleging patent invalidity, antitrust
violations, and interference with economic relations. Headwaters denies the
counter-claims; however, if Nalco prevails on its counter-claims, the result
could have a material adverse effect on Headwaters' business. Because the
litigation is at an early stage and resolution is uncertain, legal counsel
cannot express an opinion as to the ultimate amount, if any, that might be
recovered.
F-31
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
License Fees. Pursuant to the contractual terms of an agreement with a
certain licensee, the cumulative net license fees generated by Headwaters,
totaling approximately $6,000,000 as of September 30, 2002, have been placed
in escrow for the benefit of Headwaters. Headwaters currently expects the
escrowed amounts to increase as additional license fees are generated and
that most, if not all, of such amounts will be recognized as revenue at some
future date. Certain accounting rules governing revenue recognition require
that the seller's price to the buyer be "fixed or determinable" as well as
reasonably certain of collection. In this situation, those rules appear to
currently preclude revenue recognition. Accordingly, none of the escrowed
amounts have been recognized as revenue in the consolidated statements of
income.
Other. Headwaters and its subsidiaries are also involved in other legal
proceedings that have arisen in the normal course of business. For example,
certain subsidiaries of ISG are involved in legal proceedings involving
allegations of breach of warranty and sales of defective building products
applied by third parties to building exteriors. Generally, ISG denies and
defends such allegations or resolves such matters as appropriate. Management
does not believe that the outcome of these matters will have a significant
adverse effect upon the operations or the financial position of Headwaters;
however, it is possible that a change in management's estimates of probable
liability could occur and the change could be significant.
Employment Agreements - Headwaters and its subsidiaries have entered into
employment agreements with its Chief Executive Officer and 15 other officers
and employees. The agreements have original terms ranging from two to five
years and are generally renewable by Headwaters, usually for one-year terms.
They provide for annual salaries currently ranging from approximately
$75,000 to $400,000 annually per person. The annual commitment under all
agreements combined is currently approximately $2,990,000. All agreements
provide for termination benefits, ranging from at least six months' salary,
up to a maximum period equal to the remaining term of the agreement.
16. Related Party Transactions
In addition to related party transactions disclosed elsewhere, Headwaters
purchases certain insurance benefits for its employees from various
companies for which a director of Headwaters acts as a broker or agent.
Gross payments to those insurance companies totaled approximately $361,000
in 2000, $381,000 in 2001 and $532,000 in 2002.
17. Quarterly Financial Data (Unaudited)
Summarized quarterly financial data for 2001 and 2002 is as follows:
2001
----------------------------------------------------------------
First Second Third Fourth
(thousands of dollars, except per-share data) Quarter Quarter Quarter Quarter (1) Full Year
---------------------------------------------- ----------- ------------ ------------ ------------- ------------
Net revenue $12,316 $9,754 $10,699 $12,695 $45,464
Gross profit 7,590 6,245 6,600 7,434 27,869
Net income (1) 5,406 4,576 4,956 6,579 21,517
Basic net income per common share 0.23 0.20 0.22 0.29 0.94
Diluted net income per common share 0.22 0.19 0.20 0.26 0.87
2002
----------------------------------------------------------------
First Second Third Fourth
(thousands of dollars, except per-share data) Quarter Quarter Quarter Quarter (2) Full Year
---------------------------------------------- ----------- ------------ ------------ ------------- ------------
Net revenue $18,422 $25,256 $31,968 $43,699 $119,345
Gross profit 10,253 11,544 15,703 20,895 58,395
Net income (2) 4,727 5,459 6,736 7,364 24,286
Basic net income per common share 0.20 0.23 0.27 0.30 1.00
Diluted net income per common share 0.19 0.21 0.26 0.28 0.94
(1) In the fourth quarter of 2001, Headwaters recognized approximately
$7,470,000 of its deferred tax asset (see Note 12), recorded losses
totaling approximately $3,812,000 related to write-offs of notes
receivable and losses on equity
F-32
HEADWATERS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
___________
investments (see Note 2), and recorded $2,400,000 of expense related to
in-process research and development purchased in the HTI acquisition
(see Note 3).
(2) In the fourth quarter of 2002, Headwaters recorded approximately
$2,568,000 of losses related to the write-off of deferred project /
financing costs incurred in 2002 because management decided not to
pursue the proposed projects / financings. Also, Headwaters recorded an
impairment loss of approximately $986,000 related to a note receivable
(see Note 5).
F-33