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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 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 (I.R.S. Employer Identification No.)
of incorporation or organization)
10653 South River Front Parkway, Suite 300
South Jordan, Utah 84095
- -------------------------------------------- ------------
(Address of principal executive offices) (Zip Code)
(801) 984-9400
-----------------------------------------------------
(Registrant's telephone number, including area code)
11778 South Election Road, Suite 210, Draper, Utah 84020
---------------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
The number of shares outstanding of the Registrant's common stock as of
January 31, 2003 was 27,429,348.
HEADWATERS INCORPORATED
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Page No.
ITEM 1. FINANCIAL STATEMENTS (Unaudited):
Condensed Consolidated Balance Sheets - As of
September 30, 2002 and December 31, 2002............... 3
Condensed Consolidated Statements of Income -
For the three months ended December 31, 2001
and 2002............................................... 5
Condensed Consolidated Statement of Changes in
Stockholders' Equity - For the three months
ended December 31, 2002................................ 6
Condensed Consolidated Statements of Cash Flows
- For the three months ended December 31, 2001
and 2002............................................... 7
Notes to Condensed Consolidated Financial Statements .... 8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.................... 16
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK............................................ 20
ITEM 4. CONTROLS AND PROCEDURES.................................. 21
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS ....................................... 21
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS ............... 21
ITEM 3. DEFAULTS UPON SENIOR SECURITIES ......................... 21
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ..... 21
ITEM 5. OTHER INFORMATION........................................ 22
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ........................ 22
SIGNATURES................................................................. 23
CERTIFICATIONS............................................................. 24
Forward-looking Statements
Statements in this Form 10-Q, 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 caption
entitled "Forward-looking Statements" in Part I, Item 2 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
ITEM 1. FINANCIAL STATEMENTS
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, December 31,
(thousands of dollars) 2002 2002
- --------------------------------------------------------------------------------------------- --------------- ----------------
ASSETS
Current assets:
Cash and cash equivalents $ 7,284 $ 8,311
Short-term investments 5,907 5,690
Trade receivables, net 50,331 42,003
Inventories 8,442 7,847
Deferred income taxes 1,814 1,504
Other current assets 4,155 2,889
--------------- ----------------
Total current assets 77,933 68,244
--------------- ----------------
Property, plant and equipment, net 50,549 49,851
--------------- ----------------
Other assets:
Notes and accrued interest receivable 4,593 4,596
Intangible assets, net 118,918 117,292
Goodwill 113,367 113,367
Debt issue costs and other assets 7,497 7,051
--------------- ----------------
Total other assets 244,375 242,306
--------------- ----------------
Total assets $ 372,857 $ 360,401
=============== ================
See accompanying notes.
3
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS, continued
(Unaudited)
September 30, December 31,
(thousands of dollars and shares, except per-share data) 2002 2002
- -------------------------------------------------------------------------------------------- --------------- ----------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 20,773 $ 13,102
Accrued personnel costs 7,293 4,498
Accrued interest 394 3,149
Income taxes 1,244 2,507
Other accrued liabilities 13,250 9,791
Current portion of long-term debt 15,578 18,681
Current portion of unamortized non-refundable license fees 4,378 1,645
--------------- ----------------
Total current liabilities 62,910 53,373
--------------- ----------------
Long-term liabilities:
Long-term debt 154,552 141,975
Deferred income taxes 51,357 52,547
Unamortized non-refundable license fees 5,010 4,716
Other long-term liabilities 432 435
--------------- ----------------
Total long-term liabilities 211,351 199,673
--------------- ----------------
Total liabilities 274,261 253,046
--------------- ----------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.001 par value; authorized 50,000 shares, issued and
outstanding 27,327 shares at September 30, 2002 (including 526 shares
held in treasury) and 27,389 shares at December 31, 2002 (including 514
shares held in treasury) 27 27
Capital in excess of par value 126,265 126,994
Accumulated deficit (24,418) (16,366)
Treasury stock, at cost (3,013) (2,964)
Other (265) (336)
--------------- ----------------
Total stockholders' equity 98,596 107,355
--------------- ----------------
Total liabilities and stockholders' equity $ 372,857 $ 360,401
=============== ================
See accompanying notes.
4
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended December 31,
-------------------------------
(thousands of dollars, except per-share data) 2001 2002
- -------------------------------------------- ---------------- -------------
Revenue:
Chemical reagent sales $ 10,343 $ 29,068
License fees 5,816 8,778
Coal combustion products revenues -- 38,286
Manufactured products sales -- 11,084
Other revenues 2,263 1,493
--------------- -------------
Total revenue 18,422 88,709
--------------- -------------
Operating costs and expenses:
Cost of chemical reagents 7,229 19,011
Cost of coal combustion products revenues -- 27,996
Cost of manufactured products -- 8,605
Cost of other revenues 896 998
Depreciation and amortization 331 3,084
Research and development 534 1,014
Selling, general and administrative 2,250 10,024
--------------- -------------
Total operating costs and expenses 11,240 70,732
--------------- -------------
Operating income 7,182 17,977
--------------- -------------
Other income (expense):
Interest and net investment income (loss) (28) 90
Interest expense (39) (4,526)
Other, net 742 61
--------------- -------------
Total other income (expense), net 675 (4,375)
--------------- -------------
Income before income taxes 7,857 13,602
Income tax provision (3,130) (5,550)
--------------- -------------
Net income $ 4,727 $ 8,052
=============== =============
Basic net income per common share $ 0.20 $ 0.30
=============== =============
Diluted net income per common share $ 0.19 $ 0.29
=============== =============
See accompanying notes.
5
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
For the Three Months Ended December 31, 2002
Common Stock Common stock
---------------------- Capital in excess Accumulated held in
(thousands of dollars and shares) Shares Amount of par value deficit treasury Other
- --------------------------------------------------------- ---------- --------------- ---------------- ---------------- -------------
Balances as of September 30, 2002 27,327 $27 $ 126,265 $(24,418) $(3,013) $(265)
Exercise of stock options 62 -- 63
Tax benefit from exercise of stock options 570
12 shares of treasury stock transferred to
employee stock purchase plan, at cost 96 49
Other (71)
Net income 8,052
----------- -------- --------------- ------------------ ---------------- -----------
Balances as of December 31, 2002 27,389 $27 $126,994 $(16,366) $(2,964) $(336)
=========== ======== =============== ================== ================ ===========
See accompanying notes.
6
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended
December 31,
-------------- -------------
(thousands of dollars) 2001 2002
- ---------------------------------------------------------------------------------------------------- -------------- -------------
Cash flows from operating activities:
Net income $ 4,727 $ 8,052
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Deferred income taxes 2,632 1,500
Income tax benefit from exercise of stock options 440 570
Depreciation and amortization 331 3,084
Interest expense related to amortization of debt discount and debt issue costs 15 951
Amortization of non-refundable license fees (276) (294)
Net loss (gain) on disposition of property, plant and equipment 15 (19)
Other changes in operating assets and liabilities (9,803) (2,356)
-------------- -------------
Net cash provided by (used in) operating activities (1,919) 11,488
-------------- -------------
Cash flows from investing activities:
Collections on notes receivable 6,778 28
Purchase of property, plant and equipment (178) (718)
Net increase in other assets (252) (84)
-------------- -------------
Net cash provided by (used in) investing activities 6,348 (774)
-------------- -------------
Cash flows from financing activities:
Proceeds from issuance of short-term borrowings 2,056 --
Payments on long-term debt and short-term borrowings (6,295) (9,895)
Employee stock purchases 46 145
Proceeds from exercise of options and warrants 1,447 63
Purchase of common stock for the treasury (101) --
-------------- -------------
Net cash used in financing activities (2,847) (9,687)
-------------- -------------
Net increase in cash and cash equivalents 1,582 1,027
Cash and cash equivalents, beginning of period 999 7,284
-------------- -------------
Cash and cash equivalents, end of period $ 2,581 $ 8,311
============== =============
See accompanying notes.
7
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
__________
1. Nature of Operations and Basis of Presentation
Operations - Headwaters Incorporated provides technologies and services
that maximize the value of fossil fuels. Headwaters is focused on providing
services to energy companies, converting fossil fuels into alternative
energy products, and generally adding value to energy. Headwaters generates
revenues from managing coal combustion products ("CCPs") and from licensing
its innovative chemical technologies to produce alternative fuel.
Headwaters intends to expand its business through growth of existing
operations, commercialization of technologies currently being developed,
and strategic acquisitions of entities that operate in adjacent industries.
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.
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 2). ISG is the nation's largest provider of CCP 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 bagged
concrete, stucco, mortar and block products. ISG also develops and deploys
technologies for maintaining and improving fly ash quality.
Headwaters also owns 100% of Hydrocarbon Technologies, Inc. ("HTI"), a New
Jersey company formed in 1995 and acquired by Headwaters in August 2001.
HTI's research and development activities are directed at catalyst and
nano-catalyst technologies used to convert coal and heavy oils into
environment-friendly, higher-value liquid fuels.
Basis of Presentation - The accompanying unaudited condensed consolidated
financial statements have been prepared in accordance with the rules and
regulations of the Securities and Exchange Commission ("SEC") for quarterly
reports on Form 10-Q. In the opinion of management, all adjustments
considered necessary for a fair presentation have been included, and
consist of normal recurring adjustments. Certain information and footnote
disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United
States have been condensed or omitted. These financial statements should be
read in conjunction with the consolidated financial statements and notes
thereto included in Headwaters' Annual Report on Form 10-K for the year
ended September 30, 2002 ("Form 10-K"). Certain prior period amounts have
been reclassified to conform with the current period's presentation. The
reclassifications had no effect on net income or total assets.
Headwaters' fiscal year ends on September 30 and unless otherwise noted,
all future references to 2002 refer to Headwaters' fiscal quarter ended
December 31, 2002 and all references to 2001 refer to Headwaters' fiscal
quarter ended December 31, 2001.
ISG's results of operations for the three-month period ended December 31,
2002 are consolidated with Headwaters' 2002 results. ISG's results of
operations for periods prior to the September 2002 acquisition date have
not been consolidated with Headwaters' 2001 results. Due in part to the
seasonality of ISG's business, Headwaters' consolidated results of
operations for 2002 are not indicative of the results to be expected for
the full fiscal 2003 year.
2. 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. As described in more detail in the notes to
the consolidated financial statements included in the Form 10-K, 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. The final
allocation of the purchase price, including the estimated fair values for
certain acquired property, will likely differ from the preliminary
allocation reflected in the Form 10-K after final valuations and other
procedures have been completed.
8
3. 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, Headwaters now operates in three business segments,
alternative energy, CCPs, and manufactured products.
The following segment information for 2002 has been prepared in accordance
with SFAS No. 131, "Disclosure about Segments of an Enterprise and Related
Information." 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 overhead, research and development expenses and
other administrative departmental costs. Segment assets reflect those
specifically attributable to individual segments and primarily include
accounts receivable, inventories, property, plant and equipment, intangible
assets and goodwill. Other assets are included in the "Corporate" column.
Alternative Manufactured
(thousands of dollars) Energy CCPs Products Corporate Totals
------------------------------------------- ------------ ------------ -------------- ------------- ------------
Segment revenue $ 39,339 $ 38,286 $ 11,084 $ -- $ 88,709
============ ============ ============== ============= ============
EBITDA $ 18,159 $ 7,364 $ 963 $ (5,425) $ 21,061
Depreciation and amortization (290) (2,520) (174) (100) (3,084)
------------ ------------ -------------- ------------- ------------
Operating income $ 17,869 $ 4,844 $ 789 $ (5,525) 17,977
============ ============ ============== =============
Net interest expense (4,436)
Other income (expense), net 61
Income tax provision (5,550)
------------
Net income $ 8,052
============
Capital expenditures $ 109 $ 568 $ 28 $ 13 $ 718
============ ============ ============== ============= ============
Segment assets $ 34,444 $ 275,325 $ 19,670 $ 30,962 $ 360,401
============ ============ ============== ============= ============
4. Inventories
Inventories consisted of the following at:
September 30, December 31,
(thousands of dollars) 2002 2002
----------------------------------- --------------- ----------------
Raw materials $ 1,198 $ 892
Finished goods 7,244 6,955
--------------- ----------------
$ 8,442 $ 7,847
=============== ================
5. Intangible Assets and Goodwill
Intangible Assets - As more fully described in the notes to the
consolidated financial statements in the Form 10-K, with the exception of
certain disclosures which could not be early implemented, Headwaters
implemented SFAS No. 142, "Accounting for Goodwill and Intangible Assets,"
effective with the acquisitions of HTI in August 2001 and ISG in September
2002. Effective October 1, 2002, Headwaters fully implemented SFAS No. 142,
which mandates the following disclosures.
9
Headwaters has no intangible assets that are not being amortized. The
following table summarizes the gross carrying amounts and the related
accumulated amortization of all amortizable intangible assets as of:
September 30, 2002 December 31, 2002
-------------------------------- --------------------------------
Gross Gross
Estimated Carrying Accumulated Carrying Accumulated
(thousands of dollars) useful lives Amount Amortization Amount Amortization
----------------------------- -------------- --------------- ---------------- --------------- ----------------
ISG contracts 20 years $ 106,400 $ 179 $ 106,400 $ 1,509
HTI patented technology 15 years 9,700 647 9,700 808
ISG patents 7 1/2 years 2,764 4 2,764 97
Other 9 - 10 years 1,522 638 1,522 680
--------------- ---------------- --------------- ----------------
$ 120,386 $ 1,468 $ 120,386 $ 3,094
=============== ================ =============== ================
Total amortization expense related to intangible assets was approximately
$204,000 in 2001 and $1,626,000 in 2002. Total estimated amortization
expense for fiscal years 2003 through 2007 is approximately $6,507,000 per
year.
Goodwill - In accordance with SFAS No. 142, Headwaters does not amortize
goodwill, all of which relates to the acquisitions of ISG and HTI. There
were no changes in the carrying amount of goodwill during 2002. SFAS No.
142 requires Headwaters to periodically perform a test for goodwill
impairment. Step 1 of the initial impairment test must be performed by
March 31, 2003 and thereafter no less often than annually, or sooner if
evidence of possible impairment arises. Impairment testing is performed at
the reporting unit level and Headwaters has identified four reporting
units: the Covol Fuels division and HTI (which together comprise the
alternative energy segment), CCPs and manufactured products. Currently,
goodwill exists only in the HTI and CCPs reporting units.
Step 1 of the impairment test consists of determining and comparing the
fair values of the reporting units to the carrying values of the reporting
units. If step 1 is failed for either HTI or the CCPs reporting units,
indicating a potential impairment, Headwaters would be required to complete
step 2, which is a more detailed test to calculate the implied fair value
of goodwill and compare that value to the carrying value of the goodwill.
In June 2002, Headwaters performed an impairment test for HTI's goodwill
using the former standards for impairment testing. No impairment was
observed at that time. ISG's goodwill, all of which was assigned to the
CCPs reporting unit, was determined in September 2002. Prior to March 31,
2003, Headwaters will perform step 1 tests for goodwill impairment for both
HTI and the CCPs reporting units. If potential impairment is indicated
during that test, Headwaters will perform step 2 testing prior to the end
of fiscal 2003.
6. Long-term Debt
Long-term debt consisted of the following at:
September 30, December 31,
(thousands of dollars) 2002 2002
--------------------------------------------------------------- ----------------- ----------------
Senior secured debt with a face amount totaling $155,000 at
September 30, 2002 and $145,125 at December 31, 2002 $ 150,378 $ 140,905
Senior subordinated debentures with a face amount totaling
$20,000 19,603 19,622
Other 149 129
----------------- ----------------
170,130 160,656
Less: current portion (15,578) (18,681)
----------------- ----------------
Total long-term debt $ 154,552 $ 141,975
================= ================
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
10
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 December 31, 2002), and is repayable in quarterly
installments through August 2007. In December 2002, principal repayments
totaling $9,875,000 were made, which included a $6,000,000 optional early
repayment. When optional prepayments are made, required principal
repayments for all future periods are reduced and now total approximately
$11,164,000 for the remainder of fiscal 2003, approximately $29,769,000 in
fiscal years 2004, 2005 and 2006, and approximately $44,654,000 in fiscal
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 of "excess cash flow," ranging
up to 100%, which percentage is based on Headwaters' "leverage ratio."
The credit 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 December 31, 2002,
Headwaters must maintain a total leverage ratio of 2.75:1.0 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 December 31, 2002 must be
2.25:1.0 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
December 31, 2002 was 4.0:1.0 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 December 31, 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 under the available
revolving credit line. As of January 31, 2003, 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 January 31, 2003. Headwaters pays a fee of 5/8% on the
unused portion of the revolving credit agreement.
Senior Subordinated Debentures - In connection with the ISG acquisition,
Headwaters also entered into a $20,000,000 subordinated loan agreement,
under which senior subordinated debentures were issued at a 2% discount,
with Headwaters receiving net cash proceeds of $19,600,000. The original
issue discount 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 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 December 31, 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
2.25:1.0 or less. The interest coverage requirement at December 31, 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
4.75:1.0 or more. Headwaters was in compliance with all debt covenants as
of December 31, 2002.
11
Interest Costs - As a result of the $6,000,000 early repayment of principal
in December 2002, additional non-cash interest expense of approximately
$365,000 was incurred, representing accelerated amortization of debt
discount and debt issue costs associated with that principal amount. During
2002, Headwaters incurred total interest costs of approximately $4,533,000,
including approximately $951,000 of non-cash interest expense and
approximately $7,000 of interest costs that were capitalized. During 2001,
Headwaters incurred total interest costs of approximately $39,000,
including approximately $15,000 of non-cash interest expense. No interest
costs were capitalized in 2001. The weighted-average interest rate on
outstanding long-term debt was approximately 7.3% at September 30, 2002 and
7.4% at December 31, 2002.
7. Stock Options
Headwaters has elected to continue to apply the intrinsic value method as
prescribed by APB 25 in accounting for options granted to employees,
officers 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"), as
amended by SFAS No. 148, 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 $23,000 in both 2001 and 2002. If the fair
value provisions of SFAS No. 123 would have been applied to all options
granted, compensation expense would have been approximately $558,000 in
2001 and approximately $833,000 in 2002.
If Headwaters had elected to account for options granted based on their
fair values, as prescribed by SFAS 123, net income and income per share for
2001 and 2002 would have been changed to the pro forma amounts shown in the
table below.
Three Months Ended December 31,
(thousands of dollars, except --------------------------------
per-share data) 2001 2002
--------------------------------------- ------------- ---------------
Net income - as reported $4,727 $8,052
- pro forma 4,192 7,242
Basic income per share - as reported 0.20 0.30
- pro forma 0.18 0.27
Diluted income per share - as reported 0.19 0.29
- pro forma 0.17 0.26
The fair values of the 2001 and 2002 option grants were determined using
the Black-Scholes option pricing model and the following assumptions:
expected stock price volatility of 40% to 60%, risk-free interest rates
ranging from 1.7% to 4.0%, weighted average expected option lives of five
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 that 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.
In October 2002, the number of shares that can be granted under Headwaters'
2002 Stock Incentive Plan was increased by 350,000 shares. Subsequently, in
November 2002, Headwaters granted to the new ISG employees non-statutory
options to purchase approximately 500,000 shares of common stock. These
options have an exercise price of $16.97 per share, which was equal to the
fair market value of Headwaters' common stock on the date of grant. In
January 2003, Headwaters granted to non-employee directors options to
purchase 36,000 shares of common stock. These options have an exercise
price of $14.38 per share, which was equal to the fair market value of
Headwaters' common stock on the date of grant.
12
In January 2003, Headwaters' Board of Directors adopted, subject to
shareholder approval in Headwaters' March 2003 Annual Meeting, a new stock
option plan, the 2003 Stock Incentive Plan, which is described in more
detail in Headwaters' Proxy Statement filed with the SEC on January 28,
2003. The 2003 Stock Incentive Plan reserves for issuance 1,000,000 shares
of common stock. Stock options, restricted stock and stock appreciation
rights may be granted under the 2003 Plan.
8. Income Taxes
The income tax provision consisted of the following:
Three Months Ended December 31,
---------------------------------
(thousands of dollars) 2001 2002
----------------------------------------- ---------------- ----------------
Current tax provision:
Federal $ -- $ 2,940
State 60 540
---------------- ----------------
Total current tax provision 60 3,480
Deferred tax provision:
Federal 2,810 1,865
State 260 205
---------------- ----------------
Total deferred tax provision 3,070 2,070
---------------- ----------------
Total income tax provision $ 3,130 $ 5,550
================ ================
9. Earnings per Share
Three Months Ended December 31,
----------------- ----------------
(thousands of dollars and shares, except per-share data) 2001 2002
------------------------------------------------------------- ----------------- ----------------
Numerator - Net income $ 4,727 $ 8,052
================= ================
Denominator:
Denominator for basic earnings per share - weighted-average
shares outstanding 23,592 26,834
Effect of dilutive securities - shares issuable upon
exercise of options and warrants 1,621 1,332
----------------- ----------------
Denominator for diluted earnings per share -
weighted-average shares outstanding after
assumed exercises 25,213 28,166
================= ================
Basic net income per share $ 0.20 $ 0.30
================= ================
Diluted net income per share $ 0.19 $ 0.29
================= ================
Anti-dilutive securities not considered in the diluted earnings per share
calculations, consisting of out-of-the money options, totaled approximately
695,000 shares in 2001and 290,000 shares in 2002.
10. Commitments and Contingencies
Commitments and contingencies as of December 31, 2002 not disclosed
elsewhere, are as follows:
Medical Insurance - For calendar 2002, ISG established a self-insured
medical insurance plan for its employees. This plan has stop-loss coverage
for amounts in excess of $75,000 per individual and approximately
$5,100,000 in the aggregate for the plan year ended December 31, 2002. ISG
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 for claims incurred but not
13
reported at the balance sheet date. As of December 31, 2002, approximately
$1,041,000 has been accrued for this liability. Effective January 1, 2003,
Headwaters adopted a self-insured medical insurance plan for employees of
all of its subsidiaries. This plan has stop-loss coverage for amounts in
excess of $75,000 per individual and approximately $5,400,000 in the
aggregate for the plan year ending December 31, 2003.
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
14
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.
License Fees. Pursuant to the contractual terms of an agreement with a
certain licensee, the cumulative net license fees generated by Headwaters,
totaling approximately $10,000,000 as of December 31, 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.
Incentive Agreements with ISG Principals. In January 2003, Headwaters
executed incentive agreements, with an effective date of November 2002,
with three of the former stockholders and officers of ISG, all of whom are
current officers of either Headwaters or ISG. The agreements call for
contingent payments totaling up to $5,000,000 in the event of (i) a change
in control, as defined, or (ii) continuing employment through September
2004 and an increase in the average stock price for Headwaters' common
stock for any calendar quarter exceeding $20 per share. The maximum
payments would be required if there were a change in control prior to
October 2004, or if the officers remain employed through September 2004 and
the average stock price for any calendar quarter reaches $25 per share or
more.
11. 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. The most likely use of proceeds
from securities offered under the shelf registration would be to reduce
long-term debt; however, proceeds could also be used for working capital
and other general corporate purposes.
12. Recent Accounting Pronouncements
In December 2002, SFAS No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure," was issued. This statement amends SFAS No. 123
to provide alternative methods of transition for a voluntary change to the
fair value method of accounting for stock-based employee compensation. It
also requires disclosures in interim financial statements about the method
of accounting for stock-based employee compensation and the effect of the
method used on reported results. Headwaters does not currently intend to
voluntarily change to the fair value method of accounting for stock-based
compensation, but has implemented the interim financial statement
disclosure requirements (see Note 7).
In July 2002, SFAS No. 146, "Accounting for Costs Associated with Exit or
Disposal Activities," was issued. This pronouncement must be implemented by
Headwaters as of January 1, 2003. Headwaters has reviewed this standard 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.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with the accompanying unaudited consolidated financial statements and notes
thereto.
Acquisition of ISG and Segments
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 2 to the consolidated
financial statements, ISG was acquired on September 19, 2002. Accordingly, ISG's
results of operations for the three-month period ended December 31, 2002 are
consolidated with Headwaters' 2002 results. ISG's results of operations for
periods prior to the September 2002 acquisition date have not been consolidated
with Headwaters' 2001 results. ISG's business is seasonal; its strongest quarter
is typically the September quarter, followed by the June and December quarters.
The slowest quarter for ISG is the March quarter. Due in part to the seasonality
of ISG's business, Headwaters' consolidated results of operations for 2002 are
not indicative of the results to be expected for the full fiscal 2003 year.
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. 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 research and development
activities directed at catalyst and nano-catalyst technologies used to convert
coal and heavy oils into environment-friendly, higher-value liquid 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 continually seeks to
increase the volumes of CCPs used as ingredients in the mortars, stuccos and
blocks that the manufactured products segment produces.
Three Months Ended December 31, 2002 Compared to Three Months Ended
December 31, 2001
The information set forth below compares Headwaters' operating results
for the three months ended December 31, 2002 ("2002") with operating results for
the three months ended December 31, 2001 ("2001").
Revenue. Total revenue for 2002 increased by $70.3 million or 382% to
$88.7 million as compared to $18.4 million for 2001. The major components of
revenue are discussed in the sections below.
Chemical Reagent Sales. Chemical reagent sales during 2002 were $29.1
million with a corresponding direct cost of $19.0 million. Chemical reagent
sales during 2001 were $10.3 million with a corresponding direct cost of $7.2
million. The increase in chemical reagent sales during 2002 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 fiscal 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 fiscal 2003 to be as high as it was for fiscal 2002. The gross profit
margin increased in 2002 from 2001 due primarily to the reduction or elimination
of certain temporary pricing discounts and differing chemical reagent formula
requirements of certain licensees and new customers. Headwaters currently
expects fiscal 2003 gross profit margins to be generally consistent with the
2002 reported gross profit margin.
License Fees. During 2002, Headwaters recognized license fee revenue
totaling $8.8 million, an increase of $3.0 million or 52% over $5.8 million of
license fee revenue recognized during 2001. License fees in 2002 consisted of
recurring license fees or royalty payments of $8.5 million and deferred revenue
amortization of $0.3 million. License fees in 2001 consisted of recurring
license fees of $5.5 million and deferred revenue amortization of $0.3 million.
16
A major licensee which purchased four facilities from a former licensee
in October 2001 did not operate those facilities during 2001. Headwaters earned
approximately $3.2 million in license fees from this licensee in 2002. This
factor was the primary cause of the increase in license fee revenue for 2002
over 2001. Headwaters currently expects license fee revenue in fiscal 2003 to
exceed the amounts reported for the respective fiscal 2002 periods. 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 $10.0 million as of December 31, 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.
ISG Revenues and Cost of Revenues. Coal combustion products revenues
and manufactured product sales and the related cost of revenue captions
represent ISG's revenues and cost of revenues for 2002. There were no comparable
revenues and cost of revenues for ISG in 2001.
Depreciation and Amortization. These costs increased by $2.8 million to
$3.1 million in 2002 from $0.3 million in 2001. The increase was primarily
attributable to the depreciation and amortization of the tangible and intangible
assets related to the ISG acquisition. Depreciation and amortization expense in
subsequent quarters should be comparable to 2002, but will increase
substantially in fiscal 2003 over the respective 2002 periods as a result of the
ISG acquisition.
Research and Development. Research and development expenses increased
by $0.5 million to $1.0 million in 2002 from $0.5 million in 2001. The increase
was primarily attributable to the costs of ISG's research and development
activities. In 2001, research and development expenses primarily represent costs
related to HTI's activities.
Selling, General and Administrative Expenses. These expenses increased
$7.7 million or 335% to $10.0 million for 2002 from $2.3 million for 2001. The
increase in 2002 was due primarily to the inclusion of ISG's costs and to a
lesser extent an increase in compensation-related costs of approximately $0.8
million and an increase in professional services expenses of approximately $0.5
million. The increase in compensation-related costs related primarily to an
increase in incentive-based pay as a result of improved operating results. The
increase in professional services expenses was due primarily to increased legal
activity during the quarter associated with legal actions Headwaters is
currently pursuing.
Other Income and Expense. During 2002, Headwaters reported net other
expenses of $4.4 million compared to net other income of $0.7 million during
2001. The change of $5.1 million is primarily attributable to an increase in
interest expense of $4.5 million and a one-time gain in 2001 for $0.8 million
related to the collection of a note receivable that had previously been written
off.
Interest expense increased in 2002 due to the substantial increase in
debt incurred in September 2002 to finance the acquisition of ISG. Interest
expense in 2002 also includes $0.4 million related to accelerated amortization
of debt discount and debt issue costs associated with a $6.0 million early
repayment of senior debt principal. Interest expense will be significantly
higher in fiscal 2003 compared to the respective fiscal 2002 periods as a result
of the debt incurred to facilitate the ISG acquisition. In addition, any future
early repayments of debt principal will accelerate the amortization of debt
discount and debt issue costs.
Income Tax Provision. In 2001, Headwaters recorded an income tax
provision with an effective tax rate of approximately 40%. In 2002, the
effective tax rate was 41%.
Liquidity and Capital Resources
Net cash provided by operations during 2002 was $11.5 million compared
to $1.9 million of net cash used in operations during 2001. Most of the positive
cash flow from operating activities in both periods was attributable to net
income; however in 2001, due to the significant growth in Headwaters' business
and the corresponding cash requirements, operating activities resulted in a net
cash outflow. During 2002, investing activities consisted primarily of payments
for the purchase of property, plant and equipment. Investing activities in 2001
consisted primarily of the collection of a $6.5 million note receivable.
Financing activities in both 2002 and 2001 consisted primarily of repayments of
long-term debt and short-term borrowings.
Operating Activities. Cash provided from operations in 2002 of $11.5
million primarily resulted from net income of $8.1 million, non-cash deferred
income taxes, depreciation and amortization and the non-cash portion of interest
expense (amortization of debt discount and debt issue costs).
17
Investing and Financing Activities. Headwaters acquired ISG in
September 2002. In order to obtain the cash necessary to acquire ISG and retire
ISG's debt, Headwaters issued $175.0 million of new debt consisting of $155.0
million of senior secured debt and $20.0 million of subordinated debt (see Note
6 to the consolidated financial statements). In December 2002, principal
repayments of the senior debt totaling $9.9 million were made, which included a
$6.0 million optional early repayment. When optional prepayments are made,
required principal repayments for all future periods are reduced. Currently, the
remaining required fiscal 2003 principal repayments total $11.2 million.
Headwaters may, in the future make additional optional early repayments of the
senior debt depending on actual cash flows, Headwaters' current and expected
cash requirements and other factors deemed significant by management.
In 2002, payments for the purchase of property, plant and equipment
totaled $0.7 million. These capital expenditures primarily related to ISG's
business, in particular the CCP segment. Capital expenditures are currently
expected to total approximately $10.0 million in fiscal 2003.
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. As of December 31, 2002, this note
has a carrying value of $2.7 million. Headwaters could incur additional losses
if the remaining balance on the note is not repaid. At September 30, 2001,
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.
In 2002, cash proceeds from employee stock purchases and from the
exercise of options and warrants totaled $0.2 million, compared to $1.5 million
in 2001. Option and warrant exercise activity is largely dependent on
Headwaters' stock price and is not predictable. To the extent non-qualified
stock options are exercised, or there are disqualifying dispositions of shares
obtained upon the exercise of incentive stock options, Headwaters receives a tax
benefit generally equal to the income recognized by the optionee. Such amounts,
reflected in cash flows from operations in the consolidated statements of cash
flows, were $0.6 million in 2002 and $0.4 million in 2001.
Headwaters intends to expand its business through growth of existing
operations, commercialization of technologies currently being developed, and
strategic acquisitions of entities that operate in adjacent industries.
Acquisitions over a certain size require the approval of current senior 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. The most likely use of proceeds from
securities offered under the shelf registration would be to reduce long-term
debt; however, proceeds could also be used for working capital and other general
corporate purposes.
Working Capital. Headwaters' working capital remained essentially
unchanged from September 30, 2002, to December 31, 2002. Decreases in current
assets, primarily trade receivables, were offset by decreases in current
liabilities, primarily accounts payable. These changes in current assets and
current liabilities were primarily due to the seasonality of ISG's business.
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 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. The debt is secured by all assets of
Headwaters, bears interest at a variable rate (approximately 5.9% at December
31, 2002), and is repayable in quarterly installments through August 2007.
Required principal repayments for all future periods currently total
approximately $11.2 million for the remainder of fiscal 2003, approximately
$29.8 million in fiscal years 2004, 2005 and 2006, and approximately $44.7
million in fiscal 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 of "excess cash flow,"
ranging up to 100%, which percentage is based on Headwaters' "leverage ratio."
The credit 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 December 31, 2002, Headwaters must maintain a total
leverage ratio of 2.75:1.0 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 December
31, 2002 must be 2.25:1.0 or less, declining over time through June 2004, at
18
which time it must be maintained at 1.5:1.0 or less. The interest coverage
requirement at December 31, 2002 was 4.0:1.0 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 December 31, 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 under the available revolving credit line. As
of January 31, 2003, two letters of credit for a total of $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 January 31, 2003.
Headwaters pays a fee of 5/8% on the unused portion of the revolving credit
agreement.
In connection with the ISG acquisition, Headwaters also entered into a
$20.0 million subordinated loan agreement. 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 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 December 31, 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 2.25:1.0 or less. The
interest coverage requirement at December 31, 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 4.75:1.0 or more. Headwaters was in
compliance with all debt covenants as of December 31, 2002.
Income Taxes. Although Headwaters has some net operating loss
carryforwards ("NOLs") in certain states, remaining NOLs for federal tax
purposes are not significant. Accordingly, Headwaters' cash requirements for
income taxes in fiscal 2003 will be significant. In 2002, payments totaling
approximately $2.3 million were made. Income tax payments for the remainder of
fiscal 2003 are expected to be much higher proportionately than for the fiscal
2002 period.
Summary of Future Cash Requirements. 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.
Recent Accounting Pronouncements
In December 2002, SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," was issued. This statement amends
SFAS No. 123 to provide alternative methods of transition for a voluntary change
to the fair value method of accounting for stock-based employee compensation. It
also requires disclosures in interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. Headwaters does not currently intend to voluntarily
change to the fair value method of accounting for stock-based compensation, but
has implemented the interim financial statement disclosure requirements (see
Note 7).
In July 2002, SFAS No. 146, "Accounting for Costs Associated with Exit
or Disposal Activities," was issued. This pronouncement must be implemented by
Headwaters as of January 1, 2003. Headwaters has reviewed this standard 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.
Forward-looking Statements
Statements in this Quarterly Report on Form 10-Q 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 availability of
feedstocks, and the marketability of the coal combustion products and
19
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) Liabilities in excess of Headwaters' insurance limits, not covered by
insurance, or for which insurance is not available.
(9) 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.
(10) Marketing issues relating to acceptance and regulatory permitting of
alternative fuels manufactured using Covol Fuels' technologies.
(11) Securing of suitable alternative fuel facility sites, including permits and
raw materials, for relocation and operation of alternative fuel facilities
and product sales.
(12) The market acceptance of products manufactured with Headwaters'
technologies in the face of competition from traditional products.
(13) Dependence on licensees to successfully implement Covol Fuels' technologies
and to make license and other payments to Covol Fuels.
(14) Maintenance of placed-in-service and other requirements under Section 29 of
the tax code by alternative fuel manufacturing facilities.
(15) 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.
(16) The continued availability of tax credits to licensees under the tax code
and each licensee's ability to use tax credits.
(17) The commercial feasibility of Covol Fuels' alternative fuel technologies
upon the expiration of tax credits.
(18) Ability to commercialize new technologies which have only been tested in
the laboratory and not in full-scale operations.
(19) 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.
(20) Success of HTI in conducting business in China.
(21) Success in the face of competition by others producing coal combustion
products or alternative chemical reagent products.
(22) Sufficiency of intellectual property protections.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Headwaters is exposed to financial market risks, primarily related to
changes in interest rates. Headwaters does not use derivative financial
instruments for speculative or trading purposes, and no significant derivative
financial instruments were outstanding as of December 31, 2002 or subsequent
thereto.
20
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 income. 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 6 to the consolidated financial
statements, Headwaters has outstanding $145.1 million of variable-rate long-term
debt as of December 31, 2002. The interest rate on this debt as of December 31,
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 interest expense by
approximately $1.4 million during the next 12 months, considering required
principal repayments.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure controls are procedures that are designed with an objective
of ensuring that information required to be disclosed in Headwaters' periodic
reports filed with the SEC, such as this Quarterly Report on Form 10-Q, is
recorded, processed, summarized and reported within the time periods specified
by 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
Quarterly Report. Headwaters' management, including the CEO and CFO, does not
expect that disclosure controls can or will prevent or detect all errors and all
fraud, if any. A control system, no matter how well designed and operated, can
provide only reasonable, not absolute, assurance that the objectives of the
control system are met. Also, projections of any evaluation of the disclosure
controls and procedures to future periods are subject to the risk that the
disclosure controls and procedures may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may
deteriorate.
Based on their review and evaluation as of a date within 90 days of the
filing of this Form 10-Q, and subject to the inherent limitations 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.
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See "ITEM 3: LEGAL PROCEEDINGS" in Headwaters' Annual Report on Form
10-K for the year ended September 30, 2002 for descriptions of current legal
proceedings. There have been no material changes with respect to legal
proceedings as they are described in the Form 10-K.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Recent Sales of Unregistered Securities
During the quarter ended December 31, 2002, pursuant to the exercise of
options, approximately 49,000 shares of Headwaters restricted common stock were
issued. Headwaters has several outstanding effective registration statements
filed on Forms S-3 and Forms S-8. All of the shares of restricted common stock
issued during the quarter have been registered under one of these registration
statements.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
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ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following exhibits are included herein:
10.82 Incentive Agreement between Headwaters and R Steve *
Creamer dated as of November 12, 2002
10.83 Incentive Agreement between Headwaters and Raul A. Deju *
dated as of November 12, 2002
10.84 Incentive Agreement between Headwaters and J. I. Everest, *
II dated as of November 12, 2002
99.3 Amended Incentive Bonus Plan dated 16 January 2003 *
99.5 Certification of Chief Executive Officer *
99.6 Certification of Chief Financial Officer *
99.7 2003 Stock Incentive Plan *
- ------------------------
* Filed herewith.
(b) Headwaters filed the following Forms 8-K during the quarter ended
December 31, 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
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).
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HEADWATERS INCORPORATED
Date: February 11, 2003 By: /s/ Kirk A. Benson
--------------------------------
Kirk A. Benson, Chief Executive
Officer and Principal Executive
Officer
Date: February 11, 2003 By: /s/ Steven G. Stewart
--------------------------------
Steven G. Stewart, Chief
Financial Officer and Principal
Financial Officer
23
CERTIFICATIONS
I, Kirk A. Benson, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of Headwaters
Incorporated;
2. Based on my knowledge, this Quarterly 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 Quarterly Report;
3. Based on my knowledge, the financial statements, and other financial
information included in this Quarterly 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
Quarterly 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 we
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 Quarterly 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 Quarterly Report (the "Evaluation Date"); and
c) presented in this Quarterly 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
Quarterly Report whether or not 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: February 11, 2003
/s/ Kirk A. Benson
- ---------------------------
Kirk A. Benson
Chief Executive Officer
24
I, Steven G. Stewart, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of Headwaters
Incorporated;
2. Based on my knowledge, this Quarterly 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 Quarterly Report;
3. Based on my knowledge, the financial statements, and other financial
information included in this Quarterly 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
Quarterly 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 we
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 Quarterly 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 Quarterly Report (the "Evaluation Date"); and
(c) presented in this Quarterly 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
Quarterly Report whether or not 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: February 11, 2003
/s/ Steven G. Stewart
- ---------------------------
Steven G. Stewart
Chief Financial Officer
25