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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 March 31, 2004
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)
10653 South River Front Parkway, Suite 300
South Jordan, Utah 84095
------------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
(801) 984-9400
---------------------------------------------------
(Registrant's telephone number, including area code)
Not applicable
---------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is 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 April
23, 2004 was 33,571,000.
HEADWATERS INCORPORATED
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Page No.
ITEM 1. FINANCIAL STATEMENTS (Unaudited):
Condensed Consolidated Balance Sheets - As of
September 30, 2003 and March 31, 2004........................ 3
Condensed Consolidated Statements of Income - For the three
and six months ended March 31, 2003 and 2004................. 4
Condensed Consolidated Statement of Changes in Stockholders'
Equity - For the six months ended March 31, 2004............. 5
Condensed Consolidated Statements of Cash Flows - For the six
months ended March 31, 2003 and 2004......................... 6
Notes to Condensed Consolidated Financial Statements........... 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.......................................18
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK......24
ITEM 4. CONTROLS AND PROCEDURES.........................................24
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS..............................................25
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS......................25
ITEM 3. DEFAULTS UPON SENIOR SECURITIES................................25
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............25
ITEM 5. OTHER INFORMATION..............................................26
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K...............................26
SIGNATURES...................................................................27
Forward-looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995 regarding
future events and our future results that are based on current expectations,
estimates, forecasts, and projections about the industries in which we operate
and the beliefs and assumptions of our management. Actual results may vary
materially from such expectations. Words such as "expects," "anticipates,"
"targets," "goals," "projects," "believes," "seeks," "estimates," variations of
such words and similar expressions are intended to identify such forward-looking
statements. In addition, any statements that refer to projections of our future
financial performance, our anticipated growth and trends in our businesses, and
other characterizations of future events or circumstances, are forward-looking.
For a discussion of the factors that could cause actual results to differ from
expectations, please see the captions entitled "Forward-looking Statements" and
"Risk Factors" in Item 7 of our Annual Report on Form 10-K for the year ended
September 30, 2003. There can be no assurance that our results of operations
will not be adversely affected by such factors. Unless legally required, we
undertake no obligation to revise or update any forward-looking statements for
any reason. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date of this report.
Our internet address is www.hdwtrs.com. There we make available, free of charge,
our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports
on Form 8-K and any amendments to those reports, as soon as reasonably
practicable after we electronically file such material with, or furnish it to,
the Securities and Exchange Commission ("SEC"). Our reports can be accessed
through the investor relations section of our web site. The information found on
our web site is not part of this or any report we file or furnish to the SEC.
2
ITEM 1. FINANCIAL STATEMENTS
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, March 31,
(in thousands, except per-share data) 2003 2004
- --------------------------------------------------------------------------------------- ----------------- ----------------
ASSETS
Current assets:
Cash and cash equivalents $ 18,732 $ 4,535
Short-term trading investments 2,921 33,568
Trade receivables, net 52,399 87,024
Inventories 7,827 9,924
Other current assets 6,005 5,957
------------ ------------
Total current assets 87,884 141,008
------------ ------------
Property, plant and equipment, net 52,743 53,747
------------ ------------
Other assets:
Intangible assets, net 112,414 110,121
Goodwill 112,131 112,131
Debt issue costs and other assets 8,103 4,703
------------ ------------
Total other assets 232,648 226,955
------------ ------------
Total assets $ 373,275 $ 421,710
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 17,177 $ 10,957
Accrued personnel costs 8,669 11,919
Other accrued liabilities 16,522 23,936
Current portion of long-term debt 27,475 5,012
Current portion of unamortized non-refundable license fees 3,865 2,066
------------ ------------
Total current liabilities 73,708 53,890
------------ ------------
Long-term liabilities:
Long-term debt 104,044 45,035
Deferred income taxes 50,663 51,273
Unamortized non-refundable license fees and other long-term liabilities 4,703 3,860
------------ ------------
Total long-term liabilities 159,410 100,168
------------ ------------
Total liabilities 233,118 154,058
------------ ------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.001 par value; authorized 50,000 shares, issued and
outstanding 27,878 shares at September 30, 2003 (including 467 shares
held in treasury) and 33,413 shares at March 31, 2004 (including 437
shares held in treasury) 28 33
Capital in excess of par value 130,936 229,562
Retained earnings 12,213 40,932
Treasury stock, at cost (2,783) (2,683)
Other (237) (192)
------------ ------------
Total stockholders' equity 140,157 267,652
------------ ------------
Total liabilities and stockholders' equity $ 373,275 $ 421,710
============ ============
See accompanying notes.
3
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended Six Months Ended
March 31, March 31,
--------------------------------- --------------------------------
(in thousands, except per-share data) 2003 2004 2003 2004
- ----------------------------------------------------------- ---------------- ---------------- ---------------- ---------------
Revenue:
Sales of chemical reagents $ 33,123 $ 32,229 $ 62,191 $ 63,109
License fees 8,948 36,277 17,726 45,832
Coal combustion products revenues 31,168 39,592 69,454 84,692
Sales of construction materials 11,700 11,248 22,784 23,181
Other revenues 1,114 175 2,607 4,175
------------ ------------ ------------ ------------
Total revenue 86,053 119,521 174,762 220,989
------------ ------------ ------------ ------------
Operating costs and expenses:
Cost of chemical reagents sold 21,782 21,759 40,793 43,019
Cost of coal combustion products revenues 23,422 28,501 51,418 60,746
Cost of construction materials sold 8,672 9,789 17,077 19,256
Cost of other revenues 1,135 252 2,132 317
Depreciation and amortization 3,167 3,239 6,251 6,507
Research and development 1,106 1,460 2,120 3,456
Selling, general and administrative 10,001 16,498 20,225 27,617
------------ ------------ ------------ ------------
Total operating costs and expenses 69,285 81,498 140,016 160,918
------------ ------------ ------------ ------------
Operating income 16,768 38,023 34,746 60,071
------------ ------------ ------------ ------------
Other income (expense):
Interest and net investment income 81 314 171 362
Interest expense (3,541) (6,011) (8,068) (11,350)
Losses on notes receivable (2,142) (504) (2,142) (1,038)
Other, net 23 (1,385) 84 (1,356)
------------ ------------ ------------ ------------
Total other income (expense), net (5,579) (7,586) (9,955) (13,382)
------------ ------------ ------------ ------------
Income before income taxes 11,189 30,437 24,791 46,689
Income tax provision (4,400) (11,810) (9,950) (17,970)
------------ ------------ ------------ ------------
Net income $ 6,789 $ 18,627 $ 14,841 $ 28,719
============ ============ ============ ============
Basic earnings per common share $ 0.25 $ 0.57 $ 0.55 $ 0.95
============ ============ ============ ============
Diluted earnings per common share $ 0.24 $ 0.55 $ 0.53 $ 0.91
============ ============ ============ ============
See accompanying notes.
4
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
For the Six Months Ended March 31, 2004
Common stock Capital in Total
------------------- excess Retained Common stock stockholders'
(in thousands) Shares Amount of par value earnings held in treasury Other equity
- ---------------------------------- --------- --------- -------------- ------------ ------------------ ---------- --------------
Balances as of September 30, 2003 27,878 $28 $130,936 $12,213 $(2,783) $(237) $140,157
Common stock issued for cash, net
of offering costs of $6,387 4,958 5 90,298 90,303
Exercise of stock options and
warrants 577 -- 5,082 5,082
Tax benefit from exercise of
stock options and warrants 2,910 2,910
30 shares of treasury stock
transferred to employee stock
purchase plan, at cost 336 100 436
Amortization of deferred
compensation from stock
options 45 45
Net income for the six months
ended March 31, 2004 28,719 28,719
------ ------- ----------- --------- ---------- -------- -----------
Balances as of March 31, 2004 33,413 $ 33 $ 229,562 $ 40,932 $ (2,683) $ (192) $ 267,652
====== ======= =========== ========= ========== ======== ===========
See accompanying notes.
5
HEADWATERS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended March 31,
--------------------------------
(in thousands) 2003 2004
- ---------------------------------------------------------------------------------------------- --------------- ----------------
Cash flows from operating activities:
Net income $ 14,841 $ 28,719
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Depreciation and amortization 6,251 6,507
Non cash interest expense related to amortization of debt discount
and debt issue costs 1,604 7,631
Deferred income taxes 322 743
Income tax benefit from exercise of stock options 750 2,910
Amortization of non-refundable license fees (589) (590)
Net loss (gain) on disposition of property, plant and equipment (116) 663
Write-down of notes receivable 2,142 1,038
Decrease (increase) in trade receivables 493 (34,625)
Decrease (increase) in short-term trading investments 3,121 (30,647)
Other changes in operating assets and liabilities, net (11,011) 592
------------ ------------
Net cash provided by (used in) operating activities 17,808 (17,059)
------------ ------------
Cash flows from investing activities:
Purchase of property, plant and equipment (2,910) (4,890)
Proceeds from disposition of property, plant and equipment 162 53
Increase in intangible assets -- (1,045)
Net increase in other assets (407) (1,406)
------------ ------------
Net cash used in investing activities (3,155) (7,288)
------------ ------------
Cash flows from financing activities:
Net proceeds from issuance of common stock -- 90,303
Net proceeds from issuance of long-term debt -- 49,205
Payments on long-term debt (15,137) (134,876)
Proceeds from exercise of options and warrants 692 5,082
Employee stock purchases 390 436
------------ ------------
Net cash provided by (used in) financing activities (14,055) 10,150
------------ ------------
Net increase (decrease) in cash and cash equivalents 598 (14,197)
Cash and cash equivalents, beginning of period 7,284 18,732
------------ ------------
Cash and cash equivalents, end of period $ 7,882 $ 4,535
============ ============
See accompanying notes.
6
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
1. Nature of Operations and Basis of Presentation
Operations - Headwaters Incorporated is incorporated in Delaware.
Headwaters owns 100% of Industrial Services Group, Inc. ("ISG"), a
Utah-based company acquired by Headwaters in September 2002, and 100% of
Headwaters Technology Innovation Group, Inc. ("HTI") (formerly Hydrocarbon
Technologies, Inc.), a New Jersey company acquired by Headwaters in August
2001. In addition, as described in more detail in Note 11, Headwaters
acquired VFL Technology Corporation in April 2004 and has entered into a
purchase agreement to acquire the ownership interests of Eldorado Stone,
LLC. Headwaters' focus is on enhancing the value of coal, gas, oil and
other natural resources. Headwaters currently generates revenue from
licensing its chemical technologies to produce synthetic fuel and from
managing coal combustion products ("CCPs"). Headwaters intends to continue
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 synthetic fuels primarily for use in
electric power generation plants. Headwaters currently licenses its
technologies to the owners of 28 of a company-estimated 75 coal-based solid
synthetic fuel facilities in the United States. ISG, through its
wholly-owned subsidiary ISG Resources, Inc., 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 110 locations, ISG is
the leading provider of high quality fly ash to the building products and
ready mix concrete industries in the United States. ISG's construction
materials segment develops, manufactures and distributes value-added bagged
concrete, stucco, mortar and block products that utilize fly ash. ISG also
develops and deploys technologies for maintaining and improving fly ash
quality. Headwaters, through its wholly-owned subsidiary HTI, conducts
research and development activities directed at catalyst technologies to
convert coal and heavy oil into environmentally-friendly, high-value liquid
fuels. In addition, HTI has developed a unique process to custom design
nanocatalysts that could be used in multiple industrial applications.
Basis of Presentation - The accompanying unaudited condensed consolidated
financial statements have been prepared in accordance with the rules and
regulations of the Securities and Exchange Commission ("SEC") for quarterly
reports on Form 10-Q. In the opinion of management, all adjustments
considered necessary for a fair presentation have been included, and
consist of normal recurring adjustments, including adjustments for the
transactions described in Notes 6, 9, 10 and 11. 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, 2003 ("Form 10-K") and in Headwaters' Quarterly Report
on Form 10-Q for the quarter ended December 31, 2003.
Headwaters' fiscal year ends on September 30 and unless otherwise noted,
future references to 2003 refer to Headwaters' fiscal quarter and/or
six-month period ended March 31, 2003, and references to 2004 refer to
Headwaters' fiscal quarter and/or six-month period ended March 31, 2004.
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. Due to the time required to obtain accurate
financial information related to HTI's foreign contracts, for financial
reporting purposes HTI's financial statements have historically been
consolidated with Headwaters' financial statements using a one-month lag.
Effective October 1, 2003, Headwaters eliminated this one-month lag because
of the decreased significance of HTI's foreign contracts. Accordingly,
seven months of HTI's results of operations have been included in the
consolidated statement of income for the six months ended March 31, 2004.
Due to the seasonality of ISG's business and other factors, Headwaters'
consolidated results of operations for 2004 are not indicative of the
results to be expected for the full fiscal 2004 year.
Common 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 unless required by changes in accounting
standards. The alternative fair value method of accounting prescribed by
SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"),
7
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
requires the use of option valuation models that were developed for use in
valuing traded 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 $22,000 for each of the three-month periods
ended March 31, 2003 and 2004 and approximately $45,000 for each of the
six-month periods ended March 31, 2003 and 2004. If the fair value
provision of SFAS No. 123 would have been applied to all options granted,
compensation expense would have been approximately $932,000 and $1,021,000
for the three months ended March 31, 2003 and 2004, respectively, and
approximately $1,765,000 and $2,015,000 for the six months ended March 31,
2003 and 2004, respectively, and net income and earnings per share would
have been changed to the pro forma amounts shown in the table below.
Three Months Ended March 31, Six Months Ended March 31,
-------------------------------- -----------------------------
(in thousands, except per-share data) 2003 2004 2003 2004
-------------------------------------------- ---------------- --------------- ------------- ---------------
Net income - as reported $ 6,789 $ 18,627 $ 14,841 $ 28,719
Pro forma additional compensation expense (910) (999) (1,720) (1,970)
------------ ------------ ------------ ------------
Net income - pro forma $ 5,879 $ 17,628 $ 13,121 $ 26,749
============ ============ ============ ============
Basic earnings per share - as reported $ 0.25 $ 0.57 $ 0.55 $ 0.95
- pro forma $ 0.22 $ 0.54 $ 0.49 $ 0.88
Diluted earnings per share - as reported $ 0.24 $ 0.55 $ 0.53 $ 0.91
- pro forma $ 0.21 $ 0.52 $ 0.47 $ 0.85
The fair values of stock option grants for 2003 and 2004 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 1.3% to 4.0%, 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 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 their fair value, in management's opinion, the existing
models do not necessarily provide a reliable measure of the fair value of
stock options.
Reclassifications - 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.
Recent Accounting Pronouncements - Headwaters has reviewed all recently
issued accounting standards that have not yet been adopted in order to
determine their potential effect, if any, on the results of operations or
financial position of Headwaters. Based on that review, Headwaters does not
currently believe that any of these recent accounting pronouncements will
have a significant effect on its current or future financial position,
results of operations, cash flows or disclosures.
8
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
2. Segment Reporting
The following segment information has been prepared in accordance with SFAS
No. 131, "Disclosure about Segments of an Enterprise and Related
Information," all as explained in more detail in the notes to the financial
statements in Headwaters' Form 10-K. Performance of the segments is
evaluated primarily on operating income. Intersegment sales are immaterial.
Segment costs and expenses considered in deriving segment operating income
include cost of revenues, depreciation and amortization, research and
development, and segment-specific selling, general and administrative
expenses. Amounts included in the "Corporate" column represent expenses not
specifically attributable to any segment and include administrative
departmental costs and general corporate overheads. 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 Construction
(in thousands) Energy CCPs Materials Corporate Totals
------------------------------------------ ------------- ------------ ---------------- ------------ -----------
Three Months Ended March 31, 2003
Segment revenue $ 43,185 $ 31,168 $ 11,700 $ -- $ 86,053
========== ========== ========== ========= ===========
Depreciation and amortization $ (317) $ (2,638) $ (124) $ (88) $ (3,167)
========== ========== ========== ========= ===========
Operating income (loss) $ 17,480 $ 1,918 $ 1,145 $ (3,775) $ 16,768
========== ========== ========== =========
Net interest expense (3,460)
Other income (expense), net (2,119)
Income tax provision (4,400)
-----------
Net income $ 6,789
===========
Capital expenditures $ 20 $ 1,789 $ 372 $ 11 $ 2,192
========== ========== ========== ========= ===========
Three Months Ended March 31, 2004
Segment revenue $ 68,681 $ 39,592 $ 11,248 $ -- $ 119,521
========== ========== ========== ========= ===========
Depreciation and amortization $ (310) $ (2,700) $ (162) $ (67) $ (3,239)
========== ========== ========== ========= ===========
Operating income (loss) $ 40,893 $ 4,814 $ (904) $ (6,780) $ 38,023
========== ========== ========== =========
Net interest expense (5,697)
Other income (expense), net (1,889)
Income tax provision (11,810)
-----------
Net income $ 18,627
===========
Capital expenditures $ 165 $ 1,553 $ 47 $ 19 $ 1,784
========== ========== ========== ========= ===========
9
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
Alternative Construction
(in thousands) Energy CCPs Materials Corporate Totals
------------------------------------------ ------------- ------------ ---------------- ------------ -----------
Six Months Ended March 31, 2003
Segment revenue $ 82,524 $ 69,454 $ 22,784 $ -- $ 174,762
========== ========== ========== ========= ===========
Depreciation and amortization $ (640) $ (5,177) $ (298) $ (136) $ (6,251)
========== ========== ========== ========= ===========
Operating income (loss) $ 33,792 $ 5,948 $ 1,934 $ (6,928) $ 34,746
========== ========== ========== =========
Net interest expense (7,897)
Other income (expense), net (2,058)
Income tax provision (9,950)
-----------
Net income $ 14,841
===========
Capital expenditures $ 129 $ 2,357 $ 400 $ 24 $ 2,910
========== ========== ========== ========= ===========
Six Months Ended March 31, 2004
Segment revenue $ 113,116 $ 84,692 $ 23,181 $ -- $ 220,989
========== ========== ========== ========= ===========
Depreciation and amortization $ (660) $ (5,392) $ (329) $ (126) $ (6,507)
========== ========== ========== ========= ===========
Operating income (loss) $ 59,429 $ 11,136 $ (165) $ (10,329) $ 60,071
========== ========== ========== =========
Net interest expense (10,988)
Other income (expense), net (2,394)
Income tax provision (17,970)
-----------
Net income $ 28,719
===========
Capital expenditures $ 312 $ 4,436 $ 111 $ 31 $ 4,890
========== ========== ========== ========= ===========
Segment Assets as of March 31, 2004 $ 71,855 $ 282,208 $ 21,716 $ 45,931 $ 421,710
========== ========== ========== ========= ===========
3. Issuance of Securities
Issuance of Common Stock - Headwaters has an effective universal shelf
registration statement on file with the SEC that can be used for the sale
of common stock, preferred stock, convertible debt and other securities. In
December 2003, Headwaters filed a prospectus supplement to the shelf
registration statement and issued 4,750,000 shares of common stock under
this shelf registration statement in an underwritten public offering. In
January 2004, an additional 208,457 shares of common stock were issued upon
exercise of the underwriters' over-allotment option. In total, proceeds of
$90,303,000 were received, net of offering costs of $6,387,000. Following
these issuances of common stock, approximately $53,000,000 remains
available for future offerings of securities under the shelf registration
statement. A prospectus supplement describing the terms of any additional
securities to be issued is required to be filed before any future offering
would commence under the registration statement.
2003 Stock Incentive Plan Awards - In March 2004, Headwaters' stockholders
approved an increase in the number of shares available for award grants
under Headwaters' 2003 Stock Incentive Plan by 1,500,000. In April 2004,
Headwaters granted to officers and employees options to purchase
approximately 430,000 shares of common stock and issued approximately
54,000 shares of restricted common stock, all under terms of the 2003 Stock
Incentive Plan. The stock options vest over five years and have an exercise
price of $23.79 per share, the fair market value of Headwaters' common
stock on the date of grant. The restricted stock was issued at no cost to
the recipients and also vests over five years.
10
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
4. Inventories
Inventories consisted of the following at:
September 30,
(in thousands) 2003 March 31, 2004
----------------------------------- --------------- ----------------
Raw materials $ 1,059 $ 938
Finished goods 6,768 8,986
---------- ----------
$ 7,827 $ 9,924
========== ==========
5. Intangible Assets
Intangible Assets - 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, 2003 March 31, 2004
-------------------------------- --------------------------------
Gross Gross
Estimated Carrying Accumulated Carrying Accumulated
(in thousands) useful lives Amount Amortization Amount Amortization
----------------------------- -------------- --------------- ---------------- --------------- ----------------
ISG contracts 20 years $ 106,400 $ 5,499 $ 106,400 $ 8,159
HTI patented technologies 15 years 9,700 1,293 9,700 1,670
ISG patents 7 1/2 years 2,764 373 2,764 557
Other 9 - 17 years 1,522 807 2,567 924
--------- -------- --------- --------
$ 120,386 $ 7,972 $ 121,431 $ 11,310
========= ======== ========= ========
Total amortization expense related to intangible assets was approximately
$1,626,000 and $1,659,000 for the three months ended March 31, 2003 and
2004, respectively, and approximately $3,252,000 and $3,338,000 for the six
months ended March 31, 2003 and 2004, respectively. Total estimated annual
amortization expense for fiscal year 2004 is approximately $6,630,000.
Total estimated annual amortization expense for fiscal years 2005 through
2007 is approximately $6,560,000 per year. Total estimated annual
amortization expense for fiscal year 2008 is approximately $6,400,000.
6. Long-term Debt
Long-term debt consisted of the following at:
September 30,
(in thousands) 2003 March 31, 2004
--------------------------------------------------------------- ----------------- ---------------
Senior secured debt $ -- $ 50,000
Senior secured debt with a face amount totaling $114,851,
repaid in full as of March 31, 2004 111,766 --
Senior subordinated debentures with a face amount totaling
$20,000 19,682 --
Other 71 47
---------- ----------
131,519 50,047
Less: current portion (27,475) (5,012)
---------- ----------
Total long-term debt $ 104,044 $ 45,035
========== ==========
New Senior Secured Credit Agreement - In March 2004, Headwaters entered
into a credit agreement with a syndication of lenders under which a total
of $50,000,000 was borrowed under a term loan arrangement and which
provides for an additional $50,000,000 to be borrowed under a revolving
credit arrangement. The initial $50,000,000 of proceeds were used to repay
in full the remaining balance due under Headwaters' former Term B senior
secured credit agreement.
The $50,000,000 term loan is secured by all assets of Headwaters, bears
interest at a variable rate (approximately 3.4% at March 31, 2004), and is
repayable in quarterly installments of $1,250,000, commencing June 2004 and
11
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
continuing through September 2007. The remaining principal of $32,500,000
is repayable in November 2007, the termination date of the credit
agreement. Optional prepayments of the term loan can be made at Headwaters'
discretion, subject to certain minimum amount requirements specified in the
credit agreement. Beginning December 31, 2004 and continuing each year
thereafter, Headwaters must make mandatory prepayments to the extent of 50%
of Headwaters' fiscal year "excess cash flows," as defined. Once repaid in
full or in part, no further borrowings under the term loan arrangement can
be made.
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 meet minimum net
worth requirements and maintain certain financial ratios, including
leverage ratios and a fixed charge coverage ratio, as those terms are
defined in the credit agreement. The initial net worth requirement is
$200,308,000 and is increased by 50% of Headwaters' consolidated net income
earned subsequent to March 31, 2004. Headwaters must maintain a total
leverage ratio of 2.5:1.0 or less and a senior debt leverage ratio of
1.5:1.0 or less. Headwaters is in compliance with all debt covenants as of
March 31, 2004.
Borrowing terms under the revolving credit arrangement are generally the
same as those described in the preceding paragraphs except that
reborrowings of any available portion of the $50,000,000 revolver can be
made at any time. Finally, the credit agreement allows for the issuance of
letters of credit, provided there is capacity under the revolving credit
arrangement. Currently, two letters of credit totaling $3,150,000 are
outstanding, with expiration dates in April 2005. There have been no other
letters of credit issued and no funds have been borrowed under the
revolving credit arrangement. Headwaters currently pays a fee of 0.375% on
the unused portion of the revolving credit arrangement.
Former Senior Secured Credit Agreement - In connection with the ISG
acquisition in 2002, Headwaters entered into a $175,000,000 senior secured
credit agreement with a syndication of lenders, under which a total of
$155,000,000 was borrowed as a term loan on the acquisition date. The
credit agreement also allowed up to $20,000,000 to be borrowed under a
revolving credit arrangement. The debt was issued at a 3% discount and
Headwaters received net cash proceeds of $150,350,000. The original issue
discount was accreted using the effective interest method and the accretion
was recorded as interest expense. The debt was secured by all assets of
Headwaters, bore interest at a variable rate and was repayable in quarterly
installments through August 30, 2007.
During the quarter ended December 31, 2003, principal repayments totaling
$39,714,000 were made, including $33,471,000 of optional prepayments.
During the quarter ended March 31, 2004, the remaining balance was repaid
in full using available cash and $50,000,000 of proceeds from the new
senior debt facility described above. In connection with the full repayment
of this debt, non cash interest expense totaling approximately $5,023,000
was recognized in the March 2004 quarter, representing amortization of all
of the remaining debt discount and debt issue costs related to this debt.
Senior Subordinated Debentures - In connection with the ISG acquisition,
Headwaters also entered into a $20,000,000 subordinated loan agreement,
under which senior subordinated debentures were issued at a 2% discount,
with Headwaters receiving net cash proceeds of $19,600,000. The original
issue discount was accreted using the effective interest method and the
accretion was recorded as interest expense. ISG management participated in
one-half, or $10,000,000, of the $20,000,000 of debt issued. The other half
was issued to a corporation. The debentures were due in 2007; however, in
December 2003, the debentures were repaid in full, including a 4% or
$400,000 prepayment charge paid to the corporation holding $10,000,000 of
the debentures. This charge, along with all remaining unamortized debt
discount and debt issue costs, is included in interest expense in the
consolidated statement of income.
Interest Costs - During the three- and six-month periods ended March 31,
2004, Headwaters incurred total interest costs of approximately $6,124,000
and $11,624,000, respectively, including approximately $5,043,000 and
$7,631,000, respectively, of non-cash interest expense and approximately
$113,000 and $274,000, respectively of interest costs that were
capitalized. During the three- and six-month periods ended March 31, 2003,
Headwaters incurred total interest costs of approximately $3,577,000 and
$8,114,000, respectively, including approximately $653,000 and $1,604,000,
respectively, of non-cash interest expense and approximately $36,000 and
$46,000, respectively of interest costs that were capitalized. The
12
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
weighted-average interest rate on the face amount of outstanding long-term
debt, disregarding amortization of debt issue costs and debt discount, was
approximately 7.2% at September 30, 2003 and 3.4% at March 31, 2004.
7. Income Taxes
The income tax provision consisted of the following:
Three Months Ended March 31, Six Months Ended March 31,
-------------------------------- ------------------------------
(in thousands) 2003 2004 2003 2004
------------------------------------------- ----------------- -------------- -------------- ---------------
Current tax provision:
Federal $ 5,060 $ 10,800 $ 8,510 $ 16,192
State 518 573 1,118 1,035
--------- --------- --------- ---------
Total current tax provision 5,578 11,373 9,628 17,227
Deferred tax provision:
Federal (1,050) 428 300 710
State (128) 9 22 33
--------- --------- --------- ---------
Total deferred tax provision (1,178) 437 322 743
--------- --------- --------- ---------
Total income tax provision $ 4,400 $ 11,810 $ 9,950 $ 17,970
========= ========= ========= =========
8. Earnings per Share
Three Months Ended March 31, Six Months Ended March 31,
(in thousands, except per-share data) 2003 2004 2003 2004
------------------------------------------- ----------------- -------------- -------------- ---------------
Numerator - Net income $ 6,789 $ 18,627 $ 14,841 $ 28,719
========= ========= ========= =========
Denominator:
Denominator for basic earnings per share -
weighted-average shares outstanding 26,983 32,782 26,909 30,371
Effect of dilutive securities - shares
issuable upon exercise of options and
warrants 1,118 1,322 1,224 1,222
--------- --------- --------- ---------
Denominator for diluted earnings per
share - weighted-average shares
outstanding after assumed exercises 28,101 34,104 28,133 31,593
========= ========= ========= =========
Basic earnings per share $ 0.25 $ 0.57 $ 0.55 $ 0.95
========= ========= ========= =========
Diluted earnings per share $ 0.24 $ 0.55 $ 0.53 $ 0.91
========= ========= ========= =========
Anti-dilutive securities not considered in the diluted earnings per share
calculation, consisting of out-of-the money options, totaled approximately
510,000 and 0 shares for the three months ended March 31, 2003 and 2004,
respectively, and 400,000 and 10,000 shares for the six months ended March
31, 2003 and 2004, respectively.
9. Other Revenue
In December 2003, Headwaters recorded $3,625,000 of other revenue
representing fees for technology licensed by HTI to a Chinese company. This
amount was paid to HTI in January 2004.
10. Commitments and Contingencies
Commitments and contingencies as of March 31, 2004 not disclosed elsewhere,
are as follows:
Purchase Commitments - Certain ISG contracts with its suppliers require ISG
to make minimum purchases. During the quarter ended December 31, 2003, one
of ISG's minimum purchase contracts was amended. The amendment decreased
the annual purchase commitment and also extended the term of the contract
for several years. Due to the extended life of the contract, ISG's total
13
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
future minimum purchase requirements increased by approximately $17,925,000
during 2004 through 2011.
Medical Insurance - Effective January 1, 2003, Headwaters adopted a
self-insured medical insurance plan for its employees and the employees of
all of its subsidiaries. Currently, this plan has stop-loss coverage for
amounts in excess of $100,000 per individual and approximately $7,500,000
in the aggregate for the plan year ending December 31, 2004. Headwaters has
contracted with a third-party administrator to assist in the payment and
administration of claims. Insurance claims are recognized as expenses when
incurred and include an estimate of costs for claims incurred but not
reported at the balance sheet date. As of March 31, 2004, approximately
$992,000 is accrued for claims incurred from January through March 31, 2004
that have not been paid.
Incentive Agreements with ISG Principals - In January 2003, Headwaters
executed incentive agreements with three of the former stockholders and
officers of ISG, all of whom were officers of either Headwaters or ISG
following the ISG acquisition. The agreements called 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
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. During the quarter ended
December 31, 2003, two of the three officers resigned their positions. As a
result, the maximum payment that could be required under the remaining
incentive agreement is $1,500,000 for the remaining officer. During the
quarter ended March 31, 2004, Headwaters recorded an expense of
approximately $940,000 related to this obligation.
Property, Plant and Equipment - As of March 31, 2004, Headwaters was
committed to spend approximately $7,000,000 to complete capital projects
that were in various stages of completion.
Legal or Contractual Matters - Headwaters has ongoing litigation and claims
incurred during the normal course of business, including the items
discussed below. Headwaters intends to vigorously defend and pursue its
rights in these actions. Management does not currently believe that the
outcome of these actions will have a material adverse effect on Headwaters'
operations, cash flows or financial position; however, it is possible that
a change in the estimates of probable liability could occur, and the change
could be significant. Additionally, as with any litigation, these
proceedings will require that Headwaters incur substantial costs, including
attorneys' fees, managerial time, and other personnel resources and costs
in pursuing resolution.
Boynton. In October 1998, Headwaters entered into a technology purchase
agreement with James G. Davidson and Adtech, Inc. The transaction
transferred certain patent and royalty rights to Headwaters related to a
synthetic fuel technology invented by Davidson. (This technology is
distinct from the technology developed by Headwaters.) This action is
factually related to an earlier action brought by certain purported
officers and directors of Adtech, Inc. That action was dismissed by the
United States District Court for the Western District of Tennessee and the
District Court's order of dismissal was affirmed on appeal. In the current
action, the allegations arise from the same facts, but the claims are
asserted by certain purported stockholders of Adtech. In June 2002,
Headwaters received a summons and complaint from the United States District
Court for the Western District of Tennessee alleging, among other things,
fraud, conspiracy, constructive trust, conversion, patent infringement and
interference with contract arising out of the 1998 technology purchase
agreement entered into between Davidson and Adtech on the one hand, and
Headwaters on the other. The complaint seeks declaratory relief and
compensatory and punitive damages. The District Court has dismissed all
claims against Headwaters except conspiracy and constructive trust. Because
the resolution of the litigation 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 synthetic fuel projects. In March 2002, AGTC filed an arbitration demand
in Salt Lake City, Utah claiming that it is owed commissions under the 1996
agreement for 8% of the revenues received by Headwaters from 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,
14
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
denying AGTC's claims and has asserted counterclaims against AGTC. Because
the resolution of the arbitration is uncertain, legal counsel cannot
express an opinion as to the ultimate amount, if any, of Headwaters'
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
compensatory damages as well as punitive damages. Headwaters has denied the
allegations of AJG's counter-claims. Because the resolution of the
litigation is uncertain, legal counsel cannot express an opinion as to the
ultimate amount of recovery or liability.
ISG Matters. There is litigation and pending and threatened claims made
against certain subsidiaries of ISG with respect to several types of
exterior stucco finish systems manufactured and sold by its subsidiaries
for application by contractors, developers and owners on residential and
commercial buildings. This litigation and these claims are controlled by
such subsidiaries' insurance carriers. The plaintiffs or claimants in these
matters have alleged that due to some failure of the stucco system itself
or its application, the buildings have suffered damage due to the
progressive, latent effects of water penetration through the building's
exterior. The most prevalent type of claim involves alleged defects
associated with an artificial stucco system manufactured by one of ISG's
subsidiaries, Best Masonry. Best Masonry continued to manufacture this
system through 1997, and there is a 10-year projected claim period
following discontinuation of the product.
Typically, the claims cite damages for alleged personal injuries and
punitive damages for alleged unfair business practices in addition to
asserting more conventional damage claims for alleged economic loss and
injury to property. To date, claims made against such subsidiaries have
been paid by their insurers, with the exception of minor deductibles,
although such insurance carriers typically have provided "reservation of
rights" letters. None of the cases has gone to trial, and while two such
cases involve 100 and 800 homes, respectively, none of the cases includes
any claims formally asserted on behalf of a class. While, to date, none of
these proceedings have required that ISG incur substantial costs, there is
no guarantee of insurance coverage or continuing coverage. 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. Future rate increases may also make such insurance
uneconomical for ISG to maintain. In addition, the insurance policies
maintained by ISG exclude claims for damages resulting from exterior
insulating finish systems, or EIFS, that have manifested after March 2003.
Because resolution of the litigation and claims is uncertain, legal counsel
cannot express an opinion as to the ultimate amount, if any, of Headwaters'
liability.
Former Director. Headwaters granted stock options to a member of its board
of directors in 1995. The director resigned from the board in 1996.
Headwaters believes that most of the former director's options terminated
unexercised. The former director has claimed that he is entitled to
exercise the options. No lawsuit has been filed in this matter. Resolution
is uncertain and legal counsel cannot express an opinion as to the ultimate
amount, if any, of Headwaters' liability.
Other. Headwaters and its subsidiaries are also involved in other legal
proceedings that have arisen in the normal course of business.
Senate Permanent Subcommittee on Investigations - On October 29, 2003, the
Permanent Subcommittee on Investigations of the Government Affairs
Committee of the United States Senate issued a notification of pending
15
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
investigations. The notification listed the synthetic fuel tax credit as a
new item. In March 2004, the Subcommittee described its investigation as
follows: "The Subcommittee is continuing its investigation of tax credits
claimed under Section 29 of the Internal Revenue Code for the sale of
coal-based synthetic fuels. This investigation is examining the utilization
of these tax credits, the nature of the technologies and fuels created, the
use of these fuels, and other aspects of Section 29. The investigation will
also address the IRS's administration of Section 29 tax credits." The
Subcommittee is expected to hold a hearing in June 2004 regarding its
investigation of Section 29 tax credits.
The effect that the Senate subcommittee investigation of synthetic fuel tax
credits may have on the industry is unknown. While the investigation is
pending, buyers may be unwilling to engage in transactions to purchase
synthetic fuel facilities. If current owners are unable to sell their
facilities, production may not be maximized, materially adversely affecting
Headwaters' revenues.
Legislation - Under current law, Section 29 tax credits for synthetic fuel
produced from coal expire on December 31, 2007. There have been initiatives
from time to time to modify Section 29. Recently, a member of the House of
Representatives introduced legislation to repeal Section 29. If Section 29
is repealed or adversely modified, synthetic fuel facilities would probably
either close or substantially curtail production, having a material adverse
effect on the revenues and net income of Headwaters.
License Fees - Pursuant to the contractual terms of an agreement with a
certain licensee, the license fees owed to Headwaters, which have
accumulated during the past two and a half years, have been placed in
escrow for the benefit of Headwaters, pending resolution of an audit of the
licensee by the Internal Revenue Service ("IRS"). As of March 31, 2004, the
escrowed license fees and earned interest, net of the amount Headwaters
will be required to pay to a third party, were approximately $28,000,000.
Approximately $3,000,000 of this amount related to revenue recorded in the
March 2004 quarter and approximately $25,000,000 was recorded as revenue
related to prior periods.
Prior to December 31, 2003, certain accounting rules governing revenue
recognition, requiring that the seller's price to the buyer be "fixed or
determinable" as well as reasonably certain of collection, appeared to
preclude revenue recognition for the amounts placed in escrow because they
were potentially subject to adjustment based on the outcome of the IRS
audit. Accordingly, none of the escrowed amounts were recognized as revenue
in the consolidated statements of income through December 31, 2003. During
the March 2004 quarter, the fieldwork for the tax audit of the licensee was
completed and there were no proposed adjustments to the tax credits claimed
by the licensee. As a result, Headwaters recognized revenue relating to the
funds deposited in the escrow account totaling approximately $27,900,000.
Interest income of approximately $164,000 was also recognized. The IRS
audit is currently in administrative review and disbursements from the
escrow account are expected to occur upon resolution of the IRS review, as
defined in the license agreement.
In addition to the escrowed amounts, this same licensee has also set aside
substantial amounts for working capital and other operational contingencies
as provided for in the contractual agreements. These amounts will
eventually be paid out to various parties having an interest in the cash
flows from the licensee's operations, including Headwaters, if they are not
used for working capital and other operational contingencies. As a result,
Headwaters currently expects to receive at some future date a portion of
those reserves, the amount of which is not currently determinable and
therefore, not recognizable.
11. Acquisitions
As described in the following paragraphs, in April 2004, Headwaters
completed the acquisition of one company and signed a definitive agreement
to acquire a second company.
VFL Technology Corporation - On April 9, 2004, Headwaters acquired 100% of
the common stock of VFL Technology Corporation, based in West Chester,
Pennsylvania, for a total purchase price of approximately $29,000,000,
consisting of cash and debt. This acquisition broadens the scope of
services Headwaters' CCP segment offers, as well as its client base,
16
HEADWATERS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)
principally on the east coast of the United States. VFL's results of
operations will be included in Headwaters' consolidated statement of income
beginning April 9, 2004.
Eldorado Stone, LLC - On April 21, 2004, Headwaters entered into a purchase
agreement to acquire the ownership interests of Eldorado Stone, LLC, a
leading manufacturer of architectural manufactured stone based in San
Marcos, California. Eldorado Stone will become a wholly-owned subsidiary of
Headwaters, integrated into its construction materials segment. The
acquisition, which is subject to regulatory approvals, completion of
financing, and other customary conditions, is expected to close in May
2004.
The total purchase price for Eldorado Stone, excluding direct acquisition
costs of approximately $3,500,000, is expected to be approximately
$202,500,000. The calculation of the final purchase price will vary based
on certain adjustments at the time of closing as well as total closing and
transaction costs. Headwaters will use existing cash, financing available
under its new credit facility (see Note 6) and new financing to be obtained
prior to closing to pay for the acquisition.
Deferred Acquisition Costs - In the March 2004 quarter, Headwaters expensed
approximately $829,000 of deferred acquisition costs related to other
acquisition projects that were abandoned.
17
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with the accompanying unaudited consolidated financial statements and notes
thereto included elsewhere herein. Headwaters' fiscal year ends on September 30
and unless otherwise noted, future references to 2003 refer to Headwaters'
fiscal quarter and/or six-month period ended March 31, 2003, and references to
2004 refer to Headwaters' fiscal quarter and/or six-month period ended March 31,
2004.
Consolidation 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. All significant intercompany transactions and accounts
are eliminated in consolidation. Due to the time required to obtain accurate
financial information related to HTI's foreign contracts, for financial
reporting purposes HTI's financial statements have historically been
consolidated with Headwaters' financial statements using a one-month lag.
Effective October 1, 2003, Headwaters eliminated this one-month lag because of
the decreased significance of HTI's foreign contracts. Accordingly, seven months
of HTI's results of operations have been included in the consolidated statement
of income for the six months ended March 31, 2004.
Segments. Headwaters operates in three business segments, alternative
energy, CCPs, and construction materials. 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 synthetic fuels business and HTI's business of developing
catalyst technologies to convert coal and heavy oil into
environmentally-friendly, higher-value liquid fuels as well as nanocatalyst
processes and applications. Revenues for this segment primarily include sales of
chemical reagents and license fees.
The CCP segment includes ISG's business of providing fly ash to the
building products and ready mix concrete industries. This segment markets coal
combustion products such as fly ash and bottom ash, known as CCPs. ISG has
long-term contracts, primarily with coal-fired electric power generation plants,
pursuant to which it manages the post-combustion operations for the utilities.
ISG markets 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,
with a small amount of service revenue.
The construction materials segment manufactures and distributes
value-added bagged concrete, stucco, mortar and block products. ISG has
introduced high volumes of CCPs as substitute ingredients in the products the
construction materials segment produces.
Due to the seasonality of ISG's business and other factors, Headwaters'
consolidated results of operations for 2004 are not indicative of the results to
be expected for the full fiscal 2004 year.
Three Months Ended March 31, 2004 Compared to Three Months Ended March 31, 2003
The information set forth below compares Headwaters' operating results
for the three months ended March 31, 2004 ("2004") with operating results for
the three months ended March 31, 2003 ("2003").
Revenue. Total revenue for 2004 increased by $33.4 million or 39% to
$119.5 million as compared to $86.1 million for 2003. The major components of
revenue are discussed in the sections below.
Sales of Chemical Reagents. Chemical reagent sales during 2004 were
$32.2 million with a corresponding direct cost of $21.8 million. Chemical
reagent sales during 2003 were $33.1 million with a corresponding direct cost of
$21.8 million. The decrease in chemical reagent sales during 2004 was due
primarily to decreased synthetic fuel production by customers with which
Headwaters does not have a license agreement, largely offset by increased
synthetic fuel production by Headwaters' licensees. The gross margin percentage
decreased from 2003 to 2004 due primarily to differing chemical reagent formula
requirements of certain licensees and other customers, higher chemical reagent
costs, and to a lesser extent, pricing discounts.
License Fees. During 2004, Headwaters recognized license fee revenue
totaling $36.3 million, an increase of $27.4 million or 308% over $8.9 million
of license fee revenue recognized during 2003. The primary reason for the
increase in license fee revenue in 2004 compared to 2003 was the recognition of
approximately $24.9 million of net revenue relating to funds previously
deposited in an escrow account by one of Headwaters' licensees relating to funds
deposited prior to December 31, 2003 and approximately $3.0 million of net
revenue relating to funds deposited and recorded as revenue in the March 2004
quarter.
18
Pursuant to the contractual terms of an agreement with the licensee,
the license fees owed to Headwaters, which have accumulated during the past two
and a half years, had been placed in escrow for the benefit of Headwaters,
pending resolution of an audit of the licensee by the Internal Revenue Service
("IRS"). As of March 31, 2004, the escrowed license fees and earned interest,
net of the amount Headwaters will be required to pay to a third party, were
approximately $28.0 million.
Prior to December 31, 2003, certain accounting rules governing revenue
recognition, requiring that the seller's price to the buyer be "fixed or
determinable" as well as reasonably certain of collection, appeared to preclude
revenue recognition for the amounts placed in escrow because they were subject
to adjustment based on the outcome of the IRS audit. Accordingly, none of the
escrowed amounts were recognized as revenue in the consolidated statements of
income through December 31, 2003. During the March 2004 quarter, the fieldwork
for the tax audit of the licensee was completed and there were no proposed
adjustments to the tax credits claimed by the licensee. As a result, Headwaters
recognized revenue relating to the funds deposited in the escrow account
totaling approximately $27.9 million.
In addition to the escrowed amounts, this same licensee has also set
aside substantial amounts for working capital and other operational
contingencies as provided for in the contractual agreements. These amounts will
eventually be paid out to various parties having an interest in the cash flows
from the licensee's operations, including Headwaters, if they are not used for
working capital and other operational contingencies. As a result, Headwaters
currently expects to receive at some future date a portion of those reserves,
the amount of which is not currently determinable and therefore, not
recognizable.
CCP Revenues. CCP revenues for 2004 were $39.6 million with a
corresponding direct cost of $28.5 million. CCP revenues for 2003 were $31.2
million with a corresponding direct cost of $23.4 million. The increase in CCP
revenues during 2004 was due primarily to the renegotiation of certain service
agreements and increased demand for high quality fly ash products. The gross
margin percentage increased from 2003 to 2004 due primarily to benefits realized
from the renegotiation of the service agreements.
Sales of Construction Materials. Sales of construction materials during
2004 were $11.2 million with a corresponding direct cost of $9.8 million. Sales
of construction materials during 2003 were $11.7 million with a corresponding
direct cost of $8.7 million. The decrease in sales of construction materials
during 2004 was due primarily to unfavorable weather conditions in 2004 which
impacted the construction industry. The decrease in gross margin percentage from
2003 to 2004 was due primarily to certain inventory and other balance sheet
adjustments, some of which related to original purchase price allocations.
Depreciation and Amortization. These costs were comparable in 2004 and
2003 at $3.2 million.
Research and Development. Research and development expenses increased
by $0.4 million to $1.5 million in 2004 from $1.1 million in 2003. The increase
was primarily attributable to increased HTI research and development activities.
Management currently expects fiscal 2004 research and development expenses to
outpace the level of expenses for 2003 as a result of continued emphasis on
HTI's activities.
Selling, General and Administrative Expenses. These expenses increased
$6.5 million to $16.5 million for 2004 from $10.0 million for 2003. The increase
in 2004 was due primarily to increased incentive pay expenses, along with
certain increases in various other costs incidental to growth, such as
payroll-related costs, professional services and insurance. The increase in
incentive pay expenses was the result of obligations arising from Headwaters'
bonus plans, due in turn to improved operating results in 2004 compared to 2003,
a significant portion of which related to revenue recognized from escrowed funds
as previously discussed. Cash payments for the incentive pay obligations related
to the escrowed funds revenue will be disbursed upon receipt by Headwaters of
the escrowed funds.
Other Income and Expense. During 2004, Headwaters reported net other
expense of $7.6 million compared to net other expense of $5.6 million during
2003. The change of $2.0 million was attributable to an increase in interest
expense of $2.5 million in 2004, the write-off of $0.8 million of deferred
acquisition costs related to projects that were abandoned in 2004, and an
increase in the loss on disposition of property, plant and equipment of $0.5
million, offset by a reduction of $1.6 million in note receivable losses and an
increase of $0.2 million in interest income.
Interest expense increased from $3.5 million in 2003 to $6.0 million in
2004 due primarily to accelerated non-cash interest expense related to the
substantial increase in debt repayments that were made in 2004 compared to 2003.
In 2004, debt repayments totaled approximately $74.8 million, which consisted
primarily of early repayments. In 2003, debt repayments totaled approximately
$5.2 million. As a result of the increase in repayments in 2004, non-cash
interest expense, representing amortization of debt discount and debt issue
costs, increased from $0.7 million in 2003 to $5.0 million in 2004. Partially
offsetting this large increase in non-cash interest expense was a decrease in
cash interest expense in 2004 due to the significantly lower levels of
outstanding long-term debt in 2004 compared to 2003.
19
A loss of $0.5 million was recorded on a note receivable in 2004
compared to a loss on a note receivable of $2.1 million in 2003. Interest income
increased by $0.2 million in 2004, representing interest on funds held in escrow
as described previously.
Income Tax Provision. In 2004, Headwaters recorded an income tax
provision at an effective tax rate of approximately 38.8%. In 2003, the
effective tax rate was approximately 39.3%. The primary reason for the decrease
in the effective tax rate was decreased state income taxes due to tax planning
strategies implemented for fiscal year 2004.
Six Months Ended March 31, 2004 Compared to Six Months Ended March 31, 2003
The information set forth below compares Headwaters' operating results
for the six months ended March 31, 2004 ("2004") with operating results for the
six months ended March 31, 2003 ("2003").
Revenue. Total revenue for 2004 increased by $46.2 million or 26% to
$221.0 million as compared to $174.8 million for 2003. The major components of
revenue are discussed in the sections below.
Sales of Chemical Reagents. Chemical reagent sales during 2004 were
$63.1 million with a corresponding direct cost of $43.0 million. Chemical
reagent sales during 2003 were $62.2 million with a corresponding direct cost of
$40.8 million. The increase in chemical reagent sales during 2004 was due
primarily to significantly increased synthetic fuel production by Headwaters'
licensees, largely offset by decreased synthetic fuel production by customers
with which Headwaters does not have a license agreement. The gross margin
percentage decreased from 2003 to 2004 due primarily to differing chemical
reagent formula requirements of certain licensees and other customers, higher
chemical reagent costs, and to a lesser extent, pricing discounts.
License Fees. During 2004, Headwaters recognized license fee revenue
totaling $45.8 million, an increase of $28.1 million or 159% over $17.7 million
of license fee revenue recognized during 2003. The primary reason for the
increase in license fee revenue in 2004 compared to 2003 was the recognition of
$24.9 million of net revenue relating to funds previously deposited in an escrow
account by one of Headwaters' licensees relating to funds deposited prior to
December 31, 2003 and approximately $3.0 million of net revenue relating to
funds deposited and recorded as revenue in the March 2004 quarter.
CCP Revenues. CCP revenues for 2004 were $84.7 million with a
corresponding direct cost of $60.7 million. CCP revenues for 2003 were $69.5
million with a corresponding direct cost of $51.4 million. The increase in CCP
revenues during 2004 was due primarily to the renegotiation of certain service
agreements and increased demand for high quality fly ash products. The gross
margin percentage increased from 2003 to 2004 due primarily to benefits realized
from the renegotiation of the service agreements.
Sales of Construction Materials. Sales of construction materials during
2004 were $23.2 million with a corresponding direct cost of $19.3 million. Sales
of construction materials during 2003 were $22.8 million with a corresponding
direct cost of $17.1 million. The decrease in gross margin percentage from 2003
to 2004 was due primarily to certain inventory and other balance sheet
adjustments, some of which related to original purchase price allocations.
Depreciation and Amortization. These costs increased by $0.2 million to
$6.5 million in 2004 from $6.3 million in 2003. The increase was primarily
attributable to higher property, plant and equipment balances in 2004 and an
extra month of depreciation and amortization of HTI's tangible and intangible
assets in 2004.
Research and Development. Research and development expenses increased
by $1.4 million to $3.5 million in 2004 from $2.1 million in 2003. The increase
was primarily attributable to increased HTI research and development activities
and an extra month of HTI expenses in 2004.
Selling, General and Administrative Expenses. These expenses increased
$7.4 million to $27.6 million for 2004 from $20.2 million for 2003. The increase
in 2004 was due primarily to increased incentive pay expenses, along with
certain increases in various other costs incidental to growth, primarily
payroll-related costs and insurance. The increase in incentive pay expenses was
the result of obligations arising from Headwaters' bonus plans, due in turn to
improved operating results in 2004 compared to 2003, a significant portion of
which related to revenue recognized from escrowed funds as previously discussed.
Cash payments for the incentive pay obligations related to the escrowed funds
revenue will be disbursed upon receipt by Headwaters of the escrowed funds.
Other Income and Expense. During 2004, Headwaters reported net other
expense of $13.4 million compared to net other expense of $10.0 million during
2003. The change of $3.4 million was primarily attributable to an increase in
interest expense of $3.3 million in 2004, the write-off of $0.8 million of
deferred acquisition costs related to projects that were abandoned in 2004, and
an increase in the loss on disposition of property, plant and equipment of $0.8
million, offset by a reduction of $1.1 million in note receivable losses and an
increase of $0.2 million in interest income.
20
Interest expense increased from $8.1 million in 2003 to $11.4 million
in 2004 due primarily to accelerated non-cash interest expense related to the
substantial increase in debt repayments that were made in 2004 compared to 2003.
In 2004, debt repayments totaled approximately $134.9 million, which consisted
primarily of early repayments. In 2003, debt repayments totaled approximately
$15.1 million. As a result of the increase in repayments in 2004, non-cash
interest expense, representing amortization of debt discount and debt issue
costs, increased from $1.6 million in 2003 to $7.6 million in 2004. Partially
offsetting this large increase in non-cash interest expense was a decrease in
cash interest expense in 2004 due to the significantly lower levels of
outstanding long-term debt in 2004 compared to 2003.
Losses of $1.0 million were recorded on notes receivable in 2004
compared to a loss on a note receivable of $2.1 million in 2003. Interest income
increased by $0.2 million in 2004, representing interest on funds held in escrow
as described previously.
Income Tax Provision. In 2004, Headwaters recorded an income tax
provision at an effective tax rate of approximately 38.5%. In 2003, the
effective tax rate was approximately 40.1%. The primary reason for the decrease
in the effective tax rate was decreased state income taxes due to tax planning
strategies implemented for fiscal year 2004.
Liquidity and Capital Resources
Summary of Cash Flow Activities. Net cash used in operating activities
during the six months ended March 31, 2004 ("2004") was $17.1 million compared
to $17.8 million of net cash provided by operations during the six months ended
March 31, 2003 ("2003"). The primary reason for the significant use of cash in
operating activities in 2004 was an increase in short-term trading investments
of $30.6 million. Absent the use of cash to purchase short-term trading
investments, there would have been $13.6 million of cash provided by operations
in 2004, attributable primarily to net income. In addition, trade receivables
increased by $34.6 million in 2004 primarily due to recording a receivable from
a licensee relating to funds previously deposited in an escrow account, pending
resolution of an audit of the licensee by the Internal Revenue Service ("IRS").
The fieldwork for the IRS audit of the licensee was completed in the March 2004
quarter and there were no proposed adjustments to the tax credits claimed by the
licensee. The audit is currently in administrative review and disbursements from
the escrow account and collection of the receivable are expected to occur upon
resolution of the IRS review, as defined in the license agreement.
In 2004, Headwaters issued 5.0 million shares of common stock under an
effective shelf registration statement for net cash proceeds of $90.3 million.
Headwaters used $50.0 million of the cash generated from the issuance of common
stock to repay debt and the remaining proceeds were invested in short-term
trading investments as previously discussed. During 2004, a total of $134.9
million of debt was repaid, which amount includes $50.0 million of cash obtained
from the refinancing of Headwaters' senior debt. During 2004, investing
activities consisted primarily of payments for the purchase of property, plant
and equipment. More details about these activities are provided in the following
paragraphs.
Investing Activities. In 2004, payments for the purchase of property,
plant and equipment totaled $4.9 million. These capital expenditures primarily
related to ISG's business, in particular the CCP segment. Total capital
expenditures for fiscal year 2004 are expected to be comparable with fiscal year
2003 levels.
Headwaters had two notes receivable with a combined carrying value of
approximately $2.5 million at September 30, 2003. In 2004, Headwaters wrote-off
the balance of one of these notes and recorded a write-down of the other note
receivable, which has a carrying value at March 31, 2004 of approximately $1.5
million. This note receivable is supported by collateral; however, Headwaters
could incur additional losses if the remaining balance on the note is not repaid
or if the collateral value declines.
Headwaters intends to continue 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. As described in Note 11 to the consolidated financial statements, in
April 2004, Headwaters completed the acquisition of one company and signed a
definitive agreement to acquire a second company.
On April 9, 2004, Headwaters acquired 100% of the common stock of VFL
Technology Corporation for a total purchase price of approximately $29.0 million
paid in cash (approximately $10.0 million) and debt (approximately $19.0
million), of which $13.0 million is repayable in May 2004 and $6.0 million is
repayable over a three-year period ending in 2007.
On April 21, 2004, Headwaters entered into a purchase agreement to
acquire the ownership interests of Eldorado Stone, LLC. This acquisition, which
is subject to regulatory approvals, completion of financing, and other customary
conditions, is expected to close in May 2004. The total purchase price for
Eldorado Stone, excluding direct acquisition costs of approximately $3.5
million, is expected to be approximately $202.5 million. Headwaters will use
21
existing cash, financing available under the new credit facility (described
below) and new debt financing to be obtained prior to closing to pay for the
acquisition. The new debt financing is currently expected to total approximately
$150.0 million; however, the ultimate amount of financing to be obtained, as
well as the acquisition itself, is subject to completion.
It is possible that some portion of cash and cash equivalents and
short-term trading investments will be used to fund other acquisitions of
complementary businesses in the chemical, energy, building products and related
industries. Acquisitions are an important part of Headwaters' business strategy
and to that end, Headwaters routinely reviews complementary acquisitions,
including those in the areas of CCP marketing and construction materials and
coal and catalyst technologies. The new senior secured credit agreement
generally requires approval for acquisitions funded with cash in excess of $30.0
million individually or in excess of $50.0 million in the aggregate. Approval is
required for aggregate acquisitions in excess of $20.0 million not funded with
cash. These limits apply to acquisitions in any single fiscal year. Approvals
from the lenders for the acquisitions of both VFL Technology Corporation and
Eldorado Stone were obtained when the new credit agreement was executed. In
2004, Headwaters expensed approximately $0.8 million of deferred acquisition
costs related to other acquisition projects that were abandoned.
Financing Activities. Headwaters has an effective universal shelf
registration statement on file with the SEC that can be used for the sale of
common stock, preferred stock, convertible debt and other securities. In
December 2003, Headwaters filed a prospectus supplement to the shelf
registration statement and issued 4.75 million shares of common stock under this
shelf registration statement in an underwritten public offering. In January
2004, an additional 0.2 million shares of common stock were issued upon exercise
of the underwriters' over-allotment option. In total, proceeds of $90.3 million
were received, net of offering costs of $6.4 million. Following these issuances
of common stock, approximately $53.0 million remains available for future
offerings of securities under the shelf registration statement. A prospectus
supplement describing the terms of any additional securities to be issued is
required to be filed before any future offering would commence under the
registration statement.
New Senior Secured Credit Agreement - In March 2004, Headwaters entered
into a credit agreement with a syndication of lenders under which a total of
$50.0 million was borrowed under a term loan arrangement and which provides for
an additional $50.0 million to be borrowed under a revolving credit arrangement.
The initial $50.0 million of proceeds were used to repay in full the remaining
balance due under Headwaters' former Term B senior secured credit agreement.
The $50.0 million term loan is secured by all assets of Headwaters,
bears interest at a variable rate (approximately 3.4% at March 31, 2004), and is
repayable in quarterly installments of $1.25 million, commencing June 2004 and
continuing through September 2007. The remaining principal of $32.5 million is
repayable in November 2007, the termination date of the credit agreement.
Optional prepayments of the term loan can be made at Headwaters' discretion,
subject to certain minimum amount requirements specified in the credit
agreement. Beginning December 31, 2004 and continuing each year thereafter,
Headwaters must make mandatory prepayments to the extent of 50% of Headwaters'
fiscal year "excess cash flows," as defined. Once repaid in full or in part, no
further borrowings under the term loan arrangement can be made.
Former Senior Secured Credit Agreement - In connection with the ISG
acquisition in 2002, 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 as a term loan on the acquisition date. The debt was issued
at a 3% discount and Headwaters received net cash proceeds of $150.4 million.
The original issue discount was accreted using the effective interest method and
the accretion was recorded as interest expense.
During the quarter ended December 31, 2003, principal repayments
totaling $39.7 million were made, including $33.5 million of optional
prepayments. During the quarter ended March 31, 2004, the remaining balance was
repaid in full using available cash and $50.0 million of proceeds from the new
senior debt facility described above. In connection with the full repayment of
this debt, non cash interest expense totaling approximately $5.0 million was
recognized in the March 2004 quarter, representing amortization of all of the
remaining debt discount and debt issue costs related to this debt.
Senior Subordinated Debentures - In connection with the ISG
acquisition, Headwaters also 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. The
original issue discount was accreted using the effective interest method and the
accretion was recorded as interest expense. ISG management participated in
one-half, or $10.0 million, of the $20.0 million of debt issued. The other half
was issued to a corporation. The debentures were due in 2007; however, in
December 2003, the debentures were repaid in full, including a 4% or $0.4
million prepayment charge paid to the corporation holding $10.0 million of the
debentures. This charge, along with all remaining unamortized debt discount and
debt issue costs, is included in interest expense in the consolidated statement
of income.
In 2004, cash proceeds from the exercise of options, warrants and
employee stock purchases totaled $5.5 million, compared to $1.1 million in 2003.
22
Option exercise activity is largely dependent on Headwaters' stock price and is
not predictable. To the extent non-qualified stock options are exercised, or
there are disqualifying dispositions of shares obtained upon the exercise of
incentive stock options, Headwaters receives an income tax deduction generally
equal to the income recognized by the optionee. Such amounts, reflected in cash
flows from operations in the consolidated statements of cash flows, were $0.8
million in 2003 and $2.9 million in 2004. These income tax deductions do not
impact income tax expense and the effective income tax rate; rather they are
reflected as increases in capital in excess of par value in the consolidated
balance sheet.
Working Capital. In 2004, Headwaters' working capital increased by
$72.9 million, to $87.1 million as of March 31, 2004. The most significant
changes in the components of working capital were an increase of $16.5 million
in cash and investments, an increase of $34.6 million in trade receivables and a
decrease of $22.5 million in the current portion of long-term debt. The increase
in cash and investments was due primarily to the issuance of common stock
described above. Headwaters expects operations to produce positive cash flows in
future periods, which, combined with current working capital, is expected to be
sufficient for operating needs for the next 12 months.
Long-term Debt. Management currently believes Headwaters has the
ability, if needed, to obtain additional amounts of long-term debt in the
future, either by amendment to the current senior secured credit facility or
through issuance of other debt securities. Headwaters may, in the future, make
optional prepayments of the senior debt depending on actual cash flows,
Headwaters' current and expected cash requirements and other factors deemed
significant by management.
The senior secured 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 meet minimum net worth
requirements and maintain certain financial ratios, including leverage ratios
and a fixed charge coverage ratio, as those terms are defined in the credit
agreement. The initial net worth requirement is $200.3 million and is increased
by 50% of Headwaters' consolidated net income earned subsequent to March 31,
2004. Headwaters must maintain a total leverage ratio of 2.5:1.0 or less and a
senior debt leverage ratio of 1.5:1.0 or less. Headwaters is in compliance with
all debt covenants as of March 31, 2004.
Borrowing terms under the revolving credit arrangement are generally
the same as those described in the preceding paragraphs except that reborrowings
of any available portion of the $50.0 million revolver can be made at any time.
Finally, the credit agreement allows for the issuance of letters of credit,
provided there is capacity under the revolving credit arrangement. Currently,
two letters of credit totaling $3.2 million are outstanding, with expiration
dates in April 2005. There have been no other letters of credit issued and no
funds have been borrowed under the revolving credit arrangement. Headwaters
currently pays a fee of 0.375% on the unused portion of the revolving credit
arrangement.
Income Taxes. As discussed previously, cash payments for income taxes
are reduced for disqualifying dispositions of shares obtained upon the exercise
of stock options, which totaled $2.9 million for 2004. Headwaters' cash
requirements for income taxes in fiscal 2004 are expected to approximate the
income tax provision, with some lag due to the seasonality of operations and
because estimated income tax payments are typically based on annualizing the
fiscal year's income based on year-to-date results.
Summary of Future Cash Requirements. Significant future cash needs, in
addition to operational working capital requirements and acquisition-related
funding requirements, are currently expected to consist primarily of debt
service payments on outstanding long-term debt, income taxes and capital
expenditures.
Senate Permanent Subcommittee on Investigations
On October 29, 2003, the Permanent Subcommittee on Investigations of
the Government Affairs Committee of the United States Senate issued a
notification of pending investigations. The notification listed the synthetic
fuel tax credit as a new item. In March 2004, the Subcommittee described its
investigation as follows: "The Subcommittee is continuing its investigation of
tax credits claimed under Section 29 of the Internal Revenue Code for the sale
of coal-based synthetic fuels. This investigation is examining the utilization
of these tax credits, the nature of the technologies and fuels created, the use
of these fuels, and other aspects of Section 29. The investigation will also
address the IRS's administration of Section 29 tax credits." The Subcommittee is
expected to hold a hearing in June 2004 regarding its investigation of Section
29 tax credits.
The effect that the Senate subcommittee investigation of synthetic fuel
tax credits may have on the industry is unknown. While the investigation is
pending, buyers may be unwilling to engage in transactions to purchase synthetic
fuel facilities. If current owners are unable to sell their facilities,
production may not be maximized, materially adversely affecting Headwaters'
revenues.
23
Legislation
Under current law, Section 29 tax credits for synthetic fuel produced
from coal expire on December 31, 2007. There have been initiatives from time to
time to modify Section 29. Recently, a member of the House of Representatives
introduced legislation to repeal Section 29. If Section 29 is repealed or
adversely modified, synthetic fuel facilities would probably either close or
substantially curtail production, having a material adverse effect on the
revenues and net income of Headwaters.
Recent Accounting Pronouncements
Headwaters has reviewed all recently issued accounting standards that
have not yet been adopted in order to determine their potential effect, if any,
on the results of operations or financial position of Headwaters. Based on that
review, Headwaters does not currently believe that any of these recent
accounting pronouncements will have a significant effect on its current or
future financial position, results of operations, cash flows or disclosures.
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 synthetic 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 synthetic 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 synthetic 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 Risk Factors described in "Risk Factors" in Item 7 of our Annual Report on
Form 10-K for the year ended September 30, 2003.
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 derivative financial
instruments were outstanding as of March 31, 2004 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 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 $50.0 million of variable-rate long-term
debt as of March 31, 2004, which is repayable through November 2007. The
interest rate on this debt as of March 31, 2004 was approximately 3.4%. In March
2004, Headwaters locked in this rate for three months and in June 2004,
Headwaters can lock in a new rate for periods ranging from one month to one
year. A change in the interest rate of 1% would change interest expense by
approximately $0.5 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 SEC rules and forms. Disclosure controls include, without limitation,
controls and procedures designed to ensure that such information is accumulated
and communicated to Headwaters' management, including the Chief Executive
Officer ("CEO") and the Chief Financial Officer ("CFO"), in order to allow
timely consideration regarding required disclosures.
24
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 March 31, 2004, and subject
to the inherent limitations as described above, Headwaters' CEO and CFO have
concluded that Headwaters' disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are
effective. In addition, they are not aware of any change in Headwaters' internal
control over financial reporting during the quarter ended March 31, 2004 that
has materially affected, or is reasonably likely to materially affect,
Headwaters' internal control over financial reporting.
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See "Legal or Contractual Matters" in Note 10 to the consolidated
financial statements for a description of current legal proceedings.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Recent Sales of Unregistered Securities
During the quarter ended March 31, 2004, pursuant to the exercise of
options and warrants, approximately 96,000 shares of Headwaters restricted
common stock were issued. Headwaters has several outstanding effective
registration statements filed on Forms S-3 and S-8. All but 4,000 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
An annual meeting of stockholders of Headwaters was held on March 12,
2004 for the following purposes:
1. To elect three Class I directors of Headwaters to serve until
the 2007 annual meeting, or until their successors are duly
elected and qualified;
2. To ratify the selection by the Board of Directors of Ernst &
Young LLP as independent auditors of Headwaters for the fiscal
year ending September 30, 2004; and
3. To approve an amendment to the 2003 Stock Incentive Plan
increasing the number of shares available for award grants
under the plan by 1,500,000.
A total of 30,693,144 shares were voted on proposals no. 1 and 2. A
total of 22,933,899 shares were voted on proposal no. 3. The results of voting
on these proposals were as follows:
1. To elect Mr. R. Sam Christensen as a Class I director: for -
29,794,358; withheld authority - 898,786. To elect Mr. William
S. Dickinson as a Class I director: for - 29,849,058; withheld
authority - 844,086. To elect Mr. Malyn K. Malquist as a Class
I director: for - 29,790,643; withheld authority - 902,501.
2. To ratify the selection of Ernst & Young LLP as auditors for
fiscal 2004: for - 29,907,308; against - 766,475; abstain -
19,361.
3. To approve Amendment No. 1 to the 2003 Stock Incentive Plan:
for - 16,775,815; against - 6,098,056; abstain - 60,028.
25
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following exhibits are included herein:
12 Computation of ratio of earnings to combined fixed
charges and preferred stock dividends *
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief
Executive Officer *
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief
Financial Officer *
32 Section 1350 Certifications of Chief Executive
Officer and Chief Financial Officer *
---------------------
* Filed herewith.
(b) The following Forms 8-K were filed with the SEC during the
quarter ended March 31, 2004:
o Form 8-K dated January 23, 2004 to file the press
release announcing Headwaters' results for the
quarter ended December 31, 2003.
o Form 8-K dated March 25, 2004 to file two press
releases announcing i) the execution of a commitment
letter with Bank One to provide for the refinancing
of Headwaters' senior secured credit facilities, and
ii) the recognition in the March 2004 quarter of
revenues relating to certain funds previously
deposited in an escrow account.
26
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HEADWATERS INCORPORATED
Date: May 3, 2004 By: /s/ Kirk A. Benson
------------------------------------------
Kirk A. Benson, Chief Executive Officer
(Principal Executive Officer)
Date: May 3, 2004 By: /s/ Steven G. Stewart
------------------------------------------
Steven G. Stewart, Chief Financial Officer
(Principal Financial Officer)
27