-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, EKlslh2IHujP0jf+vt674UMoM/wFxmyX24F71tB/2pa59JjZEOKtyU00zZEvCYSj k7qNo75/j296cqlkq/3hAA== 0001038838-04-000390.txt : 20040503 0001038838-04-000390.hdr.sgml : 20040503 20040503124956 ACCESSION NUMBER: 0001038838-04-000390 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20040331 FILED AS OF DATE: 20040503 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HEADWATERS INC CENTRAL INDEX KEY: 0001003344 STANDARD INDUSTRIAL CLASSIFICATION: MISCELLANEOUS PRODUCTS OF PETROLEUM & COAL [2990] IRS NUMBER: 870547337 STATE OF INCORPORATION: DE FISCAL YEAR END: 0930 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-27808 FILM NUMBER: 04772600 BUSINESS ADDRESS: STREET 1: 10653 SOUTH RIVERFRONT PARKWAY STREET 2: SUITE 300 CITY: SOUTH JORDAN STATE: UT ZIP: 84095 BUSINESS PHONE: 801-984-9400 MAIL ADDRESS: STREET 1: 10653 SOUTH RIVERFRONT PARKWAY STREET 2: SUITE 300 CITY: SOUTH JORDAN STATE: UT ZIP: 84095 FORMER COMPANY: FORMER CONFORMED NAME: COVOL TECHNOLOGIES INC DATE OF NAME CHANGE: 19951113 10-Q 1 q033104.txt 10-Q ENDED MARCH 31, 2004 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 EX-12 2 ex12q033104.txt COMPUTATION OF RATIO OF EARNINGS Exhibit 12
Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends Six Months Ended (thousands of dollars) Year Ended September 30, March 31 ---------------------------------------------------------------- --------------- 1999 2000 2001 2002 2003 2004 -------------------------------------------------------------------------------- Fixed Charges Computation Interest expensed and capitalized $ 4,178 $ 3,603 $ 145 $ 417 $ 12,060 $ 3,993 Amortized premiums, discounts, and capitalized expenses related to indebtedness 2,075 3,034 79 136 3,857 7,631 Reasonable approximation of interest within rental expense 131 26 20 72 1,139 599 -------------------------------------------------------------------------------- Total Fixed Charges 6,384 6,663 244 625 17,056 12,223 Preferred equity dividends 466 378 113 - - - -------------------------------------------------------------------------------- Total Fixed Charges and Preferred Equity Dividends $ 6,850 $ 7,041 $ 357 $ 625 $ 17,056 $ 12,223 ================================================================================ Earnings Computation Pre-tax income (loss) from continuing operations before adjustment for minority interests in consolidated subsidiaries or income or loss from equity investees $(28,402) $ 8,642 $ 14,468 $ 40,236 $ 60,081 $ 46,689 Plus Fixed charges 6,850 7,041 357 625 17,056 12,223 Minus Interest capitalized - - - - 230 274 -------------------------------------------------------------------------------- Total Earnings $(21,552) $ 15,683 $ 14,825 $ 40,861 $ 76,907 $ 58,638 ================================================================================ Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends N/A 2.23 41.53 65.38 4.51 4.80 Dollar amount of Deficiency $(28,402) N/A N/A N/A N/A N/A
EX-31.1 3 ex311q033104.txt CEO CERTIFICATION REQUIRED UNDER SECTION 302 Exhibit 31.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER I, Kirk A. Benson, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of Headwaters Incorporated; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of Headwaters as of, and for, the periods presented in this report; 4. Headwaters' other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for Headwaters and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to Headwaters, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of Headwaters' disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in Headwaters' internal control over financial reporting that occurred during the quarter ended March 31, 2004 that has materially affected, or is reasonably likely to materially affect, Headwaters internal control over financial reporting; and 5. Headwaters' other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to Headwaters' auditors and the audit committee of Headwaters' board of directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect Headwaters' ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in Headwaters' internal control over financial reporting. Date: May 3, 2004 /s/ Kirk A. Benson - -------------------------- Kirk A. Benson Chief Executive Officer EX-31.2 4 ex312q033104.txt CFO CERTIFICATION REQUIRED UNDER SECTION 302 Exhibit 31.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER I, Steven G. Stewart, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of Headwaters Incorporated; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of Headwaters as of, and for, the periods presented in this report; 4. Headwaters' other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for Headwaters and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to Headwaters, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of Headwaters' disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in Headwaters' internal control over financial reporting that occurred during the quarter ended March 31, 2004 that has materially affected, or is reasonably likely to materially affect, Headwaters internal control over financial reporting; and 5. Headwaters' other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to Headwaters' auditors and the audit committee of Headwaters' board of directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect Headwaters' ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in Headwaters' internal control over financial reporting. Date: May 3, 2004 /s/ Steven G. Stewart - ------------------------- Steven G. Stewart Chief Financial Officer EX-32 5 ex32q033104.txt CERTIFICATIONS REQUIRED UNDER SECTION 906 Exhibit 32 CERTIFICATIONS PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the filing of the Quarterly Report of Headwaters Incorporated (the "Company") on Form 10-Q for the quarter ended March 31, 2004 (the "Report"), we, Kirk A. Benson, Chief Executive Officer of the Company, and Steven G. Stewart, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (i) The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and (ii) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Kirk A. Benson - ---------------------------- Kirk A. Benson Chief Executive Officer May 3, 2004 /s/ Steven G. Stewart - ---------------------------- Steven G. Stewart Chief Financial Officer May 3, 2004 -----END PRIVACY-ENHANCED MESSAGE-----