-----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, IKHPkE0i4pWqONJ8OE9FS8gYhvUDbXxfN7unBgilJ9sYNhEdAMzNJ95N4ehI8hg1 f1oKsFAjW5WaiOjxKCVf9w== 0001038838-05-000506.txt : 20050509 0001038838-05-000506.hdr.sgml : 20050509 20050509160618 ACCESSION NUMBER: 0001038838-05-000506 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 12 CONFORMED PERIOD OF REPORT: 20050331 FILED AS OF DATE: 20050509 DATE AS OF CHANGE: 20050509 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: 001-32459 FILM NUMBER: 05811841 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 q033105.txt 10-Q ENDED MARCH 31, 2005 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, 2005 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 29, 2005 was 41,357,243. HEADWATERS INCORPORATED TABLE OF CONTENTS PART I - FINANCIAL INFORMATION Page No. ITEM 1. FINANCIAL STATEMENTS (Unaudited): Condensed Consolidated Balance Sheets - As of September 30, 2004 and March 31, 2005...................... 3 Condensed Consolidated Statements of Income - For the three and six months ended March 31, 2004 and 2005......... 4 Condensed Consolidated Statement of Changes in Stockholders' Equity - For the six months ended March 31, 2005............................................. 5 Condensed Consolidated Statements of Cash Flows - For the six months ended March 31, 2004 and 2005............... 6 Notes to Condensed Consolidated Financial Statements....... 7 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.......................................22 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK......33 ITEM 4. CONTROLS AND PROCEDURES.........................................34 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS...............................................35 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.....35 ITEM 3. DEFAULTS UPON SENIOR SECURITIES.................................35 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.............35 ITEM 5. OTHER INFORMATION...............................................35 ITEM 6. EXHIBITS........................................................35 SIGNATURES...................................................................36 Forward-looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 regarding future events and our future results that are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. Actual results may vary materially from such expectations. Words such as "expects," "anticipates," "targets," "goals," "projects," "believes," "seeks," "estimates," or variations of such words and similar expressions, are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses, and other characterizations of future events or circumstances, are forward-looking. For a discussion of the factors that could cause actual results to differ from expectations, please see the risk factors described in Item 7 of our Annual Report on Form 10-K for the year ended September 30, 2004. There can be no assurance that our results of operations will not be adversely affected by such factors. Unless legally required, we undertake no obligation to revise or update any forward-looking statements for any reason. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. Our internet address is www.headwaters.com. There we make available, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission ("SEC"). Our reports can be accessed through the investor relations section of our web site. The information found on our web site is not part of this or any report we file with or furnish to the SEC. 2 ITEM 1. FINANCIAL STATEMENTS
HEADWATERS INCORPORATED CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) September 30, March 31, (in thousands, except per-share data) 2004 2005 - -------------------------------------------------------------------------------------------------------------------------- ASSETS Current assets: Cash and cash equivalents $ 20,851 $ 5,943 Short-term trading investments 6,735 -- Trade receivables, net 129,899 122,900 Inventories 43,812 57,002 Current and deferred income taxes 15,933 12,710 Other 13,333 16,801 -------------------------- Total current assets 230,563 215,356 -------------------------- Property, plant and equipment, net 157,611 166,214 -------------------------- Other assets: Intangible assets, net 298,803 286,578 Goodwill 815,396 815,396 Other 38,406 48,850 -------------------------- Total other assets 1,152,605 1,150,824 -------------------------- Total assets $ 1,540,779 $ 1,532,394 ========================== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 29,238 $ 36,739 Accrued personnel costs 26,213 26,873 Other accrued liabilities 72,852 52,401 Current portion of long-term debt 57,873 26,093 -------------------------- Total current liabilities 186,176 142,106 -------------------------- Long-term liabilities: Long-term debt 914,641 708,569 Deferred income taxes 121,469 123,079 Other 10,338 13,361 -------------------------- Total long-term liabilities 1,046,448 845,009 -------------------------- Total liabilities 1,232,624 987,115 -------------------------- Commitments and contingencies Stockholders' equity: Common stock, $0.001 par value; authorized 100,000 shares; issued and outstanding: 33,775 shares at September 30, 2004 (including 414 shares held in treasury) and 41,319 shares at March 31, 2005 (including 385 shares held in treasury) 34 41 Capital in excess of par value 235,581 444,934 Retained earnings 76,530 101,531 Treasury stock and other (3,990) (1,227) -------------------------- Total stockholders' equity 308,155 545,279 -------------------------- Total liabilities and stockholders' equity $ 1,540,779 $ 1,532,394 ========================== 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) 2004 2005 2004 2005 - ------------------------------------------------------------------------------------------------------------------------------ Revenue: Construction materials $ 11,248 $ 109,157 $ 23,181 $ 222,885 Coal combustion products 39,592 48,467 84,692 101,519 Alternative energy 68,681 64,768 113,116 116,404 ------------------------------------------------------------- Total revenue 119,521 222,392 220,989 440,808 ------------------------------------------------------------- Operating costs and expenses: Construction materials 9,950 73,685 19,344 150,153 Coal combustion products 29,666 38,335 63,063 79,330 Alternative energy 22,011 28,590 43,336 53,245 Amortization 1,664 6,181 3,384 12,362 Research and development 1,517 2,876 3,591 5,162 Selling, general and administrative 16,690 34,212 28,200 64,312 ------------------------------------------------------------- Total operating costs and expenses 81,498 183,879 160,918 364,564 ------------------------------------------------------------- Operating income 38,023 38,513 60,071 76,244 ------------------------------------------------------------- Other income (expense): Net interest expense (5,697) (18,798) (10,988) (34,603) Other, net (1,889) (3,222) (2,394) (5,140) ------------------------------------------------------------- Total other income (expense), net (7,586) (22,020) (13,382) (39,743) ------------------------------------------------------------- Income before income taxes 30,437 16,493 46,689 36,501 Income tax provision (11,810) (4,500) (17,970) (11,500) ------------------------------------------------------------- Net income $ 18,627 $ 11,993 $ 28,719 $ 25,001 ============================================================= Basic earnings per share $ 0.57 $ 0.33 $ 0.95 $ 0.72 ============================================================= Diluted earnings per share $ 0.55 $ 0.30 $ 0.91 $ 0.65 ============================================================= See accompanying notes. 4
HEADWATERS INCORPORATED CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) For the Six Months Ended March 31, 2005 Common stock Capital in Total -------------------- excess Retained Treasury stock, stockholders' (in thousands) Shares Amount of par value earnings at cost Other equity - ----------------------------------------------------------------------------------------------------------------------------------- Balances as of September 30, 2004 33,775 $34 $235,581 $ 76,530 $(2,610) $(1,380) $308,155 Exercise of stock options 644 -- 4,120 4,120 Tax benefit from exercise of stock options 5,295 5,295 29 shares of treasury stock transferred to employee stock purchase plan, at cost 684 87 771 Common stock issued for cash, net of commissions and offering costs of $11,189 6,900 7 199,254 199,261 Amortization of deferred compensation from stock options and restricted stock 166 166 Other comprehensive income - unrealized gain on cash flow hedges, net of taxes 2,510 2,510 Net income for the six months ended March 31, 2005 25,001 25,001 ------------------------------------------------------------------------------------------ Balances as of March 31, 2005 41,319 $41 $444,934 $101,531 $(2,523) $ 1,296 $545,279 ========================================================================================== See accompanying notes. 5
HEADWATERS INCORPORATED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Six Months Ended March 31, -------------------------------- (in thousands) 2004 2005 - ------------------------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 28,719 $ 25,001 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 6,507 27,849 Non cash interest expense related to amortization of debt discount and debt issue costs 7,631 6,741 Deferred income taxes 743 (3,755) Income tax benefit from exercise of stock options 2,910 5,295 Net loss on disposition of property, plant and equipment 663 97 Write-down of notes receivable 1,038 -- Decrease (increase) in short-term trading investments (30,647) 6,735 Decrease (increase) in trade receivables (34,625) 6,999 Increase in inventories (2,097) (12,717) Increase (decrease) in accounts payable and accrued liabilities 2,431 (13,437) Other changes in operating assets and liabilities, net (332) (1,353) --------------------------- Net cash provided by (used in) operating activities (17,059) 47,455 --------------------------- Cash flows from investing activities: Purchase of property, plant and equipment (4,890) (23,509) Net increase in investments and other assets (2,451) (4,289) Proceeds from disposition of property, plant and equipment 53 182 --------------------------- Net cash used in investing activities (7,288) (27,616) --------------------------- Cash flows from financing activities: Net proceeds from issuance of common stock 90,303 199,261 Net proceeds from issuance of long-term debt 49,205 14,953 Payments on long-term debt (134,876) (253,852) Proceeds from exercise of options and warrants 5,082 4,120 Employee stock purchases 436 771 --------------------------- Net cash provided by (used in) financing activities 10,150 (34,747) --------------------------- Net decrease in cash and cash equivalents (14,197) (14,908) Cash and cash equivalents, beginning of period 18,732 20,851 --------------------------- Cash and cash equivalents, end of period $ 4,535 $ 5,943 =========================== Supplemental schedule of non-cash investing and financing activities - Purchase of variable interest in solid alternative fuel facility in exchange for commitment to make future payments $ -- $ 7,500 =========================== See accompanying notes. 6
HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) 1. Nature of Operations and Basis of Presentation Organization and Description of Business - Headwaters Incorporated is incorporated in Delaware. Headwaters owns 100% of the following subsidiaries: Headwaters Resources, Inc. and Headwaters Construction Materials, Inc. (the two of which combined were formerly Industrial Services Group, Inc., a Utah-based company acquired by Headwaters in September 2002) ("ISG"); Headwaters Technology Innovation Group, Inc. (formerly Hydrocarbon Technologies, Inc., a New Jersey company acquired in August 2001) ("HTI"); VFL Technology Corporation, a Pennsylvania company acquired in April 2004 ("VFL"); Eldorado Stone, LLC, a Delaware company acquired in June 2004 ("Eldorado"); Southwest Concrete Products, L.P., a Texas company acquired in July 2004 ("SCP"); and Tapco Holdings, Inc., a Michigan company acquired in September 2004 ("Tapco"). Headwaters' focus is on enhancing the value of energy resources in an environmentally responsible manner; expanding Headwaters' construction materials business, including opportunities to utilize products from other Headwaters operations in the production of construction materials; promoting the expanded use of coal combustion products ("CCPs"); and developing HTI's energy and nanocatalysis technologies. Headwaters currently generates revenue from the sale of construction materials, from marketing CCPs, and from licensing its chemical technologies to produce solid alternative fuel. Headwaters intends to continue to expand its business through growth of existing operations, commercialization of technologies currently being developed, and strategic acquisitions of entities that operate in adjacent industries. Headwaters' construction materials segment develops, manufactures and distributes bagged concrete, stucco, mortar and block products that utilize fly ash, and with the acquisitions of Eldorado and SCP, manufactured stone and expanded concrete block products. Tapco is a leading designer, manufacturer and marketer of building products used in exterior residential home improvement and construction. ISG's CCP operations and VFL (together referred to as Headwaters' Resources, Inc., or "Resources") represent the nation's largest provider of CCP management and marketing services to the electric utility industry, serving more than 100 coal-fired electric power generation plants nationwide. Through its distribution network of over 110 locations, Resources is the leading provider of high quality fly ash to the building products and ready mix concrete industries in the United States. Resources also develops and deploys technologies for maintaining and improving fly ash quality. Through its proprietary Covol Fuels process, Headwaters adds value to the production of coal-based solid alternative fuels, primarily for use in electric power generation plants. Headwaters currently licenses its technologies to the owners of 28 of a company-estimated 75 coal-based solid alternative fuel facilities in the United States and sells chemical reagents to licensees and other customers. Through its wholly-owned subsidiary HTI, Headwaters conducts research and development activities directed at catalysts and processes to convert coal and heavy oil into 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. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in Headwaters' Annual Report on Form 10-K for the year ended September 30, 2004 ("Form 10-K") and in Headwaters' Quarterly Report on Form 10-Q for the quarter ended December 31, 2004. Headwaters' fiscal year ends on September 30 and unless otherwise noted, future references to 2004 refer to Headwaters' fiscal quarter and/or six-month period ended March 31, 2004, and references to 2005 refer to Headwaters' fiscal quarter and/or six-month period ended March 31, 2005. The consolidated financial statements include the accounts of Headwaters, all of its subsidiaries and other entities in which Headwaters has a 7 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) controlling financial interest. All significant intercompany transactions and accounts are eliminated in consolidation. Due to the seasonality of the operations of the construction materials and CCP segments and other factors, Headwaters' consolidated results of operations for 2005 are not indicative of the results to be expected for the full fiscal 2005 year. As referred to above and described in detail in Headwaters' Form 10-K, Headwaters acquired four companies in fiscal 2004. As reported in the Form 10-K, the purchase price and final purchase price allocation for both VFL and SCP were completed in fiscal 2004 (however, as described in Note 3 to the consolidated financial statements in the Form 10-K, Headwaters agreed to pay an earn-out to the sellers of SCP if certain SCP earnings targets are exceeded during the 12 months ending December 31, 2005). Headwaters expects to finalize the determination of the purchase price and the purchase price allocation for both Eldorado and Tapco in the quarter ending June 30, 2005. Common Stock Options and Restricted Stock Grants - Headwaters has elected to continue to apply the intrinsic value method as prescribed by APB Opinion No. 25 ("APB 25") in accounting for options and restricted stock grants to employees, officers and directors and is currently considering when to adopt the fair value method required by changes in accounting standards (see "Recent Accounting Pronouncements" below). The alternative fair value method of accounting prescribed by SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"), 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 options and restricted stock grants to employees, officers and directors when the exercise price of stock options or restricted stock 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 addition, in fiscal 2004, Headwaters issued restricted stock to certain officers and employees, also with terms considered compensatory because the restricted stock was issued at no cost to the recipients. In such instances, compensation cost is amortized to expense over the applicable vesting period on a straight-line basis. If the fair value provision of SFAS No. 123 would have been applied to all options and restricted stock grants, net income and earnings per share would have been changed to the pro forma amounts shown in the following table.
Three Months Ended March 31, Six Months Ended March 31, -------------------------------------------------------------- (in thousands, except per-share data) 2004 2005 2004 2005 ----------------------------------------------------------------------------------------------------------- Reported net income $18,627 $11,993 $28,719 $25,001 Add actual amortization expense included in reported net income 22 83 45 166 Deduct expense determined under fair value provision of SFAS No. 123 (1,021) (2,102) (2,015) (4,056) -------------------------------------------------------------- Pro forma net income $17,628 $ 9,974 $26,749 $21,111 ============================================================== Basic earnings per share - as reported $ 0.57 $ 0.33 $ 0.95 $ 0.72 - pro forma $ 0.54 $ 0.28 $ 0.88 $ 0.61 Diluted earnings per share - as reported $ 0.55 $ 0.30 $ 0.91 $ 0.65 - pro forma $ $0.52 $ 0.26 $ 0.85 $ 0.55
The fair values of stock option grants for 2004 and 2005 were determined using the Black-Scholes option pricing model and the following assumptions: expected stock price volatility of 40%, risk-free interest rates ranging from 1.3% to 4.5%, weighted average expected option lives of 3 to 4 years beyond vesting date, 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 and restricted stock. 8 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) Recent Accounting Pronouncements - In September 2004, the Emerging Issues Task Force ("EITF") reached a consensus requiring the inclusion of contingently convertible securities in diluted earnings per share ("EPS") calculations. This consensus (EITF Issue 04-08, "The Effect of Contingently Convertible Debt on Diluted Earnings per Share") was effective for periods ending after December 15, 2004 and required Headwaters to include in its 2005 diluted EPS calculations, on an if-converted basis, the additional shares issuable under the terms of Headwaters' outstanding convertible senior subordinated notes described in Note 6. The EITF consensus must be applied to all applicable prior periods, which for Headwaters are the quarters ended June 30, 2004 and September 30, 2004. See Note 8 for more information on the effect on Headwaters' EPS of implementing the EITF consensus. In November 2004, the Financial Accounting Standards Board ("FASB") issued SFAS No. 151, "Inventory Costs," which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and spoilage, requiring that such costs be recognized as current-period costs regardless of whether they meet the criterion of "so abnormal," currently required by the guidance in ARB No. 43, Chapter 4, "Inventory Pricing." SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005, which for Headwaters will be fiscal 2006. Because the provisions of this standard must be applied prospectively, there will be no effect on previously-issued financial statements of Headwaters. It is not possible to predict the effect SFAS No. 151 might have on future reported results because it will depend on the levels of "abnormal" inventory costs incurred in the future, if any. In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment," ("SFAS No. 123R"), which was to be effective for interim periods beginning after June 15, 2005. In April 2005, the SEC announced that it would allow registrants to delay the adoption of SFAS No. 123R to no later than the beginning of the first fiscal year beginning after June 15, 2005, which for Headwaters would be fiscal 2006. SFAS No. 123R revises SFAS No. 123 and supersedes APB 25 and requires companies to expense the value of employee stock options and similar awards. Pro forma disclosure will no longer be an alternative. SFAS No. 123R also amends SFAS No. 95, Statement of Cash Flows, to require tax benefits from share-based payments to be reported as a financing cash flow rather than an operating cash flow, as required under current literature. Headwaters is studying the implications of SFAS No. 123R and expects it to have a material effect on Headwaters' reported results of operations when adopted, although it will have limited impact on cash flow. Headwaters may early adopt SFAS No. 123R beginning in either the June or September 2005 quarters. SFAS No. 123R permits public companies to adopt its requirements using one of two methods: i) a "modified prospective" method in which compensation cost is recognized beginning with the effective date based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date, plus compensation cost under the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date; or ii) a "modified retrospective" method which includes the requirements of the modified prospective method, but also permits companies to restate, based on the amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures, for either all prior periods, or by restating only the prior interim periods of the year of adoption. Headwaters has not yet determined which method will be used when SFAS No. 123R is adopted. The impact of adoption of SFAS No. 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future (including the stock appreciation rights and stock options granted in May 2005, as described in Note 9). However, had Headwaters adopted SFAS No. 123R in prior periods, Headwaters believes the impact of this standard would have approximated the impact of SFAS No. 123 as reflected above in the disclosures of pro forma net income and earnings per share. Adoption of SFAS No. 123R will also reduce net cash flow from operating activities and increase net cash flow from financing activities. While Headwaters cannot estimate what those amounts will be in the future, the amounts for the six months ended March 31, 2004 and 2005 were $2,910,000 and $5,295,000, respectively. Headwaters has reviewed all other recently issued accounting standards, which 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 other recent accounting pronouncements will have a significant effect on its current or future financial position, results of operations, cash flows or disclosures. 9 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) Reclassifications - Certain prior period amounts have been reclassified to conform to the current period's presentation. The reclassifications had no effect on net income or total assets. 2. Segment Reporting The following segment information has been prepared in accordance with SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information." The accounting policies of the segments are the same as those described in the notes to the financial statements in Headwaters' Form 10-K. 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 overhead. Segment assets reflect those specifically attributable to individual segments and primarily include accounts receivable, inventories, property, plant and equipment, intangible assets and goodwill. Other assets are included in the "Corporate" column. Segment information for 2005 includes the results of operations for all of the four fiscal 2004 acquisitions described in the Form 10-K, while the segment information for 2004 includes no such results since none of the acquisitions were consummated prior to March 31, 2004.
Three Months Ended March 31, 2004 --------------------------------------------------------------------- Construction Alternative (in thousands) Materials CCPs Energy Corporate Totals ---------------------------------------------------------------------------------------------------------------- Segment revenue $ 11,248 $39,592 $68,681 $ -- $119,521 ===================================================================== Depreciation and amortization $ (162) $(2,683) $ (293) $ (67) $ (3,205) ===================================================================== Operating income (loss) $ (904) $ 4,814 $40,893 $(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 $ 937 $ 663 $ 165 $ 19 $ 1,784 ===================================================================== Three Months Ended March 31, 2005 --------------------------------------------------------------------- Construction Alternative (in thousands) Materials CCPs Energy Corporate Totals ---------------------------------------------------------------------------------------------------------------- Segment revenue $109,157 $48,467 $64,768 $ -- $222,392 ===================================================================== Depreciation and amortization $ (9,348) $(3,173) $(1,556) $ (102) $(14,179) ===================================================================== Operating income (loss) $ 13,057 $ 4,025 $30,159 $(8,728) $ 38,513 ======================================================= Net interest expense (18,798) Other income (expense), net (3,222) Income tax provision (4,500) ------------- Net income $ 11,993 ============= Capital expenditures $10,379 $ 617 $ 521 $ 92 $ 11,609 =====================================================================
10 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited)
Six Months Ended March 31, 2004 --------------------------------------------------------------------- Construction Alternative (in thousands) Materials CCPs Energy Corporate Totals ---------------------------------------------------------------------------------------------------------------- Segment revenue $ 23,181 $84,692 $113,116 $ -- $220,989 ===================================================================== Depreciation and amortization $ (329) $(5,392) $ (660) $ (126) $ (6,507) ===================================================================== Operating income (loss) $ (165) $11,136 $ 59,429 $(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 $ 1,323 $ 3,224 $ 312 $ 31 $ 4,890 ===================================================================== Six Months Ended March 31, 2005 --------------------------------------------------------------------- Construction Alternative (in thousands) Materials CCPs Energy Corporate Totals ---------------------------------------------------------------------------------------------------------------- Segment revenue $ 222,885 $101,519 $116,404 $ -- $ 440,808 ===================================================================== Depreciation and amortization $ (18,763) $ (6,339) $ (2,548) $ (199) $ (27,849) ===================================================================== Operating income (loss) $ 28,529 $ 9,673 $ 51,595 $(13,553) $ 76,244 ======================================================= Net interest expense (34,603) Other income (expense), net (5,140) Income tax provision (11,500) ------------- Net income $ 25,001 ============= Capital expenditures $ 20,554 $ 1,792 $ 934 $ 229 $ 23,509 ===================================================================== Segment Assets as of March 31, 2005 $1,106,743 $308,359 $ 63,274 $ 54,018 $1,532,394 =====================================================================
3. Equity Securities Authorized Common Stock - In January 2005, Headwaters' Board of Directors approved an increase in the authorized shares of common stock from 50,000,000 to 100,000,000. This action was approved at the annual meeting of stockholders on March 1, 2005. Issuance of Common Stock - In January 2005, Headwaters filed a Form S-3 shelf registration statement with the SEC that was declared effective for the sale of up to $175,000,000 of common stock. Headwaters also 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 (under which approximately $53,000,000 was available as of January 2005). In February 2005, Headwaters filed a prospectus supplement to the shelf registration statements and in March 2005 issued 6,900,000 shares of common stock in an underwritten public offering. Proceeds of $199,261,000 were received, net of commissions and offering costs of $11,189,000. Following this issuance of common stock, approximately $18,000,000 remains available for future offerings of securities under the universal 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 York Stock Exchange Listing - Headwaters' common stock traded on the Nasdaq National Market until April 6, 2005, at which time it began trading on the New York Stock Exchange under the symbol "HW." 11 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) Stock Incentive Awards - As described in more detail in Note 9, in May 2005, the Compensation Committee of Headwaters' Board of Directors (the "Committee") granted to certain officers and employees stock incentive awards consisting of stock appreciation rights and stock options. The Committee is also considering the potential acceleration of vesting of outstanding stock options not currently vested. 4. Inventories Inventories consisted of the following at: September 30, March 31, (in thousands) 2004 2005 ---------------------------------------------------------------- Raw materials $ 8,517 $ 9,534 Finished goods 35,295 47,468 -------------------------------- $43,812 $57,002 ================================ 5. Intangible Assets Intangible Assets - Headwaters has no identified intangible assets that are not being amortized. The following table summarizes the gross carrying amounts and the related accumulated amortization of all amortizable intangible assets as of:
September 30, 2004 March 31, 2005 ----------------------------------------------------------------- Gross Gross Estimated Carrying Accumulated Carrying Accumulated (in thousands) useful lives Amount Amortization Amount Amortization --------------------------------------------------------------------------------------------------------------- CCP contracts 8 - 20 years $117,690 $11,524 $117,690 $14,890 Customer relationships 7 1/2 - 15 years 68,331 452 68,331 2,925 Trade names 5 - 20 years 63,657 268 63,657 1,955 Patents and patented technologies 7 1/2 - 15 years 52,464 2,969 52,464 5,476 Non-competition agreements 2 - 3 1/2 years 10,422 867 10,422 2,903 Other 9 - 17 1/4 years 3,382 1,063 3,382 1,219 ----------------------------------------------------------------- $315,946 $17,143 $315,946 $29,368 =================================================================
Total amortization expense related to intangible assets was approximately $1,659,000 and $3,338,000 for the three- and six-month periods ended March 31, 2004, respectively, and approximately $6,108,000 and $12,225,000 for the three- and six-month periods ended March 31, 2005, respectively. Total estimated annual amortization expense is as follows for the fiscal years presented. (in Year ending September 30, thousands) ------------------------- ---------- 2005 $24,449 2006 24,244 2007 21,899 2008 20,350 2009 20,138 2010 19,804 12 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) 6. Long-term Debt Long-term debt consisted of the following at: September 30, March 31, (in thousands) 2004 2005 ---------------------------------------------------------------------- Senior secured debt $790,000 $552,673 Convertible senior subordinated notes 172,500 172,500 Notes payable to a bank 9,787 9,300 Other 227 189 ------------------------------ 972,514 734,662 Less: current portion (57,873) (26,093) ------------------------------ Total long-term debt $914,641 $708,569 ============================== Senior Secured Credit Agreements - In September 2004 and as amended in October 2004, Headwaters entered into two credit agreements with a syndication of lenders under which a total of $790,000,000 was borrowed under term loan arrangements and which provide for up to $60,000,000 to be borrowed under a revolving credit arrangement. The proceeds were used to acquire Tapco and repay in full the remaining balance due under Headwaters' former senior secured credit agreement executed in March 2004. The $790,000,000 of term loan borrowings consisted of a first lien term loan in the amount of $640,000,000 and a second lien term loan in the amount of $150,000,000. Both term loans are secured by all assets of Headwaters and are senior in priority to all other debt, with the exception of the specific SCP assets that collateralize the notes payable to banks discussed below. In March 2005, another amendment to the credit agreements was entered into which modified certain terms of the credit facility, all as described in more detail in the following paragraphs. The first lien term loan bears interest, at Headwaters' option, at either i) the London Interbank Offered Rate ("LIBOR") plus 2.0%, 2.25%, or 2.5%, depending on the credit ratings that have been most recently announced for the loans by Standard & Poors Ratings Services ("S&P") and Moody's Investors Service, Inc. ("Moody's"); or ii) the "base rate" plus 1.0%, 1.25%, or 1.5%, again depending on the credit ratings announced by S&P and Moody's. Base rate is defined as the higher of the rate announced by Morgan Stanley Senior Funding and the overnight rate charged by the Federal Reserve Bank of New York plus 0.5%. The initial interest rate on the first lien debt was set at 6.5%, but was subsequently reduced to approximately 5.4% during the quarter ended December 31, 2004 pursuant to the terms of the agreement. The interest rate on the first lien debt was approximately 4.9% at March 31, 2005. The second lien term loan bears interest, also at Headwaters' option, at either LIBOR plus 5.5%, or the "base rate" plus 4.5%. The initial interest rate on the second lien debt was set at 9.75%, but was subsequently reduced to approximately 7.7% during the quarter ended December 31, 2004 pursuant to the terms of the agreement. The interest rate on the second lien debt was approximately 8.2% at March 31, 2005. Headwaters can lock in new rates for both the first lien and second lien loans for one, two, three or six months. The most recent rate change occurred in March 2005. The first lien term loan ($442,673,000 outstanding at March 31, 2005) is repayable in quarterly installments of principal and interest, with minimum required quarterly principal repayments of approximately $3,354,000 commencing in November 2005 through August 2010, with three repayments of approximately $125,200,000 each through April 2011, the termination date of the first lien loan agreement. The second lien term loan ($100,000,000 outstanding at March 31, 2005) is due September 2012, with no required principal repayments prior to that time. Interest is generally due on a quarterly basis. There are mandatory prepayments of the first lien term loan in the event of certain asset sales and debt and equity issuances and from "excess cash flow," as defined in the agreement. Optional prepayments of the first lien term loan are generally permitted without penalty or premium, except where the proceeds for repayment are obtained from a "financing," as defined, consummated for the purpose of lowering the interest rate on the first lien debt, in which case there is a 1% prepayment penalty. Optional prepayments of the second lien term loan under the original terms of the credit agreement were permissible only to the extent Headwaters issued new equity securities and then were further limited to a maximum of $50,000,000, so long as the first lien term loan remained outstanding. As amended, optional prepayments of the second lien term loan bear a penalty of 3% of prepayments made in the first year, 2% of prepayments made in the second 13 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) year, and 1% of prepayments made in the third year, and further, subsequent to September 8, 2005, Headwaters can prepay the second lien debt with available cash flow, unrestricted as to source. Once repaid in full or in part, no further reborrowings under either of the term loan arrangements can be made. During the quarter ended December 31, 2004, Headwaters repaid a total of $50,000,000 of the first lien term loan, which otherwise would have been due during the period from November 2004 through November 2005. In March 2005, Headwaters repaid $147,327,000 of the first lien term loan and $50,000,000 of the second lien term loan. As a result of the early repayments of debt, there was an acceleration of amortization of the related debt issue costs totaling approximately $3,954,000 and $4,919,000 for the three- and six-month periods ended March 31, 2005, respectively, all of which was charged to interest expense. A 3% prepayment penalty of $1,500,000 was paid related to the early repayment of $50,000,000 of second lien term debt, which was also charged to interest expense. Borrowings under the revolving credit arrangement are generally subject to the terms of the first lien loan agreement and bear interest at either LIBOR plus 1.75% to 2.5% (depending on Headwaters' "total leverage ratio," as defined), or the base rate plus 0.75% to 1.5%. Borrowings and reborrowings of any available portion of the $60,000,000 revolver can be made at any time through September 2009, at which time all loans must be repaid and the revolving credit arrangement terminates. The fees for the unused portion of the revolving credit arrangement range from 0.5% to 0.75% (depending on Headwaters' "total leverage ratio," as defined). During the period ended March 31, 2005, Headwaters borrowed $16,000,000 under terms of the revolving credit arrangement, $6,000,000 of which was repaid prior to March 31, 2005. In April 2005, Headwaters borrowed an additional $15,000,000 under terms of the revolving credit arrangement. All amounts outstanding under the revolving credit arrangement have been repaid as of the filing date of this Form 10-Q. Finally, the credit agreement allows for the issuance of letters of credit, provided there is capacity under the revolving credit arrangement. As of March 31, 2005, two letters of credit totaling $588,000 were outstanding, with expiration dates in June 2005 and September 2005. The credit agreements contain restrictions and covenants common to such agreements, including limitations on the incurrence of additional debt, investments, merger and acquisition activity, asset sales and liens, annual capital expenditures in excess of $62,000,000 for fiscal years 2005 and 2006, $55,000,000 for fiscal years 2007 through 2010 and $60,000,000 for fiscal year 2011, and the payment of dividends, among others. In addition, Headwaters must maintain certain leverage and fixed charge coverage ratios, as those terms are defined in the agreements. Under the most restrictive covenants, contained in the first lien agreement, Headwaters must maintain i) a total leverage ratio of 5.0:1.0 or less, declining periodically to 3.5:1.0 in 2010; ii) a maximum ratio of consolidated senior funded indebtedness minus subordinated indebtedness to EBITDA of 4.0:1.0, declining periodically to 2.5:1.0 in 2010; and iii) a minimum ratio of EBITDA plus rent payments for the four preceding fiscal quarters to scheduled payments of principal and interest on all indebtedness for the next four fiscal quarters of 1.10:1.0 through September 30, 2006, and 1.25:1.0 thereafter. Headwaters is in compliance with all debt covenants as of March 31, 2005. As required by the new senior secured credit facility, Headwaters entered into certain other agreements to limit its variable interest rate exposure. The first set of agreements effectively established the maximum LIBOR rate for $300,000,000 of the senior secured debt at 5.0% through September 8, 2005. The second set of agreements effectively sets the LIBOR rate at 3.71% for $300,000,000 of this debt for the period commencing September 8, 2005 through September 8, 2007. Headwaters accounts for these agreements as cash flow hedges, and accordingly, the fair market value of the hedges is reflected in the consolidated balance sheet as either other assets or other liabilities. The hedges had a market value at March 31, 2005 of approximately $4,120,000, which, net of $1,610,000 of income taxes, represents other comprehensive income for the period ended March 31, 2005 (yielding approximately $14,500,000 and $27,500,000, respectively, of total comprehensive income for the three- and six-month periods ended March 31, 2005). The market value of the hedges can fluctuate significantly over a relatively short period of time and as of April 29, 2005, the market value of the hedges had decreased to approximately $2,400,000. Effective with the March 2005 amendment to the credit facility, Headwaters was allowed to reduce its hedges to $150,000,000 of the senior debt and in May 2005, Headwaters reduced the hedges to that level, realizing a gain of approximately $964,000. 14 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) Convertible Senior Subordinated Notes - In connection with the Eldorado acquisition, Headwaters issued $172,500,000 of 2 ?% convertible senior subordinated notes due 2016. These notes are subordinate to the senior secured debt described above. Holders of the notes may convert the notes into shares of Headwaters' common stock at a conversion rate of 33.3333 shares per $1,000 principal amount ($30 conversion price), or 5,750,000 aggregate shares of common stock, contingent upon certain events. The conversion rate adjusts for events related to Headwaters' common stock, including common stock issued as a dividend, rights or warrants to purchase common stock issued to all holders of Headwaters' common stock, and other similar rights or events that apply to all holders of common stock. The notes are convertible if any of the following five criteria are met: 1) satisfaction of a market price condition which becomes operative if the common stock trading price reaches $39 per share for a certain period of time prior to June 1, 2011 and at any time after that date; 2) a credit rating, if any, assigned to the notes is three or more rating subcategories below the initial rating, if any; 3) the notes trade at 98% of the product of the common stock trading price and the number of shares of common stock issuable upon conversion of $1,000 principal amount of the notes, except this provision is not available if the closing common stock price is between 100% and 130% of the current conversion price of the notes; 4) Headwaters calls the notes for redemption; and 5) certain corporate transactions occur, including distribution of rights or warrants to all common stockholders entitling them to purchase common stock at less than the current market price or distribution of common stock, cash or other assets, debt securities or certain rights to purchase securities where the distribution has a per share value exceeding 5% of the closing common stock price on the day immediately preceding the declaration date for such distribution. In addition, the notes are convertible if Headwaters enters into an agreement pursuant to which Headwaters' common stock would be converted into cash, securities or other property. Headwaters may call the notes for redemption at any time on or after June 1, 2007 and prior to June 4, 2011 if the closing common stock price exceeds 130% of the conversion price for 20 trading days in any consecutive 30-day trading period (in which case Headwaters must provide a "make whole" payment of the present value of all remaining interest payments on the redeemed notes through June 1, 2011). In addition, the holder of the notes has the right to require Headwaters to repurchase all or a portion of the notes on June 1, 2011 or if a fundamental change in common stock has occurred, including termination of trading. Subsequent to June 1, 2011, the notes require an additional interest payment equal to 0.40% of the average trading price of the notes if the trading price equals 120% or more of the principal amount of the notes. Headwaters has included the additional shares of common stock contingently issuable under the notes in its 2005 diluted EPS calculation, on an if-converted basis, in accordance with the new requirements of EITF 04-08 (see Note 8). Notes Payable to a Bank - In connection with the acquisition of SCP in July 2004, Headwaters assumed SCP's obligations under its notes payable to a bank. The notes require monthly interest and quarterly principal payments and bear interest at variable rates, which as of March 31, 2005, ranged from 4.5% to 5.25%. Because the notes are callable by the bank, Headwaters has included the outstanding balance in current portion of long-term debt in the consolidated balance sheet. The notes are collateralized by certain assets of SCP and contain financial covenants specific to SCP, including a minimum fixed charge coverage ratio, a leverage ratio requirement, and limitations on capital expenditures. Headwaters was in compliance with all debt covenants as of March 31, 2005. 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, 2005, Headwaters incurred total interest costs of approximately $18,929,000 and $34,921,000, respectively, including approximately $4,800,000 and $6,741,000, respectively, of non-cash interest expense and approximately $113,000 and $240,000, respectively, of interest costs that were capitalized. The weighted-average interest rate on the face amount of outstanding long-term debt, disregarding amortization of debt issue costs, was approximately 6.3% at September 30, 2004 and 4.9% at March 31, 2005. 15 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) 7. Income Taxes Headwaters' effective income tax rate for the six months ended March 31, 2005 was approximately 31.5% (27.3% for the three months ended March 31, 2005), the estimated rate for the fiscal year ending September 30, 2005. This compares to an effective tax rate of approximately 38.5% for the six months ended March 31, 2004 (38.8% for the three months ended March 31, 2004). The primary reason for the decrease in the effective tax rate is the federal income tax credits available as a result of Headwaters' investment in an entity that owns and operates a coal-based solid alternative fuel production facility (see Note 9). The alternative fuel produced at the facility through December 2007 qualifies for tax credits pursuant to Section 29 of the Internal Revenue Code. Excluding the effect of the tax credits, Headwaters' effective tax rate in 2005 would have been approximately 40%. 8. Earnings per Share
Three Months Ended March 31, Six Months Ended March 31, (in thousands, except per-share data) 2004 2005 2004 2005 ------------------------------------------------------------------------------------------------------------ Numerator: Numerator for basic earnings per share - net income $18,627 $11,993 $28,719 $25,001 Interest expense related to convertible senior subordinated notes, net of taxes -- 1,070 -- 2,048 ---------------------------------------------------------------- Numerator for diluted earnings per share - net income plus interest expense related to convertible notes, net of taxes $18,627 $13,063 $28,719 $27,049 ================================================================ Denominator: Denominator for basic earnings per share - weighted-average shares outstanding 32,782 36,172 30,371 34,806 Effect of dilutive securities: Shares issuable upon exercise of options and warrants 1,322 1,146 1,222 1,254 Shares issuable upon conversion of convertible senior subordinated notes -- 5,750 -- 5,750 ---------------------------------------------------------------- Total potential dilutive shares 1,322 6,896 1,222 7,004 ---------------------------------------------------------------- Denominator for diluted earnings per share - weighted-average shares outstanding after assumed exercises and conversions 34,104 43,068 31,593 41,810 ================================================================ Basic earnings per share $ 0.57 $ 0.33 $ 0.95 $0.72 ================================================================ Diluted earnings per share $ 0.55 $ 0.30 $ 0.91 $0.65 ================================================================
In September 2004, the EITF reached a consensus (EITF Issue 04-08) requiring the inclusion of contingently convertible securities in diluted EPS calculations. This consensus is effective for periods ending after December 15, 2004 and required Headwaters to include in its 2005 diluted EPS calculations, on an if-converted basis, the additional shares issuable under the terms of Headwaters' outstanding convertible senior subordinated notes described in Note 6. The EITF consensus must be applied to all applicable prior periods, which for Headwaters will be the quarters ended June 30, 2004 and September 30, 2004. Anti-dilutive securities not considered in the diluted earnings per share calculations, consisting of out-of-the money options, totaled approximately 0 and 180,000 shares for the three months ended March 31, 2004 and 2005, respectively; and approximately 10,000 and 150,000 shares for the six months ended March 31, 2004 and 2005, respectively. 16 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) 9. Commitments and Contingencies Commitments and contingencies as of March 31, 2005 not disclosed elsewhere are as follows: Employee Benefit Plans and Incentive Awards - During the quarter ended December 31, 2004, Headwaters' Board of Directors approved a Deferred Compensation Plan for certain designated employees, which plan became effective on January 1, 2005. In January 2005, Headwaters' Board of Directors adopted the Headwaters Incorporated Long Term Incentive Compensation Plan ("LTIP") under which employees of Headwaters selected to participate by the Compensation Committee (the "Committee") are eligible to receive long-term incentive-based compensation. The LTIP was approved at the annual meeting of stockholders on March 1, 2005. In conjunction with the gain to be recognized from the AJG litigation settlement (discussed under "Legal or Contractual Matters," following), the Committee initiated several incentive award grants in May to certain officers and employees. The Committee granted i) approximately 3,040,000 stock appreciation rights ("SARs"), ii) stock options for the purchase of approximately 30,000 shares of common stock, iii) incentive cash bonuses and iv) performance unit awards. Approximately 1,870,000 of the SARs vest at grant date and require a payment by grantees of $2.00 per SAR, payable over a five-year period. Also, these SARs are allowed to appreciate to a maximum gain equal to the fair market value of Headwaters' common stock at the date of grant. Approximately 1,170,000 of the SARs will vest over a five-year period, and approximately 1,120,000 of these SARs will be exercisable based on the achievement of performance criteria related to growth in the "economic value added" of Headwaters. All of the SARs and stock options were granted under terms of existing stock option and stock incentive plans. The SARs and stock options have an exercise price of $31.97 per share, the fair market value of Headwaters' common stock on the date of grant. All SARs will be settled in stock when exercised by grantees. The incentive cash bonuses approximated $5,500,000. The performance unit awards have a potential value totaling approximately $6,100,000, payable in cash, if certain performance criteria are met prior to December 2009. The Committee is also considering the potential acceleration of vesting of outstanding stock options not currently vested. Headwaters is currently reviewing the costs related to accelerating the vesting of options and is considering the appropriate accounting for these costs, along with the costs of the incentive awards granted, under current accounting literature as well as under the new requirements of SFAS No. 123R (see Note 1). Headwaters expects these costs will be substantial, and a majority of such costs could be required to be reflected as expense in the quarter ending June 30, 2005, especially if Headwaters early adopts SFAS No. 123R in the June 2005 quarter, which management is considering. Medical Insurance - Headwaters has adopted self-insured medical insurance plans that cover substantially all employees. There is stop-loss coverage for amounts in excess of $100,000 to $125,000 per individual per year. Headwaters has contracted with third-party administrators to assist in the payment and administration of claims. Insurance claims are recognized as expense when incurred and include an estimate of costs for claims incurred but not reported at the balance sheet date. As of March 31, 2005, approximately $3,710,000 is accrued for claims incurred on or before March 31, 2005 that have not been paid or reported. Property, Plant and Equipment - As of March 31, 2005, Headwaters was committed to spend approximately $11,700,000 on capital projects that were in various stages of completion. Solid Alternative Fuel Facility - In September 2004, Headwaters purchased a 9% variable interest in an entity that owns and operates a coal-based solid alternative fuel production facility, where Headwaters is not the primary beneficiary. In December 2004, Headwaters purchased an additional 10% variable interest in this entity. Headwaters' 19% minority interest was acquired in exchange for initial cash payments totaling $500,000 and an obligation to pay $15,000,000 in monthly installments from October 2004 through December 2007. This obligation, recorded in other accrued 17 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) liabilities and other long-term liabilities in the consolidated balance sheet (totaling $13,968,000 at March 31, 2005), bears interest at an 8% rate. Headwaters also agreed to make additional payments to the seller based on a pro-rata allocation of the tax credits generated by the facility, also through December 2007. These additional contractual payments, along with the amortization of the $15,500,000 investment, are recorded in other expense in the consolidated statement of income. The alternative fuel produced at the facility through December 2007 qualifies for tax credits pursuant to Section 29 of the Internal Revenue Code, and Headwaters is entitled to receive its pro-rata share of such tax credits generated. Due to the combined effect of the seasonality of Headwaters' operations and the requirement to use an estimated effective tax rate for the year in calculating income taxes, Headwaters is not able to recognize the benefit of all of the tax credits earned in the December and March quarters in its results of operations for those quarters. Tax credits earned but not recognized in the December and March quarters will be recognized in the June and September quarters. Even though Headwaters can not fully recognize its portion of the benefits of the tax credits generated in 2005, Headwaters' pro-rata share of costs incurred to generate those tax credits has been recognized as other expense. Headwaters has the ability, under certain conditions, to limit its liability under the fixed payment obligations currently totaling $13,968,000; therefore, Headwaters' obligation to make all of the above-described payments is effectively limited to the tax benefits Headwaters receives. Joint Venture Obligations - In September 2004, Headwaters entered into an agreement with an international chemical company, based in Germany, to jointly develop and commercialize a process for the direct synthesis of hydrogen peroxide. Under terms of the joint venture agreement, Headwaters paid $1,245,000 for its investment in the joint venture and is further obligated to pay an additional $1,000,000 in 2005 and $1,000,000 in 2006. Headwaters has also committed to fund 50% of the joint venture's research and development expenditures, currently limited to (euro)3,000,000 (approximately $3,900,000 at March 31, 2005), through September 2007. Although there is no legal obligation to do so, the joint venture partners currently have long-range plans to eventually invest in large-scale hydrogen peroxide plants using the process for direct synthesis of hydrogen peroxide. Legal or Contractual Matters - Headwaters has ongoing litigation and asserted claims incurred during the normal course of business, including the items discussed below. Headwaters intends to vigorously defend or resolve these matters by settlement, as appropriate. Management does not currently believe that the outcome of these matters will have a material adverse effect on Headwaters' operations, cash flows or financial position. In fiscal 2004, Headwaters accrued approximately $1,400,000 for legal matters based on the most likely amounts of Headwaters' liabilities or amounts that Headwaters was willing to settle for. Claims and damages sought by claimants in excess of those amounts were not deemed to be probable. During the six months ended March 31, 2005, Headwaters expensed $2,790,000 for legal matters (excluding costs for legal counsel). Our outside counsel currently believe that unfavorable outcomes of outstanding litigation are neither probable nor remote and declined to express opinions concerning the likely outcomes or liability to Headwaters. The liability recorded as of March 31, 2005, totaling $2,500,000, represents the amount Headwaters would be willing to pay to reach settlements of outstanding cases. However, these cases raise difficult and complex legal and factual issues, and the resolution of these issues is subject to many uncertainties, including the facts and circumstances of each case, the jurisdiction in which each case is brought, and the future decisions of juries, judges, and arbitrators. Therefore, although management believes that the claims asserted against Headwaters in the named cases lack merit, there is a possibility of material losses in excess of the amounts accrued if one or more of the cases were to be determined adversely against Headwaters for a substantial amount of the damages asserted. Headwaters currently believes the range of potential loss, excluding costs for outside counsel, is from $2,500,000 up to the amounts sought by claimants. It is possible that a change in the estimates of probable liability could occur, and the changes could be material. Additionally, as with any litigation, these proceedings require that Headwaters incur substantial costs, including attorneys' fees, managerial time, and other personnel resources and costs in pursuing resolution. Costs paid to outside legal counsel for litigation, which have historically comprised the majority of Headwaters' litigation-related costs, totaled approximately $1,099,000 and $2,615,000 for the six months ended March 31, 2004 and 2005, respectively. It is not possible to estimate what these costs will be in future periods. 18 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) 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 plaintiffs seek declaratory relief and compensatory damages in the approximate amount of between $15,000,000 and $25,000,000 and punitive damages. The District Court has dismissed all claims against Headwaters except conspiracy and constructive trust. The Court has scheduled trial for September 2005. 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. AGTC was seeking approximate damages in the arbitration between $520,000 and $14,300,000. Headwaters asserted that AGTC did not perform under the agreement and that the agreement was terminated and the disputes were settled in July 1996. Headwaters filed an answer in the arbitration, denying AGTC's claims and asserting counterclaims against AGTC. The arbitrator conducted hearings during July and August of 2004 and received a post-arbitration briefing and issued a decision on December 17, 2004. The arbitrator found liability against Headwaters in the amount of $520,000 plus prejudgment interest in the amount of approximately $403,000, all of which was accrued as of December 31, 2004 and paid in January 2005 in full settlement of the matter. AJG. In December 1996, Headwaters entered into a technology license and proprietary chemical reagent sale agreement with AJG Financial Services, Inc. The agreement provided for AJG to pay royalties and allowed AJG 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 asserted claims including breach of contract and sought 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. This litigation came to the trial phase in January 2005. The jury reached a verdict substantially in favor of Headwaters and the court entered a judgment for Headwaters against AJG in the amount of approximately $175,000,000 which included approximately $32,000,000 in prejudgment interest. In May 2005, Headwaters and AJG entered into a settlement agreement calling for payments to Headwaters in the amount of $50,000,000 at the time of settlement (which payment was received in May 2005), $70,000,000 (related to a contract modification for use of technology) in January 2006, and certain quarterly payments based upon tax credits associated with AJG's facilities for calendar years 2005 through 2007. Payments based upon tax credits associated with AJG's facilities for the first three quarters of calendar year 2005 will be payable in January 2006, with all other quarterly payments for 2005 through 2007 payable 45 days after the end of each quarter. Payments based upon tax credits for 2005 through 2007 are subject to downward adjustment or elimination if a phase-out of section 29 tax credits occurs due to high oil prices. Headwaters currently expects to recognize the $50,000,000 gain, net of payments due to a third party (which are currently being determined), in the quarter ending June 30, 2005. The $70,000,000, net of payments due to a third party, will be recognized as revenue beginning April 2005 through 2007, and the future quarterly payments based upon tax credits will be recognized as revenue in accordance with Headwaters' revenue recognition policy for license fee revenue (see "Revenue Recognition" in Note 2 to the consolidated financial statements in Headwaters' Form 10-K). 19 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) McEwan. In 1995, Headwaters granted stock options to a member of its board of directors, Lloyd McEwan. The director resigned from the board in 1996. Headwaters has declined McEwan's attempts to exercise most of the options on grounds that the options terminated. In June 2004, McEwan filed a complaint in the Fourth District Court for the State of Utah against Headwaters alleging breach of contract, breach of implied covenant of good faith and fair dealing, fraud, and misrepresentation. McEwan seeks declaratory relief as well as compensatory damages in the approximate amount of $2,750,000 and punitive damages. Headwaters has filed an answer denying McEwan's claims and has asserted counterclaims against McEwan. Because resolution of the litigation is uncertain, legal counsel cannot express an opinion as to the ultimate amount of liability or recovery. Headwaters Construction Materials Matters. There are litigation and pending and threatened claims made against certain subsidiaries of Headwaters Construction Materials with respect to several types of exterior finish systems manufactured and sold by its subsidiaries for application by contractors on residential and commercial buildings. Typically, litigation and these claims are controlled by such subsidiaries' insurance carriers. The plaintiffs or claimants in these matters have alleged that the structures have suffered damage from latent or progressive water penetration due to some alleged failure of the building product or wall system. The most prevalent type of claim involves alleged defects associated with components of an Exterior Insulation and Finish System ("EIFS") which was produced for a limited time (through 1997) by Best Masonry & Tool Supply and Don's Building Supply. There is a 10-year projected claim period following discontinuation of the product. Typically, the claims cite damages for alleged personal injuries and punitive damages for alleged unfair business practices in addition to asserting more conventional damage claims for alleged economic loss and damage to property. To date, claims made against such subsidiaries have been paid by their insurers, with the exception of minor deductibles, although such insurance carriers typically have issued "reservation of rights" letters to Headwaters Resources. 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 Headwaters Resources incur substantial costs, there is no guarantee of insurance coverage or continuing coverage. These and future proceedings may result in substantial costs to Headwaters Resources, including attorneys' fees, managerial time and other personnel resources and costs. Adverse resolution of these proceedings could have a materially negative effect on Headwaters Resources' business, financial condition, and results of operation, and its ability to meet its financial obligations. Although Headwaters Resources carries general and product liability insurance, Headwaters Resources cannot assure that such insurance coverage will remain available, that Headwaters Resources' insurance carrier will remain viable, or that the insured amounts will cover all future claims in excess of Headwaters Resources' uninsured retention. Future rate increases may also make such insurance uneconomical for Headwaters Resources to maintain. In addition, the insurance policies maintained by Headwaters Resources 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 Resources' liability. Other. Headwaters and its subsidiaries are also involved in other legal proceedings that have arisen in the normal course of business. Section 29 Matters - Headwaters Energy Services' license fees and revenues from sales of chemical reagents depend on the ability of licensees and customers to manufacture and sell qualified synthetic fuels that generate tax credits under Section 29 of the Internal Revenue Code. From time to time, issues arise as to the availability of tax credits, including the items discussed below. Legislation. Under current law, Section 29 tax credits for synthetic fuel produced from coal expire on December 31, 2007. In addition, there have been initiatives from time to time to consider the early repeal or modification of Section 29. Most recently, in April 2005, an amendment to Section 29 was proposed in the House Ways and Means Committee of the United States House of Representatives that would have repealed the Section 29 credit for synthetic fuel produced from coal. The committee failed to approve the proposed amendment, but the amendment could be reintroduced. If Section 29 expires at the end of 2007 or if it is repealed or adversely modified, synthetic fuel facilities would probably either close or 20 HEADWATERS INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited) substantially curtail production. At this time, given current prices of coal and costs of synthetic fuel production, Headwaters does not believe that production of synthetic fuel will be profitable absent the tax credits. In addition, if Headwaters' licensees close their facilities or materially reduce production activities (whether after 2007, or upon earlier repeal or adverse modification of Section 29, or for any other reason), it would have a material adverse effect on the revenues and net income of Headwaters. Phase-Out. Section 29 tax credits are subject to phase-out after the average annual wellhead domestic oil price ("reference price") reaches a beginning phase-out threshold price, and is eliminated entirely if the reference price reaches the full phase-out price. For calendar 2004, the reference price was $36.75 per barrel and the phase-out range began at $51.35 and would have fully phased out tax credits at $64.47 per barrel. For calendar 2005, an estimated partial year reference price (through March 2005) is $42.92 per barrel, and an estimate of the phase-out range (using 2% inflation) begins at $52.38 and completes phase-out at $65.76 per barrel. The one-day cash trading price (which historically has trended somewhat higher than the reference price) on April 29, 2005 was $49.73 per barrel. IRS Audits. Licensees are subject to audit by the IRS. The IRS may challenge whether Headwaters Energy Services' licensees satisfy the requirements of Section 29, or applicable Private Letter Rulings, including placed-in-service requirements, or may attempt to disallow Section 29 tax credits for some other reason. The IRS has initiated audits of certain licensee-taxpayers who claimed Section 29 tax credits, and the outcome of any such audit is uncertain. In calendar 2004, a licensee announced that IRS field auditors had issued a notice of proposed adjustment challenging the placed-in-service date of three of its synthetic fuel facilities. The licensee believes that the facilities meet the placed-in-service requirement, however, the timing and final results of the audit are unknown. The inability of a licensee to claim Section 29 tax credits would reduce Headwaters' future income from the licensee. 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 2005, 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 others [sic] aspects of Section 29. The investigation will also address the IRS' administration of Section 29 tax credits." The Subcommittee conducted numerous interviews and received large volumes of data between December 2003 and March 2004. Since that time, to Headwaters' knowledge, there has been little activity regarding the investigation. Headwaters cannot make any assurances as to the timing or ultimate outcome of the Subcommittee investigation, nor can Headwaters predict whether Congress or others may conduct investigations of Section 29 tax credits in the future. The Subcommittee investigation may have a material adverse effect on the willingness of buyers to engage in transactions to purchase synthetic fuel facilities or on the willingness of current owners to operate their facilities, and may materially adversely affect Headwaters' revenues and net income. License Fees - Pursuant to the contractual terms of an agreement with a certain licensee, this licensee has set aside substantial amounts for working capital and other operational contingencies as provided for in the contractual agreements. These amounts may eventually be paid out to various parties having an interest in the cash flows from the licensee's operations, including Headwaters, if they are not used for working capital and other operational contingencies. As a result, Headwaters currently expects to receive at some future date a portion of those reserves, the amount of which is not currently determinable and therefore, not recognizable. 21 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 2004 refer to Headwaters' fiscal quarter and/or six-month period ended March 31, 2004, and references to 2005 refer to Headwaters' fiscal quarter and/or six-month period ended March 31, 2005. Introduction Over the last three years, Headwaters has executed on its two-fold plan of maximizing cash flow from its existing operating business units and diversifying revenues from over-reliance on the alternative energy segment. With the addition of the CCP management and marketing business through the acquisition of ISG in 2002, and the growth of the construction materials business, culminating in the acquisitions of Eldorado and Tapco in fiscal 2004, Headwaters has achieved revenue growth and diversification into three business segments. Because Headwaters has also incurred increased indebtedness to make strategic acquisitions and related capital expenditures, one of management's key financial objectives is to continue to focus on increased cash flows for purposes of reducing indebtedness as quickly as possible. Headwaters' acquisition strategy targets businesses that are leading players in their respective industries, that enjoy healthy margins from products and services and that are not capital intensive, thus providing additional cash flow that complements the financial performance of Headwaters' existing business segments. Headwaters is also committed to the internal development of HTI's energy-related technologies and nanotechnology and has invested in and expects to continue to invest in research and development activities. As a result of its diversification into CCPs and construction materials, Headwaters is affected by seasonality, with the highest revenues produced in the June and September quarters. With CCPs, Headwaters' strategy is to continue to negotiate long-term contracts so that it may invest in transport and storage infrastructure for the marketing and sale of CCPs. Headwaters also intends to continue to expand usage of high-value CCPs, develop uses for lower-value CCPs and expand usage of CCPs both in its construction products and the industry in general. Headwaters' acquisitions of Eldorado and Tapco have created a concentration in the residential housing market; however, the cyclicality and interest-rate sensitivity of this segment is mitigated by the fact that approximately 75% of Tapco's products are used in the home improvement and remodeling market, which is typically counter cyclical to the new construction market because remodeling is generally less expensive than a new home and is often required to maintain older homes and preserve their value. As a result, during economic downturns, Tapco's products have historically experienced strong growth rates. In light of Headwaters' leading market shares in Eldorado's and Tapco's markets, Headwaters will need to increase production capacity for Eldorado and develop and market new products from Tapco in order to maintain the historical growth rates of this segment. In fiscal 2005, Headwaters is focusing on integration of its recent acquisitions, including the marketing of diverse construction materials products through its national distribution network, and expansion of the corporate infrastructure necessary to provide the information and services that the business segments need to operate at optimal levels. Headwaters is highly leveraged as a result of the fiscal 2004 acquisitions, but has reduced its outstanding debt through cash flow from operations and most recently from an underwritten public offering of common stock in March 2005. Higher leverage levels make continued diversification at historical levels more difficult. Headwaters intends to continue to focus on repaying long-term debt as quickly as possible while continuing to look for diversification opportunities within prescribed parameters. Consolidation, Acquisitions and Segments Consolidation and Acquisitions. The consolidated financial statements include the accounts of Headwaters, all of its subsidiaries and other entities in which Headwaters has a controlling financial interest. Headwaters also consolidates any variable interest entities for which it is the primary beneficiary; however, as of March 31, 2005, there were none. For investments in companies in which Headwaters has a significant influence over operating and financial decisions (generally defined as owning a voting or economic interest of 20% to 50%), Headwaters applies the equity method of accounting. In instances where Headwaters' investment is less than 20% and significant influence does not exist, investments are carried at cost. All significant intercompany transactions and accounts are eliminated in consolidation. Headwaters acquired VFL on April 9, 2004, Eldorado Stone on June 2, 2004, SCP on July 2, 2004, and Tapco on September 8, 2004. Accordingly, these entities' results of operations have been consolidated with Headwaters' 2005 results, but the 2004 results include nothing related to these companies because none of the acquisitions were consummated prior to March 31, 2004. Due to the significance of these acquisitions, in many instances the 2004 consolidated financial statements and components of those financial statements included in the following discussion and analysis are not comparable to the 2005 financial 22 statements or components thereof. Also, due to the seasonality of the operations of the CCP and construction materials segments and other factors, Headwaters' consolidated results of operations for 2005 are not indicative of the results to be expected for the full fiscal 2005 year. As described in more detail in Note 1 to the consolidated financial statements included herein and in Note 3 to the consolidated financial statements in the Form 10-K, the determination of the final purchase price, and the allocation thereof, for both Eldorado and Tapco has not been finalized. Segments. Headwaters operates in three business segments, construction materials, CCPs and alternative energy. These segments are managed and evaluated separately by management based on fundamental differences in their operations, products and services. Prior to 2004, the businesses in the construction materials segment manufactured and distributed bagged concrete, stucco, mortar and block products. The acquisition of SCP expanded Headwaters' concrete block business and the acquisition of Eldorado added manufactured architectural stone to the construction materials product line. Tapco is a leading designer, manufacturer and marketer of building products used in exterior residential home improvement and construction. Revenues for the construction materials segment consist of product sales to wholesale and retail distributors, contractors and other users of building products and construction materials. The CCP segment markets coal combustion products such as fly ash and bottom ash, known as CCPs, to the building products and ready mix concrete industries. Headwaters markets CCPs to replace manufactured or mined materials, such as portland cement, lime, agricultural gypsum, fired lightweight aggregate, granite aggregate and limestone. Headwaters has long-term contracts, primarily with coal-fueled electric power generation plants, pursuant to which it manages the post-combustion operations for the utilities. CCP revenues consist primarily of product sales with a smaller amount of service revenue. VFL has been included in Headwaters' CCP segment since its acquisition in April 2004. The alternative energy segment includes Headwaters' traditional coal-based solid alternative fuels business and HTI's business of developing catalysts and processes 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. Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004 The information set forth below compares Headwaters' operating results for the three months ended March 31, 2005 ("2005") with operating results for the three months ended March 31, 2004 ("2004"). Revenue. Total revenue for 2005 increased by $102.9 million or 86% to $222.4 million as compared to $119.5 million for 2004. The major components of revenue are discussed in the sections below. Sales of Construction Materials. Sales of construction materials during 2005 were $109.2 million with a corresponding direct cost of $73.7 million. Sales of construction materials during 2004 were $11.2 million with a corresponding direct cost of $10.0 million. The increase in sales of construction materials during 2005 was due primarily to the acquisitions of Eldorado, SCP and Tapco in fiscal 2004. Revenues for these acquired companies for 2005 totaled $97.1 million. The increase in gross margin percentage from 2004 to 2005 was due primarily to significantly higher margins from the operations of the acquired businesses. CCP Revenues. CCP revenues for 2005 were $48.5 million with a corresponding direct cost of $38.3 million. CCP revenues for 2004 were $39.6 million with a corresponding direct cost of $29.7 million. The increase in CCP revenues during 2005 was due primarily to the acquisition of VFL in April 2004 (VFL's revenues for 2005 totaled $8.4 million). The gross margin percentage decreased from 2004 to 2005 by approximately 4% due primarily to one-time service revenue in 2004 and VFL, which typically has lower gross margins than the legacy CCP business. Alternative Energy. Headwaters' alternative energy segment revenue consists primarily of chemical reagent sales and license fee revenue related to its solid alternative fuel technologies. HTI's revenues are also included in alternative energy revenue and have historically comprised a minor portion of total segment revenue. Sales of Chemical Reagents. Chemical reagent sales (included in alternative energy revenue in the accompanying consolidated statements of income) during 2005 were $39.9 million with a corresponding direct cost of $28.4 million. Chemical reagent sales during 2004 were $32.2 million with a corresponding direct cost of $21.8 million. The increase in chemical reagent sales during 2005 was due primarily to increased synthetic fuel production by Headwaters' licensees (resulting in increased sales of $4.1 million) and by customers with which Headwaters does not have a license agreement (resulting in increased sales of $3.6 million). Of the increased sales to customers, $1.9 million represents sales of chemical reagent related to the coal-based solid alternative fuel production facility in which Headwaters is a minority owner 23 (see Note 9 to the consolidated financial statements). It is not possible to predict the trend of sales of chemical reagents. The gross margin percentage for 2005 of 29% was 3% lower than for 2004, due primarily to increases in the cost of product, which in turn is related to recent increases in the costs of petroleum-based materials, and to a lesser extent, changes in customer mix. Additional cost increases could occur and to the extent Headwaters is not able to pass on such increases to customers, margins will be adversely affected. Headwaters currently expects gross margin percentages for the rest of fiscal 2005 to continue to trend below fiscal 2004 levels. License Fees. During 2005, Headwaters recognized license fee revenue (included in alternative energy revenue in the accompanying consolidated statements of income) totaling $24.6 million, a decrease of $11.7 million or 32% from $36.3 million of license fee revenue recognized during 2004. The primary reason for the decrease in license fee revenue in 2005 compared to 2004 was the recognition in 2004 of $24.9 million of net revenue representing funds previously deposited in an escrow account by one of Headwaters' licensees, all relating to alternative fuel sold prior to December 31, 2003. Headwaters also recognized approximately $3.0 million of revenue in 2004 relating to the March 2004 quarter. In 2005, Headwaters recognized a total of $11.3 million of revenue from this licensee, for a net decrease of $16.6 million from 2004 to 2005. For more information about the 2004 revenue related to this licensee, see "License Fee Revenue Recognition" in the "Critical Accounting Policies and Estimates" section of Item 7 of Headwaters' Form 10-K. Also, pursuant to the contractual terms of the agreement with this same licensee, this licensee has set aside substantial amounts for working capital and other operational contingencies as provided for in the contractual agreements. These amounts may eventually be paid out to various parties having an interest in the cash flows from the licensee's operations, including Headwaters, if they are not used for working capital and other operational contingencies. As a result, Headwaters currently expects to receive at some future date a portion of those reserves, the amount of which is not currently determinable and therefore, not recognizable. Amortization. These costs increased by $4.5 million to $6.2 million in 2005 from $1.7 million in 2004. The increase was primarily attributable to the fiscal 2004 acquisitions and the resulting increases in amortizable intangible assets. For this same reason, Headwaters expects fiscal 2005 amortization expense to be substantially higher than it was for fiscal 2004. Research and Development. Research and development expenses increased by $1.4 million to $2.9 million in 2005 from $1.5 million in 2004. The increase was primarily attributable to increased HTI research and development activities. Headwaters remains committed to HTI's research and development efforts and future expenses are likely to outpace fiscal 2004 levels as a result of continuing efforts to commercialize existing technologies. Selling, General and Administrative Expenses. These expenses increased $17.5 million to $34.2 million for 2005 from $16.7 million for 2004. The increase in 2005 was due primarily to the fiscal 2004 acquisitions ($16.5 million) and an increase in litigation-related costs ($2.8 million), partially offset by a net decrease in other costs ($1.8 million). Selling, general and administrative expenses in 2004 included higher amounts for incentive pay expenses as a result of obligations arising from Headwaters' bonus plans, due in turn to the revenue recognized from escrowed funds, as previously discussed. As a result of the fiscal 2004 acquisitions, fiscal 2005 selling, general and administrative expenses are expected to be substantially higher than for fiscal 2004, but should be more comparable to fiscal 2004 levels when viewed as a percentage of revenue. Other Income and Expense. During 2005, Headwaters reported net other expense of $22.0 million compared to net other expense of $7.6 million during 2004. The change of $14.4 million was attributable to an increase in net interest expense of $13.1 million in 2005 and a net increase in other expenses of approximately $1.3 million in 2005. Net interest expense increased from $5.7 million in 2004 to $18.8 million in 2005 due primarily to significantly higher average levels of long-term debt in 2005 compared to 2004, primarily related to the fiscal 2004 acquisitions. In both periods, debt repayments (totaling approximately $74.8 million in 2004 and $202.6 million in 2005) consisted primarily of early repayments. Non-cash interest expense, representing amortization of debt discount (in 2004 only) and debt issue costs (in both 2004 and 2005), was $5.0 million in 2004 and $4.8 million in 2005. Due to the substantially higher amounts of outstanding debt at March 31, 2005 than existed for most of fiscal 2004, interest expense in fiscal 2005 is expected to be substantially higher than for comparable periods in fiscal 2004. The net change in other expenses of $1.3 million consisted primarily of an increase in other expenses (totaling approximately $3.3 million) related to Headwaters' costs related to its investment in the coal-based solid alternative fuel production facility described in Note 9 to the consolidated financial statements, including amortization of the related $15.5 million investment, partially offset by approximately $1.7 million of asset write-offs in 2004 that did not recur in 2005. The alternative fuel produced at the facility through December 2007 qualifies for tax credits pursuant to Section 29 of the Internal Revenue Code, and Headwaters is entitled to receive its pro-rata share of such tax credits generated. Due to the combined effect of the seasonality of Headwaters' operations and the requirement to use an estimated effective tax rate for the year in calculating income taxes, Headwaters is not able to recognize the 24 benefit of all of the tax credits earned in the December and March quarters in its results of operations for those quarters. Tax credits earned but not recognized in the December and March quarters will be recognized in the June and September quarters. Even though Headwaters can not fully recognize its portion of the benefits of the tax credits generated in 2005, Headwaters' pro-rata share of costs incurred to generate those tax credits has been recognized as other expense. Income Tax Provision. Headwaters' effective income tax rate for 2005 was approximately 27%. This compares to an effective tax rate of approximately 39% for 2004 and 35% for the quarter ended December 31, 2004. Headwaters' effective income tax rate for the entire fiscal 2005 year is currently estimated to be 31.5%. The primary reason for the decreases in the effective tax rate is federal income tax credits available as a result of Headwaters' investment in an entity that owns and operates a coal-based solid alternative fuel production facility (see Note 9 to the consolidated financial statements). The alternative fuel produced at the facility through December 2007 qualifies for tax credits pursuant to Section 29 of the Internal Revenue Code. Headwaters adjusts its income tax provision each quarter to yield the estimated effective tax rate for the fiscal year on a cumulative basis, causing each quarter's effective tax rate to vary somewhat. It is possible that Headwaters' estimate of its effective tax rate for fiscal 2005 will change in future periods, necessitating an adjustment in future periods to reflect the impact of the rate change on results for prior fiscal 2005 periods. Excluding the effect of the tax credits, Headwaters' effective tax rate in 2005 would have been approximately 40%. Six Months Ended March 31, 2005 Compared to Six Months Ended March 31, 2004 The information set forth below compares Headwaters' operating results for the six months ended March 31, 2005 ("2005") with operating results for the six months ended March 31, 2004 ("2004"). Revenue. Total revenue for 2005 increased by $219.8 million or 99% to $440.8 million as compared to $221.0 million for 2004. The major components of revenue are discussed in the sections below. Sales of Construction Materials. Sales of construction materials during 2005 were $222.9 million with a corresponding direct cost of $150.2 million. Sales of construction materials during 2004 were $23.2 million with a corresponding direct cost of $19.3 million. The increase in sales of construction materials during 2005 was due primarily to the acquisitions of Eldorado, SCP and Tapco in fiscal 2004. Revenues for these acquired companies for 2005 totaled $199.2 million. The increase in gross margin percentage from 2004 to 2005 was due primarily to significantly higher margins from the operations of the acquired businesses. CCP Revenues. CCP revenues for 2005 were $101.5 million with a corresponding direct cost of $79.3 million. CCP revenues for 2004 were $84.7 million with a corresponding direct cost of $63.1 million. The increase in CCP revenues during 2005 was due primarily to the acquisition of VFL in April 2004 (VFL's revenues for 2005 totaled $17.0 million). The gross margin percentage decreased from 2004 to 2005 by approximately 4% due primarily to one-time service revenue in 2004 and VFL, which typically has lower gross margins than the legacy CCP business. Sales of Chemical Reagents. Chemical reagent sales (included in alternative energy revenue in the accompanying consolidated statements of income) during 2005 were $76.7 million with a corresponding direct cost of $53.0 million. Chemical reagent sales during 2004 were $63.1 million with a corresponding direct cost of $43.0 million. The increase in chemical reagent sales during 2005 was due primarily to increased synthetic fuel production by Headwaters' licensees (resulting in increased sales of $6.3 million) and by customers with which Headwaters does not have a license agreement (resulting in increased sales of $7.3 million). Of the increased sales to customers, $3.5 million represents sales of chemical reagent related to the coal-based solid alternative fuel production facility in which Headwaters is a minority owner. The gross margin percentage for 2005 of 31% was 1% lower than for 2004, due primarily to increases in the cost of product, which in turn is related to recent increases in the costs of petroleum-based materials, and to a lesser extent, changes in customer mix. License Fees. During 2005, Headwaters recognized license fee revenue (included in alternative energy revenue in the accompanying consolidated statements of income) totaling $39.2 million, a decrease of $6.6 million or 14% from $45.8 million of license fee revenue recognized during 2004. The primary reason for the decrease in license fee revenue in 2005 compared to 2004 was the recognition in 2004 of $24.9 million of net revenue representing funds previously deposited in an escrow account by one of Headwaters' licensees, all relating to alternative fuel sold prior to December 31, 2003. Headwaters also recognized approximately $3.0 million of revenue in 2004 relating to the March 2004 quarter. In 2005, Headwaters recognized a total of $15.3 million of revenue from this licensee, for a net decrease of $12.6 million from 2004 to 2005. Amortization. These costs increased by $9.0 million to $12.4 million in 2005 from $3.4 million in 2004. The increase was primarily attributable to the fiscal 2004 acquisitions and the resulting increases in amortizable intangible assets. Research and Development. Research and development expenses increased by $1.6 million to $5.2 million in 2005 from $3.6 million in 2004. The increase was primarily attributable to increased HTI research and development activities. 25 Selling, General and Administrative Expenses. These expenses increased $36.1 million to $64.3 million for 2005 from $28.2 million for 2004. The increase in 2005 was due primarily to the fiscal 2004 acquisitions ($32.5 million) and an increase in litigation-related costs ($4.0 million), partially offset by a net decreases in other costs ($0.4 million). Selling, general and administrative expenses in 2004 included higher amounts for incentive pay expenses as a result of obligations arising from Headwaters' bonus plans, due in turn to the revenue recognized from escrowed funds, as previously discussed. Other Income and Expense. During 2005, Headwaters reported net other expense of $39.7 million compared to net other expense of $13.4 million during 2004. The change of $26.3 million was attributable to an increase in net interest expense of $23.6 million in 2005 and a net increase in other expenses of approximately $2.7 million in 2005. Net interest expense increased from $11.0 million in 2004 to $34.6 million in 2005 due primarily to significantly higher average levels of long-term debt in 2005 compared to 2004, primarily related to the fiscal 2004 acquisitions. In both periods, debt repayments (totaling approximately $134.9 million in 2004 and $253.9 million in 2005) consisted primarily of early repayments. Non-cash interest expense, representing amortization of debt discount (in 2004 only) and debt issue costs (in both 2004 and 2005), was $7.6 million in 2004 and $6.7 million in 2005. The net change in other expenses of $2.7 million consisted primarily of an increase in other expenses (totaling approximately $5.7 million) related to Headwaters' costs related to its investment in the coal-based solid alternative fuel production facility described in Note 9 to the consolidated financial statements, including amortization of the related $15.5 million investment, partially offset by approximately $2.2 million of asset write-offs in 2004 that did not recur in 2005 and a reduction in losses on disposition of property, plant and equipment of approximately $0.6 million. The alternative fuel produced at the facility through December 2007 qualifies for tax credits pursuant to Section 29 of the Internal Revenue Code, and Headwaters is entitled to receive its pro-rata share of such tax credits generated. Due to the combined effect of the seasonality of Headwaters' operations and the requirement to use an estimated effective tax rate for the year in calculating income taxes, Headwaters is not able to recognize the benefit of all of the tax credits earned in the December and March quarters in its results of operations for those quarters. Tax credits earned but not recognized in the December and March quarters will be recognized in the June and September quarters. Even though Headwaters can not fully recognize its portion of the benefits of the tax credits generated in 2005, Headwaters' pro-rata share of costs incurred to generate those tax credits has been recognized as other expense. Income Tax Provision. Headwaters' effective income tax rate for 2005 was approximately 31.5%. This compares to an effective tax rate of approximately 38.5% for 2004. The primary reason for the decrease in the effective tax rate is federal income tax credits available as a result of Headwaters' investment in an entity that owns and operates a coal-based solid alternative fuel production facility (see Note 9 to the consolidated financial statements). The alternative fuel produced at the facility through December 2007 qualifies for tax credits pursuant to Section 29 of the Internal Revenue Code It is possible that Headwaters' estimate of its effective income tax rate for fiscal 2005 will change in future periods, necessitating an adjustment in future periods to reflect the impact of the change on results for prior fiscal 2005 periods. Excluding the effect of the tax credits, Headwaters' effective tax rate in 2005 would have been approximately 40%. Impact of Inflation Headwaters' operations have been impacted in 2005 by rising costs for chemical reagents in the alternative energy segment, by increased cement and polypropylene costs in the construction materials segment and by increased fuel costs that have affected transportation costs in most business units. The increased costs of chemical reagents, polypropylene and fuel are directly related to the increase in prices of oil and other petroleum-based materials. Headwaters has been successful in passing on some, but not all, of these increased material and transportation costs to customers. It is not possible to predict the future trend of material and transportation costs, nor the ability of Headwaters to pass on any potential future price increases to customers. Liquidity and Capital Resources Summary of Cash Flow Activities. Net cash provided by operating activities during 2005 was $47.5 million compared to $17.1 million of net cash used in operating activities during 2004. The change was primarily attributable to changes in short-term trading investments ($37.4 million), trade receivables ($41.6 million), and depreciation and amortization ($21.3 million), partially offset by changes in inventories ($10.6 million) and accounts payable and accrued liabilities ($15.9 million). In 2004, Headwaters issued 5.0 million shares of common stock in an underwritten public offering 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 temporarily invested in short-term trading investments and ultimately used for acquisitions. In 2005, Headwaters issued 6.9 million shares of common stock in another underwritten public offering for net cash proceeds of $199.3 million. Headwaters also used these proceeds to repay debt. During 2005, $238.9 million of debt was repaid, net of proceeds from issuance of debt, compared to a net $85.7 million of debt repayments in 2004. During both periods, investing activities consisted 26 primarily of the purchase of property, plant and equipment. More details about Headwaters' investing and financing activities are provided in the following paragraphs. Investing Activities. As described in more detail in Note 3 to the consolidated financial statements in the Form 10-K, Headwaters acquired four companies in fiscal 2004. Primarily as a result of these acquisitions, expenditures for property, plant and equipment increased substantially from 2004 ($4.9 million) to 2005 ($23.5 million). These capital expenditures primarily relate to the construction materials and CCPs segments and for fiscal 2005 will continue to be much higher than for comparative periods in fiscal 2004. Capital expenditures for fiscal 2005 are currently expected to approximate the limitation on such expenditures of $62.0 million included in the senior debt covenants. As of March 31, 2005, Headwaters was committed to spend approximately $11.7 million on capital projects that were in various stages of completion. Headwaters intends to continue to expand its business through growth of existing operations, commercialization of technologies currently being developed, and strategic acquisitions of entities that operate in adjacent industries. Acquisitions are an important part of Headwaters' business strategy and to that end, Headwaters routinely reviews potential complementary acquisitions, including those in the areas of CCP marketing, construction materials, and coal and catalyst technologies. It is possible that some portion of future cash and cash equivalents and/or proceeds from the issuance of stock or debt will be used to fund acquisitions of complementary businesses in the chemical, energy, building products and related industries. The senior secured credit agreement limits acquisitions to $50.0 million each fiscal year, of which cash consideration may not exceed $30.0 million, unless Headwaters' "total leverage ratio," as defined, is less than or equal to 3.50:1.0, after giving effect to an acquisition, in which case the foregoing $30.0 million cash limitation does not apply. As described in more detail in Note 9 to the consolidated financial statements, in September 2004, Headwaters purchased a 9% variable interest in an entity that owns and operates a coal-based solid alternative fuel production facility, where Headwaters is not the primary beneficiary. In December 2004, Headwaters purchased an additional 10% variable interest in this entity. Headwaters' 19% minority interest was acquired in exchange for initial cash payments totaling $0.5 million and an obligation to pay $15.0 million in monthly installments from October 2004 through December 2007. This obligation, recorded in other accrued liabilities and other long-term liabilities in the consolidated balance sheet (totaling $14.0 million at March 31, 2005), bears interest at an 8% rate. Headwaters also agreed to make additional payments to the seller based on a pro-rata allocation of the tax credits generated by the facility, also through December 2007. These additional contractual payments, along with the amortization of the $15.5 million investment, are recorded in other expense in the consolidated statement of income. The alternative fuel produced at the facility through December 2007 qualifies for tax credits pursuant to Section 29 of the Internal Revenue Code, and Headwaters is entitled to receive its pro-rata share of such tax credits generated. The IRS has issued a Private Letter Ruling to the owners of the facility. Headwaters has the ability, under certain conditions, to limit its liability under the fixed payment obligations currently totaling $14.0 million; therefore, Headwaters' obligation to make all of the above-described payments is effectively limited to the tax benefits Headwaters receives. In September 2004, Headwaters entered into an agreement with an international chemical company, based in Germany, to jointly develop and commercialize a process for the direct synthesis of hydrogen peroxide. Under terms of the joint venture agreement, Headwaters paid $1.2 million for its investment in the joint venture and is further obligated to pay an additional $1.0 million in 2005 and $1.0 million in 2006. Headwaters has also committed to fund 50% of the joint venture's research and development expenditures, currently limited to (euro)3.0 million (approximately $3.9 million at March 31, 2005), through September 2007. Although there is no legal obligation to do so, the joint venture partners currently have long-range plans to eventually invest in large-scale hydrogen peroxide plants using the process for direct synthesis of hydrogen peroxide. Financing Activities. Due to the issuance of senior debt in September 2004 and the covenants associated with that debt, as described below, Headwaters currently has limited ability to obtain significant additional amounts of long-term debt. However, Headwaters has experienced strong positive cash flow from operations and has issued common stock which together has enabled Headwaters to repay a substantial amount of its long-term debt prior to the scheduled maturities. Headwaters expects its strong positive cash flow to continue in the future and also has the ability to access the equity markets. Headwaters has an effective universal shelf registration statement on file with the SEC that can be used for the sale of approximately $18.0 million of common stock, preferred stock, convertible debt and other securities. A prospectus supplement describing the terms of any securities to be issued is required to be filed before any future offering would commence under the registration statement. Senior Secured Credit Agreements - In September 2004 and as amended in October 2004, Headwaters entered into two credit agreements with a syndication of lenders under which a total of $790.0 million was borrowed under term loan arrangements and which provide for up to $60.0 million to be borrowed under a revolving credit arrangement. The proceeds were used to acquire Tapco and repay in full the remaining balance due under Headwaters' former senior secured credit 27 agreement executed in March 2004. The $790.0 million of term loan borrowings consisted of a first lien term loan in the amount of $640.0 million and a second lien term loan in the amount of $150.0 million. Both term loans are secured by all assets of Headwaters and are senior in priority to all other debt, with the exception of the specific SCP assets that collateralize the notes payable to banks discussed below. In March 2005, another amendment to the credit agreements was entered into which modified certain terms of the credit facility, all as described in more detail in the following paragraphs. The first lien term loan bears interest, at Headwaters' option, at either i) the London Interbank Offered Rate ("LIBOR") plus 2.0%, 2.25%, or 2.5%, depending on the credit ratings that have been most recently announced for the loans by Standard & Poors Ratings Services ("S&P") and Moody's Investors Service, Inc. ("Moody's"); or ii) the "base rate" plus 1.0%, 1.25%, or 1.5%, again depending on the credit ratings announced by S&P and Moody's. Base rate is defined as the higher of the rate announced by Morgan Stanley Senior Funding and the overnight rate charged by the Federal Reserve Bank of New York plus 0.5%. The initial interest rate on the first lien debt was set at 6.5%, but was subsequently reduced to approximately 5.4% during the quarter ended December 31, 2004 pursuant to the terms of the agreement. The interest rate on the first lien debt was approximately 4.9% at March 31, 2005. The second lien term loan bears interest, also at Headwaters' option, at either LIBOR plus 5.5%, or the "base rate" plus 4.5%. The initial interest rate on the second lien debt was set at 9.75%, but was subsequently reduced to approximately 7.7% during the quarter ended December 31, 2004 pursuant to the terms of the agreement. The interest rate on the second lien debt was approximately 8.2% at March 31, 2005. Headwaters can lock in new rates for both the first lien and second lien loans for one, two, three or six months. The most recent rate change occurred in March 2005. The first lien term loan ($442.7 million outstanding at March 31, 2005) is repayable in quarterly installments of principal and interest, with minimum required quarterly principal repayments of approximately $3.4 million commencing in November 2005 through August 2010, with three repayments of approximately $125.2 million each through April 2011, the termination date of the first lien loan agreement. The second lien term loan ($100.0 million outstanding at March 31, 2005) is due September 2012, with no required principal repayments prior to that time. Interest is generally due on a quarterly basis. There are mandatory prepayments of the first lien term loan in the event of certain asset sales and debt and equity issuances and from "excess cash flow," as defined in the agreement. Optional prepayments of the first lien term loan are generally permitted without penalty or premium, except where the proceeds for repayment are obtained from a "financing," as defined, consummated for the purpose of lowering the interest rate on the first lien debt, in which case there is a 1% prepayment penalty. Optional prepayments of the second lien term loan under the original terms of the credit agreement were permissible only to the extent Headwaters issued new equity securities and then were further limited to a maximum of $50.0 million, so long as the first lien term loan remained outstanding. As amended, optional prepayments of the second lien term loan bear a penalty of 3% of prepayments made in the first year, 2% of prepayments made in the second year, and 1% of prepayments made in the third year, and further, subsequent to September 8, 2005, Headwaters can prepay the second lien debt with available cash flow, unrestricted as to source. Once repaid in full or in part, no further reborrowings under either of the term loan arrangements can be made. During the quarter ended December 31, 2004, Headwaters repaid a total of $50.0 million of the first lien term loan, which otherwise would have been due during the period from November 2004 through November 2005. In March 2005, Headwaters repaid $147.3 million of the first lien term loan and $50.0 million of the second lien term loan. As a result of the early repayments of debt, there was an acceleration of amortization of the related debt issue costs totaling approximately $4.0 and $4.9 million for the three- and six-month periods ended March 31, 2005, respectively, all of which was charged to interest expense. A 3% prepayment penalty of $1.5 million was paid related to the early repayment of $50.0 million of second lien term debt, which was also charged to interest expense. As required by the new senior secured credit facility, Headwaters entered into certain other agreements to limit its variable interest rate exposure. The first set of agreements effectively established the maximum LIBOR rate for $300.0 million of the senior secured debt at 5.0% through September 8, 2005. The second set of agreements effectively sets the LIBOR rate at 3.71% for $300.0 million of this debt for the period commencing September 8, 2005 through September 8, 2007. Headwaters accounts for these agreements as cash flow hedges, and accordingly, the fair market value of the hedges is reflected in the consolidated balance sheet as either other assets or other liabilities. The hedges had a market value at March 31, 2005 of approximately $4.1 million, which, net of $1.6 million of income taxes, represents other comprehensive income for the period ended March 31, 2005 (yielding approximately $14.5 million and $27.5 million, respectively, of total comprehensive income for the three- and six-month periods ended March 31, 2005). The market value of the hedges can fluctuate significantly over a relatively short period of time and as of April 29, 2005, the market value of the hedges had decreased to approximately $2.4 million. Effective with the March 2005 amendment to the credit facility, Headwaters was allowed to reduce its hedges to $150.0 million of the senior debt and in May 2005, Headwaters reduced the hedges to that level, realizing a gain of approximately $1.0 million. 28 Convertible Senior Subordinated Notes - In connection with the Eldorado acquisition, Headwaters issued $172.5 million of 2 ?% convertible senior subordinated notes due 2016. These notes are subordinate to the senior secured debt described above. Holders of the notes may convert the notes into shares of Headwaters' common stock at a conversion rate of 33.3333 shares per $1,000 principal amount ($30 conversion price), or 5.75 million aggregate shares of common stock, contingent upon certain events. The conversion rate adjusts for events related to Headwaters' common stock, including common stock issued as a dividend, rights or warrants to purchase common stock issued to all holders of Headwaters' common stock, and other similar rights or events that apply to all holders of common stock. The notes are convertible if any of the following five criteria are met: 1) satisfaction of a market price condition which becomes operative if the common stock trading price reaches $39 per share for a certain period of time prior to June 1, 2011 and at any time after that date; 2) a credit rating, if any, assigned to the notes is three or more rating subcategories below the initial rating, if any; 3) the notes trade at 98% of the product of the common stock trading price and the number of shares of common stock issuable upon conversion of $1,000 principal amount of the notes, except this provision is not available if the closing common stock price is between 100% and 130% of the current conversion price of the notes; 4) Headwaters calls the notes for redemption; and 5) certain corporate transactions occur, including distribution of rights or warrants to all common stockholders entitling them to purchase common stock at less than the current market price or distribution of common stock, cash or other assets, debt securities or certain rights to purchase securities where the distribution has a per share value exceeding 5% of the closing common stock price on the day immediately preceding the declaration date for such distribution. In addition, the notes are convertible if Headwaters enters into an agreement pursuant to which Headwaters' common stock would be converted into cash, securities or other property. Headwaters may call the notes for redemption at any time on or after June 1, 2007 and prior to June 4, 2011 if the closing common stock price exceeds 130% of the conversion price for 20 trading days in any consecutive 30-day trading period (in which case Headwaters must provide a "make whole" payment of the present value of all remaining interest payments on the redeemed notes through June 1, 2011). In addition, the holder of the notes has the right to require Headwaters to repurchase all or a portion of the notes on June 1, 2011 or if a fundamental change in common stock has occurred, including termination of trading. Subsequent to June 1, 2011, the notes require an additional interest payment equal to 0.40% of the average trading price of the notes if the trading price equals 120% or more of the principal amount of the notes. Headwaters has included the additional shares of common stock contingently issuable under the notes in its 2005 diluted EPS calculation, on an if-converted basis, in accordance with the new requirements of EITF 04-08 (see Note 8 to the consolidated financial statements). Notes Payable to a Bank - In connection with the acquisition of SCP in July 2004, Headwaters assumed SCP's obligations under its notes payable to a bank. The notes require monthly interest and quarterly principal payments and bear interest at variable rates, which as of March 31, 2005, ranged from 4.5% to 5.25%. Because the notes are callable by the bank, Headwaters has included the outstanding balance in current portion of long-term debt in the consolidated balance sheet. The notes are collateralized by certain assets of SCP and contain financial covenants specific to SCP, including a minimum fixed charge coverage ratio, a leverage ratio requirement, and limitations on capital expenditures. Headwaters was in compliance with all debt covenants as of March 31, 2005. Options and Employee Stock Purchases - In 2005, cash proceeds from the exercise of options and employee stock purchases totaled $4.9 million, compared to $5.5 million in 2004. 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 $2.9 million in 2004 and $5.3 million in 2005. These income tax deductions do not affect income tax expense or 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 2005, Headwaters' working capital increased by $28.9 million, to $73.3 million as of March 31, 2005. Headwaters expects operations to produce positive cash flows in future periods. Additionally, Headwaters received $50.0 million in May 2005 from the settlement of contract litigation and will receive $70.0 million in January 2006 (see Note 9 to the consolidated financial statements). As a result of all of these factors, Headwaters expects working capital will be sufficient for operating needs for the remainder of fiscal 2005 and beyond. Long-term Debt. Due to the September 2004 issuance of senior debt and the covenants associated with that debt, as described below, Headwaters currently has limited ability to obtain significant additional amounts of long-term debt. However, as provided for in the senior debt agreements, Headwaters has available $60.0 million under a revolving credit arrangement. Borrowings under the revolving credit arrangement are generally subject to the 29 terms of the first lien loan agreement and bear interest at either LIBOR plus 1.75% to 2.5% (depending on Headwaters' "total leverage ratio," as defined), or the base rate plus 0.75% to 1.5%. Borrowings and reborrowings of any available portion of the $60.0 million revolver can be made at any time through September 2009, at which time all loans must be repaid and the revolving credit arrangement terminates. The fees for the unused portion of the revolving credit arrangement range from 0.5% to 0.75% (depending on Headwaters' "total leverage ratio," as defined). During the period ended March 31, 2005, Headwaters borrowed $16.0 million under terms of the revolving credit arrangement, $6.0 million of which was repaid prior to March 31, 2005. In April 2005, Headwaters borrowed an additional $15.0 million under terms of the revolving credit arrangement. All amounts outstanding under the revolving credit arrangement have been repaid as of the filing date of this Form 10-Q. Finally, the credit agreement allows for the issuance of letters of credit, provided there is capacity under the revolving credit arrangement. As of March 31, 2005, two letters of credit totaling $0.6 million were outstanding, with expiration dates in June 2005 and September 2005. 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 agreements contain restrictions and covenants common to such agreements, including limitations on the incurrence of additional debt, investments, merger and acquisition activity, asset sales and liens, annual capital expenditures in excess of $62.0 million for fiscal years 2005 and 2006, $55.0 million for fiscal years 2007 through 2010 and $60.0 million for fiscal year 2011, and the payment of dividends, among others. In addition, Headwaters must maintain certain leverage and fixed charge coverage ratios, as those terms are defined in the agreements. Under the most restrictive covenants, contained in the first lien agreement, Headwaters must maintain i) a total leverage ratio of 5.0:1.0 or less, declining periodically to 3.5:1.0 in 2010; ii) a maximum ratio of consolidated senior funded indebtedness minus subordinated indebtedness to EBITDA of 4.0:1.0, declining periodically to 2.5:1.0 in 2010; and iii) a minimum ratio of EBITDA plus rent payments for the four preceding fiscal quarters to scheduled payments of principal and interest on all indebtedness for the next four fiscal quarters of 1.10:1.0 through September 30, 2006, and 1.25:1.0 thereafter. Headwaters is in compliance with all debt covenants as of March 31, 2005. As described above, Headwaters has approximately $562.0 million of variable-rate long-term debt outstanding as of March 31, 2005, consisting of $552.7 million of senior debt and $9.3 million of notes payable to a bank. Disregarding the effect of the hedges described above, a change in the interest rate of 1% would change Headwaters' interest expense by approximately $5.5 million during the 12 months ending March 31, 2006, considering all outstanding balances of variable-rate debt and required principal repayments. 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 $5.3 million in 2005. Headwaters' cash requirements for income taxes in fiscal 2005 are expected to generally 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. Headwaters' effective income tax rate for 2005 was approximately 31.5%, the estimated rate for the fiscal year ending September 30, 2005. This compares to an effective tax rate of approximately 38.5% for 2004. The primary reason for the decrease in the effective tax rate is the federal income tax credits available as a result of Headwaters' investment in an entity that owns and operates a coal-based solid alternative fuel production facility (see Note 9 to the consolidated financial statements). The alternative fuel produced at the facility through December 2007 qualifies for tax credits pursuant to Section 29 of the Internal Revenue Code. Excluding the effect of the tax credits, Headwaters' effective tax rate in 2005 would have been approximately 40%. Summary of Future Cash Requirements. Significant future cash needs, in addition to operational working capital requirements, are currently expected to consist primarily of debt service payments on outstanding long-term debt, income taxes and capital expenditures. Legal or Contractual Matters Headwaters has ongoing litigation and asserted claims incurred during the normal course of business, including the items discussed below. Headwaters intends to vigorously defend or resolve these matters by settlement, as appropriate. Management does not currently believe that the outcome of these matters will have a material adverse effect on Headwaters' operations, cash flows or financial position. In fiscal 2004, Headwaters accrued approximately $1.4 million for legal matters based on the most likely amounts of Headwaters' liabilities or amounts that Headwaters was willing to settle for. Claims and damages sought by claimants in excess of those amounts were not deemed to be probable. During the six months ended March 31, 2005, Headwaters expensed $2.8 million for legal matters (excluding costs for legal counsel). Our outside counsel currently believe that unfavorable outcomes of outstanding litigation are neither probable nor remote and declined to express opinions concerning the likely outcomes or 30 liability to Headwaters. The liability recorded as of March 31, 2005, totaling $2.5 million, represents the amount Headwaters would be willing to pay to reach settlements of outstanding cases. However, these cases raise difficult and complex legal and factual issues, and the resolution of these issues is subject to many uncertainties, including the facts and circumstances of each case, the jurisdiction in which each case is brought, and the future decisions of juries, judges, and arbitrators. Therefore, although management believes that the claims asserted against Headwaters in the named cases lack merit, there is a possibility of material losses in excess of the amounts accrued if one or more of the cases were to be determined adversely against Headwaters for a substantial amount of the damages asserted. Headwaters currently believes the range of potential loss, excluding costs for outside counsel, is from $2.5 million up to the amounts sought by claimants. It is possible that a change in the estimates of probable liability could occur, and the changes could be material. Additionally, as with any litigation, these proceedings require that Headwaters incur substantial costs, including attorneys' fees, managerial time, and other personnel resources and costs in pursuing resolution. Costs paid to outside legal counsel for litigation, which have historically comprised the majority of Headwaters' litigation-related costs, totaled approximately $1.1 million and $2.6 million for the six months ended March 31, 2004 and 2005, respectively. It is not possible to estimate what these costs will be in future periods. In December 1996, Headwaters entered into a technology license and proprietary chemical reagent sale agreement with AJG Financial Services, Inc. The agreement provided for AJG to pay royalties and allowed AJG 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 asserted claims including breach of contract and sought 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. This litigation came to the trial phase in January 2005. The jury reached a verdict substantially in favor of Headwaters and the court entered a judgment for Headwaters against AJG in the amount of approximately $175.0 million which included approximately $32.0 million in prejudgment interest. In May 2005, Headwaters and AJG entered into a settlement agreement calling for payments to Headwaters in the amount of $50.0 million at the time of settlement (which payment was received in May 2005), $70.0 million (related to a contract modification for use of technology) in January 2006, and certain quarterly payments based upon tax credits associated with AJG's facilities for calendar years 2005 through 2007. Payments based upon tax credits associated with AJG's facilities for the first three quarters of calendar year 2005 will be payable in January 2006, with all other quarterly payments for 2005 through 2007 payable 45 days after the end of each quarter. Payments based upon tax credits for 2005 through 2007 are subject to downward adjustment or elimination if a phase-out of section 29 tax credits occurs due to high oil prices. Headwaters currently expects to recognize the $50.0 million gain, net of payments due to a third party (which are currently being determined), in the quarter ending June 30, 2005. The $70.0 million, net of payments due to a third party, will be recognized as revenue beginning April 2005 through 2007, and the future quarterly payments based upon tax credits will be recognized as revenue in accordance with Headwaters' revenue recognition policy for license fee revenue (see "Revenue Recognition" in Note 2 to the consolidated financial statements in Headwaters' Form 10-K). In conjunction with the gain to be recognized from the AJG litigation settlement, the Compensation Committee of the Board of Directors ("Committee") initiated several incentive award grants in May to certain officers and employees. The Committee made awards that are intended to accelerate approximately five years of long-term incentive compensation into the June 2005 quarter. A significant portion of the awards are based on grantees achieving certain performance goals and/or growth in the "economic value added" of Headwaters, all of which the Committee believes would lead to the creation of significant long-term stockholder value. If Headwaters early adopts SFAS No. 123R, it will record significant long-term incentive compensation expense in the June 2005 quarter. The Committee granted i) approximately 3.0 million stock appreciation rights ("SARs"), ii) stock options for the purchase of approximately 0.1 million shares of common stock, iii) incentive cash bonuses and iv) performance unit awards. Approximately 1.9 million of the SARs vest at grant date and require a payment by grantees of $2.00 per SAR, payable over a five-year period. Also, these SARs are allowed to appreciate to a maximum gain equal to the fair market value of Headwaters' common stock at the date of grant. Approximately 1.2 million of the SARs will vest over a five-year period, and approximately 1.1 million of these SARs will be exercisable based on the achievement of performance criteria related to growth in the "economic value added" of Headwaters. All of the SARs and stock options were granted under terms of existing stock option and stock incentive plans. The SARs and stock options have an exercise price of $31.97 per share, the fair market value of Headwaters' common stock on the date of grant. All SARs will be settled in stock when exercised by grantees. The incentive cash bonuses approximated $5.5 million. The performance unit awards have a potential value totaling approximately $6.1 million, payable in cash, if certain performance criteria are met prior to December 2009. 31 The Committee is also considering the potential acceleration of vesting of outstanding stock options not currently vested. Headwaters is currently reviewing the costs related to accelerating the vesting of options and is considering the appropriate accounting for these costs, along with the costs of the incentive awards granted, under current accounting literature as well as under the new requirements of SFAS No. 123R. Headwaters expects these costs will be substantial, and a majority of such costs could be required to be reflected as expense in the quarter ending June 30, 2005, especially if Headwaters early adopts SFAS No. 123R in the June 2005 quarter, which management is considering. Section 29 Matters Headwaters Energy Services' license fees and revenues from sales of chemical reagents depend on the ability of licensees and customers to manufacture and sell qualified synthetic fuels that generate tax credits under Section 29 of the Internal Revenue Code. From time to time, issues arise as to the availability of tax credits, including the items discussed below. Legislation. Under current law, Section 29 tax credits for synthetic fuel produced from coal expire on December 31, 2007. In addition, there have been initiatives from time to time to consider the early repeal or modification of Section 29. Most recently, in April 2005, an amendment to Section 29 was proposed in the House Ways and Means Committee of the United States House of Representatives that would have repealed the Section 29 credit for synthetic fuel produced from coal. The committee failed to approve the proposed amendment, but the amendment could be reintroduced. If Section 29 expires at the end of 2007 or if it is repealed or adversely modified, synthetic fuel facilities would probably either close or substantially curtail production. At this time, given current prices of coal and costs of synthetic fuel production, Headwaters does not believe that production of synthetic fuel will be profitable absent the tax credits. In addition, if Headwaters' licensees close their facilities or materially reduce production activities (whether after 2007, or upon earlier repeal or adverse modification of Section 29, or for any other reason), it would have a material adverse effect on the revenues and net income of Headwaters. Phase-Out. Section 29 tax credits are subject to phase-out after the average annual wellhead domestic oil price ("reference price") reaches a beginning phase-out threshold price, and is eliminated entirely if the reference price reaches the full phase-out price. For calendar 2004, the reference price was $36.75 per barrel and the phase-out range began at $51.35 and would have fully phased out tax credits at $64.47 per barrel. For calendar 2005, an estimated partial year reference price (through March 2005) is $42.92 per barrel, and an estimate of the phase-out range (using 2% inflation) begins at $52.38 and completes phase-out at $65.76 per barrel. The one-day cash trading price (which historically has trended somewhat higher than the reference price) on April 29, 2005 was $49.73 per barrel. IRS Audits. Licensees are subject to audit by the IRS. The IRS may challenge whether Headwaters Energy Services' licensees satisfy the requirements of Section 29, or applicable Private Letter Rulings, including placed-in-service requirements, or may attempt to disallow Section 29 tax credits for some other reason. The IRS has initiated audits of certain licensee-taxpayers who claimed Section 29 tax credits, and the outcome of any such audit is uncertain. In calendar 2004, a licensee announced that IRS field auditors had issued a notice of proposed adjustment challenging the placed-in-service date of three of its synthetic fuel facilities. The licensee believes that the facilities meet the placed-in-service requirement, however, the timing and final results of the audit are unknown. The inability of a licensee to claim Section 29 tax credits would reduce Headwaters' future income from the licensee. 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 others [sic] aspects of Section 29. The investigation will also address the IRS' administration of Section 29 tax credits." The Subcommittee conducted numerous interviews and received large volumes of data between December 2003 and March 2005. Since that time, to Headwaters' knowledge, there has been little activity regarding the investigation. Headwaters cannot make any assurances as to the timing or ultimate outcome of the Subcommittee investigation, nor can Headwaters predict whether Congress or others may conduct investigations of Section 29 tax credits in the future. The Subcommittee investigation may have a material adverse effect on the willingness of buyers to engage in transactions to purchase synthetic fuel facilities or on the willingness of current owners to operate their facilities, and may materially adversely affect Headwaters' revenues and net income. Recent Accounting Pronouncements In September 2004, the Emerging Issues Task Force ("EITF") reached a consensus requiring the inclusion of contingently convertible securities in diluted earnings per share ("EPS") calculations. This consensus (EITF Issue 32 04-08, "The Effect of Contingently Convertible Debt on Diluted Earnings per Share") was effective for periods ending after December 15, 2004 and required Headwaters to include in its 2005 diluted EPS calculations, on an if-converted basis, the additional shares issuable under the terms of Headwaters' outstanding convertible senior subordinated notes described in Note 6. The EITF consensus must be applied to all applicable prior periods, which for Headwaters are the quarters ended June 30, 2004 and September 30, 2004. See Note 8 for more information on the effect on Headwaters' EPS of implementing the EITF consensus. In November 2004, the Financial Accounting Standards Board ("FASB") issued SFAS No. 151, "Inventory Costs," which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and spoilage, requiring that such costs be recognized as current-period costs regardless of whether they meet the criterion of "so abnormal," currently required by the guidance in ARB No. 43, Chapter 4, "Inventory Pricing." SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005, which for Headwaters will be fiscal 2006. Because the provisions of this standard must be applied prospectively, there will be no effect on previously-issued financial statements of Headwaters. It is not possible to predict the effect SFAS No. 151 might have on future reported results because it will depend on the levels of "abnormal" inventory costs incurred in the future, if any. In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment," ("SFAS No. 123R"), which was to be effective for interim periods beginning after June 15, 2005. In April 2005, the SEC announced that it would allow registrants to delay the adoption of SFAS No. 123R to no later than the beginning of the first fiscal year beginning after June 15, 2005, which for Headwaters would be fiscal 2006. SFAS No. 123R revises SFAS No. 123 and supersedes APB 25 and requires companies to expense the value of employee stock options and similar awards. Pro forma disclosure will no longer be an alternative. SFAS No. 123R also amends SFAS No. 95, Statement of Cash Flows, to require tax benefits from share-based payments to be reported as a financing cash flow rather than an operating cash flow, as required under current literature. Headwaters is studying the implications of SFAS No. 123R and expects it to have a material effect on Headwaters' reported results of operations when adopted, although it will have limited impact on cash flow. Headwaters may early adopt SFAS No. 123R beginning in either the June or September 2005 quarters. SFAS No. 123R permits public companies to adopt its requirements using one of two methods: i) a "modified prospective" method in which compensation cost is recognized beginning with the effective date based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date, plus compensation cost under the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date; or ii) a "modified retrospective" method which includes the requirements of the modified prospective method, but also permits companies to restate, based on the amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures, for either all prior periods, or by restating only the prior interim periods of the year of adoption. Headwaters has not yet determined which method will be used when SFAS No. 123R is adopted. The impact of adoption of SFAS No. 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future (including the stock appreciation rights and stock options granted in May 2005, as described in Note 9). However, had Headwaters adopted SFAS No. 123R in prior periods, Headwaters believes the impact of this standard would have approximated the impact of SFAS No. 123 as reflected above in the disclosures of pro forma net income and earnings per share. Adoption of SFAS No. 123R will also reduce net cash flow from operating activities and increase net cash flow from financing activities. While Headwaters cannot estimate what those amounts will be in the future, the amounts for the six months ended March 31, 2004 and 2005 were $2.9 million and $5.3 million, respectively. Headwaters has reviewed all other recently issued accounting standards, which 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 other recent accounting pronouncements will have a significant effect on its current or future financial position, results of operations, cash flows or disclosures. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Headwaters is exposed to financial market risks, primarily related to changes in interest rates. Headwaters does not use derivative financial instruments for speculative or trading purposes, but has entered into hedge transactions to limit its variable interest rate exposure, as explained below. As described in more detail in Note 6 to the consolidated financial statements, Headwaters has approximately $562.0 million of variable-rate long-term debt outstanding as of March 31, 2005, consisting of $552.7 million of senior debt and $9.3 million of notes payable to a bank. The $552.7 million of term loan borrowings under the senior debt agreements consisted of a first lien term loan in the amount of $452.7 million and a second lien term loan in the amount of $100.0 million. The first lien term loan bears interest, at Headwaters' option, at either i) the London Interbank Offered Rate ("LIBOR") plus 2.0%, 2.25%, or 2.5%, depending on the credit 33 ratings that have been most recently announced for the loans by Standard & Poors Ratings Services ("S&P") and Moody's Investors Service, Inc. ("Moody's"); or ii) the "base rate" plus 1.0%, 1.25%, or 1.5%, again depending on the credit ratings announced by S&P and Moody's. Base rate is defined as the higher of the rate announced by Morgan Stanley Senior Funding and the overnight rate charged by the Federal Reserve Bank of New York plus 0.5%. The initial interest rate on the first lien debt was set at 6.5%, but was subsequently reduced to approximately 5.4% during the quarter ended December 31, 2004 pursuant to the terms of the agreement. The interest rate on the first lien debt was approximately 4.9% at March 31, 2005. The second lien term loan bears interest, also at Headwaters' option, at either LIBOR plus 5.5%, or the "base rate" plus 4.5%. The initial interest rate on the second lien debt was set at 9.75%, but was subsequently reduced to approximately 7.7% during the quarter ended December 31, 2004 pursuant to the terms of the agreement. The interest rate on the second lien debt was approximately 8.2% at March 31, 2005. Headwaters can lock in new rates for both the first lien and second lien loans for one, two, three or six months. The most recent rate change occurred in March. In connection with the new senior secured credit facility, Headwaters entered into certain hedge agreements to limit its variable interest rate exposure The first set of agreements effectively established the maximum LIBOR rate for $300.0 million of the senior secured debt at 5.0% through September 8, 2005. The second set of agreements effectively sets the LIBOR rate at 3.71% for $300.0 million of this debt for the period commencing September 8, 2005 through September 8, 2007. Headwaters accounts for these agreements as cash flow hedges, and accordingly, the fair market value of the hedges is reflected in the consolidated balance sheet as either other assets or other liabilities. The hedges had a market value at March 31, 2005 of approximately $4.1 million, which, net of $1.6 million of income taxes, represents other comprehensive income for the period ended March 31, 2005 (yielding approximately $14.5 million and $27.5 million, respectively, of total comprehensive income for the three- and six-month periods ended March 31, 2005). The market value of the hedges can fluctuate significantly over a relatively short period of time and as of April 29, 2005, the market value of the hedges had decreased to approximately $2.4 million. Effective with the March 2005 amendment to the credit facility, Headwaters was allowed to reduce its hedges to $150.0 million of the senior debt and in May 2005, Headwaters reduced the hedges to that level, realizing a gain of approximately $1.0 million. In connection with the acquisition of SCP in July 2004, Headwaters assumed SCP's obligations under its notes payable to a bank. The notes require monthly interest and quarterly principal payments and bear interest at variable rates, which as of March 31, 2005, ranged from 4.5% to 5.25%. Disregarding the effect of the hedges described above, a change in the interest rate of 1% would change Headwaters' interest expense by approximately $5.5 million during the 12 months ending March 31, 2006, considering all outstanding balances of variable-rate debt and 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, regulations 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. 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, 2005, 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, 2005 that has materially affected, or is reasonably likely to materially affect, Headwaters' internal control over financial reporting. 34 PART II -- OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS See "Legal or Contractual Matters" in Note 9 to the consolidated financial statements for a description of current legal proceedings. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On March 1, 2005, Headwaters held its 2005 annual Meeting of Stockholders. Items voted on and the results of voting are described in Headwaters' Form 8-K, filed March 3, 2005, which Form 8-K is incorporated herein by reference. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS The following exhibits are included herein: 10.94 Settlement Agreement and Mutual Release dated * May 1, 2005 between Headwaters, AJG Financial Services, Inc. and others 12 Computation of ratio of earnings to combined fixed * charges and preferred stock dividends 14 Code of Ethics * 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 99.11 Nominating and Corporate Governance Committee Charter, * dated April 25, 2005 99.12 Audit Committee Charter, dated March 9, 2005 * 99.13 Compensation Committee Charter, dated March 9, 2005 * 99.14 Form of 2005 Stock Appreciation Right Grant and related * Stock Appreciation Right Agreement (vested) 99.15 Form of 2005 Stock Appreciation Right Grant and * related Stock Appreciation Right Agreement (scheduled vesting) ----------------------- * Filed herewith. 35 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 9, 2005 By: /s/ Kirk A. Benson ------------------------------------------ Kirk A. Benson, Chief Executive Officer (Principal Executive Officer) Date: May 9, 2005 By: /s/ Steven G. Stewart ------------------------------------------ Steven G. Stewart, Chief Financial Officer (Principal Financial Officer) 36 EX-10.94 2 ex1094q033105.txt SETTLEMENT AGREEMENT AND MUTUAL RELEASE Exhibit 10.94 SETTLEMENT AGREEMENT AND MUTUAL RELEASE This Settlement Agreement and Mutual Release ("2nd Settlement Agreement") is entered into as of May 1, 2005 (the "Effective Date") by and between Headwaters Incorporated (formerly known as Covol Technologies, Inc.) ("Headwaters"), on the one hand, and Square D Company ("Square D"), Arthur J. Gallagher & Co. ("Gallagher") and AJG Financial Services, Inc. ("AJG") on the other hand. The foregoing parties will hereinafter collectively be called the "Parties." Recitals The Parties acknowledge and agree: A. On December 27, 1996 AJG and Headwaters entered into a contract entitled Agreement Concerning Additional Facilities (the "License Agreement"). B. On October 22, 1997 AJG and Headwaters entered into a letter agreement (the "Letter Agreement") which, among other things, modified the License Agreement and established royalties in connection with the Algoma Facility, as defined below. C. On June 26, 2000 AJG, Headwaters, and Square D entered into a Settlement Agreement and Release (the "1st Settlement Agreement") related to the Utah 1 Facility, as defined below. D. On October 17, 2001, Headwaters commenced litigation against AJG in the Fourth Judicial Court for Utah County, State of Utah, Case No. 000403381 (the "1st Litigation"). During the course of the 1st Litigation, Headwaters and AJG asserted claims against each other relating to the operation of and royalties payable under the License Agreement and the Letter Agreement from the following synthetic fuel manufacturing facilities: (i) two double-line synthetic fuel production facilities (hereinafter the "AJG Lines" or as termed in the License Agreement, the "Facilities") owned initially by AJG and placed in service at Pawnee, Illinois, and later relocated to Wateree and Winyah, South Carolina; (ii) one production line (hereinafter the "Algoma Facility") initially owned by Headwaters and located at Algoma, West Virginia, and later relocated to Kentucky. E. On June 7, 2002 Headwaters commenced litigation against AJG and Square D in the Fourth Judicial Court for Utah County, State of Utah, Case No. 010402901 (the "2nd Litigation"). During the course of the 2nd Litigation, the Parties asserted claims and defenses related to payments under the 1st Settlement Agreement related to the following synthetic fuel manufacturing facility: one production line (hereinafter the "Utah 1 Facility") owned initially by Headwaters and placed in service at Price, Utah, and later relocated to Canadys, South Carolina. F. On February 12, 2005, the jury in the 1st Litigation rendered a verdict in favor of Headwaters on some of the claims in the amount of $175,294,532 and a verdict in favor of AJG on some of the counterclaims in the amount of $270,734. The claims addressed in the jury's verdict included claims by Headwaters against AJG for unpaid royalties due and owing on the AJG Lines through December 31, 2004 and various counterclaims by AJG against Headwaters. The Court entered a net judgment on the verdict in the amount of $175,023,798 in favor of Headwaters on February 22, 2005 (the "Judgment"). G. The remaining unresolved claim in the 1st Litigation, which consists of Headwaters' claim against AJG for declaratory relief relating to royalty obligations in calendar year 2005 and thereafter on production from the AJG Lines, is pending before the Court. H. There has been no trial in the 2nd Litigation. I. Gallagher is the parent corporation of AJG. J. Headwaters and AJG deem it to be in their mutual best interests to modify and extend the license provided for under the License Agreement. K. Headwaters, on the one hand, and Square D and Gallagher and AJG on the other hand, desire finally and fully to resolve all claims that have been or could have been asserted by each party against each other in the 1st Litigation and the 2nd Litigation, as the case may be, and all other claims between them, subject to the limitations set forth in this 2nd Settlement Agreement, without further expenditure of time or expense of litigation and without admitting liability. Agreement In consideration of the covenants, promises, mutual releases and payments set forth herein, and intending to be legally bound, the Parties agree to the following terms, conditions and releases: 1. Gallagher or AJG will make the following payments to Headwaters: (a) Gallagher and AJG jointly and severally will pay Headwaters the sum of $50 million in currently available funds within five days of the Effective Date. The Parties agree that $6,509,000 of this amount will constitute reimbursement of Headwaters' legal fees and expenses in conducting the Lawsuit, and that the balance of said $50 million payment shall be in complete settlement and satisfaction of the Judgment. This payment will be made by wire transfer in accordance with the following instructions: Bank Name: Bank One, N. A. ABA #: 124001545 Account #: 6020641403407 Account Name: Headwaters, Inc. SWIFT Code: BONEUS44 2 (b) In consideration of Headwaters' agreement to modify the License Agreement and for the right to use the technology and other rights granted therein during the period commencing January 1, 2005 and ending December 31, 2014, in accordance with paragraph 2 below, Gallagher and AJG, jointly and severally, shall pay Headwaters the additional sum of $70 million, together with simple interest at the rate of 4% per annum from the Effective Date hereof. Such payment shall be made on or before January 15, 2006, in accordance with the wire transfer instructions set forth in subparagraph 1(a), above, regardless of whether license rights or technology are claimed to be used. 2. AJG and Headwaters hereby modify the License Agreement as of January 1, 2005, as follows: (a) Section 3 of the License Agreement as amended is further modified by deleting the text thereof in its entirety and replacing it with the following: "AJG and Arthur J. Gallagher & Co. ("Gallagher") will jointly and severally pay Headwaters additional amounts for each of calendar years 2005, 2006 and 2007 ("Modification Payments") in the amount of $0.135 per dollar of tax credit earned on all production from the Facilities for calendar years 2005, 2006 or 2007, whichever is applicable, but in no event more than $20 million for such calendar year. For example, if tax credits for calendar year 2005 for all applicable production for such year from the Facilities was $160 million before any phase out of tax credits under Section 29 of the Internal Revenue Code and then a 30% phase out was applied, the required payment would be $15,120,000 ($160 million x 70% x $0.135). On or before each February 15, May 15, August 15 and November 15, commencing May 15, 2005 and ending February 15, 2008, AJG shall cause a written report to be prepared and delivered to Headwaters which sets forth the aggregate production of synthetic fuel ("Synfuel") from the Facilities during the immediately preceding calendar quarter which report shall be accompanied by a check payable to the order of Headwaters in the amount referred to in the immediately preceding paragraph above as it relates to the reported production from the Facilities; provided, however, that the payments under this section for any calendar year shall terminate when the aggregate payments made with respect to such year's production pursuant to this section shall equal $20 million. Any such payment which is not made when it is due shall bear interest from the due date thereof until it shall be paid in full at the simple rate of four percent (4%) per annum, with respect 3 to any payment due for production in calendar year 2005, and at the simple rate of eight (8%) per annum, with respect to any payment due for production in calendar years 2006 or 2007. Within forty five (45) days after the Internal Revenue Service publishes its annual inflation adjustment factor pursuant to Section 29(d)(2), AJG and Headwaters shall mutually determine whether there has been any underpayment or overpayment, as the case may be, of amounts for which AJG is obligated to pay Headwaters pursuant to this section above. AJG shall pay to Headwaters the amount of any underpayment, or Headwaters shall pay to AJG the amount of any overpayment, as the case may be, within said forty five (45) day period. Any amount which is not paid prior to the expiration of said forty five (45) day period shall bear interest from the expiration date of said forty five (45) day period until payment is received in full at the applicable rate of interest specified in the immediately preceding paragraph. Payments hereunder shall be based on 100% of the production from the Facilities, regardless of whether AJG or its partners actually use the tax credits, regardless of where the Facilities are located at the time of production, regardless of any change in ownership of the Facilities and regardless of what technology or process AJG and its partners claim to use in producing the synfuel that qualifies for tax credits." (b) The License Agreement, section 5, Records; Inspection; Confidentiality, is modified by adding the following to the end thereof: "Disputes concerning payment obligations under section 3 hereof shall be attempted to be resolved by the parties first by discussion between the respective Chief Financial Officers of Headwaters and Gallagher. If such discussions are unsuccessful, the parties shall submit the dispute to nonbinding mediation within 30 days of the date the dispute first arises. If the parties are unable to agree upon a mutually acceptable mediator, one shall be appointed by the Utah director of the American Arbitration Association. If mediation is unsuccessful, the parties shall have the right to file suit in any Utah state court." (c) The License Agreement, section 8, Term, is modified by deleting the text thereof in its entirety and replacing it with the following: 4 "This Agreement and the license granted hereunder shall be for the period from the Closing Date to and including December 31, 2014 and AJG and any entity in which AJG has or had any ownership interest (or any transferee thereof or any purchaser of the assets of any such entity) shall have the unrestricted right, power, privilege and authority to use any technology and other rights granted in, or contemplated by, this Agreement through and including December 31, 2014; provided however, that the obligations to pay the Modification Payments shall continue only for the periods described in section 3 hereof, it being understood and agreed that no further amounts shall be payable at any time beyond the amounts provided for in section 3 respecting the subject matter of this Agreement." 3. Utah 1 Facility Payments. Square D and AJG shall continue to make Net Benefit payments to Headwaters relating to the Utah 1 Facility under the 1st Settlement Agreement as such payments have historically been calculated by AJG in the manner reflected on Exhibit A attached hereto. Payments shall be made by Square D and AJG to Headwaters on each February 15, May 15, August 15 and November 15, and each such payment shall be accompanied by a written report in the manner reflected on Exhibit A. Any payment not made when due shall bear interest from the due date thereof until payment in full at the simple rate of four percent (4%) per annum with respect to Net Benefits received with respect to calendar year 2005, and at the simple rate of eight percent (8%) per annum with respect to Net Benefits received with respect to succeeding calendar years. Headwaters, at its sole cost and expense, either directly or through its authorized representative, shall have the right, upon reasonable advance notice and during normal business hours, to inspect the books and records of Square D, AJG, and Coaltech No. 1, LP with respect to the Net Benefits received by Square D and AJG with respect to the Utah 1 Facility. Any dispute shall be resolved in the manner described in section 2(b) above. 4. Algoma Payments. Headwaters will continue to make payments to AJG relating to the Algoma Facility under the eighth bullet paragraph (as originally counted) of the Letter Agreement at the current rate of 5.9% of net royalties received by Headwaters. Payments shall be made by Headwaters to AJG on each February 15, May 15, August 15 and November 15, commencing May 15, 2005, and each such payment shall be accompanied by a written report prepared by Headwaters which sets forth a detailed calculation of the amount of net royalties received by Headwaters during the immediately preceding quarter. Any payment not made when due shall bear interest from the due date thereof until payment in full at the simple rate of four percent (4%) per annum with respect to net royalties received with respect to calendar year 2005, and at the simple rate of eight percent (8%) per annum with respect to net royalties received with respect to succeeding calendar years. AJG, at its sole cost and expense, either directly or through its authorized representative, shall have the right, upon reasonable advance notice and during normal business hours, to inspect the books and records of Headwaters with respect to the net royalties received by Headwaters with respect to the Algoma Facility. Any dispute shall be resolved in the manner described in section 2(b) above. 5 5. Joint and Several Obligations. The payment obligations of AJG and Gallagher under sections 1(a), 1(b), 2(a) and 3 (not including Square D's portion of the Net Benefits) of this 2nd Settlement Agreement are joint and several and Gallagher shall not be deemed to have any further payment obligations hereunder. 6. Mutual Release. Headwaters, on behalf of itself, its parents, subsidiaries, affiliates, officers, directors, shareholders, agents, employees, legal representatives, predecessors, successors, assigns, and their respective parents, subsidiaries, affiliates, officers, directors, shareholders, agents, employees, legal representatives, successors and assigns, and all others claiming by or through Headwaters hereby releases, remises and forever discharges each of AJG, Gallagher, Square D and owners of the AJG Lines and their respective parents, subsidiaries, affiliates, officers, directors, shareholders, partners, agents, employees, legal representatives, successors and assigns and all other acting in concert with them of and from any and all actions, causes of actions, claims, demands, costs, suits, debts, damages, liabilities, obligations, sums of monies, accounts, contracts, promises and/or executions (collectively, "Claims") of any and every kind or nature, at law or in equity, whether known or unknown, which Headwaters and any of such parties have, had or may have in the future, or claim to have for, upon or by reason of, any matter, cause or thing whatsoever, from the beginning of time through the date of this 2nd Settlement Agreement, including but not limited to any and all claims for breach of contract, negligence, intentional tort or statutory violation, with the sole exceptions of any future Claims arising by reason of a breach of (i) this 2nd Settlement Agreement, (ii) the 1st Settlement Agreement, (iii) the License Agreement, as modified herein; and (iv) the eighth bullet paragraph of the Letter Agreement. Each of AJG, Gallagher and Square D, on behalf of itself, its parents, subsidiaries, affiliates, officers, directors, shareholders, agents, employees, legal representatives, predecessors, successors, assigns, and their respective parents, subsidiaries, affiliates, officers, directors, agents, employees, legal representatives, successors and assigns, and all others claiming by or through any of the foregoing ("AJG Releasing Parties") hereby releases, remises and forever discharges Headwaters and its respective parents, subsidiaries, affiliates, officers, directors, shareholders, agents, employees, legal representatives, predecessors, successors and assigns and all other acting in concert with them of and from any and all Claims of any and every kind or nature whatsoever, at law or in equity, whether known or unknown, which AJG Releasing Parties or any of such parties has, had or may have in the future, or claim to have for, upon or by reason of, any matter, cause or thing whatsoever, from the beginning of time through the date of this 2nd Settlement Agreement, including but not limited to any and all claims for breach of contract, negligence, intentional tort or statutory violation, with the sole exceptions of any future Claims arising by reason of a breach of (i) this 2nd Settlement Agreement, (ii) the 1st Settlement Agreement, (iii) the License Agreement, as modified herein; and (iv) the eighth bullet paragraph of the Letter Agreement. 7. Covenant Not to Sue. This 2nd Settlement Agreement may be pled as a full and complete defense to any claims that may be instituted, prosecuted, or attempted in breach of this 2nd Settlement Agreement. Except for any Claims for breach of this Agreement and the other Claims expressly not released under section 6 above, Headwaters on the one hand, and AJG, Gallagher and Square D on the other hand, hereby covenant never to institute or aid in the institution or prosecution of any claim, action, complaint, charge or suit, whether at law or 6 in equity, against the other party or any of their respective parents, subsidiaries, affiliates, officers, directors, shareholders, employees, agents, legal representatives, successors or assigns in any court or administrative agency, or before any other public or private tribunal, which in any way arises from or relates to any event, dispute, or occurrence which arose on or prior to the date of this 2nd Settlement Agreement. 8. Dismissal. Within five days of the Effective Date, the Parties agree to jointly file motions for the dismissal of the 1st Litigation, including all post-trial motions, and the 2nd Litigation, both with prejudice, and a notice of satisfaction of the Judgment, each party to bear its own costs and attorneys' fees except as paid pursuant to Section 1(a) of this 2nd Settlement Agreement. 9. Confidentiality. The terms of this 2nd Settlement Agreement and all negotiations and communications relating to this 2nd Settlement Agreement shall not be disclosed to any person or entity except (a) to the extent necessary for accounting, tax, insurance or legal reporting purposes, including disclosure requirements imposed by the securities laws, (b) as may be necessary to fulfill existing third-party contract obligations of the parties; (c) as may be required by law; or (d) to the extent necessary to enforce the terms of this 2nd Settlement Agreement. 10. Denial of Liability. This 2nd Settlement Agreement is the result of a compromise of disputed claims and shall not be considered or construed as an admission of liability or responsibility by either party. Each party acknowledges the contentions and claims of the other but, by entering into this 2nd Settlement Agreement, does not acknowledge the propriety of such contentions and claims. 11. Integration Clause. This 2nd Settlement Agreement, plus the 1st Settlement Agreement, the License Agreement, as modified herein, and the eighth bullet paragraph of the Letter Agreement (the "Outstanding Agreements") contain the entire agreement between the Parties relating to the subject matter contained herein and supersedes any and all other prior agreements and negotiations between the Parties leading up to the execution of this 2nd Settlement Agreement, whether oral or in writing. The Parties each acknowledge that no other agreements, covenants, representations or warranties, inducements, promises or statements, express or implied, oral or otherwise have been made by any of the Parties that are not embodied or incorporated by reference herein, and further agree that no other agreement, covenant, representation or warranty, inducement, promise or statement not set forth in writing in the Outstanding Agreements shall be valid or binding. 12. Representation by Counsel. The Parties hereby acknowledge that each party has been represented by counsel with respect to this 2nd Settlement Agreement and has been fully advised by said counsel with respect to its rights and obligations with respect to this 2nd Settlement Agreement. 13. Modification or Amendment. This 2nd Settlement Agreement may not be modified or amended except in a writing signed by all Parties. 7 14. Construction and Interpretation. This 2nd Settlement Agreement shall be construed in accordance with the laws of the State of Delaware without regard to the principles of conflicts of laws. Counsel for each of the Parties has participated in the drafting and negotiation of this 2nd Settlement Agreement and any rule of construction to the effect that any ambiguity shall be construed against the drafting party shall not be applied to this 2nd Settlement Agreement. 15. Mistake. In entering and making this 2nd Settlement Agreement, the Parties assume the risk of any mistake of fact or law. If the Parties, or any of them, should later discover that any fact they relied upon in entering this 2nd Settlement Agreement is not true, or that their understanding of the facts or law was incorrect, the Parties shall not be entitled to set aside this 2nd Settlement Agreement by reason thereof. This 2nd Settlement Agreement is intended to be final and binding upon the Parties regardless of any mistake of fact or law. 16. Execution, Counterparts and Facsimile Signatures. This 2nd Settlement Agreement may be executed in counterparts, each of which shall be deemed an original. All counterparts taken together shall constitute one and the same original 2nd Settlement Agreement, with the same force and effect as if all signatures had been entered on one document. Facsimile signatures shall constitute original signatures. 17. Authority. Each party represents and warrants that the individual signing this 2nd Settlement Agreement on behalf of the party is authorized to do so and binds the party on whose behalf he or she is signing. The parties further represent and warrant that each is the sole holder of the claims being released in this 2nd Settlement Agreement, that the party has not assigned those claims to any other person or entity, and that no one else has any claim, title or interest in or to the claims being released herein. 8 IN WITNESS WHEREOF, the duly authorized individuals below have executed this Settlement Agreement and Mutual Release on behalf of their respective parties as indicated below. Headwaters Incorporated Arthur J. Gallagher & Co. By: /s/ Steven G. Stewart By: /s/ John C. Rosengren ------------------------- ------------------------------------- Its: CFO Its: V.P., Secretary, & General Counsel AJG Financial Services, Inc. By: /s/ John C. Rosengren ------------------------------------- Its: V.P., Secretary, & General Counsel Square D Company By: /s/ Vincent A. Inendino -------------------------------------- Its: Vice President 9 EX-12 3 ex12q033105.txt RATIO OF EARNINGS Exhibit 12
Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends Six Months Ended (in thousands) Year Ended September 30, March 31, ------------------------------------------------------ ------------ 2000 2001 2002 2003 2004 2005 ------------------------------------------------------ ------------ Fixed Charges Computation Interest expensed and capitalized $ 3,603 $ 145 $ 417 $12,060 $ 13,857 $ 28,180 Amortized premiums, discounts, and capitalized expenses related to indebtedness 3,034 79 136 3,857 6,031 6,741 Reasonable approximation of interest within rental expense 26 20 72 1,139 1,462 1,099 ------------------------------------------------------ ------------ Total Fixed Charges 6,663 244 625 17,056 21,350 36,020 Preferred equity dividends 378 113 - - - - ------------------------------------------------------ ------------ Total Fixed Charges and Preferred Equity Dividends $ 7,041 $ 357 $ 625 $17,056 $ 21,350 $ 36,020 ====================================================== ============ Earnings Computation Pre-tax income from continuing operations before adjustment for minority interests in consolidated subsidiaries or income or loss from equity investees $ 8,642 $14,468 $40,236 $60,081 $105,107 $ 36,501 Plus Fixed charges 7,041 357 625 17,056 21,350 36,020 Minus Interest capitalized - - - 230 435 240 ------------------------------------------------------ ------------ Total Earnings $15,683 $14,825 $40,861 $76,907 $126,022 $ 72,281 ====================================================== ============ Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends 2.23 41.53 65.38 4.51 5.90 2.01
EX-14 4 ex14q033105.txt CODE OF ETHICS Exhibit 14 HEADWATERS INCORPORATED CODE OF ETHICS AND BUSINESS CONDUCT FOR EMPLOYEES, OFFICERS AND DIRECTORS April 25, 2005 Headwaters expects ethical conduct from its employees, officers and directors. Your full compliance with this Code is mandatory. You are expected to participate in and foster a culture of transparency, integrity and honesty in the Company. For guidance with respect to issues not addressed in this Code, employees are directed to the Policies and Procedures Employee Handbook, which sets forth the Company's policies on a wide range of issues that arise in the course of service with the Company. Conflicts of Interest - --------------------- As an employee, director or officer of the Company, it is imperative that you avoid any interest or association that interferes or appears to interfere with your independent exercise of judgment in the Company's best interests. You may not exploit your position or relationship with the Company for personal gain. There are many situations in which a conflict of interest may arise. If you have concerns about any situation, follow the steps outlined in the Section on "Reporting Violations." Engaging in any conduct that represents a conflict of interest is strictly prohibited. Gifts, Bribes and Kickbacks - --------------------------- Other than for modest gifts given or received in the normal course of business (including travel or entertainment), neither you nor your relatives may give gifts to, or receive gifts from the Company's clients or vendors. Other gifts may be given or accepted only with prior approval of your senior supervisor or the Company's management and in no event should you put the Company or yourself in a position that would be embarrassing if the gift was made public. Dealing with government employees is often different than dealing with private persons. Many governmental bodies strictly prohibit the receipt of any gratuities by their employees, including meals and entertainment. You must be aware of and strictly follow these prohibitions Any employee or director who pays or receives bribes or kickbacks will be immediately terminated and reported as warranted, to the appropriate authorities. Corporate Opportunities - ----------------------- You are prohibited from (a) taking for yourself personally opportunities that are discovered through the use of Company property, information, or position; (b) using Company property, information, or position for personal gain, and (c) competing with the Company. You owe a duty to the Company to advance its legitimate interests when the opportunity to do so arises. Protection and Proper Use of Company Assets - ------------------------------------------- You should protect the Company's assets and ensure their efficient use. All Company assets should be used for legitimate business purposes. Every employee must safeguard the Company's property from loss or theft, and may not take such property for personal gain or use, other than manager approved incidental use. Company property includes confidential information, software, computers, supplies, tools, equipment, rolling stock, and so forth. You must appropriately -2- secure all Company property within your control to prevent its unauthorized use. Employees may make limited non-business use of the Company's electronic communications systems, provided that such use (i) is occasional (ii) does not interfere with the employee's responsibilities (iii) does not diminish productivity, and (iv) does not violate this Code or the Company's electronic communications system policy then in effect. Protection of the Company, Customer and Vendor Information. - ---------------------------------------------------------- You may not use or reveal Company, customer or vendor confidential or proprietary information to others. Confidential information includes all non-public information that might be of use to competitors, or harmful to the Company or its customers, if disclosed. Additionally, you must take appropriate steps - including securing documents, limiting access to computers and electronic media, and proper disposal methods - to prevent unauthorized access to such information. Fair Dealing - ------------ You should endeavor to deal fairly with the Company's customers, suppliers, competitors, and employees. No Company employee, director or officer should take unfair advantage of anyone through improper manipulation, concealment, abuse of privileged information, misrepresentation of material facts, or any other unfair-dealing practice. -3- Fair Competition and Antitrust Laws - ----------------------------------- The Company must comply with all applicable fair competition and antitrust laws. These laws attempt to ensure that businesses compete fairly and honestly and prohibit conduct seeking to reduce or restrain competition. If you are uncertain whether a contemplated action raises unfair competition or antitrust issues, the legal department can assist you. Securities Trading - ------------------ It is usually illegal to buy or sell securities using material information not available to the public. Persons who give such undisclosed "inside" information to others may be as liable as a person who trades securities while possessing such information. Securities laws may be violated if you, or any relatives or friends trade in securities of the Company, or any of its clients or vendors, while possessing inside information. Please refer to the Statement of Company Policy as to Trades in the Company's Securities by Company Personnel. The legal department also can assist you. Accurate Periodic Reports and Financial Statements. - --------------------------------------------------- Full, fair, accurate, timely and understandable disclosures in the Company's periodic reports to the public and to governmental authorities are legally required and are essential to the success of its business. You should exercise the highest standard of care in contributing to or preparing such reports in accordance with the following guidelines: o All the Company accounting records, as well as reports produced from those records, must be in accordance with the laws of each applicable jurisdiction. -4- o All records must fairly and accurately reflect the transactions or occurrences to which they relate. o All records must fairly and accurately reflect, in reasonable detail, the Company's assets, liabilities, revenues and expenses. o The Company's accounting records must not contain any false or intentionally misleading entries. o No transactions should be intentionally misclassified as to accounts, departments or accounting periods. o All transactions must be supported by accurate documentation in reasonable detail and recorded in the proper account and in the proper accounting period. o No information should be concealed from the internal auditors or the independent auditors. o Compliance with the Company's system of internal accounting controls is required. Compliance With Law. - -------------------- You are expected to comply with both the letter and spirit of all applicable governmental laws, rules and regulations, including insider-trading law. If you fail to comply with this Code and/or with any applicable laws, you will be subject to disciplinary measures, up to and including immediate discharge from the Company. -5- Reporting Violations - -------------------- Your conduct can reinforce an ethical atmosphere and positively influence the conduct of fellow employees. If you are powerless to stop suspected misconduct or discover it after it has occurred, you must report it to the appropriate level of management at your location. Misconduct cannot be excused because it was directed or requested by another. In this regard, you are expected to alert management whenever an illegal, dishonest or unethical act is discovered or suspected. If you are still concerned after speaking with your local management or feel uncomfortable speaking with them for whatever reason, you must (anonymously, if you wish) send a detailed note, with relevant documents, to the Company's General Counsel. Or you may directly contact the Audit Committee of the Company's Board of Directors by sending a detailed note, with relevant documents, to R. Sam Christensen, P.O. Box 5100, La Quinta, CA 92248, or via email to headwaters-hotline@blackbearventures.com. Your calls, detailed notes and/or emails will be dealt with confidentially, although there may be a point where your identity may become known or have to be revealed in the course of an investigation or to take corrective action. You have the commitment of the Company and of the Audit Committee of the Company's Board of Directors, which is composed of independent directors, that you will be protected from retaliation for your good faith actions. -6- Waiver of the Code of Ethics for Executive Officers or Directors. - ----------------------------------------------------------------- Any waiver of the Code of Ethics for executive officers or directors may be made only by the Board of Directors or a Board committee and must be promptly disclosed to shareholders. Conclusion - ---------- In the final analysis you are the guardian of the Company's ethics. While there are no universal rules, when in doubt ask yourself: Am I willing to defend my actions or lack of actions in public, in front of my peers, and my family? Any employee who ignores or violates any of the Company's ethical standards, and any manager who penalizes a subordinate for trying to follow these ethical standards, will be subject to corrective action, including immediate dismissal. However, it is not the threat of discipline that should govern your actions. The Company expects you to share its belief that a dedicated commitment to ethical behavior is the right thing to do and is good business, as well as being the surest way for the Company to remain a world class organization. -7- EX-31.1 5 ex311q033105.txt CERTIFICATION OF CHIEF EXECUTIVE OFFICER 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 the registrant; 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 the registrant as of, and for, the periods presented in this report; 4. The registrant's 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 the registrant 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 the registrant, 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 the registrant's 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 the registrant's internal control over financial reporting that occurred during the registrant's most recent quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): 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 the registrant's 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 the registrant's internal control over financial reporting. Date: May 9, 2005 /s/ Kirk A. Benson - ------------------------ Kirk A. Benson Chief Executive Officer EX-31.2 6 ex312q033105.txt CERTIFICATION OF CHIEF FINANCIAL OFFICER 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 the registrant; 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 the registrant as of, and for, the periods presented in this report; 4. The registrant's 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 the registrant 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 the registrant, 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 the registrant's 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 the registrant's internal control over financial reporting that occurred during the registrant's most recent quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): 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 the registrant's 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 the registrant's internal control over financial reporting. Date: May 9, 2005 /s/ Steven G. Stewart - ------------------------ Steven G. Stewart Chief Financial Officer EX-32 7 ex32q033105.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, 2005 (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 9, 2005 /s/ Steven G. Stewart - -------------------------- Steven G. Stewart Chief Financial Officer May 9, 2005 EX-99.11 8 ex9911q033105.txt CORPORATE GOVERNANCE COMMITTEE CHARTER Exhibit 99.11 HEADWATERS INCORPORATED NOMINATING AND CORPORATE GOVERNANCE COMMITTEE CHARTER April 25, 2005 Composition - ----------- This Charter governs the operations of the Nominating and Corporate Governance Committee. The Nominating and Corporate Governance Committee shall be comprised of such number of directors as determined by the Board of Directors. The members of the Nominating and Corporate Governance Committee shall be elected by the Board of Directors annually, shall be comprised of "independent" directors as defined by the listing standards of the NYSE and shall serve until their successors are duly elected and qualified. Unless a Chair is elected by the full Board of Directors, the members of the Nominating and Corporate Governance Committee may designate a Chair. Statement of Policy - ------------------- The Nominating and Corporate Governance Committee (hereafter referred to as "the Committee") shall provide assistance to the Board of Directors in overseeing corporate governance, and shall identify individuals qualified to become Board members, consistent with criteria set by the Board of Directors. The Committee shall make recommendations to the Board of Directors regarding a slate of persons for the Board of Directors to nominate (or direct to be nominated) for election to the Board of Directors at the annual shareholders meeting. The Committee shall also oversee the evaluation of the Board of Directors and management. Annual Performance Evaluation - ----------------------------- The Committee shall perform an annual self-evaluation of its performance. Responsibilities and Processes - ------------------------------ The following shall be the principal recurring responsibilities and principal recurring processes of the Committee. The responsibilities and processes are set forth as a guide with the understanding that the Committee may alter or supplement them as appropriate. 1. Annually, the Committee shall evaluate and select the director nominees of the Corporation to be considered for election at the annual meeting of stockholders. The Committee shall also select nominees to the Board of Directors with respect to filling vacancies on the Board of Directors. The criteria used by the Committee to evaluate and to select director nominees shall include, but shall not be limited to, relevant industry experience, general business experience, relevant financial experience, and compliance with independence and other qualifications necessary to comply with any applicable tax and securities laws and the rules and regulations of the NYSE. The Committee shall have the sole authority and shall be granted the resources to retain independent advisers, such as search firms, in order to assist the Committee in identifying and selecting nominees. Such authority shall include the sole authority to approve such advisor's fees and other retention terms. Notwithstanding anything to the contrary contained herein, if the Corporation is required by contract or otherwise to provide third parties with the ability to nominate directors, the selection and nomination of any such directors are not subject to the powers or oversight of this Committee, except to the extent that any such director shall be subject to the Corporate Governance Guidelines and the Code of Conduct of the Corporation and general oversight of this Committee. 2. The Committee shall review and make recommendations to the Board of Directors with respect to candidates for director proposed by stockholders of the Corporation. 3. The Committee shall formulate and recommend to the Board of Directors a list of "Corporate Governance Guidelines", which shall address, at a minimum, director qualification standards; director responsibilities; director access to management and, as necessary and appropriate, independent advisors; director compensation; director orientation and continuing education; management succession; and annual performance evaluation of the Board of Directors. The Committee shall from time to time or as necessary recommend to the Board of Directors any revisions to the Corporate Governance Guidelines that the Committee deems appropriate or to ensure compliance with applicable securities law and regulations and stock market rules. 4. The Committee shall formulate and recommend to the Board of Directors a code of ethics and business conduct for directors, officers and employees of the Corporation, which shall address, at a minimum, conflicts of interest, corporate opportunities, confidentiality, fair dealing, protection and proper use of company assets, compliance with laws, rules and regulations (including insider trading laws), and encouraging the reporting of any illegal or unethical behavior (a "Code of Conduct"). The Committee shall from time to time or as necessary recommend to the Board of Directors any revisions to the Code of Conduct that the Committee deems appropriate or to ensure compliance with applicable securities laws and regulations and stock market rules. 5. The Committee shall review on an annual basis the functioning and effectiveness of the Board of Directors, its committees and its individual members, and to the extent the Committee deems appropriate, recommend changes or additions to the composition of the committees of the Board of Directors. 6. The Committee shall consider and make recommendations on matters related to the practices, policies and procedures of the Board of Directors. 2 7. The Committee shall perform such other activities and functions related to the selection and nomination of directors and corporate governance as may be assigned from time to time by the Board of Directors. 8. In performing any of its duties and responsibilities, the Committee may consult with the Corporation's internal or outside legal counsel and shall have the sole authority and shall be granted the resources to retain independent legal counsel, which shall include the sole authority to approve any such counsel's fees and other retention terms. 9. The Committee may delegate its duties and responsibilities to a subcommittee consisting of one or more members of the Nominating and Corporate Governance Committee, or to senior officers of the Corporation. Any delegation may be made only to the extent permitted by the NYSE rules, Securities and Exchange Commission rules and applicable law. Reports - ------- 1. The Committee may, as it desires, prepare or cause the preparation of a report for inclusion in the Corporation's annual proxy statement. 2. The Committee shall submit any recommendations for changes to the Nominating and Corporate Governance Committee Charter to the full Board of Directors for approval. 3. The Committee shall maintain minutes of its meetings and regularly report its activities to the Board of Directors. Reliance on Information Provided - -------------------------------- In adopting this Nominating and Corporate Governance Committee Charter, the Board of Directors acknowledges that the Nominating and Corporate Governance Committee members may not be legal experts and are not providing any expert or special assurance as to the Corporation's legal compliance. Each member of the - Committee shall be entitled to rely on the integrity of those persons and organizations within and outside the Corporation that provide information to the Committee and the accuracy and completeness of the corporate governance and other information provided to the Committee by such persons or organizations absent actual knowledge to the contrary. 3 EX-99.12 9 ex9912q033105.txt AUDIT COMMITTEE CHARTER Exhibit 99.12 HEADWATERS INCORPORATED AUDIT COMMITTEE CHARTER March 9, 2005 Purpose and Composition - ----------------------- This Charter governs the operations of the Audit Committee. The Audit Committee shall be comprised of three or more directors as determined by the Board of Directors and shall meet the qualification requirements of the New York Stock Exchange listing standards. The members of the Audit Committee shall be elected by the Board of Directors annually and shall serve until their successors are duly elected and qualified. Unless a Chair is elected by the full Board of Directors, the members of the Audit Committee may designate a Chair by majority vote of the full Audit Committee membership. Statement of Policy - ------------------- The Audit Committee shall provide assistance to the Board of Directors in overseeing the integrity of the Corporation's financial statements, disclosure controls and procedures, the systems of internal accounting and financial controls, the Corporation's compliance with legal and regulatory requirements, the qualifications and independence of the independent auditors, the performance of the Corporation's internal audit functions and independent auditors, and the quarterly reviews and annual independent audit of the Corporation's financial statements. The independent auditor for the Corporation is ultimately accountable to the Audit Committee and the Board of Directors. The Audit Committee and the Board shall have the ultimate authority and responsibility to select, evaluate and, where appropriate, replace the independent auditor. Annual Performance Evaluation - ----------------------------- The Audit Committee shall conduct an annual self-evaluation of the Audit Committee's performance. Responsibility and Processes - ---------------------------- The primary responsibility of the Audit Committee is to oversee the Corporation's financial reporting process on behalf of the Board of Directors and report the results of its activities to the Board of Directors. It is not the duty of the Audit Committee to plan or conduct audits, to determine that the Corporation's financial statements are complete and accurate and are in accordance with generally accepted accounting principles or to assure compliance with laws. These are the responsibilities of management, the internal auditor, and the independent auditor. The following shall be the principal recurring processes of the Audit Committee in carrying out its oversight responsibilities. The processes are set forth as a guide with the understanding that the Audit Committee may alter or supplement them as appropriate. 1. Annually, the Audit Committee shall recommend to the Board of Directors the selection of the Corporation's independent auditor, subject to stockholder ratification of the selection, if such ratification is required or sought. 2. The Audit Committee shall discuss with the internal auditors and independent auditor the overall scope and plans for their respective audit examinations. The Audit Committee shall be responsible for the compensation, retention, and oversight of the work of the independent auditor (including resolution of any disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or performing other audit, review, or attest services for the Corporation. 3. The Audit Committee shall ensure that the independent auditor submits annually a formal written statement delineating all relationships between the independent auditor and the Corporation. The Audit Committee is responsible for engaging in a dialogue with the independent auditor with respect to such disclosed relationships that may impact the objectivity and independence of the independent auditor and recommending that the Board of Directors take appropriate action to satisfy itself of the independent auditor's independence. 4. The Audit Committee shall establish policies and procedures for the engagement of the independent auditor to provide non-audit services, and consider whether the independent auditor's performance of an non-audit services is compatible with the independent auditor's independence. 5. The Audit Committee shall at least annually obtain and review a report by the independent auditor describing: the firm's internal quality-control procedures; any material issues raised by the most recent internal quality-control review, or peer review, of the firm, or by any inquiry or investigation by governmental or professional authorities, within the preceding five years, respecting one or more independent audits carried out by the firm, and any steps taken to deal with any such issues. 6. The Audit Committee should review the auditor's qualifications, performance, and independence. This evaluation should include the review and evaluation of the lead partner of the independent auditor. In making its evaluation, the Audit Committee should take into account the opinions of management and the Corporation's internal auditors. In addition to assuring the regular rotation of the lead audit partner as required by law, the Audit Committee should further consider whether, in order to assure continuing auditor independence, there should be regular rotation of the audit firm itself. The Audit Committee should present its conclusions with respect to the independent auditor to the Board of Directors of the Corporation. 2 7. The Audit Committee shall discuss with management, the internal auditors, and the independent auditor the adequacy and effectiveness of the Corporation's internal controls, accounting and financial records, and the system for monitoring and managing business risk and legal compliance. Further, the Audit Committee shall meet separately with the independent auditor, with and without management present, to discuss the results of their examinations. 8. The Audit Committee shall review and discuss with management, the internal auditors, and the independent auditor the Corporation's interim financial results to be included in the Corporation's quarterly reports filed with the Securities and Exchange Commission, and the matters required to be discussed by Statement on Auditing Standards No. 61 (Communications with Audit Committees), as it may be modified or supplemented. 9. The Audit Committee shall review with management, the internal auditors, and the independent auditor the financial statements, including reviewing the Corporation's specific disclosures under "Management's Discussion and Analysis of Financial Condition and Results of Operations," to be included in the Corporation's Annual Report on Form 10-K (or the annual report to shareholders if distributed prior to the filing of Form 10-K), as well as the auditor's judgment about the quality, not just acceptability, of the Corporation's accounting principles as applied in its financial reporting. The review shall also include a discussion of the reasonableness of judgments and estimates made in the preparation of the financial statements that may be viewed as critical, as well as the clarity of financial statement disclosures. In addition, the Audit Committee shall discuss the results of the annual audit and any other matters required to be communicated to the Audit Committee by the independent auditor under generally accepted auditing standards, including the matters required to be discussed by Statement on Auditing Standards No. 61 (Communications with Audit Committees), as it may be modified or supplemented. 10. Based on its review and discussions of items 3 and 8, the Audit Committee shall recommend to the Board of Directors whether the financial statements, including the Corporation's specific disclosures under "Management's Discussion and Analysis of Financial Condition and Results of Operations," should be included in the Annual Report on Form 10-K (or the annual report to shareholders if distributed prior to the filing of Form 10-K). 11. As a whole, or through the Chair, the Audit Committee shall review the impact on the financial statements of significant events, transactions, or changes in accounting principles or estimates which potentially affect the quality of the financial reporting with management and the independent auditor prior to the filing of the Corporation's Reports on Form 10-Q or 10-K, or as soon as practicable if the communications cannot be made prior to its filing. 12. Management and the independent auditor shall discuss with the Audit Committee significant changes to the Corporation's auditing and accounting 3 principles, policies, controls, procedures and practices proposed or contemplated by the independent auditor or management. 13. The Audit Committee shall review and reassess this Charter annually and recommend any appropriate changes to the Board of Directors. 14. The Audit Committee shall discuss the Corporation's earnings press releases, as well as financial information and earnings guidance provided to analysts and ratings agencies. 15. The Audit Committee shall discuss guidelines and policies with respect to risk assessment and risk management, including the Corporation's major financial risk exposures and the steps management has taken to monitor and control such exposures. 16. The Audit Committee shall meet separately, periodically, with management, with internal auditors (or other personnel responsible for the internal audit function) and with independent auditors. 17. The Audit Committee shall set clear hiring policies for employees or former employees of the independent auditors. 18. The Audit Committee shall establish procedures for the receipt, retention, and treatment of complaints received by the Corporation regarding accounting, internal accounting controls, or auditing matters. The Audit Committee shall also establish procedures for the confidential, anonymous submission by employees of the Corporation of concerns regarding questionable accounting or auditing matters. 19. The Corporation shall provide for appropriate funding, as determined by the Audit Committee, for payment of compensation to the independent auditor, compensation to any advisors employed by the Audit Committee, and ordinary administrative expenses of the Audit Committee that are necessary or appropriate in carrying out its duties. 20. The Audit Committee shall review with the independent auditor any audit problems or difficulties, and management's response. The scope of review should include any restrictions on the scope of the independent auditor's activities or access to requested information, and any significant disagreement that is brought to its attention, after inquiry, among management and the independent auditor or internal auditor in connection with the preparation of the Corporation's financial statements. The Audit Committee should encourage both management and the independent auditor to communicate openly with the Audit Committee regarding such disagreements. In addition, the Audit Committee shall review with management and the independent auditor any pending or threatened action by regulators or government agencies and any employee complaints or published reports that raise material issues regarding the Corporation's financial statements or accounting policies. The Audit Committee may request any officer or employee of the Corporation or the Corporation's outside counsel or independent auditor to attend a meeting of the Audit Committee or to meet with any members of, or consultants to, the Audit Committee. The Audit Committee 4 shall also have the resources and authority appropriate to discharge its responsibilities, including the authority to engage outside auditors for special audits, reviews and other procedures and to retain special counsel and other experts or consultants. Reports - ------- 1. The Audit Committee shall prepare or cause the preparation of the report required by the rules of the Securities and Exchange Commission for inclusion in the Corporation's annual proxy statement. 2. The Committee shall submit any recommendations for changes to the Audit Committee Charter to the full Board of Directors for approval. 3. The Audit Committee shall maintain minutes of its meetings and regularly report its activities to the Board of Directors. Reliance on Information Provided In adopting this Audit Committee Charter, the Board of Directors acknowledges that the Audit Committee members are not employees of the Corporation and are not providing any expert or special assurance as to the Corporation's financial statements or any professional certification as to the independent auditor's work or auditing standards. Each member of the Audit Committee shall be entitled to rely on the integrity of those persons and organizations within and outside the Corporation that provide information to the Audit Committee and the accuracy and completeness of the financial and other information provided to the Audit Committee by such persons or organizations absent actual knowledge to the contrary. 5 EX-99.13 10 ex9913q033105.txt COMPENSATION COMMITTEE CHARTER Exhibit 99.13 HEADWATERS INCORPORATED COMPENSATION COMMITTEE CHARTER March 9, 2005 This Charter governs the operation of the Compensation Committee of the Board of Directors of Headwaters Incorporated (the "Corporation"). Composition - ----------- The Compensation Committee shall be comprised of two (2) or more individuals selected by the Board of Directors from among its own members. The members of the Compensation Committee shall be elected each year by the Board of Directors, shall be comprised of "independent" directors as defined by the listing standards of the New York Stock Exchange ("NYSE"), and shall serve until such time as they resign or their successors are duly elected and qualified by the Board of Directors. Unless a chairperson for the Compensation Committee is designated by election of the Board of Directors, the members of the Compensation Committee may elect, by their own majority vote, a chairperson. Statement of Policy - ------------------- The Compensation Committee shall provide assistance to the Board of Directors in overseeing compensation policies and practices of the Corporation. Compensation shall be understood to include all cash, benefits, and equity paid, in whatever form, to an employee, officer, or director of the Corporation. The criteria used by the Committee to evaluate compensation policies and practices shall include but not be limited to (1) value added during a compensation period, (2) level of responsibility, (3) appropriate incentives, (4) industry comparables, (5) principles of fairness and balance, and (6) general principles of sound business practice. Annual Performance Evaluation - ----------------------------- The Compensation Committee shall perform an annual self-evaluation of the performance of the Compensation Committee. Responsibilities and Processes - ------------------------------ The following shall be the principal recurring responsibilities and processes of the Compensation Committee. The responsibilities and processes are set forth as a guide with the understanding that the Compensation Committee may alter or supplement them as appropriate. 1. Review and approve the compensation levels and policies for the members of the Board of Directors of the Corporation. 1 2. Review and approve the corporate goals and objectives with respect to compensation for the chief executive officer ("CEO"). Evaluate the chief executive officer's performance in light of corporate goals and objectives and, based upon these evaluations, determine and approve the CEO's compensation, including salary, bonus, incentive, and equity compensation. In determining the long-term incentive component of the CEO's compensation, the Compensation Committee should consider the Corporation's performance and relative stockholder return, the value of similar incentive awards to CEOs at comparable companies, and the awards given to the Corporation's CEO in past years. 3. Make recommendations to the Board of Directors with respect to non-CEO executive officer compensation, and incentive-compensation and equity-based plans that are subject to Board of Director approval, including salary, bonus, incentive, and equity compensation. 4. Produce a Compensation Committee report on executive officer compensation as required by the Securities Exchange Commission (the "SEC") to be included in the Corporation's annual proxy statement or annual report on Form 10-K filed with the SEC. 5. Review and approve the compensation guidelines or practices for the Company's employees and the criteria by which bonuses to the Company's employees are determined. 6. Administer the Corporation's stock incentive plans, authorize grants under such plans, and recommend changes in such plans to the Board of Directors, as needed. Changes may include recommendations to amend such plans or change the number of shares reserved for issuance thereunder. 7. The Compensation Committee shall perform such other activities and functions related to the compensation policies and practices of the Corporation as may be assigned from time to time by the Board of Directors. 8. In performing any of its duties and responsibilities, the Committee may retain compensation consultants, experts, or advisors, as needed, and may consult with the Corporation's internal or outside legal counsel. Further, the Committee may and shall have the authority to retain independent legal counsel and to approve such counsel's fees and other terms of retention. 9. Compensation Committee members shall be chosen based on their competence and ability to add substance to the deliberations of the Compensation Committee. 10. The Compensation Committee may delegate its duties and responsibilities to a subcommittee consisting of one or more members of the Compensation Committee, or to senior officers of the Corporation. Any delegation may be made only to the extent permitted by the NYSE rules, Securities and Exchange Commission rules and applicable law. The Compensation Committee may 2 not, however, delegate any of its duties and responsibilities with regard to (i) compensation arrangements, including salary and short term and long term incentive awards, with respect to the CEO and any Section 16 Officer, or (ii) the Corporation's annual proxy statement. Reports and Meetings - -------------------- 1. The Compensation Committee shall prepare or cause the preparation of a report as required by the Securities and Exchange Commission to be included in the Corporation's annual proxy statement or annual report. 2. The Committee shall maintain minutes of its meetings and regularly report its activities to the Board of Directors of Directors. 3. The Committee shall submit any recommendations for changes to the Compensation Committee Charter to the full Board of Directors for approval. Reliance on Information Provided - -------------------------------- In adopting this Compensation Committee Charter, the Board of Directors acknowledges that the Compensation Committee members may not be legal experts and are not providing any expert or special assurance as to the Corporation's legal compliance. Each member of the Compensation Committee shall be entitled to rely on the accuracy and completeness of the compensation information and other information provided by persons and organizations within and outside the Corporation, absent actual knowledge to the contrary. 3 EX-99.14 11 ex9914q033105.txt NOTICE OF STOCK APPRECIATION RIGHT GRANT Exhibit 99.14 HEADWATERS INCORPORATED [______] STOCK INCENTIVE PLAN NOTICE OF STOCK APPRECIATION RIGHT GRANT [Employee's Name and Address] - --------------------------- - --------------------------- - --------------------------- Headwaters Incorporated (the "Company") has granted to you a Stock Appreciation Right ("SAR") based on the Fair Market Value of the common stock of the Company under the Headwaters Incorporated [____] Stock Incentive Plan (the "Plan") as follows. Each of the capitalized terms herein shall have the meaning given it by the Plan except if the context of such term herein clearly assumes a different meaning. - --------------------------------------------------------- Date of Grant - --------------------------------------------------------- Total Number of Shares Covered By this SAR (Number of SAR Units) - --------------------------------------------------------- Exercise Base Price Per Share of Common Stock - --------------------------------------------------------- Expiration Date 1. Exercise of the SAR. Subject to the provisions of the Plan, you shall have the right to exercise the SAR in whole or in part and to receive payment with respect to each SAR Unit in the form of shares of the common stock of the Company with a Fair Market Value equal to the difference between (i) the lesser of the Fair Market Value per share of the common stock of the Company on the date of exercise or $_______,(1) less (ii) the Exercise Base Price per share of the common stock of the Company ("Distributable Amount"). Notwithstanding the foregoing, no fractional share shall be distributed in settlement of the SAR, and any exercised portion of the SAR which would be settled in a fractional share shall be rounded down to a whole share with no additional payment to be made in cash except as otherwise permitted by the Internal Revenue Service under an exemption from the application of Section 409A of the Internal Revenue Code. 2. Exercise Base Price. The Exercise Base Price per share of common stock shall not be less than the Fair Market Value of the common stock of the Company on the Date of Grant. 3. Vesting. The SAR shall be fully vested and exercisable on the Date of Grant. 4. Exercise Period. The SAR may be exercised by you for the period of your employment with the Company or its subsidiary and three (3) months after the termination of your employment with the Company (but in no event later than the Expiration Date), provided, that your employment is not terminated for "Cause." The SAR shall terminate immediately upon the termination of your employment for "Cause" (as defined in the Stock Appreciation Right Agreement a copy of which is - -------- (1) Dollar figure to be set equal to two times the Exercise Base Price. 1 attached hereto), as determined by the Board of Directors of the Company with or without notice to you. Upon the termination of your employment with the Company or its subsidiary due to your Disability (as defined in the Stock Appreciation Right Agreement a copy of which is attached hereto) or death, this SAR may be exercised by you or your probate estate (if applicable) for the period of twelve (12) months after your termination of employment with the Company with the Company. By your signature and the signature of the Company's representative below, you and the Company agree that this SAR is granted under and governed by the terms and conditions of the Plan, this Notice of Stock Appreciation Right Grant, and the attached Stock Appreciation Right Agreement, copies of all of which are attached and made a part of this instrument. GRANTEE HEADWATERS INCORPORATED - --------------------------------- ------------------------------------ Signature Signature - --------------------------------- ------------------------------------ Name Printed Name ------------------------------------ Title 2 EXHIBIT A HEADWATERS INCORPORATED [_________ ] STOCK INCENTIVE PLAN PLAN DOCUMENT 3 EXHIBIT B HEADWATERS INCORPORATED [_______] STOCK INCENTIVE PLAN STOCK APPRECIATION RIGHT AGREEMENT 1. Grant of SAR. The Board of Directors of Headwaters Incorporated, a Delaware corporation (the "Company"), hereby grants to the individual ("you") named in the Notice of Stock Appreciation Right Grant (the "Notice of Grant") to which this Stock Appreciation Right Agreement (this "Agreement") is attached, a Stock Appreciation Right (the "SAR"), subject to the terms, definitions and provisions of the Headwaters Incorporated [________] Incentive Plan (the "Plan") adopted by the Company, which is incorporated herein by reference, and pursuant to this Agreement. Unless otherwise defined herein, the terms defined in the Plan or Notice of Grant shall have the same defined meanings in this Agreement. In the event of a conflict between the terms of the Plan and this Agreement, the Plan shall prevail. 2. Value of the SAR. The SAR shall entitle you, upon exercise of the SAR, to receive from the Company the Distributable Amount in shares of Common Stock of the Company, as determined by the Administrator in its sole discretion. 3. Nonassignability of SARs. The SAR is not assignable or transferable by you except by will or by the laws of descent and distribution and as otherwise consistent with the terms of the Plan and this Agreement. During the your lifetime, only you shall be entitled to exercise the SAR. 4. Exercise of SAR. (a) Exercise Period. The SAR may be exercised only within the term set forth in the Notice of Grant and may be exercised during such term only in accordance with the terms of the Plan and this Agreement. (b) Definitions. Solely for purposes of the SAR, the following terms shall have the meanings given them below. (i) Cause. The term "Cause" shall mean any one of the following: (1) the commission by you of a felony or a misdemeanor involving moral turpitude, (2) any intentional act of fraud, embezzlement or misappropriation of property of the Company by you which has a materially adverse impact on the business or affairs of the Company, 4 (3) any intentional unauthorized use or disclosure by you of confidential information or trade secrets of the Company (or any affiliated corporation or entity of the Company ("Affiliate")), (4) any other intentional misconduct by you which has a materially adverse impact on the business or affairs of the Company (or any Affiliate), or (5) the failure or refusal by you to perform the duties of your position with the Company, provided that solely for the purpose of this item (5), you shall be given thirty (30) days written notice (and the opportunity to correct such conduct if such conduct can be corrected during that notice period) of the Company's intention to terminate the employment of Executive and to deem the termination of your employment to be for the foregoing reason. (ii) Disability. The term "Disability" shall mean your inability to perform your duties due to a disability (as defined and determined under the terms of the Company's long-term disability plan). 5. Method of Exercise. The SAR shall be exercisable by written notice (in the form attached as Exhibit C to the Notice of Grant) which shall state the election to exercise the SAR and the number of shares of common stock of the Company as to which the SAR is to be exercised. Such written notice shall be signed by you and shall be delivered in person or by certified mail to the Company. The SAR shall be deemed to be exercised upon receipt by the Company of such written notice. 6. Form of Payment. The Company shall satisfy its obligation upon exercise of the SAR in shares of the common stock of the Company, as determined by the Administrator in its sole discretion. 7. Termination of Status as an Employee. In the event you cease to serve as an Employee of the Company or a subsidiary of the Company for any reason, except due to death or Disability, you may exercise the SAR during the Termination Period set out in the Notice of Grant, but only to the extent it was exercisable at the date of such termination (but in no event later than the "Expiration Date" of the SAR as set forth in the Notice of Grant). To the extent that you were not entitled to exercise this SAR at the date of such termination, and to the extent that you do not exercise this SAR (to the extent otherwise so entitled) within the time specified herein, this SAR shall terminate. 8. Tax Consequences. By accepting the SAR, you acknowledge that (i) you understand that upon either the grant or the exercise of the SAR, you may recognize adverse tax consequences, and (ii) you understand that the Company will be required to withhold any income and employment taxes required by any governmental authority. You are encouraged to consult with a tax advisor concerning the tax consequences of exercising this SAR. You agrees that the SAR shall be administered and settled as required for the SAR to be deemed not to be deferred compensation subject to the provisions of Section 409A of the Internal Revenue Code of 1986, as amended, as provided in Internal Revenue Service Notice 2005-1. 5 9. Other Acknowledgements and Agreements. The parties acknowledge the following: (a) Nothing in this Agreement, nor in the Plan, the terms of which are incorporated herein by this reference, shall confer upon you any right to continuation of employment by the Company or its affiliates, nor shall this Agreement interfere in any way with your right or the Company's right to terminate your employment at any time. (b) Nothing in this Agreement, the Notice of Grant or the Plan, nor in the grant of a SAR, shall confer upon you any rights as a stockholder of the Company. (c) You have received a copy of the Plan and certain information related thereto and represents that you are familiar with the terms and provisions thereof, and hereby accept this Agreement subject to all of the terms and provisions of the Plan. You have reviewed the Plan and this SAR Agreement in their entirety, have had an opportunity to obtain the advice of independent counsel prior to executing this Agreement and fully understands all provisions relating to this Agreement. You hereby agree to accept as binding, conclusive and final all decisions or interpretations of the Administrator upon any questions arising under the Plan or this Agreement. 10. Compliance with Applicable Laws, Regulations and Rules and the Company's Policies. In accepting the SAR, you agree to comply with all applicable laws, regulations and rules of governing state and federal governmental agencies as well as the applicable regulations and rules of any stock exchange on which the securities of the Company are traded, and any policies as now or hereafter established by the Company (including but not limited to any insider trading policies of the Company), with regard to the SAR and the shares of the common stock of the Company received upon an exercise of the SAR. You acknowledge and agree that you may be required to disgorge any and gains and payments under the SAR to the extent required by applicable laws, stock exchange regulations and rules, and the policies of the Company. 11. Governing Law. The interpretation and administration of the SAR (including the Notice of the Stock Appreciation Right Grant, the Stock Appreciation Right Agreement and Stock Appreciation Right Exercise Notice) shall be governed by the laws of the state of Delaware other than the choice of law principles of that state. 6 EXHIBIT C HEADWATERS INCORPORATED [_______] INCENTIVE PLAN STOCK APPRECIATION RIGHT EXERCISE NOTICE Headwaters Incorporated 10653 S River Front Parkway, Suite 300 South Jordan, UT 84095 Attention: Corporate Secretary 1. Exercise of SAR. Effective as of today, _______________, _____, the undersigned ("Grantee") hereby elects to exercise a stock appreciation right with respect to _________ shares of the Common Stock (the "Shares") of Headwaters Incorporated ("Company") pursuant to the Notice of Stock Appreciation Right Grant ("Notice of Grant"), stock appreciation right agreement ("SAR Agreement") by and between Grantee and the Company, dated _______________and pursuant to the Headwaters Incorporated [______] Incentive Plan (the "Plan"). 2. Representations of Employee. Grantee acknowledges that Grantee has received, read and understood the Plan, the SAR Agreement, and the Notice of Grant and agrees to abide by and be bound by their terms and conditions. 3. Tax Treatment of SAR. Grantee understands that Grantee may suffer adverse tax consequences as a result of Grantee's exercise of rights under the SAR and this Notice. Grantee represents that Grantee has consulted with his or her own independent tax advisor in connection with exercising rights under this SAR and that Grantee is not relying on the Company for any tax advice. 4. Entire Agreement. The terms of the Plan, Notice of Grant and the SAR Agreement are incorporated herein by reference and constitute the entire agreement of the parties and supersede in their entirety all prior undertakings and agreements of the Company and Grantee with respect to the subject matter hereof, and are governed by Utah law except for that body of law pertaining to conflict of laws. Submitted By: Accepted By: GRANTEE HEADWATERS INCORPORATED - --------------------------------- ------------------------------------ Signature Signature - --------------------------------- ------------------------------------ Name Printed Name ------------------------------------ Title 7 EX-99.15 12 ex9915q033105.txt NOTICE OF STOCK APPRECIATION RIGHT GRANT Exhibit 99.15 HEADWATERS INCORPORATED [______] STOCK INCENTIVE PLAN NOTICE OF STOCK APPRECIATION RIGHT GRANT [Employee's Name and Address] - --------------------------- - --------------------------- - --------------------------- Headwaters Incorporated (the "Company") has granted to you a Stock Appreciation Right ("SAR") based on the Fair Market Value of the common stock of the Company under the Headwaters Incorporated [____] Stock Incentive Plan (the "Plan") as follows. Each of the capitalized terms herein shall have the meaning given it by the Plan except if the context of such term herein clearly assumes a different meaning. - --------------------------------------------------------- Date of Grant - --------------------------------------------------------- Total Number of Shares Covered By this SAR (Number of SAR Units) - --------------------------------------------------------- Exercise Base Price Per Share of Common Stock - --------------------------------------------------------- Service Vesting Commencement Date - --------------------------------------------------------- Expiration Date 1. Exercise of the SAR. Subject to the provisions of the Plan, you shall have the right to exercise the SAR in whole or in part and to receive payment with respect to each SAR Unit in the form of shares of the common stock of the Company with a Fair Market Value equal to the difference between (i) the lesser of the Fair Market Value per share of the common stock of the Company on the date of exercise or $_______,(1) less (ii) the Exercise Base Price per share of the common stock of the Company ("Distributable Amount"). Notwithstanding the foregoing, no fractional share shall be distributed in settlement of the SAR, and any portion of the SAR which would be settled in a fractional share shall be rounded down to a whole share with no additional payment to be made in cash except as otherwise permitted by the Internal Revenue Service under an exemption from the application of Section 409A of the Internal Revenue Code. 2. Exercise Base Price. The Exercise Base Price per share of common stock shall not be less than the Fair Market Value of the common stock of the Company on the Date of Grant. 3. Vesting. The SAR shall become vested based on the following service vesting schedule beginning on the Service Vesting Commencement Date: Year of Service Vested Percentage of the SAR --------------- ---------------------------- [To be determined.] ------------------- - -------- 1 Dollar figure to be set equal to two times the Exercise Base Price. 1 4. Exercise Period. (a) Commencement of Exercise Period. The SAR shall become first exercisable subject to the following terms and conditions. [To be determined.] (b) Term of Exercise Period. The vested and exercisable portion of the SAR may be exercised by you for the period of your employment with the Company or its subsidiary and three (3) months after the termination of your employment with the Company (but in no event later than the Expiration Date), provided, that your employment is not terminated for "Cause." The SAR shall terminate immediately upon the termination of your employment for "Cause" (as defined in the Stock Appreciation Right Agreement a copy of which is attached hereto), as determined by the Board of Directors of the Company with or without notice to you. Upon the termination of your employment with the Company or its subsidiary due to your Disability (as defined in the Stock Appreciation Right Agreement a copy of which is attached hereto) or death, this SAR may be exercised by you or your probate estate (if applicable) for the period of twelve (12) months after your termination of employment with the Company with the Company. By your signature and the signature of the Company's representative below, you and the Company agree that this SAR is granted under and governed by the terms and conditions of the Plan, this Notice of Stock Appreciation Right Grant, and the attached Stock Appreciation Right Agreement, copies of all of which are attached and made a part of this instrument. GRANTEE HEADWATERS INCORPORATED - -------------------------------- ------------------------------------ Signature Signature - -------------------------------- ------------------------------------ Name Printed Name ------------------------------------ Title 2 EXHIBIT A HEADWATERS INCORPORATED [_________ ] STOCK INCENTIVE PLAN PLAN DOCUMENT 3 EXHIBIT B HEADWATERS INCORPORATED [_______] STOCK INCENTIVE PLAN STOCK APPRECIATION RIGHT AGREEMENT 1. Grant of SAR. The Board of Directors of Headwaters Incorporated, a Delaware corporation (the "Company"), hereby grants to the individual ("you") named in the Notice of Stock Appreciation Right Grant (the "Notice of Grant") to which this Stock Appreciation Right Agreement (this "Agreement") is attached, a Stock Appreciation Right (the "SAR"), subject to the terms, definitions and provisions of the Headwaters Incorporated [________] Incentive Plan (the "Plan") adopted by the Company, which is incorporated herein by reference, and pursuant to this Agreement. Unless otherwise defined herein, the terms defined in the Plan or Notice of Grant shall have the same defined meanings in this Agreement. In the event of a conflict between the terms of the Plan and this Agreement, the Plan shall prevail. 2. Value of the SAR. The SAR shall entitle you, upon exercise of the SAR, to receive from the Company the Distributable Amount in shares of Common Stock of the Company, as determined by the Administrator in its sole discretion. 3. Nonassignability of SARs. The SAR is not assignable or transferable by you except by will or by the laws of descent and distribution and as otherwise consistent with the terms of the Plan and this Agreement. During the your lifetime, only you shall be entitled to exercise the SAR. 4. Exercise of SAR. (a) Exercise Period. The SAR may be exercised only within the term set forth in the Notice of Grant and may be exercised during such term only in accordance with the terms of the Plan and this Agreement. (b) Definitions. Solely for purposes of the SAR, the following terms shall have the meanings given them below. (i) Cause. The term "Cause" shall mean any one of the following: (1) the commission by you of a felony or a misdemeanor involving moral turpitude, (2) any intentional act of fraud, embezzlement or misappropriation of property of the Company by you which has a materially adverse impact on the business or affairs of the Company, 4 (3) any intentional unauthorized use or disclosure by you of confidential information or trade secrets of the Company (or any affiliated corporation or entity of the Company ("Affiliate")), (4) any other intentional misconduct by you which has a materially adverse impact on the business or affairs of the Company (or any Affiliate), or (5) the failure or refusal by you to perform the duties of your position with the Company, provided that solely for the purpose of this item (5), you shall be given thirty (30) days written notice (and the opportunity to correct such conduct if such conduct can be corrected during that notice period) of the Company's intention to terminate the employment of Executive and to deem the termination of your employment to be for the foregoing reason. (ii) Disability. The term "Disability" shall mean your inability to perform your duties due to a disability (as defined and determined under the terms of the Company's long-term disability plan). 5. Method of Exercise. The SAR shall be exercisable by written notice (in the form attached as Exhibit C to the Notice of Grant) which shall state the election to exercise the SAR and the number of shares of common stock of the Company as to which the SAR is to be exercised. Such written notice shall be signed by you and shall be delivered in person or by certified mail to the Company. The SAR shall be deemed to be exercised upon receipt by the Company of such written notice. 6. Form of Payment. The Company shall satisfy its obligation upon exercise of the SAR in shares of the common stock of the Company, as determined by the Administrator in its sole discretion. 7. Termination of Status as an Employee. In the event you cease to serve as an Employee of the Company or a subsidiary of the Company for any reason, except due to death or Disability, you may exercise the SAR during the Termination Period set out in the Notice of Grant, but only to the extent it was exercisable at the date of such termination (but in no event later than the "Expiration Date" of the SAR as set forth in the Notice of Grant). To the extent that you were not entitled to exercise this SAR at the date of such termination, and to the extent that you do not exercise this SAR (to the extent otherwise so entitled) within the time specified herein, this SAR shall terminate. 8. Tax Consequences. By accepting the SAR, you acknowledge that (i) you understand that upon either the grant or the exercise of the SAR, you may recognize adverse tax consequences, and (ii) you understand that the Company will be required to withhold any income and employment taxes required by any governmental authority. You are encouraged to consult with a tax advisor concerning the tax consequences of exercising this SAR. You agrees that the SAR shall be administered and settled as required for the SAR to be deemed not to be deferred compensation subject to the provisions of Section 409A of the Internal Revenue Code of 1986, as amended, as provided in Internal Revenue Service Notice 2005-1. 5 9. Other Acknowledgements and Agreements. The parties acknowledge the following: (a) Nothing in this Agreement, nor in the Plan, the terms of which are incorporated herein by this reference, shall confer upon you any right to continuation of employment by the Company or its affiliates, nor shall this Agreement interfere in any way with your right or the Company's right to terminate your employment at any time. (b) Nothing in this Agreement, the Notice of Grant or the Plan, nor in the grant of a SAR, shall confer upon you any rights as a stockholder of the Company. (c) You have received a copy of the Plan and certain information related thereto and represents that you are familiar with the terms and provisions thereof, and hereby accept this Agreement subject to all of the terms and provisions of the Plan. You have reviewed the Plan and this SAR Agreement in their entirety, have had an opportunity to obtain the advice of independent counsel prior to executing this Agreement and fully understands all provisions relating to this Agreement. You hereby agree to accept as binding, conclusive and final all decisions or interpretations of the Administrator upon any questions arising under the Plan or this Agreement. 10. Compliance with Applicable Laws, Regulations and Rules and the Company's Policies. In accepting the SAR, you agree to comply with all applicable laws, regulations and rules of governing state and federal governmental agencies as well as the applicable regulations and rules of any stock exchange on which the securities of the Company are traded, and any policies as now or hereafter established by the Company (including but not limited to any insider trading policies of the Company), with regard to the SAR and the shares of the common stock of the Company received upon an exercise of the SAR. You acknowledge and agree that you may be required to disgorge any and gains and payments under the SAR to the extent required by applicable laws, stock exchange regulations and rules, and the policies of the Company. 11. Governing Law. The interpretation and administration of the SAR (including the Notice of the Stock Appreciation Right Grant, the Stock Appreciation Right Agreement and Stock Appreciation Right Exercise Notice) shall be governed by the laws of the state of Delaware other than the choice of law principles of that state. 6 EXHIBIT C HEADWATERS INCORPORATED [_______] INCENTIVE PLAN STOCK APPRECIATION RIGHT EXERCISE NOTICE Headwaters Incorporated 10653 S River Front Parkway, Suite 300 South Jordan, UT 84095 Attention: Corporate Secretary 1. Exercise of SAR. Effective as of today, _______________, _____, the undersigned ("Grantee") hereby elects to exercise a stock appreciation right with respect to _________ shares of the Common Stock (the "Shares") of Headwaters Incorporated ("Company") pursuant to the Notice of Stock Appreciation Right Grant ("Notice of Grant"), stock appreciation right agreement ("SAR Agreement") by and between Grantee and the Company, dated _______________and pursuant to the Headwaters Incorporated [______] Incentive Plan (the "Plan"). 2. Representations of Employee. Grantee acknowledges that Grantee has received, read and understood the Plan, the SAR Agreement, and the Notice of Grant and agrees to abide by and be bound by their terms and conditions. 3. Tax Treatment of SAR. Grantee understands that Grantee may suffer adverse tax consequences as a result of Grantee's exercise of rights under the SAR and this Notice. Grantee represents that Grantee has consulted with his or her own independent tax advisor in connection with exercising rights under this SAR and that Grantee is not relying on the Company for any tax advice. 4. Entire Agreement. The terms of the Plan, Notice of Grant and the SAR Agreement are incorporated herein by reference and constitute the entire agreement of the parties and supersede in their entirety all prior undertakings and agreements of the Company and Grantee with respect to the subject matter hereof, and are governed by Utah law except for that body of law pertaining to conflict of laws. Submitted By: Accepted By: GRANTEE HEADWATERS INCORPORATED - --------------------------------- ------------------------------------ Signature Signature - --------------------------------- ------------------------------------ Name Printed Name ------------------------------------ Title 7 -----END PRIVACY-ENHANCED MESSAGE-----