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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended September 30, 2002,
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission file number 0-27808
HEADWATERS INCORPORATED
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(Exact name of registrant as specified in its charter)
Delaware 87-0547337
- ------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
11778 South Election Road, Suite 210
Draper, Utah 84020
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(Address of principal executive offices) (Zip Code)
(801) 984-9400
--------------------------------------------------
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
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None
Securities registered pursuant to Section 12(g) of the Act:
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Common Stock, $.001 par value
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes [X] No [ ]
The aggregate market value of the voting stock held by non-affiliates
of the registrant as of March 31, 2002 was $358,682,169 based upon the closing
price on the Nasdaq National Market reported for such date. This calculation
does not reflect a determination that persons whose shares are excluded from the
computation are affiliates for any other purpose.
The number of shares outstanding of the registrant's common stock as of
November 30, 2002 was 27,377,539.
___________________________
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the following document are incorporated herein by
reference: Portions of the registrant's definitive proxy statement to be issued
in connection with registrant's annual stockholders' meeting to be held in 2003.
TABLE OF CONTENTS
Page
PART I
ITEM 1. BUSINESS...........................................................3
ITEM 2. PROPERTIES.........................................................9
ITEM 3. LEGAL PROCEEDINGS.................................................10
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............11
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS.............................................11
ITEM 6. SELECTED FINANCIAL DATA...........................................13
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.......................................14
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........33
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.......................34
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE.............................34
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................35
ITEM 11. EXECUTIVE COMPENSATION............................................35
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT....35
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................35
PART IV
ITEM 14. CONTROLS AND PROCEDURES...........................................35
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
ON FORM 8-K.....................................................36
SIGNATURES.................................................................[TBA]
Forward-looking Statements
Statements in this Form 10-K, including those concerning the Registrant's
expectations regarding its business, and certain of the information presented in
this report, constitute forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. As such, actual results may
vary materially from such expectations. For a discussion of the factors that
could cause actual results to differ from expectations, please see the captions
entitled "Forward-looking Statements" and "Risk Factors Affecting Future Results
of Operations" in Item 7 hereof. There can be no assurance that the Registrant's
results of operations will not be adversely affected by such factors. Registrant
undertakes no obligation to revise or publicly release the results of any
revision to these forward-looking statements. Readers are cautioned not to place
undue reliance on these forward-looking statements, which reflect management's
opinion only as of the date hereof.
Availability of SEC Filings
Headwaters makes available, free of charge, through its website (www.hdwtrs.com)
its Forms 10-K, 10-Q and 8-K, as well as its registration statements, as soon as
reasonably practicable after those reports are electronically filed with the
SEC.
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PART I
ITEM 1. BUSINESS
General Development of Business
Introduction. Headwaters Incorporated is a world leader in developing
and deploying energy related technologies to the marketplace. Headwaters is
focused on converting fossil fuels such as gas, coal and heavy oils into
alternative energy products. As part of its long-term growth strategy,
Headwaters acquired Hydrocarbon Technologies, Inc. ("HTI") on August 28, 2001
and Industrial Services Group, Inc. ("ISG") on September 19, 2002 and these
entities are now wholly-owned subsidiaries of Headwaters. ISG, through its own
wholly-owned operating subsidiary, ISG Resources, Inc., is the nation's largest
manager and marketer of coal combustion products. With the ISG acquisition,
Headwaters is in a unique position to provide a full range of value-added
services to the coal-fired electric generating industry, as well as capitalize
on opportunities to develop related energy technologies.
Headwaters' Company History. Headwaters was incorporated in Delaware in
1995 under the name Covol Technologies, Inc. In September 2000, Covol's name was
changed to Headwaters Incorporated. Headwaters' stock trades under the Nasdaq
symbol HDWR.
Unless the context otherwise requires, "ISG" refers to Industrial
Services Group, Inc. and its operating subsidiary ISG Resources, Inc., together
with their consolidated subsidiaries. References to "Headwaters," "combined
company," "company," "we," "our," and "us," refer to Headwaters Incorporated and
its division Covol Fuels, together with its consolidated subsidiaries ISG and
HTI.
Headwaters operates its business through two wholly-owned subsidiaries
and one division: ISG focuses on utilizing, marketing, and disposing of large
volumes of coal combustion products. HTI develops and markets innovative energy
and catalyst technologies. Covol Fuels licenses technology and sells chemical
reagents to produce solid alternative fuel.
ISG
ISG's Company History. ISG was incorporated in Delaware in 1997.
Beginning in October 1997, ISG acquired through a series of transactions a
number of companies to form a national coal combustion products business. ISG
Resources, Inc., which was incorporated in Utah in August 1998, and its
subsidiaries, operate this business.
Principal Products and their Markets by Division. ISG's coal combustion
products ("CCPs") division is a supplier of post-combustion services and
technologies to the coal-fired electric utility industry. ISG manages
approximately 20 million tons annually of CCPs for a majority of the nation's
largest coal-fired utilities, as well as for other industrial clients. ISG
markets CCPs (primarily fly ash and bottom ash) to replace manufactured or mined
materials, such as Portland cement, lime, agricultural gypsum, fired lightweight
aggregate, granite aggregate and limestone. Based upon available information,
ISG believes it is the largest manager and marketer of CCPs in North America.
Fly ash is a pozzolan that, in the presence of water, will combine with
an activator (lime, Portland cement or kiln dust) to produce a cement-like
material. This characteristic makes fly ash a cost-competitive substitute for
other more expensive cementitious building materials. Concrete manufacturers can
typically use fly ash as a substitute for 15% - 30% of their cement
requirements, depending on the quality of the fly ash and the end-use of the
concrete. In addition to its cost-benefit, fly ash provides greater structural
strength and durability in applications such as road and dam construction.
Bottom ash is utilized as an aggregate in concrete block construction and for
road base construction.
ISG's manufactured products division manages the production and sale of
masonry mortars, block and stucco materials, as well as some of ISG's
value-added technology products for the construction market. Key geographic
areas of production and sales are Texas, California, Georgia, Florida and
Louisiana. ISG utilizes high volumes of CCPs as ingredients in the mortars,
blocks and stuccos that ISG produces.
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ISG has developed and continues to develop new technologies to promote
the use of CCPs. Projects currently in development and/or use include (i) rapid
setting, high strength concretes for road repairs and other uses; (ii) fiber
reinforced, non-autoclaved aerated concrete panels and block for residential and
commercial construction; (iii) carbon fixation technology which utilizes
chemical additives to increase the marketability of fly ash with high or
unpredictable levels of residual carbon; and (iv) ammonia removal technology to
remove ammonia from fly ash that has been contaminated by pollution control
devices or natural operating conditions.
Sources of Available Raw Materials and Inventory Requirements. Coal is
the largest indigenous fossil fuel resource in the United States, with current
U.S. annual coal production in excess of one billion tons. The use of coal to
generate electricity has nearly tripled in the last 30 years. Today, coal
generates over half of all electricity consumed in the U.S., more than all other
fuel sources combined. The government estimates that electricity generated from
coal will increase 25% by 2020. The combustion of coal results in a high
percentage of residual materials which serve as the "raw material" for the CCP
industry. According to the American Coal Ash Association, more than two-thirds
of CCPs produced in 2000 were disposed of in landfills, providing ample
opportunities for continuing increases in CCP utilization. As long as the
majority of electricity in this country comes from the use of coal-fired
generation, ISG believes it will have an adequate supply of raw materials.
Competitive Business Conditions. Although ISG is the nation's leading
manager and marketer of CCPs, ISG still faces significant competition. Such
competitors include LaFarge North America, Boral, Holcim, Inc. and Mineral
Resource Technologies. Although CCPs have been utilized since the mid-1960's, in
recent years fly ash has seen greater acceptance in the construction industry.
Fly ash is now widely used for its superior strength, durability, alkali
resistance and environmental friendliness. ISG expects to continue to be a
leader in this industry with its nation-wide infrastructure, long-term
contractual relationships with existing utilities, and aggressive growth
strategies.
ISG's manufactured products division faces challenges from its many
larger competitors in the mortar, stucco and construction materials industries.
ISG intends to maintain its competitiveness and expand its operations through
the development of unique proprietary formulas and by implementing aggressive
marketing and distribution strategies.
Electric Utility Deregulation. The process of electric utility
deregulation has slowed substantially compared to predictions from previous
years. The impact that full deregulation of the industry will have on ISG is
something that cannot be accurately projected. The major area of impact concerns
the individual sources of CCPs that ISG manages and markets. Deregulation could
result in some sources being put out of service because they are not
economically competitive. Alternatively, deregulation efforts have spurred
renewed interest in the construction of new coal-fired electric generating
facilities. ISG believes that no significant changes to the availability of CCPs
will occur. However, since this change to the industry continues to evolve, ISG
could be materially adversely affected if major changes occur.
Covol Fuels
Principal Products. Covol Fuels develops and applies proprietary
technologies used to produce coal-based solid alternative fuel. As an operating
division of Headwaters, Covol Fuels has developed, patented and commercialized a
chemical technology that converts carbon-based feedstock, such as coal, to a
qualified solid alternative fuel that is eligible for federal tax credits under
Section 29 of the Internal Revenue Code. Covol Fuels licenses this technology to
owners of solid alternative fuel facilities for which it receives royalty
revenues. The owners of the solid alternative fuel facilities are eligible to
receive federal tax credits based on the amount of qualified solid alternative
fuel produced using Covol Fuels' technology. Covol Fuels has pioneered work with
the IRS relating to Section 29 credits and obtained one of the first Private
Letter Rulings from the IRS for a coal-based synthetic fuel process. Covol
Fuels' in-house personnel work closely with customers to achieve compliance with
IRS guidelines and to improve alternative fuel production. In addition to
royalty revenues, Covol Fuels also sells its proprietary chemical reagents
essential to the production of solid alternative fuels both to its licensee
plants and to other customers' plants.
In fiscal 2002, prior to its acquisition of ISG, Headwaters generated
over 90% of its revenues through license fees from its technology and sale of
chemical reagents to owners of solid alternative fuel facilities whose
facilities were placed into service prior to July 1, 1998, qualifying them for
Section 29 tax credits. Covol Fuels currently has technology licensing
agreements with 28 alternative fuel facilities. Under the terms of the
contracts,
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Covol Fuels is generally paid a quarterly royalty fee based on either facility
production or tax credits generated by the facilities. In certain instances,
Covol Fuels was also paid initial license fees when certain events occurred or
when certain production levels were reached.
Sources of Available Raw Materials and Inventory Requirements. Covol
Fuels' chemical reagents are manufactured by Dow Reichhold Specialty Latex LLC
("Dow") under a long-term, fixed-price supply contract. Covol Fuels relies on
Dow through its several regional distribution centers to supply its licensees
and customers with timely and adequate supplies of chemicals. Separately, the
alternative fuel facility owners have unrelated feedstock agreements that
provide a supply of raw coal for processing at their facilities. These licensees
and customers in turn have production agreements to supply alternative fuel to
end users (usually coal-fired electric generating facilities).
Competitive Business Conditions. Covol Fuels' alternative fuel
technologies compete with other alternative fuel products as well as traditional
fuels. Competitive factors include price, quality, delivery cost, and handling
costs. Covol Fuels may experience competition from other alternative fuel
technology companies and their licensees, particularly those companies with
technologies to produce coal-based solid alternative fuels. Competition may come
in the form of the licensing of the competing technologies to process coal
derivatives, the marketing of competitive chemical reagents, the marketing of
end products qualifying as synthetic fuel, and the development of alternative
fuel projects. Competition includes, for example, Nalco Chemical Company in the
chemical reagent sales business. Headwaters also experiences competition from
traditional coal and fuel suppliers and natural resource producers, in addition
to those companies that specialize in the recycling and upgrading of industrial
waste products. Many of these companies have greater financial, management, and
other resources than Headwaters. Covol Fuels believes that it will be able to
compete effectively, but there can be no assurance that it will be able to do so
successfully.
Major Customers. The following table presents revenues for all
customers that accounted for over 10% of total revenue during 2000, 2001 or
2002. Most of the named customers are energy companies.
(thousands of dollars) 2000 2001 2002
---------------------------------------- ----------------- ---------------- -----------------
TECO Coal Corporation affiliates Less than 10% $16,044 $20,292
DTE Energy Services, Inc. affiliates Less than 10% 5,111 19,660
Marriott International, Inc. affiliates Less than 10% Less than 10% 19,105
AIG Financial Products Corp. affiliates Less than 10% Less than 10% 16,900
PacifiCorp affiliates $15,511 4,978 Less than 10%
Pace Carbon Fuels, L.L.C. affiliates Less than 10% 4,675 Less than 10%
Fluor Corporation affiliate 3,138 Less than 10% Less than 10%
HTI
HTI has developed catalyst and nano-catalyst technologies to convert
coal, gas and heavy/waste oils to liquid fuels. The conversion from low to high
value products also allows HTI to extract troublesome elements such as sulfur,
nitrogen and heavy metals out of the fuel, resulting in ultra clean fuels. The
development of nano-catalyst technology places HTI at the forefront of applying
advanced molecular science to multiple energy and chemical processes. HTI
maintains a staff of engineers, scientists, and technicians at its pilot plant
and laboratory facilities with experience in the design and operation of
high-pressure and temperature process plants. These facilities are used to
further technology development efforts as well as for outside services provided
to other companies and government agencies.
Initially formed in 1943 as Hydrocarbon Research, Inc., HTI and its
predecessor have a long history of developing and commercializing chemical and
energy technologies. One of the core competencies developed by HTI is working at
the molecular level to control how atoms of precious metals catalysts are fixed
on substrate materials. Nanotechnology is one of the most significant
advancements in catalysis technology during the past 20 years, and HTI is
currently positioning to participate within this market through its research
expertise and increasing portfolio of patents.
5
HTI offers technology for producing ultra-clean liquid fuels directly
from coal. In this process, coal molecules are changed into diesel, gasoline and
other fuel molecules, and sulfur, nitrogen, ash and other impurities are
removed, leaving a very high grade liquid fuel.
HTI has developed a patented technology to change complex heavy oil
molecules into lighter molecules. The HTI process is a novel hydrocracking
process using HTI's proprietary slurry catalyst and close-coupled hydrotreating
to produce ultra-clean diesel fuel, jet fuel, gasoline or fuel oil. The
technology can be applied in new or existing hydrocrackers.
Commercialization of slurry-phase Fischer-Tropsch (F-T) technology is a
major objective of both government and industry to provide the nation with
adequate clean diesel fuels from indigenous fossil fuel resources. HTI has
developed a novel skeletal-iron F-T catalyst specifically designed for
slurry-phase reactors. It is stronger than conventional F-T catalysts and
delivers improved economics, making F-T technology more competitive in the
marketplace.
Research and Development
In 2001, research and development expenses consisted of $2,400,000 of
acquired in-process research and development related to the HTI acquisition. The
acquired in-process research and development consisted primarily of efforts
focused on developing catalysts and catalytic processes to lower the cost of
producing alternative fuels and chemicals while improving energy efficiency and
reducing environmental risks. In 2002, research and development expenses of
$2,322,000 consisted primarily of ongoing activities at HTI. In 2003, research
and development expenses are expected to increase as a result of the ISG
acquisition in late 2002.
Headwaters' Business Strategy
Headwaters' competitive strengths include: (i) pre- and post-combustion
coal market leadership; (ii) strong cash flows; (iii) ability to provide
comprehensive services along the coal value chain; (iv) nationwide capabilities
and infrastructure; (v) development of leading energy technologies; (vi) strong
growth profile driven by increasing market acceptance; (vii) responsiveness to
industry demands; and (viii) the ability to provide products and services that
address environmental concerns. Headwaters intends to capitalize on these
strengths in pursuing the following strategic initiatives:
Expand and Enhance Core Businesses. Headwaters intends to expand its
coal-based alternative fuel business by expanding royalty and chemical reagent
revenues by assisting customers to increase production and offering value-added
services, such as technical and plant support, that drive increased production
at facilities using its technology and chemical reagents. Headwaters believes
ISG can increase the market penetration of fly ash and other CCPs in the
concrete and other construction products industries through established and
historically successful customer training programs. In addition, ISG intends to
continue to provide CCP management services to current coal-fired utility
customers and seek new service opportunities with other utilities.
Leverage Complementary Relationships and Capabilities. Covol Fuels and
ISG each maintains long-standing relationships with many of the nation's largest
producers of electricity derived from coal. Most of these relationships are
complementary, which Headwaters believes will provide significant opportunities
to expand and strengthen its position among coal-fired power generation
utilities. By leveraging these complementary relationships Headwaters intends to
increase ISG's penetration with coal-fired power generation companies that are
Covol Fuels' customers and to capitalize on ISG's numerous nationwide
relationships with coal-fired power generation facilities to increase awareness
and acceptance of Covol Fuels' coal-based solid alternative fuel technology.
Develop and License New Energy Technologies. Headwaters intends to
develop technologies that address various needs along the coal value chain, in
particular in the pre-combustion and post-combustion stages, primarily for
licensing, rather than building and owning manufacturing assets. As part of its
pre-combustion strategy, Covol Fuels intends to continue to develop technologies
that improve coal handling, enhance coal combustion characteristics and reduce
air emissions. ISG is developing new technologies such as ammonia removal and
carbon fixation, as well as proprietary chemical surfactant technology that
increases both the quality and usefulness of fly ash from coal combustion. In
addition to developing coal-based technologies, HTI is developing other
technologies
6
that add value to other fossil fuels and chemicals. These efforts focus on
upgrading heavy oil to lighter fuels, changing gas into liquid fuels, turning
otherwise unusable products into fuels and other energy-related
nanotechnologies.
Pursue Complementary and Expansionary Acquisitions. Headwaters intends
to identify and analyze additional acquisition opportunities to strengthen and
fortify its position as a leading value enhancer to fuels. Specifically,
Headwaters will evaluate possible acquisitions of complementary businesses
aligned to the chemical, mineral, or energy industries in which Headwaters does
business. If suitable candidates are not found in these industries, Headwaters
may pursue possible acquisition candidates in other growing industries where
promising financial returns exist.
Intellectual Property
ISG has 14 U.S. patents that expire between 2009 and 2018 and nine U.S.
patent applications pending. ISG has 14 registered trademarks and two pending
trademark applications. While these collective patents and trademarks are
important to ISG's competitive position, no single patent or trademark is
material to ISG.
Covol Fuels has nine U.S. patents that expire between 2011 and 2014.
Covol Fuels has one registered trademark and one pending trademark application.
HTI has 16 U.S. patents that expire between 2011 and 2020 and 17 U.S.
patent applications pending. HTI has two registered trademarks and one pending
trademark application.
There can be no assurance as to the scope of protection afforded by the
patents. In addition, there are other technologies in use and others may
subsequently be developed, which do not, or will not, utilize processes covered
by the patents. There can be no assurance that Headwaters' patents will not be
infringed or challenged by other parties or that Headwaters will not infringe on
patents held by other parties. Because many of these patents represent new
technology, the importance of the patents to Headwaters' business will depend on
its ability to commercialize these technologies successfully, as well as its
ability to protect its technology from infringement or challenge by other
parties.
In addition to patent protection, Headwaters also relies on trade
secrets, know-how, and confidentiality agreements to protect these technologies.
However, such methods may not afford complete protection and there can be no
assurance that others will not independently develop such know-how or obtain
access to Headwaters' know-how, concepts, ideas, and documentation.
Since Headwaters' proprietary information is important to its business,
failure to protect ownership of its proprietary information would likely have a
material adverse effect on Headwaters. Headwaters' current revenues are
dependent upon license fees and chemical sales. Headwaters believes that its
patents, trade secrets, know-how and confidential information are the basis upon
which it obtains and secures licensing agreements.
Effect of Federal, State and Local Laws
Headwaters and its subsidiaries are subject to federal, state, and
local environmental regulations. Headwaters believes that it has obtained all
required permits pertaining to its business and operations, and that it is in
substantial compliance with all applicable laws.
ISG. The Federal Clean Air Act of 1970 ("Clean Air Act"), Amendments to
the Clean Air Act, and corresponding state laws regulating air emissions, affect
the coal industry directly and indirectly. The coal industry may be directly
affected by permitting requirements of the Clean Air Act and/or emissions
control requirements relating to particulate matter (e.g., "fugitive dust"). The
coal industry may also be impacted by future regulation of fine particulate
matter. In July 1997, the United States Environmental Protection Agency ("EPA")
adopted new, more stringent National Ambient Air Quality Standards ("NAAQS") for
particulate matter and ozone. Because electric utilities emit nitrogen oxides,
which are precursors to ozone, ISG's utility customers and suppliers are likely
to be affected when the revisions to the NAAQS are implemented by the states.
State and federal regulations, including the new NAAQS, may reduce the available
quantities of CCPs. The extent of the potential impact of the NAAQS on the coal
industry will depend on the policies and control strategies associated with the
7
state implementation process under the Clean Air Act. Nonetheless, the NAAQS
could have a material adverse effect on ISG's financial condition and
operations.
The Clean Air Act indirectly affects ISG's operations by limiting the
air emissions of sulfur dioxides, nitrous oxides, and other compounds emitted by
coal-fired utility power plants. The affected utilities have been (or may be)
able to meet these requirements by switching to lower sulfur fuels, installing
new more efficient equipment and pollution control devices such as scrubbers,
reducing electricity generating levels, or purchasing or trading "pollution
credits." Specific emission sources will receive these credits, which utilities
and other industrial concerns can trade or sell to allow other units to emit
higher levels of sulfur dioxide.
The Clean Air Act Amendments also require utilities that are currently
major sources of nitrogen oxides in moderate or higher ozone nonattainment
areas, to install reasonably available control technology for nitrogen oxides.
In addition, the EPA currently plans to implement stricter ozone standards
(discussed above) by 2004. EPA promulgated a rule (the "SIP call") in 1998
requiring 22 eastern states to make substantial reductions in nitrogen oxide
emissions. Under this proposal, the EPA expects that states will achieve these
reductions by requiring power plants to make substantial reductions in their
nitrogen oxide emissions. Installation of reasonably available control
technology and additional control measures required under the SIP call will make
it more costly to operate coal-fired utility power plants and could make coal a
less attractive fuel alternative in the planning and building of future utility
power plants. Any reduction in coal-fired power generation could have a material
adverse effect on ISG's financial condition and operations. ISG cannot predict
the effect of these regulations on the coal industry with any certainty. No
assurance can be given that the implementation of the Clean Air Act Amendments
or any future regulatory provisions will not materially adversely affect ISG.
As utilities take steps to meet more stringent emissions control
guidelines, residual carbon in fly ash becomes a growing problem for ISG. ISG
cannot fully utilize this lower quality fly ash in some products and
applications. Therefore, ISG has pursued research and development technologies
to develop a carbon fixation process to treat fly ash that could not otherwise
be used due to its quality. This technology renders some ash products usable for
the first time without having any negative impact on the quality of the finished
concrete product. ISG is successfully working with several utilities utilizing
this technology.
ISG has also filed a provisional patent application for a technology to
control ammonia in fly ash. Ammonia is another emerging challenge in the ash
industry. As utilities implement more stringent air pollution controls, many are
treating boiler exhaust gases with ammonia to remove nitrous oxides. Some of the
unreacted ammonia is deposited on fly ash particles. To address this challenge,
ISG's technology uses a chemical reagent to convert ammonia into harmless
compounds. ISG is currently working with two utilities to implement the
technology.
Covol Fuels. Covol Fuels and the alternative fuel operations of its
licensees are subject to federal, state and local environmental regulations that
impose limitations on the discharge of pollutants and establish standards for
the treatment, storage and disposal of waste materials. In order to establish
and operate alternative fuel plants, Covol Fuels and its licensees have obtained
various state and local permits.
In processing alternative fuel from coal, acid is the only hazardous
material which is used and stored. Despite safeguards, the possibility exists
that regulatory noncompliance or accidental discharges could create an
environmental liability. Therefore, alternative fuel operations owned or
operated by Covol Fuels and its licensees could incur future liabilities arising
from the discharge of pollutants into the environment or from improper waste
disposal practices. In addition, the enactment of more stringent environmental
regulations, or failure to maintain or comply with such regulations, could have
a material adverse effect on Covol Fuels or its licensees.
HTI. HTI and its subsidiaries are also subject to federal, state, and
local environmental regulations. HTI and its subsidiaries use their facilities
in the ordinary course of business to research, develop, process and/or recycle
waste coal, oil and chemicals. As a result, petroleum and other hazardous
materials have been and continue to be present on these properties. HTI and its
subsidiaries hire independent contractors to transport and dispose of hazardous
materials and to send hazardous wastes to federally approved off-site waste
facilities. HTI and its subsidiaries believe that appropriate handling and
training procedures are in effect for all properties and operations. Despite
safeguards, the possibility exists that regulatory noncompliance or accidental
discharges could create an environmental liability. Therefore, operations owned
or operated by HTI and its subsidiaries could incur future
8
liabilities arising from the discharge of pollutants into the environment or
from improper waste disposal practices. In addition, the enactment of more
stringent environmental regulations, or failure to maintain or comply with such
regulations, could have a material adverse effect on HTI and its subsidiaries.
Headwaters is also subject to federal and state safety and health
standards. Therefore, Headwaters is committed to providing effective management
of worker safety and health protection. In addition, Headwaters has developed
safety policies designed to raise and maintain safety awareness by management
and employees. Headwaters has a positive working relationship with MSHA. Failure
by Headwaters and its customers and licensees to comply with safety and health
standards could have a material adverse affect on business operations. For
example, a regulatory inspector could close an alternative fuel facility until
the licensee meets the required standards.
Number of Employees
Headwaters currently employs approximately 840 employees full-time. Of
these employees, approximately 60 are in corporate administration, 50 are
employed by Headwaters' Covol Fuels division, 40 are employed by HTI, 500 are
employed by ISG's CCP division, and 190 are employed by ISG's manufactured
products division. Approximately 20 employees work under collective bargaining
agreements (primarily laborers, equipment operators and truck drivers in Iowa).
ITEM 2. PROPERTIES
Headwaters
Headwaters' principal office is located at 11778 South Election Road,
Suite 210, Draper, Utah 84020, and its telephone number is (801) 984-9400.
Headwaters' web site is www.hdwtrs.com. The information on Headwaters' website
does not constitute a part of this document.
In October 2000, Headwaters leased for a five-year term approximately
7,000 square feet of office space in Draper, Utah, which houses Headwaters'
executive offices. The lease provides for a monthly rent of approximately
$8,000, with certain adjustments for inflation plus expenses.
By February 2003, Headwaters will have consolidated corporate and other
business functions in a new location at 10653 South River Front Parkway, Suite
300, South Jordan, Utah 84095. This new lease for approximately 26,500 square
feet provides for a six-year term. The monthly rent will be approximately
$40,000, with certain adjustments for inflation plus expenses.
ISG
ISG's principal office is located at 136 East South Temple, Suite 1300,
Salt Lake City, Utah 84111, and its telephone number is (801) 236-9700. ISG's
website is www.isgresources.com. The information on ISG's website does not
constitute a part of this document.
ISG currently leases approximately 13,400 square feet on a
month-to-month basis for its executive offices in Salt Lake City, Utah. The
lease provides for a monthly rent of approximately $18,000, with certain
adjustments for inflation plus expenses. It is expected that ISG will terminate
this lease in early 2003. ISG also leases property in three states for regional
offices and laboratory facilities.
In addition, ISG owns or leases approximately 20 parcels in 17 states
for its fly ash storage and distribution operations. ISG also owns or leases
nine properties in three states for its building products manufacturing and
sales operations.
HTI
In 1995, HTI purchased approximately six acres in Lawrenceville, New
Jersey, where its headquarters and research facilities are now located.
9
ITEM 3. LEGAL PROCEEDINGS
Headwaters has some significant ongoing litigation discussed below.
Headwaters intends to vigorously defend and pursue its rights in these actions.
Adtech. In October 1998, Headwaters entered into a technology purchase
agreement with James G. Davidson and Adtech, Inc. The transaction transferred
certain patent and royalty rights to Headwaters related to an alternative fuel
technology invented by Davidson. (This technology is distinct from the
technology developed by Headwaters.) In September 2000, Headwaters received a
summons and complaint from the United States District Court for the Western
District of Tennessee filed by Adtech, Inc. against Davidson and Headwaters. In
the action, certain purported officers and directors of Adtech alleged that the
technology purchase transaction was an unauthorized corporate action and that
Davidson and Headwaters conspired together to effect the transfer. The complaint
asserted related causes of action and sought unspecified money damages and other
relief. In August 2001, the trial court granted Headwaters' motion to dismiss
the complaint. Plaintiffs appealed the case to the Sixth Circuit Court of
Appeals. In June 2002, the Sixth Circuit Court of Appeals issued an order i)
affirming the District Court's judgment and order of dismissal, and ii)
transferring to the Federal Circuit Court of Appeals plaintiff's appeal of the
District Court's order denying the motion for relief from judgment. Because
resolution of the appeal is uncertain, legal counsel cannot express an opinion
as to the ultimate amount, if any, of Headwaters' liability.
Boynton. This action is factually related to the Adtech matter. In the
Adtech case, the alleged claims are asserted by certain purported officers and
directors of Adtech, Inc. In the Boynton action, the allegations arise from the
same facts, but the claims are asserted by certain purported stockholders of
Adtech. In June 2002, Headwaters received a summons and complaint from the
United States District Court for the Western District of Tennessee alleging,
inter alia, fraud, conspiracy, constructive trust, conversion, patent
infringement, and interference with contract arising out of the 1998 technology
purchase agreement entered into between Davidson and Adtech on the one hand, and
Headwaters on the other. The complaint seeks declaratory relief and compensatory
and punitive damages. Because the litigation is at an early stage and resolution
is uncertain, legal counsel cannot express an opinion as to the ultimate amount,
if any, of Headwaters' liability.
AGTC. In March 1996, Headwaters entered into an agreement with AGTC and
its associates for certain services related to the identification and selection
of alternative fuel projects. In March 2002, AGTC filed an arbitration demand
claiming that it is owed a commission under the 1996 agreement for eight percent
of the monetized price of the Port Hodder project. Headwaters asserts that AGTC
did not perform under the agreement and that the agreement was terminated and
the disputes were settled in July 1996. Headwaters has filed an answer in the
arbitration, denying AGTC's claims and has asserted counterclaims against AGTC.
Because the arbitration is at an early stage and resolution is uncertain, legal
counsel cannot express an opinion as to the ultimate amount of recovery or
liability.
AJG. In December 1996, Headwaters entered into a technology license and
proprietary chemical reagent sale agreement with AJG Financial Services, Inc.
The agreement called for AJG to pay royalties and to purchase proprietary
chemical reagent material from Headwaters. In October 2000, Headwaters filed a
complaint in the Fourth District Court for the State of Utah against AJG
alleging that it had failed to make payments and to perform other obligations
under the agreement. Headwaters asserts claims including breach of contract,
declaratory judgment, unjust enrichment, and accounting and seeks money damages
as well as other relief. AJG's answer to the complaint denied Headwaters' claims
and asserted counter-claims based upon allegations of misrepresentation and
breach of contract. AJG seeks unspecified compensatory damages as well as
punitive damages. Headwaters has denied the allegations of AJG's counter-claims.
Because the litigation is at an early stage and resolution is uncertain, legal
counsel cannot express an opinion as to the ultimate amount of recovery or
liability.
Nalco. In October 2000, Headwaters filed a complaint in the United
States District Court for the District of Utah against Nalco Chemical Company
("Nalco"). Headwaters alleges that Nalco, by its sale and marketing of materials
for use in creating alternative fuel, breached a non-disclosure agreement,
misappropriated trade secrets, and violated patent rights of Headwaters.
Headwaters seeks by its complaint injunctive relief and damages to be proven at
trial. Nalco filed an answer denying the allegations in the complaint and
asserting counter-claims alleging patent invalidity, antitrust violations, and
interference with economic relations. Headwaters denies the counter-claims;
however, if Nalco prevails on its counter-claims, the result could have a
material adverse effect on
10
Headwaters' business. Because the litigation is at an early stage and resolution
is uncertain, legal counsel cannot express an opinion as to the ultimate amount,
if any, that might be recovered.
Other. Headwaters and its subsidiaries are also involved in other legal
proceedings that have arisen in the normal course of business. For example,
certain subsidiaries of ISG are involved in legal proceedings involving
allegations of breach of warranty and sales of defective building products
applied by third parties to building exteriors. Generally, ISG denies and
defends such allegations or resolves such matters as appropriate. Management
does not believe that the outcome of these matters will have a significant
adverse effect upon the operations or the financial position of Headwaters;
however, it is possible that a change in management's estimates of probable
liability could occur and the change could be significant.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The shares of Headwaters' common stock trade on the Nasdaq National
Market under the symbol "HDWR." Options on Headwaters' common stock are traded
on the Chicago Board Options Exchange under the symbol "HQK." The following
table sets forth, for the periods presented, the high and low trading prices of
Headwaters' common stock as reported by Nasdaq.
Fiscal 2001 Low High
----------- --- ----
Quarter ended December 31, 2000 $2.13 $ 3.25
Quarter ended March 31, 2001 2.25 6.53
Quarter ended June 30, 2001 6.44 16.00
Quarter ended September 30, 2001 7.11 14.19
Fiscal 2002
-----------
Quarter ended December 31, 2001 $ 9.00 $13.10
Quarter ended March 31, 2002 11.16 15.55
Quarter ended June 30, 2002 11.37 19.15
Quarter ended September 30, 2002 11.87 16.74
As of November 30, 2002, there were approximately 410 stockholders of
record of Headwaters' common stock. Headwaters has not paid dividends on its
common stock to date and does not intend to pay dividends on its common stock in
the foreseeable future. Pursuant to debt agreements Headwaters entered into in
September 2002, Headwaters is prohibited from paying cash dividends so long as
any of the long-term debt is outstanding. Headwaters intends to retain earnings
to finance the development and expansion of its business. Payment of common
stock dividends in the future will depend, among other things, upon Headwaters'
debt covenants, its ability to generate earnings, its need for capital, its
investment opportunities and its overall financial condition.
Recent Sales of Unregistered Securities
The following sets forth all securities issued by Headwaters within the
past three years without registration under the Securities Act of 1933, as
amended. No underwriters were involved in any stock issuances nor were any
commissions paid in connection therewith. However, Headwaters did pay finders
fees in the form of cash, stock or warrants in connection with various
securities issuances.
11
Headwaters believes that the following issuances of securities were
exempt from the registration requirements of the Securities Act of 1933, as
amended, pursuant to the exemption set forth in Section 4(2) thereof. Each
security was issued subject to transfer restrictions. Each certificate for each
security bears a restricted legend. Each investor made representations to
Headwaters that it was accredited as that term is defined in Regulation D and
that the security was acquired for investment purposes. However, Headwaters has
several effective registration statements filed on Form S-3 or Form S-8. These
registration statements have registered many of the securities described in this
section.
During November 1998, Headwaters completed a financing transaction that
consisted of debt and equity including warrants to purchase shares of restricted
common stock at an exercise price of $7.50 per share. The warrants' original
term was set to expire on June 30, 2000. During 2000 the exercise period for the
purchase of approximately 183,000 of these warrant shares was extended for
approximately seven months.
During January 1999, Headwaters completed a financing transaction with
a major shareholder and lender to Headwaters, that consisted of the sale of
1,000 shares of a new series of non-voting, 7% dividend, convertible preferred
stock, designated as Series C. Headwaters received approximately $900,000 in net
proceeds from the issuance of this preferred stock. During January 2000, all of
the remaining shares of Series C preferred stock were converted. Approximately
237,000 shares of common stock were issued on conversion of the preferred stock
and related accrued but unpaid dividends. There are no outstanding shares of
Series C preferred stock.
On March 17, 1999, Headwaters completed a financing transaction with a
large investment fund. The financing consisted of the issuance of $20,000,000
face value of convertible secured debt, issued at a 50% discount, and the
issuance of 60,000 shares of cumulative convertible preferred stock (Series D)
for $6,000,000, for total gross proceeds of $16,000,000. Warrants for the
purchase of common stock were also issued as part of the financing and were
valued at approximately $3,000,000. Net cash proceeds were used to retire
maturing short-term debt and related accrued interest, for working capital and
other general corporate purposes. This transaction is described in detail in the
Form 8-K filed March 24, 1999 and in the Form 10-Q/A for the quarterly period
ended March 31, 1999. Beginning in November 1999 and through March 2000,
Headwaters issued approximately 2,632,000 shares of common stock on conversion
of 24,369 shares of Series D preferred stock. The preferred stock was
convertible at $5.00 or 90% of market, whichever was less. By May 2000,
Headwaters had redeemed all of the investment fund's $20,000,000 face value
convertible debt and incurred early prepayment costs of approximately
$6,037,000. By March 2000, Headwaters had redeemed the investment fund's 35,631
remaining Series D preferred shares for $4,454,000 including a redemption
premium of approximately $1,882,000. There are no outstanding shares of Series D
preferred stock.
In December 1999, Headwaters placed $1,500,000 of financing less a 10%
placement fee with an investor. The debt was convertible at $0.73 per share, the
market price at closing, or market price on the conversion date, whichever was
less. In January 2000, Headwaters redeemed all of this convertible debt for
redemption consideration of approximately $1,900,000 plus 205,435 shares of
common stock. The agreement required the issuance of warrants to purchase
Headwaters shares equal to 40% of the shares issuable under the debt agreement.
Warrants for the purchase of approximately 923,000 shares were issued. The
warrants had a three-year exercise period and an exercise price of $0.88 per
share.
In March 2000, Headwaters completed a private placement financing
transaction by selling to 49 investors approximately 3,629,000 shares of
restricted Headwaters common stock, $0.001 par value, at a price of $1.36 per
share, yielding to Headwaters $4,666,000, net of $270,000 in placement costs.
The investors received registration rights for the stock purchased.
In April 2000, Headwaters completed a private placement financing
transaction by selling to one of its directors and three officers a total of
approximately 379,000 shares of restricted Headwaters common stock, $0.001 par
value, at a price of $1.56 per share and warrants for the purchase of
approximately 133,000 shares of common stock, for net cash proceeds to
Headwaters of approximately $588,000. The warrants are exercisable through March
2005 at a price of $1.56 per share. The investors received registration rights
for the stock purchased and the warrant shares.
In April 2000, an investor acquired from a third party a Headwaters'
14% note due in April 2000 with an approximate $3,000,000 balance and at the
same time also acquired from the third party warrants to purchase
12
100,000 shares of Headwaters' common stock. Headwaters and the investor agreed
to extend for one year the repayment date for $1,000,000 of the principal amount
of the note. Headwaters and the investor further agreed to the satisfaction of
$2,000,000 of the note in exchange for 1,185,818 shares of Headwaters restricted
common stock, $0.001 par value, and warrants to purchase 296,000 shares of
Headwaters' common stock. The warrants were exercised in fiscal 2002 at a price
of $2.10 per share. In July 2000, Headwaters repaid the $1,000,000 note balance
which was accruing interest at 14%. A former director of Headwaters was also a
manager and 2.5% owner of the investor. The director disclaims any beneficial
interest in the investor's securities in Headwaters.
During the fiscal year ended September 30, 2001, pursuant to the
exercise of options, approximately 116,000 shares of Headwaters restricted
common stock were issued.
In August 2001, Headwaters acquired 100% of the common stock of HTI for
total costs at closing of approximately $11,774,000, including the issuance of
approximately 593,000 shares of Headwaters restricted common stock, valued at
$5,485,000. In April 2002, Headwaters and the former HTI stockholders reached a
final settlement of all outstanding contingent payments and Headwaters paid the
former HTI stockholders additional consideration with a value totaling
$3,242,000. This consideration included the issuance of approximately 178,000
shares of Headwaters restricted common stock valued at $2,823,000. Headwaters
filed a registration statement on Form S-3 to register all of the restricted
stock issued to the former HTI stockholders.
In September 2002, Headwaters acquired 100% of the common stock of ISG.
Total consideration at closing was approximately $257,856,000 and included the
issuance of 2,100,000 shares of Headwaters restricted common stock valued at
$32,718,000. Headwaters filed a registration statement on Form S-3 to register
all of the restricted common stock issued to the former ISG stockholders. In
order to obtain the cash necessary to acquire ISG and retire the ISG debt,
Headwaters issued $175,000,000 of new debt consisting of $155,000,000 of senior
secured debt with a five-year term and a variable interest rate and $20,000,000
of subordinated debt with an approximate five-year term and a fixed interest
rate. ISG management participated in one-half, or $10,000,000, of the
subordinated debt. Total cash proceeds from the issuance of new debt, net of
debt discounts, was $169,950,000. Headwaters incurred approximately $6,200,000
of debt issuance costs to place the new debt, which had an initial combined
effective weighted-average interest rate of approximately 9.0%.
During the fiscal year ended September 30, 2002, pursuant to the
exercise of options and warrants, approximately 646,000 shares of Headwaters
restricted common stock were issued. Headwaters has several outstanding
effective registration statements filed on Form S-3 and Form S-8. All but
approximately 6,000 shares of restricted common stock issued during fiscal 2002
have been registered on one or more of these registration statements.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from the consolidated
financial statements of Headwaters. This information should be read in
conjunction with the consolidated financial statements, related notes and other
financial information included herein. As more fully described in Note 14 to the
consolidated financial statements, in 2000 Headwaters recorded approximately
$16.9 million of net gains on sale of facilities and approximately $17.8 million
of asset write-offs and other charges. Headwaters believes these items are not
directly related to its core business and does not expect similar items in the
future. As more fully described in Note 14 to the consolidated financial
statements, in 2000 Headwaters recorded an extraordinary loss on early
extinguishment of debt of $7.9 million. As more fully described in Note 12 to
the consolidated financial statements, in 2000 and 2001, Headwaters recorded
approximately $3.0 million and $7.5 million, respectively, of income tax benefit
primarily related to the reduction of its deferred tax asset valuation
allowance.
Also, as more fully described in Note 3 to the consolidated financial
statements, in August 2001, Headwaters acquired HTI, the financial statements of
which are consolidated with Headwaters' financial statements using a one-month
lag. Accordingly, HTI's August 2001 acquisition date balance sheet was
consolidated with Headwaters' September 30, 2001 balance sheet, but no results
of operations of HTI were included in Headwaters' consolidated results for
fiscal 2001. HTI's August 31, 2002 balance sheet was consolidated with
Headwaters' September 30, 2002 balance sheet and HTI's results of operations for
the year ended August 31, 2002 were consolidated with Headwaters' 2002 results.
As more fully described in Note 3 to the consolidated financial
13
statements, in September 2002, Headwaters acquired ISG. The results of ISG from
September 19, 2002 (date of acquisition) through September 30, 2002 are included
in Headwaters' consolidated results for fiscal 2002, but ISG's results of
operations up to September 18, 2002 have not been included in Headwaters'
consolidated results for any period.
The selected financial data as of and for the years ended September 30,
1998 and 1999 and as of September 30, 2000 are derived from audited financial
statements not included herein. The selected financial data as of September 30,
2001 and 2002 and for the years ended September 30, 2000, 2001, and 2002 were
derived from the audited financial statements of Headwaters included elsewhere
herein.
Year Ended September 30,
-----------------------------------------------------------------
(thousands of dollars, except per-share data) 1998 1999 2000 2001 2002
- ------------------------------------------------- ------------ ------------ ------------ ------------ -------------
OPERATING DATA:
Total revenue $ 2,186 $ 6,719 $27,886 $45,464 $119,345
Net income (loss) (11,308) (28,393) 3,682 21,517 24,286
Diluted net income (loss) per common share (1.17) (2.39) 0.07 0.87 0.94
As of September 30,
-----------------------------------------------------------------
(thousands of dollars) 1998 1999 2000 2001 2002
- ------------------------------------------------- ------------ ------------ ------------ ------------ -------------
BALANCE SHEET DATA:
Working capital (deficit) $ 6,575 $ (2,721) $ 8,393 $ 8,619 $ 15,023
Net property, plant and equipment 15,809 14,182 552 2,680 50,549
Total assets 68,061 58,095 33,441 55,375 372,857
Long-term obligations:
Long-term debt and other liabilities 14,879 18,422 5,235 3,055 154,984
Unamortized portion of non-refundable
license fees 7,455 6,579 7,681 5,805 5,010
Redeemable convertible preferred
stock -- 4,332 -- -- --
Deferred income taxes -- -- -- -- 51,357
Total long-term obligations 23,256 30,255 12,916 8,860 211,351
Total stockholders' equity (deficit) 14,746 (1,028) 10,747 31,086 98,596
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with the information set forth under the caption entitled "ITEM 6. SELECTED
FINANCIAL DATA" and the consolidated financial statements and notes thereto
included elsewhere herein. Headwaters' fiscal year ends on September 30 and
unless otherwise noted, all future references to years shall mean Headwaters'
fiscal year rather than a calendar year.
Acquisitions of ISG and HTI
The consolidated financial statements include the accounts of
Headwaters and all of its subsidiaries, only two of which have significant
operations, ISG and HTI. As more fully described in Note 3 to the consolidated
financial statements, ISG was acquired on September 19, 2002 and HTI was
acquired in August 2001. Accordingly, ISG's results of operations for the period
from September 19, 2002 through September 30, 2002 have been consolidated with
Headwaters' 2002 results and ISG's balance sheet has been consolidated with
Headwaters' balance sheet as of September 30, 2002. Due to the time required to
obtain accurate financial information related to HTI's foreign contracts, for
financial reporting purposes HTI's financial statements are consolidated with
Headwaters' financial statements using a one-month lag. Accordingly, HTI's
August 2001 acquisition date balance sheet was consolidated with Headwaters'
September 30, 2001 balance sheet, but no results of operations of HTI were
included in the consolidated statement of income for 2001. HTI's August 31,
14
2002 balance sheet was consolidated with Headwaters' September 30, 2002 balance
sheet and HTI's results of operations for the year ended August 31, 2002 were
consolidated with Headwaters' 2002 results.
ISG Acquisition. On September 19, 2002, Headwaters acquired 100% of the
common stock of ISG, assumed or paid off all of ISG's outstanding debt and
redeemed all of ISG's outstanding preferred stock. ISG is headquartered in Salt
Lake City, Utah and is engaged primarily in the management of long-term
contracts for coal combustion products and the distribution of related building
materials and construction products throughout the United States, all through
its wholly-owned subsidiary, ISG Resources, Inc. Headwaters has focused on using
technology to add value to fossil fuels, particularly coal. The acquisition of
ISG provides Headwaters with a significant position in the last step of the coal
value chain due to its competencies in managing the products resulting from the
combustion of coal. The acquisition of ISG also brings to Headwaters substantial
management depth, comprehensive corporate infrastructure and critical mass in
revenues and operating profit.
In order to obtain the cash necessary to acquire ISG and retire ISG's
outstanding debt, Headwaters issued $175.0 million of new debt consisting of
$155.0 million of senior secured debt with a five-year term and a variable
interest rate and $20.0 million of subordinated debt with an approximate
five-year term and a fixed interest rate (see Note 8 to the consolidated
financial statements). ISG management participated in one-half, or $10.0
million, of the subordinated debt. Total cash proceeds from the issuance of new
debt, net of debt discounts, was $169.9 million. Headwaters incurred
approximately $6.2 million of debt issuance costs to place the new debt, which
had an initial combined effective weighted-average interest rate of
approximately 9.0%. Total consideration paid for ISG was approximately $257.9
million, which consisted of the issuance of Headwaters' common stock, cash
payments to the former ISG stockholders, cash paid to retire ISG debt, and costs
directly related to the acquisition.
The ISG acquisition was accounted for using the purchase method of
accounting as required by Statement of Financial Accounting Standards ("SFAS")
No.141, "Business Combinations." Assets acquired and liabilities assumed were
recorded at their estimated fair values as of September 19, 2002. Approximately
$109.2 million of the purchase price was allocated to identifiable intangible
assets consisting primarily of contracts with coal-fired power generation
plants. This amount is being amortized over the estimated combined useful life
of 20 years. The remaining purchase price not attributable to the tangible and
identifiable intangible assets (approximating $109.1 million) was allocated to
goodwill. The final allocation of the purchase price, in particular the
estimated fair values for certain acquired property, will likely differ from the
preliminary allocation after final valuations and other procedures have been
completed.
HTI Acquisition. In August 2001, Headwaters completed the acquisition
of 100% of the common stock of HTI, a New Jersey-based company. HTI develops and
commercializes catalysts and catalytic processes for producing chemicals and
converting low-value fossil fuels into high-value alternative fuels. Total
consideration at closing, including the direct costs incurred by Headwaters to
consummate the acquisition, was approximately $11.8 million. In accordance with
the original HTI acquisition agreements, additional contingent consideration
could be earned by the former HTI stockholders during calendar 2002 based on the
attainment of certain operating targets and other milestones. In April 2002,
Headwaters and the former HTI stockholders agreed to an amendment of the
acquisition agreements and reached a final settlement of all outstanding
contingent payments. Headwaters paid the former HTI stockholders additional
consideration with a value totaling approximately $3.2 million. Total
consideration paid for HTI was therefore approximately $15.0 million, which
consisted of the issuance of Headwaters' common stock and options to acquire
Headwaters common stock, cash payments to the former HTI stockholders, cash paid
to retire HTI debt, and costs directly related to the acquisition.
The HTI acquisition was accounted for using the purchase method of
accounting. Assets acquired and liabilities assumed were recorded at their
estimated fair values as of the acquisition date. Approximately $9.7 million of
the purchase price was allocated to identifiable intangible assets consisting of
existing patented technology with an estimated useful life of 15 years.
Approximately $2.4 million of the purchase price was allocated to purchased
in-process research and development, consisting primarily of efforts focused on
developing catalysts and catalytic processes to lower the cost of producing
alternative fuels and chemicals while improving energy efficiency and reducing
environmental risks. This amount represented the estimated purchased in-process
technology for projects that had not reached technological feasibility and had
no alternative use as of the acquisition date, and was expensed in 2001.
Approximately $4.3 million of the purchase price was allocated to goodwill.
Segments. Until Headwaters acquired ISG in September 2002, Headwaters
operated in and reported as a single industry segment, alternative energy. With
the acquisition of ISG in September 2002, Headwaters now operates
15
in three business segments, alternative energy, CCPs, and manufactured products.
These segments are managed and evaluated separately by management based on
fundamental differences in their operations, products and services.
The alternative energy segment includes Headwaters' traditional
coal-based solid alternative fuel business and HTI's business of developing and
commercializing catalysts and catalytic processes for producing chemicals and
converting low-value fossil fuels into high-value alternative fuels. Revenues
for this segment include primarily sales of chemical reagents and license fees.
The CCP segment includes ISG's business of supplying post-combustion
services and technologies to the coal-fired electric utility industry. This
segment markets and manages coal combustion products such as fly ash and bottom
ash, known as CCPs. ISG has long-term contracts, primarily with coal-fired
electric generating utilities, pursuant to which it manages the post-combustion
operations for the utilities. ISG markets these CCPs to replace manufactured or
mined materials, such as portland cement, lime, agricultural gypsum, fired
lightweight aggregate, granite aggregate and limestone. CCP revenues consist
primarily of the sale of products, along with a small percentage of service
revenue.
The manufactured products segment produces and sells standard masonry
and stucco construction materials and supplies, packaged products and blocks, as
well as some of ISG's value-added technology products. ISG has introduced high
volumes of CCPs as ingredients in the mortars, stuccos and blocks that the
manufactured products segment produces.
Critical Accounting Policies and Estimates
Headwaters' significant accounting policies are identified and
described in Note 2 to the consolidated financial statements. The preparation of
financial statements in conformity with accounting principles generally accepted
in the United States requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements, and
the reported amounts of revenue and expenses during the reporting period.
Headwaters continually evaluates its policies and estimation
procedures. Estimates are often based on historical experience and on
assumptions that are believed to be reasonable under the circumstances, but
which could change in the future. Some of Headwaters' accounting policies and
estimation procedures require the use of substantial judgment and actual results
could differ materially from the estimates underlying the amounts reported in
the consolidated financial statements. The following is a discussion of these
critical accounting policies and estimates.
License Fee Revenue Recognition. There are 28 alternative fuel
facilities that are currently licensed to use Headwaters' patented technology
and from which Headwaters earns license fees. These recurring license fees or
royalty payments are recognized in the period when earned, which generally
coincides with the sale of alternative fuel by Headwaters' licensees. In certain
instances, Headwaters receives timely regular written reports from licensees
notifying Headwaters of the amount of solid alternative fuel sold and the
royalty due Headwaters under the terms of the respective license fee agreements.
Moreover, in most instances, Headwaters has experienced a regular pattern of
payment by the licensees of these reported amounts due.
Generally, estimates of license fee revenue earned, where required, can
be reliably made based upon historical experience and / or communications from
licensees for whom an established pattern exists. In some cases, however, such
as when a licensee is beginning to produce and sell alternative fuel or when an
alternative fuel facility is sold by a licensee to another entity, and for which
there is no pattern or knowledge of past or current production and sales
activity, there may be more limited information upon which to determine an
estimate of license fee revenue earned. In these situations, Headwaters uses
such information as is available and where possible, attempts are made to
substantiate the information, such as observing the levels of chemical reagents
purchased by the licensee and used in the production of the solid alternative
fuel. In certain limited situations, Headwaters is unable to reliably estimate
the license fee revenues earned during a period, and therefore revenue
recognition is delayed until a future date when sufficient information is known
from which to make a reasonable estimation.
Realizability of Receivables. Allowances are provided for uncollectible
accounts and notes receivable when deemed necessary. Such allowances are based
on an account-by-account analysis of collectibility or impairment and totaled
approximately $0 at September 30, 2001 and approximately $0.4 million at
September 30, 2002 for trade receivables and $0 at September 30, 2001 and 2002
for notes receivable. Headwaters performs periodic credit evaluations of its
customers, but collateral is not required for trade receivables. Collateral,
generally consisting of most or all assets of the debtor, is required for notes
receivable.
16
With regard to Headwaters' trade receivables from the alternative
energy segment, past allowances have been minimal as have any required
write-offs. Trade receivables from the CCP and manufactured products segments
involve substantially more customers and receivable allowances are required.
Headwaters reviews the collectibility of its trade receivables as of the end of
each reporting period.
Losses recognized on notes receivable were $0 in 2000, approximately
$3.7 million in 2001 and approximately $0.7 million in 2002. Because the notes
generally relate to nonoperating activities, these losses are included in other
expense in the consolidated statements of income. The losses on receivables in
2001 consisted entirely of write-offs or impairments of notes receivable from
unrelated high-risk entities which Headwaters loaned funds to in late fiscal
2000 and early fiscal 2001, which amounts were determined to be uncollectible or
worthless. Headwaters no longer makes these loans, and in September 2001,
Headwaters sold all its remaining loans and equity investments in these entities
to a limited liability corporation, in exchange for a $4,000,000 note
receivable, due no later than September 2004. This note is being accounted for
on the cost recovery basis. Headwaters reviews collectibility of this note
receivable at the end of each reporting period. This collectibility review
consists of consideration of payments of required interest and principal and the
sufficiency of the collateral to support the outstanding note receivable
balance. To the extent impairment is indicated, Headwaters writes down the note
receivable to its estimated net realizable value at that time. An impairment
loss of approximately $1.0 million was recorded in 2002 due to a decline in the
value of the underlying collateral.
Headwaters considers its receivable allowances adequate as of September
30, 2002; however, changes in economic conditions generally or in specific
markets in which Headwaters operates could have a material effect on required
reserve balances.
Valuation of Long-Lived Assets, including Intangible Assets and
Goodwill. Headwaters periodically evaluates the carrying value of long-lived
assets, including intangible assets and goodwill, as well as the related
amortization periods, to determine whether adjustments to these amounts or to
the useful lives are required based on current events and circumstances. Changes
in circumstances such as technological advances, changes to Headwaters' business
model or changes in Headwaters capital strategy could result in the actual
useful lives differing from Headwaters' current estimates. In those cases where
Headwaters determines that the useful life of property, plant and equipment or
intangible assets should be shortened, Headwaters would amortize the net book
value in excess of salvage value over its revised remaining useful life, thereby
increasing depreciation or amortization expense.
The carrying value of a long-lived asset is considered impaired when
the anticipated cumulative undiscounted cash flow from that asset is less than
its carrying value. In that event, a loss is recognized based on the amount by
which the carrying value exceeds the fair market value of the long-lived asset.
Impairment-related losses recognized in Headwaters' consolidated statement of
income for 2000 are more fully described in Note 14 to the consolidated
financial statements. There were no losses recorded in 2001 or 2002. Indicators
of impairment include such things as a significant adverse change in legal
factors or in the general business climate or an expectation that significant
assets will be sold or otherwise disposed of.
Beginning in 2003, Headwaters will perform periodic impairment tests of
its intangible assets, most of which were acquired in connection with the
acquisitions of ISG and HTI, in accordance with the requirements of SFAS No.
142, "Accounting for Goodwill and Intangible Assets." The new rules require,
among other things, that goodwill be tested for impairment at least annually
using a two-step process that begins with an estimation of the fair value of the
reporting unit giving rise to the goodwill. Headwaters currently believes that
neither the ISG- nor HTI-related identifiable intangible assets and goodwill are
impaired under either the existing rules for testing impairment, or under the
new rules required by SFAS No. 142.
Identified intangible assets consist primarily of ISG long-term
contracts and HTI patented technology. It is possible that some of Headwaters'
tangible or intangible long-lived assets or goodwill could be impaired in the
future and that the resulting write-downs could be material.
Legal Matters. Headwaters is involved in several legal proceedings that
have arisen out of the normal course of business, all as explained in more
detail in "ITEM 3. LEGAL PROCEEDINGS" and Note 15 to the consolidated financial
statements. Of the five primary legal matters described in Note 15, Headwaters
is a defendant in three cases, and both a plaintiff and defendant in two cases.
Management in all cases intends to vigorously defend its position. Management
does not currently believe that the outcome of these activities will have a
significant effect upon the operations or the financial position of Headwaters;
however, it is possible that a change in management's estimates of probable
liability could occur and the change could be significant. In regards to all of
these legal matters, legal counsel cannot express an opinion as to the ultimate
amounts of recovery or liability.
17
Year Ended September 30, 2002 Compared to Year Ended September 30, 2001
The information set forth below compares Headwaters' operating results
for fiscal 2002 with its operating results for fiscal 2001.
Revenue. Total revenue for 2002 increased by $73.8 million or 162% to
$119.3 million as compared to $45.5 million for 2001. The major components of
revenue are discussed in the sections below.
Chemical Reagent Sales. Chemical reagent sales during 2002 were $74.4
million with a corresponding direct cost of $50.1 million. Chemical reagent
sales during 2001 were $22.4 million with a corresponding direct cost of $14.5
million. The increase in chemical reagent sales in 2002 over 2001 was due to
increased alternative fuel production by Headwaters' licensees, as well as sales
of chemical reagents to new customers. Currently, Headwaters expects its future
chemical reagent sales revenue from all licensees and other customers to be
higher than the amounts reported for 2002 due to anticipated increases in
alternative fuel production by licensees and increased sales of chemical
reagents to new customers. However, Headwaters does not expect the rate of
growth in 2003 to be as high as it was for 2002.
License Fees. During 2002, Headwaters recognized license fee revenue
totaling $30.5 million, an increase of $9.7 million or 47% over $20.8 million of
license fee revenue recognized during 2001. License fees in 2002 consisted of
recurring license fees or royalty payments of $29.0 million and deferred revenue
amortization of $1.5 million. License fees in 2001 consisted of recurring
license fees of $18.8 million and deferred revenue amortization of $2.0 million.
A major licensee significantly reduced its production and sale of
alternative fuel in early 2001 and did not operate its four facilities for most
of 2001. This licensee sold the facilities in October 2001, and Headwaters
earned approximately $3.7 million more in license fees from these facilities in
2002 than in 2001. This factor, combined with increased alternative fuel sales
by most other licensees, caused the increase in license fee revenue for 2002
over 2001. Headwaters currently expects license fee revenue to increase in 2003
by an amount comparable to the 2002 increase. However, these increases are
expected to decline in the future as this business segment continues to mature
and it is possible that unforeseen adverse events could occur in the future that
would cause license fee revenue to decrease.
Pursuant to the contractual terms of an agreement with a certain
licensee, the cumulative net license fees generated by Headwaters, totaling
approximately $6.0 million as of September 30, 2002, have been placed in escrow
for the benefit of Headwaters. Headwaters currently expects the escrowed amounts
to increase as additional license fees are generated and that most, if not all,
of such amounts will be recognized as revenue at some future date. Certain
accounting rules governing revenue recognition require that the seller's price
to the buyer be "fixed or determinable" as well as reasonably certain of
collection. In this situation, those rules appear to currently preclude revenue
recognition. Accordingly, none of the escrowed amounts have been recognized as
revenue in the consolidated statements of income.
Other Revenues and Cost of Revenues. Coal combustion product sales and
services and manufactured product sales and the related cost of revenue captions
represent ISG's revenues and cost of revenues for the period from September 19,
2002 through September 30, 2002. Approximately $2.9 million of other revenues
and $5.2 million of cost of other revenues represent HTI's revenues and cost of
revenues for 2002. There were no comparable revenues and cost of revenues for
ISG and HTI in 2001.
Depreciation and Amortization. These costs increased by $1.4 million to
$1.8 million in 2002 from $0.4 million in 2001. The increase was primarily
attributable to the depreciation and amortization of the tangible and intangible
assets acquired in the HTI acquisition in August 2001 ($1.0 million) and the
depreciation and amortization of the tangible and intangible assets acquired in
the ISG acquisition in September 2002 ($0.4 million). Depreciation and
amortization expense will increase substantially in 2003 as a result of the ISG
acquisition.
Research and Development. Approximately $2.4 million of the HTI
purchase price was allocated to purchased in-process research and development,
all of which was expensed in 2001. In 2002, research and development expenses of
$2.3 million represent primarily $2.1 million of costs related to HTI
activities.
Selling, General and Administrative Expenses. These expenses increased
$5.1 million or 59% to $13.7 million for 2002 from $8.6 million for 2001. The
increase in 2002 was due primarily to ISG costs of approximately $1.6 million,
an increase in compensation-related costs of approximately $1.2 million, an
increase in professional services expenses of approximately $1.1 million and
smaller increases in most of the other expense categories. The increase in
compensation-related costs related primarily to an increase in incentive-based
pay as a result of
18
improved operating results. The increase in professional services expenses was
due primarily to legal costs associated with legal actions Headwaters is
currently pursuing. The increases in other expense categories were due primarily
to the growth of Headwaters' business during 2002.
Other Income and Expense. During 2002, Headwaters reported net other
expenses of $0.8 million compared to net other expenses of $5.2 million during
2001. The change of $4.4 million or 85% is primarily attributable to i) an
increase in interest and net investment income of $0.3 million, ii) a decrease
in equity and debt investment-related losses of approximately $5.5 million, and
iii) a gain on the sale of assets of approximately $1.3 million; partially
offset by the write-off of deferred project / financing costs of approximately
$2.6 million and an increase in interest expense of approximately $0.3 million.
The increase in interest income from 2001 to 2002 primarily related to
an increase in the average balance of short-term investments in 2002 over 2001,
partially offset by a decrease in interest income from a $6.5 million note
receivable from a licensee which was collected in October 2001.
During 2000, Headwaters made several equity investments in and loans to
unrelated high-risk entities and in 2001, Headwaters recorded losses totaling
approximately $6.3 million related to write-offs of these investments and loans.
In September 2001, Headwaters sold all of its remaining high-risk investments in
exchange for a $4.0 million note receivable from a limited liability
corporation. Headwaters wrote down this note receivable as of September 30, 2002
and recorded an impairment loss of approximately $1.0 million in 2002 due to a
decline in the value of the underlying collateral.
The $1.3 million gain on sale of assets resulted from the sale of a 50%
interest in one of Headwaters' original alternative fuel facilities. Headwaters
recorded approximately $2.6 million of losses related to the write-off of
deferred project / financing costs in 2002 resulting from the abandonment of
certain projects or the postponement or redirection of activities for which
costs had previously been deferred pending the ultimate outcome of the projects
and activities. Interest expense increased in 2002 due to the substantial
increase in outstanding debt incurred in September 2002 to finance the
acquisition of ISG. Interest expense will increase substantially in 2003 as a
result of the debt incurred to facilitate the ISG acquisition.
Income Taxes. In 2001, Headwaters reported a net income tax benefit of
$7,049,000, consisting of the recognition of $7,470,000 of its deferred tax
asset, reduced by $100,000 of federal alternative minimum tax and $321,000 of
current state income tax expense. In 2002, as a result of recording the full
value of its deferred tax asset in 2001, Headwaters recorded an income tax
provision with an effective tax rate of approximately 40%.
Year Ended September 30, 2001 Compared to Year Ended September 30, 2000
The information set forth below compares Headwaters' operating results
for fiscal 2001 with its operating results for fiscal 2000.
Revenue. Total revenue for 2001 increased by $17.6 million or 63% to
$45.5 million as compared to $27.9 million for 2000. The major components of
revenue are discussed in the sections below.
Chemical Reagent Sales. Chemical reagent sales during 2001 were $22.4
million with a corresponding direct cost of $14.5 million. Chemical reagent
sales during 2000 were $9.8 million with a corresponding direct cost of $6.6
million. The increase in chemical reagent sales in 2001 over 2000 was due to
increased alternative fuel production by Headwaters' licensees, as well as sales
of chemical reagents to new customers. There were no similar sales of chemical
reagents to new customers in 2000.
License Fees. During 2001, Headwaters recognized license fee revenue
totaling $20.8 million, an increase of $3.5 million or 20% over $17.3 million of
license fee revenue recognized during 2000. License fees in 2001 consisted of
recurring license fees or royalty payments of $18.8 million and deferred revenue
amortization of $2.0 million. License fees in 2000 consisted of recurring
license fees of $16.5 million and deferred revenue amortization of $0.8 million.
Recurring license fees in 2000 included $11.7 million related to a
single licensee that owned four facilities. This licensee did not report and pay
certain prior period royalty obligations to Headwaters timely, resulting in some
"catch-up" revenue recognition in 2000 for royalties related to periods other
than the year ended September 30, 2000. Moreover, this licensee significantly
reduced its production and sale of alternative fuel in early 2001 and did not
operate the four facilities for most of 2001. These two factors combined
resulted in a decline in recurring license fees from the licensee of
approximately $8.0 million in 2001 as compared to 2000. Due to increased
alternative fuel
19
sales, there was an increase of approximately $10.2 million in recurring license
fees from all other licensees in 2001 over 2000. In 2001, the largest single
licensee accounted for $6.2 million of earned license fees.
Depreciation and Amortization. These costs decreased by $0.8 million to
$0.4 million in 2001 from $1.2 million in 2000. The decrease was primarily
attributable to elimination of depreciation associated with the three facilities
owned by Headwaters which were sold in 2000.
Research and Development. Approximately $2.4 million of the HTI
purchase price was allocated to purchased in-process research and development,
all of which was expensed in 2001.
Selling, General and Administrative Expenses. These expenses increased
$0.6 million or 7% to $8.6 million for 2001 from $8.0 million for 2000. The
increase in 2001 was due primarily to an increase in professional services
expenses of approximately $1.3 million and an increase in compensation-related
costs of approximately $0.5 million. These increases were partially offset by
the elimination of approximately $1.1 million of costs associated with the
facilities owned by Headwaters which were sold in 2000 and the wash plant
located in Utah, as well as the resolution in 2001 of certain liabilities for
$0.2 million less than previously recorded. The increase in professional
services expenses was due primarily to legal costs associated with legal actions
Headwaters is pursuing. The increase in compensation-related costs related
primarily to an increase in marketing department headcount.
Asset Write-offs and Other Charges. In 2000, Headwaters recorded an
impairment charge of approximately $14.8 million related to assets located in
Utah and Alabama. This impairment charge consisted of an approximate $12.6
million write-down to net realizable value of certain ancillary plant equipment
which remained on the sites when the facilities were sold and was idled, plus an
approximate $2.2 million write-off of an intangible asset which was no longer
considered recoverable due to the relocation of a licensee facility. Headwaters
also recorded employee severance and other non-cash charges from incremental
amortization of deferred compensation from stock options (resulting from the
termination of employees whose stock options became fully vested upon
termination) totaling approximately $1.5 million. Other settlement charges ($1.0
million) and asset write-downs ($0.5 million) were recorded in 2000. All of
these asset write-offs and other charges totaled approximately $17.8 million.
There were no similar charges recorded in 2001.
Other Income and Expense. During 2001, Headwaters reported net other
expenses of $5.2 million compared to net other income of $14.3 million during
2000. The change of $19.5 million or 136% is primarily attributable to i) a
decrease in gains on sale of facilities of $16.9 million, ii) a decrease in
interest and investment income of approximately $1.1 million, iii) an increase
in equity and debt investment-related losses of approximately $5.5 million, and
iv) a decrease of $1.1 million from gains on other transactions, related to the
satisfaction of a $0.8 million contingent contract liability and a $0.3 million
gain recognized on a note receivable transaction in 2000. These changes were
partially offset by a decrease of approximately $4.6 million in interest expense
and an increase in the mark-to-market adjustment of the carrying value of a
related party note receivable of approximately $0.5 million.
In 1999, Headwaters sold a facility located in Pennsylvania on which a
loss of approximately $1.8 million was recognized. Headwaters also entered into
an agreement under which it operates this facility on behalf of the owner. In
2000, upon achieving specified operating performance milestones, Headwaters
received additional cash payments related to the sale of this facility. These
payments, net of obligations to third parties, approximated $7.4 million. Of the
net amount received, Headwaters recognized $4.4 million as a gain in 2000
because there were no ongoing obligations associated with those payments.
Headwaters deferred the recognition of $3.0 million, which amount was
characterized in the sales agreement as prepaid royalties. This amount is being
recognized as revenue on a straight-line basis through December 2007.
In 2000, Headwaters sold the three remaining alternative fuel
facilities it owned plus an option to acquire a licensee facility. One of these
sold facilities was located in Utah, two of these facilities were located in
West Virginia, and the facility under option was located in Nevada. Headwaters
reported net gains on these transactions totaling approximately $12.5 million.
Headwaters also entered into its standard supply agreements with the new owners
of the facilities to sell proprietary chemical material used at the facilities
and receives ongoing royalties based upon the sale of alternative fuel from the
facilities.
The decrease in interest income from 2000 to 2001 primarily related to
a decrease in interest from the related party note receivable discussed below
from $0.5 million in 2000 to $0 in 2001 and a decrease in the interest rate on a
$6.5 million note receivable from a licensee. During 2000, Headwaters made
several equity investments in and loans to unrelated high-risk entities and in
2000, Headwaters recognized approximately $0.8 million of losses related to its
equity investments. During 2001, Headwaters recorded additional losses totaling
approximately $6.3
20
million related to write-offs of notes receivable and losses on equity
investments, for an increase of $5.5 million in the 2001 losses compared to
2000.
Interest expense decreased in 2001 primarily due to the significantly
lower average levels of outstanding borrowings that existed in 2001 as compared
to 2000. During 1996, Headwaters sold certain construction companies and
received as consideration a $5.0 million note receivable. The note was "marked
to market" each period based upon the market value of Headwaters' common stock
held as collateral and was reflected in the consolidated balance sheet at the
underlying value of this collateral, $0.5 million at September 30, 2000. In
2001, Headwaters accepted as full satisfaction of the note receivable the shares
of Headwaters' stock collateralizing the note and a new note receivable which
was recorded at $0 due to substantial uncertainty of both the collectibility of
the new note and the value of the new collateral. This transaction resulted in
recognition of a gain in 2001 of approximately $0.6 million, representing the
increase in value of the collateral from September 30, 2000 to the date the
collateral was surrendered in payment of the note. The corresponding adjustment
in 2000 resulted in a write-up of $0.1 million for a net increase in the
adjustment of $0.5 million in 2001 compared to 2000.
Income Taxes. In 2000, Headwaters reported a net income tax benefit of
$2.9 million, consisting of the recognition of $3.0 million of its deferred tax
asset, reduced by $0.1 million of federal alternative minimum tax. In 2001,
Headwaters reported a net income tax benefit of $7.0 million, consisting of the
recognition of $7.4 million of its deferred tax asset, reduced by $0.1 million
of federal alternative minimum tax and $0.3 million of current state income tax
expense.
Headwaters' valuation allowance decreased by $14.2 million during 2001.
A valuation allowance is provided if it is more likely than not that some
portion or all of a deferred tax asset will not be realized. Based primarily on
results of operations in 2001 and expected future results of operations,
Headwaters determined that as of September 30, 2001, it was more likely than not
that its deferred tax assets would be realized and the valuation allowance was
eliminated.
Extraordinary Item. In 2000, Headwaters redeemed all of its remaining
convertible debt. The redemption consideration and early prepayment costs
included approximately $7.0 million in cash plus the issuance of approximately
0.2 million shares of common stock. The loss recognized as a result of the total
redemption consideration paid plus the acceleration of amortization of the
unamortized debt discount and debt issuance costs in excess of the debt carrying
value totaled approximately $7.9 million.
Liquidity and Capital Resources
Net cash provided by operating activities during 2002 was $42.8 million
compared to $19.8 million during 2001. Most of the cash flow from operating
activities in both periods was attributable to net income. During 2002,
investing activities consisted primarily of payments for the acquisition of ISG.
Financing activities in 2002 consisted primarily of net proceeds from the
issuance of long-term debt used to finance the acquisition of ISG.
Operating Activities. Headwaters reported net income for 2002 of $24.3
million. Moreover, most of Headwaters' reported income tax expense of $15.9
million consisted of deferred income taxes, largely as a result of using
Headwaters' net operating loss carryforwards which did not require the use of
cash. For 2002, cash provided from operations was reduced by a significant
increase in trade receivables approximating $7.7 million, net of ISG's trade
receivables as of the date of acquisition. This increase in trade receivables is
due to the significant increase in revenues.
Investing and Financing Activities. Headwaters acquired ISG in
September 2002. Payments to acquire ISG, net of cash acquired, were
approximately $205.9 million. In order to obtain the cash necessary to acquire
ISG and retire the ISG debt, Headwaters issued $175.0 million of new debt
consisting of $155.0 million of senior secured debt with a five-year term and a
variable interest rate and $20.0 million of subordinated debt with an
approximate five-year term and a fixed interest rate (see Note 8 to the
consolidated financial statements). Total cash proceeds from the issuance of new
debt, net of debt discounts, was $169.9 million. Headwaters incurred
approximately $6.2 million of debt issuance costs to place the new debt, which
had an initial combined effective weighted-average interest rate of
approximately 9.0%.
In September 2001, Headwaters sold all of its remaining high-risk
investments in exchange for a $4.0 million note receivable from a limited
liability corporation. This note is due no later than September 2004, is
collateralized by the bridge loans and equity investments sold and is being
accounted for on the cost recovery method. Following an impairment loss of
approximately $1.0 million recorded in 2002, this note has a carrying value of
$2.7 million as of September 30, 2002. Headwaters could incur additional losses
if the remaining balance
21
on the note is not repaid. At September 30, 2001, in addition to the $4.0
million note receivable, Headwaters had outstanding one other note receivable in
the amount of $6.5 million. This note and the related accrued interest were
collected in October 2001.
Financing activities during 2002 also included proceeds from the
exercise of stock options and warrants of approximately $5.4 million.
Headwaters intends to expand its business through growth of existing
operations and strategic acquisitions of entities that operate in adjacent
industries. Any acquisitions, however, would require the approval of current
debt holders.
In July 2002, Headwaters filed a $250.0 million universal shelf
registration statement with the SEC that can be used for the sale of common
stock, preferred stock, convertible debt and other securities, should Headwaters
so choose. This registration statement was declared effective by the SEC in
August 2002; however, a prospectus supplement describing the terms of any
securities to be issued is required to be filed before any offering would
commence under the registration statement. Headwaters could use the proceeds
from securities offered under the shelf registration to reduce long-term debt,
or for working capital and other general corporate purposes. Headwaters
currently has no plans to utilize the shelf registration.
Working Capital. Headwaters' working capital increased from $8.6
million at September 30, 2001, to $15.0 million at September 30, 2002. This
increase in working capital resulted primarily from increased revenue and
profitability and was partially offset by the cash used to acquire ISG and an
increase in the current portion of long-term debt. Headwaters expects operations
to produce positive cash flows in future periods, which, combined with current
working capital and the $20.0 million revolving line of credit described below,
is expected to be sufficient for Headwaters' operating needs for the next 12
months.
Long-term Debt. In connection with the ISG acquisition, Headwaters
entered into a $175.0 million senior secured credit agreement with a syndication
of lenders, under which a total of $155.0 million was borrowed on the
acquisition date. The remaining $20.0 million is available for borrowing under
the terms of this credit agreement. This debt was issued at a 3% discount and
Headwaters received net cash proceeds of $150.3 million. The debt is secured by
all assets of Headwaters, bears interest at a variable rate (approximately 5.9%
at September 30, 2002), and is repayable quarterly beginning December 2002
through August 2007. Required principal repayments total $15.5 million in 2003,
$31.0 million in 2004, 2005 and 2006, and $46.5 million in 2007. In certain
situations, for example when Headwaters receives "excess cash flow," as defined,
mandatory prepayments are required. Mandatory prepayments are calculated as a
percentage ranging up to 100% of "excess cash flow," which percentage is based
on Headwaters' "leverage ratio." The debt agreement also allows optional
prepayments. Headwaters currently expects to make prepayments that will retire
the debt prior to its scheduled maturity.
The debt agreement contains restrictions and covenants common to such
agreements, including limitations on the incurrence of additional debt,
investments, merger and acquisition activity, asset liens, capital expenditures
in excess of $15.0 million in any fiscal year, and the payment of dividends,
among others. In addition, Headwaters must maintain certain financial ratios,
including leverage ratios and interest coverage, as those terms are defined in
the credit agreement. As of September 30, 2002, Headwaters must maintain a total
leverage ratio of 3.0:1.0 or less. The maximum ratio declines over time until
June 2004, at which time the ratio must remain at 2.0:1.0 or less. There is a
similar leverage ratio requirement for the senior debt alone, which at September
30, 2002 must be 2.5:1.0 or less, declining over time through June 2004, at
which time it must be maintained at 1.5:1.0 or less. The interest coverage
requirement at September 30, 2002 was 3.75:1.0 or more. This ratio requirement
increases over time, until December 2003, at which time the ratio must be
maintained at a level of 5.0:1.0 or more. Headwaters was in compliance with all
debt covenants as of September 30, 2002.
Under the terms of the senior secured credit agreement, Headwaters may
borrow up to a total $175.0 million; provided, however, that, except for the
initial $20.0 million of available revolving credit, the maximum borrowing limit
is permanently reduced by the amount of any repayments of the initial $155.0
million borrowed in September 2002. Terms of any additional borrowings under the
credit agreement are generally the same as described in the preceding
paragraphs. Finally, the credit agreement allows for the issuance of letters of
credit, provided there is capacity available under the total credit line. As of
November 15, 2002, two letters of credit for a total of approximately $3.0
million have been issued with expiration dates of March 2003 and November 2003.
No other borrowings have been drawn or letters of credit issued through November
15, 2002. Headwaters pays a fee of 5/8% on the unused portion of the revolving
credit agreement.
22
Also in connection with the ISG acquisition, Headwaters entered into a
$20.0 million subordinated loan agreement, under which senior subordinated
debentures were issued at a 2% discount, with Headwaters receiving net cash
proceeds of $19.6 million. ISG management participated in one-half, or $10.0
million, of the $20.0 million of debt issued. The other half was issued to a
corporation. The debt is not secured, bears interest at an 18% rate, and is
repayable in September 2007. It is senior to all other debt except the senior
secured debt described above. The debt agreement allows for optional
prepayments. Any prepayments paid to the corporation are subject to a prepayment
charge which ranges from 5% of the principal prepaid in the first year to 1% of
the principal prepaid in the last year of the five-year term of the debt
agreement. Interest is payable quarterly, beginning October 2002 and is payable
in cash at a 12% rate. At Headwaters' option, interest calculated at an
additional 6% rate may be added to the principal balance in lieu of payment in
cash. Headwaters currently intends to pay in cash the entire amount of interest
which accrues.
The loan agreement contains restrictions and covenants common to such
agreements, and these are generally consistent with those described above for
the senior secured debt. As of September 30, 2002, Headwaters must maintain a
total leverage ratio of 3.25:1.0 or less. The maximum ratio declines over time
until June 2004, at which time the ratio must remain at 2.25:1.0 or less. The
interest coverage requirement at September 30, 2002 was 3.50:1.0 or more. This
ratio requirement increases over time, until December 2003, at which time the
ratio must be maintained at a level of 4.75:1.0 or more. Headwaters was in
compliance with all debt covenants as of September 30, 2002.
Income Taxes. As of September 30, 2001, Headwaters had net operating
loss carryforwards ("NOLs") of approximately $24.0 million and research and
development tax credit carryforwards of approximately $0.2 million for federal
tax purposes. During 2002, Headwaters utilized all of these NOLs and tax credit
carryforwards except for approximately $0.9 million of HTI's acquisition date
NOLs that are subject to an annual limitation of approximately $0.8 million due
to the change in ownership of HTI. Headwaters expects to utilize HTI's remaining
NOLs in 2003 and 2004.
During 2002, Headwaters made estimated payments for alternative minimum
taxes and for certain state income taxes in states where NOLs are not available.
Due to the passage in March 2002 of the Job Creation and Worker Assistance Act
of 2002 (the "Act"), Headwaters filed for a refund of the alternative minimum
taxes paid in fiscal 2001 and filed for refunds related to the carryback of
HTI's 2000 and 2001 losses, which pursuant to the Act can be carried back for
five years instead of the statutory two-year period. Due to NOLs for regular
federal tax purposes and in many states where Headwaters had operations, the
provisions of the Act allowing Headwaters' NOLs to offset 100% of the
alternative minimum tax liability for fiscal 2002, and due to tax benefits from
the exercise of stock options, Headwaters did not pay significant amounts of
income taxes in 2002.
Significant future cash needs, in addition to operational working
capital requirements, are currently expected to consist primarily of (i) debt
service payments on outstanding long-term debt, (ii) income taxes, and (iii)
capital expenditures. Capital expenditures are currently expected to be
approximately $10.0 million in 2003, with somewhat higher requirements in
succeeding years.
Contractual Obligations and Contingent Liabilities and Commitments
Other than operating leases for certain equipment and real estate,
Headwaters has no significant off-balance sheet transactions, derivatives, or
similar instruments and is not a guarantor of any other entities' debt or other
financial obligations. The following table presents a summary of Headwaters'
contractual obligations and payments, by period as of September 30, 2002.
Cash Payments Due by Period
----------------------------------------- -----------------------------------------------------------------
(millions of dollars) Total 1 Year 2 -3 Years 4 -5 Years After 5 Years
----------------------------------------- ---------- ------------ ------------ ------------ ---------------
Senior secured debt $155.0 $15.5 $62.0 $ 77.5 $ --
Senior subordinated debt 20.0 -- -- 20.0 --
Other long-term debt 0.1 0.1 -- -- --
---------- ------------ ------------ ------------ ---------------
Total long-term debt 175.1 15.6 62.0 97.5 --
Operating leases 30.7 8.9 11.7 5.8 4.3
Unconditional purchase obligations 35.7 8.1 11.0 5.9 10.7
Employment contracts, minimum royalties,
and other long-term obligations 5.7 3.9 1.8 -- --
---------- ------------ ------------ ------------ ---------------
Total contractual cash obligations $247.2 $36.5 $86.5 $109.2 $15.0
========== ============ ============ ============ ===============
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Subsequent to September 30, 2002, Headwaters entered into a new
headquarters office lease arrangement which expires in 2008. Total minimum
rental payments under the new lease agreement, which are not included above,
total approximately $2.6 million.
Under the terms of the senior secured credit agreement, Headwaters may
borrow up to a total $175.0 million; provided, however, that, except for the
initial $20.0 million of available revolving credit, the maximum borrowing limit
is permanently reduced by the amount of any repayments of the initial $155.0
million borrowed in September 2002. The credit agreement allows for the issuance
of letters of credit, provided there is capacity available under the total
credit line. As of November 15, 2002, two letters of credit for a total of
approximately $3.0 million have been issued with expiration dates of March 2003
and November 2003. No other borrowings have been drawn or letters of credit
issued through November 15, 2002.
Headwaters is involved in several legal proceedings that have arisen
out of the normal course of business, all as explained in more detail in "ITEM
3. LEGAL PROCEEDINGS" and Note 15 to the consolidated financial statements. Of
the five primary legal matters described in Note 15, Headwaters is a defendant
in three cases, and both a plaintiff and defendant in two cases. Management in
all cases intends to vigorously defend its position. Management does not
currently believe that the outcome of these activities will have a significant
effect upon the operations or the financial position of Headwaters; however, it
is possible that a change in management's estimates of probable liability could
occur and the change could be significant. In regards to all of these legal
matters, legal counsel cannot express an opinion as to the ultimate amounts of
recovery or liability.
Recent Accounting Pronouncements
Headwaters has implemented SFAS No. 142, "Accounting for Goodwill and
Intangible Assets," with the exception of certain additional disclosures which
may not be early implemented. Full implementation of SFAS No. 142 will require
certain additional disclosures regarding ISG's and HTI's identified intangible
assets and goodwill beginning October 1, 2002. In addition, SFAS No. 142, when
fully implemented in fiscal 2003, will require Headwaters to review for
impairment those intangible assets and goodwill in accordance with the
requirements of SFAS No. 142, instead of following the existing rules for
impairment testing. The new rules require, among other things, that goodwill be
tested for impairment at least annually using a two-step process that begins
with an estimation of the fair value of the reporting unit giving rise to the
goodwill. Headwaters currently believes that neither the ISG- nor HTI-related
identifiable assets and goodwill are impaired under either the existing rules
for testing impairment, or under the new rules required by SFAS No. 142.
In April 2002, SFAS No. 145, "Rescission of FASB Statements No. 4, 44,
and 64, Amendment of FASB Statement No. 13, and Technical Corrections," was
issued. SFAS No. 145, in rescinding SFAS No. 4, will require that the loss on
early extinguishment of debt, classified as an extraordinary item in 2000, no
longer be classified as extraordinary, but rather as other expense. SFAS No. 145
is required to be implemented by Headwaters in 2003 and management does not
expect it to have a material effect on Headwaters' future financial position or
results of operations.
In August 2001, SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets," was issued, and in July 2002, SFAS No. 146,
"Accounting for Costs Associated with Exit or Disposal Activities," was issued.
These pronouncements must be implemented by Headwaters as of October 1, 2002 and
January 1, 2003, respectively. Headwaters has reviewed these standards and all
other recently issued, but not yet adopted, accounting standards in order to
determine their potential effect, if any, on the future results of operations or
financial position of Headwaters. Based on that review, Headwaters does not
currently believe that any of these recent accounting pronouncements will have a
significant effect on its current or future financial position or results of
operations.
Impact of Inflation
During 2002, Headwaters' operations were not materially impacted by
inflation.
Forward-looking Statements
Statements in this Annual Report on Form 10-K regarding Headwaters'
expectations as to the managing and marketing of coal combustion products,
operation of facilities utilizing alternative fuel technologies, the marketing
of alternative fuels, the receipt of licensing fees, royalties, and product
sales revenues, the development, commercialization and financing of new
technologies and other strategic business opportunities and acquisitions and
other information about Headwaters that is not purely historical by nature,
including those statements regarding Headwaters' future business plans, the
operation of facilities, the availability of tax credits, the
24
availability of feedstocks, and the marketability of the coal combustion
products and alternative fuel, constitute forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995. Although
Headwaters believes that its expectations are based on reasonable assumptions
within the bounds of its knowledge of its business and operations, there can be
no assurance that actual results will not differ materially from its
expectations. In addition to matters affecting the coal combustion products and
alternative fuel industries or the economy generally, factors which could cause
actual results to differ from expectations stated in these forward-looking
statements include, among others, the following:
(1) Ability to repay our substantial debt obligations, including significant
interest payments, under our senior secured credit facility and senior
subordinated debentures.
(2) Restrictions on our ability to operate the businesses because of covenants
in the senior secured credit facility and senior subordinated debentures.
(3) Satisfactory resolution of several significant disputes in litigation.
(4) Increased use and market acceptance of fly ash.
(5) Fluctuations in the price and sales of cement and concrete products markets
in which ISG competes.
(6) Clean Air Act Amendments and regulations that could adversely impact coal
consumption or the quality and quantity of coal combustion products.
(7) Potential property damage claims and the availability of insurance cover