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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, 2003,
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
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
10653 South River Front Parkway, Suite 300
South Jordan, Utah 84095
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(Address of principal executive offices) (Zip Code)
(801) 984-9400
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: 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, 2003 was $374,304,448, 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, 2003 was 28,068,818.
___________________________
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 2004.
TABLE OF CONTENTS
Page
PART I
ITEM 1. BUSINESS...........................................................3
ITEM 2. PROPERTIES........................................................14
ITEM 3. LEGAL PROCEEDINGS.................................................14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS.............................................16
ITEM 6. SELECTED FINANCIAL DATA...........................................17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.......................................18
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........35
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.......................36
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE........................................36
ITEM 9A. CONTROLS AND PROCEDURES...........................................37
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................37
ITEM 11. EXECUTIVE COMPENSATION............................................37
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT....37
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................38
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES............................38
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
ON FORM 8-K.....................................................38
SIGNATURES...................................................................41
Forward-looking Statements
This Annual Report on Form 10-K, contains forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995 regarding future
events and our future results that are based on current expectations, estimates,
forecasts, and projections about the industries in which we operate and the
beliefs and assumptions of our management. Actual results may vary materially
from such expectations. Words such as "expects," "anticipates," "targets,"
"goals," "projects," "believes," "seeks," "estimates," variations of such words
and similar expressions are intended to identify such forward-looking
statements. In addition, any statements that refer to projections of our future
financial performance, our anticipated growth and trends in our businesses, and
other characterizations of future events or circumstances, are forward-looking.
For a discussion of the factors that could cause actual results to differ from
expectations, please see the captions entitled "Forward-looking Statements" and
"Risk Factors" in Item 7 hereof. There can be no assurance that our results of
operations will not be adversely affected by such factors. Unless legally
required, we undertake no obligation to revise or update any forward-looking
statements for any reason. Readers are cautioned not to place undue reliance on
these forward-looking statements, which speak only as of the date of this
report.
Our internet address is www.hdwtrs.com. There we make available, free of charge,
our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports
on Form 8-K and any amendments to those reports, as soon as reasonably
practicable after we electronically file such material with, or furnish it to,
the Securities and Exchange Commission ("SEC"). Our reports can be accessed
through the investor relations section of our web site. The information found on
our web site is not part of this or any report we file or furnish to the SEC.
PART I
ITEM 1. BUSINESS
General Development of Business
Introduction. Headwaters develops and commercializes technologies that
enhance the value of coal, gas, oil and other natural resources. We are the
largest provider of technologies used to produce coal-based solid synthetic
fuels, and we are the industry leader in managing and marketing coal combustion
products ("CCPs") in the United States. We are developing and commercializing
proprietary technologies to convert or upgrade fossil fuels into higher-value
products and are developing nanocatalyst technologies that have multiple
applications. Headwaters has experienced dramatic growth over the last several
years, generated from internal growth as well as through acquisitions. Our
revenues have grown from $6.7 million in 1999 to $387.6 million for the fiscal
year ended September 30, 2003.
We have successfully commercialized technologies and processes that
enhance the value of coal used to generate electricity. Coal is one of the
world's most abundant and affordable natural resources and is the primary fossil
fuel used world-wide for electricity generation. In 2001, coal represented 62%
of the world's fossil fuel energy reserves, while crude oil and natural gas
represented 20% and 18%, respectively. Coal serves as a primary resource for
baseline electricity production in the United States and was used to produce
approximately half of the electricity generated in the United States during
2002. The United States Department of Energy ("DOE") has predicted that the use
of coal will continue to grow in the United States and throughout the world.
Headwaters focuses on the "coal value chain" which can be categorized
into three major phases: (i) pre-combustion, which includes coal mining,
preparation, treatment, and transportation; (ii) combustion, which results in
energy generation; and (iii) post-combustion, which includes emissions control
and the utilization and disposal of CCPs which are created when coal is burned,
such as fly ash and bottom ash. In the pre-combustion phase, Headwaters'
proprietary technologies and chemical reagents are used to convert coal into a
solid synthetic fuel intended to generate tax credits under Section 29 of the
Internal Revenue Code ("Section 29"). In the post-combustion phase, Headwaters
manages and markets CCPs which would otherwise be disposed of in landfills and
uses CCPs to produce commercial building products.
Headwaters' Company History. Headwaters was incorporated in Delaware in
1995 under the name Covol Technologies, Inc. In September 2000, the Company's
name was changed to Headwaters Incorporated. Headwaters' stock trades under the
Nasdaq symbol HDWR.
As used herein, "Headwaters," "combined company," "company," "we,"
"our" and "us" refers to Headwaters Incorporated and its division Covol Fuels,
together with its consolidated subsidiaries ISG and HTI, unless the context
otherwise requires. "ISG" refers to Headwaters' subsidiary, Headwaters Olysub
Corporation, formerly Industrial Services Group, Inc., and its subsidiary, ISG
Resources, Inc., together with their consolidated subsidiaries, and "HTI" refers
to Headwaters Technology Innovation Group, Inc. together with its consolidated
subsidiaries, unless the context otherwise requires. All of these terms are used
for convenience only, and are not intended as a precise description of any of
the separate companies, each of which manages its own affairs.
______________________________________
Covol Fuels
Principal Products and their Markets. Through our Covol Fuels operating
division, Headwaters has developed and commercialized technology that interacts
with coal-based feedstocks to produce a solid synthetic fuel intended to be
eligible for Section 29 tax credits. The sale of qualified synthetic fuel
enables facility owners who comply with certain statutory and regulatory
requirements to claim federal tax credits under Section 29, which currently
expires on December 31, 2007. Headwaters has licensed this technology to owners
of solid synthetic fuel facilities for which it receives royalty revenues.
Headwaters also sells proprietary chemical reagents to licensees for use in the
production of the coal-based solid synthetic fuel and to other solid synthetic
fuel facility owners with whom Headwaters has reagent supply agreements.
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Headwaters licenses the Covol Fuels process to owners of synthetic fuel
production facilities and is paid a royalty stream generally based on the tax
credits generated from synthetic fuels sold to utilities and other industrial
coal consumers. Headwaters also receives revenues from the sale of its chemical
reagents. Covol Fuels' licensees and chemical reagent customers include major
utilities in the synthetic fuel industry.
In addition to technology licensing and chemical reagent sales,
Headwaters provides on-site facility services to licensees of its technology and
purchasers of its reagents. Headwaters has experience in producing synthetic
fuel and optimizing the production capabilities of synthetic fuel facilities.
This experience complements Headwaters' ongoing laboratory testing and
development of synthetic fuels. Headwaters employs chemical, electrical and
mechanical engineers and field personnel with extensive plant and equipment
operating experience to perform these on-site facility services and other
technical support functions.
Licensing Fees. In fiscal 2001 and 2002, prior to its acquisition of
ISG, Headwaters generated 95% or more of its revenues through license fees from
its technologies and sale of chemical reagents to owners of coal-based solid
synthetic fuel facilities. In fiscal 2003, these license fees and chemical
reagent sales contributed approximately 42% of revenues and ISG contributed
approximately 57%. See Note 4 to the consolidated financial statements for
revenues, profits and total assets set forth by segment. Headwaters currently
licenses its technologies to 28 of a company-estimated total of 75 coal-based
solid synthetic fuel facilities in the United States. In addition, Covol Fuels
sells its proprietary chemical reagents to 19 of these licensee facilities as
well as to more than ten other synthetic fuel facilities.
Current licensees include electric utility companies, coal companies,
financial institutions and other major businesses in the United States. License
agreements contain a quarterly earned royalty fee generally set at a prescribed
dollar amount per ton or a percentage of the tax credits earned by the licensee.
License agreements generally have a term continuing through the later of January
1, 2008 or the date after which tax credits may not be claimed or are otherwise
not available under Section 29.
Despite the growth in revenues, there continues to be under-utilization
of production capacity in several facilities employing Headwaters' technologies,
because of factors such as feedstock quality and the inability of certain owners
to utilize all the available Section 29 tax credits. See "ITEM 7. MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-Risk
Factors."
Chemical Reagent Sales. The transformation of the feedstock to a
synthetic fuel involves the use of a chemical reagent in a qualified facility.
Headwaters markets two proprietary latex-based chemicals, Covol 298 and Covol
298-1, which are widely used for the production of coal-based solid synthetic
fuel. The chemical reagent alters the molecular structure of the feedstock to
produce a synthetic fuel.
Covol 298 and Covol 298-1 are produced by Dow Reichhold Specialty Latex
LLC ("Dow Reichhold") under long-term agreements. Headwaters does not maintain
or inventory any chemicals. Instead, Headwaters arranges for the shipping of the
chemical reagents directly from Dow Reichhold's production facilities to the
synthetic fuel plants. The chemical reagents can be manufactured in 13 Dow
Reichhold plants throughout North America, assuring short lead-time deliveries
and the ability to meet increasing reagent demand. Additionally, Headwaters has
an arrangement with Dow Reichhold for technical support services relating to new
product development and manufacture.
Headwaters believes the benefits of its proprietary chemical reagents
as compared to competitive materials include clean and efficient combustion
characteristics, ease of application, concentrated form of shipment and lack of
damage to material handling, pulverizing or combustion equipment. Headwaters
believes the chemical reagents used in the Covol Fuels process are
environmentally safe, possess superior handling characteristics, burn
efficiently and are competitively priced. Additionally, Headwaters' chemical
reagents have been reviewed by the IRS and tested by independent laboratories.
The parameters of the Covol Fuels process are consistent with the criteria for
future private letter rulings as outlined by the IRS in Revenue Procedure
2001-30, as modified by Revenue Procedure 2001-34.
On-site Facility Services. In addition to licensing its technology and
supplying chemical reagents, Headwaters also employs hands-on technical account
managers that are available to assist its customers. Headwaters' engineers have
years of experience operating synthetic fuel manufacturing equipment, including
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mixers, extruders, pellet mills, briquetters and dryers. Headwaters' employees
are experts in applying our chemical reagents on multiple types of coal
feedstocks. Headwaters has operated synthetic fuel facilities utilizing multiple
types of coal feedstocks, and has developed and demonstrated process
improvements in commercial facilities. Headwaters has also designed and
constructed reagent mixing and application systems and has retrofitted existing
facilities to use our reagents. For new customers, Headwaters has a mobile,
skid-mounted reagent delivery system that allows for on-site demonstration
testing. Headwaters believes that this full spectrum of services makes it unique
in providing goods and services to the coal-based solid synthetic fuel business.
Headwaters maintains analytical laboratories, including bench-scale
equipment for the production of coal-based solid synthetic fuel and
comprehensive analytical testing equipment for performing standard coal
analyses. We also monitor, document and substantiate the chemical change process
required to obtain Section 29 tax credits.
Sources of Available Raw Materials and Inventory Requirements. Covol
Fuels' chemical reagents are produced by Dow Reichhold under a long-term
agreement. Covol Fuels does not maintain or inventory any chemicals. Instead,
Covol Fuels arranges for the drop shipping of the chemical reagents directly
from Dow Reichhold's production facilities to the synthetic fuel plants. The
chemical reagents can be manufactured in its Dow Reichhold plants throughout
North America assuring short lead-time deliveries and the ability to meet
increasing reagent demand. 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
electricity generating facilities).
Major Customers. The following table presents revenues for all
customers that accounted for over 10% of total revenue during 2001, 2002 or
2003. Most of the named customers are energy companies. Affiliate relationships
are determined for the period in which events are calculated.
(thousands of dollars) 2001 2002 2003
------------------------------------------ ---------------- --------------- ----------------
DTE Energy Services, Inc. affiliates $ 5,111 $19,660 $42,013
TECO Coal Corporation affiliates 16,044 20,292 Less than 10%
Marriott International, Inc. affiliates Less than 10% 19,105 Less than 10%
AIG Financial Products Corp. affiliates Less than 10% 16,900 Less than 10%
PacifiCorp affiliates 4,978 Less than 10% Less than 10%
Pace Carbon Fuels, L.L.C. affiliates 4,675 Less than 10% Less than 10%
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 CCP business. ISG Resources, Inc., which
was incorporated in Utah in August 1998, and its subsidiaries, operate this
business. Headwaters acquired ISG in September 2002.
Principal Products and their Markets. ISG is currently the largest
manager and marketer of CCPs in the United States and also manages and markets
CCPs in Canada. ISG has long-term exclusive management contracts with coal-fired
electric generating utilities throughout the United States and provides CCP
management services at more than 110 power plants. ISG markets CCPs where
markets exist, and manages much of the disposal of the rest, typically in
landfills. ISG has established long-term relationships with many of the nation's
major utilities.
ISG markets CCPs as a replacement for manufactured or mined materials,
such as portland cement, lime, agricultural gypsum, fired lightweight aggregate,
granite aggregate and limestone. Additionally, ISG's construction materials
subsidiary, American Construction Materials, Inc., manufactures masonry and
stucco construction materials, packaged products and blocks for the construction
industry, which contain a high percentage content of CCPs.
Utilities produce CCPs year-round, including in the winter when demand
for electricity increases in many regions. In comparison, sales of CCPs and
construction materials produced using CCPs are keyed to construction market
demands that tend to follow national trends in construction with predictable
increases during temperate seasons. CCPs must be stored, usually in terminals,
during the off-peak sales periods as well as transported to where they are
needed for use in construction materials. In part because of the cost of
transportation, the market for CCPs used in construction materials is generally
5
regional, although ISG ships products significant distances to states such as
California and Florida that do not have coal-fired electric utilities producing
high quality CCPs. However, ISG enjoys advantages in both logistics and sales
from its status as the largest manager and marketer of CCPs in the United
States. ISG maintains more than 30 stand-alone CCP distribution terminals across
North America, as well as approximately 90 plant site supply facilities. ISG's
operations utilize a fleet of more than 1,000 private railcars and 340 trucks so
that it can meet the transportation needs for both disposing and marketing CCPs.
In addition, ISG has more than 50 area managers and technical sales
representatives nationwide to manage customer relations.
Fly Ash and Other CCPs. The benefits of CCP use in construction
applications include improved product performance, cost savings and positive
environmental impact. Fly ash improves both the chemical and physical
performance of concrete. Physically, fly ash particles are smaller than cement
particles, allowing them to effectively fill voids and create concrete that is
denser and more durable. Fly ash particles are spherical and they have a "ball
bearing" effect, which lubricates the concrete mix and allows enhanced
workability with less water. Chemically, the requirement of less water
contributes to decreased permeability and greater durability of concrete.
Because fly ash is also typically less expensive than the cement it replaces,
concrete producers are able to improve profitability while improving concrete
quality.
When fly ash is used in concrete it provides environmental benefits.
According to the EPA, one ton of fly ash used as a replacement for portland
cement eliminates approximately one ton of carbon dioxide emissions, or the
equivalent of retiring an automobile from the road for two months. These
benefits are recognized in major "green building" movements, such as the United
States Green Building Council's LEED classification system. The value of
utilizing fly ash in concrete has been recognized by numerous federal agencies,
including the United States DOE and Environmental Protection Agency ("EPA"),
which has issued comprehensive procurement guidelines directing federal agencies
to utilize fly ash. Almost all states specify or recommend the use of fly ash in
state and federal transportation projects. Other government entities that
frequently specify or recommend the utilization of fly ash in concrete include
the Federal Highway Administration, the United States Army Corps of Engineers
and the United States Bureau of Reclamation. Numerous state departments of
transportation are also increasing their reliance on fly ash as a component for
improving durability in concrete pavements. Several major cement companies have
identified increasing the use of fly ash as a key environmental strategy for the
next two decades.
High quality fly ash is generally the most profitable CCP, as it has a
variety of higher margin commercial uses. In 2002, ISG sold approximately 5.75
million tons of high quality CCPs, including 5.25 million tons of high quality
fly ash of the approximately 12 million tons of high quality fly ash sold in the
United States. The quality of fly ash produced by the combustion process at
coal-fired facilities varies widely and is affected by the boilers used by the
utilities and by the efficiency of the combustion process. ISG assists its
utility clients in their efforts to improve the production of high quality fly
ash at their facilities. ISG tests the fly ash to certify compliance with
applicable industry standards. A comprehensive quality control system ensures
that customers receive fly ash that conforms to their specifications while ISG's
extensive investment in transportation equipment and terminal facilities
provides reliability of supply.
ISG supports its marketing sales program by focusing on customer
desires for quality and reliability. Marketing efforts emphasize the performance
value of CCPs, as well as the attendant environmental benefits.
ISG undertakes a variety of marketing activities to increase fly ash
sales. These activities include:
o Professional Outreach. To promote the acceptance of fly ash in
construction projects, all levels of ISG's sales and marketing
organization are involved in making regular educational
presentations such as continuing professional education
seminars to architects, engineers, and others engaged in
specifying concrete mix designs.
o Technical Publications. ISG publishes, in print form and on
its web site at www.isgresources.com, extensive technical
reference information pertaining to CCPs and CCP applications.
ISG also prominently promotes the environmental benefits of
CCP use.
o Relationships with Industry Organizations. ISG personnel
maintain active leadership positions in committees of the
American Concrete Institute and the American Society for
Testing and Materials, and serve on the boards of the American
Coal Ash Association, the Western Region Ash Group, the Texas
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Coal Ash Utilization Group, the Midwest Coal Ash Association
and the American Coal Council. These organizations help
establish standards and educate the construction industry and
the general public about the benefits of CCP use.
o Trade Shows. ISG promotes the use of CCPs at more than 30
local and national trade shows and association meetings each
year. ISG is also an exhibitor at the nation's leading
conferences for utilization of environmentally friendly
building products.
o Government Affairs. ISG has taken a leadership role in
encouraging state and federal legislation and regulations that
lead to greater utilization of fly ash by emphasizing its
environmental, performance and cost advantages. Legislative
recognition of the benefits of fly ash as well as the use of
fly ash in governmental projects helps familiarize
contractors, architects and engineers with the benefits of the
product for other construction uses.
o Advertising. ISG advertises for fly ash sales and utilization
in a number of publications, including: Architectural Record,
Engineering News-Record, Construction Specifier, Concrete
Products, Concrete Producer, Concrete International and
Environmental Design & Construction. ISG's website is also a
source of sales leads.
o Creation of Branded Specialty Products. ISG has developed
several specialty products that increase market penetration of
CCPs and name recognition for ISG's products for road bases,
structural fills, industrial fillers and agricultural
applications. These include:
o Alsil(R)- Processed fly ash used as an industrial
filler;
o C-Stone(TM)- Quality crushed aggregate manufactured
from fly ash and used in road base and feedlot
applications;
o Flexbase(TM) - FGD scrubber sludge, pond ash, and/or
lime proportionally mixed for road base or pond liner
material;
o Powerlite(R) - Processed fly ash and bottom ash,
meeting American Society for Testing and Materials
C331 standards, for use as a high quality aggregate
in the concrete block industry; and
o Peanut Maker(R) - A synthetic gypsum used as a land
plaster in agricultural applications.
New Technologies for CCP Utilization. In an effort to maximize the
percentage of CCPs marketed to end users and to minimize the amount of materials
disposed of in landfills, ISG's research and development activities focus on
expanding the use of CCPs by developing new products that utilize high volumes
of CCPs. Through these research and development activities, ISG has developed
FlexCrete(TM), a new commercial and residential building product in its pilot
stages. FlexCrete(TM) is an aerated concrete product with 60% fly ash content
that is cured at lower temperatures and ambient pressure. We expect
FlexCrete(TM) will offer advantages for construction, including low cost, ease
of use, physical strength, durability, energy efficiency, fire resistance and
environmental sensitivity.
Technologies to Improve Fly Ash Quality. ISG also has developed
technologies that maintain or improve the quality of CCPs, further expanding and
enhancing their marketability. Utilities are switching fuel sources, changing
boiler operations and introducing ammonia into the exhaust gas stream in an
effort to decrease costs and/or to meet increasingly stringent emissions control
regulations. All of these factors can have a negative effect on fly ash quality,
including an increase in the amount of unburned carbon in fly ash and the
presence of ammonia slip. ISG has addressed these challenges with the
development and/or commercialization of two technologies. Designed to be simple,
economical and highly effective, these technologies can be implemented without
the large capital expenditures often associated with controlling quality
problems.
Carbon Fixation. Under certain conditions, unburned carbon in fly ash
inhibits the entrainment of air in concrete, undermining the strength and
integrity of finished product. Technologies designed to remove residual carbon
are often capital intensive and are therefore rarely used. ISG has the exclusive
license in North America to utilize a carbon fixation technology used to
pre-treat fly ash. The technology uses a liquid reagent to coat unburned carbon
particles in the fly ash and hinder the impact on the concrete mix. Carbon is
not removed, but its effects on air entrainment are minimized. The technology
also renders some ash products usable for the first time without having any
impact on the quality of finished concrete. Full scale carbon fixation units
have been installed and are operating at major power plants.
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Ammonia Slip Mitigation. As electric utilities move to implement
stringent new air pollution controls, many are treating boiler exhaust gases
with ammonia to remove NOx. This can result in unreacted ammonia being deposited
on fly ash. The use of ammonia contaminated fly ash in concrete production can
result in the release of ammonia gas, exposing concrete workers to varying
levels of ammonia. ISG has developed a technology that uses a chemical reagent
to mitigate the ammonia slip effects. When water is added to the concrete mix
containing ammoniated fly ash, the reagent converts ammonia to harmless
compounds. The process allows the reagent to be added and blended with the dry
fly ash at any time from when the fly ash is collected at the power plant to
when the fly ash is used in the production of concrete.
American Construction Materials. ISG has focused on increasing the
utilization of CCPs in building products that have not traditionally included
CCPs. To accelerate acceptance of CCPs in these markets, ISG created a
construction materials subsidiary, American Construction Materials, which
includes several well-known brands, such as Magna Wall(R) stuccos and BEST(TM)
and Hill Country Mortar Mix(TM) masonry and mortar cements. ISG operates a
network of manufacturing and distribution facilities and retail supply stores
that are strategically located throughout the southern United States and that
provide access to many of the most rapidly growing regions in the nation. ISG
has formulated masonry cements, mortar cements, stucco and block products to
utilize CCPs in residential and commercial building applications. This strategy
has secured an outlet for previously unutilized CCPs while promoting the
increased use of CCPs as components of building products in the future. Unlike
most of its competitors, ISG has dedicated significant resources to the
acquisition and development of new technologies for the use of CCPs in building
products applications. We believe that strong brand recognition and the high
performance characteristics of our products make us a preferred supplier to home
builders and contractors from Florida to Southern California. A key component of
our growth strategy has been the development of superior products utilizing
innovative fly ash-based formulations.
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. Coal serves as a
primary resource for baseline electricity production in the United States and
was used to produce approximately half of the electricity generated in the
United States in 2002. The government estimates that annual coal consumption
will increase from 1.06 billion tons to 1.44 billion tons by 2025. 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, approximately two-thirds of CCPs produced in 2002 were disposed
of in landfills, providing ample opportunities for continuing increases in CCP
utilization. As long as a significant amount of electricity in this country is
generated from coal-fired generation, ISG believes it will have an adequate
supply of raw materials.
HTI
HTI provides research and development support to Headwaters. HTI
maintains a staff of engineers, scientists and technicians with expertise in the
design and operation of high-pressure and temperature process plants at its
Lawrenceville, New Jersey pilot plant and laboratory facilities. The following
are some of the technologies currently under development.
o Nanocatalyst Technology. HTI has developed the capability to
work at the molecular level in the aligning, spacing and
adhering of nano-sized crystals of precious metals on
substrate materials. The net effect is higher performance with
lower precious metal content, and nearly 100% selectivity for
certain chemical reactions (i.e., byproducts and waste are
minimized and the desired reaction is maximized). Potential
applications for this nanotechnology include new processes for
direct synthesis of hydrogen peroxide and production of
propylene oxide. This same technique can also be used to
regenerate spent precious metal catalysts and to improve
volatile organic compound oxidation, naphtha reforming and
fuel cell catalysts. Headwaters has entered into a preliminary
joint venture agreement for fuel cell technology development
and commercialization with the Dalian Institute of Chemical
Physics of the People's Republic of China.
o Direct Coal Liquefaction Technology. Headwaters has developed
an advanced technology for producing clean liquid fuels
directly from coal. Shenhua Group, China's largest coal
company, has purchased elements of Headwaters' direct coal
liquefaction technology for its plant to be built in Majata,
China. The plant is expected to become the first commercial
direct coal liquefaction plant in the world with an ultimate
capacity of 50,000 barrels per day.
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o Heavy Oil Upgrading Technology. HTI has obtained the exclusive
worldwide license to develop, market and sublicense an
innovative catalytic heavy oil upgrading technology known as
(HC)3. This technology is a hydrocracking process used for
upgrading heavy oil, bitumen or bottom-of-the-barrel residual
oil into synthetic crude or clean liquid fuels. The process
uses a proprietary, highly active molecular catalyst. There
are several heavy oil upgrading plants located around the
world that could immediately apply and benefit from the (HC)3
technology with minimal modification to plant and equipment.
o Gas-To-Liquids Technology. Commercialization of slurry-phase
Fischer-Tropsch ("FT") technology provides a new source of
clean diesel fuels from fossil fuel resources. HTI has
developed a skeletal-iron FT catalyst specifically designed
for slurry-phase reactors that converts gaseous materials into
a range of liquid fuels. We believe that HTI's skeletal-iron
FT catalyst is stronger and more economical to utilize than
conventional FT catalysts, and that existing petrochemical and
chemical plants could be adapted to produce diesel fuel.
Research and Development
In 2001, research and development expenses were $2.4 million,
consisting primarily of acquired in-process research and development related to
the HTI acquisition. In 2002, research and development expenses were $2.3
million, consisting primarily of ongoing activities at HTI. Research and
development expenses increased by $2.4 million to $4.7 million in 2003. The
increase was primarily attributable to the inclusion of additional costs
relating to ISG's research and development activities.
Headwaters' Business Strategy
Headwaters intends to pursue the following business strategy:
o Enable Customers to Maximize Production and Value of Synthetic Fuel
Facilities. In order for our customers to maximize the production and
value of their coal-based synthetic fuel facilities, we will continue
to assist them in operating their facilities more efficiently, and we
will actively market the benefits of synthetic fuel to electric power
generators. Covol Fuels intends to continue to develop technologies
that improve coal handling, enhance coal combustion characteristics and
reduce air emissions.
o Expand Consumption and Enhance Quality of CCPs. We intend to expand our
market presence geographically and continue to seek increased market
acceptance of CCPs through targeted marketing of industry decision
makers, such as architects and engineers, and through efforts to
increase governmental recommendations and mandates to use CCPs. An
important part of our strategy is to focus on alternative uses of CCPs,
including road beds, embankments, building products and waste
stabilization. ISG also intends to continue to seek new business
opportunities with other utilities.
o Leverage Complementary Relationships and Capabilities. Covol Fuels and
ISG each maintains long-standing relationships with many of the largest
coal-fired electricity producers in the United States. Headwaters
believes these complementary relationships will provide opportunities
to expand and strengthen its position among coal-fired power generation
utilities. Headwaters intends to market new technologies and services
to its existing client base, as well as other utilities.
o Develop and License New Technologies. Headwaters will continue to
develop and commercialize technologies that add value to coal, gas, oil
and other natural resources. These efforts will focus on upgrading
heavy oil to lighter fuel, gas-to-liquid fuels conversion and
converting or upgrading fossil fuels into higher value products. In
addition, ISG is developing and/or commercializing new technologies
such as carbon fixation and ammonia removal to improve the quality of
fly ash. HTI's nanocatalyst technologies should provide us with an
opportunity for commercialization of multiple custom designed
catalysts. Headwaters will seek to develop strategic relationships with
major companies in the energy and chemical industries to accelerate
commercialization of its energy and catalyst technologies.
o Pursue Complementary and Expansionary Acquisitions. Headwaters intends
to identify and analyze additional acquisition opportunities to
strengthen its position as a leading value enhancer of fossil fuels and
9
other natural resources. Headwaters will evaluate possible acquisitions
of complementary businesses in the chemical, energy, building products
and related industries. Significant acquisitions may be financed with
additional indebtedness.
Competition
Headwaters experiences competition from traditional coal and fuel
suppliers and natural resource producers, in addition to those companies that
specialize in the use and upgrading of industrial byproducts. Many of these
companies have greater financial, management and other resources than
Headwaters, and may be able to take advantage of acquisitions and other
opportunities more readily.
Coal-based solid synthetic fuels made using Covol Fuels' technologies,
from which Covol Fuels derives license revenues and revenues from sales of
chemical reagents, compete with other synthetic fuel products, as well as
traditional fuels. For Covol Fuels competition may come in the form of the
marketing of competitive chemical reagents and the marketing of end products
qualifying as synthetic fuel. Covol Fuels competes with other companies
possessing technologies to produce coal-based solid synthetic fuels and
companies that produce chemical reagents such as Nalco Chemical Company and
Accretion Technologies, LLC.
Covol Fuels also experiences competition from traditional coal and fuel
suppliers and natural resource producers, in addition to those companies that
specialize in the use and upgrading of industrial byproducts. These companies
may have greater financial, management and other resources than Headwaters has.
Further, many industrial coal users are limited in the amount of synthetic fuel
product they can purchase from Covol Fuels' licensees because they have
committed to purchase a substantial portion of their coal requirements through
long-term contracts for standard coal.
Generally, the business of marketing traditional CCPs and construction
materials is intensely competitive. ISG has substantial competition in three
main areas: obtaining CCP management contracts with utility and other industrial
companies; marketing CCPs and related industrial materials; and marketing its
construction materials. ISG has a presence in every region in the United States
but, because the market for the management of CCPs is highly fragmented and
because the costs of transportation are high relative to sales prices, most of
the competition in the CCP management industry is regional. There are many
local, regional and national companies that compete for market share in these
areas with similar products and with numerous other substitute products.
Although ISG typically has long-term CCP management contracts with its clients,
some of such contracts provide for the termination of such contract at the
convenience of the utility company upon a minimum 90-day notice. Moreover,
certain of ISG's most significant regional CCP competitors appear to be seeking
a broader national presence. These competitors include Lafarge North America
Inc., Boral Material Technologies Inc. and Cemex. Construction materials are
produced and sold regionally by the numerous owners and operators of concrete
ready-mix plants. Producers with sand and gravel sources near growing
metropolitan areas have important transportation advantages. In Texas, ISG's
most important construction materials market, Featherlite Building Products is
among ISG's competitors.
Many of the world's major chemical companies are devoting significant
resources to researching and developing nanocatalysts and catalytic processes.
These companies have greater financial, management and other resources than
Headwaters has. Headwaters' strategy is to enter into license agreements or
joint ventures with major chemical companies for the further development and
commercialization of Headwaters' nanocatalyst technologies.
Intellectual Property
Headwaters itself has one registered trademark and one pending
trademark application.
ISG has 13 U.S. patents that expire between 2009 and 2017 and over 10
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.
10
HTI has 17 U.S. patents that expire between 2011 and 2022 and over 15
U.S. patent applications pending. HTI has three registered trademarks and four
pending trademark applications.
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.
Despite these safeguards, such methods may not afford complete protection and
there can be no assurance that others will not either independently develop such
know-how or unlawfully 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
Section 29. Headwaters' coal-based solid synthetic fuel business is
subject to compliance with the terms of Section 29. The issuance of private
letter rulings ("PLRs") under Section 29 by the Internal Revenue Service ("IRS")
is important to the willingness of the owners of synthetic fuel facilities to
operate and to their ability to transfer ownership of those facilities. The IRS
has suspended the issuance of PLRs to synthetic fuel facility owners several
times in the past, and there can be no assurance that the IRS will not suspend
the issuance of PLRs in the future. Most recently, in June 2003, the IRS stated,
in summary, in Announcement 2003-46 that it "has had reason to question the
scientific validity of test procedures and results that have been presented as
evidence that fuel underwent a significant chemical change, and is currently
reviewing information regarding these test procedures and results," and that
pending its review of the issue it was suspending the issuance of new PLRs
regarding significant chemical change.
The IRS release of Announcement 2003-46 caused certain of Headwaters'
licensees to reduce or cease synthetic fuel production, which resulted in a
material adverse impact on Headwaters' revenues and net income. In October 2003,
the IRS stated in summary in Announcement 2003-70 that it continues to question
whether processes it had approved under its long-standing ruling practice
produce the necessary level of chemical change required under Section 29 and
Revenue Ruling 86-100. Nonetheless, the IRS indicated that it would continue to
issue PLRs regarding chemical change under the standards set forth in Revenue
Procedures 2001-30 and 2001-34, and that the industry's chemical change test
procedures and results are scientifically valid if applied in a consistent and
unbiased manner. Although the IRS resumed its practice of issuing PLRs, it
expressed continuing concerns regarding the sampling and data/record retention
practices prevalent in the synthetic fuels industry.
Also on October 29, 2003, the United States Senate Permanent
Subcommittee on Investigations issued a notification of pending investigations.
The notification listed the synthetic fuel tax credit as a new item, stating:
The Subcommittee has initiated an investigation of potential abuses of
tax credits for producers of synthetic fuel under Section 29 of the
Internal Revenue Code. The Subcommittee anticipates that this
investigation will focus on whether certain synthetic fuel producers
are claiming tax credits under Section 29, even though their product is
not a qualified synthetic fuel under Section 29 and IRS regulations. In
addition, the investigation will address whether certain corporations
are engaging in transactions solely to take advantage of unused Section
29 credits, with no other business purpose. Lastly, the investigation
will address the IRS's efforts to curb abuses related to the Section 29
tax credits.
The effect that the Senate subcommittee investigation of synthetic fuel
tax credits may have on the industry is unknown.
11
Environmental. The coal-based solid synthetic fuel operations of
Headwaters and its licensees are subject to federal, state and local
environmental regulations that impose limitations on the discharge of pollutants
into the air and water and establish standards for the treatment, storage and
disposal of waste products. Moreover, in order to establish and operate the
synthetic fuel plants, power plants and operations to collect and transport CCPs
and bottom ash, we and our licensees and customers have obtained various state
and local permits and must comply with processes and procedures that have been
approved by regulatory authorities. Compliance with permits, regulations and the
approved processes and procedures help protect against pollution and
contamination. We believe that all required permits to construct and operate
these solid synthetic fuel facilities have been obtained and believe they are in
substantial compliance with all relevant laws and regulations governing
synthetic fuel operations.
In spite of safeguards, our operations entail risks of regulatory
noncompliance or accidental discharge that could create an environmental
liability because hazardous materials are used or stored during normal business
operations. For example, we and our subsidiaries use and share other hazardous
chemicals in order to conduct operations involving distillation to purify
products, analysis, packaging of chemicals and the selling and manufacturing of
chemicals in small research volumes. Our subsidiaries also use their facilities
to perform research and development activities involving coal, oil, chemicals
and industrial gases such as hydrogen. As a result, petroleum and other
hazardous materials have been and are present in and on their properties. We
generally hire independent contractors to transport and dispose of any hazardous
materials generated and send any hazardous wastes only to federally approved,
large scale and reputable off-site waste facilities.
The federal Clean Air Act of 1970 and subsequent amendments
(particularly the Clean Air Act Amendments of 1990), and corresponding state
laws, which regulate the emissions of materials into the air, affect the coal
industry both directly and indirectly. The coal industry is directly affected by
Clean Air Act permitting requirements and/or emissions control requirements,
including requirements relating to particulate matter (such as, "fugitive
dust"). The coal industry may also be impacted by future regulation of fine
particulate matter measuring 2.5 micrometers in diameter or smaller. In July
1997, the EPA adopted new, more stringent National Ambient Air Quality
Standards, or NAAQS, for particulate matter and ozone. Although the NAAQS have
been challenged in litigation, slowing their implementation, the standards were
upheld by the United States Supreme Court, and states will ultimately be
required to revise their existing state implementation plans ("SIPs") to attain
and maintain compliance with the new NAAQS. Because electric utilities emit
nitrogen oxide ("NOx"), which are precursors to ozone and particulate matter,
ISG's utility customers are likely to be affected when the new NAAQS are
implemented by the states. State and federal regulations relating to fugitive
dust and the implementation of the new NAAQS may reduce ISG's sources for its
products. The extent of the potential impact of the new NAAQS on the coal
industry will depend on the policies and control strategies associated with the
state implementation process under the Clean Air Act.
The 1990 Clean Air Act Amendments require utilities that are currently
major sources of NOx in moderate or higher ozone non-attainment areas to install
reasonably available control technology for NOx. EPA currently plans to finalize
stricter ozone NAAQS (discussed above) by 2004. EPA promulgated a rule (the "NOx
SIP call") in 1998 requiring 22 eastern states to make substantial reductions in
NOx emissions. Under this rule, EPA expects that states will achieve these
reductions by requiring power plants to make substantial reductions in their NOx
emissions. The NOx SIP call must be implemented by May 31, 2004. In addition to
the NOx SIP call, by May 31, 2004, EPA must directly regulate NOx emissions from
states upwind of four eastern states that petitioned EPA (pursuant to section
126 of the Clean Air Act). The section 126 rule will be withdrawn in any state
that submits an approvable NOx SIP. Installation of reasonably available control
technology and additional control measures required under the NOx SIP call or
the section 126 rule will make it more costly to operate coal-fired utility
power plants and, depending on the requirements of individual SIPs, could make
coal a less attractive fuel alternative in the planning and building of utility
power plants in the future. The effect such regulation or other requirements
that may be imposed in the future could have on the coal industry in general and
on ISG in particular cannot be predicted with certainty. No assurance can be
given that the ongoing implementation of the Clean Air Act (including the 1990
Amendments) or any future regulatory provisions will not materially adversely
affect ISG.
In addition, the 1990 Clean Air Act Amendments require a study of
utility power plant emissions of certain toxic substances, including mercury,
and direct EPA to regulate emissions of these substances, if warranted. EPA has
submitted reports to Congress on Mercury (1997) and Utility Air Toxics (1998).
On December 14, 2000, EPA announced its finding that regulation of hazardous air
pollutant emissions from oil- and coal-fired electric utility steam generating
units is necessary and appropriate. EPA expects to propose emission standards by
12
December 15, 2003 and to finalize them by December 15, 2004. These regulations
are likely to require reductions in mercury emissions, and such requirements, if
promulgated, could result in reduced use of coal if utilities switch to other
sources of fuel.
The Clear Skies Initiative, announced by the Bush Administration in
February 2002 (S.485 and H.R. 999, and revised by S.1844), seeks to develop
strategies for reducing emissions of sulfur dioxide ("SOx"), NOx and mercury
from power plants. Because the Initiative must be implemented by legislation
that has not yet been enacted, its effect on ISG cannot be determined at this
time. However, in February and April 2003, two four-pollutant bills (S.366 and
S.843, respectively) for power plants were referred to the Senate Environment
and Public Works Committee. In addition to the three pollutants covered under
the Clear Skies Initiative, these bills include the greenhouse gas carbon
dioxide. If enacted as written, these bills could result in reduced use of coal
if utilities switch to other sources of fuel as a means of complying with more
stringent emission limits.
Coal-fired boilers have been impacted by regulations under the 1990
Clean Air Act Amendments, which established specific emissions levels for SOx
and NOx in order to reduce acid rain. These emissions levels have required
utilities to undertake many of the following changes: change their fuel
source(s), add scrubbers to capture SOx, add new boiler burner systems to
control NOx, add or modify fuel pulverizers/air handling systems to control NOx,
introduce flue gas conditioning materials to control particulate emissions in
conjunction with meeting SOx emissions targets and in some very isolated cases
shut down a plant. All of these changes can impact the quantity and quality of
CCPs produced at a power plant and can add to the costs of operating a power
plant. Furthermore, proposed regulations to control mercury emissions could
result in implementation of additional technologies at power plants that could
negatively affect fly ash quality.
Further, inappropriate use of CCPs can result in faulty end products.
Since most of the products marketed by ISG typically consist of a mixture of
client-supplied CCPs, ISG does not control the quality of the final end product,
but may share such control with the manufacturer of the ingredient materials.
Therefore, there is a risk of liability regarding the quality of the materials
and end products marketed by ISG. In cases where ISG is responsible for
end-product quality, such as a structural fill (where material is used to fill a
cavity or designated area), ISG depends solely on its own quality assurance
program.
Materials sold by ISG vary in chemical composition. Fossil fuel
combustion wastes have been excluded from regulation as "hazardous wastes" under
subtitle C of the Resource Conservation and Recovery Act ("RCRA"). However, EPA
has determined that national regulations under subtitle D of RCRA (dealing with
state and regional solid waste plans) are warranted for coal combustion
byproducts disposed of in landfills or surface impoundments, or used to fill
surface or underground mines. EPA is planning to publish a proposed rulemaking
under subtitle D of RCRA in January 2004. ISG manages a number of landfill and
pond operations that may be affected by EPA's proposed regulations. In most of
these operations the permitting is contractually retained by the client and the
client would be liable for any costs associated with new permitting
requirements. The effect of such regulations on ISG cannot be completely
ascertained at this time.
ISG is engaged in providing services at one landfill operation that is
permitted and managed as a hazardous waste landfill. ISG provides the services
necessary to landfill the client's hazardous wastes and operates certain
in-plant equipment and systems for the client. Accordingly, there can be no
assurance that ISG will not be named in third-party claims relating to the
project.
CCPs contain small concentrations of metals that are considered as
"hazardous substances" under CERCLA. Land application of CCPs is regulated by a
variety of federal and state statutes, which impose testing and management
requirements to ensure environmental protection. Under limited circumstances,
mismanagement of CCPs can give rise to CERCLA liability.
Electric utility deregulation has slowed substantially from previous
years' predictions. Deregulation could negatively impact ISG because it could
result in some sources of CCPs being put out of service because they are not
economically competitive. On the other hand, deregulation efforts have spurred
renewed interest in construction of new coal-fired electricity generating
capacity. We believe no significant changes to the sources of CCPs under
contract will occur. However, since this change to the industry continues to
evolve, the impact of deregulation cannot be accurately projected, and
Headwaters could be materially adversely affected if major changes occur to
specific sources.
13
Employees
Headwaters currently employs approximately 800 employees full-time. Of
these employees, approximately 43 are in corporate administration, 34 are
employed by Headwaters' Covol Fuels division, 41 are employed by HTI, 487 are
employed by ISG's CCP division and 192 are employed by ISG's construction
materials division. ISG has more than 50 area managers and technical sales
representatives nationwide. Approximately 19 employees work under collective
bargaining agreements.
ITEM 2. PROPERTIES
Headwaters' headquarters are located at 10653 South River Front
Parkway, Suite 300, South Jordan, Utah 84095. The lease for this office space of
approximately 26,500 square feet provides for a six-year term. The monthly rent
is approximately $41,000, with certain adjustments for inflation plus expenses.
ISG owns or leases approximately 20 parcels of real property in 17
states for its fly ash storage and distribution operations. ISG also owns or
leases approximately ten properties in three states for its building products
manufacturing and sales operations.
In 1995, HTI purchased approximately six acres in Lawrenceville, New
Jersey, where its headquarters and research facilities are now located.
ITEM 3. LEGAL PROCEEDINGS
Headwaters has ongoing litigation and claims incurred during the normal
course of business, including the items discussed below. Headwaters intends to
vigorously defend and/or pursue its rights in these actions. Management does not
currently believe that the outcome of these actions will have a material adverse
effect on Headwaters' operations, cash flows or financial position; however, it
is possible that a change in the estimates of probable liability could occur,
and the change could be significant. Additionally, as with any litigation, these
proceedings will require that Headwaters incur substantial costs, including
attorneys' fees, managerial time, and other personnel resources and costs in
pursuing resolution.
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 a synthetic 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 affect the transfer. 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 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. The Federal Circuit Court of Appeals has
affirmed the District Court's order denying the motion for relief from judgment
and the case is now fully resolved.
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,
among other things, fraud, conspiracy, constructive trust, conversion, patent
infringement and interference with contract arising out of the 1998 technology
purchase agreement entered into between Davidson and Adtech on the one hand, and
Headwaters on the other. The complaint seeks declaratory relief and compensatory
and punitive damages. Because the resolution of the litigation is uncertain,
legal counsel cannot express an opinion as to the ultimate amount, if any, of
Headwaters' liability.
AGTC. In March 1996, Headwaters entered into an agreement with AGTC and
its associates for certain services related to the identification and selection
of synthetic fuel projects. In March 2002, AGTC filed an arbitration demand
claiming that it is owed a commission under the 1996 agreement for 8% of the
14
revenues received by Headwaters from the Port Hodder project. Headwaters asserts
that AGTC did not perform under the agreement and that the agreement was
terminated and the disputes were settled in July 1996. Headwaters has filed an
answer in the arbitration, denying AGTC's claims and has asserted counterclaims
against AGTC. Because the resolution of the arbitration is uncertain, legal
counsel cannot express an opinion as to the ultimate amount, if any, of
Headwaters' liability.
AJG. In December 1996, Headwaters entered into a technology license and
proprietary chemical reagent sale agreement with AJG Financial Services, Inc.
The agreement called for AJG to pay royalties and to purchase proprietary
chemical reagent material from Headwaters. In October 2000, Headwaters filed a
complaint in the Fourth District Court for the State of Utah against AJG
alleging that it had failed to make payments and to perform other obligations
under the agreement. Headwaters asserts claims including breach of contract,
declaratory judgment, unjust enrichment and accounting and seeks money damages
as well as other relief. AJG's answer to the complaint denied Headwaters' claims
and asserted counter-claims based upon allegations of misrepresentation and
breach of contract. AJG seeks compensatory damages as well as punitive damages.
Headwaters has denied the allegations of AJG's counter-claims. Because the
resolution of the litigation is uncertain, legal counsel cannot express an
opinion as to the ultimate amount of recovery or liability.
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 alleged that Nalco, by its sale and marketing of materials
for use in creating synthetic fuel, breached a non-disclosure agreement,
misappropriated trade secrets, and violated patent rights of Headwaters. 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 denied the counter-claims.
Effective in January 2003, the parties settled the dispute and the case was
dismissed. There was no material effect on Headwaters' operations, cash flows or
financial position as a result of the settlement.
ISG Matters. There is litigation and pending and threatened claims made
against certain subsidiaries of ISG with respect to several types of exterior
stucco finish systems manufactured and/or sold by its subsidiaries for
application by contractors, developers and owners on residential and commercial
buildings. This litigation and these claims are controlled by such subsidiaries'
insurance carriers. The plaintiffs and/or claimants in these matters have
alleged that due to some failure of the stucco system itself and/or its
application, the buildings have suffered damage due to the progressive, latent
effects of water penetration through the building's exterior. The most prevalent
type of claim involves alleged defects associated with an artificial stucco
system manufactured by one of ISG's subsidiaries, Best Masonry. Best Masonry
continued to manufacture this system through 1997, and there is a 10-year
projected claim period following discontinuation of the product.
Typically, the claims cite damages for alleged personal injuries and
punitive damages for alleged unfair business practices in addition to asserting
more conventional damage claims for alleged economic loss and injury to
property. To date, claims made against such subsidiaries have been paid by their
insurers, with the exception of minor deductibles, although such insurance
carriers typically have provided "reservation of rights" letters. None of the
cases has gone to trial, and while two such cases involve 100 and 800 homes,
respectively, none of the cases includes any claims formally asserted on behalf
of a class. While, to date, none of these proceedings have required that ISG
incur substantial costs, there is no guarantee of coverage or continuing
coverage. These and future proceedings may result in substantial costs to ISG,
including attorneys' fees, managerial time and other personnel resources and
costs. Adverse resolution of these proceedings could have a materially negative
effect on ISG's business, financial condition and results of operation, and its
ability to meet its financial obligations. Although ISG carries general and
product liability insurance, ISG cannot assure that such insurance coverage will
remain available, that ISG's insurance carrier will remain viable or that the
insured amounts will cover all future claims in excess of ISG's uninsured
retention. Future rate increases may also make such insurance uneconomical for
ISG to maintain. In addition, the insurance policies maintained by ISG exclude
claims for damages resulting from exterior insulating finish systems, or EIFS,
that have manifested after March 2003. Because much of the litigation and claims
are at an early stage and resolution is uncertain, legal counsel cannot express
an opinion as to the ultimate amount, if any, of the liability resulting to
Headwaters.
Former Director. Headwaters granted stock options to a member of its
board of directors in 1995. The director resigned from the board in 1996.
Headwaters believes that most of the former director's options terminated
15
unexercised. The former director has claimed that he is entitled to exercise the
options. No lawsuit has been filed in this matter. Resolution is uncertain and
legal counsel cannot express an opinion as to the ultimate amount, if any, of
Headwaters' liability.
Other. Headwaters and its subsidiaries are also involved in other legal
proceedings that have arisen in the normal course of business.
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 2002 Low High
- ----------- --- ----
Quarter ended December 31, 2001 $ 9.10 $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
Fiscal 2003
- -----------
Quarter ended December 31, 2002 $12.81 $18.03
Quarter ended March 31, 2003 13.50 16.64
Quarter ended June 30, 2003 13.25 20.25
Quarter ended September 30, 2003 12.86 16.30
As of November 30, 2003, there were approximately 366 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. . See Note 12 to
the consolidated financial statements for a description of securities authorized
for issuance under equity compensation plans.
Recent Sales of Unregistered Securities
The following sets forth all securities issued by Headwaters during the
year ended September 30, 2003 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.
During the year ended September 30, 2003, pursuant to the exercise of
options and warrants, approximately 236,000 shares of Headwaters restricted
common stock were issued. Headwaters has several outstanding effective
registration statements filed on Forms S-3 and Forms S-8. All of shares of
restricted common stock issued during the year have been registered under one of
these registration statements
16
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 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, no results of operations of HTI were included in the
consolidated statement of income for 2001. HTI's August 31, 2001, 2002 and 2003
balance sheets were consolidated with Headwaters' September 30, 2001, 2002 and
2003 balance sheets and HTI's results of operations for the twelve months ended
August 31, 2002 and 2003 were consolidated with Headwaters' 2002 and 2003
results. Also, as more fully described in Note 3 to the consolidated financial
statements, Headwaters acquired ISG on September 19, 2002 and accordingly, ISG's
results of operations for the period from September 19, 2002 through September
30, 2003 have been consolidated with Headwaters' 2002 and 2003 results. ISG's
results of operations up to September 18, 2002 have not been included in
Headwaters' consolidated results for any period. As more fully described in Note
11 to the consolidated financial statements, in 2001, Headwaters recorded
approximately $7.5 million of income tax benefit primarily related to the
reduction of its deferred tax asset valuation allowance.
The selected financial data as of and for the years ended September 30,
1999 and 2000 and as of September 30, 2001 are derived from audited financial
statements not included herein. The selected financial data as of September 30,
2002 and 2003 and for the years ended September 30, 2001, 2002, and 2003 were
derived from the audited financial statements of Headwaters included elsewhere
herein.
Year ended September 30,
-----------------------------------------------------------------
(in thousands) 1999 2000 2001 2002 2003
- ------------------------------------------------- ------------ ------------ ------------ ------------ -------------
OPERATING DATA:
Total revenue $ 6,719 $ 27,886 $ 45,464 $ 119,345 $ 387,630
Net income (loss) (28,393) 3,682 21,517 24,286 36,631
Diluted earnings (loss) per share 0.07 0.87 0.94 1.30
(2.39)
As of September 30,
-----------------------------------------------------------------
(in thousands) 1999 2000 2001 2002 2003
- ------------------------------------------------- ------------ ------------ ------------ ------------ -------------
BALANCE SHEET DATA:
Working capital (deficit) $ (2,721) $ 8,393 $ 8,619 $ 15,023 $ 14,176
Net property, plant and equipment 14,182 552 2,680 50,549 52,743
Total assets 58,095 33,441 55,375 372,857 373,275
Long-term obligations:
Long-term debt 17,887 5,055 149 154,552 104,044
Unamortized non-refundable license
fees and other long-term liabilities 8,036 7,861 8,711 5,442 4,703
Redeemable convertible preferred
stock 4,332 -- -- -- --
Deferred income taxes -- -- -- 51,357 50,663
Total long-term obligations 30,255 12,916 8,860 211,351 159,410
Total stockholders' equity (deficit) (1,028) 10,747 31,086 98,596 140,157
17
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, future references to years refer to Headwaters' fiscal
year rather than a calendar year.
Acquisitions of ISG and HTI and Segments
The consolidated financial statements include the accounts of
Headwaters and all of its subsidiaries, only two of which have significant
operations, ISG and HTI. All significant intercompany transactions and accounts
are eliminated in consolidation. ISG was acquired on September 19, 2002 and
accordingly, ISG's results of operations for the period from September 19, 2002
through September 30, 2003 have been consolidated with Headwaters' 2002 and 2003
results. HTI was acquired in August 2001. 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, no results of
operations of HTI were included in the consolidated statement of income for
2001. HTI's August 31, 2002 and 2003 balance sheets were consolidated with
Headwaters' September 30, 2002 and 2003 balance sheets and HTI's results of
operations for the twelve months ended August 31, 2002 and 2003 were
consolidated with Headwaters' 2002 and 2003 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 the leading provider
of high quality fly ash to the building products and ready mix concrete
industries in the United States. ISG also develops, manufactures and distributes
value-added bagged concrete, stucco, mortar and block products that utilize fly
ash through its construction materials segment. Headwaters' historical focus has
been on using technology to add value to fossil fuels, particularly coal. The
acquisition of ISG provided Headwaters with a significant position in the last
phase of the coal value chain due to ISG's competencies in managing CCPs. The
acquisition of ISG also brought to Headwaters substantial management depth,
comprehensive corporate infrastructure and critical mass in revenues and
operating income.
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 9 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
$170.0 million. Headwaters also 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%. The total consideration
paid for ISG was $257.9 million and is described in more detail in Note 3 to the
consolidated financial statements.
The ISG acquisition was accounted for using the purchase method of
accounting as required by SFAS No. 141, "Business Combinations." Assets acquired
and liabilities assumed were recorded at their 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
electric power generation plants and patents. 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 was
allocated to goodwill, none of which is tax deductible. All of the intangible
assets and all of the goodwill were allocated to the CCP segment.
HTI Acquisition. In August 2001, Headwaters acquired 100% of the common
stock of HTI, a New Jersey-based company. HTI's activities are directed at
catalyst technologies to convert coal and heavy oil into
environmentally-friendly, higher-value liquid fuels, as well as nanocatalyst
processes and applications. The total consideration paid for HTI was $15.0
million and is described in more detail in Note 3 to the consolidated financial
statements.
The HTI acquisition was accounted for using the purchase method of
accounting. Assets acquired and liabilities assumed were recorded at their 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 synthetic fuels
18
and chemicals while improving energy efficiency and reducing environmental
risks. This amount represented projects that had not reached technological
feasibility and had no alternative use as of the acquisition date, and was
expensed in 2001.
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, Headwaters now operates in three business segments,
alternative energy, CCPs, and construction materials. These segments are managed
and evaluated separately by management based on fundamental differences in their
operations, products and services.
The alternative energy segment includes Headwaters' traditional
coal-based solid synthetic fuels business and HTI's business of developing
catalyst technologies to convert coal and heavy oil into
environmentally-friendly, higher-value liquid fuels as well as nanocatalyst
processes and applications. Revenues for this segment primarily include sales of
chemical reagents and license fees.
The CCP segment includes ISG's business of providing fly ash to the
building products and ready mix concrete industries. This segment markets coal
combustion products such as fly ash and bottom ash, known as CCPs. ISG has
long-term contracts, primarily with coal-fired electric power generation plants,
pursuant to which it manages the post-combustion operations for the utilities.
ISG markets CCPs to replace manufactured or mined materials, such as portland
cement, lime, agricultural gypsum, fired lightweight aggregate, granite
aggregate and limestone. CCP revenues consist primarily of the sale of products,
with a small amount of service revenue.
The construction materials segment manufactures and distributes
value-added bagged concrete, stucco, mortar and block products. ISG has
introduced high volumes of CCPs as substitute ingredients in the products the
construction materials segment produces.
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 disclosures 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. Such policies and estimation
procedures have been reviewed with Headwaters' audit committee. The following is
a discussion of critical accounting policies and estimates.
License Fee Revenue Recognition. Headwaters currently licenses its
technologies to the owners of 28 of a company-estimated 75 coal-based solid
synthetic fuel facilities in the United States. Recurring license fees or
royalty payments are recognized in the period when earned, which generally
coincides with the sale of synthetic fuel by Headwaters' licensees. In most
instances, Headwaters receives timely reports from licensees notifying
Headwaters of the amount of solid synthetic fuel sold and the royalty due
Headwaters under the terms of the respective license fee agreements.
Additionally, Headwaters has experienced a regular pattern of payment by these
licensees of the reported amounts.
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 synthetic fuel or when a
synthetic 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 estimate the
license fee revenue earned. In these situations, Headwaters uses such
information as is available and where possible, substantiates the information
through such procedures as observing the levels of chemical reagents purchased
by the licensee and used in the production of the solid synthetic 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. Collateral is
not required for trade receivables, but Headwaters performs periodic credit
evaluations of its customers. Collateral is generally required for notes
receivable and has historically consisted of most or all assets of the debtor.
19
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 construction materials 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.
Net losses recognized on notes receivable were approximately $3.7
million in 2001, $0.7 million in 2002 and $2.1 million in 2003. Notes receivable
generally relate to nonoperating activities and accordingly, losses are included
in other expense in the consolidated statements of income. The losses on notes
receivable in 2001 consisted entirely of write-offs or impairments of notes from
unrelated, high-risk entities to which Headwaters loaned funds 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 company, in exchange for a $4.0 million 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. If an
impairment is indicated, Headwaters writes down the note receivable to its
estimated net realizable value. Impairment losses of approximately $1.0 million
and $2.1 million were recorded in 2002 and 2003, respectively, due to declines
in the value of the underlying collateral, which management deemed other than
temporary, during those periods.
Headwaters considers its receivable allowances adequate as of September
30, 2003; 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. Long-lived assets consist primarily of property, plant and equipment,
intangible assets and goodwill. Intangible assets consist primarily of
identifiable intangible assets obtained in connection with the acquisitions of
ISG (long-term contracts and patents) and HTI (existing patented technology).
These intangible assets are being amortized on the straight-line method over
their remaining estimated useful lives. Goodwill consists of the excess of the
purchase price for ISG and HTI over the fair value of identified assets
acquired, net of liabilities assumed. In accordance with Statement of Financial
Accounting Standards ("SFAS") No. 142, "Accounting for Goodwill and Intangible
Assets," goodwill is not amortized, but is tested at least annually for
impairment. Goodwill is normally tested as of June 30, using a two-step process
that begins with an estimation of the fair value of the reporting unit giving
rise to the 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.
There were no impairment losses recorded for long-lived assets in any of the
years presented. 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.
In accordance with the requirements of SFAS No. 142, Headwaters does
not amortize goodwill. SFAS No. 142 requires Headwaters to periodically perform
tests for goodwill impairment. Step 1 of the initial impairment test was
required to be performed no later than March 31, 2003; thereafter impairment
testing is required to be performed no less often than annually, or sooner if
evidence of possible impairment arises. Impairment testing is performed at the
reporting unit level and Headwaters has identified four reporting units: (i) the
Covol Fuels division and (ii) HTI (which together comprise the alternative
energy segment), (iii) CCPs and (iv) Construction Materials. Currently, goodwill
exists only in the CCPs and HTI reporting units.
Step 1 of impairment testing consists of determining and comparing the
fair values of the reporting units to the carrying values of those reporting
units. If step 1 were to be failed for either the CCPs or HTI reporting units,
indicating a potential impairment, Headwaters would be required to complete step
2, which is a more detailed test to calculate the implied fair value of
goodwill, and compare that value to the carrying value of the goodwill. If the
carrying value of the goodwill exceeds the implied fair value of the goodwill,
an impairment loss is required to be recorded.
20
Headwaters performed step 1 impairment tests of the recorded goodwill
in the CCPs and HTI reporting units as of October 1, 2002, the beginning of
fiscal year 2003. Headwaters performed its annual, recurring tests for potential
impairment using the date of June 30, 2003. The tests indicated that the fair
values of the reporting units exceeded their carrying values as of both October
1, 2002 and June 30, 2003. Accordingly, step 2 of the impairment tests was not
required to be performed, and no impairment charge was necessary.
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 and its subsidiaries are involved in several
legal proceedings and contractual matters that have arisen in the normal course
of business, all as explained in more detail in "ITEM 3. LEGAL PROCEEDINGS" and
Note 14 to the consolidated financial statements. Management in all cases
intends to vigorously defend Headwaters' position. In regards to all of the
unsettled legal matters, legal counsel cannot express an opinion as to the
ultimate amount of recovery or liability. Management does not believe that the
outcome of these matters will have a significant adverse effect upon the
operations, cash flows 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 accounting for legal matters, Headwaters follows the guidance in
SFAS No. 5, "Accounting for Contingencies," under which loss contingencies are
accounted for based upon the likelihood of an impairment of an asset or the
incurrence of a liability. If a loss contingency is "probable" and the amount of
loss can be reasonably estimated, it is accrued. If a loss contingency is
"probable," but the amount of loss cannot be reasonably estimated, or if a loss
contingency is "reasonably possible," disclosure is made. Loss contingencies
that are "remote" are neither accounted for nor disclosed. Gain contingencies
are given no accounting recognition, but are disclosed if material.
Year Ended September 30, 2003 Compared to Year Ended September 30, 2002
The information set forth below compares Headwaters' operating results
for the year ended September 30, 2003 ("2003") with operating results for the
year ended September 30, 2002 ("2002").
Revenue. Total revenue for 2003 increased by $268.3 million or 225% to
$387.6 million as compared to $119.3 million for 2002. The major components of
revenue are discussed in the sections below.
Sales of Chemical Reagents. Chemical reagent sales during 2003 were
$128.4 million with a corresponding direct cost of $87.4 million. Chemical
reagent sales during 2002 were $74.4 million with a corresponding direct cost of
$50.1 million. The increase in chemical reagent sales during 2003 was due to
increased synthetic fuel production by Headwaters' licensees, as well as sales
of chemical reagents to new customers with which Headwaters does not have a
license agreement.
License Fees. During 2003, Headwaters recognized license fee revenue
totaling $35.7 million, an increase of $5.2 million or 17% over $30.5 million of
license fee revenue recognized during 2002. License fees in 2003 consisted of
recurring license fees or royalty payments of $34.5 million and deferred revenue
amortization of $1.2 million. License fees in 2002 consisted of recurring
license fees of $29.0 million and deferred revenue amortization of $1.5 million.
The primary reason for the increase in license fee revenue in 2003 compared to
2002 was a major licensee that purchased four facilities from a former licensee
in October 2001, but did not begin operating those facilities until early
calendar 2002. Headwaters earned approximately $11.3 million in license fees
from this licensee in 2003 and $7.4 million in 2002.
Pursuant to the contractual terms of an agreement with a certain
licensee, the cumulative license fees owed to Headwaters have been placed in
escrow for the benefit of Headwaters pending resolution of certain
contingencies. 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. As of September 30, 2003, the
license fees, net of anticipated expenses, total approximately $20.0 million.
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. In addition to these escrowed
amounts, this same licensee has also set aside substantial amounts for various
operational contingencies as provided for in the contractual agreements. These
reserves, if not needed, will eventually be paid out to various parties having
an interest in the cash flows from the licensee's operations, including
Headwaters. As a result, Headwaters currently expects to receive at some future
date a portion of those reserves, the amount of which is not currently
determinable and therefore, not recognizable.
21
ISG Revenues and Cost of Revenues. CCP revenues and sales of
construction materials and the related cost of revenue captions represent ISG's
revenues and cost of revenues. Because ISG was purchased on September 19, 2002,
there were only 12 days of operations included in 2002 compared to a full year
in 2003.
Depreciation and Amortization. These costs increased by $11.2 million
to $13.0 million in 2003 from $1.8 million in 2002. The increase was primarily
attributable to depreciation and amortization of ISG's tangible and intangible
assets.
Research and Development. Research and development expenses increased
by $2.4 million to $4.7 million in 2003 from $2.3 million in 2002. The increase
was primarily attributable to the inclusion of additional costs relating to
ISG's research and development activities. In 2002, research and development
expenses represented primarily costs related to HTI's activities, which remained
relatively unchanged during 2003.
Selling, General and Administrative Expenses. These expenses increased
$27.0 million to $40.7 million for 2003 from $13.7 million for 2002. The
increase in 2003 was due primarily to the inclusion of ISG's costs, and to a
lesser extent, an increase in professional services expenses of approximately
$1.1 million related to legal actions in which Headwaters is currently involved.
Other Income and Expense. During 2003, Headwaters reported net other
expense of $17.0 million compared to net other expense of $0.8 million during
2002. The change of $16.2 million was attributable to i) an increase in interest
expense of $15.1 million, ii) a decrease in interest income of $0.7 million, and
iii) an increase in net losses on notes receivable and investments of $1.7
million, substantially offset by an increase in net other income of $1.3
million.
Interest expense increased in 2003 due to the substantial increase in
debt incurred in September 2002 to finance the acquisition of ISG. Interest
expense in 2003 includes $1.5 million related to accelerated amortization of
debt discount and debt issue costs associated with $25.5 million of early
repayments of senior debt principal. Interest income decreased from 2002 to 2003
primarily due to lower average balances of cash and short-term investments as a
result of Headwaters using a substantial amount of cash to purchase ISG and
applying available cash generated in 2003 to repay long-term debt. Lower
interest rates in 2003 also affected interest income.
Losses on notes receivable were $1.4 million higher in 2003 as compared
to 2002. In both years, the majority of the losses represented write-downs of a
note receivable which is being accounted for on the cost recovery method. The
write-downs in both years were necessary due to declines in the value of the
underlying collateral. The carrying value of this note receivable at September
30, 2003 was $0.5 million. In 2003, Headwaters also recorded a $0.3 million loss
on an investment.
Net other income increased by $1.3 million in 2003 compared to 2002
primarily due to two non-recurring transactions in 2002. A $1.3 million gain on
sale of assets resulted from the sale of a 50% interest in one of Headwaters'
original synthetic fuel facilities. Also, Headwaters recorded approximately $2.6
million of losses related to the write-off of deferred project / financing costs
resulting from the abandonment of certain projects or the postponement or
redirection of activities for which costs had previously been deferred.
Income Tax Provision. In 2003, Headwaters recorded an income tax
provision at an effective tax rate of approximately 39%. In 2002, the effective
tax rate was approximately 40%.
Year Ended September 30, 2002 Compared to Year Ended September 30, 2001
The information set forth below compares Headwaters' operating results
for the year ended September 30, 2002 ("2002") with operating results for the
year ended September 30, 2001 ("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.
Sales of Chemical Reagents. 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 synthetic fuel production by Headwaters' licensees, as well as
sales of chemical reagents to new customers.
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.
22
A major licensee significantly reduced its production and sale of
synthetic 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 synthetic fuel sales by most
other licensees, caused the increase in license fee revenue for 2002 over 2001.
Other Revenues and Cost of Revenues. CCP revenues and sales of
construction materials and the related cost of revenue captions represent ISG's
revenues and cost of revenues. ISG was purchased on September 19, 2002, and
accordingly, there were only 12 days of operations included in 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 either ISG or 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).
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 represented 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 improved operating results. The increase in professional
services expenses was due primarily to legal costs associated with legal actions
in which Headwaters is currently involved. 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 was 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 that 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 synthetic 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.
Income Taxes. In 2001, Headwaters reported a net income tax benefit of
$7.1 million, consisting of the recognition of $7.5 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. 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%.
23
Liquidity and Capital Resources
Net cash provided by operations during the fiscal year ended September
30, 2003 ("2003") was $56.4 million compared to $42.8 million of net cash
provided by operations during the fiscal year ended September 30, 2002 ("2002").
Most of the cash flow from operating activities in both periods was attributable
to net income. Consistent with Headwaters' strategic priority to repay debt and
de-leverage its balance sheet, Headwaters used most of the cash generated during
the year ended September 30, 2003 to repay debt. During 2003, investing
activities consisted primarily of payments for the purchase of property, plant
and equipment and proceeds from disposition of property, plant and equipment.
Investing activities in 2002 consisted primarily of cash payments for the
acquisition of ISG of $205.9 million and the collection of a $6.5 million note
receivable. Financing activities in both 2003 and 2002 consisted primarily of
proceeds from and repayments of long-term debt and short-term borrowings, and
proceeds from exercise of options, warrants and employee stock purchases. More
details about these activities are provided in the following paragraphs.
Operating Activities. Cash provided from operations in 2003 of $56.4
million resulted primarily from net income of $36.6 million plus depreciation
and amortization of $13.0 million.
Investing Activities. In 2003, payments for the purchase of property,
plant and equipment totaled $9.7 million. These capital expenditures primarily
related to ISG's business, in particular the CCP segment. Capital expenditures
for 2004 are expected to be comparable with 2003 levels.
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. In 2003, Headwaters recorded a $2.1
million write-down of this note and as of September 30, 2003 this note has a
carrying value of $0.5 million. Headwaters could incur additional losses if the
remaining balance on the note is not repaid or if the collateral value declines.
At September 30, 2001, Headwaters had outstanding one other note receivable in
the amount of $6.5 million. This note and the related accrued interest were
collected in 2002.
Financing Activities. Headwaters acquired ISG in September 2002. 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 and $20.0 million of subordinated debt (see Note 9 to the
consolidated financial statements). During 2003, principal repayments of the
senior debt totaling $40.1 million were made, including $25.5 million of
optional prepayments. Subsequent to September 30, 2003 and through November 30,
2003, principal repayments totaling $9.7 million have been made, including
optional prepayments of $3.5 million.
In 2003, cash proceeds from the exercise of options, warrants and
employee stock purchases totaled $2.9 million, compared to $5.7 million in 2002.
Option and warrant exercise activity is largely dependent on Headwaters' stock
price and is not predictable. To the extent non-qualified stock options are
exercised, or there are disqualifying dispositions of shares obtained upon the
exercise of incentive stock options, Headwaters receives a tax benefit generally
equal to the income recognized by the optionee. Such amounts, reflected in cash
flows from operations in the consolidated statements of cash flows, were $3.0
million in 2002 and $2.1 million in 2003.
Headwaters intends to continue to expand its business through growth of
existing operations, commercialization of technologies currently being
developed, and strategic acquisitions of entities that operate in adjacent
industries. Currently the senior secured credit facility requires approval for
acquisitions funded with aggregate cash consideration in excess of $50.0
million.
Headwaters has an effective $150.0 million universal shelf registration
statement on file with the SEC that can be used for the sale of common stock,
preferred stock, convertible debt and other securities. The most likely use of
the shelf registration statement would be to issue equity securities to reduce
long-term debt and for general corporate purposes, including acquisitions. A
prospectus supplement describing the terms of any securities to be issued is
required to be