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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, 2004,
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission file number 0-27808
HEADWATERS INCORPORATED
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(Exact name of registrant as specified in its charter)
Delaware 87-0547337
- --------------------------------- ------------------------------------
(State or other jurisdiction (I.R.S. Employer Identification No.)
of 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:
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None
Securities registered pursuant to Section 12(g) of the Act:
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Common Stock, $.001 par value
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
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, 2004 was $829,944,861, 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, 2004 was 33,905,043.
___________________________
DOCUMENTS INCORPORATED 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 2005 are
incorporated by reference into Part III of this report on Form 10-K.
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TABLE OF CONTENTS
Page
PART I
ITEM 1. BUSINESS.......................................................... 4
ITEM 2. PROPERTIES........................................................ 21
ITEM 3. LEGAL PROCEEDINGS................................................. 21
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............... 23
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES............... 23
ITEM 6. SELECTED FINANCIAL DATA........................................... 24
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS....................................... 25
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........ 49
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................... 50
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE........................................ 50
ITEM 9A. CONTROLS AND PROCEDURES........................................... 50
ITEM 9B. OTHER INFORMATION................................................. 51
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................ 51
ITEM 11. EXECUTIVE COMPENSATION............................................ 51
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.... 51
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................... 51
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES............................ 51
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES........................... 52
SIGNATURES................................................................... 55
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 Headwaters' future results that are based on current expectations,
estimates, forecasts, and projections about the industries in which Headwaters
operates and the beliefs and assumptions of its 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 Headwaters'
future financial performance, its anticipated growth and trends in its
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 caption entitled "Risk Factors" in
Item 7 hereof. There can be no assurance that Headwaters' results of operations
will not be adversely affected by such factors. Unless legally required,
Headwaters undertakes 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.
Headwaters' Internet address is www.headwaters.com. There Headwaters makes
available, free of charge, its 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 Headwaters electronically files such
material with, or furnish it to, the Securities and Exchange Commission ("SEC").
Headwaters' reports can be accessed through the investor relations section of
its web site. The information found on Headwaters' web site is not part of this
or any report it files with or furnishes to the SEC.
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PART I
ITEM 1. BUSINESS
General Development of Business
Introduction. Headwaters is a diversified growth company providing
products, technologies and services to the energy, construction and home
improvement industries. Headwaters has grown dramatically over the last several
years, both organically and through strategic acquisitions that have allowed it
to diversify and pursue other growth opportunities. Headwaters' revenues have
grown from $27.9 million in 2000 to $892.1 million for the fiscal year ended
September 30, 2004 on a pro forma basis as if all 2004 acquisitions had occurred
as of October 1, 2003. Headwaters' acquisition strategy has concentrated on
opportunities that complement existing business lines, command leading market
positions, are accretive to earnings and generate significant positive cash
flow.
Headwaters conducts its business primarily through the following
business units:
Headwaters Energy Services (formerly known as Covol Fuels) is the
market leader in enhancing the value of coal used in power generation through
licensing proprietary technologies and selling chemical reagents that convert
coal into a solid alternative fuel.
Headwaters Resources (formerly known as ISG) is the largest manager and
marketer of coal combustion products ("CCPs") in the United States. Headwaters
Resources creates commercial value for CCPs using CCPs primarily as a
replacement for portland cement in a variety of concrete products. CCPs, such as
fly ash and bottom ash, are created when coal is burned and have traditionally
been an environmental and economic burden for coal-fueled power generators but,
when properly managed, can result in additional revenue for the utilities.
Headwaters Technology Innovation Group, known as HTI, develops and
commercializes proprietary technologies to convert or upgrade fossil fuels into
higher-value products and develops nanocatalyst technologies that have multiple
industrial and chemical applications. The energy-related technologies developed
or under development include direct coal liquefaction, the conversion of
gas-to-liquid fuels and the upgrading of heavy oil to lighter materials. HTI has
also developed a proprietary nanocatalyst technology that will allow for the
custom design of catalysts on an atomic scale for multiple industrial
applications, which should reduce costs and increase the efficiency of chemical
reactions.
Headwaters Construction Materials (formerly known as American
Construction Materials) is a market leader in designing, manufacturing and
marketing architectural stone products under the Eldorado Stone brand acquired
in June 2004 and also holds regional market leadership positions in
manufacturing and marketing concrete blocks, mortar and stucco materials. In
September 2004, Headwaters acquired Tapco Holdings, Inc. ("Tapco"), a leading
manufacturer of building products accessories (such as window shutters, gable
vents and mounting blocks) and professional tools used in exterior residential
remodeling and construction. The acquisitions of the Tapco and Eldorado Stone
businesses in 2004 have significantly transformed the Headwaters Construction
Materials business unit and given Headwaters a national presence in the
commercial and residential improvement market.
Headwaters' Company History. Headwaters was incorporated in Delaware in
1995 under the name Covol Technologies, Inc. In September 2000, its name was
changed to Headwaters Incorporated. Headwaters' stock trades under the Nasdaq
symbol "HDWR".
As used herein, "Headwaters," "combined company," "we," "our" and "us"
refer to Headwaters Incorporated and its consolidated subsidiaries, including
Headwaters Energy Services Corp. and its subsidiaries and affiliates; Headwaters
Resources, Inc. and its subsidiaries; Headwaters Technology Innovation Group,
Inc. and its subsidiaries and affiliates; and Headwaters Construction Materials,
Inc. and its subsidiaries and affiliates, including Eldorado Stone LLC and Tapco
Holdings, Inc., unless the context otherwise requires. As used in this report,
"HES" refers to Headwaters Energy Services Corp., together with its consolidated
subsidiaries and affiliates; "HRI" refers to Headwaters Resources, Inc. and its
consolidated subsidiaries; "HTI" refers to Headwaters Technology Innovation
Group, Inc., together with its consolidated subsidiaries and affiliates; and
"HCM" refers to Headwaters Construction Materials, Inc., together with its
consolidated subsidiaries and affiliates, including "Eldorado", which refers to
HCM Stone, LLC and Eldorado Stone LLC and all of their subsidiaries; and
"Tapco," which refers to Tapco Holdings, Inc., and its subsidiaries, unless the
context otherwise requires.
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Headwaters Energy Services
Principal Products and their Markets. Headwaters Energy Services Corp.,
together with its subsidiaries and affiliates (collectively "HES"), develops and
commercializes technologies that interact with coal-based feedstocks to produce
a solid alternative fuel intended to be eligible for Section 29 tax credits. The
sale of qualified alternative 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 alternative 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
alternative fuel and to other solid alternative fuel facility owners with whom
Headwaters has reagent supply agreements.
Licensees. Headwaters licenses its technologies to 28 of a
company-estimated total of 75 coal-based solid alternative fuel facilities in
the United States. In addition, during fiscal 2004 Headwaters sold its
proprietary chemical reagents to approximately 32 licensee and other alternative
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.
Chemical Reagent Sales. The transformation of the feedstock to an
alternative fuel involves the use of a chemical reagent in a qualified facility.
Headwaters primarily markets two proprietary latex-based chemicals, Covol 298
and Covol 298-1, which are widely used for the production of coal-based solid
alternative fuel. The chemical reagent alters the molecular structure of the
feedstock to produce an alternative fuel.
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 HES process are environmentally safe,
possess superior handling characteristics, burn efficiently and are
competitively priced. Additionally, Headwaters' chemical reagents have been
reviewed often by the IRS and tested by independent laboratories. The parameters
of the HES 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 and IRS Announcement 2003-70.
On-site Facility Services. In addition to licensing its technology and
supplying chemical reagents, HES employs chemical, electrical and mechanical
engineers and field personnel with extensive plant and equipment operating
experience to perform on-site facility services and other technical support
functions. HES's engineers have years of experience operating alternative fuel
manufacturing equipment, including mixers, extruders, pellet mills, briquetters
and dryers. HES's employees are experienced in applying its chemical reagents on
multiple types of coal feedstocks. HES has operated alternative fuel facilities
utilizing multiple types of coal feedstocks and has developed and demonstrated
process improvements in commercial facilities. HES has also designed and
constructed reagent mixing and application systems and has retrofitted existing
facilities to use its reagents. For new customers, HES has a mobile,
skid-mounted reagent delivery system that allows for on-site demonstration
testing. HES believes that this full spectrum of services makes it unique in
providing goods and services to the coal-based solid alternative fuel business.
HES maintains analytical laboratories, including bench-scale equipment
for the production of coal-based solid alternative fuel and comprehensive
analytical testing equipment for performing standard coal analyses. Headwaters
also monitors, documents and substantiates the chemical change process required
to obtain Section 29 tax credits.
Sources of Available Raw Materials and Inventory Requirements.
Headwaters' chemical reagents 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 drop shipping of
5
the chemical reagents directly from Dow Reichhold's production facilities to the
alternative 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-fueled electricity generating facilities).
Headwaters Resources
Principal Products and their Markets. Headwaters Resources is currently
the largest manager and marketer of coal combustion products ("CCPs") in the
United States and also manages and markets CCPs in Canada and Puerto Rico. HRI
has long-term exclusive management contracts with coal-fueled electric
generating utilities throughout the United States and provides CCP management
services at more than 110 power plants. HRI markets CCPs in areas where
sufficient demand exists, and manages much of the disposal of the rest of the
CCPs it obtains, typically in landfills. HRI has established long-term
relationships with many of the nation's major utilities and also assists
utilities with their overall CCP management programs.
HRI 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, HRI provides its affiliate,
Headwaters Construction Materials, CCPs for use in certain construction products
such as mortars, stucco and concrete blocks.
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. In part because of the cost of transportation,
the market for CCPs used in construction is generally regional, although HRI
ships products significant distances to states such as California and Florida
that have limited coal-fueled electric utilities producing high quality CCPs.
HRI enjoys advantages in both logistics and sales from its status as the largest
manager and marketer of CCPs in the United States. HRI maintains more than 30
stand-alone CCP distribution terminals across North America, as well as
approximately 90 plant-site supply facilities. HRI owns or leases approximately
1,300 rail cars and more than 150 trucks, and also contracts with other carriers
so that it can meet its transportation needs for the marketing and disposal of
CCPs. In addition, HRI 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. Chemically, fly ash combines silicon with free lime
created by cement hydration to produce additional binding ability within
concrete - decreasing permeability and enhancing durability. 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 have a "ball bearing" effect which lubricates the concrete mix and
allows enhanced workability with less water. The requirement of less water also
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. In
addition to conserving landfill space, fly ash usage conserves energy and
reduces green house gas emissions. According to the EPA, one ton of fly ash used
as a replacement for portland cement eliminates approximately one ton of carbon
dioxide emissions associated with cement production. This is 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 Department of Energy and EPA, which has issued comprehensive procurement
guidelines directing federal agencies to utilize fly ash. The EPA has also
created the Coal Combustion Products Partnership ("C2P2") to nationally promote
CCP utilization. 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
6
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.
Higher quality fly ash and other high value CCPs have the greatest
value to HRI because of the wide variety of higher margin commercial uses. In
fiscal 2004, HRI sold approximately 5.79 million tons of high value CCPs. The
quality of fly ash produced by the combustion process at coal-fueled facilities
varies widely and is affected by the type of coal feedstock used and the boilers
maintained by the utilities. HRI assists its utility clients in their efforts to
improve the production of high value CCPs at their facilities. HRI tests fly ash
to certify compliance with applicable industry standards. A quality control
system ensures that customers have a specific quality of CCPs for various
applications while HRI's extensive investment in transportation equipment and
terminal facilities provides reliability of supply.
HRI 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.
HRI 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 HRI'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. HRI publishes technical reference
information pertaining to CCPs and CCP applications. HRI also
prominently promotes the environmental benefits of CCP use.
o Relationships with Industry Organizations. HRI 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
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. HRI promotes the use of CCPs at more than 30
local and national trade shows and association meetings each
year. HRI is also an exhibitor at the nation's leading
conferences for utilization of environmentally friendly
building products.
o Government Affairs. HRI 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. HRI advertises for fly ash sales and utilization
in a number of publications, including: Architectural Record,
Construction Specifier, Concrete Products, Concrete Producer,
Concrete International and Environmental Design &
Construction.
o Creation of Branded Specialty Products. HRI has developed
several specialty products that increase market penetration of
CCPs and name recognition for HRI'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) - Flue Gas Desulphurization (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
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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, HRI'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, HRI has developed
FlexCrete(TM), a new commercial and residential building product in its early
commercialization stages. FlexCrete(TM) is an aerated concrete product with 60%
fly ash content that is cured at lower temperatures and ambient pressure. HRI
expects 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. HRI has also 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. HRI 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 thereby reducing its resistance to
the effects of freeze-thaw conditions. Technologies designed to remove residual
carbon are often capital intensive and are therefore rarely used. HRI 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 adverse effects on the quality of finished concrete. Full scale
carbon fixation units have been installed and are operating at major power
plants.
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. HRI 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.
Sources of Available Raw Materials and Inventory Requirements. Coal is
the largest indigenous fossil fuel resource in the United States. The U.S.
Department of Energy (DOE) estimates that in 2003 annual coal production was in
excess of one billion tons. Almost 92% of all coal consumed in the United States
was for electrical power generation. The DOE further estimates that 2003 U.S.
coal consumption was for electrical power generation was at a record level of
slightly more than one billion tons. 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. 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, about 37 million tons of CCPs are beneficially used each year
in the United States with more than 81 million tons of CCPs disposed of in
landfills. This provides for opportunities for continuing increases in CCP
utilization. As long as a significant amount of electricity in this country is
generated from coal-fueled generation, HRI believes it will have an adequate
supply of raw materials.
Headwaters Technology Innovation Group
Headwaters Technology Innovation Group, Inc., together with its
subsidiaries and affiliates (collectively "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.
8
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 for the production of
chemicals such as propylene oxide. This same technique can
also be used to improve existing chemical refining of precious
metal catalysts, improve volatile organic compound oxidation,
naphtha reforming and the production of high performance
catalysts including fuel cell catalysts. In September 2004 HTI
entered into a joint venture with Degussa AG, located in
Dusseldorf, Germany, to develop and commercialize a process
for the direct synthesis of hydrogen peroxide (H2O2). The
venture aims to invest in large facilities to produce low-cost
hydrogen peroxide for chemical intermediates. High-volume
producers will be able to use the H2O2 from these facilities
to produce intermediates such as propylene oxide (PO). Subject
to terms and conditions of the agreement, the joint venture
intends to complete process development by 2007, and will be
responsible for any subsequent development and
commercialization of manufacturing facilities.
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 (DCL) technology for its plant to be built in
Majata, China. Although completion of the plant is several
years away, it is expected to become the first commercial
direct coal liquefaction plant in the world with an ultimate
capacity of 50,000 barrels per day. In October 2004, HTI was
awarded a contract by Oil India Limited, a government of India
enterprise, to study the technical and economic feasibility of
applying HTI's direct coal liquefaction technology in India.
Oil India is a public sector company engaged in petroleum
exploration and production in the Assam region of northeastern
India, an area rich in natural resources but distant from
established oil refining operations. Under a concurrently
signed memorandum of understanding, the companies have agreed
that pending a positive result from the feasibility study, if
Oil India elects to proceed with a commercial-scale DCL
project, HTI will provide the technology license under
negotiated commercial terms.
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. An upgrading plant using the (HC)3 technologies can
produce 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
technologies 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 transportation 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 and chemicals, e.g., propylene. In
June 2004, HTI formed a joint venture with Rentech, Inc.
called FT Solutions LLC in order to accelerate the development
of FT technology. FT Solutions LLC combines the FT
technologies of both parties and holds the rights to license
the combined technology and supply engineering, technical
services and catalysts for FT projects.
Headwaters Construction Materials
Principal Products and their Markets. Headwaters Construction Materials
is a nation-wide market leader in designing, manufacturing and marketing
shutters, gable vents, mounting blocks and tools (under various Tapco brands),
and architectural manufactured stone (under the Eldorado Stone(R) brand). In
addition, HCM is a regional leader in manufacturing and distributing concrete
blocks and other masonry units (under the Southwest and Palestine brands), as
well as various mortars and stuccos (under the Best Masonry, Magna Wall(R) and
other brands). The acquisitions of Tapco, Eldorado and Southwest in 2004 have
significantly transformed Headwaters Construction Materials business unit and
given Headwaters a national presence in the commercial and residential
improvement market. HCM uses fly ash in the manufacture of its block, mortar and
stucco products and intends to use fly ash in its manufactured stone products.
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Eldorado
In June 2004, Headwaters acquired Eldorado Stone, LLC, together with
its wholly-owned subsidiaries.
Principal Products and their Markets. Eldorado offers a wide variety of
high-quality, hand-made manufactured stone products to meet a variety of design
needs. Eldorado's architectural manufactured stone siding incorporates several
key features important to a successful siding product, including: high aesthetic
quality, ease of installation, durability, low maintenance, reasonable cost and
widespread availability. Eldorado's product line has been designed and is
manufactured to be one of the most realistic architectural stone products in the
world. Eldorado's architectural stone siding is a lightweight, adhered siding
product used by national, regional and local architectural firms, real estate
developers, contractors, builders and homeowners. Eldorado Stone(R) is used in
construction projects ranging from large-scale residential housing developments
and commercial projects to do-it-yourself home improvement jobs. In addition to
its use as a primary siding material, the Eldorado product line is used in a
variety of external and internal home applications such as walls, archways,
fireplaces and landscaping. Headwaters believes that Eldorado's focus on product
quality, breadth and innovation, combined with a geographically diversified
manufacturing platform, provides it with significant advantages in leading
architects, builders and end-users to choose Eldorado over traditional materials
such as natural stone, brick or stucco.
Eldorado Stone(R) is available in 60 distinct stone types, developed
from 12 stone profiles and crafted in a variety of natural colors designed by
Eldorado's artistic staff. Eldorado also offers regional stone products based on
the characteristics of the stone native to the regions. Each stone profile is
manufactured using numerous real stone models, which creates a realistic,
non-repetitive, natural stone look and is crafted in a variety of natural
colors. Eldorado believes its collection developed over the last 30 years of
more than 10,000 natural stones, which are used as models for the profiles, is
not easily replicated.
Manufacturing. Eldorado manufactures the molds for its stone profiles
as well as the manufactured stone created from these molds. Although Eldorado
does not currently use fly ash in its manufactured stone products, Headwaters
intends to replace a portion of the cement used in the production of Eldorado
Stone(R) with fly ash for greater durability, aesthetic enhancement and
environmental advantages. Headwaters believes that Eldorado's existing plants
may be modified to allow this substitution without material additional expense.
Eldorado has made recent investments in both its manufacturing operations and
sales and marketing capabilities. It has initiated production at its new Rancho
Cucamonga, California facility and has expanded its customer service operations
and staffing. Eldorado currently manufactures its products through a network of
plants strategically situated throughout the U.S. in proximity to its customers.
These locations allow for a high level of customer service, shorter lead times
and lower freight costs. Eldorado has manufacturing facilities at locations
including: Rancho Cucamonga, California; Pueblo, Colorado; Red Bud, Illinois;
Fayetteville, North Carolina; Apple Creek, Ohio; Greencastle, Pennsylvania ;
Carnation, Washington; and Royal City, Washington. In addition, Eldorado has
four distribution centers located at: Stockton, California; Orlando, Florida;
Portland, Oregon; and Arlington, Washington. A new manufacturing facility is
under construction in Dublin, Georgia.
Sales and Marketing. Eldorado distributes its architectural
manufactured stone products primarily on a wholesale basis through a network of
distributors, including masonry and stone suppliers, roofing and siding
materials distributors, fireplace suppliers and other contractor specialty
stores. Eldorado also has a small direct sales force. Eldorado's sales force
works closely with architects and contractors to provide information concerning
the attributes and ease of installation of its manufactured product and to
promote market acceptance over traditional building materials.
Southwest Concrete Products
In July 2004 HCM purchased the assets of Southwest Concrete Products,
LP through HCM's indirect subsidiary, HCM Block & Brick, LP ("Southwest").
Southwest is a leading manufacturer of concrete blocks in South Texas.
Principal Products and their Markets. Southwest, together with HCM's
existing operations (Palestine Concrete Tile Co., LP), makes HCM one of the
largest manufacturer and seller of concrete block in the Texas market, one of
America's largest block markets. The Southwest acquisition also provides
Headwaters with the opportunity to use fly ash in the manufacturing process for
concrete block, brick and foundation blocks.
10
Manufacturing. Southwest operates one of the most modern concrete block
and brick manufacturing facilities in the industry. It has recently launched a
new line of concrete bricks. Southwest has operations in Alleyton, San Antonio
and Houston which complement HCM's similar operations in Dallas and Palestine,
Texas.
Sales and Marketing. Combining SCP's modern manufacturing facilities
for concrete block and brick with those of HCM provides coverage of all the key
metropolitan areas in Texas, without duplication of facilities. The established
position of the combined block facilities may also provides Eldorado a strategic
location for expansion.
Tapco
In September 2004 Headwaters acquired Tapco Holdings, Inc. Tapco is a
leading designer, manufacturer and marketer of building products and
professional tools used in exterior residential home improvement and
construction.
Principal Products and their Markets. Tapco's building products, which
are either injection-molded from polypropylene or extruded, enhance the
appearance of homes and include window shutters, gable vents, mounting blocks
for exterior fixtures, roof ventilation, exterior decor products and specialty
siding products. Professional tools include portable cutting and shaping tools
used by contractors, on site, to fabricate customized aluminum shapes that
complement the installation of exterior siding.
Tapco markets its products under the brands "Tapco Products,"
"Mid-America Building Products," "Mid-America Master Series," "Builders Edge,"
"Atlantic Shutter Systems," "Vantage," and "The Foundry." Tapco markets its
injection-molded building product accessories to retailers and mass
merchandisers through its Builders Edge and Vantage brands and to the
manufactured housing market through the Manufactured House Products brand. In
addition, Tapco markets its tools through its Tapco brand, its functional
shutters and storm protection systems through its Atlantic Shutter Systems
brand, and its specialty siding product through its Foundry brand.
Building Products. Tapco designs, manufactures and markets
injection-molded window shutters, gable vents and exterior fixture mounting
blocks. In addition, Tapco manufactures roof vents, specialty vents, window
mantels, door surrounds, accent windows, functional shutters and specialty vinyl
siding. Tapco's building products serve the needs of the siding, roofing, and
window and door installation industries. Tapco's injection-molded products are
designed to enhance the exterior appearance of the home while delivering
durability at a lower cost compared to similar aluminum, wood and plastic
products while the functional shutters offer storm protection and also enhance
the exterior appearance of the home and can be manufactured to meet certain
hurricane codes. The injection-molded exterior products feature copolymer
construction and U.V. stabilized molded-through color.
o Decorative Shutters. Tapco offers the industry's most complete
line of standard and custom plastic window shutters, with an
extensive number of sizes and colors. Standard shutters, both
open louver and raised panel, are available in two widths, 14
standard lengths, 16 colors and paintable. Style-a-Shutter,
Tapco's line of custom shutters and matching shutter
components, is available in up to 13 widths, practically any
length, 24 styles, 18 colors and paintable. All of Tapco's
shutters feature the patented Shutter-Lok fastening system,
which facilitates ease of installation on any siding material
including wood, aluminum, vinyl, stucco, hardboard or brick.
o Gable Vents. GableMaster gable vents accommodate any
architectural style with over 35 size and design variations
available in over 220 colors including paintable and
stainable. Style-a-Vent, Tapco's line of custom vents, is
available in many shapes and sizes and in two colors.
GableMaster vents not only provide the needed ventilation, but
also add an important aesthetic benefit to a home. Each gable
vent features a patented lock-on ring, which significantly
reduces installation time by eliminating the need for caulking
or channeling and, like Tapco's shutters, can be easily
installed on any siding material. The GableMaster product line
is screened for insect protection and includes a double baffle
system for weather resistance.
o Mounting Blocks. Tapco manufactures the industry's most
extensive line of mounting blocks, used for the mounting of
exterior fixtures such as lights, electrical outlets, faucets,
doorbells, and address plates. Each mounting block also
features a patented lock-on ring for easy installation and
comes in 27 different styles and over 220 colors.
11
o Roof Vents. Tapco produces a line of roof ventilation
products, including ridge, hip, and stack covers. Tapco
believes that its roof ventilation products are the industry
leaders in terms of functionality, durability, and appearance.
o Specialty Vents. Tapco manufactures a broad line of specialty
vents, including air intake and exhaust vents, dryer vents and
foundation vents in over 200 colors including paintable.
o Functional Shutters. Tapco manufactures functional shutter
systems for storm protection and decorative applications. They
are available in numerous styles and almost any size and any
color.
o Specialty Siding. Tapco manufactures specialty siding (replica
cedar and shake siding) under the Foundry brand. Tapco's
specialty siding product is available in 10 different profiles
and 16 different colors. The siding can be used for accent
applications or whole house applications and can be installed
easily by a professional siding installer. The Foundry's
specialty siding utilizes a proprietary extrusion and in-line
forming process for production, as opposed to the
injection-molded process utilized by most competitors. The
extrusion process allows for changes in profiles and panel
dimensions at a lower cost than injection molding. This cost
savings has allowed Tapco to sell it at a lower price point
than traditional injection molded specialty siding products.
In addition, the installation process of Tapco's specialty
siding is the same as traditional siding, unlike the
specialized installation process required by competitors'
specialty siding products. The Foundry siding can be installed
faster and with less scrap than its injection-molded specialty
siding competitors. These characteristics increase the
profitability of using The Foundry's product relative to other
types of vinyl siding.
o Exterior Decor. Tapco also manufactures a variety of other
exterior decor items such as window headers, door surrounds
and exterior trim. These items are available in over 30 colors
and will fit any window or door.
o Professional Tools. Tapco believes it is the largest
manufacturer of portable cutting and shaping tools for the
professional siding contractor in the United States. These
tools enable installers of vinyl and aluminum siding to form
virtually any required shape on-site. Tapco's principal
installation tool is the bending brake. Brakes hold sheet
metal in place for bending and cutting during the installation
process. Tapco's MAX II, Pro-14 and Pro-19 brakes feature deep
working areas, enabling greater flexibility in making any
shape, and strong locking systems. Tapco's Pro-III
Port-O-Bender is the best selling portable brake. Tapco also
manufactures a brake, the MAX II Port-O-Bender, that is
designed to shape heavier gauge metal that is typically used
in commercial buildings. Tapco also offers numerous
accessories for brakes which include the Pro Cut-Off,
Side-Winder and Brake Buddy.
Distribution. Tapco's products are distributed throughout the United
States and Canada through four primary distribution channels: one-step
distributors that sell directly to contractors, two-step distributors that sell
Tapco's products to lumberyards and one-step distributors, retail home
centers/mass merchandisers, and manufactured housing.
Tapco distributes is accessory products to the one-step and two-step
distribution channels under the "Master Series(R)" brand and Mid-America
Building Products company name. Tapco distributes its accessory products to the
retail mass merchandiser channel through Builders Edge(R) and Vantage(R) brands.
Tapco distributes its products to the manufactured housing industry through
Manufactured Housing Products ("MHP"), a division of Metamora Products
Corporation. MHP has an exclusive supplier relationship with one of the largest
distributors to the manufactured housing market. Tapco also distributes its
products through all of the major vinyl siding, roofing, and window
distributors. Many competitors, in contrast, manufacture accessory products as
an adjunct to their core siding business.
Tapco's large number of distribution points is due in large part to the
strong customer "pull thru" demand for its products. Tapco seeks to be the
leader in each meaningful distribution channel by providing the broadest
selection of products coupled with high levels of customer service. Tapco is
able to secure multiple distribution points in local markets because its
products are not limited to any of the major branded roofing, siding, window and
door distributors. Many of Tapco's competitors offer products as an adjunct to
their core roofing, siding, window or door operations. As a result, their
distribution is typically limited to the authorized distributor of their core
branded products.
12
Sales and Marketing Organization. Tapco's sales and marketing
organization supports the one-step, two-step distribution, and retail channels
through various networks of sales support that include almost 200 independent
sales representatives and a small group of regional sales managers and sales
executives.
Tapco maintains relationships with thousands of local contractors,
professional builders, and other end-users by participating in over 1,000 local
shows and six national shows annually. Local shows, sponsored by local
distributors, enable Tapco to promote its products through hands-on comparisons
to competing products. These shows enable Tapco to receive useful feedback from
local contractors, which leads to new product ideas, as well as significant
goodwill within the trade.
Tapco supports distributors with product literature, displays, videos,
product training programs and showroom merchandising designed to increase
awareness among homeowners and contractors about the benefits of Tapco's
products. In addition, Tapco maintains a large mailing list of active
contractors, which Tapco gathers from warranty registration cards, local and
national shows and requests for CDs and product literature.
Major Customers. Tapco has a large customer base. Because all of the
one- and two-step distributors have multiple locations and each individual
location has autonomy to stock various products from different suppliers, the
number of ship-to locations is a better measure of the breadth of sales than is
the total number of customers. In the residential home improvement and building
products market, Tapco has over 4,500 non-retail ship-to locations and over
5,200 retail ship-to locations. Sales are broadly diversified across customers
and ship-to locations. For fiscal 2004, two retail home center customers
together represented approximately 25% of Tapco's total sales.
Manufacturing. Tapco conducts its manufacturing, distribution and sales
operations through 14 facilities, which total approximately 850,000 square feet.
Tapco's manufacturing assets include more than 100 injection molding presses,
almost all of which are automated through robotics or conveyor systems. Robotic
automation has reduced cycle times and helped reduce waste by keeping cycle
times consistent from part to part. Tapco has realized cycle time improvements
on all presses utilizing automation. Tapco's high volume allows it to invest in
multi-cavity tooling, resulting in significantly lower unit costs over single
cavity tooling.
Tapco follows strict quality control standards in its efforts to
produce products of consistent quality and free of production flaws. Any
nonconforming plastic parts are reused as raw material, further minimizing
waste. Tapco mandates quality control checks at each step of the manufacturing
process.
Sources of Available Raw Materials. Tapco has long-standing
relationships with its major suppliers. The raw materials Tapco purchases
include polypropylene and styrene pellets, plastic extrusions, and packaging
materials for Tapco's building product lines. Tapco primarily purchases
polypropylene and styrene from single (separate) suppliers. In addition, Tapco
purchases fabricated anodized aluminum, hinges and other components, and
packaging materials for its professional installation tools. Historically, Tapco
has not experienced difficulty in obtaining raw materials or components to meet
its production requirements. From time to time, prices for some of the raw
materials used in Tapco's production/assembly process fluctuate. Although Tapco
does not have any contracts with its suppliers and purchases supplies on a
purchase order basis, Tapco occasionally makes volume purchases of materials to
lock-in pricing.
Major Customers
Until Headwaters acquired Headwaters Resources in September 2002,
Headwaters operated in and reported as a single industry segment, alternative
energy. Since the acquisition of Headwaters Resources, Headwaters now operates
in three business segments, alternative energy, coal combustion products, and
construction materials. Additional information about segments is presented in
Note 4 to the consolidated financial statements included herein. The following
table presents revenues for all customers that accounted for over 10% of total
revenue during 2002, 2003 or 2004. All of these revenues are attributable to the
alternative energy segment. Most of the named customers are energy companies.
Affiliate relationships are determined for the period in which events are
calculated.
13
(in thousands) 2002 2003 2004
- -----------------------------------------------------------------------------------------
Pace Carbon Fuels, L.L.C. affiliates Less than 10% Less than 10% $57,602
DTE Energy Services, Inc. affiliates $19,660 $42,013 Less than 10%
TECO Coal Corporation affiliates 20,292 Less than 10% Less than 10%
Marriott International, Inc. affiliates 19,105 Less than 10% Less than 10%
AIG Financial Products Corp. affiliates 16,900 Less than 10% Less than 10%
Research and Development
In 2002, Headwaters' research and development expenses were $2.3
million, attributable primarily to activities at HTI. In 2003, research and
development expenses increased to $4.7 million, with the increase primarily
attributable to the inclusion of additional costs relating to HRI's research and
development activities. In 2004, research and development expenses increased to
approximately $7.3 million, with the increase attributable primarily to
activities at HTI.
Headwaters' Business Strategy
Headwaters intends to pursue the following business strategy:
Enable Customers to Maximize Production and Value of Alternative Fuel
Facilities. In order for Headwaters' customers to maximize the production and
value of their coal-based alternative fuel facilities, Headwaters intends to
continue to assist them in operating their facilities more efficiently, and
Headwaters intends to actively market the benefits of alternative fuel to
electric power generators. Headwaters intends to continue to develop
technologies that improve coal handling, enhance coal combustion characteristics
and reduce air emissions.
Develop and License New Technologies. Headwaters intends to 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, improving the quality of fly ash,
and converting or upgrading fossil fuels into higher value products. In
addition, HTI's nanocatalyst technologies should provide Headwaters with an
opportunity for commercialization of multiple custom designed catalysts.
Headwaters intends to seek to develop strategic relationships with major
companies in the energy and chemical industries to accelerate commercialization
of its energy and catalyst technologies.
Leverage Energy and CCP Relationships. HES and HRI maintain
longstanding relationships with many of the largest coal-fueled electricity
producers in the United States. Headwaters believes these relationships will
provide opportunities to expand and strengthen its position among coal-fueled
power generation utilities.
Expand Commercial Use and Enhance Quality of CCPs. Headwaters intends
to expand its 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
Headwaters' strategy is to expand alternative uses of CCPs, which allows for
increased sales of CCPs as well as attracting and maintaining utility customers
who value Headwaters' efforts to develop the market for CCPs. Alternative uses
of CCPs include roadbeds, embankments, building products (such as concrete
blocks and manufactured stone) and waste stabilization applications. Headwaters
intends to use fly ash in the production of Eldorado architectural manufactured
stone products as a partial replacement for cement. Headwaters intends to
continue to market the environmental and performance benefits of CCP-based
building products to industry decision makers.
Leverage Distribution Systems. The Tapco, Eldorado and stucco products
have strong pull-through effect from Headwaters' end customers, primarily
architects, engineers and contractors. Headwaters plans to leverage the
complementary distribution systems of Tapco, Eldorado and its stucco, blocks and
mortar products to accelerate sales of Headwaters' diverse construction
materials product portfolio. For example, Tapco's strong distribution and
marketing presence in the home improvement industry creates a marketing and
sales opportunity for Eldorado Stone that is primarily marketed and distributed
to the new construction market. Headwaters Construction Materials has
relationships with a nationwide distribution network encompassing over 10,000
wholesale distributors as well as leading retail home centers. Further,
Eldorado's strong presence in the Southwest United States and its leading
regional concrete block presence in Texas creates new distribution channels for
Tapco products. Headwaters intends to leverage these complementary distribution
networks to create a national distribution network to market and sell its
diverse portfolio of products to new customers and new segments of the
construction market.
14
Leverage Manufacturing Capability. Headwaters is committed to
implementing improvements throughout its manufacturing system. Headwaters
intends to capitalize on Tapco's manufacturing expertise to reduce manufacturing
costs across all of its business units. Through the application of
state-of-the-art manufacturing processes, best practices and economies of scale,
Headwaters intends to optimize its manufacturing processes, increase product
volume, reduce waste and lower costs, all of which should lead to greater
product margins.
Pursue Complementary and Strategic Acquisitions. Headwaters continually
evaluates the potential acquisition of companies, technologies or products that
will complement its existing business lines, manufacturing and distribution
strengths and build on its leading market positions. Acquisition opportunities
will be evaluated based on strategic fit, accretion to earnings and ability to
generate significant cash flow.
Competition
Headwaters experiences competition from traditional coal and fuel
suppliers, natural resource producers, and 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 alternative fuels made using Headwaters Energy
Services' technologies, from which Headwaters derives license fee revenues and
revenues from sales of chemical reagents, compete with other alternative fuel
products, as well as traditional fuels. For Headwaters Energy Services,
competition may come in the form of the marketing of competitive chemical
reagents and the marketing of end products qualifying as alternative fuel.
Headwaters Energy Services competes with other companies possessing technologies
to produce coal-based solid alternative fuels and companies that produce
chemical reagents such as Nalco Chemical Company and Accretion Technologies,
LLC.
Headwaters Energy Services 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 alternative fuel product they can purchase from Headwaters
Energy Services' 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 is intensely
competitive. Headwaters Resources has substantial competition in two main areas:
obtaining CCP management contracts with utility and other industrial companies;
and marketing CCPs and related industrial materials. Headwaters Resources 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 Headwaters Resources 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 Headwaters Resources' 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.
Headwaters Construction Materials has competition from numerous, larger
manufacturers of mortars, stuccos and concrete masonry units. With respect to
concrete masonry units, national and regional competition would include
Oldcastle, Featherlite and Pavestone. In addition, notwithstanding Eldorado's
large market share as a producer of manufactured architectural stone, Eldorado
faces significant competition from other national and regional producers of
similar products, and in particular from Owens Corning. Tapco's primary
competition includes Alcoa and Pinckney in the accessories market, and
CertainTeed and Nailite in the specialty siding market.
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 pursue complimentary acquisitions or
15
enter into license agreements or joint ventures with major chemical companies
for the further development and commercialization of Headwaters' nanocatalyst
technologies.
Positive and Negative Factors. There are positive and negative factors
pertaining to the competitive position of Headwaters and its subsidiaries.
Headwaters Energy Services enjoys the benefits of a leading market position in
the Section 29 licensing and reagent sales businesses, license agreements that
extend through the life of Section 29, and a manufacturing process and reagent
products that have withstood IRS scrutiny. From a broader alternative fuel
industry perspective, Headwaters Energy Services suffers from greater dependence
on United States tax policy and administration than some competitors in
alternative fuels.
Headwaters Resources competitive position also has positive factors of
a leading market position and long-term contracts. In addition, Headwaters
Resources has built a nationwide CCP distribution system not enjoyed by its
competition. Negatively, Headwaters Resources is sometimes adversely affected by
inclement weather slowing concrete construction (the largest market for CCPs).
For Headwaters Construction Materials, the block and bagged products
businesses are not national in breadth, although the block business enjoys a
strong regional market position in Texas. Where its market strength is limited,
the HCM block and bagged products businesses do not have strong economies of
scale, price leadership, and have only limited product brand strength.
Eldorado Stone's competitive position has some identifiable positive
factors. Eldorado is developing a recognized name in the architectural stone
veneer industry and a strong market share. Its product has excellent
authenticity and broad selection alternatives. Negatively, Eldorado Stone has a
limited, albeit growing, distribution network, strong competition from regional
producers that do not have long shipping routes, and financial limitations that
may not be shared by its largest national competitor.
Tapco has a leading market position in its siding accessories business
because of its strong ability to manufacture and distribute a broad range of
products economically and rapidly. However, Tapco's strong market position
suggests that its future growth will come largely from finding new products to
put into its manufacturing and distribution channels, not from increasing market
share in the siding accessories industry.
Intellectual Property
Below is a summary of Headwaters' intellectual property. Collectively,
the intellectual property is important to Headwaters, although there is no
single patent or trademark that is itself material to Headwaters at the present
time.
Headwaters itself has one registered trademark and one pending
trademark application.
Headwaters Energy Services has nine U.S. patents and one registered
trademark.
Headwaters Technology Innovation Group has 19 U. S. patents and 18 U.S.
patent applications pending. There are also nine foreign patents applications
pending. Headwaters Technology Innovation Group has six registered trademarks.
Headwaters Resources has 10 U.S. patents and 7 U.S. patent applications
pending. Headwaters Resources also has three foreign patents with five pending
foreign applications. Headwaters Resources has 15 registered trademarks and two
pending applications.
Headwaters Construction Materials has 93 U.S. patents and 36 U.S.
patent applications pending (primarily for Tapco). There are eight foreign
patents and 11 foreign patent applications pending. Headwaters Construction
Materials has 37 U.S. registered trademarks, 18 foreign trademarks, and 34
foreign trademark applications pending (primarily for Eldorado).
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
16
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.
Regulations
Section 29. Headwaters' coal-based solid alternative (or synthetic)
fuel business is subject to compliance with the terms of Section 29 of the
Internal Revenue Code. Under current law, Section 29 tax credits for synthetic
fuel produced from coal expires on December 31, 2007. There have been
initiatives from time to time to consider the early repeal or modification of
Section 29. For example, in 2004, a bill was introduced in the United States
House of Representatives that would repeal the Section 29 credit for synthetic
fuel produced from coal. Headwaters believes that it is unlikely that the bill
will pass Congress, but it could be reintroduced n the future.
The IRS has suspended the issuance of private letter rulings (PLRs) to
synthetic fuel facility owners several times in the past. 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 temporarily reduce or cease synthetic fuel production, which
resulted in a reduction of Headwaters' revenue 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, and PLRs issued following
the release of Announcement 2003-70 have required taxpayers (i) to maintain
sampling and quality control procedures that conform to American Society for
Testing and Materials or other appropriate industry guidelines at the synthetic
fuel facilities, (ii) to obtain regular reports from independent laboratories
that have analyzed the fuel produced in such facilities to verify that the coal
used to produce the fuel undergoes a significant chemical change and (iii) to
maintain records and data underlying the reports that taxpayers obtain from
independent laboratories including raw FTIR data and processed FTIR data
sufficient to document the selection of absorption peaks and integration points.
Also, in October 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. In March 2004,
the Subcommittee described its investigation as follows: "The Subcommittee is
continuing its investigation [of] tax credits claimed by Section 29 of the
Internal Revenue Code for the sale of coal-based synthetic fuels. The
investigation is examining the utilization of these tax credits, the nature of
the technologies and fuels created, the use of these fuels, and others [sic]
aspects of Section 29. The investigation will also address the IRS'
administration of Section 29 tax credits."
The Subcommittee conducted numerous interviews and received large
volumes of data between December 2003 and March 2004. Since then, there has been
little activity on the investigation. The effect that the Senate subcommittee
investigation of synthetic fuel tax credits may have on the industry is unknown.
While the investigation is pending, it may have a material adverse effect on the
17
willingness of buyers to engage in transactions to purchase synthetic fuel
facilities or on the willingness of current owners to operate their facilities,
and may materially adversely affect Headwaters' revenues and net income. The
Subcommittee has not scheduled a hearing as of the date of this report.
Headwaters cannot make any assurances as to the timing or ultimate outcome of
the Subcommittee investigation, nor can Headwaters predict whether Congress or
others may conduct investigations of Section 29 tax credits in the future.
Section 29 Phase-Out. In addition, tax credits claimed by a synfuel
plant operator may begin to be phased-out or eliminated prior to the sunset date
of December 31, 2007 if the "reference price" of oil exceeds an annual range of
oil prices, both adjusted annually for inflation. In May 2004, the IRS announced
that the phase-out range for 2003 beginning at $50.14 and ending with a $0 tax
credit at $62.94. Because the calendar year 2003 reference price of oil was
below that range, there was not a phase-out of the credit for qualified fuel
sold in 2003.
The reference price of oil and the inflation adjustment factor (IAF)
are determined annually (and released in early April for the previous year),
while the predetermined oil price range is fixed, but adjusted annually for
inflation. The reference price of oil is defined as the annual average wellhead
price per barrel for all domestic crude oil not subject to regulation by the
U.S.
Licensees are subject to audit by the IRS. The IRS may challenge
whether Headwaters' licensees satisfy the requirements of Section 29, or
applicable Private Letter Rulings, including placed-in-service requirements, or
may attempt to disallow Section 29 tax credits for some other reason. The IRS
has initiated audits of certain licensee-taxpayers who claimed Section 29 tax
credits, and the outcome of any such audit is uncertain. Recently, a licensee
announced that IRS field auditors have issued a notice of proposed adjustment
challenging the placed-in-service date of three of its synthetic fuel
facilities. The licensee believes that the facilities meet the placed-in-service
requirement, however, the matter is at an early stage and the timing and final
results of the audit are unknown. The inability of a licensee to claim Section
29 tax credits would reduce Headwaters' future income from the licensee.
Environmental. Headwaters' operations and those of its suppliers and
customers involved in coal-based energy generation, primarily utilities, are
subject to federal, state and local environmental regulation. 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, which add to the cost of
doing business and expose Headwaters to potential fines for non-compliance.
Moreover, in order to establish and operate the synthetic fuel plants, power
plants and operations to collect and transport CCPs and bottom ash, Headwaters'
and its 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 and
are critical to Headwaters' business. Any failure to comply could result in the
issuance of substantial fines and penalties and cause us to incur environmental
liabilities.
Headwaters believes that all required permits to construct and operate
these solid alternative fuel facilities have been or will be obtained and
believe the facilities are in substantial compliance with all relevant laws and
regulations governing alternative fuel operations.
In spite of safeguards, Headwaters' 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, Headwaters and its subsidiaries use and
share other hazardous chemicals in order to conduct operations involving
distillation to purify products, analysis, packaging of chemicals and the
selling, warehousing and manufacturing of organic chemicals in small research
volumes. Headwaters' 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. Headwaters generally hires
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
18
1997, the EPA adopted new, more stringent National Ambient Air Quality
Standards, or NAAQS, for particulate matter and ozone. Although the NAAQS were
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. The new eight-hour ozone
nonattainment designations and classifications were published April 30, 2004,
along with Phase 1 of the final implementation rule for the eight-hour standard.
Both rules took effect June 15, 2004, and both are currently being litigated.
The Phase 2 implementation rule for the eight-hour standard is currently
expected in February or March 2005. The fine particulate matter nonattainment
designations have been projected to be finalized by the end of 2004, with their
implementation rule to follow at some future date. Because electric utilities
emit NOx, which are precursors to ozone and particulate matter, Headwaters
Resources' 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 Headwaters Resources'
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 promulgated a rule (the
"NOx SIP call") in 1998 requiring 22 eastern states to make substantial
reductions in NOx emissions. Court action eliminated one state and portions of
two others from the rule. Under this rule, EPA expects that states will achieve
these reductions by requiring power plants to make substantial reductions in
their NOx emissions. The affected states were required to implement Phase I of
the NOx SIP call by May 31, 2004. On April 21, 2004, EPA published Phase II of
the NOx SIP call, which will require an additional reduction of about 100,000
tons of NOx per year by 2007. In addition to the NOx SIP call, EPA's April 21,
2004 rule also addressed the requirement that it 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-fueled
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 Headwaters Resources 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 Headwaters Resources.
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-fueled electric utility steam generating
units is necessary and appropriate. On January 30, 2004, EPA published the
proposed Utility Mercury Reductions Rule, which sought comments on two
approaches for reducing mercury emissions from coal-burning power plants. EPA is
currently projecting that the rule will be finalized in March of 2005.
Additionally, on January 30, 2004, EPA published a proposal, known as the Clean
Air Interstate Rule, that would require coal-burning power plants to upgrade
their facilities to reduce emissions of sulfur dioxide ("SOx") by 70% and NOx by
65%. EPA currently anticipates finalizing that rule by the end of 2004. Taken
together, these rules, once they are finalized, 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 SOx, NOx and mercury from power plants.
Because the Initiative must be implemented by legislation that has not yet been
enacted, its effect on Headwaters Resources 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. It is not likely that any of these bills will be
enacted during 2004, but the Administration intends to make a strong push to
enact Clear Skies in the 109th Congress. Many of the goals of Clear Skies
legislation will be accomplished by the Utility Mercury Rule and the Clean Air
Interstate Rule, once they are finalized (see discussion above).
19
Coal-fueled 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 Headwaters Resources typically consist of
a mixture of client-supplied CCPs, Headwaters Resources 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
Headwaters Resources. In cases where Headwaters Resources is responsible for
end-product quality, such as a structural fill (where material is used to fill a
cavity or designated area), Headwaters Resources depends solely on its own
quality assurance program.
Materials sold by Headwaters Resources 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 proposed rules
for CCPs generated by commercial electric power producers in March 2007 and for
management of CCPs at mine facilities in October 2007 which will address, among
other things, state and regional solid waste plans for CCPs disposed of in
landfills or surface impoundments, or used to fill surface or underground mines.
These proposed rules could make coal burning more expensive or less attractive
to Headwaters Resources' utility clients. Headwaters Resources 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 Headwaters
Resources cannot be completely ascertained at this time.
Headwaters Resources is engaged in providing services at one landfill
operation that is permitted and managed as a hazardous waste landfill.
Headwaters Resources 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 Headwaters Resources will
not be named in third-party claims relating to the project.
CCPs may contain small concentrations of metals that are considered as
"hazardous substances" under the Comprehensive Environmental Response
Compensation and Liability Act ("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 Headwaters Resources
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-fueled electricity
generating capacity. Headwaters believes that 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.
Employees
Headwaters employs approximately 3,680 full-time employees. There are
approximately 45 employees in Headwaters' corporate administration. The
following lists the approximate number of employees by business units:
Headwaters Energy Services, 20
20
Headwaters Resources, 710
Headwaters Technology Innovation Group, 45
Headwaters Construction Materials, 2,860
Approximately 16 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.
Headwaters Energy Services directs its operations primarily from
Headwaters' South Jordan, Utah location.
Headwaters Technology Innovation Group owns approximately six acres in
Lawrenceville, New Jersey where it maintains offices and its research
facilities.
Headwaters Resources owns or leases 16 properties nationwide for its
fly ash storage and distribution operations with East, Central, and West
regional divisions. Headwaters Resources also conducts operations at numerous
other sites via rights granted in various CCP through-put, handling and
marketing contracts (for example, operating a storage or load-out facility
located on utility-owned properties).
Headwaters Construction Materials owns or leases 51 properties
nationwide for its building products manufacturing distribution, and sales
operations. Tapco is headquartered in Wixom, Michigan and has major
manufacturing facilities in Metamora, Michigan and Elkland, Pennsylvania.
Eldorado is headquartered in San Marcos, California and has major manufacturing
facilities in Rancho Cucamonga, California and Greencastle, Pennsylvania.
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 or resolve these matters by settlement, as appropriate.
Management does not currently believe that the outcome of these matters will
have a material adverse effect on Headwaters' operations, cash flows or
financial position.
In 2004, Headwaters accrued approximately $1,400,000 of reserves for
legal matters because it concluded that claims and damages sought by claimants
in excess of that amount were not probable. Our outside counsel believe that
unfavorable outcomes are neither probable nor remote and declined to express
opinions concerning the likely outcomes or liability of Headwaters. The reserves
represent the amounts Headwaters would be willing to pay to reach a settlement.
However, these cases raise difficult and complex legal and factual issues, and
the resolution of these issues is subject to many uncertainties, including the
facts and circumstances of each case, the jurisdiction in which each case is
brought, and the future decisions of juries, judges, and arbitrators. Therefore,
although management believes that the claims asserted against Headwaters in the
named cases lack merit, there is a possibility of material losses in excess of
the amounts accrued if one or more of the cases were to be determined adversely
against Headwaters for a substantial amount of the damages asserted. Headwaters
believes the range of potential loss is from $1,400,000 up to the amounts sought
by claimants. It is possible that a change in the estimates of probable
liability could occur, and the changes could be significant. Additionally, as
with any litigation, these proceedings require that Headwaters incur substantial
costs, including attorneys' fees, managerial time, and other personnel resources
and costs in pursuing resolution. Costs paid to outside legal counsel for
litigation, which comprise the majority of Headwaters' litigation-related costs,
totaled approximately $1,700,000 in 2002, $3,000,000 in 2003, and $3,800,000 in
2004. It is not possible to estimate what these costs will be in future periods.
Boynton. In October 1998, Headwaters entered into a technology purchase
agreement with James G. Davidson and Adtech, Inc. The transaction transferred
certain patent and royalty rights to Headwaters related to a synthetic fuel
technology invented by Davidson. (This technology is distinct from the
21
technology developed by Headwaters.) This action is factually related to an
earlier action brought by certain purported officers and directors of Adtech,
Inc. That action was dismissed by the United States District Court for the
Western District of Tennessee and the District Court's order of dismissal was
affirmed on appeal. In the current action, the allegations arise from the same
facts, but the claims are asserted by certain purported stockholders of Adtech.
In June 2002, Headwaters received a summons and complaint from the United States
District Court for the Western District of Tennessee alleging, among other
things, fraud, conspiracy, constructive trust, conversion, patent infringement
and interference with contract arising out of the 1998 technology purchase
agreement entered into between Davidson and Adtech on the one hand, and
Headwaters on the other. The plaintiffs seek declaratory relief and compensatory
damages in the approximate amount of between $15,000,000 and $25,000,000 and
punitive damages. The District Court has dismissed all claims against Headwaters
except conspiracy and constructive trust. The Court has scheduled trial for
April 2005. Because the resolution of the litigation is uncertain, legal counsel
cannot express an opinion as to the ultimate amount, if any, of Headwaters'
liability.
AGTC. In March 1996, Headwaters entered into an agreement with AGTC and
its associates for certain services related to the identification and selection
of alternative fuel projects. In March 2002, AGTC filed an arbitration demand in
Salt Lake City, Utah claiming that it is owed commissions under the 1996
agreement for 8% of the revenues received by Headwaters from the Port Hodder
project. AGTC is seeking approximate damages in the arbitration between $520,000
and $14,300,000. 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 filed an answer in the arbitration, denying AGTC's claims
and asserting counterclaims against AGTC. The arbitrator conducted hearings
during July and August of 2004 and has received a post-arbitration briefing but
has not yet issued a decision. 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 in the approximate amount of
$71,000,000 and punitive damages. Headwaters has denied the allegations of AJG's
counter-claims. The court has scheduled trial for January 2005. Because the
resolution of the litigation is uncertain, legal counsel cannot express an
opinion as to the ultimate amount of recovery or liability.
McEwan. In 1995, Headwaters granted stock options to a member of its
board of directors, Lloyd McEwan. The director resigned from the board in 1996.
Headwaters has declined McEwan's attempts to exercise most of the options on
grounds that the options terminated. In June 2004, McEwan filed a complaint in
the Fourth District Court for the State of Utah against Headwaters alleging
breach of contract, breach of implied covenant of good faith and fair dealing,
fraud, and misrepresentation. McEwan seeks declaratory relief as well as
compensatory damages in the approximate amount of $2,750,000 and punitive
damages. Headwaters has filed an answer denying McEwan's claims and has asserted
counterclaims against McEwan. Because resolution of the litigation is uncertain,
legal counsel cannot express an opinion as to the ultimate amount of liability
or recovery.
Headwaters Construction Materials Matters. There are litigation and
pending and threatened claims made against certain subsidiaries of Headwaters
Construction Materials with respect to several types of exterior finish systems
manufactured and sold by its subsidiaries for application by contractors on
residential and commercial buildings. Typically, litigation and these claims are
controlled by such subsidiaries' insurance carriers. The plaintiffs or claimants
in these matters have alleged that the structures have suffered damage from
latent or progressive water penetration due to some alleged failure of the
building product or wall system. The most prevalent type of claim involves
alleged defects associated with components of an Exterior Insulation and Finish
System (EIFS) which was produced for a limited time (through 1996) by best
Masonry & Tool Supply. There is a 10-year projected claim period following
discontinuation of the product.
Typically, the claims cite damages for alleged personal injuries and
punitive damages for alleged unfair business practices in addition to asserting
more conventional damage claims for alleged economic loss and damage to
property. To date, claims made against such subsidiaries have been paid by their
insurers, with the exception of minor deductibles, although such insurance
carriers typically have issued "reservation of rights" letters to Headwaters
Construction Materials. 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
22
claims formally asserted on behalf of a class. While, to date, none of these
proceedings have required that Headwaters Construction Materials incur
substantial costs, there is no guarantee of insurance coverage or continuing
coverage. These and future proceedings may result in substantial costs to
Headwaters Construction Materials, including attorneys' fees, managerial time
and other personnel resources and costs. Adverse resolution of these proceedings
could have a materially negative effect on Headwaters Construction Materials'
business, financial condition, and results of operation, and its ability to meet
its financial obligations. Although Headwaters carries general and product
liability insurance, Headwaters cannot assure that such insurance coverage will
remain available, that the insurance carriers will remain viable, or that the
insured amounts will cover all future claims in excess of the uninsured
retention. Future rate increases may also make such insurance uneconomical for
Headwaters Construction Materials to maintain. In addition, the insurance
policies maintained by Headwaters excludes claims for damages resulting from
exterior insulating finish systems, or EIFS, that have manifested after March
2003. Because resolution of the litigation and claims is uncertain, legal
counsel cannot express an opinion as to the ultimate amount, if any, of
Headwaters Construction Materials' 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, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
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 2003 Low High
----------- --- ----
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
Fiscal 2004
-----------
Quarter ended December 31, 2003 $14.78 $20.87
Quarter ended March 31, 2004 19.50 25.99
Quarter ended June 30, 2004 19.50 29.60
Quarter ended September 30, 2004 23.12 32.02
As of November 30, 2004, there were 352 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 2004, 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.
23
Recent Sales of Unregistered Securities
In June 2004 Headwaters issued $172.5 million in aggregate principal
amount of 2 7/8% Convertible Senior Subordinated Notes due 2016 in a private
placement pursuant to Section 4(2) of the Securities Act of 1933, as amended.
The initial purchasers of the notes were Morgan Stanley & Co. Incorporated; J.P.
Morgan Securities, Inc.; Adams, Harkness & Hill, Inc.; RBC Capital Markets
Corporation; and Stephens Inc. The initial purchasers resold the notes to
"qualified institutional buyers," as defined in Rule 144A under the Securities
Act of 1933, as amended, in reliance of Rule 144A. The net proceeds from the
issuance of notes were $166.3 million after deducting selling discounts and
commissions and offering expenses. The proceeds were used to finance, in part,
Headwaters acquisition of Eldorado Stone. The notes are due on June 1, 2016.
Headwaters pays interest on the notes on June 1 and December 1 of each year,
beginning December 2, 2004. Subject to the terms of the notes, holders may
convert the notes into shares of Headwaters' common stock at a conversion price
of $30.00 per share, which is equivalent to a conversion rate of 33.3333 shares
of Headwaters common stock per $1,000 principal amount of notes. This conversion
rate is subject to adjustment under the terms of the notes. Conversion can occur
only under certain circumstances, including generally when the sale price of
Headwaters common stock exceeds 130% of the conversion price, which would be
$39.00 per share. The notes are general, unsecured obligations that are
subordinated to all existing and future senior indebtedness and Headwaters'
subsidiaries indebtedness and other liabilities. Headwaters may redeem any
portion of the notes at anytime on or after June 4, 2011, and if specific
conditions are satisfied, any time on or after June 1, 2007. On June 1, 2011, or
upon the occurrence of a designated event, holders of the notes may require
Headwaters to repurchase the notes. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity and Capital Resources"
of Item 7 hereof for a more detailed description of the notes.
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.
In August 2001, Headwaters acquired HTI, the financial statements of
which have historically been 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. Effective October 1, 2003, Headwaters eliminated the
one-month lag and accordingly, 13 months of HTI's results of operations have
been included in the consolidated statement of income for 2004.
Also, as more fully described in Note 3 to the consolidated financial
statements, Headwaters acquired HRI on September 19, 2002 and accordingly, HRI's
results of operations for the period from September 19, 2002 through September
30, 2004 have been consolidated with Headwaters' 2002 through 2004 results.
HRI's results of operations up to September 18, 2002 have not been included in
Headwaters' consolidated results for any period. Headwaters acquired VFL on
April 9, 2004, Eldorado Stone on June 2, 2004, SCP on July 2, 2004, and Tapco
Holdings on September 8, 2004. These entities' results of operations for the
periods from the acquisition dates through September 30, 2004 have been
consolidated with Headwaters' 2004 results and their operations up to the dates
of acquisition have not been included in Headwaters' consolidated results for
any period.
In 2001, Headwaters recorded approximately $7.5 million of income tax
benefit primarily related to the reduction of its deferred tax asset valuation
allowance. In 2004, Headwaters recognized revenue relating to funds deposited in
an escrow account totaling approximately $27.9 million, most of which related to
prior periods (see Note 14 to the consolidated financial statements). In
addition, revenue and net income for 2004 were materially affected by the 2004
acquisitions (see Note 3 to the consolidated financial statements).
The selected financial data as of and for the years ended September 30,
2000 and 2001 and as of September 30, 2002 are derived from audited financial
statements not included herein. The selected financial data as of September 30,
2003 and 2004 and for the years ended September 30, 2002, 2003, and 2004 were
derived from the audited financial statements of Headwaters included elsewhere
herein.
24
Year ended September 30,
-----------------------------------------------------------------
(in thousands, except per share data) 2000 2001 2002 2003 2004
- -------------------------------------------------------------------------------------------------------------------
OPERATING DATA:
Total revenue $27,886 $45,464 $119,345 $387,630 $ 553,955
Net income 3,682 21,517 24,286 36,631 64,317
Diluted earnings per share 0.07 0.87 0.94 1.30 1.95
As of September 30,
-----------------------------------------------------------------
(in thousands) 2000 2001 2002 2003 2004
- -------------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA:
Working capital $ 8,393 $ 8,619 $ 15,023 $ 14,176 $ 44,387
Net property, plant and equipment 552 2,680 50,549 52,743 157,611
Total assets 33,441 55,375 372,857 373,275 1,540,779
Long-term obligations:
Long-term debt 5,055 149 154,552 104,044 914,641
Deferred income taxes -- -- 51,357 50,663 121,469
Other long-term liabilities 7,861 8,711 5,442 4,703 10,338
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Total long-term obligations 12,916 8,860 211,351 159,410 1,046,448
Total stockholders' equity 10,747 31,086 98,596 140,157 308,155
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.
Introduction
Over the last three years, Headwaters has executed on its two-fold plan
of maximizing cash flow from its existing operating business units and
diversifying revenues from reliance on the alternative energy segment. With the
addition of the CCP management and marketing business through the acquisition of
ISG in 2002, and the growth of the construction materials business culminating
in the acquisitions of Eldorado and Tapco in 2004, Headwaters has achieved
revenue growth and diversification into three business segments. Because
Headwaters has also incurred increased indebtedness to make strategic
acquisitions and related capital expenditures, one of management's key financial
objectives is to continue to focus on increased cash flows for purposes of
reducing indebtedness as quickly as possible.
Headwaters' acquisition strategy targets businesses that are leading
players in their respective industries, enjoy healthy margins from products and
services and are not capital intensive, thus providing additional ca