Headwaters (HW)

Utah-based Headwaters Incorporated (HW) provides products, technologies and services to the energy, construction, and home improvement industries in the United States. The company develops and commercializes technologies for enhancing the value of coal, gas, oil, and other natural resources. It also distributes coal combustion products (CCP) and construction materials in the U.S. and Canada. Headwaters Technology Innovation subsidiary is engaged in the conversion of coal and heavy oil into high-value liquid fuels. It also custom-designs nanocatalysts for multifarious industrial applications. The company operates three segments: Construction Materials, Alternative Energy, and Coal Combustion Products (CCPs).

Construction Materials division (45% of fiscal 2007 revenue) is a leading provider of manufactured architectural stone products and siding accessories (such as window shutters, gable vents, mounting blocks, simulated wood shake siding, and composite roofing) and professional tools used in exterior residential remodeling and construction. This segment is a market leader in designing, manufacturing, and marketing architectural stone veneer under the Eldorado Stone, StoneCraft, and Dutch Quality Stone brands, and is a leading designer, manufacturer, and marketer of resin-based siding accessories and professional tools used in exterior residential home improvement and construction, under the Tapco brands. In addition, the company is also one of the largest manufacturer and seller of concrete block in the Texas market, one of America's largest block markets.

Alternative Energy unit (30% of FY07 revenue) is focused on reducing waste and increasing the value of energy feedstocks, primarily in the areas of low-value coal and oil. The company is using its engineered fuels expertise to develop new opportunities in the burgeoning clean coal marketplace. The segment develops and deploys a range of breakthrough technologies that improve natural resource utilization, including heavy oil upgrading, coal liquefaction, and nanocatalyst applications. This unit also licenses technology and sells reagents to the coal-based solid alternative fuel industry. Additionally, the segment owns (51% share) and operates a 50 million gallon per year corn-to-ethanol facility near Underwood, North Dakota.

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Company Products/Services/Markets:

 In the construction materials sector, Headwaters designs, manufactures, and sells architectural stone and resin-based exterior siding accessories (such as shutters, mounting blocks, and vents) and related products. It believes that it has a leading market position in its principal construction materials businesses. Headwaters is also a nationwide leader in the management and marketing of coal combustion products, including fly ash used as a substitute for portland cement. Headwaters believes it is uniquely positioned to manufacture an array of construction materials that use fly ash, such as block, stucco, and mortar. Revenue from the construction materials and coal combustion products businesses are diversified geographically and also by market, including the new construction, remodeling and home improvement markets. 

Headwaters participate in what it believes to be two of the highest growth segments within the siding industry, manufactured stone and specialty siding.   

Manufactured Stone. Under the Eldorado Stone^®, StoneCraft, and Dutch Quality Stone brands, HW offer a wide variety of high-quality, hand-made manufactured stone products to meet a variety of design needs.  The Eldorado Stone product line has been designed and is manufactured to be one of the most realistic architectural stone products in the world. Headwaters’ architectural stone siding is a lightweight, adhered siding product used by national, regional and local architectural firms, real estate developers, contractors, builders and homeowners. HW's stone products are 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 Stone product line is used in a variety of external and internal home applications such as walls, archways, fireplaces and landscaping. In 2006, HW introduced an architectural brick veneer product. Additionally, HW sells Syndecrete^®, a light-weight cement-based composite using natural minerals and recycled materials. It is used primarily in custom countertops and outdoor tiles. Headwaters focus on product quality, breadth and innovation, combined with a geographically diversified manufacturing platform, gives it a significant marketing advantages over traditional materials such as natural stone, brick or stucco. 

Exterior Siding Accessories. Headwater is a leading designer, manufacturer and marketer of resin-based siding accessories and professional tools used in exterior residential home improvement and construction under the Tapco brands. These products, which are either injection-molded or extruded, enhance the appearance of homes and include decorative window shutters, gable vents, and mounting blocks for exterior fixtures, roof ventilation, window and door trim products, specialty siding products, synthetic roofing tiles, and window well systems.

        These building products serve the needs of the siding, roofing, and window and door installation industries. HW'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 enhance the exterior appearance of the home and can be manufactured to meet certain hurricane codes. 

Concrete Block. HCM is one of the largest manufacturers and sellers of concrete block in the Texas market, one of America’s largest block markets. HCM uses fly ash in the manufacturing process for concrete block, brick and foundation blocks. They also market mortar and stucco under the Best Masonry and Magna Wall® brands.

Major Customers:

Headwaters a large customer base for its construction products. 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, HW has approximately 6,100 non-retail ship-to locations and approximately 7,400 retail ship-to locations for its products. Sales are broadly diversified across customers and ship-to locations. For fiscal 2006, three large customers together represented approximately 30% of total sales of our resin-based accessory products. None of our other construction materials businesses had a customer representing 10% of its product sales.

Coal Combustion Products

In addition to finished products, HW sells coal combustion products (“CCPs”), such as fly ash and bottom ash, which are created when coal is burned.  CCPs have traditionally been an environmental and economic burden for power generators but, when properly managed, can be valuable products. HCM supplies CCPs as a replacement for Portland Cement in a variety of concrete infrastructure projects and building products. HW iscurrently the largest manager and marketer of CCPs in the United States and also manage and market CCPs in Canada and Puerto Rico. HW has a number of long-term exclusive management contracts with coal-fueled electric generating utilities throughout the United States and provide CCP management services at more than 110 locations.

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, decreasing permeability and enhancing durability. 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 U.S. Environmental Protection Agency (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.

In the alternative energy sector, Headwaters is focused on reducing waste and increasing the value of energy feedstocks, primarily in the areas of low-value coal and oil. In coal, it owns and operates two coal reclamation facilities that remove rock, dirt, and other impurities from waste coal, resulting in higher-value, marketable coal. It also licenses technology and sells reagents to the coal-based solid alternative fuels industry. In oil, Headwaters’ heavy oil upgrading technology represents a substantial improvement over current refining technologies. Headwaters’ heavy oil upgrading process uses a liquid catalyst precursor to generate a highly active molecular catalyst to convert residual oil feedstocks into higher-value distillates that can be refined into gasoline, diesel and other products. In addition, Headwaters is constructing its first ethanol plant and proceeding with the commercialization of multiple catalyst technologies.

Headwaters Energy Services Corp. (“HES”) is believed to be the market leader in enhancing the value of coal used in power generation through licensing technologies and selling chemical reagents that convert coal into a solid alternative fuel. This solid alternative fuel qualifies for tax credits under Section 45K of the Internal Revenue Code based upon the Btu content of the alternative fuel produced and sold. The sale of qualified alternative fuel enables facility owners who comply with certain statutory and regulatory requirements to claim federal tax credits under Section 45K, which currently expires on December 31, 2007. HES also develop and own coal cleaning facilities. These facilities provide HES with an opportunity to reduce sulfur oxides (SOx), nitrogen oxides (NOx) and mercury emissions from coal, greatly increasing coal’s cleanliness and usability. HW also develops and commercializes technologies to convert or upgrade fossil fuels into higher-value products, including direct coal liquefaction, and the conversion of gas-to-liquid fuels.

      Principal Products and their Markets

HES began its business with the development and commercialization of technologies that interact with coal-based feedstocks to produce a solid alternative fuel intended to be eligible for Section 45K (formerly Section 29) tax credits. Since the tax credits are due to expire in 2007 and have been subject to phase out as a result of higher oil prices (see “Risk Factors”), our strategy has been to develop new alternative fuel business by taking advantage of our expertise.

Strategy:

During the past several years, Headwaters' has executed on a two-fold plan of maximizing cash flow from their existing operating business units and diversifying from over-reliance on the legacy alternative energy segment Section 45K [formerly Section 29] business. With the addition and expansion of the CCP management and marketing business through acquisitions in 2002 and in 2004, and the growth of the construction materials business, culminating in several large and small acquisitions in 2004, 2006 and 2007, HW has achieved revenue growth and diversification into three business segments. Because HW also incurred increased indebtedness to make strategic acquisitions, one of its ongoing financial objectives is to continue to focus on increased cash flows for purposes of reducing indebtedness.

Headwater Energy Services (HES):

HES began its business with the development and commercialization of technologies that interact with coal-based feedstocks to produce a solid alternative fuel intended to be eligible for Section 45K (formerly Section 29) tax credits. Since the tax credits are due to expire in 2007 and have been subject to phase out as a result of higher oil prices (see “Risk Factors”), HES's strategy has been to develop new alternative fuel business by taking advantage of its expertise in coal cleaning and liquefaction.

      New Business Opportunities

        As part of its alternative energy strategy, HES is developing the following businesses and technologies:

        Coal Cleaning: HES has acquired an operating waste coal recovery facility and access to approximately 150 million tons of waste coal material, which it estimates may provide sufficient coal recovery to support the construction of up to three additional coal cleaning facilities. HES uses coal cleaning processes that upgrade low value or waste coal by separating ash from the carbon. The resultant coal product is lower in ash, including sulfur, mercury and other impurities, and higher in Btu value. HES is currently operating two coal cleaning facilities in Utah and Alabama and is developing plans to build additional facilities at various locations.

        Ethanol: In 2006 HES entered into a joint venture with Great River Energy (“GRE”) of Elk River, Minnesota to develop and construct a 50 million gallon-per-year ethanol production facility. The joint venture is named Blue Flint Ethanol, LLC and is owned 51% by HES and 49% by GRE. The Blue Flint production facility is located at the GRE Coal Creek pulverized coal electric power station near Underwood, North Dakota. Coal Creek station will supply steam, water and other services to Blue Flint. Headwaters will operate the facility. The facility is expected to begin ethanol production in the first calendar quarter of 2007.

        Coal Drying. HES and GRE are developing a project to use coal drying technology developed by GRE at its Coal Creek station. This technology utilizes waste heat from the power plant to dry high moisture coal which will result in higher boiler efficiencies during the combustion process. This technology can be utilized with lignite and other high-moisture coals.

        Coal Liquefaction.   HES has developed technology for producing clean liquid fuels from coal. This technology was evaluated during 2005 in a commercial pre-feasibility study commissioned by Oil India Limited, a Government of India enterprise. Oil India is a public sector company engaged in energy services in the Assam Region of northeastern India, an area rich in natural resources but distant from established oil refining operations. HES believes that its direct coal liquefaction (“DCL”) technology may assist Oil India in converting the Assam region’s abundant and soluble coal into transportation fuels. The technology involved encompasses some of the same elements that the Shenhua Group, China’s largest coal company, purchased from an HES affiliate in 2004 for a DCL project in Majiata, China. HES also has developed a catalyst specifically designed for application in slurry-phase Fischer-Tropsch (“FT”) reactors that convert gaseous materials into a range of liquid fuels and chemicals, e.g., propylene. When the FT process is applied to gas derived from coal, the process is referred to as indirect coal liquefaction (“ICL”). The company has entered into agreements with the government of the Philippines and with a private company in China, for feasibility and pilot plant studies related to site-specific applications of our coal-to-liquids technologies, including both direct and indirect coal liquefaction.

        Heavy Oil Upgrading Technology: HES holds an exclusive, worldwide license to develop, market and sublicense a unique heavy oil upgrading technology for the catalytic hydrocracking of heavy residual oils such as petroleum vacuum residue (so-called “bottom of the barrel”) and tar sand bitumen into lighter, more valuable petroleum materials. The process uses a proprietary, highly active, molecular-scale catalyst (HCATTM) to efficiently convert all components of heavy oils, including the asphaltenic components, which are generally considered the most difficult to process. In 2007, it plans to continue discussions with operators of several heavy oil upgrading facilities (in the U.S. and overseas) to explore how the addition of this technology to their existing refineries could increase product yields and reduce downtime caused by equipment fouling with minimal modifications to the existing facilities. In early 2006, HES announced the completion of the first commercial scale demonstration of the heavy oil upgrading technology at a large commercial refinery. Later in 2006, HES completed a second full scale refinery test of this technology. They are negotiating contracts to sell the HCAT catalyst precursor material and license the associated process to petroleum refiners.

        Hydrogen Peroxide: In September 2004, HW 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, or H2O2. The venture aims to develop or 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. In October 2005, the joint venture announced the success of pilot plant operations. In October 2006, a demonstration plant in Germany was completed and began startup operations. This demonstration plant is intended to prove how the H2O2 process performs on a larger scale, a prerequisite for engineering a commercial scale H2O2 project. In September 2006, HES and Degussa AG acquired a hydrogen peroxide plant in Korea to provide hydrogen peroxide to SKC Chemicals for use in the manufacture of polypropylene. The joint venture plans to expand the Korea facility, in part to demonstrate the direct synthesis of hydrogen peroxide technology on a commercial scale. The joint venture is developing plans and exploring markets to build additional hydrogen peroxide production facilities in other strategic locations to help meet the expected world-wide growth in demand for H2O2 as a chemical intermediate.

      Section 45K Business

        Licensees. HES licenses technologies to produce solid alternative fuel from coal to 28 of its estimated total of 75 coal-based solid alternative fuel facilities in the United States. In addition, during fiscal 2006 Headwaters sold its proprietary chemical reagents to approximately 35 licensee and other alternative fuel facilities. 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 45K.

        Chemical Reagent Sales. The transformation of the feedstock to an alternative fuel involves the use of a chemical reagent in a qualified facility. HES primarily market 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.

        Headwater believes the benefits of their 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. Competitive benefits of 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.

Competitors:

        Construction Materials. Notwithstanding our national position as a leading producer of manufactured architectural stone, HCM faces stiff competition from other national and regional producers of similar products, and in particular from Owens Corning. Its primary competition for resin-based products includes Alcoa and Pinckney in the accessories market, and CertainTeed and Nailite in the specialty siding market. HCM has competition from a number of larger manufacturers of mortars, stuccos and concrete masonry units. With respect to concrete masonry units, national and regional competition includes Oldcastle, Featherlite and Pavestone.

        CCPs. The business of marketing traditional CCPs is intensely competitive. HRI has substantial competition in two main areas: obtaining CCP management contracts with utility and other industrial companies and marketing CCPs and related industrial materials. HRI 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 HRI has a number of long-term CCP management contracts with its clients, some of these contracts allow for the termination of the contract at the convenience of the utility company upon a minimum 90-day notice. Moreover, certain of HRI’s most significant regional CCP competitors appear to be seeking a broader national presence. These competitors include Lafarge North America Inc., Boral Material Technologies Inc. and Cemex. Construction materials are produced and sold regionally by the numerous owners and operators of concrete ready-mix plants. Producers with sand and gravel sources near growing metropolitan areas have important transportation advantages.

        Alternative Fuels. Coal-based solid alternative fuels made using HES’s technologies, from which HES derives licensing fee revenues and revenues from sales of chemical reagents, compete with other alternative fuel products, as well as traditional fuels. For HES, competition may come in the form of the marketing of competitive chemical reagents and the marketing of end products qualifying as alternative fuel. HES 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.

        HES also experiences competition from traditional coal and fuel suppliers and natural resource producers. Further, many industrial coal users are limited in the amount of alternative fuel product they can purchase from HES’s licensees because they have committed to purchase a substantial portion of their coal requirements through long-term contracts for standard coal.  

      Headwater's Blue Flint ethanol plant will experience significant competition from many producers of ethanol and other biofuels throughout the United States.

        HW's new technologies also experience competition from many of the world’s major energy and chemical companies. Major catalyst developers include Johnson Matthey and Engelhard, among others. Those companies are devoting significant resources to researching and developing nanocatalysts and catalytic processes. These companies have greater financial, management and other resources than does HW.

        Positive and Negative Factors. There are positive and negative factors pertaining to our competitive position.

        Construction Materials. HCM has developed a recognized name in the manufactured architectural stone industry and a strong market share. Its products have excellent authenticity and broad selection alternatives. Their architectural stone business 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. HCM has a leading market position in our siding accessories business because of our strong ability to manufacture and distribute a broad range of products economically and rapidly. However, its resin-based siding accessory business’ 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. The block and bagged products business is not national in breadth, although the block business enjoys a strong regional market position in Texas where its market strength is limited. The bagged products businesses do not have strong economies of scale or price leadership, and have only limited product brand strength.

        CCPs. Headwaters’ competitive position has positive factors of a leading market position and long-term contracts. In addition, HW has built a nationwide CCP distribution system not enjoyed by its competition. However, HW's CCP business is sometimes adversely affected by inclement weather slowing concrete construction, the largest market for CCPs. HW also faces increasingly aggressive competition in marketing and sales of CCPs.

        Alternative Energy. HES enjoys the benefits of a leading market position in its Section 45K licensing and reagent sales businesses, license agreements that extend through the life of Section 45K, and a manufacturing process and reagent products that have withstood IRS scrutiny. However, Section 45K is due to expire in 2007. From a broader alternative fuel industry perspective, HES suffers from greater dependence on United States tax policy and administration than some competitors in alternative fuels, including our coal cleaning and coal drying businesses.

        Most of its business units are experiencing greater competition for key raw materials including latex, styrene, polypropylene, cement and aggregates. This competition has contributed to shortages and price increases for raw materials used by Headwater.

Industry Trends and News:

Two key industry trends are having material effects on Headwaters business and income:

1) Since peaking in 2005, existing home sales are down 15% from their peak impacting the demand for new construction.  The weak U.S. housing market is hurting cement makers and the construction materials business.  Homebuilders have pulled back on construction as weakening demand resulted in supply gluts.  Headwaters is no less immune to this trend and development than other construction materials manufacturers.

2) During 2006, industry production of solid alternative fuel was severely curtailed or stopped during the months of highest oil prices as facility owners evaluated the effect of oil prices on the availability of Section 45K tax credits. The industry’s significant, albeit temporary, reduction in alternative fuel production during calendar 2006 caused a material reduction in license fees and chemical reagent sales revenues to HES.

As oil prices rise, Headwaters’ Section 45 revenue will decrease. A material amount of Headwaters’ consolidated revenues (23% in FY2006) and net income is derived from license fees and sales of chemical reagents, both of which depend on the ability of licensees and other customers to manufacture and sell qualified synthetic fuels that generate tax credits under Section 45K [formerly Section 29] of the Internal Revenue Code. Headwaters also claims Section 45K tax credits based upon synthetic fuel sales from facilities in which Headwaters owns an interest. 

Section 45K tax credits are subject to phase-out after the average annual U.S. wellhead oil price (“reference price”) reaches a beginning phase-out threshold price, and are eliminated entirely if the reference price reaches the full phase-out price.  Based upon using an inflation adustment factor on 2006 phase-out range, Headwaters estimated calendar 2007 phase-out range begins at $55 and completes phase-out at $76 per barrel. By law, Section 45K tax credits for synthetic fuel produced from coal expire on December 31, 2007.

"We have made a lot of progress building a company that is independent of Section 45K, but 2007 will be another transition year for Headwaters. We anticipate a challenging year in our construction materials business due to the downturn in residential construction, but we also are excited about our niche strategy and the growth potential from new products. Over time, we will completely replace Section 45K revenues and operating income."

Kirk A. Benson Chairman and Chief Executive Officer

Acquisitions, Divestitures, Major Transactions, Spin-offs :

In June 2004, acquired Eldarado Stone from Graham Partners, a  middle market private equity firm, for an enterprise value of approximately $202.5 million.  The acquisition allowed Headwaters to diversify away from dependence on the commodity coal combustion materials business into high growth, branded building products.  Eldorado gives Headwater a national building products distribution system in which to target additional acquisitions for filling the channel with product.  The purchase price was funded with approximately $145 million received from a 2 7/8% convertible subordinated debt offering, $44 million from its senior secured revolver, and internally generated funds.

In September 2004, Headwaters announced the acquisition of Tapco Holdings, Inc,  a leading manufacturer of building products and professional tools used in residential remodeling and construction for $715 million in cash.  The purchase price was funded with proceeds from the company's senior secured credit facility.  Tapco is a leading designer, manufacturer and marketer of building products and professional tools used in exterior residential home improvement and construction.   Tapco claims to be greater than 75% of the market in its core products.  Sales are currently impacted by growth in the siding market, and more practically in the vinyl siding market.  Approximately 75% of Tapco's sales during fiscal 2003 were tied to the home improvement industry, which is typically less cyclical than new construction because remodeling is generally less expensive than a new home and is often required to preserve the value of a home.  The Tapco acquisition furthers Headwaters' efforts to diversify its construction materials platform with complementary products and move its cash flow downstream to higher margin branded products lessoning its dependence on commodity construction materials (fly ash).

Tapco and Eldorado acquisition rationale:

• Further diversify cash flow and earnings.
• Access to extensive distribution network comprising over 9,000 ship-to-locations including retailers Home Depot and Lowe's.
• Counter the cyclicality of its commodity construction materials cash flow.
• Move into higher margin "branded" construction material products.
• Diversify Headwaters' cash flow away from revenue associated with it's Section 45 business activities.

Management – Pros & Cons, Changes:

Enter Management - Pros & Cons, Changes Here

COMPANY OUTLOOK

HES’s license fees and revenues from sales of chemical reagents depend on the ability of its licensees and customers to manufacture and sell qualified alternative fuels that generate tax credits. By law, Section 45K tax credits are not available for alternative fuel sold after December 31, 2007. Given current prices of coal and costs of alternative fuel production, HES does not believe that production of alternative fuel will be profitable absent the tax credits. If Headwaters’ licensees close their facilities or materially reduce production activities (whether after 2007, upon earlier repeal or adverse modification of Section 45K or for any other reason such as the potential phase out of tax credits described above), it would have a material adverse effect on the recognition and timing of their revenues and net income.

In FY 2006, alternative energy accounted for 23.2% of Headwaters’ revenue and 30% of operating profits. Alternative energy operating margins for 2004 and 2005 were 47.19% and 57.5%, respectively. Without the Section 45K tax credit, synthetic fuel derived from coal is expected to be unprofitable.  Commencing with the discontinuance of the Section 45K tax credits in 2008, it is expected that licensee fees and revenues from synthetic fuel production will be dramatically curtailed or suspended resulting in a material loss in revenue and income to Headwaters.

The One-Two Punch.  Just as the Company moved to diversify away from dependence on Section 45K revenue, the building and construction materials business entered a cyclical downturn.  Construction materials now account for 75% of Headwaters’total revenues, up 62% from 2004.  Construction materials and CCP’s contribution to operating margins is averaging around 14%.  As the alternative energy business goes away, the company is now more reliant on a lower margin construction and building materials business.  Thus as margins decline and business slows, revenues have not grown enough to make up for the coming loss in the high margin alternative energy business.  Not only have high oil prices resulted in a phasing out of Section 45K revenues, it has also squeezed margins in both the chemical reagent and construction materials business by resulting in higher operating expenses that are not easily passed on in today’s softer real estate and construction market.

Headwaters’ share price has declined roughly 30% over the past twelve months and some 64% since its July 2005 high of nearly $46 per share.  In 2004, HW took on significant debt in order to finance the acquisitions of Eldarodo and Tapco.  Long-term debt rose from $104 million in 2003 to $914.6 million in 2004.  The Company’s debt-equity ratio rose from 0.74 to 2.96.  Since that time, the Company has paid down debt and grown earnings to the point to where at the end of FY2006, the ratio was back to a more manageable 0.734.  Almost 65% of the Company’s Total Assets consist of Goodwill and Intangibles which in all accounts were derived from its acquisitions.  Although the Company’s auditors annually test the assets for impairment, and to date have not found reason to incurr any material write-offs, any good analyst would build in a margin of safety to the economic worth of the assets and the risk of their ability to produce sufficient income to service the amount of long-term debt on the Company’s books.  Headwaters’ stated plan is to maintain a debt to ebitda ratio of 2.0.  It is currently 2.73.  It’s interest coverage ratio is 5.0 which is good.  A company’s ability to service its debt begins to come into question when the ratio dips below 1.5.   Although leveraged, without a serious downturn in its business, Headwaters’s does not appear to be at risk to manage its existing debt. As well, due to its indenture covenants, Headwaters can not take on any new debt at this time.  It also does not appear to be at risk of violating any operating covenants of its debenture agreement.

Due to its expansion into the construction materials business, Headwaters’ revenues are now more seasonal.  The construction industry picks up in the summer and slows in the winter.  During the first two quarters in fiscal 2007 (which tend to be weaker for HW), revenues were off 9% over the prior period in fiscal 2006.  Management is providing guidance in the range of $1.60 – 1.80 per share for all of fiscal 2007 down from $2.44 per share in 2006.  During the Q2 conference call, only SG&A, debt service, and R&D were covered by the operating profits of non-Section 45K business and did not contribute in a positive way to EPS. 
 
The stock is currently trading at a P/E of 6.7 on 2007 earnings.  At its high and prior to the slowdown in the real estate and new home construction market, the stock’s P/E was slightly over 14.  The Company’s market cap has declined from a high in 2005 of  $1.920 billion to its current level of $735 million.  Shareholder equity (book value) at the end of FY2006 was $801 million.  Thus, the Company’s market value is currently trading at a 14% discount to its book value and a 25% discount to its projected revenue. 
 
Based upon these valuation metrics, the company appears to be cheap.  However, several uncertainties still surround the business.  It is still too early to call a bottom in the real estate market let alone a recovery or turn around.  Most analysts are projecting continued weakness through the remainder of this year with a stabilizing and slight recovery in 2008.  Although, Headwaters is pursuing new ventures in the alternative energy space, they still face execution risk and validation.  Recently, a new 50 million gallon ethanol plant went online. However, feedstock costs have doubled since entering into the venture.  High energy prices may lead to further synfuel opportunities and growth in coal liquefaction through which Headwaters stands to benefit from licensing its technology and selling catalysts.

Although the construction materials and CCP business is lower margin business, due to the financial leverage, any pick up in construction spending should lead to earning growth and P/E expansion.  Thus, my outlook for Headwaters share price is to tread water at best for the next twelve months or so, and at worst decline in line with any further deterioration in its business.  However, I do believe that considerable negative news is built into the stock for the time being and it is more likely to rise on any hint of a turn around in its business than to decline on further deterioration.  Management seems to be battening down the hatches and for the time being focusing on improving operating efficiencies and bringing new businesses on line.  Thus, I would expect the company to weather any further weakness in the construction industry without a significant hit to earnings from here.

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