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| HW > SEC Filings for HW > Form 10-K on 21-Nov-2008 | All Recent SEC Filings |
21-Nov-2008
Annual Report
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 related notes included in this Form 10-K. Our fiscal year ends on September 30 and unless otherwise noted, future references to years refer to our fiscal year rather than a calendar year.
Overview
Consolidation and Segments. The consolidated financial statements include the accounts of Headwaters, all of our subsidiaries, and other entities in which we have a controlling interest. All significant intercompany transactions and accounts are eliminated in consolidation. We made one acquisition in 2007 and several smaller acquisitions in 2006 and 2008. These entities' results of operations for the periods from the acquisition dates through September 30, 2008 have been consolidated with our results; their operations prior to the dates of acquisition have not been included in the consolidated results for any period.
We currently operate in three industries: building products, coal combustion products (CCPs) and energy. In the building products segment, we design, manufacture, and sell architectural stone and resin-based exterior siding accessories (such as shutters, mounting blocks, and vents), concrete block and other building products. Revenues consist of product sales to wholesale and retail distributors, contractors and other users of building products. We are a nationwide leader in the management and marketing of CCPs, including fly ash used as a substitute for portland cement. Revenues in the CCP segment consist primarily of product sales with a small amount of service revenue. In the energy segment, we are focused on reducing waste and increasing the value of energy-related feedstocks, primarily in the areas of low-value coal and oil. Revenues for the energy segment through December 31, 2007 consisted primarily of sales of chemical reagents and license fees related to our former Section 45K business. Beginning January 1, 2008, and for the foreseeable future, revenues for this segment consist primarily of coal sales.
Operations and Strategy. During the past several years, we have executed our
two-fold plan of maximizing cash flow from our existing operating business units
and diversifying from significant reliance on the legacy energy segment
Section 45K (formerly Section 29) business. With the addition and expansion of
our CCP management and marketing business through acquisitions beginning in
2002, and the growth of our building products business through several
acquisitions beginning in 2004, we have achieved revenue growth and
diversification in three business segments. Because we also incurred increased
indebtedness to make strategic acquisitions, one of our historical financial
objectives has been to focus on increasing cash flows to reduce debt levels. In
2008, our primary focus has been on growing our coal cleaning business and our
current primary use of cash consists of capital expenditures, primarily in the
energy segment for coal cleaning facilities.
A material amount of our consolidated revenue and net income through
December 31, 2007 was derived from license fees and sales of chemical reagents,
both of which were dependent on the ability of licensees and other customers to
manufacture and sell qualified synthetic fuel that generated tax credits under
Section 45K of the Internal Revenue Code. We have also claimed Section 45K tax
credits for synthetic fuel sales from facilities in which we owned an interest.
By law, Section 45K tax credits for synthetic fuel produced from coal expired
for synthetic fuel sold after December 31, 2007. With the expiration of
Section 45K at the end of calendar 2007, our licensees' synthetic fuel
facilities and the facilities we owned were closed because production of
synthetic fuel was not profitable absent the tax credits. The closure of these
synfuel facilities has had, and will continue to have, a material adverse effect
on our current and future revenue, net income and cash flow, when compared to
prior periods.
Section 45K tax credits were subject to phase-out after the average annual U.S. wellhead oil price (reference price) reached a beginning phase-out threshold price, and would have been eliminated entirely if the reference
price had reached the full phase-out price. The calendar 2007 reference price and phase-out range were announced in calendar 2008 and accordingly, in the March and June 2008 quarters we adjusted previously recognized revenue and tax credits as required to reflect the finalized phase-out. The existence and unpredictability of phase-out has materially adversely affected both the amount and timing of recognition of our revenue, net income and cash flow beginning in fiscal 2006 and continuing into 2008. At the current time, we do not believe there are any material residual contingencies related to phase-out.
We own and operate several new and recently-renovated coal cleaning facilities that remove rock, dirt, and other impurities from waste coal, resulting in higher-value, marketable coal. In addition, we are currently constructing several additional coal cleaning facilities, which will begin operating prior to December 31, 2008. Construction of these facilities was our largest single investment of cash during fiscal 2008 and currently we expect construction activities in the energy segment and other segments to be our most significant investment of cash in 2009. Capital expenditures in 2008 were financed primarily with available cash and with lease financing. In 2008, coal sales were $38.7 million, compared to $2.1 million in 2007.
Our CCP segment business strategy is to continue to negotiate long-term contracts with suppliers supported by investment in transportation and storage infrastructure for the marketing and sale of CCPs. We are also continuing our efforts to expand the use of high-value CCPs and to develop more uses for lower-value CCPs, such as blending. Our building products segment has been significantly affected by the depressed new housing and residential remodeling market and our current strategy is to reduce operating costs as much as possible and be positively positioned to take advantage of an industry turnaround at some point in the future. We are also continuing to develop new building products and leverage our robust distribution system which we believe is a competitive advantage for us. Our CCPs and building products businesses are significantly affected by seasonality, with the highest revenue and profitability produced in the June and September quarters.
Our acquisition strategy targets businesses that are leading companies in their respective industries and that have strong operating margins, thus providing additional cash flow that complements the financial performance of our existing businesses. In 2006, we began to acquire small companies in the building products industry with innovative products that can be marketed using our existing distribution channels. We are also committed to continuing to invest in research and development activities that are focused on energy-related technologies and nanotechnology. We participate in joint ventures that operate an ethanol plant located in North Dakota and a hydrogen peroxide plant in South Korea. We are also investing in other energy projects such as the refining of heavy crude oils into lighter transportation fuels.
In 2005 and subsequent years, we focused on the integration of our large 2004 acquisitions, including the marketing of diverse kinds of building products through our national distribution network. We became highly leveraged as a result of those acquisitions, but reduced our outstanding debt significantly since that time through cash generated from operations, from an underwritten public offering of common stock and from proceeds from settlement of litigation. During 2005 through 2008, we made several early repayments of our long-term debt. In 2008, early repayments of long-term debt decreased as compared to earlier years primarily due to our investments of available cash in developing and growing our coal cleaning business in the energy segment. Significant cash needs for capital expenditures will continue in 2009, so we are focused on liquidity to enable us to continue implementing our growth plans. Although our historical emphasis on the early repayment of long-term debt has diminished temporarily, a significant amount of our long-term debt is repayable beginning in 2011. Management believes that operational improvements and the continued growth in the coal cleaning business will increase cash flow from operations and that this increase, along with the cash flow currently being generated, will provide sufficient funds to retire this maturing debt. Furthermore, we believe there may be additional alternatives to restructure our current credit facilities and capitalization.
Critical Accounting Policies and Estimates
Our significant accounting policies are identified and described in Note 2 to the consolidated financial statements. The preparation of consolidated financial statements in conformity with U. S. generally accepted
accounting principles requires us to make estimates and assumptions that affect
i) the reported amounts of assets and liabilities and disclosures of contingent
assets and liabilities at the date of the financial statements, and ii) the
reported amounts of revenue and expenses during the reporting period. Actual
results could differ materially from those estimates.
We continually evaluate our policies and estimation procedures. Estimates are often based on historical experience and on assumptions that are believed to be reasonable under the circumstances, but which could change in the future. Some of our accounting policies and estimation procedures require the use of substantial judgment, and actual results could differ materially from the estimates underlying the amounts reported in the consolidated financial statements. Such policies and estimation procedures have been reviewed with our Audit Committee. The following is a discussion of critical accounting policies and estimates.
License Fee Revenue Recognition. Through December 31, 2007, we licensed our technologies to the owners of 28 coal-based solid alternative fuel facilities in the U.S. License agreements contained 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. Recurring license fees or royalty payments were recognized in the period when earned, which coincided with the sale of alternative fuel by our licensees, provided standard revenue recognition criteria such as amounts being "fixed or determinable" were met. In most instances, we received timely reports from licensees notifying us of the amount of solid synthetic fuel sold and the royalty due us under the terms of the respective license fee agreements. Additionally, we experienced a regular pattern of payment by these licensees of the reported amounts.
Estimates of license fee revenue earned, where required, could be reliably made based upon historical experience and/or communications from licensees with whom an established pattern existed. In some cases, however, such as when a licensee was beginning to produce and sell synthetic fuel or when a synthetic fuel facility was sold by a licensee to another entity, and for which there was no pattern or knowledge of past or current production and sales activity, there may have been more limited information available to estimate the license fee revenue earned. In these situations, we used such information as was available and where possible, substantiated the information through such procedures as observing the levels of chemical reagents purchased by the licensee and used in the production of the solid synthetic fuel. In certain limited situations, we were unable to reliably estimate the license fee revenues earned during a period, and revenue recognition was delayed until a future date when sufficient information was known from which to make a reasonable estimation.
The amount of license fee revenue recognized during 2006 and 2007 was negatively
affected by reduced revenues for certain licensees whose license agreements
called for us to be paid a portion of the tax credits earned by the licensee.
Certain accounting rules limit revenue recognition to amounts that were "fixed
or determinable" and as a result of uncertainties related to phase-out of
Section 45K tax credits and other licensee-specific factors, the timing of
revenue recognition was delayed for certain licensees during those years.
Due to publication of the Section 45K calendar 2006 reference price and the phase-out range, finalization of calendar 2006 phase-out was made possible during the quarter ended June 30, 2007. As a result of the availability of this information and the clarification of other licensee-specific factors, certain calendar 2006 and prior year license fee revenue totaling approximately $31.5 million was recognized in 2007. This amount related to periods ending on or prior to December 31, 2006 and was recognized in 2007 when it met the "fixed or determinable" recognition criterion and it was remote that any negative adjustment would be required in the future. We applied the same policy in 2007 with regard to the recognition of revenue for calendar 2007 tax credit-based license fees. The final determination of revenue pertaining to fiscal and calendar 2007 occurred in 2008 when the calendar 2007 reference price and phase-out range were published and we adjusted previously recognized revenue and tax credits as required to reflect the finalized phase-out. The existence and unpredictability of phase-out has materially adversely affected both the amount and timing of recognition of revenue, net income and cash flow beginning in 2006 and continuing into 2008. At the current time, we do not believe there are any material residual contingencies related to phase-out.
Income Taxes. Significant estimates and judgments were required in the
calculation of our income tax provisions for the years presented. One of the key
estimates affecting our tax provisions was the amount of Section 45K (formerly
Section 29) tax credits that would ultimately be available related to our 19%
interest in an entity that owned and operated a coal-based solid alternative
fuel production facility, plus two other smaller alternative fuel facilities
that we owned and operated (see Note 10 to the consolidated financial
statements).
The calendar 2006 Section 45K tax credit phase-out percentage was not finalized until the quarter ended June 30, 2007. The calendar 2007 phase-out percentage was not finalized until the quarter ended June 30, 2008. As of September 30, 2006 and 2007, we used our best estimates of what the phase-out percentages for calendar 2006 and 2007 would be, using available information as of those dates. Adjustments to reflect final phase-out percentages were reflected in our consolidated financial statements in subsequent periods as necessary.
As described in more detail in Note 7 to the consolidated financial statements, we recorded goodwill impairment charges of $98.0 million and $205.0 million in 2007 and 2008, respectively. The impairment charge in 2007 was not deductible for tax purposes and most of the impairment charge in 2008 was not tax deductible and therefore had a significant negative effect on our reported effective tax rates for both 2007 and 2008.
As described in Note 11 to the consolidated financial statements, approximately $3.9 million of stock-based compensation in 2007 resulted from the early voluntary cancellation of SARs and other stock-based awards, requiring an acceleration of expense recognition for unrecognized compensation cost that remained as of the cancellation dates. As a result of the cancellation of the stock-based awards, approximately $10.0 million of deferred tax assets were written off.
As described in more detail in Note 10 to the consolidated financial statements, we adopted Interpretation No. 48, "Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109" (FIN 48) effective as of October 1, 2007, the beginning of our 2008 fiscal year, with a cumulative adjustment to decrease retained earnings and increase income tax liabilities for unrecognized income tax benefits by approximately $19.8 million. As of September 30, 2008, we had approximately $18.4 million of unrecognized tax benefits, net of an $11.2 million refund claim related to an uncertain tax position. Approximately $25.6 million of gross unrecognized income tax benefits would affect the 2008 effective tax rate if released into income.
The calculation of our tax liabilities involves uncertainties in the application of complex tax regulations in multiple jurisdictions. For example, we are currently under audit by the IRS for the years 2003 through 2006 and have open tax periods subject to examination by both federal and state taxing authorities for the years 2003 through 2008. We recognize potential liabilities for anticipated tax audit issues in the U.S. and state tax jurisdictions based on estimates of whether, and the extent to which, additional taxes and interest will be due. If events occur and the payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when it is determined the liabilities are no longer probable or necessary. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result. It is reasonably possible that the amount of our unrecognized income tax benefits will significantly change within the next 12 months. These changes could be the result of ongoing tax audits or the settlement of outstanding audit issues. However, due to the number of years under audit and the matters being examined, at the current time, an estimate of the range of reasonably possible outcomes cannot be made.
In evaluating our ability to recover our recorded deferred tax assets, in full or in part, all available positive and negative evidence, including our past operating results and our forecast of future taxable income on a jurisdiction by jurisdiction basis, is considered and evaluated. In determining future taxable income, we are responsible for assumptions utilized including the amount of federal, state and international pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we are using to manage our underlying businesses.
Valuation of Long-Lived Assets, including Intangible Assets and Goodwill. Long-lived assets consist primarily of property, plant and equipment, intangible assets and goodwill. Intangible assets consist primarily of identifiable intangible assets obtained in connection with acquisitions. These intangible assets are being amortized using the straight-line method over their estimated useful lives.
Goodwill consists of the excess of the purchase price for businesses acquired over the fair value of identified assets acquired, net of liabilities assumed. In accordance with the requirements of SFAS No. 142, we do not amortize goodwill, all of which relates to acquisitions. SFAS No. 142 requires us to periodically test for goodwill impairment, at least annually, or sooner if evidence of possible impairment arises. We perform our annual impairment testing as of June 30, using the two-step process described in Note 7 to the consolidated financial statements.
With the exception of the Tapco reporting unit in 2007 and the aggregated building products reporting unit in 2008, the step 1 tests indicated that the fair values of the reporting units, calculated primarily using discounted expected future cash flows, exceeded their carrying values as of the test dates. Accordingly, step 2 of the impairment tests was not required to be performed for those reporting units, and no impairment charges were necessary. As a result of the depressed new housing and residential remodeling market, the Tapco reporting unit failed step 1 in 2007 and the aggregated building products reporting unit failed step 1 in 2008. This required completion of step 2, which resulted in a determination that Tapco's goodwill was impaired in 2007 and the building products segment goodwill was impaired in 2008. Accordingly, non-cash impairment charges of $98.0 million and $205.0 million were recorded in 2007 and 2008, respectively. The impairments did not affect our cash position, cash flow from operating activities or senior debt covenant compliance, and will not have any impact on future operations.
As discussed above, the fair values of the reporting units are calculated primarily using discounted expected future cash flows. There are many estimates and assumptions involved in preparing these expected future cash flows, including most significantly the weighted average cost of capital used to discount future cash flows, anticipated long-term growth rates, future profit margins, working capital requirements and required capital expenditures. Management uses its best efforts to reasonably estimate all of these and other inputs in the cash flow models utilized; however, it is certain that actual results will differ from these estimates and the differences could be material. Materially different input estimates and assumptions would necessarily result in materially different calculations of discounted expected future cash flows and reporting unit fair values and materially different goodwill impairment estimates.
In addition to the annual review, we evaluate, based on current events and circumstances, the carrying value of long-lived assets, including intangible assets and goodwill, as well as the related amortization periods, to determine whether adjustments to these amounts or to the useful lives are required. Changes in circumstances such as technological advances, or changes in our business model or capital strategy could result in the actual useful lives differing from our current estimates. In those cases where we determine that the useful lives of property, plant and equipment or intangible assets should be changed, we amortize the net book value in excess of salvage value over the revised remaining useful lives, thereby prospectively adjusting depreciation or amortization expense as necessary.
The carrying value of a long-lived asset is considered impaired when the anticipated cumulative undiscounted cash flow from that asset is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair market value of the long-lived asset. Indicators of impairment include such things as a significant adverse change in legal factors or in the general business climate, a decline in operating performance indicators, a significant change in competition, or an expectation that significant assets will be sold or otherwise disposed of. In 2006, the building products segment revised downward the estimated useful lives of certain assets resulting in accelerated depreciation charges in order to fully depreciate the assets over shorter periods. No other significant changes have been made to estimated useful lives during the periods presented.
It is possible that some of our tangible or intangible long-lived assets or goodwill could be impaired in the future and that resulting write-downs could be material.
Stock-Based Compensation. We early adopted the fair value method of accounting for stock-based compensation required by SFAS No. 123R in 2005. We recognize compensation expense equal to the grant-date fair value of stock-based awards for all awards expected to vest, over the period during which the related service is rendered by grantees. The fair value of stock-based awards is determined primarily using the Black-Scholes-Merton option pricing model (B-S-M model), developed for use in estimating the fair value of traded options that have no vesting restrictions and that are fully transferable. Option valuation models require the input of certain subjective assumptions, including expected stock price volatility. For stock-based awards, we primarily use the "graded vesting" or accelerated method to allocate compensation expense over the requisite service periods. Our estimated forfeiture rates are based largely on historical data and ranged from 1% to 3% from 2006 to 2008, depending on the type of award and the award recipients. As of September 30, 2008, the estimated forfeiture rate for most unvested awards was 3% per year.
The fair values of stock options and SARs have been estimated using the B-S-M model, adjusted where necessary to account for specific terms of awards that the B-S-M model does not have the capability to consider. One such adjustment was used in determining the fair value of SARs which had a cap on allowed appreciation. For these SARs, the output determined by the B-S-M model was reduced by an amount determined by a Quasi-Monte Carlo simulation to reflect the reduction in fair value associated with the appreciation cap.
The two most critical estimates in determining fair value are expected stock price volatility and expected lives. Expected stock price volatility was estimated using primarily historical volatilities of our stock. Implied volatilities of traded options on our stock, volatility predicted by a "Generalized AutoRegressive Conditional Heteroskedasticity" model, and an analysis of volatilities used by other public companies in comparable lines of business were also considered. In estimating expected lives, we considered the contractual and vesting terms of awards, along with historical experience; however, due to insufficient historical data from which to reliably estimate expected lives, we used estimates based on the "simplified method" set forth by the SEC in Staff Accounting Bulletins No. 107 and 110, where expected life is estimated by summing the award's vesting term and the contractual term and dividing that result by two. Insufficient historical data from which to reliably estimate expected lives is expected to exist for the foreseeable future due to different terms associated with awards granted in recent years, along with other factors. Risk-free interest rates used were the US Treasury bond yields with terms corresponding to the expected terms of the awards being valued.
As of September 30, 2008, there was approximately $5.3 million of total compensation cost related to nonvested awards not yet recognized. This unrecognized compensation cost is expected to be recognized over a weighted-average period of approximately 1.7 years. Due to the grant of stock-based awards subsequent to September 30, 2008, the amount of total compensation cost related to nonvested awards has increased, and the weighted-average period over which compensation cost will be recognized has changed.
Approximately $3.9 million of the 2007 stock-based compensation resulted from the early voluntary cancellation of SARs and other stock-based awards, requiring an acceleration of expense recognition for unrecognized compensation cost that remained as of the cancellation dates. The early voluntary cancellation of SARs and other stock-based awards was a direct result of our low stock price as compared to the exercise prices of the cancelled SARs.
Year Ended September 30, 2008 Compared to Year Ended September 30, 2007
The information set forth below compares our operating results for the year ended September 30, 2008 (2008) with operating results for the year ended . . .
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