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HW > SEC Filings for HW > Form 10-Q on 31-Jul-2014All Recent SEC Filings

Show all filings for HEADWATERS INC



Quarterly Report


The following discussion and analysis should be read in conjunction with the interim condensed consolidated financial statements and related notes included in this Form 10-Q. Our fiscal year ends on September 30 and unless otherwise noted, references to years refer to our fiscal year rather than a calendar year.


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 currently operate primarily in two construction-oriented business segments: light building products and heavy construction materials, and have several product lines within those segments. Our construction-oriented end markets include new residential, residential repair and remodeling, commercial, institutional and infrastructure. Our third non-core operating segment is in energy technology.

Operations and Strategy. In the light building products segment, we design, manufacture, and sell manufactured architectural stone, exterior siding accessories (such as shutters, mounting blocks, and vents), roofing materials, concrete block and other building products. We manufacture our light building products in approximately 20 locations. Revenues consist of product sales to wholesale and retail distributors, contractors and other users of building products. A restructuring effort in the light building products segment was initiated in 2011 and completed in March 2012. In December 2012, we acquired the assets of Kleer Lumber, Inc., a manufacturer of PVC trim board and moulding products; in December 2013, we acquired 80% of the equity interests of Roof Tile, Inc., a manufacturer of high quality concrete roof tiles and accessories marketed primarily under the Entegra brand; and in May 2014, we acquired the stone coated metal roofing materials business of Metals USA Building Products, which products are marketed under the Gerard and Allmet brands.

Our heavy construction materials business acquires fly ash from coal-fueled electric generating utilities. Using a nationwide storage and distribution network, we primarily sell fly ash directly to concrete manufacturers who use it as an admixture for the partial replacement of portland cement in concrete. In addition to fly ash and other coal combustion products (CCP) sales, revenues also include CCP disposal services provided to utilities.

The energy technology segment has been focused on reducing waste and increasing the value of energy-related feedstocks, primarily in the areas of low-value oil and coal. Currently, revenues for the energy technology segment consist primarily of catalyst sales to oil refineries. In the past, revenues consisted primarily of coal sales; however, in September 2011 we committed to a plan to sell our coal cleaning business and since then the coal cleaning business has been presented as a discontinued operation. In January 2013, we sold all of our remaining coal cleaning facilities.

Light Building Products Segment. For several years, our light building products segment has been significantly affected by the depressed new housing and residential remodeling markets. Accordingly, we significantly reduced operating costs to be positively positioned to take advantage of an anticipated industry turnaround. Although new housing construction continues to be substantially below the median for the last 50 years, there was improvement in end markets in 2013. Performance in 2014 has been somewhat uneven, with mixed results as the year has unfolded. Demand for new homes appears to be rising, although there is still an environment characterized by tight credit conditions which constrain new building and purchases. New residential construction starts as of June 2014 are about the same as last year at a seasonally-adjusted annualized level of approximately 0.9 million units.

Existing home sales have been relatively steady. The National Association of Realtors reported that for all of calendar 2013, there were 5.1 million sales, which was 9% higher than for calendar 2012. June 2014 total existing home sales were at a seasonally-adjusted annual rate of 5.0 million units, a slight decrease from 5.1 million units in June 2013. Total housing inventory as of June 30, 2014 was 2.3 million existing homes for sale, representing a 5.5-month supply. This compares to a 5.2-month supply as of June 30, 2013 and a 4.3-month supply in May 2005, near the peak of the housing boom. The median sales price for existing homes of all types in June 2014 was 4% higher than in June 2013. We believe population growth, pent-up household formation, somewhat increased builder confidence and growing rental demand are some of the factors that have resulted in positive momentum. Repair and remodel markets, however, continue to be weak.

We, like many others in the light building products industry, experienced a large drop in sales and a reduction in our margins beginning in 2008 and continuing through 2012. While mortgage and home equity loan interest rates have been low in recent years, volatility continues to exist in credit and equity markets, increased borrowing requirements prevent many potential buyers from qualifying for home mortgages and equity loans and there exists a continued lack of consumer confidence. It is not possible to know when improved market conditions and a housing recovery will become sustainable for the long-term and there are no assurances that improvements in our light building products markets will continue.

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Heavy Construction Materials Segment. Our business strategy in the heavy construction materials industry is to negotiate long-term contracts with suppliers, supported by investment in transportation and storage infrastructure for the marketing and sale of CCPs. Demand for CCPs is somewhat dependent on federal and state funding of infrastructure projects, which has decreased in recent years as compared to earlier periods. We are continuing our efforts to expand the demand for high-quality CCPs, develop more uses for lower-quality CCPs, and expand our CCP disposal services and site service revenue generated from CCP management. While all of our businesses were affected by the recent recession, the impact on our heavy construction materials segment was somewhat less severe than on our light building products segment. However, to the extent that coal combustion power plant units are shut down or idled in the future, our business may be adversely affected.

Energy Technology Segment. Currently, continuing revenues for the energy technology segment consist primarily of catalyst sales. In 2011, we announced the decision by one refinery to commercially implement our HCAT® heavy oil upgrading technology following a lengthy evaluation and there are currently two refineries utilizing the HCAT technology. We have signed license agreements with three additional potential customers and expect those refineries to complete evaluation of the technology over the next six months, potentially leading to additional HCAT sales.

Until January 2013, we owned and operated coal cleaning facilities that remove impurities from waste coal, resulting in higher-value, marketable coal. In 2011, we assessed the strategic fit of our various operations and decided to divest our coal cleaning business, which did not align with our long-term strategy. In September 2011, the Board of Directors committed to a plan to sell the coal cleaning business, which has been classified as a discontinued operation since that time. We sold one coal cleaning facility during 2012 and the remaining ten facilities in 2013.

During 2010, 2011 and 2012, many of our coal cleaning assets were idled or produced coal at low levels of capacity and were cash flow negative for these or other reasons. As a result, we recorded significant asset impairments in those years to reduce the carrying value of the assets to fair value less estimated selling costs. We recognized small estimated gains on the 2012 and 2013 sales transactions, and subsequent to the dates of sale, adjustments of the previously recognized estimated gains have been recognized. We currently expect that additional adjustments to the estimated gains and losses may be recognized in fiscal 2014 and beyond as certain contingencies are resolved.

Seasonality and Weather. Both our light building products and our heavy construction materials segments are greatly impacted by seasonality. Revenues, profitability and EBITDA are generally highest in the June and September quarters and both segments are affected by weather to the extent it impacts construction activities.

Capitalization and Liquidity. We became highly leveraged as a result of acquisitions consummated in the 2004 timeframe, but reduced our outstanding debt significantly through 2008 by using cash generated from operations, from underwritten public offerings of common stock and from proceeds from settlement of litigation. In 2011, we recommenced making early debt repayments as our business improved and free cash flow increased.

In 2010 and 2011, we restructured our long-term debt twice which culminated in the issuance of $400.0 million of 7-5/8% senior secured notes for net proceeds of approximately $392.8 million. We used most of those proceeds to repay in full the formerly outstanding 11-3/8% senior secured notes. The 7-5/8% senior secured notes mature in April 2019 while the 11-3/8% notes were scheduled to mature in 2014.

During 2012 and 2013, we repaid a total of $85.6 million of our convertible senior subordinated notes and during 2014 we repaid $7.7 million of these notes. Currently, we have outstanding approximately $49.8 million face value of convertible debt, all of which is due in February 2016.

In December 2012, we issued 11.5 million shares of common stock for net proceeds of approximately $78.0 million. Approximately $43.3 million of the net proceeds were used to acquire the assets of Kleer Lumber. In December 2013, we issued $150.0 million of 7¼% senior notes for net proceeds of approximately $146.2 million. Approximately $57.5 million of the net proceeds were used to acquire 80% of the equity interests of Entegra. Capital expenditures beginning in fiscal 2010 have been significantly lower than in prior years, which allowed us to focus on liquidity and the early repayment of debt and enabled us to continue implementing our overall operational strategy. As of June 30, 2014, we have approximately $114.5 million of cash on hand and total liquidity of approximately $175.0 million. Additional cash flow is expected to be generated from operations over the next 12 months.

In summary, our strategy for fiscal 2014 and subsequent years is to continue activities to improve operational efficiencies and reduce operating costs. We also plan to pursue growth opportunities through targeted capital expenditures as well as potential additional strategic acquisitions of niche products or entities that expand our current operating platform, when opportunities arise.

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Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013

The information set forth below compares our operating results for the three months ended June 30, 2014, the third quarter of our 2014 fiscal year (2014), with operating results for the three months ended June 30, 2013, the third quarter of our 2013 fiscal year (2013). Except as noted, the references to captions in the statements of operations refer to continuing operations only.

Summary. Our third quarter 2014 consolidated revenue increased by 13% to $223.4 million from $197.0 million for the third quarter of 2013. Gross profit increased by 16%, to $67.7 million, compared to $58.5 million in the third quarter of 2013 and operating income improved from $23.2 million in 2013 to $25.7 million in 2014. Income from continuing operations was $11.1 million, or $0.14 per diluted share, for the third quarter of 2014, compared to $9.3 million, or $0.13 per diluted share, for the third quarter of 2013. Net income including discontinued operations was $10.9 million, or $0.14 per diluted share, for the third quarter of 2014, compared to $11.0 million, or $0.15 per diluted share, for the third quarter of 2013.

Revenue and Gross Margins. The major components of revenue, along with gross margins, are discussed in the sections below, by segment.

Light Building Products Segment. Sales of light building products in 2014 were $140.6 million with a corresponding gross profit of $42.9 million. Sales of light building products in 2013 were $118.0 million with a corresponding gross profit of $35.9 million. The 19% revenue increase in 2014 was due to both organic growth of approximately 9% and the acquisitions of Entegra and Gerard in December 2013 and May 2014, respectively. Weather conditions improved slowly from the difficult winter, primarily impacting sales of our siding-related products. Our manufactured stone, block, and roofing products experienced positive revenue growth in the quarter as we benefited from market share gains and good economic conditions in Texas and Florida.

Operating income increased by 21% to $18.7 million from $15.5 million. The operating income margin was affected by revenue mix, as sales of our higher-margin siding accessories in the Northeast and Midwest were slow to materialize following the difficult winter. In addition, increases in transportation, marketing and raw material costs negatively impacted our siding group's margins. Our block group more than offset increases in cement costs with price increases and manufacturing efficiencies, a combination which led to margin expansion. In the June quarter, our stone group achieved strong top line growth, coupled with margin expansion.

According to the National Association of Home Builders (NAHB), the most current 10- and 50-year averages for new housing starts were 1.2 million and 1.5 million units, respectively. New housing starts were only 0.8 million units and 0.9 million units in calendar 2012 and 2013, respectively, and during the last 50 years, the six years with the lowest number of housing starts were the six calendar years 2008 through 2013. According to the NAHB, in June 2014 the seasonally-adjusted annual number of new housing starts was 0.9 million units. Also impacting some of our product offerings is a continuing weakness in the repair and remodel end markets.

The significant weakness in the new housing and residential remodeling markets which began several years ago appeared to ease somewhat during fiscal 2013, but the recovery has been more uneven during fiscal 2014. In addition, there has been and continues to be significant regional differences in the strength of the improvement that has occurred. For example, the recovery has been more robust in some areas of the U.S., such as parts of the South and West, as compared to other regions such as the Northeast and Midwest, where growth has been minimal. These regional differences in the health of the housing market impact the sales of our various product groups differently. We believe our niche strategy and our focus on productivity improvements, cost reductions and price increases have tempered somewhat the impact of the weak housing market; however, it is not possible to know when improved market conditions and a housing recovery will become sustainable over the long-term.

Given our market leadership positions and reduced cost structure, we believe that we are positioned to benefit from a sustained recovery in the housing market when it occurs. We believe the long-term growth prospects in the industry are strong because the current seasonally-adjusted annualized housing starts are still below the 10- and 50-year averages. Also, according to a 2014 report by The Joint Center for Housing Studies of Harvard University, household growth is projected to average between approximately 1.2 million and 1.3 million units a year from 2015 to 2025.

Heavy Construction Materials Segment. Heavy construction materials revenues for 2014 were $80.6 million with a corresponding gross profit of $23.6 million. Heavy construction materials revenues for 2013 were $75.1 million with a corresponding gross profit of $20.5 million. This revenue growth was due to increases in product volume and price, slightly offset by a decrease in lower-margin service revenue. Service revenue represented approximately 22% of total segment revenue for the third quarter of 2014, compared to 25% for the third quarter of 2013 and 29% for all of fiscal 2013. Site service revenue as a percent of total segment revenue is normally higher in the December and March quarters and lower in the June and September quarters, primarily due to seasonality.

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Gross profit increased by 15% to $23.6 million in the third quarter of 2014, compared to $20.5 million in 2013, and gross margin increased by approximately 200 basis points to 29%. Operating income increased $2.2 million, or 17%, from $12.8 million in 2013 to $15.0 million in 2014. The increases in gross profit and operating income in 2014 were primarily due to increases in fly ash revenue resulting from positive changes in both volume and price, as well as to cost management initiatives.

According to the Portland Cement Association (PCA), calendar 2012 cement consumption increased 9.0% over calendar 2011 and cement consumption was projected to increase 4.5% in calendar 2013. It is not possible to accurately predict the future trends of either cement consumption or cement prices, nor the correlation between cement usage and prices and fly ash sales and prices. Nevertheless, because fly ash is sold as an admixture for the partial replacement of portland cement in a wide variety of concrete uses-including infrastructure, commercial, and residential construction-statistics and trends for portland and blended cement sales can be an indicator for fly ash sales. In November 2013, the PCA estimated the growth rate for calendar 2014 will be 8.1% and the PCA's Chief Economist believes the trough point for road construction, which accounts for the largest area of public cement consumption, was reached in 2013.

Low natural gas prices, EPA regulations, and reduced power demand, have combined to force the long-term shutdown or temporary idling of multiple coal combustion power plant units (primarily older, smaller units), negatively impacting the supply of CCPs for beneficial use in certain areas. This trend, which is currently expected to continue until the industry adjusts to requirements to update coal burning plants, has impacted somewhat our CCP supplies in certain regions of the country; however, we have multiple sources of supply and a broad distribution system, which allow us to move CCPs to locations where power plant units have closed, creating an opportunity for potential growth. Reallocating CCP supplies can increase our transportation costs, some but not all of which we have historically been able to pass on to customers.

The question of whether disposal of fly ash should be regulated under Subtitle C of RCRA (Resource Conservation and Recovery Act) or Subtitle D, as solid waste, is near resolution. In a consent decree proposed by the parties in 2014 to the U.S. District Court for the District of Columbia, the EPA agreed by December 19, 2014 to "sign for publication in the Federal Register a notice taking final action regarding EPA's proposed revision of RCRA Subtitle D regulations pertaining to coal combustion residuals." The Court is expected to accept the proposed consent decree and there has been no material change to the positive direction taken by the EPA. We believe that the EPA's statement makes it highly likely that fly ash disposal will be regulated under Subtitle D as a solid waste.

We have worked with the EPA for almost five years, and feel comfortable with the EPA's settlement with us and the other plaintiffs. We previously reported that the EPA had said that its plan to align new fly ash impoundment water standards with proposed CCP disposal rules "could provide strong support for a conclusion that regulation of [coal combustion residuals] under RCRA Subtitle D would be adequate." That alignment is consistent with finalizing Subtitle D regulations for fly ash disposal.

There is still a possibility that Congress could move forward with statutory language that requires states to follow national disposal standards backed up by EPA enforcement powers. The legislation would be protective of the environment, create a rational enforcement mechanism, and improve overall management of fly ash disposal. We support the legislation, but Subtitle D regulations would resolve the uncertainty surrounding beneficial use.

Energy Technology Segment. Following the decision to sell the coal cleaning business in fiscal 2011, our energy technology segment currently consists primarily of operations related to HCAT, our heavy oil upgrading catalyst. Energy technology segment revenues for 2014 were $2.2 million, compared to revenues for 2013 of $3.9 million. The change in revenue related primarily to the timing of HCAT shipments, which vary quarter to quarter, depending upon the timing of orders and onsite inventory levels of our current customers. We have entered into license agreements with three new potential customers and expect those customers to complete evaluations of the technology over the next six months, potentially leading to additional HCAT sales.

Operating Expenses. Amortization of intangible assets was not materially different between 2014 and 2013 because the decrease in amortization expense for assets that have been fully amortized offset most of the increased amortization for the assets acquired in the 2014 acquisitions. Future amortization expense will depend in part on the values and useful lives of the acquired intangible assets, once those are finalized. Selling, general and administrative expenses increased 22% from 2013 to 2014 due primarily to recurring expenses of the businesses acquired in 2014, direct acquisition costs for those businesses, increased selling and marketing costs (including some non-routine customer acquisition-related costs and costs designed to spur incremental organic revenue growth), an increase in expense for cash-based compensation tied to stock price, plus small increases in several other cost categories related to revenue growth. During the remainder of fiscal 2014, we expect to incur additional non-routine customer acquisition-related costs, primarily in the energy technology segment.

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Net Interest Expense. For 2014, we reported net interest expense of $12.1 million, compared to net interest expense of $11.1 million for 2013. Net interest expense increased $1.0 million due primarily to the new senior debt which was issued in December 2013, partially offset by a decrease in interest expense for convertible senior subordinated notes, the average balance of which decreased in 2014 as compared to 2013. In 2013, there was approximately $1.0 million of accelerated debt discount and debt issue cost amortization as a result of early repayments of convertible debt. In 2014, we had no early repayments of long-term debt. Interest expense for fiscal 2014 is currently expected to total approximately $47.0 million.

Income Tax Provision. See Note 9 to the condensed consolidated financial statements for the reasons for the 22% reported effective income tax rate in 2014 and the 18% rate for 2013, including why we recorded a valuation allowance on our net operating losses, tax credits and other deferred tax assets in both periods. A valuation allowance is required when there is significant uncertainty as to the realizability of deferred tax assets. The ability to realize deferred tax assets is dependent upon our ability to generate sufficient taxable income within the carryforward periods provided for in the tax law for each tax jurisdiction. We have considered the following possible sources of taxable income when assessing the realization of our deferred tax assets:

† future reversals of existing taxable temporary differences;

† future taxable income or loss, exclusive of reversing temporary differences and carryforwards;

† tax-planning strategies; and

† taxable income in prior carryback years.

Because our operations in domestic and foreign jurisdictions have generated losses in recent years, management determined that we do not meet the "more likely than not" threshold that NOLs, tax credits and other deferred tax assets will be realized. Accordingly, a valuation allowance is required.

During fiscal 2015, we may realize a three-year cumulative accounting profit. If this occurs, we will also consider other factors in evaluating the continued need for a full, or partial, valuation allowance. These factors include:

† current financial performance;

† our ability to meet short-term and long-term financial and taxable income projections;

† the overall market environment; and

† the volatility and trend of the industries in which we operate.

All of the factors we are considering in evaluating whether and when to release all or a portion of the deferred tax asset valuation allowance involve significant judgment. For example, there are many different interpretations of "cumulative losses in recent years" which can be used. Also, significant judgment is involved in making projections of future financial and taxable income, especially because our financial results are significantly dependent upon industry trends, including the new residential, repair and remodel, and infrastructure construction markets. Most of the markets in which we participate are currently in varying states of recovery from the historic downturn experienced in recent years; however, it is not possible to accurately predict whether recovery will continue, and if it does, at what rate and for how long. Any reversal of the valuation allowance will favorably impact our results of operations in the period of reversal.

During fiscal 2014, we may realize a three-year cumulative accounting profit in certain state jurisdictions. If this occurs, we will consider the factors above in determining the continued need for a valuation allowance on the deferred tax assets related to those state jurisdictions.

Discontinued Operations. We recorded $0.2 million of loss from discontinued operations in the third quarter of 2014, representing $0.1 million of operating losses (primarily expenses for certain litigation which commenced prior to disposal of the business) and $0.1 million of loss related to the coal cleaning facilities sold in the January 2013 sales transaction. We recorded $1.8 million of income from discontinued operations in the third quarter of 2013, representing $0.9 million of loss related to the sale of coal cleaning facilities and $2.7 million of income tax benefit, due primarily to the reversal of unrecognized income tax benefits related to audit periods that closed. We currently expect that additional adjustments to the estimated gains and losses from sale of the facilities may be recognized in fiscal 2014 and beyond as certain contingencies are resolved.

For all facility sales transactions, a majority of the consideration is in the form of potential production royalties and deferred purchase price, which amounts are dependent upon future plant production levels over several years. Potential future production royalties and deferred purchase price on the sales transactions were not considered in the gain calculations and will be accounted for in future periods when any such amounts are received.

In accordance with the terms of the asset purchase agreement for one of the sales transactions, the buyer of the coal cleaning facilities agreed to assume the lease and reclamation obligations related to certain of the facilities. Subsequent to the

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