Headwaters Q4 2008 Earnings Call Transcript

Nov. 4.08 | About: Headwaters Incorporated (HW)

Call Start: 11:00

Call End: 12:07

Headwaters, Inc. (NYSE:HW)

Q4 2008 Earnings Call

November 4, 2008 11:00 a.m. ET

Executives

Tricia Ross - Contact, Financial Relations Board

Sharon Madden - Vice President of Investor Relations

Kirk Benson - Chairman and Chief Executive Officer

Steven Stewart - Chief Financial Officer

Analysts

Al Kaschalk – Wedbush Morgan Securities

Jim Moore – Canaccord Adams

Michael Molnar – Goldman Sachs

Ron Oster - Broadpoint Armtec

Pearce Hammond – Simmons & Company

Daniel J. Mannes – Avondale Partners, LLC

John Bridges – J.P. Morgan

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Headwaters Incorporated fourth quarter 2008 conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions.

(Operator Instructions) This conference is being recorded today, Tuesday, November 4, 2008. I would now like to turn the conference over to Tricia Ross of the Financial Relations Board. Please go ahead.

Tricia Ross

Welcome to Headwaters Incorporated fiscal fourth quarter and year end 2008 conference call. By now you should have all received a press release outlining Headwaters' results for the quarter and the year. If you have not received the press release, please contact my office at 213-486-6540, and we will get a copy to you right away.

Without further delay I would now like to turn the call over to Sharon Madden, Headwaters' Vice President of Investor Relations.

Sharon Madden

Thank you, Tricia. Good morning to everyone. Thank you for joining us, and welcome to Headwaters' Q4 fiscal '08 conference call. On the call today, it will be conducted by Kirk Benson, Headwaters' Chairman and Chief Executive Officer, and Steven Stewart, Headwaters' Chief Financial Officer.

Before we get started today, I would like to remind you that certain statements made during this call, including statements relating to our expected future business and financial performance may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, both as amended.

Forward-looking statements by their nature address matters that are, to different degrees, uncertain. These uncertainties, which are described in more detail in the annual and quarterly reports filed with the SEC, may cause our actual future results to be materially different than those expressed in our forward-looking statements, whether as a result of new information, future events, or otherwise, except as may be required by law.

You may find Headwaters' annual report on Form 10-K, quarterly report on form 10-Q, and other SEC filings readily available from the SEC's website, Headwaters' website, or directly from the Company.

I will now turn the call over to Mr. Steven Stewart, Chief Financial Officer of Headwaters. Steve.

Steven Stewart

Thank you, Sharon. Good morning everybody. I apologize for my voice, we're getting our second snowstorm here in Utah and I think I'm getting my first winter cold, so bear with me as I go through this. Attached to the press release that Tricia mentioned we provided you with condensed consolidated financial statements that include our statements of operations for the quarter and the year ended September 30, 2008, 2007.

There are also balance sheets as of September 30, 2008 and 2007. My comments are derived from those condensed consolidated statements and the schedules that we attached therein. We expect to file our Form 10-K prior to the Thanksgiving holiday.

Headwaters' fiscal 2008 year was a difficult year and the September quarter continued to be significantly impacted by the weakness in the new housing and residential remodeling markets. This was heightened by the significant investment we are currently making in new clean coal facilities.

Capital alternatives are virtually non-existent in today's environment, and accordingly Headwaters continues to look for opportunities for operational improvements in cost reduction initiatives in all of our businesses, but in particular in our building products segment as it continues to experience a slowdown.

These initiatives, along with marketing new products and brands mitigated some of the declining trends we continued to experience in 2008. We continue to be optimistic about our new coal cleaning operations and continued strong coal prices support our expectations that the growth in this business will offset a lot, if not all, of the Section 45K business that ended on December 31, 2007 and the building products slowdown.

We also continue to believe that Headwaters' resources, our coal combustion products, or CCP business, will continue to show modest growth in 2009. We know that 2008 was going to be a transition year for Headwaters.

The difficulties we expected and planned for were significantly heightened by the drop in the new housing and residential remodeling markets. We expect 2009 will show a significant improvement, although we expect some of the slowdown we experienced in 2008 to carry into 2009.

There was approximately $13.8 million of net income from the Section 45K operations in our fiscal 2008 results. These operations are now completely finished. The coal cleaning business that Headwaters started a couple of years ago was intended to replace the phased out Section 45K business. Fiscal 2009 will be a year of significant development and growth as we continue to work through the problems we are facing and a challenge we are sure to encounter in future periods as we expand these new businesses and identify future opportunities for Headwaters.

Headwaters continued to have adequate liquidity and our cash flow from operations has historically continued to be strong through the December quarter. During the September quarter Headwaters was able to repay the outstanding balance on our revolving line of credit of 35 million, and prepay 10 million of our senior secured debt, reducing our total senior secured debt to $200 million.

As previously announced, Headwaters was able to amend our senior secured credit facility in the September quarter, which eased our debt covenant requirements and expanded our leasing options. Headwaters is in compliance with all of our debt covenants at September 30, 2008.

The March quarter is our weakest quarter and we will be required to make borrowings on our revolving line of credit to meet seasonal operational needs and to complete the capital costs we have been incurring in placing our eleven coal cleaning facilities in service.

Capital expenditure requirements in 2009 of approximately $90 million will be significantly lower than the expenditures in 2008 which totaled approximately $116 million. If you remove Section 45K operations and the goodwill impairment from both the fiscal 2007 and 2008 operations, revenues declined by only 4.5% and diluted earnings per share only declined from $0.29 in 2007 to $0.27 in 2008, a decrease of 6.9%.

I believe that this is a significant accomplishment in light of the extremely difficult economy we have experienced and the significant decline in the new housing and residential remodeling markets, and reflects the strong market position of our products and brands and Headwaters' strength and ability to adapt and change.

Many of my comparisons of the September quarter and fiscal 2008 year to 2007 will exclude the goodwill impairment and the Section 45K operations, so as to make these comparisons more meaningful. Section 45K revenue in the September 2008 quarter was 4.9 million compared to 77.3 million in the 2007 quarter.

Adjusted for these amounts, revenue in the September 2008 quarter declined 6.1% when compared to 2007. Section 45K revenue in the fiscal 2008 year was 67.5 million compared to 350.2 million in fiscal 2007.

Headwaters' gross profit margin, excluding Section 45K operations, decreased from 31.4% in September 2007 quarter to 25.7 in the 2008 quarter. Headwaters' gross profit margin declined from 29% in fiscal 2007 to 25.4% in fiscal 2008.

The decline in gross profit is the result of lower gross margins in our building products segment, which results from lower sales and the impact fixed charges have from being spread over a smaller revenue base, plus increased energy and fuel costs and the change in product sales mix.

The decline in gross profit was also negatively impacted by ramp-up costs in the new coal cleaning operations. The gross profit margin in our CCP operations declined slightly as a result of higher service revenues which normally have lower margins and increased transportation costs.

Excluding Section 45K operations and the goodwill impairment, net income for the September 2008 quarter was 7.3 million compared to 10 million for the September '07 quarter, or a decrease of 27%. Net income for fiscal 2008 was 10.9 million compared to 13.6 million in 2007, or a decrease of 20%. The effective income tax rate, excluding the effects of the goodwill impairment, was approximately 29% for fiscal 2008 compared to 24.5% for fiscal 2007.

With the expected significant increase in our coal cleaning operations and the income tax credits that these operations generate, we expect our income tax rate for 2009 to be comparable or slightly lower than the 2000 effective tax rate of 24.5%.

Our diluted earnings per share decreased from $2.53 for fiscal 2007 to $0.60 for fiscal 2008, if you adjust for the effects of this goodwill impairment. If you also include Section 45K operations, the diluted earnings per share decreased from $0.29 in fiscal 2007 compared to $0.27 in fiscal 2008.

The diluted weighted average shares outstanding is lower at September 30th in 2008 than in 2007 as a result of the 1.2 million shares of Headwaters' common stock we repurchased in the December 2007 quarter. This is offset by a small amount of new stock issuances in fiscal 2008.

Shares issuable in connection with Headwaters' convertible debt were excluded from the weighted average shares outstanding calculation, as the effect of including the convertible debt in earnings per share would have been anti-dilutive. There were approximately 41.4 million weighted average shares outstanding at September 30, 2008.

Selling, general and administrative expenses for fiscal 2008 and the September quarter were lower than the comparable periods in 2007. This decrease is the result partially of lower sales and marketing costs, but is also impacted by lower employee-related costs, the effects of some of our operational improvement in cost reduction programs, all of which we initiated in 2008.

SG&A expenses incurred in connection with the coal cleaning operations will be higher as a percent of sales as we continue to go through the significant expansion and wrap-up period, which will probably last well into fiscal 2009. We expect SG&A expenses for fiscal 2009 to be lower than fiscal 2008, both in absolute dollars and as a percentage of revenues.

R&D expenses for fiscal 2008 were approximately 15% lower than the prior year. R&D expenses for fiscal 2009 should continue at levels comparable to 2008. Headwaters has an indebtedness of $532.5 million as of September 30th 2008, which represents a $10 million increase when compared to September 30th, 2007.

Headwaters generated approximately $123.5 million of cash flow from operating activities during fiscal 2008 compared to approximately $150 million in 2007. We spent $116 million on capital expenditures during fiscal 2008, compared to approximately $55 million in 2007.

Our revolving credit facility provides for total borrowings of $60 million and we are currently using the revolver to support about $10 million of letters of credit, which leaves $50 million available to be drawn on the revolver.

On September 30th, 2008, Headwaters has approximately $21.6 million of cash and cash equivalents on hand, thus providing Headwaters with over $70 million of total liquidity. Net interest expense was lower during 2008 compared to 2007. Interest expense in fiscal 2009 will be higher than 2008, as a result of the debt amendment previously discussed and the resulting increase in the interest rates on the senior secured debt.

Capital expenditures during 2009 are estimated to be approximately $90 million. Headwaters should enjoy good cash flow generation and liquidity in 2009. We expect cash flow from operations in fiscal 2009 to be as much as $115 million.

Capital expenditures related to the coal cleaning initiative will decrease significantly in 2009. Depreciation and amortization was approximately $74 million for fiscal 2008 and we expect appreciation and amortization for fiscal 2009 to be approximately $82 million.

Headwaters has three significant debt compliance ratios in connection with our senior secured credit facility, along with other standard requirements. The three ratios relate to total indebtedness to EBITDA, senior indebtedness to EBITDA, and fixed charge coverage. We are in compliance with all of our ratios, covenants, and other debt requirements as of September 30th, 2008.

The discontinuance of section 45-K operations and the decrease in building products revenues has caused our trailing 12-month EDITDA to decline significantly as of September 30th, 2008 and will probably continue to decline through the December 2008 quarter before we believe it will level out and then begin to increase in 2009.

The significant increase in capital expenditures in fiscal 2008, along with the decline in EBITDA, caused these ratios to tighten to an uncomfortable level and was a primary reason we amended our senior secured credit facility in August of 2008.

This amendment caused the interest rate to increase from LIBOR plus 200 basis points to a LIBOR plus 450 basis points. The interest rate for our revolving credit line increase and is now the same as the senior secured credit facility. The revolving credit line expires in September 2009.

We currently believe that our operations will produce good cash flow in future periods, and believe these cash flows that are current working capital, along with leasing alternatives will be sufficient to complete our currently planned coal cleaning facility construction, and will be sufficient to meet our operating needs.

The weighted average shares outstanding decreased in September 2, 2008, when compared to 2007 as a result of the stock repurchased previously discussed. At today's stock price, substantially all of Headwaters options and SARs are out of the money and are therefore excluded in the diluted weighted average shares outstanding calculation.

As of September 2008, Headwaters had approximately 41.5 million shares outstanding, the net of our treasury shares. As we have discussed in the past, Headwaters issued $172.5 million in convertible debt in 2004 that is treated as if converted into 5.8 million shares of Headwater stock, even though the conversion price is at $30 a share. These shares were not included in the calculation of September 30th, 2008 as their inclusion would have been anti-dilutive.

We believe the results of fiscal 2008 year reflect a difficult building products market we are experiencing and the significant impact of the conclusion of our Section 45-K business. It is difficult to predict when new housing starts or residential remodeling activities will improve, and the building products segment will experience a rebound. However, we continue to be optimistic about the potential of our new coal cleaning operation and that growth in this business segment is expected to more than offset any continued weakness in the building products segment.

Accordingly, we are providing guidance for fiscal 2009 of diluted earnings-per-share of $0.70 to $0.95. We will continue to look for opportunities to reduce our operating expenses, accelerate the ramp-up of our coal cleaning business, implement additional operational improvements, efficiently manage our CCP business, and pursue additional commercial validations of our technologies.

I'd be glad to discuss specific questions about 2008 results during the question-and-answer period. I would like now to turn the call over to Mr. Kirk Benson, Headwaters Chairman and Chief Executive Officer.

Kirk Benson

Thank you, Steve. First, I would like to make some comments on Headwaters resources. We completed the year with revenue up over 2% to $313 million. In context, our performance is exceptional. The Portland Cement Association forecast saw a 12% decline in cement consumption in 2008 and another 6% drop in 2009. Construction activity is expected to decline 9% in 2008 and an additional 7% in 2009.

Our performance is markedly better than may be expected. In a down market, we are able to respond in two ways. First, Ready Mix users increased the percentage of fly ash used as a substitute for Portland cement in an effort to maintain higher margins using a higher percentage of the lower cost substitute.

So even though Portland cement volume declined, we end up with a higher substitution percentage.

The second way we respond to a down market is to increase our utility service revenues, which were not dependent upon fly ash sales. Although Portland cement volumes are declining at double-digit rates, pricing has declined at a slower rate. This allows us the opportunity to maintain, or even slightly increase, our pricing in some markets.

Throughout the year we have focused on increasing our access to a supply of high quality fly ash. We continue our CapEx expansion and anticipate over the next 18 months that we will not be supply constrained, as our new contracts, storage, and blending all come on line. Importantly, as many forecasting market recovery in 2010, we believe that our fly ash business will be well positioned to supply the increased demand, and specifically both the Florida and California markets.

As you know, the California Air Resources Board has proposed rules implanting AB32 to reduce greenhouse gases in California. For every ton of cement that is produced there is nearly one ton of carbon dioxide emitted into the atmosphere.

To partially address the issue of global warming and CO2 emission, the California Air Resources Board released a proposed plan to reduce cement consumption. The plan could be adopted as early as this month and result in as much as a 25% substitution level when it is fully implemented.

California's recent cement consumption was 15 million tons and have an average replacement of somewhat less than 9%, or approximately 1.3 million tons. At a 25% substitution level, the fly ash consumption would approximate 3.6 million tons, a substantial increase over current usage. Importantly, we have the capacity to supply fly ash into the California market and meet the increased demands for cement substitution.

Our outlook for 2009 is for a 2% to 4% revenue growth. Margins could decline slightly based on geographic and product mixed changes, but there is significant up-side based upon the rule changes in the California market.

Now turning to our billing products segment. First, some market data. Home construction fell again in September to an annualized level of 817,000 units, a 6% drop from the level seen in August and a 31% decline from the levels seen in September 2007. Single-family starts are 61% below the September 2006 level.

New home sales increased 2.7% in September to a seasonally adjusted 464,000 homes, but new home sales are 33% below last year and 54% below 2006 September level. In September, median new home prices experienced its second straight monthly decline. We are at the lowest median new home price level for any month since September 2004.

Months of existing home inventory declined in September for the third straight month. At the current sales pace, there are 9.9 months of supply of existing homes on the market. Months of inventory are now at their lowest levels since February.

As expected, we continue to be impacted by the down-cycle in new residential construction. After taking into account the sale of our mortar stucco business, our building products revenue was down 12% year-over-year comparing favorably to the 30% decline in residential construction.

Two areas of our building products group continue to have strong growth, even in a weak market offsetting some of the sales decline in our core products. First, when we sold the mortar stucco business, we acquired additional block manufacturing capacity that helped us meet demand.

Our block product group increased its sales by 19.6% during the fiscal year. Second, we are experiencing strong growth rate in several of our new products as we leverage our national distribution system and expand the geographic penetration of our new products.

Examples of products that grew at double-digit rates during the year include our InSpire Roofing product and our Stonecraft brand of architectural stone. We expect continued high growth rates from new products as we leverage our combined distribution strengths across our industry-lead building products brands.

Our margins have declined for three principle reasons. First, because of lower sales volume we experienced with these margins caused by low overhead absorption. Our fixed costs are becoming a larger percent of sales. Second, there is a change in product mix occurring due to the rapid growth of new products.

We are experiencing high margin revenue, yet replacing high margin revenue in our mature products with new product revenue that have lower margins. Ultimately, the margins of our new products will grow as we produce higher sales volumes.

And, third we have been impacted by raw material cost increases and energy-related transportation costs. Many of these costs are associated with crude oil and we are already seeing some improvement as oil costs have come down.

To address margin compression, we have instituted many different cost-saving initiatives, including reduction in our building products head count. Our head count is down 42%, representing over 1,500 jobs, multiple plant consolidations at both El Dorado and Tapco, transportation realignments, manufacturing productivity.

Our total SG&A costs were down $6.5 million in 2008 and we have identified another $9 million cost reduction plan for 2009. We will also benefit from lower crude oil prices in transportation and raw materials.

In addition to cost control activities, we are aggressively increasing prices. During the September quarter, we instituted a price increase of approximately 8% for most of our mature resin-based building products, and November 1 we instituted a price increase in our El Dorado architectural stone product.

Looking forward to 2009 we anticipate that housing starts will continue to decline. Our 2009 new residential construction is slightly higher than 700,000 units based on our fiscal year down from approximately 1 million units in our current fiscal year, a projected 30% decline.

Our drop in revenue will probably be in the 5% to 10% range because the growth in new products will not fully offset the decline in our mature products. We anticipate a slight improvement in margins, as we benefit from our cost-control activities and lower energy and raw material cost-flow through the income statement.

Now I'd like to make some comments on our energy services division. First, about market conditions. There is some uncertainty in coal prices as we face a global slowdown and at least a short term decline in energy demand. Long term, of course, energy is forecasted by the U.S. Department of Energy to grow 50% by 2030 and coal is projected to be one of the fastest growing segments projected to grow more than 70%.

Below the long term fundamentals, such as population growth and improvements in living standards will cause demand for energy to remain strong for decades. Although there may be short term price corrections, increasing energy demand coupled with challenges in coal production will result in relatively high coal prices compared to historical standards.

Ace loading, plus the demand created by multiple, new coal fire plants that will come on-line between 2010 and 2012 should provide for growth in the U.S. domestic market. From a steam coal pricing perspective, U.S. coal and specifically northern and central App coal continue to be in demand internationally.

U.S. exports are 44% ahead of 2007 and should approach 85 million tons. Production issues persist for Appalachian coal, including permitting and more difficult geology. In the short term, we have seen some softening of coal prices, but we do not expect a significant fall-off and we are comfortable with the steam component included in our estimated price range.

We expect that there will be some softness in the met market due to a decline in the demand for steel, but coal prices will continue to be very high by historical standards. It appears that international met coal prices settling in the $200 to $250 range, depending upon quality, is quite realistic. So we are comfortable with the met component included in our projected price range.

From a facility perspective, our objective was to replace and service ten coal cleaning facilities by the end of calendar 2008. We started the fiscal year with two facilities and currently have eight facilities in service.

Three additional facilities are nearing the end of construction and will be placed in service by the end of the calendar year. The facilities that we acquired needed upgrades, and the upgrades should be completed during the next quarter. So going into 2009 calendar year, we should have 11 facilities at various stages of production.

I would like to comment briefly on our 2008 production history. Excluding our tolling coal in the December 2007 quarter, Headwaters sold approximately 27,000 tons of coal into the steam market at $38 per ton. In the September quarter, Headwaters sold approximately 365,000 tons of coal into the steam and met markets at an average price of $48 per ton.

Unsold increased almost 14 times as we ramp-up production at our facilities and put this on a run-rate of 1.4 million tons for 2009. From a revenue perspective, we have experienced growth from approximately $1 million in the December quarter to over $17 million in the September quarter, 70 times growth between the first and fourth quarters.

Our goal was to generate between $30 and $40 million in revenue for the year and we finished the year with over $38 million in revenue.

For 2009, we continue to anticipate that our coal sales will be in the range of 2.5 to 3.5 million tons at a sales price range of $55 to $63 per ton. The midpoint of the range results in revenue of about $180 million. If we achieve the midpoint of our range, it will result in growth from $38 million to $180 million in the next 12 months.

We do not expect the growth to be linear, but will be staged as our facilities ramp-up with the larger increase coming in the March and later quarters. Ultimately, the revenue growth will depend upon how quickly we can ramp up the facilities and the price per ton for which we sell the coal.

We currently have 81% of our coal marketed with our coal company partners. Accordingly, we have adopted their contractual terms and we have commitments similar to our coal company partners. We are contracting independently of any coal company partner 19% of our coal sales. Of this percentage, 100% of our tons are contracted for in 2009.

On our other technologies, we continue to make full but consistent progress. For example, in a recent article in the Economic Times, Headwaters had an agreement with Reliance Industries, as mentioned. Headwaters has signed a collaboration agreement to provide coal processing technology and assistance to Reliance in preparing an application to the Indian government for the allocation of 1.5 billion tons of coal for a coal-to-liquid project.

The HCAT test that was scheduled for the December quarter has been delayed at least into the March quarter. We are moving towards testing at all three refineries that have used HCAT in the past and continue to develop research data at our pilot plant to support HCAT commercialization.

We continue to make progress with our hydrogen peroxide facility in South Korea and expect to have an expansion to meet additional demand by FKC Chemicals. So thank you very much for your participation, I'd like to turn the time back to the operator so that we can now answer questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question and answer session. (Operator instruction) And our first question comes from the line of Al Kaschalk with Wedbush Morgan. Please go ahead.

Al Kaschalk – Wedbush Morgan Securities

Good morning, Kirk, good morning, Steve.

Kirk Benson

Good morning, Al.

Al Kaschalk – Wedbush Morgan Securities

Kirk, I guess I want to start on maybe the coal side first. In terms of the facilities and the operations, could you comment on the yield of those that are coming up to speed or those that you have been operating relative to expectations?

Kirk Benson

Yes, we continue to believe that we're going to get a 20% to 25% yield. The facilities vary, some are lower, some are higher, but the average is coming in as expected in that range of 20% to 25%.

Al Kaschalk – Wedbush Morgan Securities

If that looks at the mid-point of your gardens, though, what's the extension of top end of revenues? Is it more better pricing on your side or is it more yield for improvements?

Kirk Benson

I think the, we've got a potential of moving to the upper end of the guidance on yield. There's probably a greater potential of us beating the guidance on yield than there is on price. I think that there may be a little bit of room on price, but as everyone knows, prices have softened a bit. We're still clearly within the range that we projected, but I think there's probably more upside on yield than there is on pricing.

Al Kaschalk – Wedbush Morgan Securities

All right, and can you just clarify, I may have missed, did you say you have 80% of what you're marketing with your partner contracted in terms of price?

Kirk Benson

They, 81% of our coal is sold as a blended product with our coal company partners, and so we're basically piggybacking on to the coal contracts of those coal companies. And so that's the coal where we don't have the direct sales and marketing responsibility, but rather we're using the existing contracts of these coal companies.

Al Kaschalk – Wedbush Morgan Securities

And how much of that is contracted, then, for calendar '09?

Kirk Benson

It varies depending upon the underlying coal company, but most of the coal is under contracted, or is being contracted currently. In the met market when you're shipping the coal internationally, the pricing is still in that phase of negotiations. The tons are pretty well set, people know what the tons are going to be shipped; the pricing in the international market is still not set yet.

Al Kaschalk – Wedbush Morgan Securities

And is that something you feel comfortable with in terms of the percentage relative to the gardens that you gave, or at least the range you gave in that segment?

Kirk Benson

Yes, we said that our sales would be 30% to 35% net coal and we feel pretty comfortable with that, yes.

Al Kaschalk – Wedbush Morgan Securities

All right, and then my final question, if we could switch over to construction materials and that area, sort of a two-part question. First, I assume you've had discussions with your customers. Have they given you any indication on drop in volume or where they're seeing the next 12 months goes relative to what you saw at this point in FY '08 and if you could add something to that that would be great.

The second part is with the modification you did comment on commodity costs maybe coming in a little bit, but in terms of keeping margins relatively steady, do you see more of that coming from price reduction or your ability to get a little bit of price through to these customers?

Kirk Benson

There is clearly going to be a step-down in the new home construction over the next 12 months. If you view that from a fiscal year perspective, and so these numbers are a little bit higher than the calendar year numbers because we're basically, our year ends one quarter earlier than the calendar numbers. And so what we have built our views of 2009 based on a 30% decline.

That 30% decline is pretty consistent with what we're seeing from our distributors and our customers. So we tried to be realistic in setting our expectations for 2009 and that decline is basically the same as what happened in 2008, a 30% decline.

So we're seeing that kind of drop and that's what we've built into our forecast. From a margin perspective, there's three things going on to impact our margins. One is the price increase. I think that our price increases so far have held and that should help us, of course, from a margin perspective.

The second thing is becoming more efficient with our manufacturing process. As an example, we've been working for some time to get fly ash introduced into our architectural stone products and this last year we've been successful in doing that.

That reduces the amount of Portland cement that we have to put into the architectural stone, and by the way, it improves the quality of the product as well, but it ends up reducing, then, our total material costs that go into the product.

In addition, resin prices have declined along with crude oil prices. And so we're starting to see that, we've got about a 90 to 120 day lag in drop in crude oil prices, but again that flows into our P&L. So we'll start seeing a drop in our raw material costs late November and into December, we'll start seeing some of those improvements come through.

So its price increases, better productivity in the use of our raw materials and changing the mix of raw materials, and then the final component is a drop in some of the pricing, particularly pricing of crude oil, hence the resin.

Al Kaschalk – Wedbush Morgan Securities

What price increase did you say, or range did you go out with? What are you comfortable with sharing?

Kirk Benson

Yes, our price increase on our resin based products was 8%, and the price increase in the stone products will vary a little bit, but it's in like the 5% range.

Al Kaschalk – Wedbush Morgan Securities

Thank you.

Operator

Thank you. Our next question comes from the line of John Quealy with Canaccord Adams. Please go ahead.

Jim Moore – Canaccord Adams

Yes, thanks, actually it's Jim Moore for John. I guess first on the coal side, could you give us a range for how much Walter purchased in the quarter?

Kirk Benson

One thing that we haven't done is broken out the sales by our different facilities. We have as a way to estimate that, however, there are, we have three operating facilities in Alabama when we will complete the construction of a fourth one, that are related to JWR. So of our total production sales of 365,000 tons, a significant portion of that is attributable to our Alabama production.

So we've had, I'm not counting the Utah facility, we have seven facilities in operation. The three facilities are tied to JWR, and the sales are somewhat weighted towards the JWR sales because of those three facilities are more mature than the other four facilities that we're operating during the quarter.

Jim Moore – Canaccord Adams

Okay, and when we look at the guidance of 2.5 to 3.5 million tons for '09, can we assume that the 30% or so of met coal is already spoken for and the rest, the steam, I guess, is sold on a merchant basis?

Kirk Benson

No, well, it's all, from our perspective, it's all kind of sold on a merchant basis. It's spoken for meaning that we'll sell the both of the coal produced in Alabama and so the quality that can be sold on the met market.

And so that will supply that coal and in that sense is spoken for and then our Pinnacle facility also produces coal of net quality and it's spoken for in the sense that we'll sell that coal in partnership with our coal company partner.

And so it gets blended into their products and so the concept is absolutely correct that it is spoken for.

The coal that's sold into the steam market is also sold under contracts. So there's not a lot of spot coal sales, a little bit, but the bulk of the coal is sold under steam contracts either contracts that we negotiated for 19% of our sales or coal that our coal company partners have contracted for.

Chip Moore - Canaccord Adams

Okay. And I guess if I could switch gears and talk about the energy bill that was passed with the relief package. Maybe you can just give us an overview of how that impacts you guys, maybe if that opens up steel slag opportunity at all?

Kirk Benson

Yes, there were two changes of note in the bill. One was that there was an extension of the refined coal credit extending the place and service date from 12/31/08 to 12/31/09 and with that extension, there was a couple changes in the qualification criteria. In the older criteria required a 50% increase in value creation from the feed stock, that is, you sold your end product at a price 50% higher than your feed stock cost. That criteria was eliminated.

The prior criteria was that you needed to have a 20% improvement in the SOx or mercury reduction and the new criteria is a 40% reduction in SOx or mercury. All of our facilities that we'll have placed through by 12/31/08 are grandfathered under the old criteria. We think that we may very well be able to meet the new criteria as well and so it may give us the possibility of placing some facilities in service in 2009 that will qualify for a credit.

The second provision that could potentially have some impact on us is (inaudible) take some of the waste carbon material (inaudible).

Chip Moore - Canaccord Adams

Okay. And I guess lastly on the building materials, the goodwill writedown, maybe you could just go over the allocation there and kind of where you think the exposure was if any?

Steven Stewart

Could you repeat that question?

Chip Moore - Canaccord Adams

Just maybe if you could go over the goodwill writedown in the building materials segment, where that was allocated to.

Steven Stewart

We treat the building products group as a total and so when we do the impairment testing, we look at that as a total, but probably a third of it related to the Eldorado operations and two-third of it related to the Tapco operations, but clearly those operations are starting to blend together, so I mean really the right way to look at it is the whole 205 million related to building products group.

Chip Moore - Canaccord Adams

Okay. And you'd say fairly comfortable in terms of not expecting future writedowns?

Steven Stewart

Well, it's very much an estimation process and I guess we'll have to see what happens during '09 relative to the new housing and residential remodeling markets, those find a bottom, start to level out, then it would probably eliminate any future. They have significant declines to carry into '10 and we might have to go through this process again in a year, but we were pretty conservative in what we did, hopefully the goodwill impairments are behind us.

Chip Moore - Canaccord Adams

Great. Alright. Thanks.

Operator

Thank you. Our next question comes from the line of Michael Molnar with Goldman Sachs. Please go ahead.

Michael Molnar – Goldman Sachs

Good morning everyone. I don't have too many questions as you had a lot of content in the prepared remarks. Just a few things, regarding the balance sheet, just wanted to clarify, so no debt is rolling over until 2011.

And then the second thing would be, can you just give us the coverage ratios that you have to hit for those three main covenants that you mentioned? I know you're in compliance now, but what are the rates, the key ratios for those three covenants that you talked about?

Steven Stewart

You're correct. There's no debt that rolls over before 2011. As I mentioned though, our revolver, and we'll probably make borrowings on our revolver to meet our seasonal needs in the March quarter and that would have to be repaid because the revolver will mature in September of 2009. Relative to the covenants, the three covenants are total indebtedness to EBITDA that covenant requirement currently is at 4.35.

That covenant was amended in our amendment and it increases to 4.75 in the December and March quarter. It comes down to 4.25 in the June '09 quarter and then it comes down to 3.75 in the September '09 quarter. 3.75 was the covenant level in our original debt.

The senior indebtedness I believe is at 2.5 and we're significantly below that covenant and that actually increases to 2.75 going forward and then drop back down to 2.5 when we get out into the September '09 quarter and that actually decreases a little bit further as we get closer to the maturity.

The fixed charge coverage ratio is at 1 going forward and in making that calculation, the amendment that we went through in August provides for $90 million of our CapEx incurred in connection with our coal cleaning facilities to be excluded from CapEx in the fixed charge recovery ratio calculation.

Michael Molnar – Goldman Sachs

Got it. And I did not catch the whole thing was it, did you say the fixed charge coverage was what? I did not hear the whole--

Steven Stewart

One to one, so it's 1.0.

Michael Molnar – Goldman Sachs

One to one. Got it. Just last question is the coal that you process, how variable is your input cost? Do the agreements you have in place have stipulations where, let's say the price of Central Appalachian Coal goes down to $50 let's say, does your input cost, is it variable with that or is that more of a fixed cost?

Kirk Benson

Well, it varies because we're paying a percentage of our sales. So I guess the input cost absolutely varies with pricing because ultimately we end up paying a percentage of the sales price.

Michael Molnar – Goldman Sachs

Got it. Okay. Thank you very much.

Kirk Benson

You bet you.

Operator

Thank you. Our next question comes from the line of Ron Oster with Broadpoint Armtec. Please go ahead.

Ron Oster - Broadpoint Armtec

Good morning. Just a few questions on the coal business, actually the question you just answered, your costs vary with the sales price. Is there any color you can give with regards to gross margins assumptions if you were to assume the midpoint of your guidance for the energy and the clean coal business?

Kirk Benson

You know what, the guidance that we've given is down to the operating line, so we haven't tried to break out the SG&A or costs below the operating margins and so the guidance that we have given is that we expect operating margins to be in the 20 to 25% range.

Ron Oster - Broadpoint Armtec

So not much of an improvement from current levels as you ramp up operations?

Kirk Benson

Right, we basically have maintained the same guidance. One of the reasons for doing that is that there is a potential for improvement in these margins, but we're still fairly early in this ramp up process, so we'd like to be somewhat conservative as we ramp the facilities up because we're learning about the cost structure. And so far we're pretty comfortable in that 20 to 25% range, but we're not projecting any improvement in that range yet. We need some more experience before we can do that.

Ron Oster - Broadpoint Armtec

Okay. And you've mentioned a few times about the percentage of your coal sales that are contracted or spoken for. Are there fixed prices associated with that or are those floating prices within those contracted sales?

Kirk Benson

Well, ultimately the prices will be fixed. Now all of the pricing is not yet fixed for 2009 particularly in the met prices for the coal that is sold in the international market. Those prices haven't yet settled. When those do settle, then the pricing will be fixed for 2009, but most of the steam prices are fixed for 2009.

Ron Oster - Broadpoint Armtec

Can you quantify as of today what percentage is locked in or fixed?

Kirk Benson

Well, our projection is that 30 to 35% of our coal will be sold in the met market and so those prices haven't settled yet so that's the bulk of the coal where the pricing has not yet been set. Some of the steam pricing haven't been set either, but that's it. So probably the 35% is going to be the bulk of the coal where pricing hasn't yet been set.

Ron Oster - Broadpoint Armtec

Okay. And then lastly, you mentioned in your prepared comments opportunities to accelerate the coal ramp. Can you just provide a little more color on what some of those opportunities might be, might it be acquisitions or accelerating the schedule or exactly what that might entail?

Kirk Benson

I think that we're pretty comfortable that we're going to be able to go from the run rate of the 1.4 million tons and go to the 2.5 to 3.5 million tons over the next 12 months. And there is some upside to the total tons, so I think we'll end up being on the higher end of that range.

We may be able to accelerate some of that growth through the use of dredges and through better productivity in the dredge part of the operation. That's really where a lot of the risk is associated with the dredge operations and so that's where the upside lies.

And so part of what we're doing is applying some very concentrated, lean managerial techniques into this process and we go through literally hundreds of Kaizen (ph) events to improve the operations of these facilities and I think that there is an opportunity for improved productivity and utilization particularly in the dredge part of operations.

Ron Oster - Broadpoint Armtec

Okay. Great. Thanks. And then just a clarification, did you say cash flow from operations for '09 was expected to be 150 or 115?

Kirk Benson

One hundred and fifteen, 115.

Ron Oster - Broadpoint Armtec

Okay. Great. Thank you.

Kirk Benson

You're welcome.

Operator

Thank you. Our next question comes from the line of Pearce Hammond with Simmons & Company. Please go ahead.

Pearce Hammond – Simmons & Company

Good morning.

Kirk Benson

Hi Pearce.

Pearce Hammond – Simmons & Company

I know you haven't given Q1 EPS guidance per se, but just trying to get a sense of how Q1 is looking. I know Q2 is normally your weakest quarter. So one is, how is Q1 looking and secondly, how should we think about it? Is it sort of a break even type result?

Kirk Benson

I think the comment on how it is looking is October is typically a pretty good month for us. It's the last good month of the year and October this year was okay, so we did well in October and so we feel pretty good going into the December quarter.

So we are probably ahead of where we thought we would be in October. Now we're just closing the books, so I'm basing my comment on the sense of the revenue generated during the quarter. We haven't seen the operating results yet, but based upon our sales and the revenue that includes the fly ash sales, building products, the coal sales, we feel very good about our October which of course bodes well then for the December quarter.

November is a reasonably good month and then we get into the winter months in December. So I think that we should be close to break even, potentially profitable in the December quarter and then we probably will lose money in the March quarter. Steve, you want to add anything to that or--

Steven Stewart

No, I think that is accurate. I mean a lot of it will depend on the coal cleaning operations ramping up and how strong they come in in March, but our biggest expectations for that really is more of a June, September impact.

Pearce Hammond – Simmons & Company

Alright. Well, perfect. Thank you very much, Steve and Kirk.

Kirk Benson

Okay.

Operator

Thank you. Our next question comes from the line of Dan Mannes with Avondale Partners. Please o ahead.

Daniel J. Mannes – Avondale Partners, LLC

Good morning, everybody.

Kirk Benson

Good morning.

Steven Stewart

Hi Dan.

Daniel J. Mannes – Avondale Partners, LLC

A couple follow-up questions mostly on coal cleaning, first of all, in your guidance for next year, the 2.5 to 3.5, is that inclusive or exclusive of the tolling.

Kirk Benson

Exclusive.

Daniel J. Mannes – Avondale Partners, LLC

Okay. And then secondly on the pricing side, the range you're giving, 55 to 63, if you're already contracted on the vast majority of what you're doing and the only open piece is the metallurgical side and you mentioned earlier metallurgical, you still expect to be say 200 to 250. I guess can you give a little bit of color.

I would have thought the range would have been higher than that if you think that 30% of your coal's going to be sold at that kind of pricing and even admitting your only getting I assume a 50% share of that.

Kirk Benson

Right. I think that we've got a very good chance of being in the range and there probably is some movement towards the upper part of that range. But clearly if our sales settle at $200 per ton, then our revenue share, if we split that 50% with our coal company partner, would be $100 per ton, and that will make a pretty significant difference in the average cost per ton if you get your met sales in the 30 to 35% at a net price to us of $100 to $125 per ton.

So as that settles out, it could move the range up. I think that your perception is pretty accurate and there is the possibility that we'll be at the upper end of that range or potentially the range could even increase. But the other thing that you have to keep in mind is that we're producing some of this coal in the Illinois basin and the Illinois basin is a lower value coal product and so the Illinois basin production brings that range down so the met coal brings it up, but the Illinois basin coal brings it down and so that's why we decided to stay at the range that we had forecasted.

Daniel J. Mannes – Avondale Partners, LLC

Okay. Just switching gears real quick just on the whole alternative energy segment, I think in your fiscal third quarter you mentioned that you were break even just on the coal cleaning business and you're hopeful you'd be break even or positive op and comfortable on the whole segment. It looked like you were still a little bit negative this quarter. Was that because the ramp at coal cleaning was slow or was that cost and some of the other parts of that business?

Kirk Benson

Well, one of the things that we have going on is a foreign currency loss adjustment because of our facility that we have in joint venture with Evonik in South Korea is the debt of that facility which is non-recourse to Headwaters.

We don't have any obligation on that debt, but that debt is in euros and the functional currency for South Korea is the won and so the South Korean joint venture is required to do a foreign currency translation because of that euro debt. For fiscal 2008, we recorded about $6.6 dollars of foreign currency losses and note those losses are in that energy segment and for the quarter, it was about $1 million of loss.

And so that's part of what's going on in that segment and so we were somewhat negative and at least the portion of that was related to these foreign currency losses and then there were also some hedging losses in the ethanol facility. The coal cleaning operations are pretty much on track with what we thought it would be for the quarter.

Daniel J. Mannes – Avondale Partners, LLC

So is it fair to assume that on an operating income basis, are you up to the 20% already relative to the revenue you're producing or are you still a little bit below that during the ramp?

Kirk Benson

I think we're more than that because of the ramp and so at some of the more mature facilities, were hitting the 20, 25% type of operating income, but that's offset with the facilities that have lower production and so you end up with a lower overall operating income level until these facilities mature some more.

Daniel J. Mannes – Avondale Partners, LLC

Got you. And last question on the coal cleaning segment, how does your production match up with actual sales? Do you have periods when either you're inventorying or selling it through your contractual counterparty, but they're not selling in the quarter? Can you give us a little color sort of on how that flows?

Kirk Benson

Yes, it isn't mature by a long shot, we're just getting started in the ramp up of this business and so there have been some inventory fluctuations. In the 09/30 quarter, we built inventory, so inventory went up in the quarter and one of the things that we're trying to manage with our coal company partners is to maintain some control over that inventory growth.

We want our coal company partners to take the inventory. The coal company partners so far I don't think are sitting on very much of our inventory and so we don't have like an inventory build up at the coal company level. They're basically taking it as they ship it and that's caused these inventory fluctuations at our level and we built some extra inventory in the quarter that we hope to be able to sell in the 12/31, the 03/31 quarters.

Daniel J. Mannes – Avondale Partners, LLC

So you're saying you actually sold less than you produced this quarter?

Kirk Benson

I think that's correct.

Steven Stewart

Yes, slightly.

Kirk Benson

Yes.

Daniel J. Mannes – Avondale Partners, LLC

Okay. Great. That's very helpful. Thank you.

Kirk Benson

Okay.

Operator

Thank you. And we have time for one more question. Our last question comes from the line of John Bridges with J.P. Morgan. Please go ahead.

John Bridges – J.P. Morgan

Alright. Thanks. Thanks for the color. So we have a pretty good idea now of how to do the financials on the coal cleaning side. What about the toll treating component of that? How should we look at the cost and sort of base structure of that?

Kirk Benson

I think the easiest way to view that, John, is to view it as break even to slightly profitable. So it's by and large you're modeling would not be far off in just assuming a break even contribution from the tolling operations.

John Bridges – J.P. Morgan

Okay, okay, that's helpful. Thanks again for the color.

Kirk Benson

Okay, very good.

Steven Stewart

Thank you.

Operator

Thank you and at this time I'd like to turn the call back over to management for any closing remarks.

Sharon Madden

Thank you, operator. With that we will go ahead and close the call. We appreciate your participation. Thank you.

Operator

Ladies and gentlemen, this concludes the Headwaters Incorporated fourth quarter 2008 conference call. If you'd like to listen to a replay of today's conference, please dial (303) 590-3000 or (800) 405-2236 with an access code of 11121892 pound. Thank you for your participation and you may now disconnect.

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