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Executives

Tricia Ross - Vice President

Sharon A. Madden - Vice President of Investor Relations

Kirk A. Benson - Chairman and Chief Executive Officer

Donald P. Newman - Chief Financial Officer and Principal Accounting Officer

David S. Ulmer - President of Siding Division

William H. Gehrmann - Former President of Headwaters Resources Inc

Analysts

Chip Moore - Canaccord Genuity, Research Division

Daniel J. Mannes - Avondale Partners, LLC, Research Division

Seth B. Yeager - Jefferies & Company, Inc., Research Division

David A. Daglio - The Boston Company Asset Management, LLC

Jeffrey Bernstein

Headwaters Incorporated (HW) Q1 2013 Earnings Call January 29, 2013 11:00 AM ET

Operator

Good morning, ladies and gentlemen, and thank you for standing by. And welcome to the Headwaters Incorporated First Quarter 2013 Earnings Conference Call. [Operator Instructions] And as a reminder, this call is being recorded today, January 29, 2013. I would now like to turn the call over to Tricia Ross of Financial Profiles. Please go ahead, ma'am.

Tricia Ross

Good morning, everyone and thank you for joining us for the Headwaters Incorporated First Quarter Fiscal Year 2013 Conference Call. There are slides accompanying today's presentation that can be found on the webcast link at the Headwaters Incorporated website under the Events and Presentations link. Please go there to follow along with the slides. If you have any issues, please feel free to email me at tross@finprofiles.com, and I can also e-mail you a copy. I would now like to turn the call over to Sharon Madden, Vice President of Investor Relations at Headwaters Incorporated.

Sharon A. Madden

Thank you, Tricia. Good morning, everyone, and thank you for joining us as we report Headwaters' fiscal 2013 Q1 results. Kirk Benson, Headwaters' Chairman and Chief Executive Officer; and Don Newman, Headwaters' Chief Financial Officer will be conducting this morning's call along with Bill Gehrmann, who is President of Headwaters Resources and heavy construction materials segment; and Dave Ulmer, who is President of Tapco International.

Before we get started on this morning's call, I would like to remind everyone that Headwaters is sponsoring its 11th Annual Analyst & Investor Day Conference here in Salt Lake City on March 21 and 22 at the Grand America Hotel. Our guest speaker this year will be Ivy Zelman, the CEO of Zelman & Associates. Ivy is recognized as one of the preeminent figures within the housing and housing-related industries today. For more information on attending, please feel free to contact me through our corporate offices or by e-mailing me at smadden@headwaters.com. I will be happy to supply you with any additional information.

While listening to the call today, please remember that certain statements made during the call, including statements relating to our expected future business and financial performance may be considered forward-looking 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 very nature, address matters that are, to different degrees, uncertain. These uncertainties are described in more detail in Headwaters' annual and quarterly reports filed with the SEC. You can 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 Kirk Benson. Kirk?

Kirk A. Benson

Thank you, Sharon. Overall, we had a very good quarter. We were particularly pleased with the performance of our product groups that have exposure to new residential construction. Based on positive year-over-year comparisons on the top line and the acquisition of Kleer Lumber, we've raised our projected adjusted EBITDA guidance range to $110 million to $125 million. Revenue increased by 9% in the quarter, gross profit by 8% and operating income by 37%. The strength in the quarter was in light building products, where operating income increased over 300%, reflecting the improvements in new residential construction. Results in heavy construction materials were soft, primarily because of reduced services caused by unplanned outages and low electricity generation at certain of our utility plant sites. We also had a decrease in the number of tons shipped during the quarter because of weather-related conditions.

We were successful in acquiring the assets of Kleer Lumber, Inc. We look -- and we look at acquisitions from the following perspective: first, the opportunity for Headwaters from a business perspective, is it adjacent to what we are already doing? In the Kleer situation, there is a close adjacency in distribution, which means that we may be able to sell Kleer's products through our existing distribution, and we may be able to sell our existing products through Kleer's distribution. Cellular PVC trim board is a product sold into a niche market in which we may be able to achieve our leadership economic goals from an adjusted EBITDA perspective. Kleer has excellent manufacturing capabilities and product quality. We believe that the operational risks are relatively low. Second, will the transaction be accretive to our shareholders? Kleer met this criterion, and the transaction will be accretive to 2013 earnings per share. Third, is the transaction consistent with our strategy to reduce financial risk? Kleer also met this criteria, and we have reduced our financial risk. The follow-on offering was successful in increasing our equity base, reducing leverage, introducing Headwaters to new long-term shareholders and increasing liquidity. Our average daily shares traded has increased substantially since the transaction.

Shortly after the end of the quarter, we successfully concluded the sale of our remaining coal cleaning facilities, completing our exit from ownership of coal-related assets. To make the coal cleaning transaction successful, we needed 3 things: an entrepreneurial drive that could first identify feedstock sources; second, execute offtake agreements; and third, we needed capital. It took us time to put a qualified buyer together with the assets, but we ultimately succeeded in putting all 3 elements together in a deal. We feel very good about the transaction, both from the financial benefit to our balance sheet, but also because it eliminates the distraction associated with coal cleaning.

Turning to Slide 4, you can see a little more detail on the Kleer transaction. Kleer has one of the best trim board products in the marketplace and is introducing decking and railing. Over the past 4 years, the compounded growth rate has been nearly 20%. There was an even growth at the bottom of the building cycle. The market size for trim, decking and railing is in the $4 billion to $5 billion range.

Looking at Slide 5, you can see the leading building products brands that we bring to the market, literally wrapping the exterior of a new home or remodel project with high margin niche products. In fact, as you look at Slide 6, our niche product offering compares very favorably with other leading light building products companies.

So I'd now like to turn the call over to Don for a financial review of the quarter. The business segment presentation will be made by Bill and Dave.

Donald P. Newman

Thank you, Kirk. Good morning and thank you for joining us. Before discussing Slide 7, I wanted to mention that we intend to file our Form 10-Q later this week. My comments today will be directed to the slides that were sent out this morning and to a lesser extent, the condensed consolidated balance sheets and statements of operations that were attached to the press release.

Starting with Slide 7, our revenue from continuing operations in the quarter was $149.6 million, up $12.2 million or 9% from the prior year revenue of $137.4 million. Gross profit increased 8% to $37.2 million, and our operating income increased 37% to $6 million. Adjusted EBITDA from continuing operations for the quarter was $19.7 million, down slightly from the prior year's EBITDA of $20.4 million, due primarily to compensation expense, resulting from the $1.98 per share or 30% increase in the company's stock price in Q1. Excluding this compensation expense, adjusted EBITDA increased $1.5 million or 7% from 2012. In Q1, we saw the bottom line from continuing operations improve 70% year-over-year and believe we are on track to generate a profit in 2013, the first annual net profit since 2007. We ended the year with liquidity of more than $116 million, including $78.4 million of cash on the balance sheet.

Let's move on to Slide 8 and take a closer look at the quarter's financial results. Heavy construction materials revenue increased $5 million or 8% in -- from 2012 levels, due to higher sales in the central and east regions and to improved site services revenue. Light building products revenue increased $3.4 million or 5%, largely due to higher volumes and to increases in average sales prices. Energy technology's revenue was up $3.8 million year-over-year due to customer maintenance outages and timing of orders last year. The gross profit increase was driven by the higher revenue. Operating expenses increased $1.2 million year-over-year due to increases in SG&A, offset by decreases in amortization and restructuring costs. The $3.2 million increase in SG&A resulted from the compensation expense related to the company's 30% increase in stock price, resulting in a $2.1 million increase in year-over-year compensation expense. We also incurred approximately $1 million in professional fees associated with the Kleer acquisition. SG&A was otherwise flat year-over-year. Interest expense decreased $2 million as a result of debt repayments during 2012. Other expense of $4.1 million in 2012 largely reflects a noncash charge related to the sale of our interest in the Blue Flint Ethanol facility. And that was partially offset by a $2 million gain on early retirement of debt. Discontinued operations reflect the results for coal cleaning. We completed the sale of 2 coal cleaning plants in October and sold the remaining 8 coal cleaning plants in January. Proceeds from the sale of the 10 plants include approximately $3.8 million of cash paid at closing and approximately $10 million of additional cash to be paid by the end of calendar 2013, which includes the release of bond collateral and certain reimbursements. Additionally, the buyer agreed to pay Headwaters' potential royalties and deferred purchase price totaling up to $53.4 million over approximately an 8-year period. It's subject to the buyer's production of coal products. The buyer also assumed certain plant liabilities, including lease and reclamation obligations. Payment of royalties and deferred purchase price based upon production is currently scheduled to begin in the latter part of calendar 2013. We expect to report a book gain on the sale of the coal cleaning plants in the second quarter.

Now let's move on to Slide 9. Slide 9 shows the quarterly revenue and adjusted EBITDA breakdown for 2012 and the first quarter of 2013. You can see the Q1 2013 revenue exceeding 2012, and the 2013 adjusted EBITDA slightly below the 2012 levels due to the compensation expense resulting from the increase in the stock price during Q1.

Let's move on to Slide 10 and spend a few minutes discussing debt. Our debt position has continued to improve over the past 6 quarters as we've increased our trailing 12 months adjusted EBITDA and reduced our net debt levels. We closed the current quarter with a net debt to adjusted EBITDA ratio of 4.7:1 after reaching a high point of 6.7:1 in the June 2011 quarter. Over the trailing 12 months, we've reduced our leverage ratio a full turn as a result of improving our adjusted EBITDA by $5.3 million and reducing our net debt by more than $58 million.

Starting on Slide 11, Dave will discuss light building products.

David S. Ulmer

Thanks, Don and good morning, everybody. On Slide 11, you can see revenues from our light building products segment for the quarter grew $3.4 million to $76.7 million, an increase of 5% compared to fiscal year 2011. According to the Census Bureau, non-seasonally adjusted single-family housing starts for the 3 months ended December 31, 2012 were 29% higher than housing starts for the 3 months ended December 31, 2011. Economists are optimistic for growth in 2013 for both new housing starts and remodeling. We are confident that we have sufficient manufacturing capacity to meet the resulting demand. Since most of our products are applied towards the end of the construction project, our revenue usually lags 4 to 6 months behind the starts. Of course, we are in the middle of the winter season, further delaying construction and the application of our products. Our architectural stone product group had the largest growth in sales because of its exposure to the new residential construction. We've previously announced that our architectural stone group brought its 3 stone brands under 1 operating structure to provide pricing and channel clarity to the market. This new structure broadened customer revenue opportunities across all price points, and we expect it to be helpful going forward in attracting new customers and increasing market share. The block product group also had positive year-over-year comps, reversing the trend for the last 3 quarters of fiscal year 2012. Our block business mainly serves the Texas and Louisiana markets. You may recall, 2012 results were hurt by slower school construction, while retail and residential markets were strong. We look forward to growing revenue in 2013 due to the addition of new products such as polished and textured custom block, as well as additional sales to Lowe's and a strengthened position in Louisiana due to previously announced acquisition of a block plant in Baton Rouge.

Our siding group continued to see strength in its specialty siding product line in the first quarter. Our newly reorganized manufacturing and engineering team continues to focus on process improvements and cost reductions, as well as ways to optimize our manufacturing processes. As Kirk touched on earlier, we completed the acquisition of Kleer Lumber at the end of the first quarter. We are excited to add these high-quality and eco-friendly products to our existing distribution system. Kleer is an excellent add-on acquisition that provides the opportunity to pursue leadership economics in an adjacent niche end market. Gross profit margins improved 180 basis points in the first quarter versus fiscal year 2012's first quarter, leading to operating income growth of over 300%. Adjusted EBITDA increased to $11.9 million for the first quarter of fiscal year 2013, a 5% improvement over last year's first quarter.

Slide 12 illustrates what we have already discussed. Revenue and adjusted EBITDA both grew over last year in the first quarter. This was the fifth straight quarter of growth year-over-year in both revenue and adjusted EBITDA.

Now I'll turn the presentation over to Bill.

William H. Gehrmann

Thanks, Dave, and good morning, everyone. On Slides 13 and 14, you can see that revenue for the December 2012 quarter in our heavy construction materials business was $68.2 million compared to $63.1 million for the December 2011 quarter, resulting in an 8% year-over-year increase. Headwaters' client services provide site services to many of our utility clients. Site service revenue was up year-over-year for the December quarter and accounted for approximately 33% of our overall revenue for the quarter, compared to 28% for the fiscal 2012 year. 3 projects started at new power plants over the last year led to the revenue increase, helping to offset lower electric generation at several plants due to lower regional load demand. This lower generation resulted in margin pressure as fixed cost increased as a percentage of revenue. Since these services typically have lower operating margins than our product sales, the larger mix of services in the December and March quarters contribute to a lower overall EBITDA margin for the segment. Gross profit for the December 2012 quarter decreased by 9% to $14.6 million, compared to $16 million for the December 2011 quarter. Adjusted EBITDA for the December 2012 quarter decreased 19% to $10.8 million, compared to $13.3 million for the December 2011 quarter. The year-over-year declines in gross profit and EBITDA were the result of lower electric generation experienced in our site service business, the geographic product mix of fly ash sales and a large amount of nonrecurring high margin revenue that was recorded in 2012. We also saw a return to the normal seasonality of our product sales revenue as we experience rain in the South and on the West Coast, along with a more normal weather pattern in the Midwest. We indicated in the September quarter that our prices were up compared to the prior year. This trend continued in the December quarter. In the current quarter, our prices are up compared to last year in the 10%-plus range, but because of the weather-related issues and the completion of major projects in the West, our tons for the December quarter declined. Combined with the nonroutine revenue that was booked last year and did not carryover into the December quarter this year, our revenue on a netted basis was relatively flat. Cement pricing seems to be trending up 4% to 6%. It continues to be our strategy to match the increase in cement prices. Included in this strategy is a goal to get an additional increase to offset the increases in transportation costs that we are seeing in most markets. We will be looking forward to similar opportunities to do it again this year as we get into the March and June quarter, where most price increases are implemented. This month the Portland Cement Association raised its forecast for 2012 cement consumption growth to 8.1%, citing an increase in residential construction as the major driver. It also indicated that the year-over-year comparison for the March quarter may not be positive due to the mild winter conditions in 2012 coupled with a return to a more normal weather pattern in 2013.

I'll now turn the call back to Kirk.

Kirk A. Benson

Thank you, Bill. Slide 15 reports the results of our energy segment. Our energy technology segment consists of our heavy oil upgrading technology, HCAT, and its 2 related technologies. Revenue increased year-over-year to $4.7 million, reflecting a more normal purchasing pattern from our customers. However, since Neste Oil is our major customer, when it does a turnaround, you can expect that it will result in reduced revenue during the turnaround period. Last year's turnaround, however, was longer than what was expected.

Slide 16 shows the quarterly changes in revenue and EBITDA. We anticipate that the energy segment will be flat to positive EBITDA for the year compared to a loss last year.

Turning to Slide 17, as we noted, we are benefiting from increased new residential construction. The March quarter will be a difficult comparison because of the mild weather in 2012, but our light building products operating income was up 300% in the December quarter, and our product groups with exposure to new residential construction continue to perform well in January. Subject to the contingencies noted on Slide 17, we feel comfortable raising our adjusted EBITDA guidance for the year to $110 million to $125 million.

So with that, I'd now like to turn the time back to the operator for the question-and-answer session.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question does come from the line of John Quealy with Canaccord Genuity.

Chip Moore - Canaccord Genuity, Research Division

It's Chip Moore for John. It looks like you're assuming flat remodel markets in your guidance, but we've seen some studies out there talking about double-digit accelerated growth. Are you seeing anything different in your channel or is that just a little bit of cautiousness?

Kirk A. Benson

I think that we've seen the same guidance in the - I think the [indiscernible] is up, like a 17% growth in 2013. And we have not yet seen that in our products that have exposure to repair and remodel. So we continue to be cautious about the repair and remodel because we've not yet seen that growth come through in our specific products that have exposure to the repair and remodel market.

Chip Moore - Canaccord Genuity, Research Division

Okay, that's helpful. And in terms of price increases, is that across SKUs and geographies? When do you expect those to take effect and be covered?

Kirk A. Benson

Are you referring to light building products or heavy construction materials?

Chip Moore - Canaccord Genuity, Research Division

I guess, both.

Kirk A. Benson

So right now, in the light building products, we've been able to implement price increases in the Texas market with our block products. Those price increases have stuck and there is -- as we sell those products directly in the Texas market, there's usually a 3 or 4 month lag between the point in time when you quote a product at an increased price and when the revenue hits. And so there is a little bit of lag, but we are quoting prices now with those price increases in place. And so we'll start to see the impact of those price increases, some of that probably in the -- at least in the June quarter for sure, maybe a little bit in the March quarter. But those price increases look like they're going to stick in the marketplace. As Bill discussed in his script, on the fly ash side of the business, we generally are able to get price increases in the March quarter towards the very end of the March quarter and into the beginning of the June quarter. And so I think with what is happening with Portland cement, we should be able to get some price increases that would then have an impact in the -- like in the September quarter.

Chip Moore - Canaccord Genuity, Research Division

Okay. And just a little bit of housekeeping. The income tax at 12% for the year, is that a one-year phenomenon and then that gets normalized in the out years or how should we be looking at that.

Donald P. Newman

This is Don. A phenomenon in that it is such a low and relative number percentage?

Chip Moore - Canaccord Genuity, Research Division

Correct.

Donald P. Newman

Yes. And the reason for that is, we do have a substantial amount of federal NOLs that are fully reserved. And so as we become profitable we'll be able to take some of those NOLs and shelter our federal tax expense. And so that's why it looks much lower than you would typically see. It would be expected that over time as the company continues to generate profits, and we release those NOL reserves and consume those NOLs, then we would return to a more normalized tax rate in the future.

Chip Moore - Canaccord Genuity, Research Division

Okay. Yes. That makes sense. Go ahead.

Donald P. Newman

I was going to say -- but that normalization, that's going to be several years away. We've got nearly $200 million of NOLs that are on the books that are fully reserved, and then we have an additional more than $20 million of tax credits that will also be available to shelter us from federal -- the bulk of the federal tax.

Chip Moore - Canaccord Genuity, Research Division

Okay. So it should continue a bit more like that 12% rate until you burn through those?

Donald P. Newman

Yes, something like that. Yes.

Chip Moore - Canaccord Genuity, Research Division

And then lastly on the stock comp expense. Can you give just a sense of -- around the $10 share price right now, where that comes out to for '13?

Donald P. Newman

When we ended last year with a stock price of $6.58 and the guidance that we've given is, for every $1 of stock price increase, you would expect a full year expense of about $1 -- or excuse me, $1.5 million. So for every $1 of stock change, $1.5 million of expense change is effectively it. It was a little bit lighter in the first half of the year than that $1.5 million per $1, largely because we have a portion of those awards that are also tied to financial performance in the business. And because -- better than -- about 3/4 of our financial performance is generated in the second half of the year. The majority of that part of the expense is recognized in the second half of the year, but the long and the short is, about $1.5 million of expense for every $1 of movement.

Operator

And our next question does come from the line of Dan Mannes with Avondale Partners.

Daniel J. Mannes - Avondale Partners, LLC, Research Division

I wanted to focus a little bit on heavy construction materials. First, Bill, I want to make sure I heard your comments correct, did you mention you got ballpark at 10% realized price increase this quarter and is that broad-based or is that more sort of regional and specific to certain customers?

William H. Gehrmann

Now yes. The 10% number is correct. That's in the ballpark, and we take that -- we've averaged that or based that across board. That's not a regional number.

Daniel J. Mannes - Avondale Partners, LLC, Research Division

Okay. So if you can help me square that because it sounds like from your press release it looked like your ash sale revenue was roughly flat year-over-year. So if you got 10% average pricing, does that imply volumes were actually down 10%?

William H. Gehrmann

No. You've got to remember, Dan, that we've got a revenue share structure in all of our agreements, where we share anywhere from 30% to 60% of the revenue with our utility clients.

Kirk A. Benson

But Dan, you're absolutely correct. Volumes in the 12/31 quarter were down, so you're absolutely right. And then you do have to take into account what Bill just said, which is, that if you've got like a 10% price increase and you've got -- and the way that our supply agreements are structured, we're sharing those price increases with utilities, and so you basically have a -- say you're at a 50% revenue share, and you got a 10% price increase, half of that price increase ends up going to utilities. And that has an impact, of course, on the margins, and that's reflected in the cost of goods sold in the business. But to specifically answer the question that you asked, that you're absolutely correct, and that's what -- I had indicated that in my comments and Bill also indicated that in his script and that is that the tonnage in the 12/31 quarter was down compared to 2011, and we think that the tonnage was down primarily because of a reversion to more normal weather patterns. That's one of the primary factors that's going on. A second factor is that we had some large projects in the Western region. For example, in Utah, there was a very significant construction in the -- on I-15, right? That's our freeway here. And that construction project ended as well as a few other construction projects, and so you had lower volume because of the end of some of those projects. So you're absolutely correct. The volume in the 12/31 quarter was down.

Daniel J. Mannes - Avondale Partners, LLC, Research Division

So 2 quick clarifications, the revenue share you mentioned, that doesn't reduce the top line, that will go through COGS, correct?

Kirk A. Benson

That's right. And that's why -- and so you're right. And so if you look just at revenue, the biggest impact there was -- one was price increase, but the other one was the decline in volume. And then there was one other thing going on when you compare the 12/31/2012 quarter with the 2011 quarter, and that is that we had some nonrecurring 100% project margin revenue in the 2012 (sic) [2011] quarter, and we didn't have any of that in that 2012 quarter. It's approximately $2 million. And so that's also -- that impacts the revenue line, as well as the margin line because it was -- that $2 million was a 100% margin revenue.

Daniel J. Mannes - Avondale Partners, LLC, Research Division

Got it. And then one last clarification on the service side of the business. Obviously, it sounds like you picked up a bunch of new clients and you were doing more work in aggregate. But just so I understand, when some of your customers go down, are the revenues volume-based, i.e., you're being paid sort of per ton of ash, I guess, your servicing or processing or disposing for a fee? Is that why the margins got hit or if you could help us out a little bit there with maybe why you saw some of the margin declines because of plant downtime and reduced usage during the quarter. That would be helpful.

Kirk A. Benson

I'll let Bill add some specific details to the answer, but in the services part of the business, the financial model there is relatively high fixed cost and a very high contribution margin. So when you have -- if the utility produces less electricity, and therefore, less ash that needs to be disposed of. Your question is whether or not our revenue is variable based upon production, and the answer is yes. And Bill will add more detail to that but -- and so generally, if your revenue declines because of the high contribution margin, it has -- your fixed cost become a larger percentage of revenue, and it has a negative impact on your operating income and EBITDA margin. That's what we experienced in the 12/31 quarter. Bill, why don't you add a little bit to how we generate revenue and what we are paid to do, and how that's impacted by the level of activity at a utility site.

William H. Gehrmann

Yes, typically Dan, in those types of contracts, the bulk of the revenue is generated by the ton handled in land filled. There is additional work done around the landfill, but that also will be based on volume. As you move more material, you have more of that additional work to do. So yes, there's a direct correlation between revenue and tons generated.

Operator

And our next question does come from the line of Seth Yeager with Jefferies & Company.

Seth B. Yeager - Jefferies & Company, Inc., Research Division

Is it possible to provide the EBITDA that was purchased with Kleer? I didn't see that in your prior filings. And how much of the updated guidance includes Kleer and any expected purchasing or distribution synergies with that acquisition?

Kirk A. Benson

Yes. I think there's little bit of math we can get there. The EBITDA margin was in the 12% to 13% range on about $38 million of revenue. And so you're in the range of very close to -- this is pre-synergies by the way. On a pre-synergy basis, you're in the range right around $5 million of adjusted EBITDA. And post-synergies, we think we can get that margin up to 16% to 17% range. And so those are -- we went from a 12% to 13% pre-synergy to like about a 16% or so post-synergy.

Seth B. Yeager - Jefferies & Company, Inc., Research Division

Okay. And that's deemed to be about in line with Trex, and I think those guys typically get 15% to 20%, right? So with the guidance going forward, what's the timing from your stand point as far as how quickly those synergies roll through in the acquisition?

Kirk A. Benson

The way we typically model it into our forecast and our work is we assume 50% in the first year and 50% in the second year.

Seth B. Yeager - Jefferies & Company, Inc., Research Division

Okay. All right. That's helpful. On the building product side, I didn't -- maybe I missed it, but can you talk about the price increases on siding during the quarter and how did that market fared?

Kirk A. Benson

Dave, do you follow -- did you want to respond to that question? I responded mostly on the block business relative to price increases. I'm not sure we're seeing a lot of price increase activity currently on the siding side of the business, but why don't you clarify that, Dave?

David S. Ulmer

Okay. We're not seeing increases in the market currently, and we don't have any price increases on siding that are planned. We're, as always, watching the raw material market, and if need be, we'll adjust. But there is nothing that we're seeing from competition, and we have no current plans other than to obviously react if the market calls for it.

Seth B. Yeager - Jefferies & Company, Inc., Research Division

Okay, that's helpful. And just on the raw material side then, I assume most of that's under control at this point?

Kirk A. Benson

Yes. It is. The one thing though that we are anticipating is that we're going to have -- there's going to be some price pressure on increases in polypropylene prices. Now so far this year, those prices have been lower than prior year, and so we've actually had a little bit of a tailwind relative to the polypropylene prices. But what we are anticipating is those prices are going to go up, and that's where we're going to have to monitor the situation very closely relative to a price increase related to those increases in polypropylene raw material cost. And we'll be monitoring the market relative to how people react to changes in the raw material cost over the next quarter or so. That's something that we got to stay very attuned to because those prices can change quite rapidly, and we are anticipating an increase in polypropylene prices over the next quarter or so.

Seth B. Yeager - Jefferies & Company, Inc., Research Division

Okay. All right. That's helpful. And just last question, based on the updated guidance, I would imagine you guys should be generating some pretty decent free cash flow for the year. How do you guys think about proceeds in allocating capital. Any anticipation of repurchasing bonds, tuck-in acquisitions? I guess just generically, what's the focus going forward? And do you all have a leverage target maybe that your looking to work around?

Kirk A. Benson

So we are -- our first priority is our balance sheet and so our use of cash is to -- first and foremost is to ensure that we reduce our gross leverage. And so we got about $55 million of subordinated debt that is due in February of 2014, and that's our #1 priority. And we -- based upon our current cash position and the cash flow that we will generate between now and then, we feel very comfortable that we're going to be able to repay that debt when it comes due. Then we have about $49 million of debt due in 2016, and that becomes the next priority, is to ensure that we will retire that debt as it comes due. Now in the meantime, we might go into the marketplace. We do have the ability to take out some of the 2014 debt. Our senior debt covenants do not allow us to prepay any of the 2016 debt. And so, we will be in that debt until 2016. We do have an ability to take out some of our senior debt and depending upon our free cash flow and the generation of cash, we may be in a position to take out some of that senior debt. The response to your last question, we would like to be in the debt-to-EBITDA ratio between 2.5 and 3x, taking into account the cyclicality of the business. And so we feel pretty comfortable that we're going to get there, and we're going to be at that ratio, and we continue to move in that direction and focus on the balance sheet. So as far as acquisitions are concerned, we will look at opportunities where the adjacency to what we are doing makes sense as long as our balance sheet is front and center in the decision-making and that we don't do anything that disrupts our direction of de-risking and de-leveraging the business.

Operator

And our next question does comes from David Daglio with The Boston Company.

David A. Daglio - The Boston Company Asset Management, LLC

A couple of questions, on the sale of the coal assets, you mentioned potential reoccurring EBITDA for about 8 years, will you capitalize that in the sale or will you just accrue that as they come?

Kirk A. Benson

I think what we're probably going to do is we'll accrue it as we get those payments. That's the more conservative way of recognizing the gain. In effect what that does is it defers the gain until you actually receive the cash. And so I think that's the accounting treatment that we're going to pursue.

David A. Daglio - The Boston Company Asset Management, LLC

Maybe a follow-up to that, do you expect -- what are the odds you would put on receiving either all or some of that $54 million?

Kirk A. Benson

I don't want to set an expectation higher than reality, but there is a fair amount of capital that's being invested in these facilities. And so I think that we've got a fairly good likelihood of receiving a part or a significant part of those future royalty repayments. And the reason I say that is because there is a fairly significant amount of capital that's being invested. I know that the buyer has -- as I indicated in my script, we needed 3 things to make this work. We needed someone that can find feedstock, arrange offtake agreements, and then we needed to have capital. We were able to put together all 3 of those conditions. So the new feedstock arrangements are quite positive, and the capital was used to put the equipment in touch with those new sources of feedstock. And so as people spend money to put the facilities in the location where the feedstock is situated and offtake agreements are in place, then we're going to get some production, which means that we're going to get paid royalties. And so I think the likelihood is on the higher side that we're going to get paid part or a significant portion of those royalty payments.

David A. Daglio - The Boston Company Asset Management, LLC

My last question is on fly ash pricing. And I'm curious, as these coal plants shut down in these regional markets, are you seeing any bump in fly ash pricing as -- presumably, there's less supply of that material and maybe that would have a difference or are you just price taking from the Portland cement and it doesn't matter at all?

Kirk A. Benson

No, I think it does matter, and we are -- the pricing with Portland cement is a very important consideration and something that clearly has an impact on our pricing capabilities is what the Portland cement folks do. In addition to that, when you get a facility that might shut down and we transport ash into that market, you can also have a -- we would attempt to get a price increase related to the increase in transportation cost if we had to move ash a greater distance or from a different source then that also has an impact on pricing. So there's really both things that are going on. The changing in Portland cement pricing is very, very important, but you also have a change in the source and transportation of the ash and that can have an impact on pricing as well.

Operator

And we have time for one final question and it does come from the line of Jeff Bernstein with AH Lisanti Capital Growth.

Jeffrey Bernstein

I just wanted to revisit on the heavy construction material side again. I guess the lower operating rates at utilities sounded like it was a seasonal and economic-related issue. Do you sort of change where you're sourcing fly ash as a result of that? Is that just a temporary issue? Can you just go through that a little bit?

Kirk A. Benson

I think one of the things that we ought to clarify for sure, and that is some of our comments were directed to the services part of the business. And so if you have a utility that produces less electricity, that means that they're producing less ash that we dispose off for them, and so our revenue declines because of the reduced disposal revenue. And that had an impact on us because the fixed cost nature of that business, and that did negatively impact our margins in the quarter. From a perspective of the marketing the ash, that had less of an impact on us. In certain circumstances, it can have a short-term impact. As an example, we had a short term shutdown of a facility called Sammus in Ohio, and that facility was a source of high-quality ash and what happened when that facility temporarily shut down is that we had to transport ash from other sources. And so it didn't have -- the shutdown of the facility didn't necessarily have an impact in the total tons that we sell. It did have an impact on our transportation cost as we had to reroute ash to supply that Sammus market. Now what's going to happen, it's coming back online and so that turned out to be a temporary disruption in our supply sources. And so generally, from a marketing of ash, what we've seen relative to changes in electricity production and power demand from an ash sales perspective, those have only been temporary changes. Bill, do you want add any color to that response?

William H. Gehrmann

I think you basically hit the nail on the head, but yes, the site services is impacted by the fixed cost, and there is a difference between that and the supply. But we've invested quite a lot in our logistics infrastructure so when we see some of these short term or temporary shutdowns at coal-fired units on the supply side, we've typically been able to quickly react and continue to supply a market from another source.

Jeffrey Bernstein

Okay. So I guess Peabody this morning was talking about the US Coal fleet running at only 55% utilization, but they're expecting that to be improving, so we should expect that you'll get some leverage on costs. You'll get some -- you'll avoid some frictional type cost that happen in a lower utilization environment if they are in fact correct going forward?

Kirk A. Benson

I think that's generally true. We do this -- there's a lot of change going on right now as you can imagine. And that's what Peabody was kind of speaking to. And so as we get back to more normal production levels, we should see a reduction in the variability, which should ultimately improve our performance.

Operator

And at this time, I would like to turn the call back over to management for any closing comments.

Sharon A. Madden

If there are no further questions, I think we'll go ahead and end the call. We'd like to thank you all, for your participation.

Operator

Thank you very much. Ladies and gentlemen, that will conclude the conference for today. If you would like to listen to a replay of this conference, you may do so by dialing either (303) 590-3030 or 1 (800) 406-7325. You will need to enter the access code of 4592382. Again, we do thank you for your participation on today's call. You may now disconnect your lines at this time.

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