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Headwaters, Inc. (NYSE:HW)

F1Q09 (Qtr End 12/31/08) Earnings Call

February 03, 2009 11:00 AM ET

Executives

Tricia Ross - Financial Relations Board

Sharon Madden - Vice President, Investor Relations

Steven G. Stewart - Chief Financial Officer

Kirk A. Benson - Chief Executive Officer and Chairman

Analysts

Al Kaschalk - Wedbush Morgan Securities

John Bridges - J.P. Morgan

Ron Oster - Broadpoint Armtec

Mark Segal - Canaccord Adams

Daniel J. Mannes - Avondale Partners, LLC

Operator

Good morning ladies and gentlemen. Thank you so much for standing by. And welcome to the Headwaters Inc First Quarter 2009 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). As a reminder, the conference is being recorded today on Tuesday the 3 of February 2009.

I will now turn the conference over to Ms. Tricia Ross of the Financial Relations Board. Please go ahead.

Tricia Ross

Welcome to Headwaters Incorporated fiscal first quarter 2009 conference call. If you have not yet received a copy of today's press release please contact my office at 213-486-6540 and we will get one 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, please go ahead.

Sharon Madden

Thank you, Tricia. Good morning everyone and thank you for joining us today for Headwaters Q1 fiscal '09 conference call. The call today will be conducted by Kirk Benson, Headwaters Chairman and Chief Executive Officer and Steve 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 related to our expected future business and financial performance may be considered forward-looking statements within the meaning of Section 27A and Section 21E of the Securities Exchange Act. 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 Report and quarterly reports filed with the Securities and Exchange Commission 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. You could also reach those documents on Headwaters website or directly from the company.

I would now like to turn the call over to Mr. Steve Stewart, Chief Financial Officer of Headwaters. Steve?

Steven G. Stewart

Thank you Sharon and good morning everyone. Welcome to our 2009 first quarter conference call. Attached to the press release that Tricia mentioned with condensed consolidate financial statements that includes statements of operations for the quarters ended December 31st, 2008 and 2007. There are also balance sheets as of December 31, 2008 and September 30, 2008. My comments are derived primarily from those condensed consolidated statements and schedules included therein. We intend to file our Form 10-Q after December quarter this week.

Our first fiscal 2009 quarter continue to be significantly impacted by the weakness in the new housing and residential remodeling markets and during this quarter was also significantly impacted by the rapid decline in the demand and price for coal, particularly metallurgical grey coal.

As you all know and have experienced, capital alternatives are virtually not existed in today's environment, with little or no changes in the capital markets in the last 120 days, we have hoped -- focused a lot of our efforts on opportunities for operational improvements and cost reductions in all of our business units. These improvements in cost reductions will mitigate the continued effects of this recession which many believe will continue well into 2009 or beyond.

There was no revenue from Section 45K operations in our December 2008 quarter and approximately 54.4 million in the December 2007 quarter. These operations are now completely finished and we expect no operational contribution from these operations in the future.

Headwater was successful in placing 11 qualified coal cleaning facilities in service by December 31, 2008. Headwaters initiated this coal cleaning business a few years ago and we continue to be hopeful that as we complete the ramp up of these operations and as they mature there will be a significant replacement for the expired Section 45K operations.

The last 150 days have presented significant challenges for these operations. As coal prices have declined with a significant reduction in demand and usage in the metallurgical grade coal markets. With all coal cleaning facilities operational, we will continue to work our ramp up issues, but we will also focus a large amount of our efforts on identifying alternative coal markets while reducing operating in SG&A expenses.

Recent activities in this area have initially identified almost $20 million of annualized costs that we hope to be able to eliminate from current operating costs levels. We have also identified significant costs reduction initiatives in our other business segments and in corporate overhead. These cost saving initiatives have consisted of head count reductions, elimination of the 401(k) company match, changing of our employees medical insurance administrator with a corresponding reduction in medical expenses; improved reporting and monitoring report related accidents with a corresponding reduction in our workers compensation expense. The elimination of non-critical outside services, reduction in non-essential travel, 2009 salary freeze on salaried management personnel, planned consolidations, reduced number of manufacturing shifts and a line-by-line review of operating expenses, with the goal of reducing Headwaters consolidated SG&A and operating expenses by over $25 million or 17% when compared to 2008.

We are also looking very closely at capital expenditures with a goal of reducing fiscal 2009 capital expenditures to 60 to $65 million compared to capital expenditures in fiscal 2008 of $116 million.

Headwaters continues to have adequate liquidity and cash flow from operations through the December 2008 quarter, and we have no borrowings on a revolving credit facility as of today.

As we have said in the past, our operations are very seasonal and we expect I apologize for my voice this morning -- and we expect to utilize our revolving credit facility during the winter and spring months. These seasonal borrowings have historically been paid-off by June or July. Headwaters is in compliance with all of our debt covenants at December 31, 2008. We monitor our debt covenants on a regular basis and believe we have several potential actions that could be initiated, if the headroom on our debt covenants were to decline to an uncomfortable level.

If you remove section 45K operations, revenues declined by $28 million or 15% in the December 2008 quarter when compared to 2007. The gross profit margin decreased from 26% in the December '07 quarter to 19% in the 2008 quarter. The decline in the gross profit margin is a result of the negative gross margin on the coal cleaning operations in the December quarter, lower gross margins in our building product segment which resulted from lower sales and the impact of fixed cost having being spread over smaller revenue base and changes in product sales mix within our building products group.

The gross profit margin in our CCP business fly ash business, increased from 28% in the December 2007 quarter to 30% in the 2008 quarter. Our coal combustion products business continues to perform well but could be impacted by reduced spending at the State and Federal levels. We believe that 2009 could result in operations for this business at levels comparable to 2008.

During 2008, Headwaters recorded a goodwill impairment of $205 million relating entirely to the building product segment. We are required to test for a goodwill impairment at least annually or sooner if evidence of a possible impairment arises. Due to the continuing decline in the new housing and residential remodeling markets and the continuing downward projections by market analysts of near term expectations, management believes that a further impairment in the fair value of the building product segment may have occurred.

Accordingly, we have commenced a goodwill impairment test that is expected to be completed in the March 31, 2009 quarter. This process is in the early stages and is not currently possible to reasonably estimate the range of a potential goodwill impairment charge if any.

Consolidated operating expenses were 25% of revenue in the December 2008 quarter compared to 23% in the 2007 quarter, but were $4 million lower in the December quarter when compared to 2007. I believe this reduction is reflecting some of the cost reduction initiatives previously discussed. I also believe that the performance of our business segments is a very accomplishment in light of the extremely difficult economy we're experiencing.

Significant decline in coal prices and a continue decline that we see in new housing and residential remodeling. Finally, I believe this reflects the strong market position of our building products and other brands and Headwaters strengthened ability to adapt and change in these difficult times.

Headwaters total indebtness at December 31, 2008 was $514.9 million which represents a decrease of $17.6 million when compared to September 30, 2008. This decrease is a result of the convertible debt exchange we completed in December, which I will discuss in more detail in a minute.

Headwaters generated approximately $41.6 million of cash flow from operating activities during the December 2008 quarter compared to approximately 34.6 million for the 2007 quarter. Our revolving credit facility provides for total borrowings of $60 million and we currently are utilizing that revolver to support approximately $10 million of letters of credit which makes 50 million available to be drawn on the revolver.

At December 31st, Headwaters had approximately 45 million of cash and cash equivalents on hand, thus providing us with over 90 million of total liquidity. The revolving credit facility expires in September 2009. We currently believe that our operations will continue to produce good cash flow and will be sufficient for our operating needs. We also believe that Headwaters have some alternatives including leasing and sale of assets which could be used to supplement cash flow from operations.

Net interest expense increased approximately 2.9 million in the December quarter compared to 2007. This increase is a direct result of the convertible debt exchange that caused approximately 1 million of accelerated amortization of unamortized debt issuance costs, an increase to coupon rate on the new convertible debt along with the increased interest rates on our senior secured debt that resulted from our August 2008 amendment.

At today's interest rates, total interest expense in 2009 could be as high as 35 million, including approximately $4 million of non-cash amortization of debt issuance costs. Depreciation and amortization was approximately 19.5 million in the December '08 quarter compared to 17 million a year ago. We expect depreciation and amortization for fiscal 2009 could be as high as $90 million.

In December, Headwaters executed an exchange of $80.9 million of our two and 7-8% convertible debt that matures in 2016 but has a put provision in June of 2011. These were exchanged for 63.3 million, up 16% convertible debt that matures in 2016 but we extended the put provision one year out to June of 2012.

This exchange will cause an annualized increase in interest expense of approximately 7.8 million. The exchange resulted in a reduction of the outstanding convertible debt of 17.6 million with a corresponding gain on extinguishment of debt of 17.4 million. This gain is included in Headwaters EBITDA calculation for debt covenant purposes. It also changed 80.9 million of principal that could have been payable in June of '11 based on the current put provision we have to now being only 63.3 million that is payable no sooner than June of 2012.

The new convertible debt also has a net share settlement provision, which provides for payment in cash rather than the issuance of stock for any appreciation in Headwater stock price over the convertible debt conversion price. This provision affects the calculation of diluted earnings per share.

The weighted average shares outstanding used in our earnings per share calculation is approximately 41.4 million shares at December 31, 2008. This is net of approximately 475,000 shares of treasury stock we hold and about 375,000 shares of unvested restricted stock.

At today's stock price, substantially all of Headwater's options and SARs are out of the money and are therefore excluded in the diluted earnings per share outstanding calculations. As we've discussed in the past, Headwaters had 172.5 million of convertible debt that was issued in 2004, 91.6 million remains outstanding after the convertible debt exchange. This debt is treated as if converted in the earnings per share calculation and adds approximately 3.1 million shares to the diluted weighted average shares outstanding calculation. However, these shares were not included in the December 31, 2008 earnings per share calculation, as the affect of treating this debt as if converted was anti-dilutive.

We believe that our business units are performing very well in a very difficult market. It is difficult to quantify when the ramp up issues and related high operating costs in our coal cleaning operations will be worked out. But we continue to be optimistic about the potential of this new business. It is not possible to predict where coal prices will be over the next 12 months or when the new housing and remodeling markets will improve and the building product segment will experience a rebound.

The timing of the turnaround of these two significant events is impossible to project today. Accordingly, we are reducing our guidance for fiscal 2009 for diluted earnings per share to $0.35 to $0.70.

We will continue to look for opportunities to reduce our operating expenses, accelerate ramp up of the coal cleaning business, implement further operational improvements, efficiently manage our fly ash or CCP business and pursue commercial validation of our technologies. I'd be glad to discuss specific questions about the December quarter 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 A. Benson

Thank you, Steve. First I'd like to make some comments on Headwaters resources. Tons of Portland cement shipped have declined due to the recession. Shipments are currently forecast to be down around 12% in 2009, a forecast that will probably deteriorate. However, pricing has not declined as much as expected because of the competitive dynamics in cement industry.

We anticipate that shipments of fly ash will decline during the year but at a slower rate than cement. Our view on 2009 fly ash shipments have not materially changed during the quarter except as we may be impacted by weather, and we continue to feel that pricing will be stable. Our business clearly is not the same as a cement business generally. There are two reasons for the difference. First; due to the lower ready mix design costs achieved through the substitution of quality fly ash, our sales actually increased during a downturn because of increased substitution. Hence our shipments are not down commensurate with the cement industry.

Second, we are very much an energy business related to coal utilities. The service portion of our business has grown and is somewhat impervious to the recession since utilities continue to operate, generate new electricity. Although the service element of our business have somewhat lower margins than fly ash sales, it is very stable.

Our margins improved during the quarter even with a drop in revenue, due to cost savings measures that improved productivity and because of more transportation costs. Accordingly, in our November earnings call, we indicated that our fly ash business will be flat or a little bit better for the year. Through the first quarter, we maintained the view that the fly ash business is trending towards a flat year, understanding that winter weather is a significant unknown. Upside opportunities include to bail our plan, investing in shovel ready infrastructure projects and the reduction of carbon dioxide through cement substitution.

The down side relates to the recession and the slowing of commercial and institutional construction at a rate faster than we anticipate. The half passed stimulus package provided for $90 billion in infrastructure spending, the 55 billion being designated for building projects. Additional funds will find their way into shovel ready projects. For example, Utah recently announced that it would move forward with some additional spending. We should be well positioned to benefit from these projects.

In December, the California Air Resources Board adopted a Climate Plan mandated by AB 32. AB 32 is the 2006 State Law requiring achievement of 1993 house gas emission levels by 2020. The plan outlines 31 areas of regulation intended to achieve greenhouse gas reductions.

Development of specific regulations will be ongoing over the next few years with the goal of program implementation by 2012. We continue to expect that we will benefit through flat fly ash substitution for Portland cement, based upon the Climate Plan adopted by the California Air Resources Board.

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

Now I would like to turn to our building product segment. The total number of homes started fall in December to 550,000 units on an annual basis. A 16% drop from the level seen in November, and a 45% decline from the level seen in December 2007. New home sales dropped 14.7% in December. New home sales at the lowest levels since data started to be in track in 1963. On a year-over-year basis, new home sales were down 44% from 2007 at 66% from 2006.

In December, new home inventories declined. So that's positive news. The number of new homes for sale continues to steadily decline and have not recorded a monthly increase since May of 2007. Inventory is now at its lowest level since September 2003. However, even declining inventory levels were not enough to keep months of inventory from rising again due to lower sales. There were 12.9 months of supply. Amount of the new home inventory are now at all time highs.

One bright spot is the affordability ratio. The new home affordability ratio in December jumped to a new all time high at meeting home prices as mortgage rates dropped. The affordability ratio now stands at 56.1% compared to 50.9% in November. This is the highest the new home affordability ratio has been since 1990.

On our last earnings call we acknowledged that housing starts will continue to decline and based on revenue guidance, a new residential construction estimate of 700,000 units. During the quarter, housing took another steep decline, resulted in a lower estimate of construction for 2009. The current decline from last year is approximately 45% which is below the 30% decline that we originally forecast.

We anticipate a 10% decline in revenue but consistent with the greater drop in housing construction. Our revenue declined 17% in the quarter. In addition to the down cycle, poor weather played a role in the overall drop in revenue. It's quite likely that our 2009 revenue will be of more than the 10% that we originally predicted, probably in the 15 to 20% range. Currently our block product line in Texas is our strongest performing building products business.

Adjusting for the stone, water stucco operation, sales grew more than 10% year-over-year. Our strategy to concentrate on block has proven to be successful, as we added capacity that has been utilized to meet demand. The business primarily sells to institutional construction and the next 12 months continues to look reasonably strong, however it may come under pressure as the commercial market softens in Texas.

We continue to see some strength in a few of our new products like InSpire Roofing and StoneCraft architectural stone.

We recently launched a new true (ph) board product and expect two of our distributors to take all of our production.

Eldorado Stone as developed a strategy to bring the stone inside the house as well as in outdoor applications like patio kitchens.

Our attempts to market new products and innovative applications of existing products have been successful in the past and we anticipate growth from these endeavors. We should soon start to see some easing of margin pressure from raw materials and transportation, as energy cost decline and as oil-based raw material costs drop. Resin prices have come down materially from their peak last summer.

As our raw material and finished goods inventory turn, those cost reductions should begin to show up on our income statement. We continue to read these costs eliminating both salary and hourly positions, closing facilities and improving productivity.

As an example, our building products headcount is down nearly 30%. Because of the severance cost and timing, some of our cost savings activities won't be reflected in the income statement until the March quarter.

Now I'll make some comments about the energy division. The uncertainty in coal prices for our domestic steam coal and metallurgical coal has increased over the last quarter as we face a global slowdown and at least a short-term decline in energy demand.

Steel production is down approximately 40% and steel companies have curtailed production and shutdown blast furnaces. Recession has also resulted the demand for electricity to decline, reducing the demand for steam coal.

In 2008, there was an increase in demand globally led by Asia and Pacific countries. The U.S increased its exports to meet this demand which strengthened prices for most of the year. We are now experiencing a short-term softness in the global market due to the recession.

But the recovery for coal will be strong as the recession ends and additional coal slabs come online.

We believe that 2009 coal demand will be soft due to the recession both in the U.S. and the demand for U.S. coal globally. However domestic supply cuts have been announced by multiple producers in an effort to better match supply and demand.

Longer-term, we will benefit from international growth through increased exports. Domestically there's about 15,000 megawatts of capacity under construction, representing an increase in demand of about 50 million tons of annual coal consumption.

And the cost and difficulty in producing Eastern Coal continues to increase, which should lead to higher prices as the difficulty in production limit supply.

From our facility perspective, we achieved our goal up 11 coal cleaning plants placed in service by putting three additional plants in service in the December quarter.

We believe that meeting the deadline of December 31, allowed us to qualify all of the facilities for the refined coal tax credit under Section 45. We now have nameplate capacity of approximately 5 million tons which provides us with the potential for substantial credits to be earned over the next 10 years.

Our operating performance in the quarter was lower than expected because we had some lower prices than anticipated due to reduced met coal sales; lower volumes primarily again from reduced met coal sales and higher cost from the rapid introduction of new facilities and the attendant start-up costs and operating costs before revenue is actually generated.

We are responding to the current market conditions by moderating our production to match sales and reduce costs to be consistent with those production levels. Finally, we will transition away from met coal on to domestic steam coal until the met market recovers.

For 2009, we previously indicated that coal sales will be in the range of 2.5 to 3.5 million tons with the sales price range of 55 to $63 per ton. This is a change in the met market and softening of steam pricing, we need to change that guidance. Our sale should be in the 2 to 2.5 million ton range and pricing in the 45 to $50 per ton range.

But the pricing and tons are dependent upon met coal settlements.

Many companies are not giving guidance because of the uncertainty in the met markets. However, we continue to anticipate a dramatic increase in coal-based revenue from last year based on the ramp up of our facilities.

Just add some brief comments on our other technologies; now Headwaters provided its direct coal liquefaction technology to Schenva (ph) for use in a commercial scale plant.

The first trial operation of this $1.5 billion facility was launched on December 30, 2008, and quality end-products were produced. The manager of the project was quoted to say in that the results far exceeded expectations. The end-products are composed of 70% clean diesel and the rest in Liquefied Natural Gas and Naphtha which could be used at chemical feedstocks.

Schenva's Chairman was quoted as saying, 'This technology certainly produces clean fuels with low sulphur, nitrogen and metal content.' We minimize the pollutants and could achieve almost zero emission during the production process. It is clearly a positive commercial confirmation of our technology. We also continue to move forward with heavy oil offering (ph) and hydrogen peroxide.

So, I'd like to turn the time back to the operator for the question and answer period of our conference call.

Question-and-Answer Session

Operator

Alright, thank you sir. Ladies and gentleman, this time we will begin our question and answer session. (Operator Instructions). Our first question's from the line of Burk Chow (ph) with Simmons & Company. Please go ahead.

Unidentified Analyst

Hi. Good morning everyone. Thanks for taking the call. Just a couple of questions and the first question is basically on the debt covenants. If you look at the cyclicality of the business, the quarter that we are currently in, is generally the weakest quarter. And if you do kind a quick swag at the indebtedness of the EBITDA covenants, we get pretty close. You mentioned that you have a certain ... some strategies in place if you do feel uncomfortable at the head room.

So the first question is that how comfortable are you and how likely is it going to be that you do bump up against those debt covenants? And secondly, if you could give some color on what those strategies would be if you get close enough to those?

Kirk Benson

I'll comment first and then Steve can follow up. We are of course quite cognizant of these debt covenants. It's something that is a high priority for the management team to monitor and manage in such a way that we can maintain compliance with the covenants.

So some of the things that we are implementing is a very straight approach to comparing our actual performance with our ... with the cost savings initiatives that we have in place. So we've established a base line of performance and we are monitoring against that base line to ensure that we maintain our covenant compliance. So, that's the matter of, of course meeting weekly and working on these issues weekly and then monitoring monthly, comparing our baseline performance with the cost improvements that we have underway.

So that's one of the significant areas that we're involved in to ensure that we stay in compliance with the covenants.

Second thing that we're looking at is the opportunity to sell some assets that may not be core assets to the business. There are opportunities to be able to do that and the sales wouldn't have a significant impact on EBITDA but would allow us to continue to reduce the amount of our senior debt.

We also think that if you look at the covenants that we're closest to non-compliance, is our total indebtedness to EBITDA covenant. We are ... we have significant head room in our senior debt to EBITDA covenant, which basically means that our senior debt have a lot more room in the covenant which should allow us if we think that it is necessary to request an amendment to the debt, because were still under leveraged relative to our senior indebtedness. For example, in the quarter we have trailing 12 months EBITDA of about 130, well more than $130 million and $200 million of senior indebtedness. So, we are not overly leveraged in the senior debt category.

So, we do think that there is an opportunity if it's required that we could amend our senior debt. There is, as everyone is aware we did a convert exchange which lowered our total indebtedness and there is a potential to do additional exchanges of our convertible debt because the convert debt is selling substantially below par. So Steve, would you like to add anything to?

Steven Stewart

I will just add a couple of things, the income covered very well but one thing to focus on to is that if you look at our December '07 quarter, building products was unusually strong in that quarter. So we substituted a strong quarter in '07 for a lower quarter in '08; going forward from here now... we think that the performance of the units in the remainder of '08 were significantly lower than that quarter. So you won't have such a dramatic change in trailing EBITDA as we pull out in '08 quarter and put in '09 quarter.

The last thing I'll comment to is the debt covenants that we amended to in August, step down in the June and September quarters. That... Kirk mentioned going back to our senior secured debt holders, the ask might be as easy as not having those covenants step down. They were comfortable with the covenant levels that we're going to be over the next three quarters. They were comfortable with those covenant levels and perhaps they would be comfortable leaving those covenant levels where they are currently at which would again provide for significant headroom.

Unidentified Analyst

Okay. And in the case it seems that you guys have done a lot of work on that. But in your case that you do actually bump up or you bust one of those covenants, what are the... for these the total indebtedness to EBITDA and when you are closest to? What are the consequences at the bay with your revolvers and everything like that?

Kirk Benson

If you, of course the covenants are basically conditions of the notes on the underlying credit facility. So there is an incentive on the part of both Headwaters and our senior credit participants to ensure that we don't breach those covenants. And so we don't have any intention to breach them. I mean the consequence of course is that you end up in a work out situation with your senior creditors. And that it's not something that they want to do, it's not something that we want to do either. But basically, that's the outcome of violating those covenants as you get into a work out situation with the lenders.

Unidentified Analyst

Okay, great. Thanks so much.

Operator

Well thank you. Our next question is from the line of Al Kaschalk with Wedbush Morgan. Please go ahead.

Al Kaschalk - Wedbush Morgan Securities

Good morning guys.

Kirk Benson

Good morning, Al.

Al Kaschalk - Wedbush Morgan Securities

Kirk, between your comments and Steve's, I was wondering within the guidance that you've given, are you anticipating the coal cleaning business to have an operating profit or can you just calibrate between the cost reduction efforts, the pricing and volume situation, the visibility for the balance of FY'09?

Steven Stewart

We spent a fair amount of time working with the coal cleaning business unit over the last couple of weeks and as Steve indicated, we've identified a significant amount of cost savings that was in the run rate in the December quarter that we can take out of that cost structure. Yes, we are successful and been able to execute on those cost saving endeavors, the way that the numbers work out is a positive operating income position for the year. So we're working towards having a positive operating income.

Al Kaschalk - Wedbush Morgan Securities

Do you anymore visibility or confidence in the contractual and delivery of production over the next I guess would be nine months or six to seven-eight months in that segment?

Kirk Benson

Does that relate to... on the sales side or on the production side?

Al Kaschalk - Wedbush Morgan Securities

Well, you've given us production capacity and I think you targeted 2 to 2.5 million of sales.

Kirk Benson

Right.

Al Kaschalk - Wedbush Morgan Securities

And I am just wondering if there is any update you can give us on the, that forward calendar if contractually you have these ready to be delivered or is there still negotiations to fill out that 2 to 2.5 million?

Kirk Benson

I think that the major change that took place in the quarter was the decline in metallurgical coal sales. And those internationally met settlements traditionally have occurred in the March quarter. There is some talk that those settlements will be delayed because there are 2008 contracts that have not been filled and that will flip over into 2009.

The biggest exposure that we have in the 2 to 2.5 million tons probably relates to met coal settlements and met shipments. When we saw the decline begin to occur towards the beginning of the 12/31 quarter and into the 12/31 quarter, we started to accelerate negotiations with utilities for steam coal sales as substitutes for those met coal sales. And so, I think that we can be in a 2 and 2.5 million ton range and so the two variables to achieve that goal would be first, the net coal settlements and being able to ship some met coal out towards the middle and the 9/30 quarter and the other variable then are the steam coal sales that we would be using to substitute for these further decline in the met coal.

So, those are the two variables that we have to be successful at to achieve the 2 to 2.5 million tons of coal which would be the substitute steams contracts which we're making some progress on or alternatively a recovery of some of our met coal sales.

Al Kaschalk - Wedbush Morgan Securities

Okay. And then two house keeping items, first on the fly ash business, what... can you remind us what percentage of revenue or operating profit in the service business?

Kirk Benson

It's probably right now running about 25% of revenue, right around that range 25 and maybe a little behind 25%.

Al Kaschalk - Wedbush Morgan Securities

And then Steve just on the reconciliation between the $0.02 of reported GAAP, you had 17 million of a gain. What are the non-recurring expenses were included in that number? Trying to get a kind of a run-rate type of EPS for the quarter?

Steven Stewart

One of the analyses that my accounting people provide for me is to identify any one time non-recurring revenues or expenses in a quarter. I went back and looked at some of the items that would offset the one time gain on the convert exchange. One of the items that I mentioned in my comments was that caused over $1 million of acceleration in amortization of debt issuance costs. So clearly that would not be a recurring thing.

We had severance costs of $1.5 million. We had...we've talked about our ethanol plant and some of the difficulties we've had with our hedging transactions. We have moved away from hedging at that facility and have actually replaced a person there that was responsible for that and but some of the hedges that were put in place a while ago are still playing out. We had almost 1.6 million of hedge loss that came through in the December quarter which we wouldn't expect going forward because we're not entering hedges at those levels. There was also about $2 million dollars of one time expenses that were incurred by our coal cleaning operations. Those are the major items. There are a bunch of other small items but if I add those up, there's 8 to $10 million of non-recurring expenses in the quarter that would offset the gain on the converted exchange of about 17 million.

If you net those out, you end up with ... and you apply a 20% income tax rate, as the guidance that we have given, then you end up with an earnings per share impact of something between $0.14 to $0.18.

Al Kaschalk - Wedbush Morgan Securities

Thank you very much Steve.

Operator

Thank you. John Bridges from J.P. Morgan. Please go ahead with your question.

John Bridges - J.P. Morgan

Hi Kirk and Steve. Can you hear me?

Kirk Benson

Yes, yes good morning.

Steven Stewart

Good morning.

John Bridges - J.P. Morgan

Just wondering if you could give us a bit of breakdown as to what's going into that coal line? If I simply take the three Nigel (ph) powers and less the total treatment multiplied by the price then I don't get a price for the total treatment. How is that made up?

Steven Stewart

In this, one of the things and the way that it is presented in the P&L, on the coping in sales, there is also the ethanol plant that's included in that number and that makes up probably the most significant difference between the ... approximately $12 million of revenue we had and what's shown on that line in the income statement.

And then of course is the difference between the totaling revenue which is about 3.5 to $4 per ton and the $53 per ton that we generate from the sale of our merchant facility coal sales.

John Bridges - J.P. Morgan

So you are reporting negative revenue for ethanol or are you just putting the net equity through this income?

Steven Stewart

There is negative revenue with the ethanol. I mentioned the hedge loss that was about $1.6 million and then there was four to $500,000 of actual operating loss with ethanol prices declining and we have purchased some corn a while ago, that still was ... prices are a little bit higher than what coal is today. So, it actually operated. I mean excuse me, core not coal, it actually operated in loss in the quarter two.

So, about $2 million of losses on the ethanol facility are included, John in that revenue line that we identify as energy.

John Bridges - J.P. Morgan

Okay. And you are aiming for a 20% margin on that business presumably when you are operating these plans about half speed then you'd be looking at something below that, what would be these numbers sort of, 5 to 10%?

Steven Stewart

Yeah, I think that the ... as I have in response to Al's question about what risks we have to get to the 2 and 2.5 million tons of. So you have the met coal risk and you have the transition to some steam contracts. If we are successful in accomplishing that you may be able to get to about 5% operating margin. As I indicated to Al, we'd expect to be profitable for the year if we are successful in executing our plan to reduce cost. I don't think that those margins will be greater than 5% and that is depended upon being able to successfully execute our plans

John Bridges - J.P. Morgan

Okay. You mentioned, like a lot of the other coal miners already, that steel makers have been unwilling to take deliveries. So these guys are breaking contracts with the D&E legal recourse on that?

Kirk Benson

We're the wrong coal company to ask that question because we're basically blending our material with other companies. So, we don't have direct contracts with the steel companies.

John Bridges - J.P. Morgan

And then in order again to find tune our models, the impact of the Pinnacle closure, what tonnage was coming out of there and when did it come off?

Kirk Benson

It's a very recent event and so we had, the Pinnacle facility was one that we acquired and as part of the acquisition, well ... our plan to increase the production of that facility required that we do some modifications to the Pinnacle plant during the last couple of quarters and so our production haven't been that significant in the last that couple of quarters.

We think that we should be able to produce somewhere in the range of 400,000 tons of material from that Pinnacle plant. We haven't been at those levels because we have been ... we've been modifying the facility so that it could operate at those levels but we think that that's kind of the potential is in that range.

The facility is basically the shutdown has just very recently occurred and I think that the public announcement was that it was anticipated that the shutdown would last for about 30 days.

John Bridges - J.P. Morgan

Very well, I'll keep my fingers crossed on that one. Okay probably a good news piece, presumably you made money on the peroxide business. What income figure can we put in the models for that?

Steven Stewart

Contribution from the peroxide business is also included in that and that line and it was slightly profitable in this quarter, few hundred thousand dollars.

John Bridges - J.P. Morgan

Okay that's all for me. Many, many thanks and good luck guys.

Kirk Benson

Thank you, John.

Operator

Well thank you. Ron Oster with Broadpoint Armtec. Please go ahead with your question.

Ron Oster - Broadpoint Armtec

Good morning. I just had that question. You gave some parameters in your press release regarding some of the pricing metrics you are assuming for the high-end of your guidance? Wondering if you could give similar information for the low-end of guidance?

Kirk Benson

I think that on the coal part of the guidance, the upper end really relates to being able to sell some met coal. The lower end of the guidance assumes that we aren't successful in selling the met coal and that our coal goes into the steam markets.

So, what we're doing from a steam perspective, the Illinois basin coal is being sold at prices in the high 20s and low 30s. The Central App coal is being sold in ... there is quite a bit of a range here and we're selling some coal in the 90s to $100 range and some of the coal is in, is somewhat below that.

We've got some other steam contracts in the Southern part of the country in about the $45 range. So, there is the variety of different prices depending upon of course the, where the coal originated but the high end of the range relates to being able to sell a big portion of our coal into the met market and our low end of the range relates to the steam sales.

Ron Oster - Broadpoint Armtec

Okay, and then on the building products business, are gross profit margins expected to ... any guidance there in terms of year-over-year what we should expect in '09 versus 2008 levels? Should we assume flat or up modestly with some of the cost cutting measures? Just wanted to see if I could get some greater clarity there?

Steven Stewart

One of the things that makes the building products business difficult is the seasonality of the business and so you have fairly wide margin swings between the 12/31 and 3/31 quarters, compared to the-the margins for the year.

From an operating margin perspective, what we had originally anticipated was that our operating margins would be relatively flat for the year. And so that was right around a 6% operating margin, right in that range.

Now, with the step-down in construction that took place in the 12/31 quarter, I think that those 6% margins have the potential of slipping at least from the perspective of revenue dropping more than what we had originally anticipated. The counter to that is we've instituted additional cost cutting measures and we'll have some margin improvement from the drop in raw material costs. So I think that the... what is probably reasonable to do would be to assume that the margins will be a little bit softer than last year probably a couple of hundred bases points, probably a couple of hundred basis point softer maybe even 250 basis points softer.

Ron Oster - Broadpoint Armtec

Okay, thanks. That's helpful. And then on the... it seems accretive to be in this new revised guidance as the cost cutting at the SG&A line. Is the $25 million reduction, can you kind of tell us where you are today and what kind of at the end of day does that leave you, it seems like that might leave you close to an annual run rate of around 100 million per year. Does that seem reasonable?

Kirk Benson

We're here in the right bulk part relative to the total run rate, it might be and be a little bit higher, slightly higher. But with the 25 million is basically spread out amongst the different business units and then the corporate SG&A. So you take that $25 million and break it out into... actually into five different pieces and we're on... we're pretty much on track probably forward, probably not on track yet for the full 25 million. We're probably on track now for somewhere between 15 and 20 million is where I think we're and maybe not probably pretty close to the 20 million range.

We set the goal of course a little bit higher than what we actually think that we need from a covenant perspective, so that we would have some stretch in the goal. But I think we're probably pretty close to being on track to a somewhere between the 15 and $20 million range and may be closer to the 20 million.

Ron Oster - Broadpoint Armtec

Okay, that's all I had. Thank you.

Operator

Thank you. John Quealy with Canaccord Adams. Please go ahead with your question.

Mark Segal - Canaccord Adams

Hi good morning. This is Mark Segal for John. Just one clarifying question here, the revised guidance that does reflect the gain on the debt extinguishment in the quarter, correct?

Kirk Benson

Yes.

Mark Segal - Canaccord Adams

Okay. And then just one question on the coal cleaning business, are you able to quantify perhaps on a percentage basis how much towards your '09 guidance is sold thus far and perhaps with the average selling lines of those contacts might be?

Steven Stewart

To answer the second part first, I don't we have very much if any coal that goes beyond the 12 month contract.

Mark Segal - Canaccord Adams

Okay.

Steven Stewart

And we probably have something in the range of 30 to 40 may be even a little bit higher percent than a 40% that's contracted for currently.

Mark Segal - Canaccord Adams

Okay that's all from me. Thanks a lot.

Operator

Thank you. And we do have time for one more question, that will be coming from Dan Mannes with Avondale Partners. Please go ahead.

Daniel Mannes - Avondale Partners, LLC

Good morning everyone.

Kirk Benson

Hi, Dan.

Daniel Mannes - Avondale Partners, LLC

A couple of follow up questions, first on met coal, just as you look at your fiscal first quarter, can you tell us of the 240,000 tons you said you sold of merchant coal. How much was solved met versus steam?

Kirk Benson

I think we'll get... it's in the tens of thousands of tons its not... its not a significant percentage. Our met coal sales fell of dramatically after the end of the 9/30 quarter. So, we did have some met coal sales but its sales are in tens of thousands. So it's not a significant numbers and we'll be happy to get the precise number to you, but it's not very much.

Daniel Mannes - Avondale Partners, LLC

Okay. So, and is this basically anything you produced and sold and I assume is baking your inventory number which ironically looks pretty flat year-over-year... quarter-over-quarter.

Kirk Benson

I think the inventory the inventory in 12/31 quarter went up a fair amount compared to the 9/30 quarter.

Daniel Mannes - Avondale Partners, LLC

Okay, all right. A couple of other quick follow up questions there. In terms of contracts you had, as it relates again to the met side, so these weren't from volume, these were sort of as desired contracts? And at this point you are still waiting to see what the negotiation is for the '09 contract, before you can figure out what the demand will be for your tonnage, is that a fair way to characterize it?

Kirk Benson

Yes.

Daniel Mannes - Avondale Partners, LLC

Okay. Just switching things a little quick, going over to the fly ash business, you mentioned AB 32, given away its being scoped in all the uncertainty, is it reasonable to assume that this is creating any near-term demand or incremental demand for fly ash? I mean outside of the cyclical factors, or is this sort of just setting the stage that a couple of years from now we could see an uptake in fly ash demand in the concrete business?

Kirk Benson

I don't think that AB 32 is going to create demand in 2009. So, I don't think there is near-term demand that you have the possibility that between now and 2012 when the plan is supposed to be fully implemented that you will get some incremental demand, but I don't think you're going to see too much of that in 2009.

Daniel Mannes - Avondale Partners, LLC

Okay. And then just last question on the cost cutting, when you guys were talking about cuts especially in the alt energy segment. How much of this relates to the R&D group which I think is running M&O 15 million a year so in costs versus other SG&A?

Kirk Benson

We've taken our R&D group, we took down in the 9/30 quarter from a run rate its actually the run rate was a little bit higher or at least I guess the run rate was about what is in that range 160 million. We've taken the run rate down to find an annualized base of now to between 6.3 and about 7.5, between 63 &75 is the new run rate based upon the cost cutting that we did in the December quarter.

Daniel Mannes - Avondale Partners, LLC

So when you look at that 25 million of savings does that come towards it or is that incremental? That I guess that would be an almost on your $9 million dollar cut?

Kirk Benson

Well that is a piece of the total 25 million. It's a little bit the way that we did it it's a little bit less than the 9 million. But because we were trying to do it on an annualized basis, but yes that is included in the cuts. And those cuts should show up in the March quarter.

Daniel Mannes - Avondale Partners, LLC

Great. Thank you very much.

Kirk Benson

Okay.

Operator

Thank you. That does conclude the question and answer period. Management please continue for any closing comments.

Sharon Madden

Thank you. With that we'll go ahead and close the call. Thank you for your participation.

Operator

Thank you. And ladies and gentlemen this does conclude the Headwaters Incorporated first quarter 2009 conference call. If you would like to listen to a replay of today's conference in its entirety you can do so by dialing 1800-405-2236 or 303-590-3000 and put the access code 11125745.

Yes, we would like to thank you very much for your participation today. You may now disconnect. Have a very pleasant rest of your day.

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