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Executives

Tricia Ross – IR, Financial Profiles, Inc.

Sharon Madden – VP of IR

Steve Stewart – CFO

Kirk Benson – Chairman & CEO

Bill Gehrmann – President of Headwaters Resources, Inc.

Jack Lawless – President of Headwaters Construction Materials, Inc.

Analysts

Trey [ph] – Stephens Incorporated

Pearce Hammond – Simmons & Company

Al Kaschalk – Wedbush Morgan

John Quealy – Canaccord Adams

Dan Mannes – Avondale

Headwaters Incorporated (HW) F3Q09 (Qtr End 06/30/09) Earnings Call Transcript August 4, 2009 11:00 AM ET

Operator

Good morning, my name is Stephanie and I will be your conference operator today. At this time, I would like to welcome everyone to the Headwaters Incorporated third quarter fiscal 2009 earnings conference call. All line have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator instructions) I would now like to turn the conference over to Tricia Ross of Financial Profiles. Ms. Ross, you may begin your conference.

Tricia Ross

Hello and thank you for joining us for Headwaters’ third quarter fiscal 2009 conference call. If you have not yet received a copy of today's press release, please contact my office at 310-277-4711. I would now like to turn the call over to Sharon Madden, Headwaters’ Vice President of Investor Relations.

Sharon Madden

Thank you, Tricia. Good morning everyone and thank you for joining us today for Headwaters’ Q3 fiscal ‘09 conference call. Today’s call will be conducted by Kirk Benson, Headwaters’ Chairman and Chief Executive Officer and Steve Stewart, Headwaters’ Chief Financial Officer. We also have Bill Gehrmann, President of Headwaters Resources, and Jack Lawless, President of Headwaters Construction Materials, reporting on their individual business segments.

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

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

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

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

Steve Stewart

Thank you, Sharon, and welcome everyone this morning. Attached to the press release, that Sharon mentioned, are condensed consolidated financial statements that include statements of operations for the quarters and the nine months that ended June 30, 2009 and 2008.

There are also balance sheets as of June 30the, 2009, and our year-end September 30th, 2008. My comments are derived primarily from those condensed consolidated statements and the schedules included therein. We expect to file our Form 10-Q in the next few days.

We continue to experience weakness in the housing and residential remodeling markets, a continuing decline in the demand and price for coal, and the slowdown in commercial and institutional construction, directly impacting demand and consumption of fly ash. While the June quarter saw a significant increase in revenues when compared to the March quarter, most of this increase was related to the seasonal of our businesses.

Total consolidated revenues in the June 2009 quarter decreased approximately 24% when compared with the June 2008 quarter. Headwaters’ gross profit and operating income were also lower in 2009 when compared to 2008 as a result of this revenue decrease.

However, the impact of this revenue decline was mitigated by cost reductions and operational improvements, which reduced our operating expenses by over $25 million, or 18%, when you compare the nine months ended June 2009 to the 2008 period. We will continue to focus our efforts on identifying opportunities for operational improvements and cost reductions in all of our business units. We believe the benefits of these activities will have a significant impact on fiscal 2010 when we will enjoy the full year’s effect of these savings.

In addition to cost reductions, we have also significantly reduced our fiscal 2009 capital expenditures. We expect capital expenditures for fiscal 2009 to be less than $65 million, which is over $50 million less than fiscal 2008, and approximately $25 million less than what we budgeted at the beginning of our fiscal year. We will continue to manage capital expenditures closely and expect fiscal 2010 expenditure could be as much as 40% below fiscal 2009 levels.

Our operations continue to be very seasonal, and we utilized our revolving credit facility during the winter and spring months. We currently have $25 million draw in on our revolving credit facility. Our revolving credit facility matures on September 7th, 2009.

Headwaters’ total indebtedness at June 30, 2009, was $530.7 million. On June 29th, we announced that we had reached an agreement with our senior debt holders to amend our current credit facility. While the amendment provides numerous changes, the key provisions were and adjustment to covenants and an agreement to release collateral so that Headwaters could put an asset based loan, or ABL, in place to replace our revolving credit facility.

Some of the other provisions included

a waiver of the total indebtedness covenants at June 30, 2009; permitted additional asset sales; provided for an add back for non-cash losses resulting from equity-for debt exchanges; reduced our annual capital expenditure limits; increased our interest rate and provided the 3% LIBOR floor; and required a consent fee to be paid to the debt holders of just 50 basis points. We were pleased to complete the amendment and believe that it provides additional options for Headwaters as we move forward.

Headwaters has now signed a term sheet with a major bank that has agreed to arrange our ABL facility. The ABL has a minimum of size of $50 million and a maximum size of $70 million and will be collateralized by a first lean secured interest in the inventory and receivables of the Building Materials segment and the receivables of the Resources or fly ash segment. The maturity date of the ABL cannot be earlier than the maturity date of the senior date and it is currently expected to be for approximately four years.

Headwaters contracted with KPMG out of their Chicago office some time ago and they prepared a lot of the information and analysis necessary for the ABL loan. This information has been provided to the bank along with other information they requested and they are completing their due diligence procedures and drafting documents.

We hope to complete the ABL loan by the middle to end of August. Once the ABL is completed, additional loan modifications will apply as follows. The interest rate on our senior debt will increase by 100 basis points. Our total indebtedness covenant will increase to 5.25 at September 30th, 5.5 at December 31st, it goes up to then 5.75 for two quarters, and then declines to 4.75 through its maturity.

The fixed charge covenant is modified to exclude scheduled maturities of our senior debt. Headwaters is required to make a payment of $25 million no later than December 31st, 2009. Our interest rate will increase by 25 basis points beginning January 1, 2010 if Headwaters hasn’t repaid a total of $50 million on the senior debt. And we are – will be required to make an additional payment to our debt holders of 25 basis points.

We have several activities in process with a goal of reducing our debt that will mature or otherwise be repayable in 2011 and 2012. Our goal is to reduce those maturities by $100 million. The activities include cost reductions, the sale of assets, the exchange of debt for equity, and other refinancings. One segment of activities was completed in July with the exchange for equity of approximately $35 million of our convertible debt that would have otherwise been repayable in 2011 and 2012. The retirement of this debt will reduce interest expense by approximately $3 million in fiscal 2010.

Because these exchanges were effected at a significant discount from the par value of the convertible debt, the value for Headwaters’ stock in these exchanges was approximately $4.23, which is approximately a 35% premium over what the stock closed at yesterday.

Other activity – another activity that we are actively involved in is the sale of assets. This is a difficult market in which to execute this type of transaction, but we have had discussions with numerous entities and groups and we are optimistic that we will be able to meet the sales goal we have set. We have identified assets with a total book value in excess of $100 million that are candidates for sale. We also have been pursuing a possible sale and leaseback that could be used to refinance some of the 2011 or 2012 debt maturities or could be used to reduce our revolving credit facility balance.

We believe that these activities will provide us with the ability to repay the revolving credit facility prior to its maturity and will our necessary liquidity going forward. Headwaters is in compliance with all of our debt covenants at June 30th, 2009.

When you compare the June 2009 quarter to 2008, there are no significant non-recurring or non-routine items except for the convertible debt exchange that I mentioned. If you compare the nine month periods ending June 2009 to June 2008, there was approximately $9.7 million of revenue from the sale of motor and stepper products in 2008 in addition to a gain of approximately $8 million from the sale of the motor and stepper business that is included in the June 2008 operating results.

The last item that I would like to discuss now are income taxes. We have provided guidance in the past that we expect Headwaters’ effective tax rate to be less than 20% in fiscal 2009. This guidance includes all operating results, including any goodwill impairments recorded. Headwaters has three items that make income taxes in fiscal 2009 difficult to analyze. First, the significant goodwill impairment that was recorded in March of 2009, some of which will be deductible for income tax purposes.

Second, income tax generated from the coal cleaning operations that are available to be used to reduce a significant portion of our expected income tax expense. And lastly, significantly lower pre-tax operating results from what was projected at the beginning of the year causing discrete and permanent tax differences to have a much more significant effect on our income taxes when you exclude the effect of the goodwill impairment.

During the June 2009 quarter, Headwaters estimated its effective tax rate would be approximately 1.5% higher than we had estimated in March. This percentage increase when multiplied by Headwaters’ expected loss before income taxes for fiscal 2009, which at June 30th, 2009, was approximately $480 million, caused a significant benefit to be recorded in the June quarter, thus contributing to the net income tax benefit of 6.89 that you see reflected in the financial statement. I would be glad to speak offline with anybody if you would like to go with our income taxes in more detail.

At June 30th, 2009, Headwaters had approximately $14 million of cash and cash equivalents on hand thus providing Headwaters with slightly over $34 million of total liquidity. This liquidity continues today. At today’s interest rates, total interest expense in 2009 could be $40 million, including as much as $5 million of non-cash amortization of debt issuance costs.

We expect depreciation and appreciation for fiscal 2009 to be around $75 million. The weighted average shares outstanding used in our dilutive earnings per share calculation is approximately 44.8 million shares. This includes approximately one million shares that results from treating the 2 and 7/8% convertible notes as if converted. When you add back the interest on those notes along with including those shares in the denominator, they effectively offset each other and accordingly you have the same earnings per share of $0.27 on both the basic and diluted share bases.

At today’s stock price, substantially all of Headwaters’ options and stock appreciating rights, or SARs, are out of the money and are therefore in the diluted weighting shares outstanding calculation.

In conclusion, we are pleased with the debt amendment that we were able to sign and the options that we believe it provides. We continue to believe that the combination of our coal cleaning operations with our CCP business will create synergies and reduce costs. We will continue to look for opportunities to reduce cost and improve operational efficiencies as we go forward through these recessionary times. We believe we will be successful in completing an ABL facility. We believe Headwaters is positioned well to take advantage of the economic rebound once this recession ends.

I’d be glad to discuss specific questions with you concerning the June 2009 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 Benson

Thank you, Steve. For the first time in history or Headwaters Resources, our fly ash shipments are following shipment of Portland cement and are reflecting a downturn in construction due to the recession. The bright spot for us is the strength of our services business and the success of our expansion activities. Bill Gehrmann is going to discuss our fly ash business.

The new residential construction market has decline to the lowest level since record-keeping was implemented in the 1950s. Fortunately, there isn’t much room for additional declines, so there seems to be some stabilization at today’s low levels of construction. Stability is a welcome relief from the years of decline. Jack Lawless will provide you with an update on our Building Products business.

After Jack has concluded, Bill Gehrmann will discuss the progress we have made in our coal cleaning business. The integration and attention to cost has resulted in a reduction in our fixed cost per ton by more than 50%. Although the overall coal market supply and demand is still out of balance, we are starting to see some encouraging signs for our specific coal production.

So, Bill, why don’t you go ahead and give us an update on our fly ash business.

Bill Gehrmann

Thank you, Kirk, and good morning everybody. Year-over-year revenue for the June 2009 quarter in our coal combustion products business was down 22%. Product revenues in the Southeast and the Southwest continue to be impacted by slow economic activity and in the June quarter we began to see an impact in the South Central region. Overall, pricing for high-quality fly ash has remained stable, although volumes are down 27% year-over-year. Low natural gas prices continue to negatively impact coal-fired generation, resulting in lower fly ash production.

Portland cement economists continue to forecast (inaudible) increase in Portland cement as a result of the stimulus bill passed by congress in the spring. However, current projection for infrastructure spending related to the stimulus package forecast that less than 25% of the budgeted funding will be spent in 2009. There will be greater impact in 2010 than in 2009.

Service revenues are 50% -- 30% year-over-year for the quarter and 38% year-to-date. This increase in service revenue continues to be a mix of new contract and additional site work at locations where we already provide management services. We continue to see new opportunities to expand this side of our business.

This U.S. Environmental Protection Agency has announced plans to strengthen regulation of the disposal of coal ash and several states have undertaken similar efforts. Increased regulation of ash disposal may require coal users to assess their ash management strategies and change certain operations.

We recently announced the formation of our utility services division. This new division should provide valuable services to the utilities for complying with changing disposal regulations while developing options for increasing the safe beneficial use of coal ash. We are increasing our focus on the service side of our business by drawing on our extensive experience managing landfill operations, converting disposal operations from wet to dry ash handling, and deploying systems that improve ash quality.

In the June quarter we completed the installation of a wet to dry ash handling system that is expected to provide up to an additional 200,000 tons per year of high quarter ash. Much of this ash should be exported to Canada and sales are already committed. We also completed the installation of a fly ash blending facility to improve the quality of existing ashes. On other side, we completed the construction of additional storage and truckload out system.

Our continuous improvement initiative continue to positively impact our overall cost structure. Year-to-date, we have identified and implemented annualized cost saving of over $9 million and anticipate year-over-year cost reductions of $5 million to $6 million in 2009. These cost reductions include process improvements, headcount, maintenance, and operating leases.

We continue to believe that the efforts we have made to expand supply increase our service work and reduce our overall cost structure, strengthen our ability to meet the needs of our client and customers, as the economy recovers.

Jack will now discuss our Building Products business.

Jack Lawless

Thanks, Bill, and good morning everybody. Revenue from our Building Products business in the June 2009 quarter was $92.6 million, a decrease of 28% from $129.3 million in the June 2008 quarter.

Despite a significant decline in revenues, the gross margin of 28% in the June 2009 quarter increased from the June 2008 gross margin of 27%, and the operating margin of 8% in the June 2009 quarter was the same as the June 2008 quarter. We believe that consistent margins in the face of declining revenues are attributable to improved efficiencies and cost reductions implemented over the past 12 months.

On our last call, I spoke about March of 2009 being the first sign of our business emerging from a long string of consecutive monthly revenue declines. There were some guarded optimism for the second half of the year. Despite difficult market conditions and attention by our customers to avoid any inventory build, since March of 2009, our Building Products group has now achieved four consecutive months where sales reflect a stable relationship to last year bolstering our belief that the worst of this housing recession is now behind us and we may be moving into a period of relative stability.

During the same four month time period, the significant impact of our business restructuring and cost reduction efforts are clearly apparent. Our revenue fell approximately $47 million or 28% on a year-over-year basis in the four months from March to June of 2009. Our EBITDA for the same period decreased less than $400,000 compared to last year. This is a direct result of the substantial effort of our Building Products team to get as close in line with current demand as well as the push to improve the efficiency of all of our operations.

It is important to note, however, that despite our aggressive restructuring, cost reductions, and efficiency improvements, we have still retained the vast majority of our 2006 capacity levels. As our industry inevitably recovers from its historic lows, we will be able to materially increase our sales of our core products from existing facilities. In addition, as our sales recover, our new and improved operating model should yield materially improved operating margins.

While capital has been scarce, we have used it wisely to support the growth of our product lines that are showing relatively good sales even during this downturn. We are adding capacity to our IQm trim board product line. IQm trim board is an advanced cellular PVC product that was created by Tapco with a number of patent pending features. We introduced our trim board product this spring and we are already nearing capacity. We are also adding two new product line extensions to our popular foundry line of specialty siding and adding a new (inaudible) roofing panel to our InSpire line of roofing products.

On the Eldorado side of the business, we believe we are having success increasing market share on the high-end side of the business because of improved service levels relative to our competition and an intense focus on expanding our distribution network. In addition, the launch of our interior gemstone wall program, our outdoor living campaign, and our John Deere landscape program all have received a favorable response from the market as we continue to expand into the remodeling and interior side of the business.

Our Southwest Concrete located in Texas continues to achieve record operating results as it continues to make inroads on its competition in the Texas block and specialty block business. Because of its continued operational improvements, its inventory is down materially from year-ago levels, its service levels have improved, and its operating profit metrics are at all-time highs. While we do not expect to see meaningful improvements in the macro environment over the next six to 12 months, we continue to see areas that give us encouragement heading into the end of 2009 and the beginning of 2010.

One, our cost structure in place today will yield materially higher operating earnings for 2010 even if sales levels do not improve over forecasted 2009 levels. Two, we have a number of new products and programs that we have already or will soon launch that should provide meaningful sales and operating earnings over the next several years. And three, we believe that the market share gains that we have gained over the past 12 months will accrue to us as our industry recovers.

In summary, it is my belief that our industry-leading Building Product companies have never been better positioned to take advantage of the inevitable rebound in our industry.

Bill will now discuss our coal cleaning business. Bill?

Bill Gehrmann

Thanks, Jack. Coal revenue for the June 2009 quarter was $13.3 million on sales of 433,000 tons of coal. Although total revenue for the quarter was comparable to last year, we sold $75,000 more tons or an increase in tons sold of over 20%. But there was a shift to thermal sales in the lower priced Illinois basin and Utah coal, resulting in lower average sales price per ton of $34.

Low natural gas prices reduced electricity demand and mild weather continue to negatively impact the steam coal market. Coal inventories remain while our year-over-year demand is over $115 million. Coal production has been reduced by about $100 million, so there is still excess supply in the market.

Excluding China, global steel production through June has declined approximately 35%, resulting in a continued lack of demand for metallurgical coal. However, China’s coal imports are growing and coal demand in China and India should ultimately improve the demand for U.S. coal. In the June quarter we reduced plant operations to manage inventories and match production to the current market demand. This resulted in the operation of seven plants during the quarter in reduced shifts at most of those plants that did operate. The plants that operated during the quarter demonstrated the ability to improve quality by lowering ash contents while also increasing production.

We continue to see the positive impact of our continuous improvement initiatives in our coal cleaning business. Year-to-date we have identified and implemented annualized cost savings of almost $10 million and we are continuing to identify additional opportunities in the area of process improvement, equipment utilization, and maintenance. Our fixed cost per ton have declined from $48 in the December quarter to $23 per ton in the June quarter, a greater than 50% reduction.

During the June quarter, the Utah (inaudible) facility was converted to a merchant facility, which we believe should allow Headwaters to claim Section 45 tax credits on the output of the facility and increase our revenue generated from coal sales. We also set a monthly production record at that facility.

In Alabama, improved quality in our efforts to demonstrate the ability to move (inaudible) shipments makes us cautiously optimistic that pricing may stabilize and sales should begin to improve. We anticipate ramping up production at some of those sites in the September quarter.

For the month of June, our coal cleaning business would have been EBITDA neutral without non-recurring adjustments for inventory and severance costs. We are beginning to see positive results from our efforts to improve quality while increasing production and improving our overall cost structure.

We expect these operating trends to continue and to leverage our operating results as the steam and metallurgical coals markets stabilize. Kirk?

Kirk Benson

Well, thanks Bill. Bill and his team have made real progress in coal cleaning. In fact, the Energy segment, as a whole, has shown positive trends. EBITDA for the Energy segment was $3.8 million negative for the quarter, but turned positive in the month of June. We are beginning to have some positive results in a couple of other energy areas in addition to coal cleaning. For example, we had positive earnings and EBITDA from our ethanol plant and from our hydrogen peroxide plant. Otherwise, we are controlling R&D cost and minimizing our cash outflow.

As Steve indicated earlier, we have two key financial strategies that we are executing. First, a strategy to improve liquidity. This strategy has three key elements. First, an amendment of our senior credit facility to replace our cash flow revolver, which we successfully completed. Second, obtaining an asset based loan secured by receivables and inventory. And third, a substantial reduction in CapEx expenditures for 2010. Execution of this strategy should resolve liquidity concerns.

Second, a strategy to refinance our debt in late 2010. As Steve mentioned, we completed an exchange of our equity for debt. This is part of a broad strategy to reduce our senior indebtedness and total indebtedness with a view towards refinancing our 2011 and 2012 maturities in late 2010. As of June 30th, our total 2011 and 2012 maturities were $352 million and we want to reduce those maturities by $100 million. The goal is to reduce our refinancing requirements so that our 2010 senior debt to EBITDA is below 2.5 and our total indebtedness ratio is under 4.0.

The exchanges of equity for convertible debt was the first step in our debt reduction and we have reduced our 2011 and 2012 maturities and total indebtedness by $35 million. To achieve our goal of $100 million reduction in 2011 and 2012 maturities, we need additional reductions of $65 million. We expect to further reduce our 2011-2012 maturities primarily by asset sales. And as Steve said, we’ve identified over $100 million of assets that we could sell.

A portion of our debt could also be refinanced through sale and leaseback transactions prior to 2010 further reducing the pressure on the 2010 refinancing. Given the time that we have to execute our strategy, we feel comfortable that it’s doable and that Headwaters can be positioned to successfully refinance our debt in 2010. Headwaters should be well positioned to benefit then from the end of the recession with a lower cost structure and ample production capacity.

So, I would now like to turn the time back over back to the operator for question and answers.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Steve Sanders with Stephens Incorporated.

Trey -- Stephens Incorporated

Good morning

This is Trey [ph] for Steve. First, in the release, you noted that the Energy segment was breakeven for the month of June. How shall we be thinking about that going forward and if you think this breakeven, I guess slight profitability is sustainable going forward? What assumptions are you baking in terms of pricing, demand, et cetera, just anything you can give there would be helpful.

Kirk Benson

I think there is – in the Energy segment there is – there are four components that impact the EBITDA, operating income of that segment. The most important component is coal cleaning. And we have made significant progress in the coal cleaning business, reducing our fixed cost and changing the cost structure of the coal cleaning business. We are also starting to see some indication that there is improved interest in purchasing our coal. So, if we were able to operate that part of the business in the range of breakeven, that bodes very well of course for the entire segment, because to a large degree this segment is going to be impacted most significantly by coal cleaning. And I think we’ve got a fairly good chance of operating that segment close to breakeven in the September quarter. Bill, do you want to add something to that on coal cleaning?

Bill Gehrmann

Yes. I think obviously one thing – a couple of things that we have done and Kirk has addressed some is obviously our fixed cost structure and we will continue to work on that, but on the marketing side the top line side of that business, obviously we’ve had a couple of additional quarters to learn to operate these plants. We’ve shown significant improvement in the quality of the material in relation to ash content. That overcomes some of the potential stigmas of the fines in the marketplace. And on top of that, we have gone out and had several substantial sales of fines only coal, which we’ve proven the ability for not only ourselves, but transporters and end-users to handle these fines-only shipments. So, I think that bodes well for the coal-cleaning business in the future.

Kirk Benson

The second thing that’s important in that segment is the ethanol plant. We anticipate that it will produce positive operating income in the September quarter. The third thing is the hydrogen peroxide plant in South Korea. It’s been operating profitability, but you also have the added risk from an operating income perspective of foreign currency exchanged gains or loses. So – and that’s something that has been a material factor and so that – and that’s a little bit difficult for us to predict what’s going to happen from a foreign currency exchange perspective. But the facility itself has been operating profitably.

And then the final thing is controlling cost in our R&D center, which I think we’ve done a pretty good job there. So, I don’t think there is – I don’t think there is much risk that costs are going to change very much in the R&D center. The South Korean facility has been operating profitably, but you have foreign currency exchange losses or gains that could make a difference. And then our ethanol plant will operate profitably.

So, we are reasonably optimistic that we can operate close to breakeven in the 09/30 quarter. Again, the big risk is what happens to coal cleaning and whether or not there are some losses in the 09/30 quarter in coal cleaning.

I’ll just mention briefly on the HCAT. That’s the -- the cost associated with that are of course included in our R&D spending. We are moving towards having some – we’ll have some trial runs, but probably not until the nine and 12/31 quarter. And so we are not expecting any financial impact really from HCAT in the 09/30 quarter and then we do expect to have some runs in refineries in the 12/31 quarter.

Trey -- Stephens Incorporated

Okay. Thank you for that. That was. And then I think Jack may have touched on this in his commentary on the Building Products side. Assuming 2000 – revenues in that segment are flat and there is no big moves in commodities, mix, et cetera, what do you pick up in 2010 EBIT given just the incremental cost savings next year versus what you have implemented this year?

Kirk Benson

So, I think that’s part of what we are going through right no, Trey, in our – as we are going through our budgeting process for 2010, we are looking at the trends in our cost savings numbers and clearly we’ll have a full year of those cost savings in 2010. So there is going to be some pickup, but the – and so that’s what we are working on that right now in our 2010 planning. It’s – it will be multiple millions of dollars of additional savings, but I think we need to finish up some of that planning before we refine that number. But Jack, why don’t you go ahead add a little bit to that?

Jack Lawless

Yes, Kirk, I think you are right. I think the range is – it’s going to – it’s very material, but it’s certainly north of a couple of million dollars and these cuts and things are already done and in the system and efficiency gains. So, we feel pretty good about heading into 2010 if the revenue comes in at 2009 levels that we’ll have a nice – a very nice material pickup in our operating earnings EBIT and EBITDA.

Trey -- Stephens Incorporated

Okay great. And then lastly, just to clarify on the ABL process, is there an agreement in principle already or are those terms that you mentioned in the prepared remarks just kind of a starting point for negotiations?

Kirk Benson

I think what – we have an executed term sheet and so all the principal terms are agreed to. So, Steve.

Steve Stewart

No, that’s right. Yes, we’ve signed that and as we move forward through this due diligence process, I don’t know of any significant changes that have been necessary to the terms that we outlined.

Trey -- Stephens Incorporated

Okay. So, it’s just a timing thing. It’s not an ‘If,’ it’s just the ‘when.’

Steve Stewart

That’s what we believe, Trey.

Trey -- Stephens Incorporated

Okay great, thanks guys.

Operator

Your next question comes from the line of Pearce Hammond with Simmons and Company.

Pearce Hammond -- Simmons & Company

Good morning

Kirk Benson

Good morning.

Pearce Hammond -- Simmons & Company

With you guidance, Steve, the zero, the breakeven to $0.20 for fiscal year ’09, can you just recap what numbers for Q1, Q2, and Q3 go into calculating that?

Steve Stewart

Yes. Again, I am going to do it from the financial--

Kirk Benson

(inaudible) you clarify whether this is without – with or without goodwill. I think the question relates to without goodwill for everybody, so that’s – so think that’s – so, Steve’s response is going to be without the goodwill. Is that right, that’s what the question you are asking?

Pearce Hammond -- Simmons & Company

Yes, that’s exactly – I am just trying to make – because there has been a number of different sort of one-timers, just trying to get it all straight.

Kirk Benson

Right.

Steve Stewart

Yes, so if you take out goodwill and again you get a significantly different answer with or without goodwill, whatever relates to income taxes. So if you look at our first quarter there wasn’t any goodwill there. And we had a loss of $0.02. If you look at Q2 and you exclude the goodwill adjustment, then we had an adjusted net income, a loss of 33.9 almost 34 billion [ph]. That results in a $0.82 loss. If you look at the cumulative effect -- again there is rounding differences each quarter -- if you look at the cumulative as March 31, for the six months, we showed a cumulative loss of $0.86.

You go to Q3 now and if you exclude the impact of the goodwill, we would end up with about $0.82 of income in the third quarter. So, if you look at the bottom of the condensed financial statement for the nine month period excluding goodwill on a cumulative basis we are at $0.02 earnings per share.

Pearce Hammond -- Simmons & Company

Okay great. And then now for Q4, in the guidance you state that it would be breakeven due to a tax provision in Q4. So, I am assuming that tax provision is included in that guidance for the full year, that breakeven to $0.20.

Steve Stewart

Yes, it is, Pearce.

Pearce Hammond -- Simmons & Company

Okay.

Steve Stewart

And so effectively what our effective tax rate is without goodwill – we’ve told you our effective tax rate is less than 20% with goodwill. Without goodwill, our effective tax rate approximates 100%, give or take a few percentage points. So, whatever the income, pretax income is in the fourth quarter, it’s likely to be offset substantially by an income tax provision.

Pearce Hammond -- Simmons & Company

And is that that the same thing as the $22.5 million that -- I mean this is not the same thing as the non-cash loss that we’ll see in Q4 of $22.5 million, which is the result of the swap for equity with the convertible debt.

Steve Stewart

Yes, you have to adjust for that $22.5 million.

Pearce Hammond -- Simmons & Company

Okay. But is the 22 – I am sorry to kind of beat this to death, but is the $22.5 million included in your guidance for the full year?

Steve Stewart

We exclude – when we do the without goodwill calculation, we are also excluding the non-cash loss associated with the exchange of equity for convertible debt.

Pearce Hammond -- Simmons & Company

Okay. Thank you. Then a housekeeping question. Probably the most recent exchanges of debt for equity, what is the share count currently for both basic and diluted?

Steve Stewart

So, if you look at the bottom of the condensed financials, the basic number is 41.7. I’ll just point out that number is slightly different from what’s on the front of the 10-Q, because we have issued restricted stock. Restricted stock that we have issued vests over a period of time. But for the front of the 10-Q, we show that restricted stock as if it is issued and outstanding, but for EPS, we do not include any unvested restricted stock. So the basic shares are 41.7 and then as I mentioned you add about a million shares to the diluted shares because of the 2 and 7/8 convertible notes we treat them as if converted. So you add that million shares and you add back to your earnings or eliminate the interest that you would recognize and then you come up with a number that’s about 44.8 million shares after you adjust for all of that.

Pearce Hammond -- Simmons & Company

Now, taken into account the most recent swaps or exchanges for debt for equity, we need to add obviously the share count will increase for that, are we going to need to increase this 44.8 by roughly seven million shares?

Steve Stewart

By what the shares that were issued in connection with both of the exchanges that were done in July total 8,350,000 shares. So you would need to take that 8,350,000 and add it to the shares outstanding. Again, you do this on a weighted average, so those are only going to be outstanding for one quarter. So, one fourth of that would get added into that – the weighted diluted average shares outstanding.

Pearce Hammond -- Simmons & Company

Great. And then just one final question. What is your expected cash as of the end of the September quarter?

Steve Stewart

We expect at the end of September there are – that we will have completed the ABL, we will have paid off the revolver, the ABL will be in place, we would anticipate being substantially undrawn on the ABL, and we’d have a few million dollars net of cash in our bank accounts.

Pearce Hammond -- Simmons & Company

Thank you.

Operator

Your next question comes from the line of Al Kaschalk with Wedbush Morgan.

Al Kaschalk -- Wedbush Morgan

Good morning guys.

Sharon Madden

Good morning.

Kirk Benson

Good morning, Al.

Al Kaschalk -- Wedbush Morgan

Kirk, my question and maybe yourself and for Bill, I wanted to talk about kind of where you are at internally on the coal cleaning and how that maps to the demand that you are seeing and if you could comment as to your hoping that demand stays soft or pricing stays soft or you would love to see pricing firm and demand increase because you have everything in order? So – I think and this would probably have to relate to 2010 or fiscal 2010 given where we are sitting, but if you could add some commentary on that in and around what you’ve already said about close to breakeven on an EBITDA basis.

Kirk Benson

I think one of the things that we are not hoping for is soft coal prices although I think because we have production capacity that is not being used and so if coal prices firmed up and I think we would be well positioned to take advantage of that increase in coal prices. So – and over time that will occur. The – a lot of Appalachian coal production has costs that are higher than the current sales price and so there has been about 100 million, somewhat has been (inaudible) basin coal, but a lot of – there has been a lot of tons that have come out of the marketplace as the market tries to reach equilibrium between production and demand. Now the inventories that are currently in place at the utilities is still pretty high because we had a fairly cool spring and so the electricity demand has been lower, which has resulted in higher inventories at the utilities than what they typically carry. All of that has meant that coal pricing has been soft.

What we – what -- Bill and his team have done a pretty good job, however, as we are kind like a new entrant into this coal market, and so Bill and has team have done a pretty good job identifying specific opportunities where we can sell our particular quality of coal. One of the good things about our Alabama coal, for example, in the thermal market, is it’s a pretty low sulfur content coal. And so utilities have an interest in blending some of our coal because of its low sulfur content and it helps them with compliance. And so, we’ve – even though we are in a very soft market, and we are – we think that that market is going to continue to be soft into 2010, we started to see some encouraging signs for our specific coal production. And so I think that it’s got to be – you got to put the edge to cautious in front of anything that you say because the markets are still very soft. But we are starting to see some encouraging signs albeit there is – it’s at the very beginning of something that’s encouraging and we have reduced our cost, so that our breakeven point is at a lower point.

Bill, why don’t you go ahead and add something – additional color to that response?

Bill Gehrmann

Sure. Good morning, Al. And Kirk addressed it pretty accurately. Obviously, from a pricing standpoint the ap [ph] coals we still see some struggle there from a pricing and volume standpoint. The Alabama coals -- and as we’ve gone through these plans and improved quality, what that has allowed us to do is firm up our pricing because I hesitate to call it introductory pricing but that’s somewhat what we have had in the past as we have introduced these coal fines to the customers. And based on the improvements in quality and demonstrated ability to handle these fines, it’s helped to stabilize that pricing. And as Kirk accurately pointed out, on the sulfur side – especially for the Alabama coal, typically you are going to see 1% sulfurs.

We are not 0.7%. And that definitely helps in there especially in the past when they have run scrubbers and it produced synthetic gypsum and had markets in a stronger construction market, building products product, now that market has softened considerably. A little higher sulfur content in your coal relates to a little more byproduct generated at the plant. So, we’ve got a little pricing strength there by mixing our coal to lower sulfur coal that results in some less disposal cost on the back side.

Al Kaschalk -- Wedbush Morgan

So we are – but we are still going to need some agreements and – to be put in place as the market adjust here or how are we set in terms of forward-looking contract, or potential forward contracts?

Kirk Benson

Well, what we are seeing out there right now, Al, is based on the fact especially in the steam coal, the thermal coal, that these utility sites are sitting on high inventories and we are getting into the time of the year where they start going and looking at 2010 commitments that it’s still reasonably soft out there. But, as I’ve pointed especially in the Alabama plants, we are starting to see some interest because of the quality. We also anticipate ramping up production, increasing shifts down there. And so we are starting to see especially in the Alabama piece of our coal cleaning plant portfolio some potential uptick in demand. Also, we have the opportunity in Alabama for met coal sales. You are seeing China rapidly start to ramp up theirs. I think in 2008 China imported about three million tons of seaborne met coal. We are seeing that potentially go to 30 million tons. And so we are talking a look at that with our partners down at Alabama as a positive sign in the met coal. We had the shipment to Brazil earlier in the year in March. Well actually it was this quarter we started it in the March quarter. But that was a fines only shipment. And what we are hearing is we had decent results with our met coal sales down there too. So, across a portfolio it’s kind of a mix, but we are optimistic that we are seeing some stabilization in pricing and some increase potential in supply and demand.

Al Kaschalk -- Wedbush Morgan

Okay and thanks for the color. This one is probably directed more towards the Building Products and I appreciate the hard work and the lack of volume that you are seeing or the reduced volumes. But are we at in terms of basing on a margin basis, particularly on the operating side. It seems like even with the lighter volume in Q3, that the operating margins may have been a little bit below where internally you had hopes, certainly a little bit lighter than we had hoped

Kirk Benson

I think when you look at – as Jack said, we had a fairly substantial reduction in revenue, but our EBITDA margin we only were off a few hundred thousand dollars from prior year at the EBITDA line and so that represents a fairly significant improvement from a cost structure perspective because our gross profit was actually increased year-over-year and so when you drop in as much as we did in revenue, but your gross profit increases and your EBITDA margins is substantially the same that reflects a significant improvement and a real victory on the part of the Building Products team. Jack, do you want to add something to that?

Jack Lawless

Yes, I want to, Kirk. I mean in the last four months, as I mentioned, our sales went off pretty materially in the last four months. I believe the number that I quoted was $47 million and EBITDA was only off $300,0000 or $400,000. So we feel very good about where our cost structure is and our EBITDA and operating margins are with today’s level of sales. We do expect them to improve as the industry recovers here a little bit. The other thing, Al, that you see is Southwest has performed -- Southwest Concrete has performed relatively better obviously than Eldorado and Tapco and Southwest generally has lower EBITDA and EBIT margins than the other two businesses. But overall I would be remiss if I said I wasn’t happy with where the margins are today relative to where the volumes are.

Al Kaschalk -- Wedbush Morgan

Thanks a lot.

Operator

Your next question comes from the line of John Quealy with Canaccord Adams.

John Quealy -- Canaccord Adams

Hi good morning. Just a couple of quick housekeeping ones. With regard to the add back to EBITDA for the convert swaps, through July how much gets added back to EBITDA for those?

Kirk Benson

In the June quarter we had with $29 million of gains that are included in our EBITDA then I think there was about $2 million of expenses that were also associated with those convert exchanges. So the number is $29 million gross and then there was $2 million of expenses. And I think you add back $29 million.

John Quealy -- Canaccord Adams

Okay. And with regards to the two just last month, what does that work out to or close to it?

Steve Stewart

The accounting expense that will be recorded is the $22.5 million.

Kirk Benson

We are now [ph] talking about the equity for converts, not the convert exchanges right?

John Quealy -- Canaccord Adams

Correct, yes.

Kirk Benson

Okay. So equity for the converts.

Steve Stewart

Yes, that’s about $22.5 million and as we mentioned when we are giving the guidance for earnings per share we are also including goodwill and that expense as an add back. Part of the reason, and someone might ask why are we adding that back to the other converts that flows through and part of the reason is if you look at the exchange of the equity for debt the $4.23 that I indicated that was the effective value of the stock that was derived in those exchanges. The accounting treatment doesn’t follow the economics of the transaction. Those transactions were very beneficial to Headwaters, but there is an accounting literature that requires an expense to be calculated based upon what date [ph] you find the inducement that caused the convert to happen. We don’t believe that has economic substance and that’s why, John, in looking at our guidance, we’ve included that as an add back with goodwill.

Kirk Benson

But generally, what we are doing is we are following the definition of EBITDA in our debt agreement. That’s what’s really driving this. And so that’s basically what we are dong is we are using the definition of EBITDA as primarily and principally the same as what’s in our debt documents. And so that’s what we are doing.

John Quealy -- Canaccord Adams

Okay. And the second question, in terms of summarizing the impacts of all of your cost optimization plans, if we look out into the fiscal 2010 timeframe, can you quantify for us from an operating expense perspective, should we look for additional cost savings or the percentage of new revenues or how shall we look at the potential cost outs in 2010 as compared to 2009?

Kirk Benson

If you assume that your revenue is flat and so that there is – so you can take the variable cost out of the analysis a bit, what we are doing is concentrating from a variable cost perspective on the contribution margin. And so our – what we want to be able to achieve is an improvement over the contribution margin that we’ve seen in 2009. So, a conservative perspective on 2010 will be a similar contribution margin. What our internal goals are is to improve that contribution margin.

From a fixed cost perspective, there will be – what will happen as you go into 2010 is you will have some of the carryover of the improvements that we have already put in place and so as again as we said in our fly ash business, we have identified $9 million of annualized savings and so far we’ve recognized about $5 million. And so there is a potential for $4 million or $5 million of incremental savings when you take into account a full year in that business.

In the coal cleaning business, we said that the annualized number is around $10 million, and we probably – we’ve recognized of course some of that probably in the range of probably half of it or something like that. And so that will continue into 2010.

Building Products as we answered that question before, the multiple millions of dollars that carry over into 2010 from the Building Products savings. So, by and large our – what we anticipate seeing is if you – it improved margins in 2010 even if revenues are flat because of the carryover of cost savings and also because we’ll be implementing new cost savings in 2010. So, it’s from a conservative perspective you could use similar margins. But what I think that we should have improved margins because the carryover of savings and also because we’ll have new cost savings initiatives in 2010.

John Quealy -- Canaccord Adams

And my last two questions. One, we talked a lot about fly ash, but if you could give us a little bit more detail on any stimulus related delays there, clearly there is a lot of drivers in Portland cement consumption, but can you touch on potential stimulus related impacts in the 2010 timeframe when more of this money gets expended for roads and infrastructure? And I just have one follow-up.

Kirk Benson

Bill, would you like to – why don’t you respond to that question?

Bill Gehrmann

Right. As I stated in the – stated earlier, we are only seeing about 25% of the projected stimulus funds get into projects in 2009. Also, typically from the concrete paving, the fly ash side of it, even once a project started we are still going to see a nine to 12 months delay before we see any activity from there. So we have seen some states in the Midwest, a few select state, Utah being one, where they’ve been a little ahead of the curve. We expect to start seeing volumes obviously stabilize. I think we’ve done a pretty good job compared to some of the -- what you are seeing reported from vertically integrated companies, larger ready-mix companies, their volumes are – have been off substantially more than ours have. So we see that – we’re stabilizing in the second to third quarter of 2010 and hopefully then the stimulus funded projects are ramped up where we start to see the paving piece of that and we can start to see some uptick in our volumes again.

John Quealy -- Canaccord Adams

And then lastly for Kirk in the past you’ve talked about monetization of some assets and clearly some coal cleaning were monetized, but could you give us some update on the status whether it’s ethanol or other pieces of the business where there is a desire to sell some assets or there is inbound increase?

Kirk Benson

Now, there is -- on the – in the Energy segment there is – we’ve got an opportunity of course to sell a couple of these coal cleaning facilities. Some of them have been idled. And so it’s – I think there is clearly an opportunity there. The ethanol plant which is – it’s kind of amazing because our ethanol plant is doing pretty well and the problem is that the market for ethanol plants is – has been below cost of construction, which doesn’t really give you an opportunity to sell the plant. We are much better off today keeping that plant than selling it because it’s – because that the income and EBITDA that it’s generating it is something that is in a sense a surplus asset that – but it – we are having very good results at our ethanol plant and it’s unfortunate that there is a not a market for those results. So it’s something that we could sell, but in today’s pricing I don’t think that’s very likely because it’s earning power is much greater than what the market gives us credit for.

Our hydrogen peroxide plant in South Korea is now profitable and is operating very well from an operations perspective. It’s an asset that we could sell and that wouldn’t have a negative on the long term valuation of the company. We are looking at some of the other technologies that we have developed and there is clearly interest in some of those technologies. And so we are having some conversation with some companies about those technologies.

And then we’ll look for opportunities in some of the others parts of our business for surplus assets and some of it – some being able to sell some assets that won't have a negative impact on the long term value and the long term increase in value of the company.

John Quealy -- Canaccord Adams

Thank you.

Sharon Madden

Operator, let me take one more question and then we will conclude the call.

Operator

Your last question comes from the line of Dan Mannes with Avondale.

Dan Mannes – Avondale

Hi good morning everyone. A couple of follow-up questions, first, on coal cleaning, can you give a little bit more color first on what happened in the pricing, was there a difference because it looks like it’s pretty much the same plants operating in this quarter versus the prior quarter, so were there for instance some legacy met coal sales or something like that in the last quarter’s results or what was it that – why are you selling it? It looks like the same output at a lower price, number one.

And number two, what was actually your production relative to what was the sale number for the quarter?

Kirk Benson

So, are you – you are wanting – you want to compare the March ’09 to the June ’09 or the June ’08 to June ’09?

Dan Mannes – Avondale

Sequential, so March to June.

Kirk Benson

So I think that the – there is a – one of the things that changed between March and June is the shift in the Utah facility from a tolling facility to a merchant facility.

Dan Mannes – Avondale

Correct.

Kirk Benson

And so – okay, that probably – that had a – I think that change in and of itself had material – that had a material drop in our average sales price per ton because of that shift. And I think there was also a bit of a shift. It was – you are absolutely right. There were similar facilities, but I think there was also a shift away from Alabama and to the Illinois basin coal. We had – we put in a – we increased the productivity in the two facilities that were in Northern Kentucky. And they are selling in Illinois basin coal, but we didn’t have – and the (inaudible) facility is one of our larger facilities and it in the March quarter didn’t contribute very much to sales although it operated, it’s productivity was pretty low. We made some changes in – that happened right around the beginning of the quarter and we had – it ended up doubling or maybe even tripling the output of that facility. And so there was a significant increase in the productivity out of the three facilities that are selling Illinois basin coal and I think that also had a major impact on change in the average price per ton. Bill, can you think of anything else that impacted that average price?

Bill Gehrmann

No, I think we’ve covered it earlier and I think you added further clarification there. As far as Dan’s question regarding production and shipments, as I have stated we’ve started to balance that. Obviously coming out of the March quarter, we did have some – we had some inventory, so we’ve balanced that in with the production. So, production to shipments is – was relatively neutral there, Dan.

Dan Mannes – Avondale

And as you had mentioned potentially starting up the Alabama units again in this quarter, and they haven’t idled all that long, and this is just to re-clarify, this is primarily for sale into the steam market not into the met market?

Bill Gehrmann

Right. Right now we are looking at the steam market obviously hoping we start to see some of the cautious optimism that we talked about come back in the met coal, but right now our plan in Alabama is to be producing steam coal. Obviously we are looking for that met coal and we are taking a look at all the Alabama plants, Dan. There is basically one even though we have five in the portfolio and when we say we bring them up now, understand that that may mean just adding a second shift to one of the plants that is operating that we are not at anywhere close to operating all five plants at this point in time.

Dan Mannes – Avondale

Assume just ramp up Greenfields?

Bill Gehrmann

That could potentially be one.

Dan Mannes – Avondale

Okay. And would you guys be able to provide any color I mean should we expect then that sales levels for the September quarter will be similar to this quarter or should they actually be higher given what you are talking about?

Bill Gehrmann

Hopefully we see a little uptick. We have some opportunities we are pursuing right now. Obviously as quickly as possible we are trying to take advantage of what we have been able to demonstrate in the marketplace regarding fines only movements and also the improvement in quality, but as we all understand that market continues to, especially on the steam side to be somewhat soft with everybody’s inventory. Everybody is bulging at the seams right now at plant side inventory. So, we see some opportunities. It’s just a matter of timing, obviously, and as whether we can take advantage of them in the next quarter.

Dan Mannes – Avondale

Got it. Last question on coal cleaning and I think you may have addressed this earlier but may be I just didn’t get it, coal cleaning standalone, especially given the lower recognized pricing, is coal cleaning anywhere close to breakeven in June or during the quarter or is that just alt energy--?

Bill Gehrmann

Right. As I said earlier in the scripted comments, for the month of June discounting, non-recurring cost of inventory and severance coal cleaning itself was close to EBITDA neutral.

Dan Mannes – Avondale

So you can theoretically produce coal at below $30 a ton, at breakeven levels?

Bill Gehrmann

Yes --

Kirk Benson

Theoretical.

Bill Gehrmann

Yes, theoretically. And obviously we are continuing to work on the – on our fixed cost structure. Obviously that’s somewhat volume related too.

Dan Mannes – Avondale

Got it. And just one last question just as we look at Q4 and understanding all the puts and takes on EPS make it somewhat difficult, could you give us maybe a look at EBITDA or cash flow or something that maybe is a little bit easier to get our arms around especially given the (inaudible)?

Kirk Benson

Why don’t – repeat that question one more time.

Dan Mannes – Avondale

Looking at Q4 and I know one of the prior questioners or prior callers had a question, sort of tried to walk through your EPS guidance and what really is embedded in Q4, given all the puts and takes especially on the tax line, could you maybe sort of redo that exercise for EBITDA or cash or operating cash flow or something that may be easier to reconcile from the outside.

Kirk Benson

Well, one of the things that we’ve given is, we haven’t given an EBITDA guidance itself for the fourth quarter. We have given guidance of $110 million to $120 million for the fiscal year and so we think that we are on track to be within that range and so when we get to – when the Q comes out we’ll – we can do the calculation – the EBITDA for the nine months and I guess then you can back into the fourth quarter pretty easily from that information. But we are still on track to be tomorrow $110 million and $120 million in EBITDA for the fiscal year.

Dan Mannes – Avondale

But you guys calculate EBITDA and I don’t want to say in an unconventional manner but its’ in line with the way you handle your covenants. So it’s – again it’s not all that easy to reconcile from the outside. So, do we – we do have to wait for the Q to get the first nine months of EBITDA on the same basis?

Kirk Benson

No, you can look in the press release. So the calculation of EBITDA --

Dan Mannes – Avondale

That’s trailing 12 months though.

Kirk Benson

Yes, that’s on a trailing 12 months basis. So, I am not sure what that number is for the nine months, but we are going to file the Q I think within the next – tomorrow--

Steve Stewart

Tomorrow or Thursday, yes.

Kirk Benson

And so when we do the – you should be – it should be – you should be able to compute it fairly easily. If you take the items that computes EBITDA and you are exactly correct, we are following the – we are following in our senior credit facility definition of EBITDA. But those items are identified in the press release. So you – the data will be -- I think the data is going to be available so that one can – you can make that calculation from the Q.

Dan Mannes – Avondale

Okay. I guess we’ll wait till then. Appreciate the color.

Sharon Madden

Thanks, Dan. With that we will conclude the call and thank you for your participation.

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Source: Headwaters Incorporated F3Q09 (Qtr End 06/30/09) Earnings Call Transcript
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