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Headwaters Incorporated (NYSE:HW)

F1Q10 (Qtr End 12/31/09) Earnings Call Transcript

February 3, 2010 11:00 am ET

Executives

Tricia Ross – Financial Profiles

Sharon Madden – VP, IR

Steve Stewart – CFO

Kirk Benson – Chairman and CEO

Bill Gehrmann – President, Headwaters Resources, Inc.

Jack Lawless – President, Headwaters Construction Materials, Inc.

Analysts

Mark Segal – Canaccord Adams

Steven Sanders – Stephens Inc.

Pearce Hammond – Simmons & Co.

Al Kaschalk – Wedbush Securities

Dan Mannes – Avondale

Operator

Good morning. My name is Rachel and I will be your conference operator today. At this time, I’d like to welcome everyone to the Headwaters Incorporated Q1 2010 earnings results conference call. All lines have been place on mute to prevent any background noise. After the speakers’ remarks, there will be question-and-answer session. (Operator Instructions) Thank you. Ms. Ross, you may begin your conference.

Tricia Ross

Welcome everyone to the Headwaters Incorporated fiscal first quarter 2010 financial results call. I would now like to turn over the call to Sharon Madden, Headwaters Vice President of Investor Relations.

Sharon Madden

Thank you, Tricia. Good morning everyone and thank you for joining us today as we report Headwaters fiscal 2010 Q1 results.

Today's call will be conducted by Kirk Benson, Headwater's Chairman and Chief Executive Officer; and Steve Stewart, our Chief Financial Officer. On the call joining us today also are Bill Gehrmann, President of Headwaters Resources; and Jack Lawless President of Headwaters Construction Materials. Both of who will be commenting on the individual business segments.

So before we get started, let me go ahead and read the forward-looking language. That certain statements made during this call including statements relating to our expected future business and financial performance maybe considered forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities 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, further events or otherwise, except as maybe required by law. You may find Headwaters annual report on Form 10-K, our quarterly report on Form 10-Q, and other SEC filings readily available from the SEC's website, Headwaters website or directly from the company.

With that, I will now turn the call over to Steve. Steve?

Steve Stewart

Thank you, Sharon, and good morning everybody, and welcome to our call. Attached to the press release that went out this morning are condensed consolidated financial statements. That include statements of operations for the quarter ended December 31, 2009 and the prior year 2008. There are also balance sheet attached to that as of December 31, 2009 and September 30, 2009, our fiscal yearend. My comments are derived primarily from those condensed consolidated statements.

We expect to file our Form 10-Q this week, and within the 10-Q needless to say we’ll provide significantly more information relative to what we’ll be talking about today. We believe the indications of stabilization we first noticed in our September 2009 fourth quarter appeared to be continuing into the December 2009 quarter. Even though we continued to experience weakness in the new housing and residential remodeling markets and a noticeable slowdown in commercial construction and infrastructure activity that directly impacts our sales of fly ash.

As we have mentioned, we have budgeted 2010 revenues to be essentially flat in comparison to 2009, and we continue to believe we will realize improved operating results because of the operational improvements in cost reductions implemented in fiscal 2009. Total consolidated revenues in the December quarter of 2009 decreased by approximately 26.5 million, or 16% when compared to the 2008 quarter. But our operating loss improved by over 30%. I believe the improvement in the operating loss is directly attribute to operational changes in cost reductions that we've implemented recently.

The capital restructuring we were able to complete in October continues to provide the benefits we had expected. Over 90% of Headwaters’ current debt has a maturity in calendar 2014 now. We currently have a $70 million asset-based revolving credit facility that at December 31, 2009 was undrawn. The working capital assets that support the ABL fluctuate during (Technical Difficulty).

Operator

Ladies and gentlemen, this is the operator. I apologize, but there will be a slight delay in today's conference. Please hold and the conference will resume momentarily. Thank you for your patience.

Steve Stewart

From operations going forward. And that these funds, along with our cash on hand, will be sufficient to meet our operational needs in addition to providing the necessary funds to retire our debt that matures in 2012. Headwaters total indebtedness at December 31, 2009 was $524.8 million on a gross basis, and $491 million net of debt discounts.

Headwaters’ current debt has a weighted average interest rate on the face amount of about 9.9% at December 31st, 2009. Of course, the interest rate that we’ll be recognizing in our financial statements will be higher than that as a result of the amortization of debt discounts. In addition to the cost reductions implemented in fiscal 2009, we have also significantly reduced our capital expenditures. Total capital expenditures for fiscal 2009 were $64.2 million, which was $52 million less than the prior year. We expect capital expenditures for 2010 to be approximately $35 million less than in 2009 or approximately $30 million. Capital expenditures through the December 31st, 2009 quarter was $7.3 million.

Our operations will continue to be seasonal, and as in the past, we expect to use cash to support our operations through the winter months and to be cash neutral as we build working capital in the June quarter and to generate cash in the September and December quarters. We believe we will generate sufficient free cash flow or be able to utilize our cash on hand to sustain our operations through the working capital trough of fiscal 2010 without the need to draw on our $70 million ABL facility.

In addition to the senior notes that we issued in October, Headwaters has three tranches of convertible debt. Our convertible debt totals approximately $197 million at December 31st, 2009. The accounting for convertible debt has changed several times over the last 10 years. On October 1, 2009, the beginning of our fiscal 2010 year, we adopted the requirements of FASB staff position APB 14-1.

This new accounting literature requires us to record interest expense on our convertible debt at what they define as a market rate on the date the debt was issued, which in all cases will be higher than the coupon rate on a convertible debt. This is because the value – there is always value attributed to the equity conversion feature. This value reduces the coupon rate on a convertible debt, and thus provides a lower coupon rate on that debt when compared to other debt that does not have a conversion feature. The new rules require retrospective application to all periods presented.

Adoption of these new accounting rules caused numerous changes to our financial statements, including recording debt discounts that reduce the face amount of our convertible debt balance by approximately $32.8 million. This face amount, net of our reduced by the related discounts is the amounts reflected in our financial statements. Increased interest expense will be recorded going forward, and we will effectively amortize this debt discount over the life of the related convertible debt. There was approximately $1.8 million of additional interest recorded in the December quarter, and we estimate our interest expense will increase by over $7 million in fiscal 2010 as a result of these new accounting rules.

Accordingly, while we expect cash interest payments to be approximately $52 million in fiscal 2010, the total interest expense recorded in the financial statements will likely be over $65 million after giving consideration to the new accounting for the convertible debt, amortization of debt discount and issuance costs, and the accelerated write-off of debt issuance cost resulted from our debt restructuring in October.

At December 31, 2009 there were approximately 60.4 million shares of Headwaters’ common stock issued and outstanding, which balances comparable to the balance we had at September 30th, 2009. Since the December 2009 quarter resulted in a diluted loss per share, none of Headwaters’ common stock equivalents which consist of stock options and stock appreciation rights, are included in our earnings per share calculation. When you compare the December 2009 quarter with 2008, there are a couple of non-recurring or non-retrieved items I want to mention.

In the December 2008 quarter, we recognized a gain of approximately $17.6 million related to convertible debt exchanges completed in that quarter. In the December 2009 quarter, there is approximately $3.3 million of non-recurring bank fees, included in our SG&A expenses, and $2.7 million of interest expense related to accelerated amortization of debt issuance costs, both of which resulted from the October debt restructuring. Additionally there is approximately $3.3 million of additional income tax expense included in the December quarter relating to re-determination of previous recorded tax liabilities.

The last item I would like to discuss our income taxes. The recorded income tax rate in the December 2009 quarter was approximately 38%. This income tax benefit was net of the 3.3 million of income tax expenses that resulted from the redetermination of prior years’ liabilities. If we were to add this amount to the income tax benefit of 8.6 million recorded in the December quarter, you would have had an effective income tax rate of approximately 50%.

Since the December quarter was a loss before income taxes, the income tax credits that Headwaters earns from the processing of refine coal increases the income tax benefit recorded. We would expect our effective income tax rate or benefit to be approximately 50% during fiscal 2010.

Headwaters does not expect to make any cash payments for federal income tax purposes in fiscal 2010. However, due to state apportionment rules, there could be a $2 million of cash payments for state income taxes. We expect depreciation and amortization, including stock-based compensation amortization in fiscal 2010 to be comparable to fiscal 2009.

We believe the signs of stabilization that we started to see towards the end of our fiscal 2009 are continuing into fiscal 2010. We are pleased with the activities of the quarter and in particular the debt restructuring that we successfully completed. We continue to believe that the energy technology segment will be on a positive EBITDA run by the end of fiscal 2010 and we believe that the combination of our coal cleaning operations with our fly ash business will help in accomplishing this goal.

We will continue to execute on operational improvements and cost reductions in all of our businesses in fiscal 2010. I would like now to turn the call over to Kirk Benson, Headwaters' Chairman and Chief Executive Officer.

Kirk Benson

Thanks you, Steven. I will make a few introductory comments and then turn the time over to Bill and Jack to talk about light and heavy building materials as well as our coal cleaning business.

During the quarter we were pleased to see positive year-over-year revenue comparisons in some of our products that are sold into the repair and remodeling markets. What's very pleasing to us is that these trends have continued into January, and we anticipate continued improvements as we begin to recover from the recession.

So Jack will share with you some additional color on our light building products segment in a moment. Shipments of fly-ash appeared to have reached a bottom in our heavy construction materials business. Although there is still some additional pressure that we'll see from a drop in commercial construction in 2010.

January shipments in the eastern central regions were comparable to last year. The western region in January the shipments were below last year, primarily because of heavy rains in southern California. So by and large we believe that we have reached a bottom in our fly-ash shipments but we'll still be subject to changing weather during the winter months.

We've seen some of the benefits from the stimulus funding but a greater impact as you would expect will occur in 2010 because the bulk of the funding has been obligated but not yet spent. The Portland Cement Association continues to forecast increased cement consumption in 2010. We made progress in our coal cleaning business year-over-year in its operating income. We still need to increase sales and capacity utilization, and so Bill will share with you that we're cautiously optimistic about an improving sales environment.

However, we don’t anticipate significant improvement in the March quarter. We think it will come later in the year. We have started to sell metallurgical coal. Last year when we had our met sales, our sales price per ton was always below spot market prices, and that raised a number of questions. So part of the reason for the discrepancy in our sales price per ton on the spot market is that the spot market is often quoted in f.o.b. vessel price.

Our sales price per ton is generally lower than spot because we've been booking revenue at an f.o.b. mine site price after adjustments for ash content and moisture content of the coal. So other factors include transportation to the dock, the adjustments from a metric to a short ton calculation and some taxes. So Bill I would turn the time over to you now to talk about the coal combustion products business, and then Jack will go over the light building products, then Bill will conclude with comments on coal cleaning. So Bill why don't you go ahead and give us your comments on the quarter for coal combustion products.

Bill Gehrmann

Thanks, Kirk, and good morning, everybody. Year-over-year revenue for the quarter in our coal combustion products business was down 17%. October revenue, which is typically the strongest month in the December quarter was down 31% on a year-over-year basis, as we had regions of the country experience two to three times their normal October rainfall.

In December, revenue was 9% below last year, so a very substantial portion of the revenue shortfall occurred in October. Product revenues continue to be impact in the three largest cement consuming regions of the United States with the largest weaknesses coming from the California, Arizona, and Nevada marks.

In addition to product sales, Headwaters' resources provides ash management services to many of its utility clients. These services include constructing and managing landfall operations, operating and maintaining material handling systems and equipment maintenance. While these services typically have lower margins than our product sales, they are not as seasonal and are nor is impacted by declines in construction spending.

We've recently added new doctors through the efforts of our utility services division. Site services revenue for the December quarter was up 12% on a year-over-year basis and was 32% of our total revenue for the quarter.

Gross profit for the December quarter was $12.5 million compared to $20.2 million for the December 2008 quarter. The year-over-year drop in gross profit is driven by several factors. Weakness in some of our higher margin product revenue market was coupled with an unusually wet October. The drop is also a result of changes in our overall product mix as a larger share of our total revenue came from site services, which I mentioned earlier carry lower margins than our product sales.

As we discussed on our last call on October 16th, EPA filed a proposed ruling with the OMB for the management of coal combustion residuals. While the EPA continues to support the beneficial reuse of coal combustion products, there are also concerned about safety of disposal impoundments after the breach of the wetting impoundment embankment in Tennessee.

Under the current the RCRA rules the EPA has no disposal regulation enforcement under subtitle D which is where fly ash is now regulated. To obtain enforcement of federal level, EPA may recommend that coal combustion product be regulated under subtitle C which may require a hazardous materials designation.

Whether the EPA recommends either subtitle C or D designation, the cost associated with the on or off-site management of coal combustion products will likely increase, creating opportunities for the continued growth in our utility services division. The subtitle C designation could also directly or indirectly limit the beneficial reuse of coal combustion products resulting in a risk to the supply as an opportunity to sell these products.

While currently no change has been made it to regulations, the industry anticipates a proposed changes by the EPA to give them more control over disposal sites will be forthcoming. Our year-over-year average fly ash price is flat, while cement prices are down slightly 3/10th of a percent and ready mix prices are up 3.2%.

Year-over-year cement consumption is forecast to increase 5.2% in 2010 primarily coming in the back half of the year and increasing over 16% in 2011. We continue to believe that the efforts we have made to expand our supply, reduce our overall cost structure and increase our focus on utility services is strengthen our ability to meet the needs of our clients and customers as the economy rebounds. Jack will now provide with you an update on our building product business.

Jack Lawless

Thanks, Bill. Good morning, everybody. Revenues from our light building products business in the December 2009 quarter were $71.2 million, a decrease of about $17 million or 19% from the December 2008 quarter. Despite the decline in revenues, our gross margin increased significantly 26.1% in the December quarter from 20.4% in the December 2008 quarter.

In addition, our operating margin increased to 2% in the December 2009 quarter from an operating loss of a negative 3.7% in the December 2008 quarter. These improved operating results are due to the numerous measures that our management team have implemented over the past four to five quarters. We expect these actions will continue to after positive impact as we move through fiscal 2010.

While our end markets continue to be weak, our current revenue trends are starting to show some signs of stabilization. In our first quarter, $14 million of the $17 million decline in our first quarter sales occurred in October with the last two months of our quarter only declining $3 million. In addition, a number of our remodeling product categories are starting to show positive revenue comparisons to last year.

For example, in the northeast, these categories are up 9.8% on a year-to-date basis, while an additional 13 states, mainly in our central and south-central regions are also showing year-over-year gains. In addition, some of our newer product offerings are starting to show some strength. For example, our foundry product line is up 7% through our first quarter.

In addition, at the recent builders show in Las Vegas, we formally introduced a number of new product these could provide some up side potential over the next 12 to 18 months, including our new trim board product, our outdoor living product line, and our resin based stone cladding line.

On a product category basis, we believe that our architectural stone line continues to have success increasing its market share in the high end of the stone veneer market. Its outdoor living product line was formally introduced at the recent national builders show as I mentioned in Las Vegas and received a very favorable reviews from the attendees.

This new product line has already been placed at over 20 distributors and should gain incremental sales and operating income in this fiscal year. Despite continued difficult business conditions, we continually to materially improve our working capital position, drive costs out of our operating system and improve all meaningful operating metrics in our stone business.

Our concrete block product category had a somewhat disappointing top line in its first quarter, mainly due to our very wet first three months in Texas, which prevented its customers from making as much progress as normal on its jobs, and to a lesser degree to a slowdown in this commercial side of the business. However, with cost cutting and efficiency improvements we still registered a solid operating income and EBITDA quarter. We expect to see top line improvement once the weather improves.

In our resin-based business, sales were down for the first quarter, but showed an improving trend with sales increasing on a year-over-year basis for the last two months of the period. In addition, EBITDA and operating income were materially higher than year-ago levels as cost improvements, efficiency gains, and to a lesser degree favorable product mix took hold.

Product sales from the remodeling side of the business enjoyed a relatively good quarter with 23 states mainly in the east, central, and south central areas of the country registering year-to-date gains.

On another positive note, as I mentioned, our foundry business exceeded last year's sales by close to double-digit gains in the first quarter.

In summary, we believe that sales in the building product group are starting to show some signs of stabilization, but we do not expect sales to begin trending ahead of last year's sales pace until at least the second half of our year. However, with the cost cutting and efficiency gains that we implement over the past several quarters, we expect to continue to see operating income and EBITDA gains as we progress through fiscal 2010.

Now I will turn it back to Bill to give an update on coal cleaning.

Bill Gehrmann

Thanks, Jack. December 2009 quarter revenues from coal sales were down 28.4% year-over-year, while tons sold was down 18.4% including December 2008 tons from tolling operations. The average revenue per ton for coal sold in December 2009 quarter was $35 per ton as compared to $52 for the December 2008 quarter when you exclude tolling operations. The year-over-year revenue and revenue per ton variance was primarily driven by the decline in metallurgical coal sales from the Pinnacle facility in general softness in thermal coal prices.

We continue to see the positive impact from the integration of our coal combustion product and refined coal businesses. SG&A costs were over a $1.5 million lower for the December 2009 quarter compared to the December 2008 quarter. In the coal combustion product business SG&A was over $400,000 lower for the quarter. Our ongoing focus on our continuous improvement initiatives resulted in another quarter where our fixed costs were lower by over $2 million compared to the September 2009 quarter, and by over

$5 million on a year-over-year basis. As a result of these efforts, our operating income for the December 2009 quarter improved 60% over the December 2008 quarter. According to EIA, total US electric consumption is forecasted to increase 1.6% in 2010.

Electric generation from natural gas is expected to drop from 22% in 2009 to 21% in 2010. However, the delivered price of thermal coal delivered to utilities is expected to drop 8% in 2010. This continued softness in prices is driven by high inventories and import coals which are projected to result in a 2.5% drop in US coal production in 2010. On the metallurgical coal side, consumption of coal at US Coke plants is forecasted to rise 10%, and global steel production is expected to rise 12%. For the December 2009 quarter, we operated at volumes below those required to break even.

We have idled our Chinook [ph] plant due to high inventory levels of utilities and softness in the thermal coal market. However, in December we started our Pinnacle plant with a one-shift operation and expect it to be operating at above break even volumes by the end of the March quarter. We've signed purchase orders for seaborne metallurgical coal sales as both blended product and fines-only shipments. As a result of this we have started one of the Alabama plants that had previously been idled and increased operations at two other Alabama facilities.

Last week we delivered the first fines-only shipment to a customer under one of these purchase orders. While the domestic steam coal market remains soft, we anticipate that the continued acceptance of our refined coal in both the thermal and metallurgical market will create additional sales opportunities for our Alabama plants. That in a combination with our ramping up of production at the Pinnacle plant and continued focus on our overall cost structure make us cautiously optimistic that we will continue to see corresponding improvements in our operating income for 2010.

Steve Stewart

Thanks, Bill. I think we'll now turn the time back over to the operator for the question-and-answer period.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of John Quealy from Canaccord Adams.

Mark Segal – Canaccord Adams

Hi good morning guys, it's Mark Segal for John. I was just wondering if you can talk a bit more about what drove the margin expansion on the construction material side, be it breakdown on new products, existing products, or better overhead absorption or a general combination of all, perhaps able to help quantify Tapco, Eldorado in concrete block, who is the leader there?

Kirk Benson

I think that you identified several of the different changes comparing last year's quarter to this year's quarter. And it really is a combination of a number of those different things. We had an improvement in our sales to in the repair and remodeling market, and so that basically constituted an improved mix in our product sales, and so some of our higher margin products actually had improved sales year-over-year. We also took a lot of costs out of the system, both fixed costs, and we've had some change in the variable cost as well, so those improving cost had an impact on the margins. So it was a combination of a number of things. So, Jack, why don't you add a little bit of color to that?

Jack Lawless

Yeah, thanks, Kirk. Yeah, Mark, it really occurred at all three companies. All three companies registered gross profit improvement over the prior quarter, and it really came from all facets of our cost structure in our cost of goods sold with the exception of indirect labor, which didn't quite fall as fast as you would expect as revenue, but everything else did. So it really came everything from materials, direct labor, overhead, transportation, and virtually all the costs. So we're pretty happy about that, that it occurred in all really of the cost areas, and at all three entities.

Mark Segal – Canaccord Adams

Okay that color is helpful. And then anecdotally, we have heard some instances of the release of stimulus funds for concrete projects in various geographies across the country. What are your expectations for the flow of funds, and can you help quantify any benefit you might see in 2010 on the fly ash side?

Kirk Benson

I think generally, the Portland Cement Association forecast of a 5% increase is something that is what we would expect to see. I don't think that we're being more aggressive than that. And then from a forecasting perspective, we've tried to forecast flat, so we did have a decline in shipments in the 12/31 quarter. A lot of that was attributable to weather, but some of it was also attributable to a decline in commercial construction. And we've seen some benefit from the stimulus bill, but we haven’t seen that much. So I don't think we would – we clearly won't be more aggressive than what the PCA has forecasted. Bill, have you seen anything else other than that?

Bill Gehrmann

I think we've shared previously some of the lesser populated states have actually let work a little quicker. Obviously those states are outside the larger cement consuming areas of the country, predominantly in the Midwest, upper Midwest, and a few western states. And as we shared, the slow release, coupled with a slow bidding process as they qualify bidders for this work, then plays into not only seasonality of our business but typically all the site preparation that takes place prior to any placement of concrete. So, as Kirk shared, I think we're forecasting somewhat step in step with the PCA relatively – some relatively flatness in market growth and consumption, and what gains we will see will be in the back half of 2010.

Mark Segal – Canaccord Adams

Okay, great. And then lastly, can you provide any more detail about the new oil conversion to biodiesel at the ethanol facility, what that might mean for you folks?

Kirk Benson

We think that we're really happy with both the construction of that ethanol plant and then the management of plant. We have some – we have excellent personnel, and in the period of time when many ethanol plants were losing money, and many of them actually going out of business and shutting down, we continue to have positive results at the plant. And so the folks are continually looking for opportunities to enhance revenue and margin. So we put in place some equipment that will take the oils from the corn feedstock, and allow us to use that, to sell that to folks that want to make biodiesel. So we think that it should end up generating, I mean, it isn’t going to materially change the performance of the business, but it will – it will generate additional several million dollars of revenue, and commensurate amount of EBITDA from those – from several million dollars of revenue. So it will be incrementally positive as we move into the second half of 2010.

Mark Segal – Canaccord Adams

Great. Thanks so much.

Operator

Your next question comes from the line of Steven Sanders from Stephen, Inc., your line is now open.

Steven Sanders – Stephens Inc.

Good morning, everyone.

Kirk Benson

Hi, Steve.

Steven Sanders – Stephens Inc.

First, maybe a question for Jack. Obviously the margins on the construction material side are recovering nicely. I know your comment was you wouldn’t expect to see the overall segment post year-over-year gains until sometime in the second half. Should we think about that as being the repair and remodel and getting pretty close to flat year-over-year, as we get into the spring, and the stone business recovering more in the June and September quarters?

Jack Lawless

Yes, I think that’s a correct way of looking at it, I think.

Steven Sanders – Stephens Inc.

And then is that a mix benefit? I think you basically indicated it was, but to the extent that the relative performance of the repair and remodel is better than stone, that’s a margin mix lift, isn’t it?

Jack Lawless

Yes, I mean generally speaking, the remodeling side of all of our businesses are operated at higher margins than the new construction side.

Steven Sanders – Stephens Inc.

Okay, and then I understand the weather problems in the Texas block business, maybe you could talk a little bit about your visibility over the balance of the year. In other words, would you expect to recover the lost sales and sort of come in flat in that business, or you think hat a potential to grow? How should we think about that?

Jack Lawless

I think the business that we lost in the last quarter with the weather will snap back. The institutional business remains strong, but the commercial side of the business will remain – will get probably weaker as we go through the year. So, I wouldn’t look at it as we expect to see sales gains in our Texas block business.

Kirk Benson

I think by and large, the block sales are probably going to decline for the year, year-over-year, primarily because of commercial construction in the Texas markets, and some flatness in institutional sales.

Steven Sanders – Stephens Inc.

Okay. And then maybe one for Bill, I know we are a little uncertain, and I’ve got a follow-up question on this about what the EPA is going to say, but are you starting to see a pipeline of service contracts related to that build, sort of regardless of what they say, I guess the management disposal costs are going up, so are you having those conversations with customers? Would you describe that as a fairly material opportunity for you over the next year or so?

Bill Gehrmann

Yes, Steve, we definitely are already bidding those types of projects, new landfill construction, wet-to-dry conversions. Those are actually in the works. So we are out – our utility services division is out with a lot of focus there and spending a lot of time looking at all the opportunities. So, yes, I think those opportunities are material.

Steven Sanders – Stephens Inc.

Okay. And then I don’t know if this is better for you, Kirk or Bill, but an EPA recommendation imminent, can you kind of walk us through what you see as the possible outcomes, kind of subtitle C down to maybe a more watered down series of recommendations?

Kirk Benson

I think Bill has been closer to that issue than I have been, although my perspective on it is that the EPA isn’t sure exactly what it is going to do, and the signals become a bit confusing. You know you have to have a little bit of sympathy for the EPA, because one of the things that they want to do is maintain or increase beneficial uses of fly ash. So they don’t want to do anything that has a negative impact on substitution fly ash for Portland cement, because that’s clearly the best possible thing that could happen with fly ash. On the other hand, they want to control these wet impoundments. And so they have a conundrum that they are working through. And so some of the signals are from the EPA are not crystal clear, and they’re changing, because they’re trying to work through this issue internally, and it’s difficult for them, and so you’ve got to have a little bit of sympathy for the position that they’re in, because (inaudible) somewhat inconsistent – somewhat inconsistent regulatory desires. But, Bill, why don’t you add some light, because you’ve been pretty close to the EPA.

Bill Gehrmann

Sure, Steve, I actually participated with the small industry group last week. We actually met with the administrator and her staff, primarily to discuss some of the potential stigma issues that are being discussed out in public forums. She basically prefaced the meeting that, you know this is all driven by the events after the embankment breach in Tennessee. She left no doubt in my mind that she and her staff continue to support beneficial reuse, but it gets back to an enforceability issue. Obviously over 50 states, there's a widespread disparity in regulations, in landfill specifications as far as construction. And that's what they're trying to get their hands around. They stated on a couple of times that they do not have anything definitive down in writing. They are still looking at different proposals internally.

In regards to subtitle C, in stigma of hazardous waste, there was actually discussion on their part that they would like recommendation from the industry to minimize any stigma, and actually internally you are looking under subtitle C, ways to get the enforceability under disposal that they desire while possibly designating CCPs is something other than hazardous waste. And that may be special waste. They didn't go into a lot of detail. But I walked away from that meeting, as Kirk shared, you get some mixed messages, but obviously they continue to be an advocate of beneficial reuse. But they're driven with a desire to get some enforceability over dispose.

Steven Sanders – Stephens Inc.

Okay. And there is no firm dead line for when they need to make a recommendation. Is that correct? So this thing could happen relatively quickly inside a month, it could also drag out?

Bill Gehrmann

That's my understanding, I think from an OMB time frame, typically when it was handed over to the OMB in the middle of October, typically that can run a 90-day course, which it did going into January. I think then OMB internally has the ability for a 30-day extension, which they obviously took. Puts it into mid February, obviously, and from that point in time, I do not have any concrete feel as to EPA presenting something from there, Steve.

Steven Sanders – Stephens Inc.

Okay, that's very helpful. Thank you for the additional color. Then the pinnacle facility specifically, can you remain us what the nameplate capacity is there? And then sort of how that should play out over the course of 2010, meaning at the end of the year if you do see some of the macro improvement, and some of the better demand for met, what would be kind of your target in terms of exiting the year for production on that facility?

Bill Gehrmann

The nameplate you’re rating on that facility is about 180,000 tons of refined product on an annual basis.

Steven Sanders – Stephens Inc.

Okay.

Bill Gehrmann

We would like to see some point in this year we may not reach those types of levels in this March quarter, but we fully anticipate trying to get that plane up to those types of monthly volumes.

Steven Sanders – Stephens Inc.

Okay. That's very helpful. Thanks.

Operator

Your next question comes from the line of Pearce Hammond from Simmons. Your line is now open.

Pearce Hammond – Simmons & Co.

Hi, guys. Thanks for taking the question. Bill maybe a question for you on this coal ash. There's been some talk EPA will ban the wet ash storage of coal ash but not declare coal ash to be hazardous. What is your take on that, and if so if that happens, what does it do to the business in general, and how – what time frame would something like that phase in?

Bill Gehrmann

Obvious this is all being driven by the incident in Tennessee, which was a worthy impoundment. I have heard discussions and speculation that a subtitle C may just land on wet disposal impoundments. Obviously there be a drive from there to take these wet to dry, to wet to dry conversion. So that is one of the many possibilities are out there.

With that being said, typically these sites where there is wet impoundment of ash have not been of good enough quality before to possibly economically justify wet to dry conversion now. Obviously with some of these drivers just from a disposal standpoint, and potential increase disposal, because obviously dry disposal, just the mechanics of it are more costly to utility, and essentially turning a valve and it's loosing material into a wet impoundment may help factor into some of those economic drivers and may allow some of that material now to get into the beneficial reuse side. So, you know, those are some of the things that the industry is weighing in on as we move forward.

Pearce Hammond – Simmons & Co.

And just taking a step back, I mean, I know the specifics of what's going to happen isn't necessarily clear just yet, but given the spectrum of potential results what does that do to the economics for a coal burning utility? From a per ton basis for a per megawatt hour basis have you guys – what do you think effects on their end is not necessarily just the Headwaters specifically?

Bill Gehrmann

Obviously it's going to increase their cost to dispose. It's hard to quantify that because it's going to be such a large range. Some of these power plants that are sitting out in very remote rural areas, have a lot of access to land, and expensive land that they currently own, it could be developed. Some of these other sites going to the other extreme are essential landlocked and may not have the ability to convert their disposal operation to a dry disposal operation on their current setting.

So they're going to have to look off site and go somewhere else which could result in substantially higher tipping fees that they may have to pay. So it's really hard to quantify that increase costs. It's going to vary significantly just based on a location of the power plant itself.

Generally it's going to put more pressure on the lower quality facilities, the older facilities and the ones that have – that are of – produce – are less efficient because they don't have as much of the economics to drive the cost of changing their disposal mechanism. So I think you will have analysis that will have to be applied to each facility to see what kind impact the increased costs will have.

Pearce Hammond – Simmons & Co.

Okay, great. Thanks for taking the question.

Operator

Your next question comes from the line of Al Kaschalk from Wedbush Securities. Your line is now open.

Al Kaschalk – Wedbush Securities

Good morning. If we can continue with Bill, that would be great. In terms of the volume on the coal cleaning side, based on the 8 million of tax credits that's disclosed in the press release, does that imply volumes are going to be slightly below where you had previously talked about for the full fiscal year?

Kirk Benson

One thing to take into account, of course, Al, is that the 8 million just relates to tons that are sold into the thermal market. So it doesn't include tons that are sold into the met markets. And we geared that projection based upon the new government guidelines, the IRS guidelines.

So the number saddle more conservative because we were cleaning some material that was a low quality coal that we think actually disqualify for the credit but may not be conservatively within the IRS guidelines.

So you can take the $8 million and divide it by the credits per ton and come up with a number of tons, but you also then have to add to that the number of tons that are sold into the met market, and you have to add to the it the number of tons that we might process of low quality on mine coal that might not fit conservatively within the guidelines.

So you've got two other factors that you have to take into account other than just dividing the credits by the credit per ton. And so I think that Bill Gehrmann go ahead and talk about production. I think that we're actually a little bit behind our plan relative to the number of tons that he we thought we would be producing. But we're only three months interest the year.

Bill Gehrmann

Right, yes, what I will add to that is, Kirk is exactly right. As far as our fiscal 2010 plan, we were a little behind overall production levels in Q1, a little lower than would we anticipated going into the year based on some of the opportunities, obviously quicker start-up of Pinnacle, which we originally looked at going into 2010 as possibly a potential late spring to early summer start-up.

Obviously we started that side up in December, so we'll see increased overall production benefits from pinnacle. We've also ramped up operations and production levels in our Alabama portfolio.

Those are primarily driven by met coal opportunities which don't play into the tax credits. But I think overall, at this point while we remain cautiously optimistic, I think it's safe to say that what we forecasted for 2010 production levels we will see with a little catch-up in the next three-quarters, and being agents more optimistic actually may surpass our original projections by just a little bit.

Al Kaschalk – Wedbush Securities

Maybe just more of an observation and well then to maybe test your reaction on this one. If I look at that time light building and the heavy construction segments, in particular on the light it seems like we're going to have some positive tailwind on the margin side even in an environment where it sounds like you're forecasting a flat top line number.

And on heavy it sounds like with the mix issue, from service side, that would also be a top line flatness but we could see some margin pressure namely at the operating margin line, really attributable to mix. So, just wondering how you could maybe comment on that as it relates to fiscal 10 full year.

Kirk Benson

One of the things I think is important to take into account is the impact of seasonality on these margins. And we didn't, in the heavy construction materials segment; we didn't have as good a quarter as what we had anticipated, primarily because of the weather in October. But from a margin perspective, we were within 200 basis points of what we expected. There wasn't that much margin deterioration in the 12/31 quarter from what we expected. A lot of that is because you have to be really careful in looking at the full year because of the seasonality.

There is as much of it as a 10 percentage point spread in margins between the quarters, between the 12/31 quarter and the 9/30 quarter. You can have a 10 percentage point spread in margins. That's primarily driven because of volume, and volume is driven by the seasonality. So, we have in the range of like a mid 55% contribution margin. So, it's very sensitive – the thing that these margins are most sensitive to is volume. I would say of the margin deterioration, the 12/31 quarter, 80% of it was the result of lower revenue, primarily in October, and maybe 20% of it was mix.

And so most of the impact on margins comes from seasonality and is because of the covering the fixed costs and the operating leverage in the business. So, for the year, we won't have a good sense of these margins until we get into the June and September quarters to see what the volumes are going to be. That's by far and away the most important factor influencing the margins. Secondarily, you have mix, but the most important factor is volume.

Al Kaschalk – Wedbush Securities

Could you make just, as a follow-up on last question, could you just make a comment in terms of your observations or the business head operation comments on going into Q1 and coming out of Q1, and then the first month of Q2 how that volume trend expectation – how your expectations on volume for the balance of this year?

Kirk Benson

I kind of said that in my introductory comments a little bit that what happened was we had a terrible October. And then what happened was that the shipments seemed to come back to more normal type of shipments in November and December, and then in January what we've seen is that the eastern region and the central region are comping ahead of last year on shipments in January. So, that what that says to me is that, that's an indication that we've reached a bottom relative to shipments, and we're starting to comp similar to what we did last year.

The exception to that was the western region, and I think a lot of that had to do with Southern California, and the rain in Southern California. Bill, why don't you go ahead and add some color to those comments.

Bill Gehrmann

Yes, I think, Kirk, you hit on most of the things. Obviously October, which is the lion's share of Q1, was severely impacted by weather and softness in the western part of the United States. As we've moved forward into January, we see the trends that we expected. I think this year it's a little easier than a year ago, where we saw some of the softening especially in the southern – in the Texas and the southwestern part of the United States, where we struggled a little more trying to determine what was weather related and what was actually being driven by softness in the construction economy.

I think we're a little more comfortable now, based on the volume trends, in being able to distinguish what is weather related, and we have had some of those obviously a lot of rainfall in the West Coast, and in some of the south-central part of the United States, early January, we were hit with some unseasonably cold temperatures. I think we can definitely track what is weather related. So, I think going back to the Q4 call where we had seen trends where we basically thought we had hit the trough outside of October and some January weather related impacts, I think we feel pretty comfortable with where we're at.

Sharon Madden

Thanks, Bill. Operator, let's go ahead and just take one more question and then we'll end the call.

Operator

Okay, your next question comes from the line of Dan Mannes from Avondale. Your line is now open.

Dan Mannes – Avondale

Thanks, good morning, and thanks for squeezing me in. Just a couple of follow-up question. First, can you – fly ash business, can you give some color on the overall exposure to the state of Texas versus the rest of the country, and was that were you saw the primary issues in terms of weather, or was it more broad based than that?

Kirk Benson

Yeah. October definitely was a very wet month for Texas, and obviously in some of those larger markets we saw up to three times our normal October rainfall. I think we do have a somewhat firm grasp, there is definitely some softness in that Texas market. I think you’re seeing that in some of the earnings results from some of the cement ready-mix companies. We're starting to see a little improvement, some signs in our stabilization work, which typically are prelude to potentially a little more increased construction activity. We've been seeing some signs there. So I think we've seen the bottom there and actually may start to see some improvement. But no doubt Texas is a large market for us, one of the top three cement consuming marks in the country, and we pay a lot of attention to the levels of activity there, Dan.

Dan Mannes – Avondale

Got it. Just switching real quick to the coal cleaning business, you gave really good color on pinnacle size and opportunity. Can you give a little bit more color on what you're doing in Alabama in terms of potentially ramping up capacity? Because I think you've been running couple of these facilities, just at fairly low rates for the last quarter or two.

Bill Gehrmann

Right. As I shared, we’ve actually brought one of the plants up that was idled; we’ve increased shifts at the other two. We continue to be optimistic, taking a look at opportunities. As I said, we’ve signed POs for met coal, not only fines only but also some blend shipments. Based on our production levels and our capabilities there, we continue to explore other opportunities, and things continue to look positive down there. As a result, we continue to ramp up production. Obviously we were quite cautious in Q1 until we actually had POs in place, just to make sure we weren’t building inventory with no sales to back them up. But, now we are ramping up production as quickly as possible, because we think there are the opportunities there to match those production levels with sales.

Dan Mannes – Avondale

Are there any direct POs with end buyers, or are they through the local coal mine?

Bill Gehrmann

Typically based on the structure of those agreements they participate in all of those in some form or fashion.

Dan Mannes – Avondale

Okay. Just two more quick ones, first, on the asset sales, have you guys made any progress or head way on some of the non-core assets? I know you had talked a bit about the ethanol performance had been very strong, and we get that, but just given the cost of the debt outstanding, it seems like there’s still an opportunity to reduce – divest some of the assets and potentially get – reduce some pretty high interest net out there?

Jack Lawless

We have several assets that we have identified as being non-core assets, and we’ve got at least one of the assets we’ve been – we’re far enough along that we're negotiating the definitive agreements on the sale of the assets. So we continue to be focused particularly on the convert debt that has a put date in 2012, and we feel pretty comfortable that we're going to be able to get some of these assets sold and generate the cash from operations and from the sale of some of these non-core assets to be able to make these payments.

Dan Mannes – Avondale

Got it. And then just last things a housecleaning item, maybe I didn’t see this in the release. Did you actually give a Q1 EBITDA number? I know you gave the trailing 12 months, but I was wondering if you had a Q1 number you could provide, especially if you can give by segments?

Kirk Benson

No, we did not provide a Q1 EBITDA number. It's going to end up being in the range on a consolidated basis, the adjusted EBITDA issued notice in the press release we added that little adjusted line, because we wanted to take into account some of the nonrecurring expenses that $3.3 million of fees that were paid as part of the restructuring. We thought that – because what we're trying to do is give a – like a – a recurring run-rate kind of a number. And so when you take into account the adjustments, so if you're talking about adjusted EBITDA for the quarter we're actually – it should be in the range of a $13 million to $14 million.

Dan Mannes – Avondale

For the quarter. Got it. Okay. That would be really helpful in the future if you would disclose a quarterly number rather than a trailing 12 months.

Kirk Benson

You'd prefer to not have the trailing 12 months?

Dan Mannes – Avondale

I think a quarterly number is more valuable to me. I can't speak for the other analysts.

Kirk Benson

Okay, very good, thank you.

Dan Mannes – Avondale

Thank you.

Operator

Thank you, Kirk, we probably will go ahead and end the call. We like to thank you all for participating. Good bye.

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Source: Headwaters Incorporated F1Q10 (Qtr End 12/31/09) Earnings Call Transcript

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