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Headwaters Inc. (NYSE:HW)

F1Q2011 (12/31/10) Earnings Conference Call

February 1, 2011 11:00 AM ET

Executives

Sharon Madden – VP, IR

Kirk Benson – Chairman and CEO

Don Newman – CFO

Dave Ulmer – President, Tapco International

Bill Gehrmann – President, Headwaters Resources and Heavy Construction Material

Analysts

Steve Sanders – Stephens Incorporated

Al Kaschalk – Wedbush Securities

Chip Moore – Canaccord

Dan Mannes – Avondale Partners

Edward McCabe [ph] – Clean Value Partners

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 first quarter fiscal year 2011 conference call. All lines have been placed to prevent any background noise. After the speakers’ remarks, there will be a question and answer session. (Operator Instructions). Thank you. Tricia Ross from Financial Profiles, you may begin your conference.

Sharon Madden

Hello, we lost Trisha. She’ll probably join us shortly. My name is Sharon Madden, I’m Vice President of Investor Relations for Headwaters Incorporated. I would like to welcome all of you to our call today as we report our fiscal 2011 Q1 results.

Today’s call will be conducted by Kirk Benson, who is Headwaters Chairman and Chief Executive Officer, and Don Newman, Headwaters’ new Chief Financial Officer. Also joining us will be Bill Gehrmann, who is President of Headwaters Resources and Heavy Construction Material segment as well as Dave Ulmer, who is President of Tapco International. Dave will be discussing Headwaters Life Building Products segment.

Before we get started with the call this morning, I would like to take a moment and remind everyone of Headwaters upcoming analyst and investor day conference being held in Salt Lake City on March 4 at the Grand America Hotel. It is a half day conference beginning at 8:00 am and concludes around 1:00 pm Mountain time. If you’re interested in attending, please feel free to contact me directly at 801-984-9428 or you can email me at smadden@headwaters.com.

As we start out call this morning, 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 in their nature, address matters that are, to a different degree, 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 my be required by.

You may find Headwaters’ annual report on Form 10-K, quarterly report on Form 10-Q and SEC filings readily available from the SEC’s website.

I would now like to turn the call over to Kirk Benson, our Chairman and CEO. Kirk.

Kirk Benson

Thank you Sharon. We’re very pleased with the quarter overall. Performance of our Heavy Construction Materials segment exceeded expectations for revenue and EBITDA margins. We anticipated that Light Building Products revenue would be soft compared to last year because of the end of the government home buyer incentive that expired in April 2010. We were also negatively impacted by increasing raw material costs in our Accessory Product group. The Energy segment had a very good quarter.

We had two major changes in personnel and this morning I’d like to introduce you to Don Newman, who has agreed to become Headwaters’ new Chief Financial Officer. We thank Steve Stewart to his commitment to Headwaters and the great service that he’s provided to us and wish him well in his second retirement from Headwaters. We welcome Don.

The second change happened in January. We announced that Jack Lawless would no longer be with us to direct our Light Building Products segment. Jack was with Tapco for many years and helped guide the company during his tenure. We felt the timing for a change was appropriate for Jack and Headwaters. The change removes one layer of management, reduces costs and evidence as Headwaters commitment to rebranding itself as a Light Building Construction Materials company.

The leaders of each of our major product categories will report directly to the CEO. We are already working on additional changes that will more closely integrate our product categories, which will lead to improved efficiencies and customer responsiveness.

We’ve invited Dave Ulmer, as the leader of our Siding Accessory product category, to present the Light Building Products script today. Dave will be taking Jack’s place at our accessories unit. Dave has over 20 years of experience in building products and ten years’ experience with siding accessories. We are very pleased to have Dave with us, and look forward to working with him to continue the development of our Light Building Products segment.

[Merky Lance] will continue to lead our Architectural Stone category and [Bob Wisnet] will continue to lead our Texas Block business.

Now we’d be happy to take any questions on either change in the question and answer period of the call.

Now turning to slide two, you can see Headwaters had a very good first quarter. Strong Heavy Construction Materials and Energy revenue led the way for an 11% increase in revenue and a 23% increase in adjusted EBITDA.

We repaid $10 million of our 16% debt, reducing interest expense for the 12 months by $1.6 million. Don will discuss our financial performance in more detail. Dave Ulmer will discuss Light Building Products and Bill Gehrmann will go through the Heavy Construction Materials and Energy.

Now I’d like to turn the call over to Don for a discussion of the quarterly financial results.

Don Newman

Thank you Kirk, and good morning and thank you for joining us. Before discussing slide three, I wanted to mention that we expect to file our 10-Q form later this week.

My comments will be directed to the slides that were sent out this morning and to a lesser extent, to the condensed consolidated balance sheet and statements of operations that were attached to the press release.

During 2010, we indicated that both our Light Building Products and our Heavy Construction Materials businesses had shown signs of stabilization. Those indications continued to be confirmed in the quarter ended December 2010.

Revenue for the quarter ended December 2010 was up 11% from the same period last year. Heavy Construction Materials revenue was up 13% year over year, largely due to increased service and ash sales.

Light Building Products revenue declined 2% year over year, reflecting continued soft housing construction repair and remodeling markets.

Energy revenue was up 74% year over year, largely due to coal cleaning, where revenue more than doubled year over year. We will discuss the segment performance in more detail in coming slides.

Gross profits were $32.8 million in the current quarter, a 12% increase over the same period last year. Gross margin percentage was 21% in the current quarter, which is consistent with last year’s gross margin percentage.

During fiscal 2010, we began tracking our contribution margin in addition to traditional GAAP measurements. Headwaters typically has a contribution margin, which is revenue less variable cash operating expenses, of between 45% and 50%. As revenue increases in the future, this high contribution margin has the potential to have a significant impact on Headwaters’ gross margin and operating income performance.

Operating expenses were down 1.2% year over year, due in part to cost reduction programs initiated in fiscal 2010. Headwaters has a significant amount of debt issuance costs and debt discounts that were amortized through interest expense. As a result, cash interest expense is much lower than interest reflected in our net income.

During the quarter ended December 2010, recurring interest expense totaled $14.7 million, which included $12.1 million of interest to be paid in cash and $2.6 million related to amortization of debt issue costs and discounts. Current interest expense also included $2.3 million of debt redemption, premiums and accelerated debt discounts and debt issue costs related to retiring $10 million of our 16% convertible subordinated notes in the quarter.

As a side note, cash interest expense on an ongoing basis for fiscal 2011 is expected to be around $47 million.

Losses before income taxes totaled $19.1 million for the quarter ended December 2010, which is a $3.4 million and 15% improvement over the same period last year. As we discussed in our last earnings call in early November, Headwaters appetite for taxable losses will be limited in fiscal 2011.

As a result, we have not recorded a tax benefit related to net operating losses or income tax credits generated in the quarter. In fact, in the current quarter, we have recorded a tax expense of $1.6 million, which largely relates to state taxes in profitable jurisdictions.

Although this tax benefits of net operating losses and income taxes generated in the quarter were not recognized in the quarter’s income, those benefits can be carried forward and potentially realized in future periods.

Consistent with prior periods, we have included income tax credits generated during the period in our adjusted EBITDA. Adjusted EBITDA for the quarter was $17.9 million, which is up $3.3 million and 23% from the same period last year. The increase reflects improved Heavy Construction materials, and coal cleaning performance.

As you know, we significantly strengthened our balance sheet during fiscal 2010 through debt refinancing and through retirements. We continue to focus on improving our capital structure. In November, we retired $10 million of 16% convertible subordinated notes. We have no material debt maturities until 2014 and we ended December 2010 with approximately $68 million of cash on our balance sheet.

Slide four shows our net debt to adjusted EBITDA ratio. Net debt to adjusted EBITDA was 4.08 to 1 at the end of the current quarter, which is consistent with the ratio at September 30, 2010 and is significantly better than the 5.47 to 1 at the close of fiscal 2009.

Net debt to adjusted EBITDA will change throughout the fiscal, largely due to changes in our cash balances, reflecting our seasonal working capital pattern.

During the quarter, we amended our $70 million asset based revolving credit facility to lower its borrowing rate and to increase flexibility to use the facility, including amending the fixed charge coverage ratio triggers and limits. We closed the current quarter with $116 million of liquidity, reflecting $48 million available under the revolving facility and nearly $68 million of cash.

Capital expenditures were $5.2 million in the current quarter, down 29% from the $7.3 million in the same quarter last year. We expect total capital expenditures for fiscal 2011 will be at levels comparable to fiscal 2010.

Slide five shows revenue and adjusted EBITDA trends since fiscal 2009. As you can see, we have had three consecutive quarters of year over year revenue growth since the low point in Q2 of fiscal 2010, due in part to aggressive steps taken by the management team to take out costs and improve operations.

We have now experienced five consecutive quarters of year over year adjusted EBITDA improvement. We are hopeful that these trends will continue as we move out of this recession.

Starting on slide 6, Dave will cover Light Building Products.

Dave Ulmer

Thanks Don, and good morning everybody. I would like to introduce myself. I’m Dave Ulmer. I’ve worked in the Light Building Products industry for over 20 years. I’ve been with Headwaters Accessories group for ten years and have most recently been responsible for all our sales, marketing, customer service and related functions. We have developed a very strong relationship with our customers and pride ourselves in service.

Starting on slide six, revenues from our Light Building Products segment in the December 2010 quarter were $69.7 million, a decrease of $1.5 million compared to the December 2009 quarter. The decrease in revenue for the quarter was primarily a result of lower sales from our manufactured architectural stone and siding accessory categories where sales fell $2.5 million in the quarter compared to the prior year.

First half comparisons for 2011 and into the June quarter will be difficult because federal tax incentives may have moved new construction and remodeling activity into periods prior to their expiration and out of the period subsequent to their expiration. Prior year revenue may have been higher than it would have been without the federal tax credits.

Revenue in the Light Building Products segment included a $1 million increase in our regional concrete block category in the December 2010 quarter, compared to the December 2009 quarter. This was the first quarterly increase in seven quarters for this product category, pointing to a stabilization of the Texas market.

We are excited about our opportunities in the concrete block category as the Texas market returns to a cycle of growth, new business recently developed with the big box companies and our new retail location for sale of brick and stone veneer.

In addition, our vinyl siding tool category, which is heavily dependent upon remodeling, was up 17% over the December 2009 quarter. Historically, remodeling has led the housing industry out of many of its past down cycles and it is expected that remodeling once again, will play that role.

Finally, we introduced a number of new products and line extensions, which were met with much enthusiasm at the recent International Builders Show in Orlando, Florida, including a cedar shake roofing tile, three new cellular PVC trim profiles, a line of accessories for fiber cement applications, new stone veneer profiles, a vinyl siding stone profile, outdoor living products, a 50th anniversary Tapco brake with numerous new design features and a line of sealers for our Eldorado stone products.

As you can see on slide seven, the impact from our lower revenue, higher material costs and a one-time benefit from the sale of assets that was included in the 2009 quarter, have made the combined effect of reducing our adjusted EBITDA by $4.3 million to $6.6 million in the December 2010 quarter.

Gross profit margins in the Light Building Products group decreased from 26% to 23% due to lost leverage on revenues as well as higher material costs. Cost of our primary resin material, increased 12% in the December 2010 quarter compared to the December 2009 quarter, but was flat to last year’s average cost.

All of our resin materials have experienced similar cost pressures over the prior 12 months. We have been successful in mitigating some of the upward pressure through the use of alternative suppliers and recycled materials, but we anticipate that there will be additional cost pressure throughout the remainder of the fiscal year.

We will continue to pursue cost reductions in all of our raw outputs through improved sourcing and alternative materials.

During the quarter, we completed two small product line acquisitions. We have been selling outdoor living products in our stone product categories for about a year. Sales have increased sufficiently that we acquired the manufacturer of the glass, fiber, reinforced concrete box system, allowing us to expand production and provide timely deliveries to customers.

We also acquired Study Build. Study Build is the manufacturer of mounting blocks for fiber cement siding. This is a very exciting line extension for us because James Hardy, one of the largest manufacturers of fiber cement siding, is recommending our product and promoting its use.

Now I’ll turn the presentation over to Bill, beginning on slide eight.

Bill Gehrmann

Thanks Dave, and good morning everybody. Revenue for the December 2010 quarter in our coal combustion products business increased 13% year over year. Overall product revenues increased year over year, though revenues continue to be weak in the three largest cement consuming regions of the United States, including California, Arizona and Nevada.

Headwaters Client services provides site services to many of its utility clients. These services include constructing and managing landfill operations, operating and maintaining material handling systems and equipment maintenance. While these services typically have lower margins in our product sales, they are not a seasonal, nor is impacted by declines in construction spending.

Client services revenue for the December quarter were up 8% on a year over year basis and were 30% of our total revenue for the quarter.

Slide nine provides a review of the proposed EPA regulatory changes. As we discussed on our last call in May of 2010, the EPA released a draft proposal for the regulation of coal that was submitted for public comment in June.

While the EPA continues to indicate that they support the beneficial use of coal combustion products because of the significant environmental benefits, including reductions in greenhouse gas emissions, they are also concerned about the safety of landfills after the breach of a wet [inaudible] embankment in Tennessee in 2008.

That proposal outlined two broad potential regulatory approaches for the disposal of coal combustion products. One approach is a sub title C designation for disposal, classifying coal combustion residuals as a special waste. This would provide the EPA with jurisdiction over the management of coal combustion products.

The other approach is a sub title D designation, which means that the coal combustion residual will be managed under the same guidelines as solid and industrial waste. Under this approach, individual states would have the jurisdiction for disposal regulations under sub title D.

The engineering standard for landfills are essentially the same under both approaches. [Inaudible] like the one in Tennessee, will essentially be phased out under either approach. The beneficial use of coal combustion products remains exempt from regulation under both approaches.

Under either approach, increased regulations for disposal are likely to increase the opportunities for Headwaters client services. The original 90 day comment period was extended 60 days and the deadline for comment was November 19.

The EPA also held eight public hearings in conjunction with the public comment period. It has been estimated the EPA received over 400,000 comments during the public comment period.

After review of the public comments, the EPA will go back to the OMB with final proposed regulation. This review is expected to take 18 to 24 months based on the number of public comments that were submitted and the EPA is under no legislative or jurisdictional deadline. Litigation over the final rule will also likely delay enactment for several years.

Slide 10 shows the year over year growth in revenue. Gross profit for the December quarter was $14.9 million compared to $12.5 million for the December 2009 quarter. Adjusted EBITDA for the December 2010 quarter was $11.8 million compared to $9.4 million for the December 2009 quarter, and the adjusted EBITDA margin for the quarter was up 190 basis points year over year.

Moving to slide 11, I will now update you on our Coal Cleaning business. December 2010 quarter revenues were up 108% year over year and up 8% over the September 2010 quarter. The average revenue per ton of coal sold in the December quarter was $39.00, an increase of $5.00 per ton year over year and an increase of $4.00 per ton compared to the prior quarter.

Headwater sold 452,000 tons of coal in the December 2010 quarter, compared to 253,000 tons in the December 2009 quarter.

On slide 12, you can see the adjusted EBITDA including tax credits, was $2.6 million compared to an adjusted EBITDA loss of $3.3 million for the December 2009 quarter, and an adjusted EBITDA of $1.1 million for the September 2010 quarter.

As we have discussed before, we continue to focus our sales efforts on the metallurgical coal market at all of the plants that have access to reserves that meet metallurgical coal specifications. We also continue to lower our ash content in order to improve quality and increase value.

We’ve begun to work at our Pinnacle plant that will allow us to expand our production capabilities, allowing for more volume to be sold into the metallurgical markets. We could see an increase in monthly production by the end of the March quarter from that project. We also feel that we can continue to increase the value of our metallurgical coal products by blending it with the coal being produced by our side hosts.

On the steam coal side of the business, we continue to reduce our cost structure. We are matching production to sales in order to manage inventory. We continue to look for opportunities to introduce new utility customers to our refined coal so that we are positioned when the market for steam coal rebounds.

Section 45 tax credits continue to be the focus of our steam coal operations. While the domestic steam coal market remains soft, we anticipated that the continued acceptance of our refined coal in the thermal markets will create additional sales opportunities.

Our increased focus on the metallurgical coal market and our efforts to improve quality and blend with other high quality metallurgical coal will continue to increase the acceptance and value of our met product.

These efforts, combined with the flooding in Australia and the forecasted growth in steel production, make up optimistic that we will continue to see corresponding improvements in our operating income for 2011.

Kirk Benson

Thanks Bill. We turn now to slide 13. Year over year revenues in our Energy segment increased 74% to $21.8 million. This revenue increase was after the loss of revenue of $3.3 million generated from our hydro peroxide facility that was sold in fiscal 2010 and from the sale of ethanol rinse credits during fiscal 2010, which have also been discontinued.

We achieved another milestone for our HCAT technology during the quarter. Neste Oil formerly acknowledged that it was accepting HCAT as a commercial technology. [Neeka Arola] is a Vice President and Refinery manager at the Porvoo Refinery. He was quoted as saying, “The work that we’ve done on this new catalyst technology has been ground breaking and is yet another example of Neste Oil’s commitment to staying at the front of the refining field.”

The introduction of HCAT technology has decreasing bowing and helped improve overall performance. HCAT technology will also improve the potential to increase conversion rates. Since the success at Neste has been announced, we have seen a significant uptick in refinery interest and we are more optimistic that we will begin to realize some of HCAT’s potential.

Slide 14 shows adjusted EBITDA increased from a negative $9.1 million to a positive $3.3 million in the quarter. We had to also overcome the loss of rinse credits and the sale of the hydro peroxide plant in our EBITDA numbers.

Looking at slide 15, you can see some of the takeaways for the quarter. Light Building Products continues to see soft demand and there is the potential for some raw material cost pressure. Heavy Construction Materials and coal cleaning had a very good first quarter with improving revenues and margins.

Overall, we are on track to achieve our guidance for 2011.

So I’d now like to turn the time over to the operator for the question and answer period.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Steve Sanders with Stephens Incorporated. Please go ahead.

Steve Sanders – Stephens Incorporated

Good morning everyone.

Kirk Benson

Morning Steve.

Steve Sanders – Stephens Incorporated

With Kirk may first, how should we think about the revenue and margin potential on Neste and then can you expand on your comments about the interest from other refineries? Do you have testing ongoing with one or more? What would be your reasonable expectation in terms of that process and then maybe adding another customer?

Kirk Benson

Relative to the financial model and what you could expect from HCAT is that the revenue generation is in the range of something slightly north of $1.00 per barrel of resid that’s treated with the material. So if you had a customer that had say 40,000 barrels per day, you can take the $1.00 a barrel and times the 330 days, and you’re going to get in the range of $12 million or so of revenue from a typical customer. It will be higher or lower depending upon the price per pound that’s negotiated, but it’s going to be in that $10 million to $12 million range.

The fixed costs that we’re required to carry this product is in the $7 million to $8 million range, and that basically is reflected in our P&L, all those fixed costs. So on the contribution margin for the – so sales is most of the variable cost, the variable cost being primarily the cost of materials, that contribution margin is going to be in the 40% range, 40% to 45%.

And so that’s basically how you could model this HCAT going forward, and we would not anticipate a significant increase in the fixed costs and it should be relatively stable as far as the variable costs are concerned.

The second part of the question was the increase in revenue. We actually have a second refinery that is currently running HCAT and so they’re in the process of evaluation. We don’t know how that evaluation is going to turn out although we’re quite optimistic because as we’ve been saying for a number of years, HCAT does what it is purported to do, which is it allows a refinery to reduce filing, which improves the efficiencies in their reactors.

So we’ve got another refinery that is moving ahead and of course, we don’t know how it’s going to turn out yet, but we have the potential of having a second customer.

Other refineries have approached us. There is some truth to that statement that once you get a commercial reference, it makes a huge difference and so we’re starting to experience that. We have two proposals now that we’ve made in the last three months or so, two refineries and so they’re starting to evaluate those proposals.

There is another couple of refineries that are moving in the direction of doing some pile plant tests on their own feedstock and I think that we are as optimistic as we’ve ever been relative to HCAT.

Steve Sanders – Stephens Incorporated

Okay, thanks. And then Bill, I think you gave us some detail on the service side of the (inaudible). It looks like the bulk class business was up substantially, so can you talk a little bit more about that and specifically address what you’re seeing in terms of pricing and volumes and some of your key markets.

Bill Gehrmann

Sure. Obviously product sales revenues were up year over year. Some of this can obviously be attributed to weather differences and some of the shovel ready projects finally getting to the point where concrete was being poured.

In regards to volume and pricing moving forward, Steve obviously the PCA fall forecast is basically forecasted just a slight increase in consumption going into 2011 based on the seasonality of the business and then being impacted by the weather we’re experiencing now.

It’s a little hard to get our hands around what we think consumption and volume of sales is going to be, but in talking across the three regions, we continue to be optimistic.

In regards to pricing, we’ve had some price increases in a few areas. Typically our pricing increases go into effect in April. We have taken a very close look at the various marketing areas and some of those will be seeing some fairly significant price increases.

The cement manufacturers basically have floated out $8.00 to $10.00 ton cement pricing increases and in the next couple of months we’ll be able to see how much of that sticks in the marketplace. But we do think there is some opportunity for pricing upside and as we come out of what is typically our lowest season, our lowest quarter as far as volume sales, we’ll be able to get a little better visibility on what volumes will look like for the rest of the year.

Kirk Benson

Steve, let me add a little bit to that which is relative to the March quarter, as everyone is aware, weather has not been our friend in January, and so the weather has put a bit of pressure on revenue both on the Light Building Products and Heavy Construction Materials going into the March quarter.

Steve Sanders – Stephens Incorporated

Right. Right. Okay, and then last question for Dave, welcome and I appreciate the color on some of the raw material pressures and some of the tough times. I did not hear you mention anything about pricing going forward so should we assume that that’s not really a lever you can pull at this point in the cycle?

Kirk Benson

Dave, I’ll lead into that a little bit. We’ve had some – we’ve had price discussions. You hear Bill comment on that from Heavy Construction Materials perspective. We’ve had the same kind of price discussions in Light Building Products.

I think that if we move into an inflationary period from a commodities perspective and raw materials perspective, pricing strategy is going to be very important at Headwaters and critical in maintaining margins because there is the potential of some inflationary pressures from raw materials and commodities.

So Dave, why don’t you go ahead and comment on that a little bit more?

Dave Ulmer

Yeah, I think that what we’re trying to decipher right now is where the market will settle after some pretty significant increases and we are looking at every brand we have and every product category we have to look at how the both raw materials impact them, and as well, some other costs regarding freight and packaging and those things, and we’re having some meetings in the next couple of weeks again with raw material suppliers to determine are we getting the best deal from them number one, and number two, what we have to do to raise our prices and how much those would be based on where did the market go and where is the market going to settle.

Steve Sanders – Stephens Incorporated

Okay.

Kirk Benson

The helpful thing is that we’re not the only ones that are experiencing these cost pressures from crude oil prices, so we’ve got a lot of company.

Steve Sanders – Stephens Incorporated

Okay. Thank you very much for taking the questions.

Operator

Your next question comes from Al Kaschalk with Wedbush Securities. Please go ahead.

Al Kaschalk – Wedbush Securities

Morning. Just following up on the cost side, I think it sounds like there’s going to – - you’re going to play a little bit of a waiting game here and we should expect in a volume flattish to down market on Light Building Products that margins should still see some headwinds going forward. Is that fair?

Kirk Benson

Yeah, I think that there’s going to be pressure on margins from raw material cost increases primarily those that are resin based. But as Dave indicated, we’re being quite proactive in addressing the issues so we’re being proactive on two fronts.

One is relative to the cost. For example, we’ve increased the amount of our recycled material and that’s had a beneficial impact on us and we’re also in conversations with suppliers. So we’re focused on the cost side of it.

But in some of our, as Dave indicated, we need to look at each one of our brands, because in some instances, it’s going to be easier for us to pass through those increased raw material costs for some brands than for others. It depends on market share. It depends upon the competitive environment, and so we’ve got to be – we have to be very strategic about price increases.

And then finally as I indicated, it’s a general issue, not an issue that’s specific to us, and that will be, that’s quite helpful because the other companies and competitors will be under similar margin pressures and so they’ll have an inclination to want to raise prices.

Al Kaschalk – Wedbush Securities

But can you refresh or recall what happened when oil was up in the 130 level? I know we were in a very sharp decline on a volume standpoint, but it seems like we’re going to be again, isolating to Headwaters, it seems like it’s going to be some delicate price increases in the market where the volume is pretty tough to come by.

Kirk Benson

What happened last time was we were able to raise prices and we were able to pass through those raw material cost increases and the price increases stuck, and it was – and so we were successful the last time around when we had these kinds of cost pressures.

So we think that we’ll be able to – - we’re certainly – it’s top of our list to be able to manage the issue. Only time will tell of course, how successfully we’re going to be and so we wanted to make sure that everyone is aware that there is the potential of some margin pressure because of raw material costs, but we have been successful with price increases in the past.

Al Kaschalk – Wedbush Securities

That’s helpful. And then on more of the strategic side, Kirk are you able to share or give us an update where you’re at on the thought process, whether you’re more firm on doing something or in keeping these businesses together or is there some evaluation or some time frame in the near future that you’re evaluating whether to segment them or drive a little bit of shareholder value here.

Kirk Benson

I don’t think there’s been a change in our general direction. We’ve indicated to the market that we are going to move in the direction of Heavy Construction Materials and Light Building Products and separate from the energy segment of the business.

I think that continues to be our strategy. We feel like we are – the confusion of being in energy and construction materials we believe, continues to have a negative impact on our valuation, and we’ve worked hard to improve the financial performance of the energy segment, and you can see the evidence of that in the 12/31 quarter.

And so we’re having some success in making the energy segment more valuable that facilitates our strategy to separate. And part of that strategy to separate is focused on valuation from a market perspective and our belief that we are discounted because we are in these different sectors, and so we want to address that issue.

But the other thing that we want to address is the balance sheet, and so to the extent that we could sell some of the non-core assets and generate cash to pay down debt, that’s a high priority for us to accomplish.

Al Kaschalk – Wedbush Securities

And then finally if I may, given the guidance, what does that imply, what type of range are you targeting on free cash flow and if it’s a metric of revenue that’s fine, but is $40 million to $50 million a number that’s feasible to achieve in fiscal 11?

Kirk Benson

If you take our EBITDA number, our guidance is $85 million to $100 million and as we indicated, we’re on track to achieve that objective. Our trailing 12 months EBITDA I believe, as disclosed in the press release is about $98 million. So we continue to feel comfortable that we’re on track to achieve that kind of EBITDA.

From the EBITDA we’ll have cash interest expense in the range of $47 million to $48 million and CapEx in the range of $20 million to $25 million, and income taxes in the range of $1 million to $2 million.

Al Kaschalk – Wedbush Securities

Okay, so that, if I did my math and followed along, you’re about $20 million to $25 million of free cash flow.

Kirk Benson

I think that’s a little bit high.

Al Kaschalk – Wedbush Securities

Okay.

Kirk Benson

One of the things that make that number is a little bit high is you need to back out. To really get to a cash flow number, as everybody knows, we include credit in our EBITDA number, and we’ve been doing that for 10 years, so we’re being consistent in doing that. But if you back out those credits of about $8 million or so, $7 million to $8 million, that would reduce the amount of the real cash flow.

Al Kaschalk – Wedbush Securities

Thank you.

Operator

Your next question comes from Chip Moore with Canaccord. Please go ahead.

Chip Moore – Canaccord

Just looking at the model on the expense side, it looked like SG&A came in a little better than we were expecting. Maybe you could just talk about run rates there going forward.

Kirk Benson

I don’t think that there’s anything that we’re currently facing that would dramatically change the trend in SG&A. We did have a few things going on in the quarters that we had some severance in the 12/31 quarter and we’re going to end up with some severance in the 3/31 quarter as we made some changes in the Light Building Products business.

We think there’s some continued opportunity for some changes there. And so there could be some one-time effects in the 3/31 quarter. Generally though, I think the trend for SG&A is pretty flat. I don’t see any real strong pressures up or down for SG&A. Maybe we might actually be able to improve it a little bit.

Chip Moore – Canaccord

Okay. That’s helpful. And on coal cleaning, maybe you could give us the mix of met versus steam coal and then where you see that going once you get Pinnacle ramped up.

Kirk Benson

So Bill, you’ll probably want to respond to this from a percentage of the total production, how much is steam and how much is met. I know that during the year, we turned on some of these steam facilities. We had more of the steam facilities idled a year ago than we do today.

And so we’re producing more steam coal today than we did a year ago. But we’ve also got opportunities in the met side as well. So the dynamics are changing a little bit, but probably the percentage of the steam is probably going up a little bit because we turned on these facilities.

But Bill, why don’t you go ahead and add to that.

Bill Gehrmann

Sure. Going back year over year, the December 2009 quarter, steam coal represented roughly 95% of our overall sales tonnages. As Kirk mentioned, at that point in time, met coal, Pinnacle was just starting to come back up and run at that point.

We have four steam coal facilities idled. We brought some of those online. For this past December, 2010 quarter, steam coal was 75% of our overall sales. Steam coal sales were up about 100,000 tons year over year, but as we ramped up our met coal production and sales, that number grew larger. So steam as a portion of overall sales actually declined.

Chip Moore – Canaccord

Okay. And sticking with the coal cleaning side, any update on divesting any of those individual assets?

Kirk Benson

I think we continue to make progress. We’ve gone through a number of potential buyers and we have discarded some of those buyers as transactions that we don’t think meet our criteria or goals. We have identified new buyers and so we’re basically going through a process of identifying transactions that will meet our financial objectives as well as our operating objectives, so it’s going to be a continuing process.

We’ve identified a couple of folks that may be interested in an entire portfolio, although I continue to believe that the most likely outcome is individual sales. We would probably favor a transaction of the entire portfolio that – but I know there are couple of instances where we’re working on that.

But it’s at this point I think the more likely outcome is one off sales and that means it’s going to take a while for us to get this done.

Chip Moore – Canaccord

Yeah, I guess just last one on the balance sheet, can you talk to us about next priorities for debt repayments, what we should be think there.

Kirk Benson

We’re trying to continue to be relatively conservative relative to our cash management and making sure that we both from a seasonality perspective, as well as contingencies. And so as we feel comfortable in repaying more of the debt, excluding asset sales, because if we sell assets, then that’s generating additional cash, which will be easier for us to apply to a debt repayment.

I think that we continue to have $9 million of 6% to 8% debt on the balance sheet, and so that’s one alternative for repayment, and then after that’s done, we then will turn to the senior debt for repayment, and we’ve got of course plenty of senior debt, so that will take us a while to get that repaid.

Don Newman

This is Don. One thing to think about on the structure, we have also the 14.75% debt that’s sitting on the balance sheet. We are restricted from being able to pay that down before maturity, so logic would say well why wouldn’t you attack that 14.75 debt before you go to the senior debt. That’s the reason why we’d go to the senior debt first, because we are restricted.

Chip Moore – Canaccord

All right. Thanks.

Operator

Your next question comes from Dan Mannes with Avondale Partners. Please go ahead.

Dan Mannes – Avondale Partners

Thanks, good morning.

Kirk Benson

Morning.

Dan Mannes – Avondale Partners

A couple of follow up questions here. First, on the Light Building Products side, you had a comment on your slide about some acquisitions of new products. Can you give us a little color first what if any contribution they had in the quarter, and two, what the cost was of acquisition.

Kirk Benson

I think – they were both small, so they’re like product line category extensions and so they’re small both from an acquisition perspective as well as a perspective of a contribution in the quarter. I think they’re probably in the range of $2 million to $3 million is the range of the acquisition cost.

As far as the contribution during the quarter, it’s the outer living product was probably more than the Sturdy Build, which is the mounting block toward the fiber cement, but I would say there’s probably – - I mean it was negligible. It was probably in the hundreds of thousands of dollars range, and so not much in the way of a contribution.

Dan Mannes – Avondale Partners

Okay. No, that’s helpful. Briefly on the coal cleaning side, you mentioned your mix at about 75% steam, 25% met. Can you talk to us at all about sort of the sales cycle versus the production cycle? I’m just wondering if there is sort of any one thing, i.e. sort of loading up a boat or something like that so you sold more in a quarter than in the next, especially on the met side. It just seemed like it’s been lumpier than we would have thought from a revenue recognition standpoint.

Kirk Benson

And I think Bill can add color to this, but the met is going to be somewhat lumpy because of the way that the shipment works. The steam should be less so, but the met certainly will be. So Bill, what do you think?

Bill Gehrmann

Yeah, I think we shared some of that. You know for example, when we made the shipment to China, that required roughly 55,000 tons, so it did take us a little while to produce and get that material down to where it was loaded on a ship.

Right now most of our shipments are going out in 20,000 to 30,000 ton vessels, or pieces of those, so we may see a little smoothing out of that, and as we get into the blend in some of the things our site hosts are doing with facilities they’ve picked up, will allow a little more steady movement.

So unless we get into some large shipments, 50,000 to 50,000 tons of – and that’s typically been (inaudible) only, I think we’ll see some of that lumpiness smooth out moving forward.

Dan Mannes – Avondale Partners

Is that fair to say though that it maybe impact this quarter. Maybe you sold more than you produced in this recent quarter. That’s something you expect to change going forward?

Don Newman

As we’ve shared Dan, what we’ve done is tried to match production to sales. If you take a look at our overall production to our sales for the last three quarters, we have essentially done that so we feel pretty good. But there are going to be times where you’re going to see a variance from one to the other if we have a large movement all at one time, where we had to ramp up production to match a shipment in the following quarter.

You may see some of that but we’ve made quite an effort to forecast, accurately forecast our needs and produce to those needs.

Dan Mannes – Avondale Partners

Sure. And then briefly on the tax credit side, you guys noted I think it was about a $2.9 million add back to adjusted EBITDA for EBITDA relative to tax credits, and my impression was you’re only getting the tax credits which is a little over $6.00 a ton on the steam coal piece and based on the 75/25, the steam coal piece was only about 340,000 tons. So I guess I’m just wondering, were there, are you booking tax credits on the met coal piece or is there something else I’m missing?

Kirk Benson

You can’t let the – - so the credits don’t apply to the met coal so it’s only on the steam coal. And there is one other. There is a tax credit that is associated with the ethanol facility that happens once a quarter and it’s the 12/31 quarter, and I think there is a little bit of that total number includes a credit from the ethanol facility.

So there is – - that only happens once a quarter and I think that is in the 12/31 number, and that probably explains a little bit of the difference.

Dan Mannes – Avondale Partners

Okay. Real quickly just on the tax side, as you look out to third and fourth quarter, to the extent that you are operating income positive in those quarters given they’re seasonally stronger, will you pay taxes in a normal fashion then or will it still be at sort of the current negligible level?

Kirk Benson

I think that – - I don’t think you do until – - Don, you answer that question. It’s a little more technical. It’s over my pay grade there.

Don Newman

What you can expect is something similar to what you saw this quarter. The requirement under the U.S. GAAP is that you have to have evidence over some period of time, and think in terms of multiple quarters, that you have an appetite for the credits before, excuse me, for the tax benefits including NOL’s and credits before you can start recognizing those as a good guy in your financial statements.

And so we’ve got to become profitable and then evidence that that profitability is not an anomaly before we can start picking those benefits back up in the income statement.

Dan Mannes – Avondale Partners

I’m not even talking – - I’m saying would you book normal tax value? If you make $1 million pretax in the third quarter, will you actually be booking for 40% tax provision or will it still be at the current nominal rate?

Don Newman

No, it’s the current nominal rate.

Dan Mannes – Avondale Partners

Okay. So we may be waiting into maybe late next year or maybe even later before you look like a sort of more normal tax person

Don Newman

That’s correct.

Dan Mannes – Avondale Partners

Okay. And then just the last thing from a presentation perspective, on your slides, the energy technology segment, the EBITDA you show there, is that inclusive of coal cleaning or is that the energy segment ex coal cleaning?

Kirk Benson

That’s inclusive.

Dan Mannes – Avondale Partners

Okay. Got it. Thank you.

Kirk Benson

Okay.

Operator

Your next question comes from Edward McCabe [ph] with Clean Value Partners. Please go ahead.

Edward McCabe – Clean Value Partners

Hi everybody. Kirk could you kind of size the market for the HCAT business. Does it apply only to ebulated bed refiners and how many are there and how many barrels per day would your technology apply to?

Kirk Benson

The initial niche in which we are focused is the niche defined by the ebulated reactors. The technology does have application beyond the ebulated bed reactors and so there is a much broader opportunity. But that broader opportunity is more difficult to attack because the CapEx is higher, and so as we get a – - as we’re successful in this ebulated bed market niche, that will position us for this broader application of HCAT.

Now, the ebulated bed niche, the current production is about 500,000 barrels per day. There are a number of facilities in the process of construction so that 500,000 is going to up to in the range of 700,000 to 750,000 barrels per day over the next couple of years and there are a number of refineries that are looking for expansion beyond that 750,000 barrel per day number, so even that niche is a growing market.

Edward McCabe – Clean Value Partners

Right.

Kirk Benson

There’s a growing application even within our niche.

Edward McCabe – Clean Value Partners

That’s great. And you may have touched on, or Bill may have touched on this during his coal section, and I hopped off for a second. But do you have plans for those three idle facilities to bring them online anytime soon? And I assume those are steam or thermal coal facilities.

Kirk Benson

Yes. They are steam facilities and each one that has a little bit of a different story and so I don’t think those facilities are going to be coming online in the next – - it could be next fiscal year before those three facilities come back online.

Edward McCabe – Clean Value Partners

Is it, are there operational issues or just not enough demand to get them going?

Kirk Benson

It’s mostly, it’s mostly – - well, it’s a – - as I said, each one of them has a different story. Feed stock is a big issue, and so feed stock is probably the predominant issue.

Edward McCabe – Clean Value Partners

Right. Okay. That’s great. And this is a question, as it regards, if you sold a steam facility and you have the tax credit sitting in your balance sheet but you can’t utilize them currently because you’re not profitable. Can you sell those tax credits along with the facility?

Kirk Benson

Yes. A transaction could be structured that way. It becomes more complicated.

Edward McCabe – Clean Value Partners

Right.

Kirk Benson

But there is a transaction structure that would accommodate that.

Edward McCabe – Clean Value Partners

Okay. Okay, good enough. Thanks very much guys.

Sharon Madden

Thank you everyone. Operator, with that, we will go ahead and conclude our call. We’d like to thank you all for your participation. Thank you.

Operator

Thank you. This concludes today’s conference call. You may now disconnect.

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