Headwaters Inc. F1Q08 (Qtr End 12/31/07) Earnings Call Transcript

| About: Headwaters Incorporated (HW)

Headwaters Inc (NYSE:HW)

F1Q08 Earnings Call

January 29, 2008 11:00 am ET


Tricia Ross - Financial Relations Board

Sharon Madden - Vice President of Investor Relations

Steven G. Stewart - Chief Financial Officer

Kirk A. Benson - Chairman and Chief Executive Officer


Al Kaschalk - Wedbush Morgan

Chip Moore - Canaccord Adams

Bill Gibson - Nollenberger Capital

Pearce Hammond - Simmons & Company

Michael Molnar - Goldman Sachs


Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Headwaters Inc., first quarter 2008 conference call. During today’s presentation, all parties will be in a listen-only mode. And following the presentation, the conference will be opened for questions. [Operator Instructions]. This conference is being recorded today, Tuesday, January 29, 2008.

Now I’d like to turn the conference over to Tricia Ross with Financial Relations Board.

Tricia Ross

Welcome to Headwaters Incorporated fiscal first quarter 2008 conference call. By now, you should have received the press release outlining Headwaters’ results for the quarter. If you have not yet received the press release, please contact my office at 213-486-6540, and we will get a copy to you right away.

Without further delay, I would now like to turn the call over to Sharon Madden, Headwaters’ VP of Investor Relations.

Sharon Madden

Thanks, Tricia. Good morning everyone. Thank you for joining us for our first quarter fiscal 2008 conference call. The call will be conducted by Kirk Benson, who is Headwaters’ Chairman and Chief Executive Officer, and Steven Stewart, our Chief Financial Officer.

Before I begin this morning with the Safe Harbor language I would like to remind everyone of our upcoming “Analyst Day” that will be held here in Salt Lake City on February 28 and 29. If you would like further information please contact me directly and you can do that my phoning me at area 801-984-9400 or e-mailing me at smadden@headwaters.com. Let’s begin the call.

Statements in this presentation that are not purely historical in nature are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended, including any statements with respect to anticipated activities using Headwaters’ technologies and anticipated financial results.

Actual results may differ materially from such forward-looking statements due to a number of risks and uncertainties. Additional information concerning factors which could cause results to differ materially from those in the forward-looking statements, can be found in Headwaters’ most recent annual report on Form 10-K, quarterly report on Form 10-Q, and other SEC filings by Headwaters. These are readily available from the SEC’s Internet website, Headwaters’ website, or directly from the company.

I will now turn the call over to Steve Stewart.

Steven G. Stewart

Thank you, Sharon. Good morning everyone. Welcome to our December 2007 quarterly conference call. Attached to the press release, as Tricia mentioned, are the condensed consolidated financial statements that include statements of income for the quarter ended December 31, 2007 and 2006.

There are also balance sheets as of December 31, 2007 and September 30, 2007. My comments are taken primarily from those condensed, consolidated statements. We expect to file our Form 10-Q at the end of the week.

Headwaters’ first fiscal 2008 quarter was significantly impacted by the continuing record high oil prices. These high oil prices caused a significant increase in the Section 45K tax credit phase-out percentage which significantly reduced the Section 45K tax credits earned at Headwaters’ own facilities and caused some of Headwaters’ licensees to reduce production levels or completely curtail operations, thus significantly reducing our chemical reagent sales and license fees.

We have estimated that these events reduced the earnings per share from Section 45K operation in the December quarter by $0.14.

Headwaters’ December quarter was also negatively impacted by the continuing weakness in the new housing and residential remodeling markets. Margin improvement initiatives put in place in the building products business during the last half of fiscal 2007, have carried into the December quarter.

Fiscal 2008 will be a transition year for Headwaters as the synfuel business comes to a stop and revenues and tax credits from the new clean co-operations continue to increase. We are pleased with the continued strength and growth of our coal combustion products segment, or CCPs.

We continue to be optimistic about the potential opportunities in 2008, as we move closer to possible commercialization of our technologies. Our debt structure is strong and positioned well and our cash flow healthy as we move into some of these uncertain times.

Our consolidated revenues for the December quarter of $248.9 million were 9% lower than the 2006 period. Gross profit declined 21% when you compare the 2007 quarter to 2006. This decline was entirely the result of lower chemical reagent sales and license fees from the Section 45K operations.

Both the gross profit and gross margin in the construction product segment improved, when you compare the December 2007 quarter with 2006. The gross profit in the CCP segment improved as a result of the increased sales in the 2007 quarter, and gross margins were comparable to 2006.

Consolidated operating income declined by $15.5 million or 46%, which was again entirely the result of Section 45K operations. Operating income increased $2.3 million, or 35% in the construction product segment and $1.8 million, or 14%, in the CCP segment.

Our income tax rate increased from 26% in 2006 to 40% in 2007, entirely as a result of the significant increase in oil prices and the resulting increase in the Section 45K tax credit phase-out.

The estimated phase-out percentage increased from 54% at September 30, 2007 to 72% at December 31, 2007. This increase caused a cumulative adjustment to Section 45K tax credits expected to be earned during the calendar 2007 year from Headwaters synfuel operations, all of which was recorded as an increase in our income taxes in the December 2007 quarter.

Our diluted earnings per share decreased from $0.37 in 2006 to $0.23 in the December 2007 quarter, a decrease of $0.14. As previously mentioned, high oil prices and the negative impact it had on Headwater Section 45K operations caused the December 2007 quarter diluted earnings per share to be $0.14 lower.

Headwaters’ coal combustion product segment continued its strong performance in December 2007 when compared to 2006, with an increase in revenues of $8.3 million, or 12%, and a 9% increase in gross profit. Total revenue for the CCP segment was $77.4 million in the December 2007 quarter.

Headwaters Energy Services segment experienced a decline in almost all measurements, as the Section 45K operations came to a conclusion. This was an event we had expected and planned for over the last five years. We look forward with high expectations and optimism as this group now focuses a majority of its efforts and attention on growing the clean coal operations.

If they are successful in hitting their current forecasts, this business could replace the Section 45K business by 2010. This is a group that works very hard, is focused on tasks at hand, and has a track record of success. I am optimistic about the potential this coal cleaning initiative provides.

Selling, general, and administrative expenses during December 2007 quarter were approximately 4% lower than the comparable 2006 quarter. SG&A for 2008 should continue to be lower than 2007 with total SG&A comparable to fiscal 2006 levels, or as much as 8% to 9% below the 2007 levels.

R&D expense for the December 2007 quarter was approximately $4.1 million, or 9% higher than the prior year quarter. R&D expenses for fiscal 2008 should be at levels comparable to or less than fiscal 2007.

During the December quarter, Headwaters put in motion the sale of a non-strategic portion of our building products segment relating to mortars and stuccos. This business generated about $37 million of revenue in 2007. We have completed the sale of about 50% of this business, with the remaining portion expected to be sold in the March quarter.

With the proceeds from the sale of the mortar and stucco business, Headwater purchased two cement block plants in Texas, and we will integrate these concrete block businesses into our existing business there.

The addition of these two facilities will assist the building products business over the next year or so to expand concrete block production capacity necessary to meet projected demand, and hopefully will more than replace the revenues that were sold.

Headwaters long-term debt was $542.5 million at December 31, 2007, a reduction of $52.4 million when you compare that to December of 2006.

Headwaters generated approximately $34.6 million of cash flow from operating activities in the December 2007 quarter, which is comparable to the cash flow generated during the December 2006 quarter.

We spent approximately $26 million on capital expenditures during the current quarter. We currently have about $20 million of cash on hand and $50 million available on a revolving credit facility, for total liquidity of $70 million.

Interest expense during the December quarter was $5.8 million. We expect that interest expense for the full fiscal 2008 year will be less than $25 million. We expect interest rates to be lower in fiscal 2008 as a result of the debt repayments that we have made and the lower interest rates currently expected through the rest of the year.

We expect cash flow from operations in 2008 will exceed $125 million with planned capital expenditures that could approach $100 million. A substantial portion of the 2008 capital expenditures relates to the clean coal initiative.

Depreciation and amortization was approximately $17 million during the December 2007 quarter and we expect depreciation and amortization for the full fiscal 2008 year will range between $70 and $75 million.

Headwaters has three significant compliance ratios in connection with our senior secured credit facility, along with other standard covenants. These three ratios relate to indebtedness to EBITDA, senior indebtedness to EBITDA, and fixed charge coverage.

We are in compliance with all of these ratios and with all of the other covenants, and we fully anticipate compliance through 2008, even with the ending of the synfuel business and a continued weakness in the new housing and residential remodeling markets.

We have no required principal repayments until February 2011. We will continue to evaluate the most efficient use of our available funds, including capital expenditures, early repayments of our senior debt, or stock repurchases.

Approximately 46% of the December 2007 quarter revenues came from the building products segment, 31% came from our coal combustion products segment, and 23% came from the alternative energy segment.

Approximately 60% of Headwaters’ operating income is produced by the coal combustion product segment, and 40% is produced by the building product segment. With the energy services operations at a breakeven level after deducting Section 45K business, and Headwaters’ R&D Technology Group located in New Jersey.

As the coal cleaning operations continue to grow and mature, they will comprise a significant portion of Headwaters’ consolidated operating income.

As we look forward, we believe that revenues from the building products segment will be less in fiscal 2008 than they were in fiscal 2007, but we believe improved operating margins experienced in the last two quarters of fiscal 2007 will carry into 2008, as you saw in the December 2007 quarter.

It is impossible to predict the depth or duration of this industry segments’ downturn, but Headwaters building products companies have seen a far smaller decrease in their revenues than has been experienced by the sector.

We believe that we are well positioned to take advantage when this industry cycle turns. We believe that the CCP segment will continue to experience annual year-over-year growth similar to the rates we experienced in 2005, 2006 and 2007, with comparable operating margins.

Kirk will cover in more detail of our expectations of the energy services segment going forward and the status of our technology development.

As we have mentioned many times in the past, Headwaters’ operations are seasonal. With the ending of the synfuel business, this seasonality will be more pronounced. Net income and earnings per share will be affected more dramatically by this seasonality than our revenues.

During fiscal 2007, approximately 38% of Headwaters’ net income was earned in our December and March quarters, while more than 62% of our net income was earned in the June and September quarters.

Going forward, these percentages will change even more with approximately 20% of Headwaters’ net income being earned in our December and March quarters, while as much as 80% of our net income will be earned during the June and September quarters.

The weighted average share outstanding on a diluted basis decreased during the December 2007 quarter, as a result of approximately 1.2 million shares that we purchased in the open market in connection with the stock repurchase plan we announced in October.

At today’s stock price a substantial part of Headwaters’ options and SARs are out of the money and are therefore excluded in the diluted weighted average shares outstanding calculation. As of December 31, 2007, Headwaters had approximately 42 million shares issued and outstanding.

We believe the results of the December 2007 quarter, particularly in light of the continued downturn in the new housing and residential remodeling markets, and of significant increases in the Section 45K phase-out as a result of high oil prices, demonstrates the strength and diversification of Headwaters’ operations.

As we indicated in the press release, Headwaters is reaffirming our fiscal 2008 guidance of $0.95 to $1.35 diluted earnings per share, with about $0.30 or less of this coming from the Section 45K operations.

We know that we will be working very hard during fiscal 2008 in order to hit our guidance. But we continue to be optimistic that the growth of the coal combustion segment; continued improvements in operational performance in building products, while that industry segment recovers; continued expansion of the commercial operations of the coal cleaning business; and commercial validation of Headwaters’ technologies, leading to other commercial operations, will all contribute to reaching that goal.

I’d be glad to discuss specific questions with you concerning the quarter when we go into our question-and-answer period.

I would now like to turn the call over to Mr. Kirk Benson, Headwaters’ Chairman and Chief Executive Officer.

Kirk A. Benson

Thank you, Steve. I’ll start with some comments on our fly ash business. Fly ash business was the highlight of our December quarter and we resulted in record performance in that business. There continues to be a large backlog infrastructure projects and increase acceptance of fly ash as a substitute for Portland cement.

During the quarter, we were able to overcome some softness in the Florida and California markets because of strengths in the Texas market. We had another record quarter in revenue and operating income.

Florida softened because of increased supply of Portland cement and a very slow residential market. The California market slowdown was primarily weather-related and we anticipate recovery over the next several months.

Cement pricing remained stable, based on high-energy costs. Ready-mix prices have also remained stable. And while ready-mix volumes are down in most markets, the result has just been a narrowing of the gap between the supply and demand for quality fly ash. Demand remained strong and we are continuing to invest in infrastructure in order to bridge that gap.

Higher fly ash replacements, resulting in lower mix design costs, are being utilized by ready-mix producers to help offset reduced revenues attributed to the overall reduction of ready-mix sales volumes.

This is the primary reason that historically our fly ash business has not been cyclical. Higher fly ash replacements are often supported in the green building initiatives that are gaining momentum in the construction industry.

In addition, we were successful in obtaining a couple of new contracts that will result in increased tonnage as the contracts are implemented. We would expect at least an increase of 5% supply in calendar 2008. The first quarter left us very optimistic for the year. We are anticipating another record year in our fly ash business.

Now I have some comments on our building products segment. December housing starts were slightly over 1 million units, down 14% from November starts and down 38% versus last year. This is the lowest level since March 1991. Geographically, that drop in housing starts was led by the west, which was down over 50%.

Full year 2007 starts fell approximately 25%, the biggest year-over-year decline since 1980. Despite the superior fall-offs, which followed a 13% reduction in 2006, we believe there is substantial room for further reduction in new residential construction in 2008.

Given high new home sales inventory and near all-time peak homeowner vacancy rates, and the risk of recession, we believe a drop in excess of 15% is possible.

We are facing a very difficult building products environment. But our building products quarterly sales were only 6.5% lower than last year, far better than what might have been expected based on the overall drop in new residential construction.

Our revenue picture is somewhat cushioned because of our diverse product and geographic base. We have a significant amount of revenue in remodeling and commercial sales. Much of our institutional and commercial sales are in the Texas market, which continues to outperform national trends and has resulted in record quarterly sales.

We do expect a short-term drop in our Texas sales because we sold our mortar-stucco business during the quarter and reinvested portion proceeds in additional block manufacturing capacity.

The demand for block and specialty block products in the Texas market was outpacing our capacity, resulting in longer lead time for customers. Overtime, we should be able to replace the lost mortar-stucco sales to increase block and specialty product sales.

In addition to institutional commercial sales, we continue to experience strong growth in our new products, such as InSpire Roofing, Foundry specialty siding, and our functional shutters. Those products grew over 20% in the quarter.

Even with the downturn in construction, we are able to expand sales through our distribution network of over 15,000 ship-to locations. The addition of two new architectural stone brands, Dutch Quality and StoneCraft, has allowed us to capture additional market share. We believe we are now the overall market share leader in this category. It shows the tremendous power of our brands as we continue to capture market share.

Even with the drop in sales, our operating income margin expanded 230 basis points and operating income increased by 35% in the quarter. The operating income margin expansion is directly attributable to two activities.

First, our continued efforts to improve productivity through application of lean principles. We have developed a strong culture supportive of continued process improvement. And second, efforts to rationalize the size of our fixed costs in a recessionary environment.

I’m very proud of our employee base that has rapidly adjusted to the down-cycle in construction and embraced the changes necessary for improved processes and margins.

We anticipate further declines in 2008 in residential construction, putting pressure on revenues. But because of the seasonality, we won’t have a good view on our revenue prospects for the year until May at the earliest.

We expect a very soft March quarter. However, we anticipate continued productivity gains, as we become a better company, offsetting the impact of a down-cycle to some extent. Nevertheless, the building products environment is very challenging.

And now some comments on our coal cleaning activities. It is estimated that U.S. coal production in 2008 will be near the record set in 2006. Although the economy is probably in recession, demand for coal is strong. The National Mining Association forecasts over a billion tons of production for 2008, slightly higher than 2007, and almost a record for the industry.

In 2007, the nation had more coal-based power plant capacity than in any year of this decade. In addition, another 24 coal-based plants are under construction.

As of October 2007, there were an additional 10 gigawatts through coal-based plants or units near construction or are already in the permit phase, ensuring coal will maintain its current 50% share of the growing market for electricity generation. Two coal plants are projected to come on line in 2008, following the addition of three plants in 2007.

At the end of the quarter, we had five operating coal cleaning facilities. One in Utah, operating as a service facility and fully operational; two in Alabama, which were fully operational; one in Kentucky, which was preparing for start-up; and one in Indiana, which is in start-up.

We have learned that it takes longer than we initially thought to bring a facility up, although we would expect that the timeframe for start-up will shorten as we become more experienced.

The Alabama facilities are operating between 70% and 80% of capacity. In all, we are probably three to four months behind our development timeline. The product quality of the coal that is being produced is high and fully meets required steam market specification.

In Alabama, typically we take about a 3,500 BTU feedstock and convert it into an 11,000 BTU coal; very significantly reduce mercury and sulfur where these elements are present in the feedstock; and we improve combustion performance because of the uniform, consistent quality of the coal.

As I indicated in our last conference call, we have executed a core marketing agreement in Alabama, and we have been working to add our production to the sales efforts of the coal company that owns the resources.

We now have agreements with utilities to purchase 100% of the projected output from our two coal cleaning facilities. It will take some time to coordinate the logistics to maximize shipping and implement sales to the utilities, but that is expected by the beginning of the June quarter.

Since the coal that we are producing is consistently high quality, we believe that we will be able to continue to increase our sales over time. Sales are in place for our new Kentucky facility as it starts up. We don’t have sales in place in Indiana yet, but there is sufficient activity that we believe we will be able to duplicate our success in Alabama and Kentucky.

We have four facilities under construction, two in Alabama and two in Kentucky. We anticipate that all four facilities will come on line during 2008.

We are also looking at several acquisitions of additional coal cleaning facilities. It is highly likely that we will have 9 to 10 operating facilities by the end of calendar 2008.

We have indicated that the average size of the facilities will be in the range of 250,000 clean tons per year; but the newer facilities are larger and will impact the average. However, we are not yet operating at a 100% capacity, as I said.

As noted in our press release, we claim Section 45 tax credit on the clean coal that we are producing. This is the first quarter that we’ve used those credits in our financial statements. We believe that we are meeting the statutory requirements for the credits.

Our entry into the coal markets is timely, because the strength of coal sales will offset the weakness in our billing products group and help us during the economic slowdown.

Now some comments on our technology development: we continue to have discussions with the first two refineries that ran our HCAT Heavy Oil Technology to improve the upgrading of oil and ebullated bed reactors. There has been no change of those refineries, and we remain cautiously optimistic that ultimately they will become long-term customers.

The third refinery is in the process of starting up its ebullated bed reactor. They have been going through the normal process and difficulties of start-up and have not yet reached a point of stable operations that would allow the addition of HCAT into their system.

Our view that the refinery presents an excellent opportunity for HCAT has not changed. One reason that we believe HCAT will add value to the refinery relates to the improved productivity of heat exchangers. Oil is heated in the ebullated bed reactors to over 800 degrees, and after the reaction, the oil needs to be cooled in heat exchangers.

Often times as the oil is cooled, part of it precipitates a solid and plugs up the heat exchangers. When we ran HCAT as the first refinery in Europe, the refinery was removing its heat exchangers every seven to ten days. During our 30-day test, the refinery did not have to replace its heat exchangers at all.

HCAT resulted in significantly lower fouling and improved productivity. We believe that HCAT will improve the performance of the new refineries’ heat exchangers exactly as it did in the first commercial run.

Large integrated refineries are complex systems and an ebullated bed reactors only one element in the system. We have positively demonstrated that we can improve the efficiency of an ebullated bed reactor, increasing the diesel yield from heavy oil and improving overall productivity.

We don’t control the timing of HCAT’s use and because of the complicated and uncertain nature of the refinery, it is an extended process. But the economics have increased conversion and ability to use cheaper and lower quality heavy oil are compelling and will drive commercial use of HCAT.

One final comment on the technology: during the quarter, our EvonikHeadwaters joint venture completed the expansion of our hydrogen peroxide in South Korea, doubling its capacity to 75,000 tons per year. We plan to begin delivering hydrogen peroxide to SKC Chemical in this quarter under our take-or-pay contract.

So, that concludes my comments. I’d like to turn the time back over to the operator for the question-and-answer period.

Question-and-Answer Session


Our first question comes from the line of Al Kaschalk - Wedbush Morgan.

Al Kaschalk - Wedbush Morgan

Kirk, just to clarify on the construction materials segment on the stucco business that was sold. If you strip that out, I assume that’s the 6.5% decline year-over-year in the quarter?

Kirk A. Benson

It’s part of it; it’s not all of it. Most of that decline is related to the downturn in new residential construction. So, it’s a smaller piece. But it’s part of it.

Al Kaschalk - Wedbush Morgan

And if we then think annually on that, I realize it’s a small amount relatively speaking, but it sounds like you were backing away from any type of top-line guidance in that area?

Kirk A. Benson

The major reason that we wouldn’t want to give top-line guidance in the building product space is because of the downturn in residential construction. And because you’re in the winter period, you really can’t tell how the revenue line is going to be impacted by the residential construction until you get into the June quarter.

Now, as far as the sale of the mortar and stucco business, that will clearly have an impact on the top-line. But what was happening is that the demand for our block and our specialty block products, all of the different types of products that we make with our manufacturing equipment, that demand was exceeding our ability to supply the products.

And so, we probably won’t be able to make back that $37 million of revenue in this fiscal year, so there’s going to be some negative impact on us from that perspective. But what it does is it positions the business extremely well for growth in the area where we’re the strongest, which is in the block and the specialty block type of products. So, we’re pretty optimistic because the demand is there for our increased capacity.

Al Kaschalk - Wedbush Morgan

And then, you have done quite a bit of work on the cost structure. It appears that with the quarter that you have just put in, and the uncertainty in the outlook, do you see operating margins in the segment annualize or could it achieve somewhere near in the 10% range? Is that a fair target for us to measure you against for this year?

Kirk A. Benson

I think it probably is, and it will depend a lot on what happens in the June and September quarters because we should exceed that operating margin level in those quarters that makes up for the December and the March quarters, because of the seasonality of the business.

But I think that would be a slight improvement over last year and so, I think that we will improve over last year, so 10% is probably a reasonable estimate.

Al Kaschalk - Wedbush Morgan

Okay, and then on the coal cleaning business, if I may switch to that for a moment. Certainly you acknowledged that things are taking a little bit longer. Are there any visible improvements in terms of off-take agreements for the nine facilities that you believe through the balance of this year will come on line?

Kirk A. Benson

Absolutely. We are still very optimistic about coal cleaning. We always had this marketing agreement as I mentioned, that has been in place. But it was getting that agreement implemented, and now it’s the issue of getting the logistics in place.

But we’ve got agreements now in place through to the utilities to purchase 100% of the output of these two Alabama facilities. The Kentucky facility is already sold. We have got some work to do in Indiana, and some of the other facilities that are under construction, some of those facilities we have got agreements in place that we think that most of the production can be sold.

So, the quality of the coal is high, and we’re very optimistic about the business and being able to sell the coal into steam market. We’re also looking at some met coal opportunities. Met coal prices have been extremely high, and that would also be quite helpful from a revenue perspective to have some coal sold into the met market.

Al Kaschalk - Wedbush Morgan

And then just a cleanup question here. Within energy services, how much of that revenue was coal cleaning? Is it under 5?

Kirk A. Benson


Al Kaschalk - Wedbush Morgan

And then finally on the CCP volumes, you expect to be up 5% year-over-year if I recall. How much of that is attributable to the new contracts?

Kirk A. Benson

We can achieve the 5% just from the new contracts and so hopefully, the 5% turns out to be a conservative number. I think we’ll get some additional supply from other sources, like increased storage, and so the 5% should turn out to be a conservative number. But just those contracts would be equivalent to a 5% increase in our fly ash sales.


Our next question is from the line of Chip Moore - Canaccord Adams.

Chip Moore - Canaccord Adams

Looking at the construction materials, obviously you have done a great job managing the cost structure there. Just wondering if you can give us a sense of how much more room you might have left to cut operating expenses?

Kirk A. Benson

Part of it, in a sense, is clearly cutting operating expenses, but what it relates to is productivity improvement. So, what we’ve been able to do is reduce the expense structure because of process improvement. It isn’t just a cost-cutting activity. It’s changing the fundamental way that we make products and improving our performance and productivity.

That’s one of the things and I continue to believe that there is room for continued improvement. It’s something that we started about 18 months ago and we clearly have room for continued improvement in the 200 basis point range.

The other thing that we’re doing is, as we are reacting to the downturn in demand and the cycle, is trying to affect our fixed costs, and we are doing that by consolidating the operational plants so you can reduce some of the fixed cost.

As an example, we took a lot of our shutter and gable vents and some of the products that we’ve manufactured, we moved the bulk of that manufacturing capacity into a single plant instead of two plants, and then we took some of our products like our InSpire roofing product, and put it into the same space that was occupied by the shutter manufacturing.

So, we’ve been able to create some significant efficiencies by consolidating some of our activities. So, I continue to be very optimistic that we’ve got room for improvement in both our process improvement, and that will go on for a long time, but I think there is clearly areas for improvement there. But there’s also opportunities to continue to rationalize the size of the business. And we’re actively pursuing that.

Chip Moore - Canaccord Adams

And getting back to the coal cleaning side, it sounds like a fairly small revenue contribution this quarter. Just wondering how the $30 to $40 million dollar expectation for the year, how does that compare to what you were looking for before, and I think it is a little bit lower. Is that just simply a function of timing and capacity?

Kirk A. Benson

It’s clearly a function of time and as I said, we are may be like a quarter behind. So, the number that we had discussed previously was $50 million, so we’ve dropped that to $30 to $40 million and that’s absolutely just a function of time.

We’re making progress on the business. As I mentioned in the script, the high quality coal, we are selling it for market prices. There is no discount involved at all and it’s really pretty exciting because this is an opportunity for us to build a business that will, as Steve said, entirely replace the Section 29 business going forward.

And I think we are a quarter behind and so we dropped that earnings estimate a little bit to reflect that quarter.

Chip Moore - Canaccord Adams

And a bit of housekeeping, just looking at the other income, looks like it has picked up this quarter. Wondering if you could just provide a little more detail on what’s going on there?

Steven G. Stewart

Let me mention three things. We track in the quarter what we call non-recurring items, so that we idea of what the recurring business is generating. There were three non-recurring items in this quarter. One of them is in that line.

We have mentioned the sale of the stucco; there was a gain from the sale of that stucco. That’s what’s included on the other income and expense line and makes up 95% of that number.

There is also two other items that are included in cost of goods sold that are also non-recurring, that offset that. So the net impact of all three of these is really zero in the quarter. One of them relates to our ethanol plant that we have in North Dakota. Back when we put that plan in production, we had entered into some hedging activities so as to protect us from decreases in the price of ethanol or increases in corn prices.

The hedge we entered into relative to the increase in corn prices has worked well, but the hedge that we took to cover decreases in the ethanol price disconnected 8 or 9 months ago. So as ethanol prices went lower, our hedge went higher and we’ve had to incur costs related to that and there was about $1 million of that that was included in this quarter.

We have now closed out most of those hedges, relative to the ethanol prices, so we don’t expect that going forward.

We also have our hydrogen peroxide operations in Korea that we have discussed in the past. The currency for that operation is the won. However, we have one piece of debt there that’s denominated in euros. So, periodically we have to restate that won debt in what the equivalent euros would be.

The euros have increased significantly over the year relative to the won and there was about a $4 million adjustment to that joint venture, 50% of which is Headwaters’ responsibility. So we also booked about a $2 million foreign currency adjustment, which again is included up in cost of revenues.

If you take those three items and you net them out, it’s only a few hundred thousand dollars, and so I think that the net income that’s reflected for the quarter is reflective of what we expect going forward.

Chip Moore - Canaccord Adams

Looking at the acquisition, it looks like a pretty good tuck in. What should we be thinking about going forward in terms of acquisitions, M&A, and what not?

Kirk A. Benson

There are two places where we will see opportunity. We’ve been quite successful at the small building product acquisitions and being able to create value around those acquisitions, putting the products into the distribution system.

So that’s something that we’re clearly interested in and of course maybe there is a bit of a silver lining in the otherwise cloudy environment in that there may be additional opportunities to leverage our distribution system through small building product acquisitions. And we are clearly interested in that.

The other thing that we are interested in is, as we build our coal cleaning business, there are opportunities to consolidate some small coal cleaning operations and we’re looking at opportunities to do that. I think that that provides as good of an opportunity as the small building product businesses, and so we would look for M&A opportunities in either one of those two areas.


Our next question is from the line of Bill Gibson - Nollenberger Capital.

Bill Gibson - Nollenberger Capital

It sounds like to me your earnings guidance, $0.30, came from Section 45 credits. Steve, is half of that coal cleaning? Did I do my math correctly?

Steven G. Stewart

No, the $0.30 guidance that we gave is primarily the synfuel operations or the section 45K. What we’ve indicated is about $0.14 of that was realized in our December quarter and we are now with the high oil prices and a significant phase-out, we’re a little bit concerned that that revenue will actually be less than the $0.30 we’d originally thought.

There could be some revenue that will trail into the March quarter as these facilities and operations completely wind down and we true up all of the numbers. There are some inflation adjustment issues that have to be pushed through the calculations. But at this point in time, we think that will be less than what we’d originally anticipated.


Our next question is from the line of Pearce Hammond - Simmons & Company.

Pearce Hammond - Simmons & Co.

Kirk, as you alluded to, the price of Central Appalachian coal has really jumped up here recently and I just wanted to better understand your potential margins in your coal cleaning business. What do you think is a normalized margin and have those widened a bit here?

And the final part of that question would be, if you had your cost to goods sold essentially aligned for your coal cleaning operations, what is that on a dollar per ton? I know it’s different per region that you’re in, but I’d love to get a sense of what your cost to produce is for each one of those regions.

Kirk A. Benson

What we have indicated in the past is that we should be able to produce at 25% operating margin and there will be some impact on coal pricing on that operating margin of course. I think that our experience so far would indicate that that’s still a reasonable number.

We have now offered these facilities long enough that we’re comfortable that our cost structure is going to come pretty close to what we had estimated and that the 25% operating margin is a pretty decent number.

Now as far as the impact on the coal pricing, actually it depends a lot on how our mineral lease is structured. But what we are trying to do with our mineral lease structure is shift as much risk of the coal prices as we could to the owner of the resource. So if prices go down, we are cushioned on the downside. As prices go up, we share in that upward pricing.

So on a marginal sales dollar, we might share 50/50 with the resource owner. So generally, what we are trying to do is get the resource owner to take most of the risk on the downside, but give us some of the upside as prices increase.

We are currently selling our coal at a price high enough that we are sharing in that upside and so that’s all pretty positive. It makes it difficult to give you a number for the cost to goods sold and that’s something that we haven’t talked about because it’s really dependent upon the mineral lease and how those mineral leases are structured for the purchase of the coal.

But, like in our Alabama facility for example, we could have, as far as our dollar margins are concerned, coal prices could drop into the $26 range and we would still be able to earn roughly the same absolute dollars. So, our margins would actually go up because of the way that the mineral leases are structured. On a percent basis our margins would go up. We would earn roughly the absolute total number of dollars.

And so we haven’t chosen to really disclose the cost to goods sold because it varies somewhat with the price of coal because of the way we structured this in shifting the risks to the resource owner. So the number that we’ve been focused on has been the operating margins and based upon our experience to date, we think that 25% operating margin number is a solid number.

Pearce Hammond - Simmons & Co.

And then, your goal for this business, as you have stated before, is to replace essentially the EBITDA that you had from the old Section 45 business by 2010; the fiscal year 2010? Or be it a run-rate at the end of 2010, where you would be in place to do it, say for 2011?

Kirk A. Benson

I think that it’s going to be bit of the run rate. I think that 2011 will be our first full year of complete operations. Now, we’re finding continued opportunities to build these facilities. The coal industry is huge, and we are pretty comfortable that we are going to be able to continue to grow this business. So, I think by the full fiscal 2011 year, based upon our budgets and performance, we should have the Section 29 business replaced.

Pearce Hammond - Simmons & Co.

And then, Steve just was talking about the ethanol business. If you could spend just a few minutes and give us an update on the ethanol business as well as what’s happening with your coal to liquids development business?

Kirk A. Benson

As far as the ethanol business is concerned, as strange as it might seem, our crush margin has actually improved a little bit. And corn prices are at record highs, but you have to take into account the sale of the by-products; there’s cattle feed, those sales are high. And ethanol pricing itself has recovered a little bit. So the crush margin has actually improved a little bit.

And so because of the way that we structured that facility, taking advantage of the waste energy from the coal-fired power plant, our cost structure is relatively favorable. And so, we’re not making a ton of money at that ethanol plant for sure, but it continues to be profitable. So that’s a positive. It’s a one-off kind of an investment and so we will have to see what the future holds for us as far as ethanol is concerned.

But the plants that we have built is operating very well and we are using our lean Six Sigma tools there as well. We saved about $1.4 million in process improvements at the ethanol plant. So we are pleased with the productivity and pleased with our employee base and what we have been able to do at that ethanol plant. We wish that the crush margin was a little bit better. But the plant itself is doing quite well.

As far as the coal to liquids is concerned, there clearly is a focus around the world on coal. It’s receiving a little bit of negative publicity in the United States at the moment because of carbon dioxide and global warming. But those issues, particularly the SO2, NOx and mercury issues are being addressed by the industry and in some point in time, although that’s clearly in the future, CO2 will be addressed as well. And so, people around the world are focusing on coal.

We’ve got our work that we have been doing for Oil India has proceeded. We’ve completed our trial run for them at our New Jersey facility and the results were positive. We’re optimistic to the extent that you can be optimistic about activity in India and China. I think there is always a lot of risk associated with the political environments in those countries, but our part is going along very well. The technology works and we are able to demonstrate that in our pilot plant testing.

We’re looking forward to the project at Shenhua and that should come on line this year. I think it’s probably going to have startup issues as any new technology, actually most old technologies, have start up issues and you could expect that at that Chinese plant. But by sometime in 2008, there will be a direct coal liquefaction commercial facility operating.

So, we will get our first indication on a commercial scale as to the opportunity as it relates to our direct coal liquefaction. So, in the near term of course we are not anticipating a significant amount of revenue or operating income from our coal to liquid activities. But clearly, we believe that the technology works and as people rely more and more upon coal for transportation fuel, I think there is an opportunity for us to be right in the mix.


Our next question comes from the line of Michael Molnar - Goldman Sachs.

Michael Molnar - Goldman Sachs

Just a couple of quick questions. You kept the guidance roughly the same for 2008, but there has been an economic slowing in the U.S. I am just wondering if you could comment on the impact of a recession on your EPS guidance and your business.

First, does your guidance reflect the potential for a recession and two, what segments would face the most challenges if it was, or if we were in a recession?

Kirk A. Benson

I will comment on each of the three segments. Right now, we are expecting that our fly ash segment will continue to perform very well for the year. So, we had a good December quarter. We have got some weather issues, but that’s clearly not anything to do with the recession. Weather does have an impact on that business and we would anticipate some weather impact in the March quarter. But that’s not of course recession oriented.

There is large backlog of projects. We feel very comfortable with what’s happened in the past has been a change in mix designs and increased utilization of fly ash and , as I indicated, we have acquired additional sources of fly ash. All of that bodes well for 2008.

Demand still exceeds supply. There is a fairly good chance that a recession would not have a negative impact on the business. Maybe a marginal impact, but the sales and the projects seem to be in place to allow us to have a good 2008 in that business.

And in the building product space, I think that’s where we would have the greatest impact from a recession and frankly, we’re already in a recession and we’re already experiencing a downturn. It started in 2006, carried over into 2007, and as I indicated, I think that 2008 will be another very difficult year and we can expect a 15% or greater downturn in new residential construction.

That’s probably as much of a recession as you can have. If the U.S. goes into recession, it will extend and exacerbate the problems that we’re already facing. The way we are addressing that of course is through putting new products in our distribution system, being able to grow those products, and being able to rationalize our fixed costs. But that’s the area where we will have the greatest impact from a recession is in our building products business.

We think that our coal cleaning business will not be dramatically impacted by a recession. Our coal provides the baseline production of electricity in the United States and, as I indicated in my script, people are projecting a near record of coal production sales in 2008.

There is really no reason to believe that coal is going to be significantly negatively impacted by a recession, which is pretty exciting for us, of course, because that’s where we’re just getting started, and we’re starting to produce coal.

And so, we’re doing that in a space that will not be enormously impacted by a recession. That should provide us with some good growth because we don’t have a stable business; we have a growing business in coal cleaning.

So, all in all, I always take all those factors into account, that’s why we left the guidance as it was. I think it’s going to be more difficult to achieve our guidance than what we thought it would be when we originally issued it. But at this point, we felt comfortable leaving it where it is.

Michael Molnar - Goldman Sachs

Just one last question on the coal cleaning: can you just describe what you’ve done or what you’ve solved here with your technology where others have failed in the past? Number 1 and number 2, what’s protected here in your intellectual property versus someone trying to replicate it if it is successful?

Kirk A. Benson

One thing that people have had a very difficult time doing is increasing the BTU content by driving off moisture through temperature and pressure. That’s the process that hasn’t succeeded particularly well in increasing BTU content.

That’s not what we are doing. What we’re doing is removing the impurities from the coal, not moisture. We change moisture content a little bit actually. In one of our processes it goes down a little bit, in one of the processes it goes up a little bit, but it is not moisture-oriented.

And so what we’re doing is significantly different than the processes that have not worked extremely well. And so we’re able to get that improved BTU content because we’re removing the ash and the non-carbon materials. The second part of your question was, what was the second part?

Michael Molnar - Goldman Sachs


Kirk A. Benson

The intellectual property part. What is fascinating to me in this activity, there is really two things that protect us, generally. One is entering into good mineral leases. It’s kind of like a coal mining company. Once you establish those resources, you’ve got the ability to mine those resources.

I think a year or so ago we had about 150 million tons of resources and I think we are now up to about 350 or 400 million tons. So, one of the things that protects you in this business is just like a coal mining company in the sense that you are acquiring natural resources, and that’s what we are doing with our mineral lease. That isn’t a technology kind of thing. But it’s basically resource-based in the same sense that a coal mining company acquires coal resources.

The second thing that has been interesting to me and that protects us − it’s not patent an intellectual property in that perspective, but there is a tremendous amount of know-how that’s associated with these facilities and being able to successfully operate them.

That’s one of the reasons that it’s taken us longer to start these facilities up because it isn’t easy and there is a learning curve associated with it and there is a know-how associated with it. And we feel pretty comfortable that we’ve seen pretty dramatic improvements in the productivity and it’s clearly a learning curve and a know-how.

The president of that division won’t let third parties visit our facilities because they feel so strongly about the know-how element of what we are doing. So, we feel pretty good about being able to grow our business going into our plan. We’re behind, there is no question about that all. But we still feel very optimistic and very good about our positioning.

Michael Molnar - Goldman Sachs

Are you filing the Q today as well?

Steven G. Stewart

Probably on Friday, we’ll file the Q.

Sharon Madden

Operator, that takes us past our hour mark, so we’ll go ahead and conclude the call now. We appreciate all of you participating and we’ll end it now. Thank you.

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