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Headwaters (NYSE:HW)

Q3 2012 Earnings Call

July 31, 2012 11:00 am ET

Executives

Tricia Ross - Vice President

Sharon A. Madden - Vice President of Investor Relations

Kirk A. Benson - Chairman and Chief Executive Officer

Donald P. Newman - Chief Financial Officer and Principal Accounting Officer

Murphy K. Lents - President of Eldorado Stone

William H. Gehrmann - President of Headwaters Resources Inc

Analysts

Trey Grooms - Stephens Inc., Research Division

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

Philip Volpicelli - Deutsche Bank AG, Research Division

Adam Wyden

Operator

Welcome to the Headwaters Incorporated Q3 Fiscal Year 2012 Conference Call on the 31st of July, 2012. [Operator Instructions] I will now hand the conference over to your host, Tricia Ross, of Financial Profiles. Please go ahead, Madame.

Tricia Ross

Good morning, everyone, and thank you, for joining us for the Headwaters Incorporated third quarter 2012 conference call. There are slides accompanying today's presentation that can be found on the webcast link at Headwaters Incorporated under the Investor Relations section of Events and Presentations. Please go there to follow along with the slides. Should you have any trouble accessing the slides, please contact me at (310) 478-2700 or tross@finprofiles.com. I would now like to turn the call over to Sharon Madden, Vice President of Investor Relations at Headwaters.

Sharon A. Madden

Thank you, Tricia. Good morning and thank you for joining us as we report Headwaters' fiscal 2012 Q3 results. Kirk Benson, Headwaters' Chairman and Chief Executive Officer; and Don Newman, Headwaters' Chief Financial Officer, will be conducting this morning's call; along with Bill Gehrmann, who is President of Headwaters Resources and Heavy Construction Materials segment; and Murphy Lents, President of Eldorado Stone.

Please remember that certain statements made during call, including statements related to our expected future business and financial performance may be considered forward-looking within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, both as amended. Forward-looking statements, by their very nature, address matters that are, to different degrees, uncertain. These uncertainties are described in more detail in Headwaters' annual and quarterly reports filed with the SEC. You can find Headwaters' annual report on Form 10-K, quarterly report on Form 10-Q, and other SEC filings readily available from the SEC's website, Headwaters' website or directly from the company.

I will now turn the call over to Kirk Benson. Kirk?

Kirk A. Benson

Thank you, Sharon. We continue to have an excellent year, with adjusted EBITDA margin up 300 basis points year-to-date, and up $16 million on the trailing 12 months basis comparing September 30 to June 30, a 22% improvement. Importantly, we forecasted our free cash flow for the current fiscal year, from continuing operations, should increase to approximately $30 million. The improvements of free cash flow and stable liquidity levels have given us the opportunity to improve our capital structure by repaying $15.2 million of subordinated debt in the quarter and $34.7 million year-to-date. Additionally, we restructured approximately $50 million of our subordinated debt to a 2016 maturity instead of a 2014 maturity, which aligns our maturity dates with the generation of free cash flow. Today, we have $58.6 million of debt due in 2014, with 2 cash flow cycles remaining of $30 million each, but we have the current capacity to repay our debt as it matures. We will look at making additional early debt repayments. As our EBITDA and free cash flow have grown, and we have reduced our debt, our risk profile has substantially improved. Debt to EBITDA has gone from 6.7% to 5% over the last year.

Performance in the quarter is consistent with the very positive improvements that we achieved in the first 2 quarters of the year. Our SBU gross margins, operating margins and adjusted EBITDA margins are all substantially better than last year. However, the improved performance in the current quarter is masked, somewhat, because we recorded approximately $5.5 million of incentive compensation in excess of normalized amounts. Typically, we target compensation in the range of the 50th percentile of peers. Our consolidated adjusted EBITDA for the quarter was essentially flat to last year, but this year, absorbed over $5 million of incentive compensation that would not be expensed in a normal year. The additional incentive compensation relates to increases in our stock price, which has increased over 250% over the year, to successfully achieving cost-saving targets greater than planned and improvements in our top line. As we look forward to 2013, we will forecast normalized incentive compensation, so we may have some benefit next year from lower SG&A. If we, otherwise, have a stable year.

As you know, we have been pursuing the sale of our coal cleaning assets. During the quarter, we successfully closed the sale of one of the facilities. We received $2 million at closing and have the potential of receiving an additional $3 million over the next 12 months, and the total potential, over $10 million. We are negotiating the sale of additional facilities and expect to close those facilities before the end of the calendar year, but due to the negative cold environment, the sale of coal facilities has been more difficult than what we originally anticipated.

I'd now like to turn the time over to Don for a review of the financials.

Donald P. Newman

Thank you, Kirk. Good morning and thank you for joining us. Before discussing Slide 3, I wanted to mention that we intend to file our Form 10-Q later this week. My comments today will be directed to the slides that were sent out this morning and to a lesser extent, the condensed consolidated balance sheets and statements of operations that were attached to the press release.

Starting with Slide 3, our second quarter revenue from continuing operations was $175.6 million, up $14.9 million or 9% from the prior year revenue of $160.7 million. Second quarter adjusted EBITDA from continuing operations was $28.7 million, an increase from prior year EBITDA of $28.5 million. Under our pay-for-performance compensation philosophy, elements of our compensation program are tied to the company stock and financial performance. As a result of the strong stock performance and above target financial performance, compensation expense in Q3 was $5.5 million higher than planned and exceeded 2011 levels. Despite the additional expense, the company continues to perform well and expects to post full year results in the mid-to-high end portion of our original EBITDA guidance range.

Our year-to-date revenue from continuing operations was $442.7 million, up $33 million or 8% from the prior year revenue of $409 million. Year-to-date adjusted EBITDA from continuing operations was $61.6 million, up $16.8 million or 38% from the prior year's revenue of $44.8 million.

Our margins continue to improve year-over-year. As a result of the improved revenues and restructuring efforts, Q3 gross margins increased 240 basis points and EBITDA margins improved 170 basis points, once adjusted for normalized compensation expense. Year-to-date gross margins expanded 310 basis points as a result of the improved revenue, as well as cost improvements in raw materials, facilities and labor.

Let's move to Slide #4 for a closer look at the quarter's financial results.

Revenue from the continuing operations in Q3 increased $14.9 million or 9% year-over-year to $175.6 million. Light building products revenue increased $5.5 million or 6%, largely due to higher volumes and to increases in average sales prices. Heavy construction materials revenue increased $12.3 million or 20% from 2011 levels, due to higher sales in the Central and West regions, and to improve site services revenue.

Q3 gross profit was $52.4 million, an $8.4 million or 19% increase from the prior year gross profit of $44 million. The increase was driven by the higher revenues, as well as cost reductions. Q3 SG&A increase $7.1 million year-over-year, largely due to increases in performance-based compensation, including short- and long-term incentive programs. Q3 adjusted EBITDA from continuing operations totaled $28.7 million, which was slightly above prior year. Current interest expense reflects approximately $5.2 million of charges that were related to early repayments and to extension of $49.8 million of debt maturities in 2016.

Discontinued operations reflect the results for coal cleaning. We completed the sale of 1 of the coal cleaning plants during the quarter, which generated sales proceeds of $2 million at close, and could generate a further $8.4 million in proceeds through $2.4 million from the release of bond collateral, $1 million related to a sales price contingency and up to $5 million in future production royalties. Sales of the remaining 10 facilities continues to progress and we are hopeful to close further sales transactions this year. During the quarter, an impairment charge of $13 million was recorded, bringing the remaining book value of all of the coal cleaning plants, net of related liabilities, to near $0. We continue to make operational changes to the plans to improve cash performance while the sales process continues. Exclusive of non-cash charges, we decreased our quarterly loss from discontinued operations to $1.6 million in the third quarter of 2012, from $5.3 million in the first quarter and $2.3 million in the second quarter.

Now let's move to Slide 5 and let's talk about the year-to-date results.

Year-to-date, revenue from continuing operations increased more than $33 million year-over-year to approximately $443 million. Light building products sales increased $21 million or 9% due to higher volumes and to increases in average sales prices. Heavy construction material sales were up more than $18 million from 2011 levels due to higher sales in the Central and West regions, and improved site services revenue, offset by lower sales in the Eastern U.S. Energy sales were down $6 million year-over-year, largely due to reduce usage as a result of customer turnaround.

Year-to-date gross profit increased 22%, year-over-year, from $97 million in 2011 to $118 million in 2012. This is driven by higher revenue and cost-reduction initiatives. Gross margins have also expanded, increasing more than 300 basis points year-over-year. SG&A dropped approximately $11.4 million year-over-year. This was due to the $15 million point and legal reserve recorded in 2011, as well as the cost actions taken. And this was partially offset by higher compensation expense.

Year-to-date adjusted EBITDA from continuing operations totaled nearly $62 million, which is a 37% increase from the $45 million of adjusted EBITDA in 2011. The $17 million improvement reflects improved revenues, as well as cost-reduction actions, partially offset by the higher performance-related compensation. The year-over-year decrease in interest expense largely reflects the charges taken related to refinancing our senior secured debt in 2011 and to debt repayments.

Let's move to Slide 6 and spend a few minutes discussing our debt.

Our debt position has continued to improve over the past 4 quarters, as we have increased our trailing 12-month adjusted EBITDA from a low point of $74.5 million in the June 2011 quarter to $94.5 million at the end of the current quarter. We closed the quarter with a net debt to adjusted EBITDA ratio of 5.0:1 after reaching a high point of 6.7:1 in the June 2011 quarter. During the quarter, we completed a debt exchange for $49.8 million of 2.5% subordinated convertible senior unsecured notes that were scheduled to mature in February of 2014. Those notes were exchanged for $49.8 million of subordinated convertible unsecured notes that will begin to work February of 2016. The interest rate for the new notes is 8.75%, and the conversion price for the new notes is $29.48 per share, which is the same as the old notes. The exchange creates a maturity of schedule that is more consistent with the cash generation of the business should end-market recoveries be delayed. We have repaid nearly $35 million of our subordinated debt in 2012, including $15.2 million in the third quarter. The 2012 debt repayments include $12.5 million of the 2.5% notes, as well as the remaining $13 million of 14.75% notes, and the remaining $9.2 million of our 16% notes. In addition to our 7 5/8 senior secured debt maturing in 2019, we have subordinated debt of $108.4 million outstanding, which includes $58.6 million of 2.5% notes maturing in 2014 and $49.8 million of 8.75% notes maturing in February 2016.

Starting on Slide 7, Murphy will cover Light building products.

Murphy K. Lents

Thanks, Don. Good morning, everybody. As you can see on Slide 7, revenues from our light building products segment, in the second quarter, grew $6 million to $97 million, an increase of 6% compared to the June quarter last year. The growth came from our siding and architectural stone product groups. Year-to-date revenues, in the segment, have increased 9% over the first 9 months of last year. We've been pleased with the strong performance during the mild winter hasn't reversed as the year progress. Sales have continued to trend higher, year-over-year, and July's in line with the trend.

Gross profit margins improved 370 basis points, year-over-year, to 31% for the June quarter. The progress is the result of our continuous improvement strategy, restructuring initiatives implemented in the second half for fiscal 2011 and price increases counteracting increase in commodity pricing.

Adjusted EBITDA increased $20.7 million for the quarter, growth of $4.1 million or 25% versus third quarter of 2011. The improvement in adjusted EBITDA as a result of higher revenues, restructuring initiatives and improvement in operating efficiencies. Margins increased 320 basis points to 21.2% for the quarter, the best adjusted EBITDA margin since 2007. Adjusted EBITDA for light building products has increased by $18.4 million to $43.6 million for the first 9 months of fiscal 2012.

We're pleased that we made significant progress in the year but we continue to look for ways to improve the business. The architectural stone group initiated it's pre-brand strategy to better serve the market, minimize channel conflict and best utilize it's SG&A structure. Benefits are beginning to be realized as we attract new customers and increase market share. In siding group, with our newly reorganize manufacturing engineering team, we continue to pursue cost reductions through process improvements. In addition, our sales team continues to identify and successfully convert new business, especially with our specialty siding and roof and product lines. Our block business, retail and residential markets are showing improvement, while slower school construction in the Texas market has dampened sales. We continue to look for avenues for additional sales, such as our new polished block product, and expanding our block business into retail.

Slide 8 illustrates what we've already discussed, improvements for each of the first 3 quarters in both revenue and adjusted EBITDA.

Now I'll turn the presentation over to Bill.

William H. Gehrmann

Thanks, Murphy, and good morning, everyone. On Slides 9 and 10, you can see the revenue, for the June 2012 quarter, in our coal combustion products business was $74.7 million compared to $62.4 million for the June 2011 quarter, resulting in a 20% year-over-year increase. The western region posted a positive year-over-year volume in revenue increase for the third quarter in a row, continuing signs that the California market continues to improve. In the central region, we were awarded a long-term management agreement to manage over 1.4 million tons of coal combustion products a year, including 900,000 tons of quality fly ash.

Headwaters' client services provide site services to many of our utility clients. These services include constructing and managing landfill operations, operating and maintaining material handling systems and equipment maintenance. Prairie State and Virginia City, 2 new long-term contracts, continued to ramp their operations, contributing to the increase in site service revenue. In the quarter, we also begin to provide long-term current site services at a new site where we will manage 600,000 tons of coal combustion products annually. We were also awarded a site services agreement for our new plant in Arkansas. Site service revenue accounted for 27% of our overall revenue for the quarter. While these services typically have lower operating margins in our product sales, they are not as seasonal. As construction activity increases in the September quarter, and product revenues expand, site service revenue will be lower percentage of our overall revenue.

Gross profit for the June 2012 quarter increased by 31% to $19.8 million compared to $15.2 million for the June 2011 quarter. Gross profit margin increased 220 basis points year-over-year, driven by improved product sales, the sales mix and our continuous improvement efforts.

Adjusted EBITDA for the June 2012 quarter increased 33% to $14.9 million compared to $11.2 million for the June 2011 quarter. Adjusted EBITDA margin increased 200 basis points year-over-year. Operating leverage, combined with our ongoing continuous improvement efforts, is evident as revenue growth of 20% resulted in adjusted EBITDA growth of 33%.

Moving to Slide 11.

As we mentioned on the previous call, on October 14, the U.S. House of Representatives passed legislation designed to protect coal ash beneficial use and strengthen coal ash disposal regulation. On April 18, the House voted to attach H.R. 2273 to the Surface Transportation Extension Act. During the final week of negotiations between the House and Senate conferees, H.R. 2273 was dropped from the transportation bill that was eventually passed. During these negotiations, significant bipartisan support incentive has been gaining for a legislative solution to coal ash disposal. We are now looking for another vehicle in which to move it through Congress. The EPA is conducting a risk evaluation of encapsulated beneficial use of coal ash. It was initially announced that the study would be concluded in April and that date has continued to slip. Upon completion of the risk evaluation, we anticipate that the EPA will confirm that there are no environmental issues associated with the use of fly ash as a partial replacement for Portland cement and concrete.

Low natural gas prices and EPA regulations have combined to force both a temporary and long-term shutdown of several coal-fired power plants, impacting the supply of coal combustion products in some markets. However, our multiple sources of supply and broad distribution system allow us to backfill supply in markets where supply has been impacted. As a result, we believe that opportunities exist for us to increase market share and fare better than our competitors in the current regulatory environment.

I'll now turn the call back to Kirk Benson for comments on our energy Technology segment. Kirk?

Kirk A. Benson

Thank you, Bill. As you can see on Slides 12 and 13, adjusted EBITDA from our HCAT business declined year-over-year by $2.3 million. The decline primarily resulted from lower revenues caused by reduced usage of HCAT by our customers as they experience turnarounds in their refineries and needed less material. There was also incentive compensation that was tied to overall consolidated performance, and the energy segment benefited from those improvements. Currently, both of our heavy oil customers are operating and using high levels of HCAT. We continue to have strong contribution margins and look forward to adding new customers to our portfolio.

Turning to Slide 14.

As we reported, incentive compensation for the quarter was higher than budget due to performance and the increase in our stock price. We anticipate the same type of occurrence in the fourth quarter because we book most of our incentive compensation split over the last 2 quarters of the fiscal year. Accordingly, we are leaving our guidance for the year in the range of $85 million to $95 million and expect to be above the midpoint of the range. Even though we anticipate operating improvements in the fourth quarter, the improvements will be masked by recording additional incentive compensation. As we plan for 2013, we will continue to be conservative relative to our top line, although the trends show improvement. We are working on a number of new products, product extensions and changes that could result in market share improvements resulting in improvements that are not tied directly to end market expansion, so we expect continued growth to our top line.

We are starting 2 major improvement projects for 2013. First, the concerted effort to improve safety. We already performed substantially better than industry averages but we believe that we can improve the safety environment for our workforce. No one should go home, from a day at work, injured. In addition to focusing on safety as a cultural value, we have also reduced workers compensation cost by more than $1 million over the last couple of years. Secondly, we are -- we have been pretty successful improving efficiencies and reducing cost through the transition to a lean approached manufacturing. But we have identified an opportunity to reinvigorate our continuous improvement activities and put us further along the path of improving margins at overall performance. We anticipate gradual improvement in margins continuing into 2013.

Since the beginning of 2011, we have reduced the annual run rate interest expense from $59.2 million to $42.3 million. And we have been able to control our CapEx to around $25 million, which covers our maintenance safety and some growth CapEx. The result of increasing margins on growing revenue, combined with lower interest expense and continued control of CapEx, positions Headwaters to be profitable next year for the first time since 2007. We're very excited about the opportunity that we have to return to profitability.

I would now like to turn the call back to the operator for the question-and-answer period.

Question-and-Answer Session

Operator

Thank you, sir. [Operator Instructions] And the first question comes from Trey Grooms.

Trey Grooms - Stephens Inc., Research Division

A couple of questions. You guys had mentioned that light building products' volumes had continued to improve year-over-year and July has continued that trend. I may have missed the commentary on the HCM business, but can you talk about how that's trended in the quarter as well?

Kirk A. Benson

And Bill can add some color to the comment. But generally, I think what we're seeing is some improved performance in the western region, and that the western region was hurt the most in the downturn because of the Nevada, Las Vegas markets, the Arizona Phoenix market and California. So those 3 markets were the most depressed across the country. And what we're seeing is some stabilization in the Arizona and Las Vegas markets, but I think that we've got an excellent opportunity to increase some market share in the Phoenix market as there's -- Bill alluded to the fact that as the natural gas prices and the EPA put pressure on coal-fired power plants, we're seeing some of our competitors are being hurt more than we are, and we have some market share opportunities. So we think that there is an opportunity for growth there, and generally, the California market has improved, we've had positive year-over-year comps for the last 3 quarters. So that's been positive in July, and the western region is continuing that kind of a trend. In the central region, we picked up some additional contracts, and so that's provided us with incremental supply and an opportunity to allocate that supply to take advantage of market conditions. I think the East has been a little bit softer, but we've been able to make up for that with the strength in the essential in the western region. So, Bill, why don't you add some color to that commentary, if you will?

William H. Gehrmann

Sure. I think you covered all I would have to say about the West, it moves back across the country. We did pick up a significant source of quality ash in the central region. We're working to reallocate to take advantage of supply and maximize that. In the upper part of the central region, we've had a competitor that's experienced some supply issues over the last month. So we're working to take advantage of that, so there's some more opportunity there. And as Kirk mentioned in the East, there's some softness. It's typically where, I think, the industry is seeing a majority of the supply issues. We've experienced a few, we're reallocating supply. We've established, in the last couple of months, 2 new rail terminals in the Northeast to backfill some supply, and we expect to see the results of that as we move forward.

Trey Grooms - Stephens Inc., Research Division

Okay, that's very helpful. So on the light building products, with that continuing to improve, I guess, sequential -- or year-over-year, as we move through kind of the spring and into the summer months, it sounds like -- I mean, are you guys, at all, surprised by that continued improvement? I know that there was a lot of speculation early on in the year, that favorable weather had really driven a lot of these, and there was some concern that you could see a pause, I guess, kind of looking into the back of the year. It doesn't look like that, what you guys are seeing. Is this kind of in line with your expectations or do you think there's just continued demand? You think there's market share gains? What do you think is driving that continued strength?

Kirk A. Benson

Generally, I think there was a little bit of surprise the way that the third quarter worked out. It was not a surprise that we had a positive comparison in April and May because, last year, what happened is that winter was extended into May. So we had a very poor April last year. So it wasn't surprising that we exceeded last year's performance in April. But then what happened last year is revenues spike in June and made up for some of the lower revenue in April and May. So this year, what happened is that we have a strong April and May but that strength continued into June and so the revenue in June actually exceeded the spiked revenue from last year. That was a little bit of a pleasant surprise because -- and it does go to the strength of the end markets, somewhat, that even though we had that spike last year, this year we had very solid revenue in June. So if you look at the 3 groups, the product grouping that is the softest is the Texas region, with the block business. That's primarily because of school construction, and to some degree commercial construction. And so that softness has tempered the segments' reported growth, because we've had some declines year-over-year in that Texas market. I think, in the stone part of the business, we're starting to see some positive results from the unification and coordination of our sales activities with our 3 brands, as we segmented that market. I think that was an important strategic decision that we made last year, to unify our approach to the market, and we're starting to see some growth in our customer base, which basically relates to market share gains. So and that, to some degree, that growth has overcome some of the softness that we've experienced in Europe. So the domestic growth in our architectural stone business has overcome that softness in Europe. We don't have -- I mean, we have a, probably -- Murphy, you can chime in here -- but we're probably around 10% or less of Europeans sales. So it's not huge. Nevertheless, the European impact has tempered the overall growth in our stone products and that's coming primarily from an improvement in end markets but also from some market share gains. The siding product group has had some very strong growth in some of our new products that we've introduced. For example, our Inspire Roofing product has grown very well and our specialty siding products has grown very well. And growth in those products -- that's basically market share, is what's happening there, as opposed to end market growth. And so I think there's little bit of combination of end market improvement, but we're also seeing some very strong growth in our new product offerings. Murphy, your shot at adding a little bit of color to that commentary, if you would?

Murphy K. Lents

Yes. Well, Kirk's right about the European business. We started really seeing that business drop off, I guess, about halfway through the quarter. But we've been fortunate that the domestic business has more than offset that weakness, that Kirk's right, it's about 10% of the -- a little less -- between 5% and 10% of the total stone sales. But some parts of the country, in the Midwest, in the Northwest, have all been doing quite well this year. California has actually seen a reasonable resurgence in the last quarter as well. So we've been happy and pleasantly surprised that the growth we've seen this year does not seem to be related to the warm weather, which you're right we were somewhat concerned about that early on, but we've done rather well in the last quarter and don't see any signs of that abating.

Trey Grooms - Stephens Inc., Research Division

One last question then I'll hop back in queue. Previously, you're giving guidance of kind of cost savings of -- I believe it was $14 million over the next few years, I guess through the end of '13. Can you give us an update on kind of how to think about that and the timing of that, '12 versus '13, and also kind of mix in light of the higher comp expense, I guess this quarter and next. Is that included in this kind of cost savings guidance that you've given us here?

Donald P. Newman

This is Donald. I'll take a shot in answering that question. Original discussion around cost savings was $14 million of cost savings and we were projecting to achieve $9 million of that in 2012 and see the remaining $5 million hit 2013. We've actually had very some good experiences with our cost-cutting initiatives, and we are ahead of plan in terms of -- not the $14 million, but the timing of when that's going to hit the financials. I'll be in a better position, obviously, to give you an answer on this when we get through Q4. But my sense, right now, is that we'll probably end up seeing between $11 million and $12 million of the $14 million hit in 2012. And so that's pulling a lot of the savings forward, which we're pretty excited about. And then we're still seeing a path to the $14 million, but obviously, there'll be less of a step-up in '13 versus '12 because we're achieving those savings faster than planned. In terms of the interaction between those cost savings and the additional compensation expense. I wouldn't point to an interchange. There's the cost savings of $14 million, that was an independent exercise from what we're seeing in terms of our compensation expense. And we do see the compensation expense as something of a bit of an anomaly, because when you look at 2012 and where we entered 2012 from a stock price standpoint, we entered the year at about $1.40, $1.42, something in that neighborhood. And so that low stock price, in concert with our limited ability to issue pure equity as an incentive to the employees, put us in a position where we needed to deliver instruments that would be cash settled. And with that, and with the low stock price, we had to issue a higher-than-normal number of units in order to deliver market based compensation. And so, when you look at 2012 and you're thinking about 2013, 2012, I think, is an anomaly for a couple of reasons. Number one is, the number of units that were issued in 2012 because of the low initial stock price. The impact that, that number of units had, in combination with the significant increase in our stock price. Our stock was up, upward of 300% year-to-date, and so very, very nice, very strong performance, but there is an impact on our comp expense because of that scenario. When you think about 2013, 2013 comp should be more normalized. Our stock price will be higher, we have greater capacity to issue pure equity-based compensation. Which means that the sensitivity of our earnings, in '13, to changes in stock price will be less than we saw in signed 2012. Does that help some?

Operator

Next question comes from out Al Kachalk from Wedbush Securities.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

I'm going to start on HCM for a second here. Can you help square up, if you have additional supply of high-quality fly ash and yet not have a turn in the end market use? How you can drive the margins where they're going. I'm just trying to appreciate a higher dollar level of service revenue, marginally higher dollar level of product revenue yet the margins were extremely well. And I know Bill and his team have done a great job on the cost side. But if you could just help me understand. We get 100,000 tons more ash, we don't get the end-use, probably, absorbing that. And I would thought that would've gone more to disposal than the product side.

Kirk A. Benson

A couple of things are important to note. One is that our highest margins are in the western region. And so, even if you had exactly the same number of tons sold, if the mix of those tons were weighted towards the western region, you would have an improvement in margin. So that's one of the things that's going on. As I've indicated, we've had 3 quarters in a row of positive year-over-year comps in the western region. And so, that's helping margins because of the mix of where the tons are sold. A second comment would be that, when you pick up a new supply source, oftentimes what you're able to do -- not all the times, but oftentimes what you're able to do is to be able to supply the local market or the regional market at a lower transportation cost. And so when you pick up a new source supply, that's very important for the business, because in that local market or the regional market you can supply ash at a lower delivered cost, which also has a positive impact on the margins. And there's also just the impact of competition and the ability to increase your revenue because of the source, the new source of supply that you picked up. So Bill, why don't you go ahead and add color to that too?

William H. Gehrmann

Yes. As Kirk alluded to, Al, it becomes a logistics issue. Where we have picked up supply, we've reallocated. To take advantage, obviously, we sell the product at a delivered price. So, obviously, we can minimize the transportation piece of that, margins increase. So as we pickup these new sources, obviously, that's the first exercise. As we talked about some of the environmental impacts on the supply, and also natural gas, that allows us to look at opportunities to increase overall sales volumes with that. With quality ash in the market, we can drive some price increases based on superior quality versus some of the ashes in that market. Then as we pick up some of these supplies, we have a variety of contracts. So we talk about -- you may have to dispose of it, at some sites we get reimbursed for it. So it's not -- obviously, it's lower margin activity, but it's not as big an impact as one would think. That help out?

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

That helps. Have you reported or disclosed the volume sold in the quarter? Or if not the volume, what the rate of change over -- you described the period whether it sequential or...

Kirk A. Benson

We use to do quarterly disclosure, they stopped doing that. We do an annual disclosure. I think, generally, what the disclosure's going to be, when we complete the fiscal quarter, is we've had an increase in tons year-over-year. Do you agree with that, Bill?

William H. Gehrmann

Yes. I think, where that becomes a little difficult, Al, is where do you draw a line or the distinction between quality ash, total CCPs, the other ashes produced. So there's some gray area in there to do some year-over-year comp. But, yes, as Kirk mentioned, I think year-over-year, we've seen volume increase.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

Okay. And then if I may just sneak one more in here, on light building products. Could you talk a little bit about maybe the pace of order pattern or the rate? And maybe what some of your customers or you're hearing from our customers, either by channel, et cetera. Because it appears that while we started fast for this sector, there does seem to be a little bit of deceleration. And I'm just wondering where you're at on that particular segment, given where you entered it in the third quarter. And then directionally, with that, could you just comment about raw material inflation and/or any inflation headwinds you're anticipating?

Kirk A. Benson

Murphy, why don’t you go ahead and comment on the stone group then I'll follow-up with siding and block folks.

Murphy K. Lents

Yes, Al, the activity we're seeing in stone side of the business is pretty broad-based. I mean, I wouldn't attribute it 100% to the relatively modest increase in new housing starts. I mean there is some of that, but a lot of it had been remodeling and smaller sorts of jobs. I mean, we're seeing a few decent sized commercial jobs out there but it's really a pretty broad-based bunch of smaller things, really, which I find encouraging, because it's not directly tied -- if housing starts to decelerate a little bit, I don't think you're going to see that have an outside impact on what we're seeing out there. I think it's more generalized widespread activity. But small remodel jobs, and that sort of thing, is where more of it seems to be coming from. And we are seeing some -- I do think that the little uptick in housing starts has helped, I mean there's no doubt about it. But it's not the whole story. So we have not seen any deceleration in our numbers, really, through today, going back to the winter. I mean it's been pretty steady without any -- like I said, without any -- there's no single thing that you can point to, which is really driving it, which I find encouraging.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

Is there a change in the volume as to new start versus remodel? Your comments would seem to lend that you're seeing -- or the experience has been that you're seeing a little more from remodel than you are new starts.

Murphy K. Lents

I would say that's true, that I would attribute more of it to things that are not directly tied to new housing starts.

Kirk A. Benson

And it's the same with the -- to some degree, true in the siding product group because it's primarily repair and remodel. So, remember, in our siding, the product group, it isn't as heavily influenced by new residential construction as it is by repair and remodel. So some of the factors going on there is that you have all of these foreclosures and the turnover in homes, and that builds up some demand on the repair and remodel side. Now that demand, of course, has been tempered because of the high unemployment rates and the difficulty to get financing. But the repair and remodel market has been more stable than the new residential construction, and we see some improvements there. But in addition to that, on the siding side, some of the newer products are where we're seeing outsized growth, and what that means is that we're basically taking some market share. In the specialty siding space there was 1 competitor that left that market and we picked up some share from that experience and we're picking up some share in the roofing product as well. So we're seeing outsized growth that isn't tied to the end markets in those products. That's basically more of a market share explanation than it is end markets, where there's new residential construction or repair and remodel. It's that those -- and the reason that that's happening is because we've made some product extensions. We've changed. We've added to our -- the portfolio of roofing products that we're selling. So, we've been pretty successful on those extensions that give us an opportunity to have growth in excess of what you expect from the end market. So, I mean, that's very positive on that siding part of the business. Again, we're having issues in Texas with the construction of schools. That's really hurts us quite a bit. But on the other side, in Texas, we are picking up some additional sales through our retail channels and we're making some progress in selling some new products in that business. We also completed a small acquisition in Baton Rouge, which -- that's our first block manufacturing plant outside of the Texas market. We understand the Louisiana market pretty well. We were selling product into that market, and on the last quarter, we closed a small acquisition. So we have our first foothold outside of Texas, in that block business, and we're encouraged by the opportunity to take our Texas business model. And that Texas business model is -- the center of that is, of course, selling the block product, but about 40% of our revenue comes from selling ancillary higher-margin products. So what our strategy is, is to take that successful business model and export that to the Louisiana market. So, the Louisiana sale, it's not huge. It's a fairly small foothold, but what it does do is it gives us a platform to take our Texas business model and apply it in Louisiana. So we're pretty interested to see how that geographic expansion works and how successful we are at taking our Texas model and putting it into an adjacent geography. So, by and large, I think that the end markets, of course, are very important. And you're absolutely right, I think as we've listened to the other reports from peers, there seems to be a little bit of concern about the end market growth. Work, as we've said, July seems to be a solid month and so we're not seeing a pullback yet. It certainly could happen in August and September. We don't know yet of course, but so far, things are moving in a very solid matter for us.

Operator

And the next question comes from Philip Volpicelli from Deutsche Bank.

Philip Volpicelli - Deutsche Bank AG, Research Division

It's Phil Volpicelli from Deutsche Bank. My question is with regard to the coal cleaning assets that you sold. Did the person who -- or the entity that bought the assets, are they the owner of the mine where the assets are located? And if so, are they willing to by other coal cleaning plants? And then the second part to that would be, what criteria would do you need to reach to be able to get the remaining $5 million of royalties?

Kirk A. Benson

So the purchaser has a mineral interests that is adjacent to the coal cleaning facility. And so, as they're developing that mineral interest, their intent is to use the coal cleaning facility to wash that coal. And so, I think we feel -- well, it's also a metallurgical coal mining interest. And so, we think we've got a fairly good shot at being able to collect on those future royalties. It is an excellent coal cleaning facility and there's also -- they have load-out capabilities to rail from that facility. And so, as they continue the development of their net coal assets, we think that there's a good likelihood that we'll be able to receive the royalty payments. So what has to happen is that they have to complete their mine development and then they start to wash that coal, we get paid on a per ton basis. So that the big risk of future royalty payments is their successful completion of their mine development.

Philip Volpicelli - Deutsche Bank AG, Research Division

Okay. And it sounds like, from your comments, Kirk, that they will not be looking at other coal cleaning assets, this is the only one.

Kirk A. Benson

Well, one of the characteristics, as the buyers are looking at these facilities, is an entrepreneurial approach. Now, they were most interested in this Crocker [ph] facility that we sold. But they're on our list of folks that we're talking to, about -- at least 1 or 2 additional facilities, so they could be a purchaser. We don't know whether they will be or they won't be. They could be a purchaser on some of the additional facilities. We've been looking for people -- the purchasers need to have access to coal, they need to have off the ability to do off-tick agreements and they had to have capital. They have to have those 3 characteristics in order to be interested in buying these facilities, and we've got a number of potential purchasers. We're further along with some than we are with others, and as we've indicated in the call, we continue to be comfortable that we've got the ability to sell these facilities. We did extend -- I don't know if anyone noticed. We changed our goal from fiscal year-end to calendar year-end, to give us a little more, a little more room. But we continue to make progress. The one thing that I want to caution everybody about is, each of these facilities are different and it would be inappropriate to extrapolate the value that we received or going to receive from the Crocker [ph] facility to the other facilities. The environment is more difficult now in selling these facilities. And like in some of the facilities, they're going to have to be relocated, and that relocation cost could range up to $5 million. And so, don't extrapolate from the 1 facility and multiply it by 10 to get an estimate of where we're going to end up on these other facilities. It's going to be different because the circumstances of the facilities are different.

Philip Volpicelli - Deutsche Bank AG, Research Division

Okay, understood. And then, Don, with regards to the compensation expenses, up about $5.5 million. Should we expect a similar range for the fourth quarter? Or, I guess, what are the criteria that would drive that?

Donald P. Newman

So, a couple of things come to mind. First, the stock price. What you would expect to have is, for every dollar change in stock price, there would be a corresponding, roughly, $2.5 million impact on our expense. That's a number that works for 2012. It's not a number that'll work for 2013, but to give you a sense for Q4, keep that in mind. Another thing to keep in mind is, that deals with the stock price portion or the stock-sensitive portion of our compensation. One of the drivers for Q4 will be our underlying performance with the business. And so, as the business continues to perform, and hopefully it continues to perform well, then we would see that impact come through. As a general expectation, what I would say is, you should assume the comp expense, we had shown $5.5 million above plan, I would expect that to be, potentially, a couple of million dollars more in Q4. In part because of the way that stock price impacts our compensation, and also, the fact that the way that we book our comp expense. As Kirk said, we booked the majority of it in the second half of the year. And then when you think about Q3 versus Q4, a bit more of it is actually allocated to Q4 because of the relative performance of Q4. It's one of our strongest quarters, the strongest quarter in the year.

Operator

The final question comes from Adam Wyden from ADW Capital.

Adam Wyden

A Couple of questions for you. On the compensation side, again, just so I understand. Do you guys like grant the compensation based on the beginning stock price so it's an accrual and then basically it accretes over the course of the year? So, for example, if the stock went from $6 to $10, the compensation you already gave to people, you'll have to record more expense in the fourth quarter because of that?

Kirk A. Benson

Yes, so 2 comments on that. First is, yes, we grant -- the equity-based compensation is granted at the beginning of the fiscal year. And so, it's based upon stock price at the beginning of the year, and then generally -- Sarbanes-Oxley on my mind. A Black-Sholes valuation is done and you end up looking at compensation. Now, the thing that's going to be different between 2012 and 2013 is that we didn't have the capacity to make a market-based grants using stocks or SARS that are settled in stock versus SARS that are settled in cash. So we had to use SARS sold in cash. That is not our preference. And so, but the accounting between settling cash and settled in stock is different and you end up with this mark-to-market accounting if it's settled in cash. When we make our grants for 2013, we'll be able to use SARS settled in stock and you won't have this variable accounting associated with 2013 SARS. And so, that's why, Don, used the word anomaly to describe what's happening in 2012 and we do consider it to be somewhat anomalous and although there'll be some of these that's still going to carryover the 2013, there'll be compensation and will be tied to stock price in 2013. We don't anticipate that it will be it will have as significant of an impact as what it's having in the June and September quarters.

Adam Wyden

Right because in order of magnitude, the stock isn't going to go up 400% next year.

Kirk A. Benson

We hope it does.

Adam Wyden

From your mouth to God's ears.

Donald P. Newman

So to Kirks point, if things unfold the way we expect that they will, we will have fewer units that are tied to this mark-to-market accounting and so of course we would always love our stock price to go up because that's good for our shareholders, but we won't see the effect of our expenses in the same magnitudes that we saw in 2012 because of the composition is just going to be different.

Adam Wyden

It's not actually cash either. When you quote your adjusted EBITDA, I mean you're deducting the stock -- you're deducting the incentive compensation which is settled in stock so from a cash flow standpoint, you're actually getting that $11 million of cash flow to delever or repurchase notes or what have you right, this is actually settled in stock, right, so?

Kirk A. Benson

It's a matter of timing. At some point in time, the SARS settled in cash will be settled in cash. But that probably that's not going to happen for several years more likely than not and so, it depends on when people exercise the SARS and so, as people book your 3-year vesting, you are going to be -- take the 100% vested, you are out at least 3 years, and so, the cash based SARS will be settled in cash, but you're absolutely right, from a timing perspective, that's not going to be a cash expense in the near term.

Adam Wyden

But when you settled as these people vest, they could just actually take stock. It's treasury method. So you can either take the amount of money that they've made in the stock over the course and you can pay them in cash and you can return the shares to treasury and you can actually give them the stock, right.

Kirk A. Benson

On the cash-based SARS, we will settle those cash-based SARS in cash.

Adam Wyden

And you guys record a liability for that or not.

Donald P. Newman

Yes we accrued for that expense and you had pointed out correctly that when you look at our EBITDA adjustment schedule, you do see some adjustments for equity based compensation. That is different than the compensation that is cash settled that Kirk's talking about. That is those equity settled are the instruments that we have used historically but because of having to issue more cash settled instruments this year, we have this additional expense and this is this additional expense of the clear as well, this additional expense was not recorded as an adjustment to our adjusted EBITDA. It is in the expenses that is included in adjusted EBITDA and if someone were looking to normalize our 2012 results for this anomalous compensation you would that $5.5 million we disclosed then you would add it to the $28.7 million for the quarter and that would give you normalized you of what the business did.

Kirk A. Benson

I've actually wanted to use it but adjusted EBITDA but Don wouldn't let me do it.

Adam Wyden

And then also for your guidance for next year, you guys have said that you been profitable. Is that can you give us a little bit more color on kind of the trend on interest expense and the trend on D&A that you're using for that. Is that a pro forma profitability number or is that based on selling nonprofitable coal cleaning assets. How do you think about that? I'm just trying to kind of reverse engineer how you're thinking about profitability on a net income basis baked in any additional housing starts or is that basically based on what you're seeing today as well like just from a housing starts standpoint.

Kirk A. Benson

If you use like $100 million of adjusted EBITDA and interest expense next year will be right in the neighborhood of $42 million and D&A will be in the range of 53. So that basically gives you about $95 million of deductions from adjusted EBITDA so the tax expense so pretax number would be around $5 million and tax expense is going to run around $2 million. We won't have any federal taxes of course, because we have NOL and credits, but you'll end up with some state taxes, so you've got, you end up using the $100 million of adjusted EBITDA, $42 million of interest expense. Of that $42 million that's about 37 or so that's cash and there's $5 million of non-cash interest expense but the P&L will show $42 million approximately of interest expense and then $53 million of depreciation amortization, we get to a positive pretax line and then a couple of million dollars of tax and you end up having a profitable net income next year. Now the one thing that could change that a little bit is if we bought back additional debt and so you had a quicker amortization of the that acquisition costs. And so that $42 million, that's assuming that we don't that basically the capital structure stays as it is. But it's reasonably close to where we should end up and so you can see how we could very easily end up with net profit for the first year of 2007 next year. We're actually very excited about that the trends and about our control of costs and the reduction in interest expense and where we think we can come up with from to be profitable next year.

Adam Wyden

If I just look at what you guys have done this year so far and I kind of reverse engineer the anomaly it seems like they're already ahead of that. Just from a standpoint if you're in the case that if you are just the kind of normalize what you did in the 9 months this year or in the trailing 12 months and you normalized that for the incentive comp, you're kind of already ahead of that. So your guidance really doesn't imply any market share gains or I guess, additional operational leverage from any of the segments or additional starts or anything like that. It seems like you're already there. You're already ahead of that I'm just trying to understand how you guys are thinking about that because the numbers seem to be trending in the right direction from that standpoint. Even with schools, the school building nationwide is supposed to increase in 2013 and '14 because of the new core standards that schools are introducing. So I would think even that segment that's depressed now would come back pretty hard so I'm just trying to understand how you're thinking about this.

Kirk A. Benson

And we agree with the commentary you've just run through, the analysis you've just run through. I pick $100 million of adjusted EBITDA because that's an even number and you can do the math very easily from that. I didn't do it from a perspective of guidance for next year but just to use that as an example of how realistic it is that we're going to be profitable next year and so we feel really good about it. And hopefully as it turns out $100 million to be a conservative number for next year. But I just pick that kind of as an easy number to subtract the interest expense and depreciation from to show that we anticipate to be profitable next year.

Adam Wyden

Previously had said like it incremental 100,000 housing starts would be about $20 million of revenue give or take on the light building products side and 50% contribution margin. That's still you guys still believe that, that statement holds water. Is that right?

Kirk A. Benson

The contribution margin on the light side. I think it was 42%, the contribution on the heavy is a little bit higher than that but it's in the ballpark, yes. We have it's one of the distinguishing features of Headwaters is the operating leverage that's associated with the business. We have a very strong contribution margin. So if you take if you look at the light building product segment, use the 42% contribution margin, that model is a good predictor of where of what we have done. I just ran through that yesterday using that information that we've disclosed. On the right side, we're actually running a little bit ahead of where that model predicts. On the heavy side, we're running just a little bit behind where that model predicts but nevertheless, I think between the two, those models are reasonable predictors of how our performance through the first quarter.

Adam Wyden

Can you discuss kind of what the normalized housing start number that you've been working off? Just so we can have an apples-to-apples comparison for the light kind of the light side over the course of the year? Is it a 430 number, a 400 number, 455, 100 and how do you think about kind of what you're working on is there lag and can you explain kind of the timing on that just it seems there's a tremendous amount of operating leverage, we're almost at we can get to 800,000 housing starts pretty quickly and then you reverse engineer that and then substantially more EBITDA from the light side, right?

Kirk A. Benson

Yes. There is we generally have been trying to be relatively conservative on what we use internally from 2006 through 2011, the market and everybody was disappointed at how steep this decline was and in staying at the bottom, for '10 and toward '11, we're starting to see some improvement so we continue to be relatively conservative in what we predict. Your comment though if they both 800,000 housing units and for total both single and multifamily construction, that's going to have a very positive impact on our operating income as we take advantage of this high contribution margin they operating leverage. And so, we've run the business with that taking that into consideration into account because that continued to be a good predictive model. And as I said, I went through this I was looking at our shareholder presentation and I looked at those 2 slides to test whether or not that model was directionally accurate but fairly close in predicting our operating income and adjusted EBITDA performance-based upon changes in revenue. And it continues to be of value in understanding Headwaters and ability to predict the impact that revenue changes revenue changes. Now there's lots of things that go on change in mix and stuff like that and that occurs and these contribution margins that we're sharing with the market are clearly averages, and so you can't take those averages and be absolutely certain that it's going to work every time because you're going to have a change in mix and we have different contribution margins on different product lines and so, it's going to vary. But through the first 3 quarters of this fiscal year, it's been a very accurate, predictive model of how we're going to perform so if the end markets improved, we expect is operating leverage to generate outsized performance of the operating income and adjusted EBITDA levels of the company.

Donald P. Newman

This is Don. We ended last year, I believe at 430,000 single-family starts and at this point, we're at, last summer I saw about 530,000 single-family starts on an annual adjusted basis. And so as we look at the horizon, we look at the business is that housing number holds. So we run our business based upon what we can see and then we also have scenarios for growth. But when we're talking about, if you're asking hey, what do we think 2013 is going to look like, from our perspective, we can see where there's been very mixed signals in terms of recovery, we're running our business based upon the current levels that we see in the business and we are preparing for growth if that growth is there and we're very well prepared for it. And we should be able to take advantage of it.

Adam Wyden

What order of magnitude, you're number one in all of the markets. Primarily on the light building products side and I think you guys are dominant in kind of servicing coal but in order of magnitude what do you think the scope of the opportunity is for market share gains in these segments marked in the kind of total potential market share and how much do think you can still over a longer period of time.

Kirk A. Benson

Let me respond to that question then share that we are near the end of our call. So let me respond to that and then that will be the last question for the call. But if you look at the I think we've got a very good opportunity in the architectural stone space to take market share. So that market is more fragmented than some of the other areas that the compete. And that's one of the challenges that I've shared with Murphy, was to design a strategy that would result in increasing market share in that business. And so, I think we have had some positive market share gains and that's a place that we are focused strategically. In deciding part of the business, and some of our core products, some of the legacy products where we have a 75% plus market share, I think there's less opportunity there for market share growth. And so.

Adam Wyden

You can increase price right, so the overall scope the market you have pretty strong handle on the price there and the only market at 75%, you can increase price pretty rigorously, right?

Kirk A. Benson

I think that's correct. We've been successful at being able to raise price in that part of our business. I think that our growth in some of the newer products as I mentioned on the call and siding products they were taking some market share and we're seeing some outsized growth clearly stronger growth than what the end markets would suggest and so, that implies that we're having so market share gains. Those the markets are especially in the roofing side very large so we're just getting started as far as the opportunity is concerned from of roofing perspective. But I think we'll see some good there and the Texas markets, I'm not sure you're going to see a lot of market share growth in block although that's why we're doing a geographical adjacency expansion and I think low season growth in some of the newer products there as well. I think in the heavy construction materials base that the market the environment rather, with the EPA and what's happening with natural gas prices has actually provided us with an opportunity for some market share gains in the heavy space so by and large it's a little bit of the next but I think we've got opportunities for market share growth. We are, I think we're going into 2013 actually feeling somewhat optimistic. As Don said, if the end markets are stable, we should have a strong 2013. We should actually do better than the end markets if we can make some progress in the stone and some of these newer siding products. So I'll give the side back to Sharon and the operator.

Sharon A. Madden

Thank you. With that, we will go ahead and conclude the call. Would like to thank you all for joining us today. Goodbye.

Operator

This concludes today's presentation. Thank you for your participation and you may now disconnect.

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