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Headwaters Incorporated (NYSE:HW)

F2Q08 Earnings Call

April 30, 2008 11:00 am ET

Executives

Tricia Ross – Analyst Contact, Financial Relations Board

Sharon Madden - Vice President of Investor Relations

Steven G. Stewart - Chief Financial Officer, Treasurer

Kirk A. Benson - Chairman and Chief Executive Officer

Kenneth Frailey – President, Energy Services Division

Jack Lawless – President, Building Products Division

Analysts

Steve Sanders - Stephens

John Quealy - Canaccord Adams

Al Kaschalk - Wedbush Morgan

Pearce Hammond - Simmons

John Bridges - JP Morgan

Operator

Welcome to the Headwaters Incorporated second quarter 2008 conference call. (Operator Instructions) I’d now like to turn the conference over to Tricia Ross with the Financial Relations Board.

Tricia Ross

Welcome to Headwaters Incorporated fiscal second quarter 2008 conference call. By now, you should have received a press release outlining Headwaters’ results for the second quarter. If you have not yet received the press release, please call 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 Vice President of Investor Relations.

Sharon Madden

Welcome to Headwaters fiscal ‘08 second quarter conference call. On the call today will be Kirk Benson, Headwaters’ Chairman and Chief Executive Officer, and Steven Stewart, Headwaters’ Chief Financial Officer, and for the question-and-answer session we will have Jack Lawless, President of our Building Products division, and Ken Frailey, President of Headwaters Energy Services division.

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

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

You may find Headwaters annual report on Form 10-K, quarterly report on Form 10-Q, and other SEC filings readily available from the SEC’s website, or you can get it from Headwaters website or directly from the company itself.

I will now turn the call over to Steven Stewart, Chief Financial Officer of Headwaters.

Steven G. Stewart

Welcome to our second quarter 2008 conference call. Attached to the press release, as Tricia mentioned, are the condensed consolidated financial statements of Headwaters that includes the statement of operations for the quarter and the six months, ended March 31, 2008 and 2007. There are also balance sheets as of March 31, 2008 and September 30, 2007. My comments are derived from those condensed consolidated statements. We expect to file our Form 10-Q within the next 10 days.

Headwaters’ second fiscal 2008 quarter continued to be significantly impacted by the weakness in the new housing and residential remodeling markets. In response to the slowing residential housing market, Headwaters put in place operational improvement initiatives in the building products business during the last half of fiscal 2007, and these initiatives along with additional improvements have continued through the March 2008 quarter.

However, these improvements get lost in the operating results as revenues continue to decline and fixed operating costs negatively impacted operating results when they are spread over smaller revenue base. As you are aware, fiscal 2008 will be significantly impacted because section 45K, the Internal Revenue Code expired on December 31, 2007, thus concluding a very significant and a very profitable business segment at Headwaters.

Fiscal 2008 will be a transition year for Headwaters as the synfuel business is now stopped and revenues and tax credits from the new clean coal business are now only beginning to reach commercial operating levels at some of the facilities constructed in 2007. Fiscal 2008 and 2009 will be years of significant development and growth, as we work through the problems we are sure to encounter, as we expand this new business opportunity.

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 and later as we move closer to possible commercialization of certain of our technologies. Our capital and debt structure is strong, but will continue to be put under pressure as we move into these very difficult and uncertain times.

Our cash flow continues to be strong, but it is clearly being outpaced currently by the significant expansion of the coal cleaning operations and other capital expenditure needs of Headwaters. The June and September quarters are our strongest operational quarters with cash flow being higher in the last six months of the calendar year. We believe these stronger operational quarters and our revolving credit facility will provide adequate cash flow to meet our needs.

The condensed consolidated financial statements include the operations of the Headwaters Resources Segment or our CCP business. It also includes our Building Products Segment, which includes our exterior accessory products, our architectural stone and concrete block operations in Texas.

Also includes is our Energy Segment and includes the old section 45K business, the new coal cleaning operations and the technologies being commercialized along with our ethanol plan, also includes our corporate operating expenses. As previously mentioned, exploration of section 45K and the resulting discontinuance of synfuel operations has caused many of the financial comparisons to prior year’s quarters to show significant decreases.

At Headwaters, we continue to focus more on recurring ongoing business, how these businesses are performing and the progress being made with new business ventures, such as our coal cleaning operations. Perhaps these business metrics, the growth we are experiencing with those operations and the relative performance of those ongoing businesses is more meaningful to our discussions today.

Accordingly, a lot of my discussion concerning the results of operation in the March 2008 quarter as compared to the March 2007 quarter will exclude the results of operations of the Section 45K business. Excluding Section 45K operations, our consolidated revenues for the March 2008 quarter of $164.1 million, was $14.2 million lower than the revenues for the 2007 quarter of $178.3 million. This represents a decrease of 8%. Substantially all of that decrease is a result of the slowdown in the residential housing market.

Gross profit decreased from $43.3 million in the March 2007 quarter to $33.9 million in the 2008 quarter which is a decrease of $9.4 million or 21.7%. If you exclude the foreign currency loss of $2.6 million that we incurred in connection with our hydrogen peroxide operations in South Korea, gross profit decreased by $6.8 million or 16% when you compare 2008 to 2007.

This decline is the result of lower gross margins in our Building Products Segment which resulted from lower sales and the impact fixed cost have from being spread over a smaller sales base plus the change in their product sales mix. The decrease in sales of coal combustion products or fly ash was partially offset by increased service revenue. However, service revenue normally produces smaller gross profit margin and both of these items contributed to lower gross profits.

Sales of CCPs was also negatively impacted by poor weather during the March 2008 quarter. Our operating loss, excluding Section 45K operations, increased from $5.1 million in the March 2007 quarter to $16.4 million in the 2008 quarter. If you exclude the foreign currency loss previously discussed and $3.8 million of restructuring cost that we incurred in the March 2008 quarter, the increase in the operating losses cut almost in half.

The majority of this net increase in our March 2008 quarter operating loss related to the Building Products Segment with the CCP operations also causing a negative impact, both offset slightly by a decrease in our corporate operating expenses.

A loss before income taxes for the March 2008 quarter excluding Section 45K and the two charges I previously discussed, decreased from $13.7 million in the March 2007 quarter to $12.3 million in the March 2008 quarter. This is an improvement of $1.4 million and is primarily the result of the gain realized of approximately $4 million on the sale of our remaining mortars and stucco business. This is offset by the negative operational items that I previously discussed.

The income tax rate increased from 17% in the March 2007 quarter to 18.5% in the 2008 quarter and was primarily the result of the interaction in the income tax calculation of the Section 45K activities. The income tax benefit recognized in the March 2008 quarter is lower than expected, and it is significantly lower because of the operating results in that quarter being low and any item having a larger impact.

Our diluted earnings per share decreased significantly from the March 2007 quarter to the 2008 quarter for all of the reasons previously discussed. As the diluted weighted average shares outstanding vary significantly when you compare 2008 to 2007 as the shares issue-able of both conversion of the convertible senior subordinated notes issued in 2004 are anti-diluting and therefore excluded from the March 2008 quarter calculation. These convertible notes have a similar impact on the six-month period ended March 31, 2008, and are therefore also excluded from the diluted earnings per share calculation.

Selling, general and administrative expenses during the March quarter were approximately 8% higher than the 2007 quarter. This increase is primarily the result of the $3.8 million restructuring charge recorded in the March 2008 quarter. SG&A expenses incurred in connection with the coal cleaning operation will be higher as a percentage of sales in the old Section 45K operations.

However, SG&A for fiscal 2008 should be lower as a percentage of sales in the March quarter as revenues increase during the June and September quarters. But we expect they will be comparable in total dollars to the March 2008 quarter levels.

R&D expenses for the March 2008 quarter was approximately 28% lower than the prior year quarter and was approximately 13% lower for the six months ended March 31, 2008 compared to the 2007 period. R&D expenses for fiscal 2008 should be at levels comparable to the six months period ending March 31, 2008.

During the December quarter, Headwaters put in motion the sale of a non-strategic portion of our Building Products Segment relating to our mortars and stucco operations. Part of this sale was completed in the December quarter and the balance was completed in the March quarter. This business generated about $37 million in revenue in 2007, and approximately $10 million of revenue had been reported from this business in a six-month period that ended March 31, 2008.

A significant portion of the proceeds we used to purchase two cement block plants in Texas that will be integrated into our concrete block business. While these block businesses might not replace the revenue from the mortar and stucco business sold, we expect that they will produce higher margins which should replace the operating income from those businesses sold over the next 12 to 18 months.

Headwaters long-term debt was $561.4 million at March 31, 2008 and represents an increase of about $18.9 million when you compare it to September 30, 2007 balances. This increase is a direct result of the significant investment being made in the new coal cleaning operating facilities.

Headwaters generated approximately $22 million of cash flow from operating activities during the six months ended March 31, 2008, which is significantly lower than the comparable 2007 period. We spent approximately $57 million on capital expenditures during the six months ended March 31, 2008.

We had a $15 million draw on our revolving credit facility at March 31, 2008 and currently those draws total $25 million. Our revolving credit facility revised for total borrowings of $60 million and we currently are utilizing the revolver to support approximately $9.4 million of letters of credit. This leaves approximately $25.6 million available to be drawn on the revolver.

Net interest expense during the March 2008 quarter was $6.2 million, and we expect interest expense for fiscal 2008 to be approximately $25 million. We expect cash flow from operations in fiscal 2008 could exceed $100 million. We also expect capital expenditures to exceed $100 million during that year. The substantial portion of the 2008 capital expenditures relate to the coal cleaning initiative, and accordingly, we would expect capital expenditures in 2009 to decrease significantly.

Operating leases and/or capital leases will also be utilized to meet our capital expenditure requirements. Depreciation and amortization was approximately $34 million during the six months ended March 31, 2008, and we expect depreciation and amortization for fiscal 2008 will be approximately $70 million.

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

The discontinuation of Section 45K operations will cause our trailing 12-month EBITDA to decline. The significant increase in capital expenditures in fiscal 2008 and the declining EBITDA will cause these ratios to tighten. We believe we have options to help manage compliance with these debt ratios and covenants including amending our senior secured credit facility, if necessary.

We currently have substantially no required principal repayments until February 2011 even though we currently expect to repay the borrowings on revolving credit facility during the next 12 months. We currently believe that our operations will produce positive cash flow in future periods and we believe that working capital along with leasing alternatives and available borrowings on our revolving credit facility will be sufficient to meet our operating needs over the next 12 months.

Currently, approximately 55% of our revenues comes from our Building Products Segment, 35% of our revenue comes from Coal Combustion products Segment, and the balance from our Energy Segment. Currently, we estimate that approximately 70% of Headwaters operating income will be produced by the Coal Combustion products Segment and approximately 30% will be produced by the Building Products Segment. With the Energy Segment at breakeven after deducting Section 45K business and the Headwaters R&D technology group located in New Jersey.

As the coal cleaning operations continue to grow and mature they will comprise a larger portion of Headwaters consolidated operating income. It is not possible to predict the depth and duration of the current slowdown in the Building Products Segment industry, but with cost improvement initiatives now in motion, we believe we are well positioned to take advantage when this industry cycle turns.

The weighted average shares outstanding decreased at March 31, 2008 when compared to September 2007 as a result of approximately 1.2 million shares of stock that we repurchased during the December quarter. At today’s stock price a substantial part of Headwaters’ options and stock appreciator rights are out of the money and are therefore excluded in the diluted weighted average shares outstanding calculation. As of March 31, 2008, Headwaters had approximately 42 million shares issued and outstanding.

We believe the results of the March 2008 quarter reflect a difficult building products market we’re experiencing and a significant impact of discontinuing the Section 45K operations. These and other events have caused us to revise our fiscal 2008 guidance for diluted earnings per share to be between $0.60 and $0.75 for the year.

We will continue to look for opportunities to reduce our operating expenses, accelerate ramp up of the coal cleaning business, efficiently manage our CCP Segment and commercially validate our technologies. I’ll be glad to discuss specific questions about the quarter during the question-and-answer period.

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

Kirk A. Benson

The strong performance of our Headwaters Resources, our bulk fly ash business was tempered in the March quarter primarily by weather in the California and Midwest markets. Strong wind and rain dampened the infrastructure projects throughout California, higher than average snowfall totals slowed construction activity in the upper Midwest.

However, even with the slowdown in residential construction, demand continues to be strong due to a large backlog of infrastructure projects and increased acceptance of fly ash as a substitute for Portland cement. The change in margins for the quarter was primarily related to the mix that made up our sales volume.

Although the quarter was slow due to adverse weather conditions, Texas showed continued strength. Florida is our third largest market and sales were impacted by weak residential construction, an increase of Portland cement supply, and diminished demand by integrated cement users. We made substantial progress during the first six months of the year to increase supply and anticipate that the next 18 months will show increased tonnage sold as our new contract, storage and blending all come on line.

Overall, we believe that demand for fly ash continues to exceed supply but there is a closer demand supply balance. There is also some indication mixed design are favoring increased levels of fly ash substitution. For example, California is considering an increase in its DOT substitution rate from 25% to as high as 50% for some types of projects. Finally, prices remain firm with the upside opportunity in the 1% to 2% range. Now, our outlook for the remainder of the year and into 2009 remains optimistic.

I’ll make some comments now about our Building Products Segment. The number of housing units started to decrease to a new 17 year low in March, single family starts were down 44% from last year, and 58% below the March 2006 peak.

New home sales dropped 8.5% in March. This is the fifth straight month in which seasonally adjusted annualized sales have declined. New home sales have fallen to their slowest annual rate since October 1991. On a year-over-year basis, new home sales were down 36% from last year and 53% from March 2006. March declines in both prices and sales indicate that the worst is not over for the new home market. Supply will need to come down much more in order to meet current demand.

The inventory of new homes for sale has declined. Non-seasonally adjusted units of unsold inventory are now at their lowest levels since July 2005 as builders continue to scale back building activities. However, seasonally adjusted months of inventory reached a new high in March due to a significant slowdown in sales. There are now 11 months of supply based on the current sales pace. Steadily declining inventory levels failed to offset the dramatic slowdown in sales.

So, as expected, we continue to be impacted by the down cycle in new residential construction. In addition, weather in the March 2008 quarter was more superior than the March 2007 quarter, exacerbating the effect of the down cycle. A combination of the residential down cycle and poor weather conditions resulted in a 19% drop in the year-over-year revenue.

We expect new single-family residential construction to be down by more than 30% in the year. We project our revenue for the year to be down 15% to 20%. We are highly seasonal and our ultimate revenue levels are determined in the summer, June and September quarters.

In contrast to the down cycle and poor weather, we are experiencing a number of positives from a revenue perspective. For example, our engineered slate tile-roofing product is up over 100% in the first six months of the year, and now has a run rate in excess of $10 million.

Our StoneCraft line is gaining momentum through opening up new channels of distribution. We now distribute StoneCraft to retail in a combination of two-step to one-step wholesale distribution. We are at approximately a $10 million run rate through new distribution channels and anticipate a $15 million run rate by the end of the year.

Because of lower sales volume, we experienced reduced margins primarily caused by lower overhead absorption. A drop in revenue can immediately impact margins, whereas productivity improvements take time to implement. In the December quarter, when we had a 6.5% drop in revenue, our margins improved by 230 basis points.

Productivity improvements continue but are masked by the drop in revenue. An additional factor impacting our margins is the rapid growth of new products which overall is a strong positive, but newer products have lower operating margins in the early stage of initial sales because of relatively higher marketing expenses and fixed overhead costs spread over fewer units sold. As the products mature and revenues expand, we anticipate normal operating margins.

We are very optimistic that our current productivity improvement efforts will ultimately fully compensate for the drop in operating margins. We have a total of more than $14 million in cost saving initiatives either completed or underway including consolidation of plants both at our accessory lines and our stone lines, plant closings, transportation freight cost savings, introduction of new Lean inventory control systems, manufacturing system changes and productivity improvements. The $14 million in productivity improvements represent more than a 25% increase in operating income based on 2007 operating income of $53 million.

Now, I will make some comments about our energy services business and particularly

coal cleaning. The most important factor that is influencing coal pricing is global demand, causing U.S. exports to increase and tightening domestic supplies. Coal has become a global commodity and domestic consumers are competing with international purchasers.

In the past, coal prices have typically not maintained momentum, but the current environment appears to be different. First, exports from the United States are on the rise in response to international demand and the reduction of exports from China. U.S. exports are also more competitive because of the weakness of the U.S. dollar.

Additionally, there has been curtailment of South African shipments and disruption of Australian coal supply due to flooding and other transportation issues. In fact, the costs structure for Eastern U.S. coal has increased and as coal prices eventually come down high production cost coal will be withdrawn from the market and supplies will naturally be reduced, resulting in prices settling at a higher price floor than in previous cycles.

Steam coal spot pricing trends have been very robust over the last six months. Central App, Illinois Basin and Pittsburgh Steam Coal have all increased by more than 70%. PRB coal has lagged at about a 25% increase. Utah and other Western bituminous coal has increased by almost 50%.

Contract pricing lagged spot prices, as contract prices must roll off before new prices can go into effect. Increase in met coal pricing has been more significant than steam coal. Driven by global market demand, spot coal prices for cargos from Australia have reached a reported $300 per metric ton.

U.S. suppliers settled contract pricing in the fall of 2007 for around $100 per metric ton, breaking a long history of U.S. suppliers settling last in the international buying cycle. These suppliers settled ‘07 and ‘08 prices before the large international price increases. But these price settlements will undoubtedly be increased in the fall of 2008 when U.S. suppliers will renegotiate pricing for ‘09.

Several major factors affect Headwaters’ pricing. First, our pricing is impacted by the mineral leases that we negotiate. Generally, our strategy has been to take a conservative lower risk approach to purchasing our coal by setting a floor price to Headwaters. We attempt to negotiate a significant portion of the initial sales dollars as Headwaters’ share and make material payments to the owner only after the sales price exceeds the floor value to Headwaters. As coal pricing increases, we benefit but not as dramatically because of our risk-sharing mechanism. For example, we may share in the upside 50/50 with the owner, after the coal price reaches a certain level.

Second, Headwaters prices its coal FOB plant site which includes customary product, coal quality parameters like ash and moisture. Transportation, loading and handling and other fees may total $30 to $40 per ton of coal, and are not included in our reported average pricing.

We currently have six coal cleaning facilities at various stages of operation. One facility has been primarily a tolling facility. We have three facilities that are currently starting up and two fully operational facilities. However, we anticipate ramping down our tolling agreements in the future.

In the December 2007 quarter, Headwaters sold approximately 85,000 tons of coal which included 58,000 tons of tolling and no met coal. Headwaters non-toll product was all contracted to be sold in the steam market at prices set last fall averaging $38 per ton.

In the March 2008 quarter, Headwaters sold approximately 191,000 tons of coal, including 53,000 tons of tolling. And those sales included both steam and met coal. The average price was $40 per ton. The average price increased primarily because we began to ship met coal.

We anticipate that sales in the June and September quarters will benefit from additional facilities as they continue to ramp up production. We estimate sales in the second half of our fiscal year to be approximately 600,000 to 700,000 tons at an average price of $40 to $42. In addition to the six facilities that we currently have at various stages of operations, we have four facilities under construction.

We believe that all four facilities will be completed in calendar year 2008 and begin ramp up in 2009. Our plans call for additional facilities to be constructed or purchased in 2009. We anticipate that our coal sales in 2009 will be in the range of 2.5 to 3.5 million tons at a sales price range of $55 to $63 per ton. In 2010, we anticipate that our coal sales to be in the 4.5 to 5.5 million tons at a sales price range of $60 to $70 per ton.

Coal prices have changed substantially over the past six months and are affected by a very dynamic environment. Accordingly, Headwaters’ projections are subject to change based on the environment and the operations of our facilities. Our coal cleaning facilities remove sulfur and mercury from the waste materials, resulting in an environmentally cleaner fuel with reduced noxious emissions. This refined coal sold into the steam market should qualify for $6 per ton tax credit.

Our other coal-related projects continue to move forward. Coal to liquids projects in India, China and the Philippines continue to progress outside the United States and our North Dakota project continues along its development plan.

Now, I’ll make a few comments on our technology developments. Commercialization of HCAT and our advanced process in unique catalysts to improve the upgrades on heavy oil continues. Our technology is unique because we create individual active catalyst molecules circulated with heavy oil throughout an upgrading reactor. Consequently, we believe our HCAT process facilitates hydrogen transfer in the upgrading reactor should produce a lighter, more stable product more effectively than existing technologies because of the intimate molecular interaction.

We are currently in discussions with all three refineries that have used HCAT over the last couple of years. The discussions are positive and we continue to be optimistic about the potential of all three refineries becoming HCAT customers. As of this date, HCAT is not operating, but the positive technical results and the relatively low risk of applying the technology continues to impress our potential refinery customers.

Expansion of our joint venture hydrogen peroxide facility in Ulsan, South Korea was completed on budget slightly ahead of schedule. We have doubled the capacity of the facility to 75 million tons of annual production. Delivery of hydrogen peroxide to SKC Chemical during the March quarter for the manufacture of propylene oxide has commenced and we anticipate profitable operating results. EvonikHeadwaters continues to develop technology related to direct synthesis of hydrogen peroxide at Evonik’s German demonstration plant.

I will now turn the time back to the operator for questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Steve Sanders - Stephens.

Steve Sanders - Stephens

First, on the guidance, I assume it’s GAAP for the year, if you could just confirm that, and then maybe make a general comment on how conservative you feel the guidance is relative to what you are seeing on the residential construction side, and how we should think about potential charges related to some of the cost savings initiatives over the balance of the year.

Steven G. Stewart

Relative to the guidance, Steve, we are $0.02 for the six months ended March 31, 2008. So, that is a GAAP basis 0.60 to $0.75, and we are now starting at $0.02 so we expect the balance to come in the next two quarters.

Kirk A. Benson

We don’t anticipate any additional restructuring charges for the remainder of the year. So, the guidance is without any additional restructuring charges but does include the one that we took in the March quarter.

Steve Sanders - Stephens

On the operating expenses, Steve, but I thought you said the March quarter is a good run rate ex the $3.8 million charge, is that correct.

Steven G. Stewart

In absolute dollars, that’s correct.

Steve Sanders - Stephens

On coal cleaning, could you just talk about the pricing and how that plays out over the course of 2008, relative to your pricing per ton projections in 2009 and 2010? In other words, by the end of this year, will the pricing be firm in 2009 and what happens over the next three to six months as we kind of shoot for that good visibility on pricing in 2009?

Kirk A. Benson

We’ve got some contracts that have already been entered with pricing based on prices as of last year. We’re in the market right now with bids out and negotiating prices for late 2008 and into 2009. Most of the pricing will firm up late in 2008 for the 2009 year.

Kenneth Frailey

What Kirk has said is right on. We will continue to negotiate these prices. We have much of our coal that is marketed through agreements with coal companies where our facilities reside, and then a few of our facilities we will negotiate those on our own.

Steve Sanders - Stephens

How do the pricing adjustment mechanisms work on the contracts going forward? In other words, if the coal spikes or drops significantly, what happens to the contract pricing?

Kirk A. Benson

Generally, our pricing is fixed for 12 months and as the contracts roll over you set new prices.

Kenneth Frailey

That’s correct. We don’t have significant penalties for coal quality because we are pretty sure of what the quality coming out of our facilities is and we can control that fairly well. So, our prices are pretty firm in the contracts that we negotiate.

Steve Sanders - Stephens

On the coal cleaning, you’ve talked about 25% EBIT margins once the facilities are ramped up and you are efficient on the production side. Obviously, you have also given us the mechanisms to work with as coal prices go higher than I think the $35 or $40 that the 25% based on.

What about the path to get there in terms of a range of EBIT margin in 2009 based on the assumptions that you’ve given us. If we look at the business as roughly breakeven this year and maybe it’s better than that, maybe it’s worse and 25% plus kind of EBIT margin in 2010. Should we use linear for 2009 so mid-teens kind of EBIT margin or how should we be thinking about that?

Kirk A. Benson

Where you’re coming from is absolutely correct because when you start up a brand new facility, you don’t have a 25% operating margin. It takes some time for those facilities to ramp up and so you end up with a lower blended margin and so something less than 25% is an okay estimate for 2009 because it will be towards the mid to the end of calendar 2009 before all these facilities are up and running. So we don’t have really a full run rate until 2010. So, I think a linear kind of an estimate is probably as reasonable as any other.

Operator

Your next question comes from John Quealy - Canaccord Adams.

John Quealy - Canaccord Adams

Going back to building products and going back several quarters, you have weathered the storm pretty well, both on sales and margins. Can you comment a little bit on what was the catalyst in this period that really hit you and caused you to lower the outlook, was it the spring-summer build in the inventory channel that was coming back? If you could just give us a little bit more on why you feel comfortable that this is an achievable level of business moving forward?

Kirk A. Benson

I think one of the things that happened in the March quarter is that we were impacted by weather to a fairly significant degree in many of our markets. So that’s one of the factors that happened in the March quarter, is weather-related.

The other thing that is that we continue to be significantly impacted by the downturn of residential construction in the California market, and that has a direct impact on our architectural stone business in particular. And so we had a worse than expected March quarter based on how we were faring in prior quarters.

We still don’t know how the June and September quarters are going to turn out, because the weather has been slow to turn this year. We’re starting to see an increase in sales for sure in April as you would expect from a seasonal prospective. But we still don’t have enough summer weeks under our belt to have a real good feeling for the June and September quarters.

Jack Lawless

Yes, Kirk, I think that’s right. I think, the impact of winter it surely had an impact in our second quarter. We do need to see a little bit more going on and through the first two or three weeks of May to get a read on this particular quarter that we are in. April results look like they’re going to on a top line basis in the building products unit it looks like we’ll be down less than 10% through April compared to being down 19% for the quarter, but it’s still early.

You still need to see the level of reorders and when the reorders come in May, just see what the sell through has been. I think one of the questions, John, you had related to the spring selling season, that’s definitely upon us now. It really wasn’t a factor at all in the January, February, and March time period.

John Quealy - Canaccord Adams

The covenants and the cash flow side, if we are looking at roughly $100 million operating cash in CapEx above that. I think on previous calls, we talked about coal cleaning as about a $60 million effort in the fiscal year, is that a decent number to use in terms of how much capital you put in work for the coal cleaning business?

Steven G. Stewart

It’s probably a little bit larger than that. Part of it, we might have been referring to CapEx as we are now doing some leasing in that. But I would think in total, the number is probably closer to $80 million as far as what we’ll put out in this fiscal year for coal cleaning.

John Quealy - Canaccord Adams

And so assuming that the Section 45 refined coal deadline sticks and you have a ramp down, you would expect a pretty decent step-down in CapEx for the ‘09 period, is that correct?

Steven G. Stewart

I think that’s correct. Clearly, we anticipate that we will be building facilities in ‘09 because there’s good economics in these. In addition to as we’ve mentioned in the conference call we bought a met plant and so the met coal when we sell in the met market does not qualify for the credits, yet the economics are even better because of the pricing of the met coal. So it will clearly fall off, John, but it’s not going to go to zero as we move into ‘09.

Kirk A. Benson

We think ‘09 is going to be closer to $30 million as opposed to the $80 for this year, so I think a fair estimate today will be in the $30 million range for ‘09.

John Quealy - Canaccord Adams

Rounding out coal cleaning, first, as we go forward in that back half 600 to 700, is this necessarily seasonal based on your deliveries to some of these coal handlers and utilities, or should we see another sequential bump as we close out the year? And then also on the margin, I know you have some volume headwinds as you start these plants up, but in terms of rail excavation processing, can you walk us through your comfort on that range on the small plants you’ve done so far?

Kirk A. Benson

This business for the next couple of years, any seasonality that’s in the business is going to be lost in the ramp up of new facilities. So we should be able to continue to grow even if there were any seasonality, because of new facilities coming online and so it will be a little bit of a step process as you bring facilities online. So it’s not going to be exactly linear, but through the steps of bringing the facilities online, you should see an increase basically quarter-over-quarter as we bring new facilities online and ramp them up.

Kenneth Frailey

I think that’s right on. We do have these facilities coming on at staggered intervals, so there will be a little bit of up and down. But I think that you will just see a gradual ramp up as we bring these facilities to full production. We’ve demonstrated what we did in December and March quarters and I feel fairly confident that we will just see that gradual ramp up continue.

John Quealy - Canaccord Adams

And if I could just come back a little bit more on the margins in terms of, you’ve got experience with six of these. Where are the areas that you would focus on as you again aside from volume characteristics, what are the areas that you are focused on to keep those margin expectations in a reasonable range?

Kenneth Frailey

Well clearly, our focus has to be to bring these facilities to full production and so we are definitely focused on doing that. But in parallel, just from a cost control point of view, definitely we will we will spend the money that we need to get these facilities to full production, but we are also very much aware of cost control issues. But the cost control will ultimately lag the production ramp up and it necessarily needs do to that, but we will optimize our costs, as our production starts to level off at the design capacity.

Kirk A. Benson

So, one good thing about starting this new business is that we can put in place are Lean principles from the very beginning. So, as an example, at our #4 facility in Alabama, we’ve already had between 300 and 400 kaizen events with productivity improvement suggestions.

So, the productivity improvement is that the fundamental basis for all of that is in place and is working at these facilities. Ken is right however, the first objective is to get the production up to budgeted levels, but we’re already working on productivity improvements as we move toward budgeted levels and so the framework for that is put in place.

Kenneth Frailey

The good thing I might add to this is we can learn from the facilities that we are already starting up and we are transferring that knowledge to each of our other facilities as they start up. Our employees, we feel, are fully trained as the facility nears its start up and we actually take our employees to operating facilities to train them, so that they can come online, each plant is different, but at least we’ll share that information crosswise across our organization.

Operator

Your next question comes from Al Kaschalk - Wedbush Morgan.

Al Kaschalk - Wedbush Morgan

It seems to me that you are well on target based on what you guided for the coal business of $30 to $40 million and perhaps need to remind folks that you’re running these businesses to get them up in service by the end of the calendar year as opposed to operating them for margin. So with that, it appears based on the additional information you disclosed, that you are well on your way to FY ‘09 of $150 million of revenue, is that fair based on the low-end of the guidance?

Kirk A. Benson

Yes. You can, yes, take that, our tonnage that we’ve projected and the price we projected and yes we feel like we are well on the way to achieve those numbers.

Al Kaschalk - Wedbush Morgan

On fly ash, could you give us a mix of business between products and service oriented because I think that’s certainly impacting some of the margin that maybe some of us had modeled?

Kirk A. Benson

Yes, in fact, what happened in the March quarter is that the sales into the western region of product declined primarily because of weather in the California market. And so that was the principle change in mix. There is a few other changes in mix but that was the most material change in mix, and at the same time we’ve won a couple of additional service contracts in the Eastern region. So, during the quarter, we actually had an increase in service sales and a decrease in product sales. And that’s why that was reflected in the margins.

As we go into the June and September quarters, we would expect margins for June and September of ‘08 to be comparable to the margins in June and September of ‘07. The margin should return to margins comparable for last year, as the mix gets back into its normal ratios. And so, I am not sure that I would recommend trying to break up the modeling between the mix of sales and the sale of the product. Because the margins, if you have disruptions like we had in the March quarter, then you are going to have, that’s going to show up in this margin change.

But, we think that the June and September quarters are going to be back to margins very comparable to last year as that sales mix ratios get back to a more normal mix. The specific answer to your question is we probably have between 20% and 30% of our revenue that is service oriented.

Al Kaschalk - Wedbush Morgan

Going back to coal cleaning, why is the guidance with fiscal ‘08 $30 to $40 million viewed maybe a little bit wide, what’s the uncertainty over the next six months to be either at the low or high end of that number?

Kirk A. Benson

We forecasted $30 to $40 million a quarter ago and you can see that significant increase between the December quarter and the March quarter. These facilities are ramping up pretty dramatically. And so, we said $30 to $40 million was a wider range because that was done before the ramp up was completed and we had seen that we could ramp up these operational activities. So that’s one reason that the range is as wide as it and we just didn’t narrow it. I think the risk has decreased for being able to achieve those numbers.

Kenneth Frailey

That’s right I don’t know that I can say too much more about it. Our ramp-up continues at a fairly good pace. I feel good, what we have accomplished in our operations to date. We don’t know all of the answers there, so we are being a bit conservative, but I think prudently so.

Al Kaschalk - Wedbush Morgan

On the tax rate for fiscal ‘08 or the second half of ‘08, what’s the assumption there?

Steven G. Stewart

Our expected tax rate is still predicted to be around 30% for the year and the thing that impacted that is these nonrecurring items, but we expect 30% for the fiscal year.

Al Kaschalk - Wedbush Morgan

On the cash flow over the next 12 months for repayment of debt, I think you said and as disclosed there is no scheduled payment for 2011, but you expect to pay that off over the next 12 months?

Steven G. Stewart

We expected to pay what’s on the revolver. So, we got $25 on the revolver right now, we would expect to pay that off over the next 12 months.

Operator

Your next question comes from Pearce Hammond - Simmons.

Pearce Hammond - Simmons

Kirk, I was just curious on the coal sales guidance in ‘09, the range of 2.5 million to 3.5 million tons, how many of those tons will qualify for that Section 45 tax credit?

Kirk A. Benson

Of course, the only tons to qualify are steam oriented tons and in that there is a mix of met coal, which doesn’t qualify and steam tons that do qualify. What we think that we are going to be able to do is manage our effective tax rate to that approximately 30% rate.

And so, you can actually do your model and you can back into the amount of the credits you need to get about a 30% tax rate and then you divide that by that 6 and you get the number of tons that would be the steam tons.

So, we have some flexibility of shifting between steam coal and met coal at some of these facilities and so, we will do that when it’s economically advantageous to do one versus the other. So if you had met coal prices come down then we could shift to a steam coal and produce the additional tax credit. But generally I think what you can do to get that flip is you can work back from the effective tax rate of 30%.

Pearce Hammond - Simmons

Sure, so the goal next year is to be at that 30% for ‘09 as it is this year the guidance for ‘08?

Kirk A. Benson

Yes.

Pearce Hammond - Simmons

On the margin, in response to Al’s question, you were given some good detail on margins in the last two quarters of the year, the June and September quarters should be comparable on the coal combustion products group. What about construction materials? How should we think of margins there for the back half of the year compared to’07?

Kirk A. Benson

Well, there are two things that are going on in building products that have a significant impact on margins. One is the drop in revenue. If we see a 20% drop in revenue, then you would anticipate margins are going to be down because even though we’re working to improve margins, we will basically be overwhelmed by the downturn in revenue.

As Jack indicated, our sales in April would direct us towards better sales than being down by 20%. So in the December quarter, we were down by 6.5% but our margins improved by 230 basis points. So, one of the factors is this drop in sales. If April turns out to be indicative for the rest of the year then our margins will be more stable because the other thing that’s going on is this $14 million or so productivity improvements that we have in process.

So those improvements will increase margins and so those are the two countervailing things that are going on, one is the drop in revenue, the other thing are the productivity improvements, the plants closing, the other things we are doing to enhance margins. I would say if we were below 10% drop in sales, then our margins would be comparable to the prior year. If we are greater than our margins will probably will be less.

Jack Lawless

Well Kirk I think that’s right, the only color that I would add would be the mix of sales. To the extent that the mix changed a little bit so the newer products are a higher percentage of sales than our mature products that have a generally higher margin that can change our mix around as well.

Kirk A. Benson

I think that’s right. When these new products are just introduced, you have lower margins because increased marketing expenses and the fixed cost over a lower base, and so that has an impact on margins as well. So, it’s those three things that are going on. What happens with the revenue, what we do at productivity improvements, and the other thing is the sales mix.

Pearce Hammond - Simmons

What key milestone or metric do you think investors should focus on to give them a sense that things have bottomed in construction materials and will be heading up from there, I know at the Analyst Day you’re pretty clear that things weren’t turning anytime soon, but if there was one metric that you would recommend focusing on more than others what would it be?

Kirk A. Benson

I will tell you the things that from my perspective is the thing that I’m focusing on is when you get to the point where you’ve got a balance in the new homes that are coming into the market and sales. And what’s happened recently is that sales have tailed off even though new home construction has dropped, sales have dropped faster, so your inventory has gone up to 11 months. That inventory number needs to be closer to four months and so, I think one really important factor to look at is the inventory in new homes. And that’s continued to go up, not down and I think it needs to come down a lot before we hit bottom in residential construction.

Jack Lawless

My thing would be more about 50% remodeling so I would concur with what Kirk said, but add being 50% residential remodeling our building products unit. I’m looking really at unlocking the residential financing markets a little bit. I think that will have a pretty big role in getting things back a little bit. To a larger extent while things are bad I think they are probably a little bit artificially low with the complete lack of funding in the residential financing markets.

Kirk A. Benson

In fact our sales, some of our sales go into Lowe’s and Home Depot, and those sales are almost 100% remodeling and it’s not exactly a bright spot, but it’s less dim. And that is that our sales into Lowe’s and Home Depot have been stronger than wholesale distribution. And that’s an indication that folks are doing remodeling with, in fact a lot of it is being done without financing, but that’s an indication that there is some remodeling demand that exists in the marketplace and, as Jack said, a lot of our sales are into the remodeling market.

Remodeling market may recover faster than new residential construction, but it is dependent, as Jack said, upon getting some financing in place so folks could take out home improvement loans. That’s an important part that isn’t happening right now.

Pearce Hammond - Simmons

You mentioned the ratio is tightening, and you mentioned you had some ability to do some things to alleviate that, could you go through those again, and then how does that work in a tight credit environment that we are entering now?

Steven G. Stewart

Couple of things, Pearce that we could do. There is ways to accelerate cash generation. We have assets that could possibly be sold, we could accelerate that process to cause the cash to come in we could use that to repay debt.

We have the ability to go back to the lenders and amend our loan agreement. We are hesitant to do that because in today’s market that becomes a very costly process, and so as a last resort if we needed to and we monitor this almost on a daily basis with cash flow projections, but if we needed to, we would go back to our senior lenders.

The ratio right now, loan to EBITDA is around two which is a pretty healthy ratio. So we think it would cost us some money, but we would be able to accomplish an amendment if we needed to.

Operator

Your final question comes from John Bridges - JP Morgan.

John Bridges - JP Morgan

I wondered with this met coal acquisition, any numbers on that? Is it meaningful?

Kirk A. Benson

Yes, I think it can be quite meaningful because we will end up with higher than our overall average pricing because it will be primarily met coal. And we feel very comfortable that met coal will be purchased because of the relationship with the coal company so you have reduced marketing risk associated with it. And it will produce a high quality met coal product.

John Bridges - JP Morgan

Do you have any numbers on what you are paying for it and that sort of thing?

Kirk A. Benson

I think it’s in the range of what we are spending for CapEx on comparable sized projects. So, that was in the range of $14 to $18 million for that size of facility.

John Bridges - JP Morgan

And the price to buy it?

Kirk A. Benson

Yes, that would be in that range, $14 to $18 million.

John Bridges - JP Morgan

And likely production?

Steven G. Stewart

About 500,000 tons annually when it’s fully ramped up.

John Bridges - JP Morgan

You have given guidance out to 2010 which is outside the 12-month range where you have prices fixed on the prices for coal cleaning. So you must be making assumptions there on thermal and met coal pricing. In order for us to get a better fix on where these prices are going what assumptions have you made on thermal and met coal?

Kirk A. Benson

I think the global assumption is that we have assumed that the tightness in the market would probably relax to some degree by 2010, but there would still be significant growth in the consumption of coal, that’s based primarily on growth assumptions in China and India and international markets, continued tightness in South Africa. We have assumed of course that Australia would solve some of their transportation and their issues but the overall assumption is by 2010 is a continued tightness with some relaxation, but continue tightness in the coal markets globally.

Kenneth Frailey

I think the only thing I would add to that is we do see the met coal markets backing off some, but we do see some strength in the steam coal markets domestically.

John Bridges - JP Morgan

So coming back to that, something like $200 for met coal?

Kenneth Frailey

Yes, I don’t know that we have.

Kirk A. Benson

In that range, yes.

John Bridges - JP Morgan

And the percentage of met versus steam in that 2010 number?

Kenneth Frailey

I think that we still show probably more met than steam. We do have the ability to float between the two depending on where we see the markets export wise for met coal. Predominantly we will ship met coal out of our West Virginia operation that you were just questioning us on, but in the Alabama market, there is probably, I don’t know, 60% of that market going to met and the other to steam.

John Bridges - JP Morgan

So you are saying that 60% of your 4.5 to 5.5 million ton guidance in 2010 is met?

Kenneth Frailey

No, in our Alabama market. I would say overall I don’t know.

Kirk A. Benson

Let’s say what we have, in some ways that’s the reverse of the question about how much is steam coal, you’re asking how much is met coal. The earlier question was how much is steam coal, my answer there was how many credits we are going to be generating. I think that overall there is going to be somewhat more steam coal in the entire mix.

Our Alabama facilities can qualify for met coal, our West Virginian facility can qualify for met coal, that’s a total of five of the ten facilities. And that’s where Ken was getting close to about a 50%. Now of those five facilities that will qualify for met coal we are going to be running some steam coal out of those facilities. So the overall number will be less than 50% production that will be met coal.

And so even though five of the facilities can produce met coal the production out of those five facilities that will be met coal will be less than 50% of our overall production. So you are probably in the range of 30% to 40% of met coal in the 2010.

John Bridges - JP Morgan

Presumably the price would be affected by this gain sharing principle that you’re using here?

Kirk A. Benson

Yes, absolutely.

John Bridges - JP Morgan

And the majority of those tons would be affected by that?

Kirk A. Benson

In almost all of our mineral leases there are gain sharing mechanisms.

Sharon Madden

Operator, we will go ahead and conclude the call now. Thank you all for joining us. Good-bye.

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Source: Headwaters Incorporated F2Q08 (Qtr End 3/31/08) Earnings Call Transcript
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