Headwaters Inc. F3Q 2008 Earnings Call Transcript

Headwaters Inc. (HW)

F3Q 2008 Earnings Call Transcript

July 29, 2008 11:00 am ET

Executives

Tricia Ross - Contact, Financial Relations Board

Sharon Madden VP of IR

Kirk Benson - Chairman and CEO

Steven Stewart - CFO

Analysts

Steve Sanders – Stephens Inc.

John Quealy - Canaccord Adams

Al Kaschalk - Wedbush Morgan

Michael Molnar - Goldman Sachs

William Gibson – Nollenberger

Julie Kutu - Simmons & Company

Presentation

Operator

Good morning, ladies and gentlemen. Thank you for standing by and welcome to the Headwaters Incorporated third quarter 2008 conference call. During today's presentation, all parties will be in a listen-only mode, and following today's presentation, the conference will be open for questions. (Operator Instructions) This conference is being recorded today, Tuesday, July 29^th of 2008. At this time, I'd like to turn the conference over to Tricia Ross with Financial Relations Board. Please go ahead.

Tricia Ross

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

Without further delay I would now like to turn the call over to Ms. Sharon Madden, Headwaters' Vice President of Investor Relations.

Sharon Madden

Thank you, Tricia. Good morning, everyone. Thank you for joining us, and welcome to Headwaters' fiscal '08 third quarter conference call. On the call today, we have Kirk Benson, Headwaters' Chairman and Chief Executive Officer, and Steven Stewart, Headwaters' Chief Financial Officer.

Before we get started today, 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 by their nature address matters that are, to different degrees, uncertain. These uncertainties, which are described in more detail in the annual and quarterly reports filed with the Securities and Exchange Commission, may cause our actual future results to be materially different than those expressed in our forward-looking statements, whether as a result of new information, future events, or otherwise, except as 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, Headwaters' website, or directly from the Company.

I'll now turn the call over to Steve Stewart, Headwaters' Chief Financial Officer. Steve?

Steven Stewart

Thank you, Sharon. Good morning and welcome to our third quarter conference call, and thank you for taking the time to join us. Attached to the press release that Tricia mentioned are condensed, consolidated financial statements that include statements of income for the quarter and the nine months that ended June 30, 2008 and 2007. There are also balance sheets as of June 30, 2008, and our year end, September 30, 2007. My comments are derived from those condensed, consolidated statements. We intend to file our form 10-Q within the next 10 days.

Headwaters' third fiscal 2008 quarter showed significant improvement over the March 2008 quarter, as you would expect, as we now move into our seasonally strongest two quarters.

However, we continue to be significantly impacted by the weakness in the new housing and residential remodeling markets, in addition to the significant investment we are making in our new coal cleaning facilities. Headwaters continues to look for opportunities for operational improvement initiative and cost reductions in all of our business units, but in particular in our building products segment as they continue to experience this slowdown.

These initiatives and the savings we have identified mitigate some of the declining trends we continue to experience in the June 2008 quarter. We will continue to look for more areas of opportunity. However, these improvements will not totally offset the revenue declines everyone is experiencing as a result of the building product industry decline, and the negative impact our fixed operating costs have when you spread those expenses over a smaller revenue base.

There is virtually no revenue from Section 45-K in our June 2008 quarter. However, the coal cleaning business that Headwaters started a couple of years ago to replace this business is starting to find traction, and although its growth is lagging behind our original expectations, this business made significant progress over the last six months, with revenues more than doubling each quarter over the last previous quarter.

We are well into fiscal 2008, our transitional year, and we feel the pain from the loss of Section 45-K. The slowdown in our building products business and the slower than expected ramp-up of the coal cleaning business. However, we are encouraged from the continued strong performance of our fly ash business, the comparatively good performance of our billing products segment, when you consider the very difficult market they are currently operating in, the higher coal prices we are receiving in our coal cleaning business, and the continued progress we are making in reaching optimal performance level at our new coal cleaning facilities.

We also appreciate all of the efforts our employees are making in controlling and reducing our operating expenses. Fiscal 2009 will be a year of significant development and growth as we continue to work through the problems we are surrounded by today and the challenges that we are sure to encounter in the future as we expand these new businesses and identify future growth opportunities for Headwaters.

Headwaters continues to have very good liquidity. However, our debt covenants continue to put pressure -- we'll continue to put pressure because of our debt covenants because of our declining EBITDA along with a significant capital expenditures that we're making in 2008.

Our cash flow from operations continues to be strong, with the September and December quarters being our best quarters, with June being a strong earnings quarter with a significant amount of growth going into our working capital requirements for inventories and accounts receivable. The March quarter is our weakest quarter.

Our strong cash flow and liquidity has allowed us to fund the new coal cleaning facility construction while meeting our debt service and operational requirements. This significant capital expenditure commitment will continue through 2008 and into early 2009, with capital expenditures in 2009 being significantly lower than they were this year.

The condensed consolidated financial statements include the operations of Headwaters' resources segment, which is our CCP business. Our building products segment, which includes our exterior accessory products, architectural stone, and concrete block operations, and our energy segment that includes our coal cleaning operations, technologies being commercialized, and our ethanol and hydrogen peroxide operations.

Our recurring ongoing businesses and how these businesses are performing and growing are our primary focus. Replacement of the Section 45-K business has also been high on our priority list for the last few years, and we are pleased with the progress being made in the new coal cleaning business.

If you remove Section 45-K operations and the mortars and stucco operations that we sold earlier this year from the June 2007 quarter, the June 2008 quarter has revenues that are comparable year over year. I believe that is a significant accomplishment in light of the extremely difficult economy we have experienced and reflects the strength and significant market position these businesses enjoy and Headwaters' ability to adapt and change.

Most of my comparisons of the June 2008 quarter to prior periods will exclude these discontinued non-recurring businesses so as to make these comparisons more meaningful.

Headwaters' gross profit decreased $10.9 million or 14.5% from $74.9 million in the June 2007 quarter compared to $64 million in the June 2008 quarter. Headwaters incurred approximately $2.9 million of losses in the June 2008 quarter, related to our ethanol operations hedges and currency translation of a note in our hydrogen peroxide operations in South Korea. That compares to a loss of approximately $1 million for these similar items in the June 2007 quarter.

The declining gross profit is the result of lower gross margins in our building products segment, which results from lower sales and the impact fixed costs have on being spread over a smaller revenue base, plus changes in their product sales mix. The declining gross profit was also negatively impacted by the new coal cleaning operations.

The gross profit in our CCP business was comparable year-over-year. Income before income taxes for the June 2008 quarter was $15 million compared to $20.8 million for the June 2007 quarter, or a decrease of approximately 28%. Income before income taxes was negatively impacted by the same causes as the gross margin, but was positively impacted by lower interest expense.

The income tax rate was significantly lower in the June 2008 quarter, as a result of some non-recurring discrete income tax items. The income tax rate for the nine months ended June 2008 was approximately 30%, which was approximately 8% higher than the comparable 2007 period.

As we have indicated before, we expect our income tax rate for our fiscal year ending September 30^th, 2008, to be approximately 30%, which will be approximately 6% higher than our 2007 effective tax rate. This is a direct result of the discontinuance of Section 45-K and the tax credits generated through those operations.

Our diluted earnings per share increased from $0.27 for the June 2007 quarter to $0.31 for the June 2008 quarter, an increase of approximately 15% when you exclude the 45-K and the mortars and stucco operations.

Our diluted earnings per share was impacted by the low income tax rate in the June 2008 quarter previously discussed. The diluted weighted average shares outstanding is lower in June 2008 than June 2007, as a result of approximately 1.2 million shares of common stock that we repurchased in the December 2007 quarter.

Selling, general and administrative expenses during the June 2008 quarter decreased by $4.4 million or approximately 11% when you compare those to the June 2007 quarter. This decrease is the result partially of lower sales and marketing costs, but is also impacted by lower employee-related costs and the effects of some of the operational improvements and cost reduction initiatives previously discussed.

SG&A expenses incurred in connection with the coal cleaning operation will be higher as a percentage of sales, as we continue to go through this significant expansion and ramp-up period, which will probably last well into and even possibly beyond fiscal 2009. We expect SG&A for fiscal 2008 to be lower than fiscal 2007, but will be higher as a percentage of sales, comparable to the June 2008 quarter percentage.

R&D expenses for the June 2008 quarter were approximately 20% lower than the prior year quarter and was approximately 50% lower for the nine months ended June 2008 compared to the same 2007 period. R&D expenses for fiscal 2008 should continue at levels comparable to the June 2008 quarter. This level of R&D spending should continue into fiscal 2009.

Headwaters has total indebtedness of $577.5 million at June 30 of 2008, which represents an increase of $35 million when you compare it to the September 30, 2007 balance. This increase resulted from seasonal working capital requirements and the investment being made in the new coal cleaning facilities.

Headwaters generated approximately $54 million of cash flow from operating activities during the nine months ended September -- excuse me, June 30, 2008, compared to approximately $76 million for the comparable 2007 period.

We spent approximately $86 million on capital expenditures during the nine months that ended June 2008. We have $35 million drawn on our revolving credit facility at June 30.

Our revolving credit facility provides for total borrowings of $60 million and we currently utilize the revolver to support approximately $9 million of letters of credit, which leaves approximately $16 million available to be drawn on the revolver.

At June 30^th, 2008, Headwaters had approximately $33.5 million of cash and cash equivalents, thus providing us with approximately $49 million of total liquidity. Net interest expense was lower during the June 2008 quarter compared to 2007, but this could change, as I will discuss in a minute.

Headwaters continues to enjoy strong cash flow generation and liquidity. We expect cash flow from operations in fiscal 2008 to be approximately $100 million, and capital expenditures could be approximately $115 million. Approximately 55% of our planned 2008 capital expenditures relates to the coal cleaning operations, and accordingly we would expect capital expenditures in 2009 to decrease significantly.

As you are aware, if these facilities are placed in service before December 31^st, 2008, they can earn a modest income tax credit. This is the primary factor in causing the significant 2008 capital expenditure investment. Operating leases will be utilized to meet a portion of these facility cost requirements, primarily as it relates to equipment.

Depreciation and amortization was approximately $51 million for the nine months ended June 30^th, 2008, and we expect depreciation and amortization for fiscal 2008 to be approximately $70 million.

Headwaters has three significant debt compliance ratios in connection with our senior secured credit facility along with other standard requirements. The three ratios relate to total indebtedness to EBITDA, senior indebtedness to EBITDA, and fixed charge coverage. We're in compliance with all of our ratios, covenants, and other debt requirements at June 30^th, 2008.

The discontinuance of Section 45-K operations and the decrease in building products revenue will cause our trailing 12-month EBITDA to decline through December 2008 before we believe it will begin to increase. The significant increase in capital expenditures in fiscal 2008 along with the declining EBITDA will cause our debt ratios to tighten to an uncomfortable level.

Except for repayment of draws on our revolver, we have no other required principal repayments until February 2011. Our current cash position is approximately equal to our current revolver balance. However, due to the continued uncertainty in the building products industry, and our continuing need to invest in our new coal cleaning facilities, we are considering amending or refinancing our senior secured credit facility.

Current credit and financing conditions in the market will make this task difficult, and will result in higher interest costs to Headwaters in the future. We have had discussions with our senior credit facilities administrator and several new potential lending sources, and believe we can complete an amendment or refinancing. This debt covenant concern is a short-term problem that will correct itself in the next three or four quarters as our coal cleaning operations come online, thus increasing our trailing EBITDA.

Capital expenditures in this segment will decrease as current facilities are being constructed or completed. We currently believe that our operations will produce strong cash flow in future periods and believe these cash flows and our current working capital, along with leasing alternatives, will be sufficient to complete our current planned coal cleaning facility construction and be sufficient to meet our other operating needs.

Currently approximately 55% of our revenue comes from our building products segment, 35% comes from our coal cleaning -- or excuse me, our coal combustion product segment, and the balance comes from our energy segment. Currently, we estimate that approximately 60% to 65% of Headwaters' operating income will come from our coal combustion product segment and approximately 30% to 35% will be produced by our building products segment, with the energy segment or the coal cleaning business currently near a breakeven level after you deduct Headwaters' R&D activities and the operations of our ethanol and hydrogen peroxide plants.

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

The weighted average shares outstanding decreased in June 30, 2008, when compared to September 2007, as a result of the stock repurchased previously discussed. At today's stock prices, a substantial part of Headwaters' options and SARs are out of the money and are therefore not included in the diluted weighted average shares outstanding calculation.

As of June 30, 2008, Headwaters had approximately 42 million shares issued and outstanding. As we have discussed in the past, Headwaters issued $172.5 million of convertible debt in 2004 that is treated as if converted for accounting purposes in the EPS calculation, even though the conversion price is $30. This conversion treatment increases the actual diluted weighted average shares outstanding by approximately 5.8 million shares.

We believe the results of the June 2008 quarter reflect the difficult building products market we are experiencing and the significant impact inclusion of Section 45-K operations. It is difficult to predict when new housing starts and residential remodeling activities will improve, and the building products segment will experience a rebound.

However, we continue to be optimistic about the potential of our new coal-clearing operations. Accordingly, we continue to believe that our current fiscal 2008 guidance for diluted earnings per share of $0.60 to $0.75 is still appropriate. We will continue to look for other opportunities to reduce our operating expenses, opportunities to accelerate the ramp-up of the coal cleaning business, ways to efficiently manage our CCP business, and we will pursue commercial validation of our technologies.

I'd be glad to discuss specific questions about our quarter results during our question and answer period. I would like now to turn the call over to Mr. Kirk Benson, Headwaters' Chairman and Chief Executive Officer.

Kirk Benson

Thanks, Steve. I'd like to talk a little bit about our three business units. First, Headwaters' resources. The progress of our bulk fly ash business was slowed in the June quarter primarily because of the economic conditions in the California and Florida markets.

Because 2008 winter weather was more severe than 2007, we couldn't determine if the slowdown in sales was a result of the weather or economic conditions. The June quarter clarified our situation. With the exceptions of floods in the Midwest, most of our markets recovered from the winter weather and are performing consistent with expectations and providing growth for the division.

However, California and Florida did not recover in the June quarter due to substantially slower economic activity resulting in overall flat performance compared to 2007.

Demand in most markets continued to be steady due to infrastructure projects and increased acceptance of fly ash as a substitute for Portland cement. The change in margins in this business for the quarter was primarily related to the mix that made up our sales volume, both geographic and products.

We made substantial progress during the first six months of the year to increase supply and anticipate over the next 18 months we will not be supply constrained as our new contracts, storage and blending all come online. Importantly, we will be positioned for growth in the California and Florida markets.

There's two important regulatory changes that may take place that could impact our business. There's some indication that mix designs are favoring increased levels of fly ash substitution. One important regulatory movement is beginning to take shape, commencing in the California market. When cement is manufactured in large kilns, carbon dioxide is the principal result of the chemical reaction, forming calcium silicate from calcium carbonate.

For every ton of cement that is produced, there is nearly one ton of carbon dioxide emitted into the atmosphere. As we all know, CO2 emissions are blamed as a major contributor to global warming. To partially address the issue of global warming and CO2 emissions, the California Air Resources Board is considering mandating higher fly ash replacement for cement in California by issuing Regulation AB32.

Adoption of Regulation AB32 will dramatically increase fly ash consumption in the California market. In addition, we believe other states will follow California as states attempt to combat global warming.

Another change in California is the adoption of the California Green Building Standards Code. The California Building Standards Commission adopted a green building code on July 17 for all new construction statewide as part of a rules package. It is the first regulatory action of its kind in the nation. These majors would at least be comparable to the requirements of the silver ratings under the lead system. We are studying the new regulatory package to determine the level of positive impact that it will have on fly ash.

Now, I'll comment a little bit about our building products segment. June single-family starts were down 5% in May, 43% over a year ago level, and 55% below the June 2006 peak.

New home sales declined a little bit less than 1% in June to its seasonally adjusted number of 530,000 homes. Sales retreated for the second straight month in June after posting its first monthly increase since October in April.

On a year-over-year basis, new home sales are down 33% from June 2007 and over 50% from June 2006. The number of new homes for sale has declined as builders continue to scale back building activity, and months in inventory declined during the quarter. There are now approximately 10 months of supply based on current sales prices.

As expected, we continue to be impacted by the down cycle in new residential construction. After taking into account the sale of our mortar stucco business, our building products revenue was down 11% year over year, showing considerable improvement over the 19% drop in sales that occurred in our March quarter.

As we are expecting housing to be down over 30% in the year, an 11% decrease in sales reflects better than the anticipated performance suggested last quarter of a 15% to 20% decline.

The stronger than anticipated sales is the result of two strategic activities. First, when we sold the mortar stucco business we acquired additional block manufacturing capacity in the Texas market. Bond issuances for school construction and block usage generally have been extremely strong in the Texas market.

Because of our strategy, we were able to reduce our delivery dates from approximately six weeks to less than two weeks on everything from standard block products to our higher-margin specialty block. In addition, we have been able to raise prices 3% to 5%.

The second strategy has been the introduction of new products into our distribution system. We are experiencing strong growth rates in several of our new products, including our roofing and Stonecraft products. As an example, we have been very successful introducing our Stonecraft stone veneer line into new channels of distribution, namely our wholesale building materials distributors and big box retailers.

We expect continued high growth rates from these type of activities, as we leverage our combined distribution strength across our industry leading building products brand.

For example, Stonecraft active ship-to locations in the building products and retail increased from 61 locations in September of 2007 to 601 in June of 2008. We believe that these investments in new products and our strategy of maximizing our distribution strength will pay dividends as the housing markets return to more normalized levels.

Because of lower sales volumes, 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.

An additional factor impacting our margins is the change in mix occurring due to the rapid growth of new products, which overall is a strong positive. Our mature products saw sales dropping in the 20% range, whereas our newer products are growing in the 15% range, but the newer products have lower operating margins in the early stage of initial sales because of relatively higher marketing expenses and fixed overhead costs where fewer units sold. As the products mature and revenues expand, we anticipate normal operating margins.

Finally, we have been impacted by cost increases in raw materials. To address margin compression, last quarter we discussed annualized cost savings initiatives, either complete or under way. So far we have completed activities that should result in over $9 million of margin improvements on an annualized basis.

In addition to our cost control activities, we are aggressively increasing prices. Commencing July 1, we instituted a price increase of approximately 8% for most of our mature resin-based building products, representing products that generate existing revenue of over $100 million.

The price increase has been accepted by the market. We are looking at additional price increases in our architectural stone products, block products, and new product line.

Now, I'd like to comment a little bit on energy services part of our business. Coal pricing continues to be impacted by expanding global demand and restricted supply, causing US exports to increase and tightening domestic supplies. Overall, there has never been a more favorable time to be involved in the coal industry.

There is increasing demand by international consumers for US steam coal, with exports rising from northern App and central App locations. The increased exports leave US consumers with little choice but to increase price as they bid for the coal.

In addition, the coal that is exported from the central App and northern App suppliers must be replaced with Illinois basin or PRB coal. Accordingly, the market is also experiencing price increases in both the Illinois basin and PRB.

Further inventories at utilities have declined compared to last year, and we still have a lot of the summer burn rate before temperatures cool in the fall. Demand should continue to be very strong through the second half of the calendar year.

Net coal prices continue to show strong increases as steel annual growth rate is in about a 6% range. It appears that net coal prices are settling in the $240 to $300 range, depending upon quality.

Now a facility update on what we have done. In the March quarter, we had six operating facilities, one of which was our tolling facility. During the quarter we acquired a facility and completed the construction of a new facility, resulting in a total of eight functional facilities.

Three of the eight facilities, the ones that we acquired, need upgrades in order to achieve pro-forma production. The upgrades will be completed over the next several months.

The two non-tolling facilities that have been in production for the longest period of time have reached pro-forma or close to pro-forma production. One of the risks that we faced as we built out these facilities was whether we could operate them at pro-forma levels. That risk has been substantially answered positively, we can operate the facilities at pro-forma level.

We currently have three facilities under construction that are on a timeline for completion in the December quarter, bringing the total number of facilities that could be online by December to 11 exceeding our goal of 10. We anticipate opportunities to continue to develop new plants in 2009, but the market has become more competitive due to the substantial increase in coal prices.

We are exploring additional business models and international opportunities that will allow us to continue to have substantial growth.

Excluding our tolling coal, in the December 2007 quarter, Headwaters sold approximately 27,000 tons of coal into the steam market at $38 per ton. In the March quarter, we sold 138,000 tons into both the steam and net markets at an average price of $40 per ton. In the June quarter, we sold 258,000 tons of coal into the steam and net markets at an average price of $48 per ton. The price increase is primarily the result of mix change, shipping a larger percentage of the total tons into the net market.

It is important to know that our coal cleaning business achieved a milestone in the quarter, we were profitable. We had forecast break-even in the September quarter but the shift in net coal and good execution by Ken Frailey and his team helped achieve profitability early.

We anticipate that sales in the September quarter will benefit from production at additional facilities, as we continue start-up and improved processes at the newer facility. We estimate sales in the second half of our fiscal year to be 300 -- actually, in the last quarter, to be 300,000 to 350,000 tons at an average price of $45 to $50 per ton.

We estimated sales in the $30 million to $40 million range for the 2008 fiscal year, growing from a little over $1 million in 2007. In the first three quarters we have recognized $20 million of revenue with $13 million revenue in the third quarter. It appears that we will be well within the projected range for the year.

We continue to anticipate that our coal sales in 2009 will be in the range of 2.5 million to 3.5 million tons with a sales price range of $55 to $63 per ton. The sales price range is our estimate and not based on existing contracts. It appears conservative, considering existing market conditions, but we will have a better view after 2009 pricing is set in the September and December quarters.

In 2010, we anticipate our coal sales to be in the range of 4.5 million to 5.5 million tons at a sales price range of $60 to $70 per ton. The price assumption for 2010 is that current market supply and demand dynamics, driven primarily by China and India and other foreign markets, continue to affect global pricing.

In addition to expanding exports, there is approximately 15 gigawatts of new coal-fired capacity under construction. The new plants in the US will require upwards of 60 million tons of new coal demand.

Our coal cleaning facilities remove sulfur and mercury from the waste materials, resulting in an environmentally cleaner fuel with reduced NOX emissions. This refined coal in the steam market should qualify for a $6 per ton tax credit.

Our technology developments continue. Our pilot plant facilities in New Jersey continue to run HCAT for existing and potentially new customers. We recognize $2 million in revenue from the sale of HCAT to the refineries that have previously used the material. We continue business discussions with all three refineries that have used HCAT over the last couple of years.

As a result of the discussions, one of the refineries has developed a plan to reintroduce HCAT into its ebullated bed reactor in the December quarter. As we have previously indicated, we believe that all three refineries will ultimately become customers.

I'd like to thank you very much for your time. I'll now turn our time back to the operator for questions and answers.

Questions-and-Answer Session

Operator

Thank you, sir. Ladies and gentlemen, we'll now begin the question and answer session. (Operator instructions) One moment, please, for our first question. And our first question is from the line of Steve Sanders with Stephens Inc. Please go ahead.

Steve Sanders – Stephens Inc.

Hello, good morning.

Kirk Benson

Hi, Steve.

Steve Sanders – Stephens Inc.

First, a couple of questions on coal cleaning. Can you just bring us up to date on what you have under contract now? Also talk a little bit about your pricing discussions for your product relative to what you see in the market. And then finally, just give us an update on maybe 2009, the expected net versus steam coal split.

Kirk Benson

Okay. So from the first question was what do we have under contract. From a mineral lease perspective we have mineral leases on all 11 sites where we are building our coal cleaning facilities. So we've got the raw material is all under contract and under mineral lease.

From a sales perspective, our off-take agreements, most of our off-take agreements will roll off towards the end of 2008, and so most of our coal does not have price fixed and we'll be able to take advantage of the market condition's increasing prices towards the end of this calendar year and the beginning of next year.

The mix for net versus steam coal, we'll have of the 11 facilities, five of them will be selling net coal, primarily, probably in the range of 85% to 90% of their production will be sold as net coal, and 10% to 15% of their production will be sold as steam coal.

Of the other six facilities, the production is going to be steam coal with one of the facilities that we may be able to switch to net in maybe not 2009, but probably in 2010. It will be also selling to net coal. So, we should have net coal sales in the range of around 40% of our sales, 40% to 45% of our sales should be in the net coal market.

Steve Sanders – Stephens Inc.

Okay. And then, just a follow-up on the pricing. So, do you anticipate selling your product at a discount to what would be comparable coming out of the coal company, or do you think you're going to get in-line pricing?

Kirk Benson

I think that generally, we're going to get in-line pricing, partially because of the strategy that we had developed to blend our coal with existing coal mining companies that are producing run-of-mine coal. So for example, if an existing coal company has a contract to sell its run-of-mine coal, we might blend, 10% to 15% of that shipment with our product. And so, our product, in some instances, actually has slightly better characteristics associated with it, but in any event it is blended with the existing run-of-mine coal and will be sold at the same prices as that run-of-mine coal.

There may be some instances, particularly in the Illinois basin coal, where we will not be blending, and in those instances there may be a slight discount relative to the handling of our coal. But generally, our coal has the same or better characteristics as run-of-mine coal, and so it should sell reasonably close to the run-of-mine coal, even when we're selling it as a stand-alone product.

Steve Sanders – Stephens Inc.

Okay, and on the fly ash side, a comment on pricing, and then specific to California, do you feel like you've really got the full impact of weakness in California this quarter as it relates to how we should think about the fly ash business going into 2009? In other words, should we be thinking about it as flat to up a bit, with margins relatively stable, or do you see more risk at this point?

Kirk Benson

I think that our view is, using the words that you used, Steve, was flat to up a little bit is a reasonable expectation. There could be a little bit of shift on the margin because of mix. I mean, we clearly experienced that on a quarter-to-quarter basis, and so you do have, you've got a mix issue going on as far as margins are concerned. I think that our clear expectation from a revenue perspective is flat to up a little bit.

Steve Sanders – Stephens Inc.

Okay. All right, and then a question on HCAT. Can you just revisit the refiner that is taking the $2 million worth of catalyst? What's your understanding of the process and the testing and the potential timing of an ongoing relationship?

Kirk Benson

I've been so poor at predicting the establishment of these relationships that I'm not even going to attempt that. I think from a technical perspective all three of these refineries understand that HCAT functions, as our pilot plants have demonstrated, are basically improving the quality of the operations of an ebullated bed reactor.

So, we continue to have discussions. I mean, each of these facilities have a different story. There is the facility that has committed to reintroducing HCAT in the December quarter, or plan to reintroduce HCAT in the December quarter, want to take advantage of the improved operational impact that HCAT brings to that ebullated bed reactor.

So, we talked about the increase of diesel yield and the increase conversion, but in addition to that, HCAT, because it increases the hydrogen content of the fuel, improves the quality, it decreases the fouling, and basically improves the operational aspects of these ebullated bed reactors.

And so, the refinery needed to go through its processes of, you know, they were shut down for a while, they've come back up. They need to get the catalyst stabilized, existing ebullated bed catalyst stabilized. And so, it's just a matter of time until these folks begin using HCAT. At least that's our view. We're pretty comfortable that they will become customers. Hopefully, after they run in the December quarter, they'll continue running and they'll be a customer after that run in the December quarter.

Steve Sanders – Stephens Inc.

Okay, thanks very much.

Operator

Thank you. Our next question comes from the line of John Quealy with Canaccord Adams. Please go ahead.

John Quealy - Canaccord Adams

Hi, good morning. Coming back to coal, if we could. Kirk, you mentioned new opportunities in terms of supply on the waste coal side. Can you talk about competition for mineral leases domestically? Are pricing or contract terms changed around, or what else are you thinking about in terms of getting more supply for these plants?

Kirk Benson

Well, one of the things that I think is happening because coal prices have gone up so rapidly, it is increasing competition for these mineral leases. We're looking at multiple sites, and so we've got some opportunities that we are pursuing.

But it's more difficult today than it was a couple of years ago, and so we'll have to see how that works out with the sites that we are currently engaged in doing some due diligence on.

The other thing that's kind of interesting to us is the potential opportunity of finding a low-quality coal resource. So if you find some coal that wouldn't necessarily be economical to mine because of the high content of ash in the coal in its natural state that might be an opportunity for us to jointly develop that resource with a coal mining company.

We don't particularly want to become a coal mining company, but if we were able to combine with a coal mining company to produce an otherwise unattractive, uneconomical coal and then clean that material, that's something that would be very interesting, and we're looking at least one opportunity to do that.

John Quealy - Canaccord Adams

And for your existing 11 sites that you have, what's the amount of supply feed stock time that you have at production rates for these, in years?

Kirk Benson

We're targeting five to seven years at a site, and then of course be able to relocate the equipment to a different site.

John Quealy - Canaccord Adams

Okay. And my last question on coal cleaning, Steve had some comments that perhaps operations were a bit slower than expected, but give or take two quarters in you're already at break even or slightly profitable. Can you just reconcile those two comments? Is the footprint running ahead of plan with 11 facilities by year end, and did you expect you'd get better yields, or what's going on?

Kirk Benson

Well, I think that Steve's comments related to that we wish we were -- we wish we had been where we are today six months ago. But I think that the learning, we're coming up that learning curve, and as far as the two facilities that are operating, I think that they are operating basically at pro-forma levels.

So, we're there, we've come up the learning curve, and so we feel very comfortable about going forward. I think Steve's comment basically related to 2007 and the history of where we have been, not so much to where we are today and where we're going forward.

John Quealy - Canaccord Adams

And I'm sorry, just one last one -- for the facility acquired this quarter, I assume it's net. Can you talk about the purchase price and how much money you have to put into it to get it to your specifications?

Kirk Benson

And the facility is not an extremely large facility. The initial production out of that facility actually will go into the steam market. That's the facility that's a swing facility. That's the one I mentioned that we may be able to convert to net in 2010.

John Quealy - Canaccord Adams

Yes, okay.

Kirk Benson

And so I think it's going to be initially steam. It wasn't a -- we're going to be able to get that facility to our specifications for -- in the mid-single digits, so in the $5 million range.

John Quealy - Canaccord Adams

And my last question, on the building products segment, I realize you've got a lot of moving pieces, you've got some good price increases with some commodity risk in overhead fixed costs. Where do you think margins go? Do you think we're even approaching the bottom with margins on building products? How shall we look at that moving forward?

Kirk Benson

I think that we're close to the bottom of our margins on a seasonal basis, because we had the ramp-up in sales between the March quarter and the June quarter, and that's, of course, just seasonal. The September quarter is comparable to the June quarter, so -- historically. I mean, there could be another step down. The market is very difficult, and so if sales stay at comparable levels, one would expect margins to stay at comparable levels. And so, I think that a lot of the increased cost pressure from raw materials we can probably address by price increases and by our productivity improvements. So, we ought to be able to maintain approximately the same margins that we have in the June quarter through price increases.

So, the only real risk to margins, I think the biggest risk to margins is another downturn in sales. If sales stay the same, our margins ought to be pretty comparable to what they were in the June quarter.

John Quealy - Canaccord Adams

Great, thank you.

Operator

Thank you. Our next question comes from the line of Al Kaschalk with Wedbush Morgan. Please go ahead.

Al Kaschalk - Wedbush Morgan

Morning, guys.

Kirk Benson

Hi, Al.

Al Kaschalk - Wedbush Morgan

Just a comment on the question on the construction materials side. Did you look at the quarter from the additional cost incurred from new products, and R&D costs, to see A, what the core business was running at from a margin perspective. It seems that from your comments in the release that it was maybe somewhat artificially low in the quarter.

Kirk Benson

Yes, I think that our mature products have very good margins. They are better than the building product industry margins by 10 or 15 percentage points. So, those margins and the ability to capture those margins are clearly still intact.

And so but it does take, when you've got a drop in revenue, it does take a little bit of time to adjust to the [discussed or] and those types of issues that are associated with the mature products.

I think that the margins on the newer products should continue to improve, because we're getting very good growth in those newer products, and so that means you're getting the opposite effect of the mature products, meaning that your revenue is growing and so your fixed-cost absorption is improving on those newer products.

And so, we actually anticipate that those margins will pick up, and again, if sales kind of stay flat, I guess, if our mature products stay flat and we had draw from these new products, we would have margin improvement. And from that perspective, the margins could potentially be a little bit lower than what we will be in the future if -- but it really does depend upon sales mix and what happens to the sales growth and the sales decline in mature versus new products.

Al Kaschalk - Wedbush Morgan

Okay. On the CCP business, you made a comment and I may have missed it, the shift in mix was something that you thought could help recover the business, or you're seeing a shift in mix. Could you elaborate or restate the comments you may have made on that? I think I missed some of the comments.

Kirk Benson

Yes, I think on the mix in the CCP business is there's a geographic impact, and generally the revenue and sales price for fly ash in the Midwest and some of the eastern states is lower than some of the other states, just because of supply is plentiful in those states and so prices are lower.

California is the second-largest consuming state of fly ash but does not produce any fly ash -- any high quality fly ash. They do produce some lower-quality ash. And so, all of the ash has to be imported into California. What that means is that you've got a little better position from a margin perspective. Transportation costs are higher, but you can still get reasonable margins in the California market compared to, say, Ohio or some of the Midwest states.

And so, when California sales drop and more of the revenue is generated in some of these other states, that has an impact on margins. The other significant mix issue is when the fly ash sales drop and more of your revenue is made up by the service contracts that we have with these utilities. Those service contracts are generally lower margin, and so when we have a fall-off in the California fly ash sales, we've actually had some pretty good opportunities on the service side of that business, but those margins are a little bit lower.

And so that's the mix that's going on, the geographic mix, and then the product mix.

Al Kaschalk - Wedbush Morgan

Okay, my final question, more for Steve. Just a clarification on the debt, what debt repayments are you required over the next 12 months, including any credit facility? And secondly, are you saying that you're definitely going to the markets on the debt side, or it's just that you're monitoring it pretty closely? Thank you.

Steven Stewart

The required payments our revolver has a maturity of September of '09. So, any remaining balance on the revolver in September of '09 would have to be repaid. There's no repayment requirements on our senior secured debt, which is the $210 million, until March of 2011. And we are very closely monitoring our covenant and the possibility of going into the market with an amendment or some other type of way to change our senior secure debt.

Al Kaschalk - Wedbush Morgan

Thank you.

Operator

Thank you. Our next question is from the line of Michael Molnar with Goldman Sachs. Please go ahead.

Michael Molnar - Goldman Sachs

Good morning, everyone.

Kirk Benson

Good morning.

Michael Molnar - Goldman Sachs

Just a couple quick ones. The 2.5 million to 3 million tons for coal cleaning in 2009, at what price did you say? I just didn't hear that.

Kirk Benson

The pricing that we're estimating for 2009 is between $55 and $63 per ton.

Michael Molnar - Goldman Sachs

All right. And is it possible, could you say the gross margin percentage and operating income percentage for coal cleaning? I'm just trying to get that break-out that sometimes you give.

Kirk Benson

What we have suggested to the market is that we should be able to achieve at least a 25% operating margin. Now clearly, we may be able to do better than a 25% operating margin because coal prices have gone up so dramatically. But the number that we have shared is a 25% operating margin number.

Michael Molnar - Goldman Sachs

And what was it last quarter?

Kirk Benson

Well, that's the 25% -- if you look at, like, an individual facility, we're probably at a 25% operating margin. In fact, we're probably better than a 25% operating margin at the facilities that are at pro-forma, or better than pro-forma.

So, those facilities are already at a 25% operating margin. But if you look at the segment, you've got facilities in ramp-up and the start-up costs and you've got your fixed overhead costs. And so we're not at a 25% operating margin. In fact, the June quarter, we thought we would be break-even in the September quarter as we ramp up this new business, but we exceeded that and we were profitable in the June quarter, but we're still -- but it's not at a 25% rate yet because we're still ramping up and we're still covering our fixed costs.

Michael Molnar - Goldman Sachs

Okay, and last question, of the operating income of the $21 million, can you just give me the breakout of the operating in come amongst building products, coal combustion, and energy?

Steven Stewart

That information we'll be putting out in our 10-Q, and so its a few days before that information will be out in the market.

Michael Molnar - Goldman Sachs

Okay, there's no way to –

Kirk Benson

We haven't released, yes, we haven't released that yet. It wasn't in the press release. It will be released in the Q, when we provide the segment information. It's probably rated towards the coal combustion products business. It's probably clearly the best of the three segments, and then building products will be next, and the segments, including our R&D expenses for energy services, will still show a loss because we're covering the HCAT and the R&D expenses are in the energy segment, and we don't break out specifically coal cleaning from those R&D expenses.

The coal cleaning business was profitable, but it will be absorbed in that segment with those other costs. So, what you can expect is that the operating income from the fly ash business was the highest contributor followed by building products, and then the energy segment will show a negative number because of the R&D expenses and HCAT.

Michael Molnar - Goldman Sachs

Okay. Is there a specific reason, just out of curiosity -- I'm thinking about modeling purposes -- that all that additional data's in the queue, which when we try to go through numbers as it comes out, it's not in the press release, or is it just that's just a timing issue?

Kirk Benson

It's just a timing issue. And we've done it this way for 10 years, and maybe we shouldn't. Maybe it ought to be in our press release, but we've just always done it this way.

Steven Stewart

We'll take that under consideration, Michael, maybe to provide that a little bit earlier than we have in the past.

Michael Molnar - Goldman Sachs

Okay, great. Thanks a lot, guys, appreciate it.

Kirk Benson

Thank you.

Operator

Our next question comes from the line of Bill Gibson within Nollenberger. Please go ahead.

William Gibson - Nollenberger

Yes, I want to throw in two cents on that, Steve. More information earlier is always better.

Steven Stewart

Okay, thanks.

William Gibson - Nollenberger

Just sort of if you could refresh me, the ethanol and hydrogen peroxide revenue, is that showing up in energy?

Steven Stewart

In our energy segment, yes.

William Gibson - Nollenberger

Okay, thanks. And then also, Kirk, on the AB32, if that passes -- you talked about the build out of transportation and storage facilities, so you think with the increased demand of that build, that you would be able to meet it?

Kirk Benson

I tell you what, we are looking forward to it.

William Gibson - Nollenberger

That's a high-class problem. Thank you.

Kirk Benson

Yes, it is. I think, we're actually quite excited about it. Even the new regulations on the Green Building Code, that's going to have an impact and that should increase demand as well. Now AB32 should dramatically increase demand, so that's more important than green building. But both of those regulatory changes could really put some tailwind into California as far as fly ash sales are concerned.

William Gibson - Nollenberger

Good. Thank you.

Operator

Thank you. We have time for one more question, and our final question comes from the line of [Julie Kutu] with Simmons and Company. Please go ahead.

Julie Kutu - Simmons & Company

Hi, I was wondering if you could just expand a bit more about how receptive the current credit market is for your thought of refinancing the senior credit facility, and along those lines, what would happen if you were not in compliance with the covenant?

Steven Stewart

The markets continue to be difficult. I mean, as we visit and have visited and watched this over the last six months, they've probably are quite a bit worse today than they were six months ago, but they seem to have kind of flattened out over the last few weeks.

Again, we believe that the markets will be receptive. If we were to go into the market and do an amendment, again, we have a good relationship with our current lenders, we think that they would be receptive to an amendment, particularly when you look at the reason for the need to even talk about amending our covenants is this aggressive building activity we're doing with our coal cleaning facilities, which in the long run will be a very positive thing for Headwaters.

So that really is what's causing the issue. We think the market will be receptive to that. We have also had some reception relative to if we wanted to refinance all of our -- it would not be easy and it will be expensive in today's market, but we do believe it's doable.

Kirk Benson

Jumping out of that too is that we've got very good senior debt coverage. We are not highly leveraged from a senior perspective at all. So the senior folks don't have an inordinate amount of risk associated with their position, and so since at the senior level Headwaters isn't highly leveraged, this is an opportunity for the lenders to mark to market since for an amendment you only need 50% support to do that.

Julie Kutu - Simmons & Company

Okay, great, and one final question. I was just wondering, given the current challenges of the ethanol market, if any thought, if any consideration had been given to selling the ethanol business or what your thoughts were on that.

Steven Stewart

Are you a buyer?

Julie Kutu - Simmons & Company

No, no.

Steven Stewart

We could very easily be sellers.

Julie Kutu - Simmons & Company

Okay. Okay, great, I appreciate it.

Kirk Benson

Thank you.

Operator

Thank you, and at this time I'd like to turn it back to management for any closing remarks.

Sharon Madden

I think with that we'll go ahead and close off the call. We appreciate your participation. Thank you.

Operator

Thank you. Ladies and gentlemen, this does conclude the Headwaters Incorporated third quarter 2008 conference call. If you'd like to listen to a replay of today's conference, please dial 1-800-405-2236 or 303-590-3000, using the access code of 11117709 followed by the pound key. ACT would like to thank you for your participation, you may now disconnect.

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