**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

# **Washington, D.C. 20549**

**FORM 10-Q**

**x****                            ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

## **Forthe quarterly period ended June 30, 2007**

### **or**

**o****                               ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

## **Forthe transition period from                to                **

### **Commissionfile number: 1-32459**

**HEADWATERS INCORPORATED**

(Exact name of registrant as specified in its charter)

| **Delaware**                                                    |   | **87-0547337**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **10653  South River Front Parkway, Suite 300**                 |   |                                  |
| **South  Jordan, Utah**                                         |   | **84095**                             |
| (Address of  principal executive offices)                       |   | (Zip Code)                            |

 

**(801) 984-9400**

(Registrant’stelephone number, including area code)

**Not applicable**

(Former name,former address and former fiscal year, if changed since last report)

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.     Yes x   No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of theExchange Act).

Large accelerated filer x                Accelerated filer o                 Non-accelerated filer o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

The number of shares outstanding of the Registrant’s common stock as ofJuly 31, 2007 was 42,389,224.

 

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**HEADWATERSINCORPORATED**

**TABLE OFCONTENTS**
|                                         | ** ** | ** **                                                                                                                         | ** ** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| **PART I – FINANCIAL INFORMATION** |       |                                                                                                                               |
| ** **                              |       |                                                                                                                               |
| ITEM 1.                                 |       | FINANCIAL STATEMENTS (Unaudited):                                                                                                  |       |       |
|                                    |       | Condensed Consolidated  Balance Sheets – As of September 30, 2006 and June 30, 2007                                           |       |       |
|                                    |       | Condensed Consolidated  Statements of Income – For the three and nine months ended June 30, 2006 and  2007                    |       |       |
|                                    |       | Condensed Consolidated  Statement of Changes in Stockholders’ Equity – For the nine months ended June 30, 2007 |       |       |
|                                    |       | Condensed Consolidated Statements  of Cash Flows – For the nine months ended June 30, 2006 and 2007                           |       |       |
|                                    |       | Notes to Condensed Consolidated  Financial Statements                                                                              |       |       |
| ITEM 2.                                 |       | MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                                        |       |       |
| ITEM 3.                                 |       | QUANTITATIVE AND QUALITATIVE  DISCLOSURES ABOUT MARKET RISK                                                                        |       |       |
| ITEM 4.                                 |       | CONTROLS AND PROCEDURES                                                                                                            |       |       |
|                                    |       |                                                                                                                               |       |       |
| **PART II  – OTHER INFORMATION**   |       |                                                                                                                               |
|                                    |       |                                                                                                                               |
| ITEM 1.                                 |       | LEGAL PROCEEDINGS                                                                                                                  |       |       |
| ITEM 1A.                                |       | RISK FACTORS                                                                                                                       |       |       |
| ITEM 2.                                 |       | UNREGISTERED SALES OF EQUITY  SECURITIES AND USE OF PROCEEDS                                                                       |       |       |
| ITEM 3.                                 |       | DEFAULTS UPON SENIOR  SECURITIES                                                                                                   |       |       |
| ITEM 4.                                 |       | SUBMISSION OF MATTERS TO A  VOTE OF SECURITY HOLDERS                                                                               |       |       |
| ITEM 5.                                 |       | OTHER INFORMATION                                                                                                                  |       |       |
| ITEM 6.                                 |       | EXHIBITS                                                                                                                           |       |       |
|                                    |       |                                                                                                                               |       |       |
| **SIGNATURES**                          |       |                                                                                                                               |       |       |

 

**Forward-looking Statements**

*This Quarterly Report on Form10-Q contains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995 regarding future events and our futureresults that are based on current expectations, estimates, forecasts, andprojections about the industries in which we operate and the beliefs andassumptions of our management. Actual results may vary materially from suchexpectations. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,”“believes,” “seeks,” “estimates,” or variations of such words and similarexpressions, are intended to help identify such forward-looking statements. Inaddition, any statements that refer to projections of our future financialperformance, our anticipated growth and trends in our businesses, and othercharacterizations of future events or circumstances, are forward-looking. For adiscussion of the factors that could cause actual results to differ fromexpectations, please see the risk factors described  in Item 1A of our Annual Report on Form 10-Kfor the year ended September 30, 2006 and in Item 1A of our Quarterly Report on Form 10-Q for the quarterended December 31, 2006. There can be no assurance that our results ofoperations will not be adversely affected by such factors. Unless legallyrequired, we undertake no obligation to revise or update any forward-lookingstatements for any reason. Readers are cautioned not to place undue reliance onthese forward-looking statements, which speak only as of the date of thisreport.*

Our internet address is *www.headwaters.com*. There we make available, free of charge, our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K and anyamendments to those reports, as soon as reasonably practicable after weelectronically file such material with, or furnish it to, the Securities andExchange Commission (“SEC”).  Our reportscan be accessed through the investor relations section of our web site.  The information found on our web site is notpart of this or any report we file with or furnish to the SEC.

2

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**ITEM1.  FINANCIAL STATEMENTS**

**HEADWATERS INCORPORATED**

###### **CONDENSED CONSOLIDATED BALANCESHEETS**

(Unaudited)
| **(in thousands, except per-share data)**                                                                                                                                                                                | ** ** | **September 30,  2006** | ** **    | **June 30,  2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|---------------|-------------------------|------------|
|                                                                                                                                                                                                                                         |       |                         |          |                    |       |
| **ASSETS**                                                                                                                                                                                                                                   |       |                         |          |                    |       |
|                                                                                                                                                                                                                                         |       |                         |          |                    |       |
| **Current assets:**                                                                                                                                                                                                                          |       |                         |          |                    |       |
| Cash and cash  equivalents                                                                                                                                                                                                                   |       | $                            | 79,151        |                    | $          | 50,774 |   |
| Trade  receivables, net                                                                                                                                                                                                                      |       | 131,608                      |          | 199,514                 |       |
| Inventories                                                                                                                                                                                                                                  |       | 62,519                       |          | 59,217                  |       |
| Deferred income  taxes                                                                                                                                                                                                                       |       | 26,465                       |          | 25,462                  |       |
| Other                                                                                                                                                                                                                                        |       | 10,294                       |          | 17,186                  |       |
| **Total  current assets**                                                                                                                                                                                                                    | ** ** | **310,037**                  | ** **    | **352,153**             | ** ** |
|                                                                                                                                                                                                                                         |       |                         |          |                    |       |
| **Property, plant and equipment,  net**                                                                                                                                                                                                      | ** ** | **213,406**                  | ** **    | **222,010**             | ** ** |
|                                                                                                                                                                                                                                         |       |                         |          |                    |       |
| **Other assets:**                                                                                                                                                                                                                            |       |                         |          |                    |       |
| Intangible  assets, net                                                                                                                                                                                                                      |       | 251,543                      |          | 243,641                 |       |
| Goodwill                                                                                                                                                                                                                                     |       | 826,432                      |          | 863,161                 |       |
| Other                                                                                                                                                                                                                                        |       | 60,311                       |          | 59,615                  |       |
| **Total  other assets**                                                                                                                                                                                                                      | ** ** | **1,138,286**                | ** **    | **1,166,417**           | ** ** |
|                                                                                                                                                                                                                                         |       |                         |          |                    |       |
| **Total  assets**                                                                                                                                                                                                                            | ** ** | **$**                        | **1,661,729** | ** **              | **$**      | **1,740,580** | ** ** |
| ** **                                                                                                                                                                                                                                   | ** ** | ** **                   | ** **    | ** **              | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                |       |                         |          |                    |       |
|                                                                                                                                                                                                                                         |       |                         |          |                    |       |
| **Current liabilities:**                                                                                                                                                                                                                     |       |                         |          |                    |       |
| Accounts payable                                                                                                                                                                                                                             |       | $                            | 23,854        |                    | $          | 33,596 |   |
| Accrued  personnel costs                                                                                                                                                                                                                     |       | 32,859                       |          | 34,874                  |       |
| Accrued income  taxes                                                                                                                                                                                                                        |       | 16,481                       |          | 15,270                  |       |
| Other accrued  liabilities                                                                                                                                                                                                                   |       | 62,190                       |          | 69,843                  |       |
| Deferred license  fee revenue                                                                                                                                                                                                                |       | 22,090                       |          | 14,063                  |       |
| Current portion  of long-term debt                                                                                                                                                                                                           |       | 7,267                        |          | —                  |       |
| **Total  current liabilities**                                                                                                                                                                                                               | ** ** | **164,741**                  | ** **    | **167,646**             | ** ** |
|                                                                                                                                                                                                                                         |       |                         |          |                    |       |
| **Long-term liabilities:**                                                                                                                                                                                                                   |       |                         |          |                    |       |
| Long-term debt                                                                                                                                                                                                                               |       | 587,820                      |          | 595,000                 |       |
| Deferred income  taxes                                                                                                                                                                                                                       |       | 96,972                       |          | 69,071                  |       |
| Other                                                                                                                                                                                                                                        |       | 11,238                       |          | 6,320                   |       |
| **Total  long-term liabilities**                                                                                                                                                                                                             | ** ** | **696,030**                  | ** **    | **670,391**             | ** ** |
| **Total  liabilities**                                                                                                                                                                                                                       | ** ** | **860,771**                  | ** **    | **838,037**             | ** ** |
|                                                                                                                                                                                                                                         |       |                         |          |                    |       |
| Commitments and  contingencies                                                                                                                                                                                                               |       |                         |          |                    |       |
|                                                                                                                                                                                                                                         |       |                         |          |                    |       |
| **Stockholders’ equity:**                                                                                                                                                                                                               |       |                         |          |                    |       |
| Common stock,  $0.001 par value; authorized 100,000 shares; issued and outstanding: 42,306  shares at September 30, 2006 (including 254 shares held in treasury) and  42,389 shares at June 30, 2007 (including 167 shares held in treasury) |       | 42                           |          | 42                      |       |
| Capital in  excess of par value                                                                                                                                                                                                              |       | 502,265                      |          | 512,928                 |       |
| Retained  earnings                                                                                                                                                                                                                           |       | 299,866                      |          | 390,458                 |       |
| Treasury stock  and other                                                                                                                                                                                                                    |       | (1,215                       | )             | (885                    | )          |
| **Total  stockholders’ equity**                                                                                                                                                                                                         | ** ** | **800,958**                  | ** **    | **902,543**             | ** ** |
|                                                                                                                                                                                                                                         |       |                         |          |                    |       |
| **Total liabilities and  stockholders’ equity**                                                                                                                                                                                         | ** ** | **$**                        | **1,661,729** | ** **              | **$**      | **1,740,580** | ** ** |

 

See accompanying notes.

3

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**HEADWATERSINCORPORATED**

###### **CONDENSED CONSOLIDATEDSTATEMENTS OF INCOME**

(Unaudited)
| ** **                                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| **(in thousands, except per-share data)** | ** ** | **2006**                                        | ** ** | **2007**                                       | ** ** | **2006** | ** ** | **2007** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| **Revenue:**                                                  |       |                                            |       |                                           |       |   |   |   |   |
| Construction materials                                        |       | $                                               | 162,067    |                                           | $          | 155,576 |   | $ | 423,744 |   | $ | 393,878 |   |
| Coal combustion products                                      |       | 74,068                                          |       | 83,237                                         |       | 197,724 |   | 214,502 |   |
| Alternative energy                                            |       | 59,794                                          |       | 97,516                                         |       | 224,692 |   | 276,978 |   |
| **Total revenue**                                             | ** ** | **295,929**                                     | ** ** | **336,329**                                    | ** ** | **846,160** | ** ** | **885,358** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| **Cost of  revenue:**                                         |       |                                            |       |                                           |       |   |   |   |   |
| Construction materials                                        |       | 107,264                                         |       | 103,327                                        |       | 288,200 |   | 281,065 |   |
| Coal combustion products                                      |       | 53,714                                          |       | 58,394                                         |       | 149,022 |   | 154,636 |   |
| Alternative energy                                            |       | 40,147                                          |       | 56,037                                         |       | 140,395 |   | 156,632 |   |
| **Total cost of revenue**                                     | ** ** | **201,125**                                     | ** ** | **217,758**                                    | ** ** | **577,617** | ** ** | **592,333** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| **Gross  profit**                                             | ** ** | **94,804**                                      | ** ** | **118,571**                                    | ** ** | **268,543** | ** ** | **293,025** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| **Operating  expenses:**                                      |       |                                            |       |                                           |       |   |   |   |   |
| Amortization                                                  |       | 6,278                                           |       | 5,730                                          |       | 18,419 |   | 17,388 |   |
| Research and development                                      |       | 3,363                                           |       | 4,343                                          |       | 9,682 |   | 13,470 |   |
| Selling, general and administrative                           |       | 35,921                                          |       | 38,717                                         |       | 103,192 |   | 113,063 |   |
| **Total operating expenses**                                  | ** ** | **45,562**                                      | ** ** | **48,790**                                     | ** ** | **131,293** | ** ** | **143,921** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| **Operating  income**                                         | ** ** | **49,242**                                      | ** ** | **69,781**                                     | ** ** | **137,250** | ** ** | **149,104** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| **Other  income (expense):**                                  |       |                                            |       |                                           |       |   |   |   |   |
| Net interest expense                                          |       | (8,156                                          | )          | (6,664                                         | )          | (25,816 | ) | (24,001 | ) |
| Other, net                                                    |       | 541                                             |       | (2,860                                         | )          | (4,960 | ) | (9,011 | ) |
| **Total other income (expense), net**                         | ** ** | **(7,615**                                      | **)**      | **(9,524**                                     | **)**      | **(30,776** | **)** | **(33,012** | **)** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| **Income  before income taxes**                               | ** ** | **41,627**                                      | ** ** | **60,257**                                     | ** ** | **106,474** | ** ** | **116,092** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Income tax  provision                                         |       | (14,220                                         | )          | (13,860                                        | )          | (32,370 | ) | (25,500 | ) |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| **Net  income**                                               | ** ** | **$**                                           | **27,407** | ** **                                     | **$**      | **46,397** | ** ** | **$** | **74,104** | ** ** | **$** | **90,592** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| **Basic  earnings per share**                                 | ** ** | **$**                                           | **0.65**   | ** **                                     | **$**      | **1.10** | ** ** | **$** | **1.77** | ** ** | **$** | **2.15** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| **Diluted earnings per share**                                | ** ** | **$**                                           | **0.58**   | ** **                                     | **$**      | **0.98** | ** ** | **$** | **1.58** | ** ** | **$** | **1.94** | ** ** |

 

See accompanying notes.

4

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**HEADWATERS INCORPORATED**

**CONDENSEDCONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY** (Unaudited)

For the Nine Months Ended June 30, 2007
| ** **                                                                                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** | **Capital in**        | ** ** | ** **               | ** ** | ** **       | ** **  | ** **             | ** ** | **Total**  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------|------------|----------------------------|------------|--------------------------|------------|------------------|-------------|------------------------|------------|------------|------------|
| ** **                                                                                                                                    | ** ** | **Common stock** | ** ** | **excess** | ** ** | **Retained**               | ** ** | **Treasury stock,** | ** ** | ** **       | ** **  | **stockholders’** | ** ** |
| **(in thousands)**                                                                                                                       | ** ** | **Shares**            | ** ** | **Amount** | ** ** | **of par value** | ** ** | **earnings**             | ** ** | **at cost** | ** **  | **Other**              | ** ** | **equity** | ** ** |
|                                                                                                                                          |       |                  |       |       |       |                       |       |                     |       |             |        |                   |       |       |       |
| **Balances  as of September 30, 2006**                                                                                                        | ** ** | **42,306**            | ** ** | **$**      | **42**     | ** **                 | **$**      | **502,265**              | ** ** | **$**            | **299,866** | ** **             | **$**      | **(2,155** | **)**      | **$** | **940** | ** ** | **$** | **800,958** | ** ** |
|                                                                                                                                          |       |                  |       |       |       |                       |       |                     |       |             |        |                   |       |       |       |
| Exercise of stock  options                                                                                                                    |       | 53                    |       | —     |       | 477                        |       |                     |       |             |        |                   |       | 477        |       |
|                                                                                                                                          |       |                  |       |       |       |                       |       |                     |       |             |        |                   |       |       |       |
| Tax benefit from  exercise of stock options                                                                                                   |       |                  |       |       |       | 24                         |       |                     |       |             |        |                   |       | 24         |       |
|                                                                                                                                          |       |                  |       |       |       |                       |       |                     |       |             |        |                   |       |       |       |
| 87 shares of  treasury stock transferred to employee stock purchase plan, at cost                                                             |       |                  |       |       |       | 1,011                      |       |                     |       | 658              |        |                   |       | 1,669      |       |
|                                                                                                                                          |       |                  |       |       |       |                       |       |                     |       |             |        |                   |       |       |       |
| Stock-based  compensation                                                                                                                     |       | 30                    |       |       |       | 4,794                      |       |                     |       |             |        |                   |       | 4,794      |       |
|                                                                                                                                          |       |                  |       |       |       |                       |       |                     |       |             |        |                   |       |       |       |
| Convertible note  hedge and related warrants, net                                                                                             |       |                  |       |       |       | (11,830                    | )          |                     |       |             |        |                   |       | (11,830    | )          |
|                                                                                                                                          |       |                  |       |       |       |                       |       |                     |       |             |        |                   |       |       |       |
| Deferred taxes on  convertible note hedge                                                                                                     |       |                  |       |       |       | 16,187                     |       |                     |       |             |        |                   |       | 16,187     |       |
|                                                                                                                                          |       |                  |       |       |       |                       |       |                     |       |             |        |                   |       |       |       |
| Other  comprehensive income (loss) – net unrealized loss on cash flow hedges and  foreign currency translation adjustments, net of taxes |       |                  |       |       |       |                       |       |                     |       |             |        | (328                   | )          | (328       | )          |
|                                                                                                                                          |       |                  |       |       |       |                       |       |                     |       |             |        |                   |       |       |       |
| Net income for  the nine months ended June 30, 2007                                                                                           |       |                  |       |       |       |                       |       | 90,592                   |       |             |        |                   |       | 90,592     |       |
|                                                                                                                                          |       |                  |       |       |       |                       |       |                     |       |             |        |                   |       |       |       |
| **Balances as of June 30, 2007**                                                                                                              | ** ** | **42,389**            | ** ** | **$**      | **42**     | ** **                 | **$**      | **512,928**              | ** ** | **$**            | **390,458** | ** **             | **$**      | **(1,497** | **)**      | **$** | **612** | ** ** | **$** | **902,543** | ** ** |

 

See accompanyingnotes.

5

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**HEADWATERSINCORPORATED**

###### **CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

###### (Unaudited)

| ** **                                                                                                                      | ** ** | **Nine Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| **(in thousands)**                                                                                                         | ** ** | **2006**                                       | ** ** | **2007** | ** ** |
|                                                                                                                            |       |                                           |       |   |   |
| **Cash  flows from operating activities:**                                                                                      |       |                                           |       |   |   |
| Net income                                                                                                                      |       | $                                              | 74,104     |   | $ | 90,592 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                                              |       |                                           |       |   |   |
| Depreciation and amortization                                                                                                   |       | 46,955                                         |       | 53,990 |   |
| Stock-based compensation expense                                                                                                |       | 5,239                                          |       | 4,794 |   |
| Interest expense related to amortization of debt  issue costs                                                                   |       | 2,231                                          |       | 3,987 |   |
| Equity in losses, net of gains, of joint ventures                                                                               |       | 214                                            |       | 1,167 |   |
| Amortization of non-refundable license fees                                                                                     |       | (16,551                                        | )          | (16,551 | ) |
| Deferred income taxes                                                                                                           |       | 5,931                                          |       | (9,578 | ) |
| Net loss on disposition of property, plant and  equipment                                                                       |       | 2                                              |       | 112 |   |
| Decrease (increase) in trade receivables                                                                                        |       | 30,122                                         |       | (65,581 | ) |
| Decrease (increase) in inventories                                                                                              |       | (11,606                                        | )          | 4,352 |   |
| Increase (decrease) in accounts payable and accrued  liabilities                                                                |       | (25,713                                        | )          | 19,130 |   |
| Other changes in operating assets and liabilities,  net                                                                         |       | 61,758                                         |       | (10,583 | ) |
| **Net  cash provided by operating activities**                                                                                  | ** ** | **172,686**                                    | ** ** | **75,831** | ** ** |
|                                                                                                                            |       |                                           |       |   |   |
| **Cash  flows from investing activities:**                                                                                      |       |                                           |       |   |   |
| Payments for acquisitions, net of cash acquired                                                                                 |       | (24,297                                        | )          | (50,219 | ) |
| Purchase of property, plant and equipment                                                                                       |       | (39,049                                        | )          | (37,744 | ) |
| Proceeds from disposition of property, plant and  equipment                                                                     |       | 1,081                                          |       | 400 |   |
| Investments in joint ventures                                                                                                   |       | (9,360                                         | )          | (1,160 | ) |
| Net increase in other assets                                                                                                    |       | (2,375                                         | )          | (162 | ) |
| **Net  cash used in investing activities**                                                                                      | ** ** | **(74,000**                                    | **)**      | **(88,885** | **)** |
|                                                                                                                            |       |                                           |       |   |   |
| **Cash  flows from financing activities:**                                                                                      |       |                                           |       |   |   |
| Net proceeds from issuance of long-term debt                                                                                    |       | —                                         |       | 154,424 |   |
| Payments on long-term debt                                                                                                      |       | (58,717                                        | )          | (160,087 | ) |
| Convertible note hedge and related warrants, net                                                                                |       | —                                         |       | (11,830 | ) |
| Proceeds from exercise of stock options                                                                                         |       | 6,365                                          |       | 477 |   |
| Income tax benefit from exercise of stock options  and stock appreciation rights (net of reversals pertaining to prior periods) |       | (2,291                                         | )          | 24 |   |
| Employee stock purchases                                                                                                        |       | 1,954                                          |       | 1,669 |   |
| **Net  cash used in financing activities**                                                                                      | ** ** | **(52,689**                                    | **)**      | **(15,323** | **)** |
|                                                                                                                            |       |                                           |       |   |   |
| **Net  increase (decrease) in cash and cash equivalents**                                                                       | ** ** | **45,997**                                     | ** ** | **(28,377** | **)** |
|                                                                                                                            |       |                                           |       |   |   |
| Cash and cash  equivalents, beginning of period                                                                                 |       | 13,666                                         |       | 79,151 |   |
|                                                                                                                            |       |                                           |       |   |   |
| **Cash  and cash equivalents, end of period**                                                                                   | ** ** | **$**                                          | **59,663** | ** ** | **$** | **50,774** | ** ** |
| ** **                                                                                                                      | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| **Supplemental  schedule of non-cash investing and financing activities:**                                                      |       |                                           |       |   |   |
| Increase in  accrued liabilities for acquisition-related commitments                                                            |       | $                                              | 1,500      |   | $ | 2,639 |   |

 

See accompanying notes.

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###### **HEADWATERS INCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**June30, 2007**

(Unaudited)

**1.****              Natureof Operations and Basis of Presentation**

Description of Business and Organization – Headwaters Incorporated (“Headwaters”)is incorporated in Delaware and is a diversified company providing products,technologies and services in two industries: building materials, which includesconstruction materials and coal combustion products (“CCPs”), and alternativeenergy. Headwaters uses technology to differentiate itself from competitors andto create value in its businesses.

In the building materials sector, Headwaters designs,manufactures, and sells architectural stone and resin-based exterior sidingaccessories (such as shutters, mounting blocks, and vents) and other products.Headwaters is also a nationwide leader in the management and marketing of CCPs,including fly ash used as a substitute for portland cement. Headwaters believesit is uniquely positioned to manufacture an array of building materials thatuse fly ash, such as block, stucco, and mortar and believes that it has aleading market position in its principal building materials businesses. Revenuefrom Headwaters’ construction materials and CCPs businesses are diversifiedgeographically and also by market, including the new construction, remodelingand home improvement markets.

In the alternative energy sector, Headwaters isfocused on reducing waste and increasing the value of energy feedstocks,primarily in the areas of low-value coal and oil. In coal, Headwaters owns andoperates two coal reclamation facilities that remove rock, dirt, and otherimpurities from waste coal, resulting in higher-value, marketable coal.Headwaters also licenses technology and sells reagents to the coal-based solidalternative fuel industry. In oil, Headwaters believes that its heavy oilupgrading technology represents a substantial improvement over current refiningtechnologies. Headwaters’ heavy oil upgrading process uses a liquid catalystprecursor to generate a highly active molecular catalyst to convert residualoil feedstocks into higher-value distillates that can be refined into gasoline,diesel and other products. In addition, Headwaters operates an ethanol plantand is proceeding with the commercialization of several catalyst technologies.

Basis ofPresentation –Headwaters’ fiscal year ends on September 30 and unless otherwise noted,references to 2006 refer to Headwaters’ fiscal quarter and/or nine-month periodended June 30, 2006 and references to 2007 refer to Headwaters’ fiscal quarterand/or nine-month period ended June 30, 2007. Other references to years referto Headwaters’ fiscal years, unless otherwise noted. The consolidated financialstatements include the accounts of Headwaters, all of its subsidiaries andother entities in which Headwaters has a controlling interest. All significantintercompany transactions and accounts are eliminated in consolidation. Due tothe seasonality of the operations of the building materials businesses andother factors, Headwaters’ consolidated results of operations for 2007 are notindicative of the results to be expected for the full fiscal 2007 year.

The accompanying unaudited condensed consolidatedfinancial statements have been prepared in accordance with the rules andregulations of the Securities and Exchange Commission (“SEC”) for quarterlyreports on Form 10-Q. In the opinion of management, all adjustments considerednecessary for a fair presentation have been included, and consist of normalrecurring adjustments.Certaininformation and footnote disclosures normally included in annual financialstatements prepared in accordance with U.S. generally accepted accountingprinciples have been condensed or omitted. These financial statements should beread in conjunction with the consolidated financial statements and notesthereto included in Headwaters’ Annual Report on Form 10-K for the year endedSeptember 30, 2006 (“Form 10-K”) and in Headwaters’ Quarterly Reports on Form10-Q for the quarters ended December 31, 2006 and March 31, 2007.

Recent Accounting Pronouncements – In July 2006, the Financial AccountingStandards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASBStatement No. 109 (“FIN 48”). This Interpretation prescribes aconsistent recognition threshold and measurement standard, as well as clearcriteria for subsequently recognizing, derecognizing and measuring taxpositions, for financial reporting purposes. FIN 48 also requires expanded disclosureswith respect to the uncertainty in income taxes. FIN 48 is effective forHeadwaters’ fiscal 2008 year beginning on October 1, 2007. Management iscurrently evaluating the impact of FIN 48. The effect of adopting FIN 48, ifmaterial, will be a transition adjustment to beginning retained earnings in theyear of adoption.

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In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements” (“SFAS No. 157”) which addresses how companies shouldmeasure fair value when they are required to use a fair value measure forrecognition or disclosure purposes under generally accepted accountingprinciples. Headwaters must adopt SFAS No. 157 no later than in its fiscal yearending September 30, 2009. Headwaters uses fair value measurements to determinethe reported amounts of assets acquired and liabilities assumed in purchasetransactions, in testing for potential goodwill impairment, for disclosure ofthe fair value of financial instruments, and elsewhere. It is thereforepossible that the implementation of SFAS No. 157 could have a material effecton the reported amounts or disclosures in Headwaters’ consolidated financialstatements in future periods.

Headwaters has reviewed all other recently issued accounting standardswhich have not yet been adopted in order to determine their potential effect,if any, on the results of operations or financial position of Headwaters. Basedon that review, Headwaters does not currently believe that any of these otherrecent accounting pronouncements will have a significant effect on its currentor future financial position, results of operations, cash flows or disclosures.

Reclassifications – Certain prior period amounts have beenreclassified to conform to the current period’s presentation. Thereclassifications had no effect on net income or total assets.

**2.****              Segment Reporting**

Headwaters currently operates intwo industries and reports three business segments, the construction materialsand CCPs segments in the building materials industry, and the alternativeenergy segment in the energy industry. Revenues for the constructionmaterials segment consist of product sales to wholesale and retaildistributors, contractors and other users of building products. CCP revenues consist primarily of fly ash andother product sales with a small amount of service revenue. Revenue for thealternative energy segment consists primarily of sales of chemical reagents andlicense fees.

The following segment informationhas been prepared in accordance with SFAS No. 131, “Disclosure about Segmentsof an Enterprise and Related Information.” Segment performance is evaluatedprimarily on revenue and operating income, although other factors are alsoused, such as income tax credits generated by activities of the alternativeenergy segment. Intersegment sales are immaterial. 

Segment costs and expensesconsidered in deriving segment operating income include cost of revenue,amortization, research and development, and segment-specific selling, generaland administrative expenses. Amounts included in the “Corporate” columnrepresent expenses not specifically attributable to any segment and includeadministrative departmental costs and general corporate overhead. Segmentassets reflect those specifically attributable to individual segments andprimarily include accounts receivable, inventories, property, plant andequipment, intangible assets and goodwill. Cash and cash equivalents and otherassets are included in the “Corporate” column.
|                                | ** ** | **Three Months Ended June 30, 2006** | ** ** |
|--------------------------------|------------|---------------------------------------------------------------|------------|
| **(in thousands)**        | ** ** | **Construction  Materials**                                   | ** ** | **CCPs** | ** ** | **Alternative  Energy** | ** ** | **Corporate** | ** ** | **Totals** | ** ** |
| ** **                     | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Segment revenue                |       | $                                                             | 162,067    |   | $ | 74,068 |   | $ | 59,794 |   | $ | — |   | $ | 295,929 |   |
|                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Depreciation and  amortization |       | $                                                             | (10,919    | ) | $ | (3,146 | ) | $ | (2,014 | ) | $ | (96 | ) | $ | (16,175 | ) |
|                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Operating income  (loss)       |       | $                                                             | 29,063     |   | $ | 14,184 |   | $ | 14,175 |   | $ | (8,180 | ) | $ | 49,242 |   |
| Net interest expense           |       |                                                          |       |   |   |   |   |   |   | (8,156 | ) |
| Other income (expense), net    |       |                                                          |       |   |   |   |   |   |   | 541 |   |
| Income tax provision           |       |                                                          |       |   |   |   |   |   |   | (14,220 | ) |
| Net income                     |       |                                                          |       |   |   |   |   |   |   | $ | 27,407 |   |
|                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Capital expenditures           |       | $                                                             | 9,270      |   | $ | 2,342 |   | $ | 2,782 |   | $ | 51 |   | $ | 14,445 |   |

 

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|                                | ** ** | **Three Months Ended June 30, 2007** | ** ** |
|--------------------------------|------------|---------------------------------------------------------------|------------|
| **(in thousands)**        | ** ** | **Construction  Materials**                                   | ** ** | **CCPs** | ** ** | **Alternative  Energy** | ** ** | **Corporate** | ** ** | **Totals** | ** ** |
|                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Segment revenue                |       | $                                                             | 155,576    |   | $ | 83,237 |   | $ | 97,516 |   | $ | — |   | $ | 336,329 |   |
|                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Depreciation and  amortization |       | $                                                             | (12,528    | ) | $ | (3,192 | ) | $ | (2,412 | ) | $ | (108 | ) | $ | (18,240 | ) |
|                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Operating income  (loss)       |       | $                                                             | 24,292     |   | $ | 17,961 |   | $ | 33,387 |   | $ | (5,859 | ) | $ | 69,781 |   |
| Net interest expense           |       |                                                          |       |   |   |   |   |   |   | (6,664 | ) |
| Other income (expense), net    |       |                                                          |       |   |   |   |   |   |   | (2,860 | ) |
| Income tax provision           |       |                                                          |       |   |   |   |   |   |   | (13,860 | ) |
| Net income                     |       |                                                          |       |   |   |   |   |   |   | $ | 46,397 |   |
|                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Capital expenditures           |       | $                                                             | 6,419      |   | $ | 1,405 |   | $ | 4,360 |   | $ | 90 |   | $ | 12,274 |   |

 
|                                         | ** ** | **Nine Months Ended June 30, 2006** | ** **    |
|-----------------------------------------|------------|--------------------------------------------------------------|---------------|
| **(in thousands)**                 | ** ** | **Construction  Materials**                                  | ** **    | **CCPs** | ** ** | **Alternative  Energy** | ** ** | **Corporate** | ** ** | **Totals** | ** ** |
|                                    |       |                                                         |          |   |   |   |   |   |   |   |   |
| Segment revenue                         |       | $                                                            | 423,744       |   | $ | 197,724 |   | $ | 224,692 |   | $ | — |   | $ | 846,160 |   |
|                                    |       |                                                         |          |   |   |   |   |   |   |   |   |
| Depreciation and  amortization          |       | $                                                            | (31,648       | ) | $ | (9,472 | ) | $ | (5,551 | ) | $ | (284 | ) | $ | (46,955 | ) |
|                                    |       |                                                         |          |   |   |   |   |   |   |   |   |
| Operating income  (loss)                |       | $                                                            | 57,321        |   | $ | 28,925 |   | $ | 67,271 |   | $ | (16,267 | ) | $ | 137,250 |   |
| Net interest expense                    |       |                                                         |          |   |   |   |   |   |   | (25,816 | ) |
| Other income (expense), net             |       |                                                         |          |   |   |   |   |   |   | (4,960 | ) |
| Income tax provision                    |       |                                                         |          |   |   |   |   |   |   | (32,370 | ) |
| Net income                              |       |                                                         |          |   |   |   |   |   |   | $ | 74,104 |   |
|                                    |       |                                                         |          |   |   |   |   |   |   |   |   |
| Capital  expenditures                   |       | $                                                            | 24,847        |   | $ | 7,099 |   | $ | 6,607 |   | $ | 496 |   | $ | 39,049 |   |
|                                    |       |                                                         |          |   |   |   |   |   |   |   |   |
| **Segment Assets as of June 30,  2006** | ** ** | **$**                                                        | **1,160,267** | ** ** | **$** | **310,789** | ** ** | **$** | **79,915** | ** ** | **$** | **101,438** | ** ** | **$** | **1,652,409** | ** ** |

 
|                                         | ** ** | **Nine Months Ended June 30, 2007** | ** **    |
|-----------------------------------------|------------|--------------------------------------------------------------|---------------|
| **(in thousands)**                 | ** ** | **Construction  Materials**                                  | ** **    | **CCPs** | ** ** | **Alternative  Energy** | ** ** | **Corporate** | ** ** | **Totals** | ** ** |
|                                    |       |                                                         |          |   |   |   |   |   |   |   |   |
| Segment revenue                         |       | $                                                            | 393,878       |   | $ | 214,502 |   | $ | 276,978 |   | $ | — |   | $ | 885,358 |   |
|                                    |       |                                                         |          |   |   |   |   |   |   |   |   |
| Depreciation and  amortization          |       | $                                                            | (37,086       | ) | $ | (9,630 | ) | $ | (6,947 | ) | $ | (327 | ) | $ | (53,990 | ) |
|                                    |       |                                                         |          |   |   |   |   |   |   |   |   |
| Operating income  (loss)                |       | $                                                            | 33,023        |   | $ | 38,614 |   | $ | 96,136 |   | $ | (18,669 | ) | $ | 149,104 |   |
| Net interest expense                    |       |                                                         |          |   |   |   |   |   |   | (24,001 | ) |
| Other income (expense), net             |       |                                                         |          |   |   |   |   |   |   | (9,011 | ) |
| Income tax provision                    |       |                                                         |          |   |   |   |   |   |   | (25,500 | ) |
| Net income                              |       |                                                         |          |   |   |   |   |   |   | $ | 90,592 |   |
|                                    |       |                                                         |          |   |   |   |   |   |   |   |   |
| Capital  expenditures                   |       | $                                                            | 20,767        |   | $ | 4,718 |   | $ | 12,127 |   | $ | 132 |   | $ | 37,744 |   |
|                                    |       |                                                         |          |   |   |   |   |   |   |   |   |
| **Segment Assets as of June 30,  2007** | ** ** | **$**                                                        | **1,170,268** | ** ** | **$** | **306,164** | ** ** | **$** | **166,587** | ** ** | **$** | **97,561** | ** ** | **$** | **1,740,580** | ** ** |

 

**3.****              Stock-Based Compensation**

Total stock-based compensationexpense, none of which involved the expenditure of cash, was approximately $1.6million and $1.4 million for the three months ended June 30, 2006 and 2007,respectively, and $5.2 million and $4.8 million for the nine months ended June 30,2006 and 2007, respectively. As of June 30, 2007, there is approximately $9.5million of total

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compensation cost related tononvested awards not yet recognized, which will be recognized in the futureover the awards’ applicable vesting terms.

**4.****              Inventories**

Inventories consisted of thefollowing at:
| (in thousands) | ** ** | **September 30, 2006** | ** ** | **June 30, 2007** | ** ** |
|---------------------|------------|----------------------------------|------------|-----------------------------|------------|
|                |       |                             |       |                        |       |
| Raw materials       |       | $                                | 12,831     |                        | $          | 12,542 |   |
| Finished goods      |       | 49,688                           |       | 46,675                      |       |
| ** **          | ** ** | **$**                            | **62,519** | ** **                  | **$**      | **59,217** | ** ** |

 

**5.****              Intangible Assets and Goodwill**

Intangible Assets – All of Headwaters’ identified intangible assetsare being amortized. The following table summarizes the gross carrying amountsand the related accumulated amortization of intangible assets as of:
|                                    | ** ** | ** **                       | ** ** | **September 30, 2006** | ** **  | **June 30, 2007**   | ** ** |
|------------------------------------|------------|----------------------------------|------------|----------------------------------|-------------|-------------------------------|------------|
| **(in thousands)**            | ** ** | **Estimated  useful lives** | ** ** | **Gross  Carrying  Amount**      | ** **  | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
|                               |       |                             |       |                             |        |                          |       |   |   |   |   |
| CCP contracts                      |       | 8 - 20 years                     |       | $                                | 117,690     |                          | $          | 24,987 |   | $ | 117,690 |   | $ | 30,035 |   |
| Customer  relationships            |       | 7 1¤2  - 15 years           |       | 68,331                           |        | 10,348                        |       | 71,503 |   | 14,269 |   |
| Trade names                        |       | 5 - 20 years                     |       | 63,657                           |        | 7,018                         |       | 68,412 |   | 9,711 |   |
| Patents and  patented technologies |       | 7 1¤2  - 19 years           |       | 53,107                           |        | 13,037                        |       | 53,469 |   | 16,879 |   |
| Non-competition  agreements        |       | 2 - 5 years                      |       | 6,852                            |        | 4,717                         |       | 3,855 |   | 2,150 |   |
| Other                              |       | 9 - 15 years                     |       | 3,556                            |        | 1,543                         |       | 3,556 |   | 1,800 |   |
| ** **                         | ** ** | ** **                       | ** ** | **$**                            | **313,193** | ** **                    | **$**      | **61,650** | ** ** | **$** | **318,485** | ** ** | **$** | **74,844** | ** ** |

 

Total amortization expenserelated to intangible assets was approximately $6.3 million and $5.7 millionfor the three months ended June 30, 2006 and 2007, respectively, and $18.4million and $17.4 million for the nine months ended June 30, 2006 and 2007,respectively. Total estimated annual amortization expense for fiscal years 2007through 2012 is shown in the following table.
| Year ending September 30: | *** *** | **(in thousands)** | *** *** |
|------------------------------------------|--------------|-------------------------|--------------|
|                                     |         |                    |         |
| 2007                                     |         | $                       | 22,877       |   |
| 2008                                     |         | 21,373                  |         |
| 2009                                     |         | 21,160                  |         |
| 2010                                     |         | 20,760                  |         |
| 2011                                     |         | 20,530                  |         |
| 2012                                     |         | 19,039                  |         |
|                                          |              |                         |              |  |

 

Goodwill – SFAS No. 142 requires Headwaters toperiodically test for goodwill impairment, at least annually, or sooner if evidence of possible impairmentarises. Headwaters performs its annual impairment testing using a testdate of June 30. Due primarily to thedepressed residential housing and remodeling market, there is risk that one ormore of Headwaters’ reporting units may fail the SFAS No. 142 goodwillimpairment test, requiring a write-down of goodwill. The goodwill impairmenttesting is expected to be completed in the quarter ending September 30, 2007,with any necessary non-cash impairment charges recorded in that quarter.

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**6.****              Long-term Debt**

Long-term debt consisted of thefollowing at:
| (in thousands)                    | ** ** | **September 30,  2006** | ** **  | **June 30,  2007** | ** ** |
|----------------------------------------|------------|------------------------------|-------------|-------------------------|------------|
|                                   |       |                         |        |                    |       |
| Senior secured  debt                   |       | $                            | 415,319     |                    | $          | 262,500 |   |
|                                   |       |                         |        |                    |       |
| Convertible  senior subordinated notes |       | 172,500                      |        | 332,500                 |       |
|                                   |       |                         |        |                    |       |
| Notes payable to  a bank               |       | 7,215                        |        | —                  |       |
|                                   |       |                         |        |                    |       |
| Other                                  |       | 53                           |        | —                  |       |
|                                   |       | 595,087                      |        | 595,000                 |       |
| Less: current  portion                 |       | (7,267                       | )           | —                  |       |
| **Total long-term debt**               | ** ** | **$**                        | **587,820** | ** **              | **$**      | **595,000** | ** ** |

 

Senior Secured Credit Agreements – Headwaters’ senior secured credit facilitycurrently consists of a first lien term loan in the amount of $262.5 million.The credit facility also provides for up to $60.0 million of borrowings under arevolving credit arrangement, with the ability to increase this amount to $100.0million, subject to obtaining additional revolving loan commitments. The firstlien term loan is senior in priority to all other debt and is secured by allassets of Headwaters. The terms of the credit facility, as currently amended,are described in more detail in the following paragraphs. Headwaters is incompliance with all debt covenants as of June 30, 2007.

The first lien term loan bears interest, atHeadwaters’ option, at either i) the London Interbank Offered Rate (“LIBOR”)plus 2.0%, 2.25%, or 2.5%, depending on the credit ratings that have been mostrecently announced for the loans by Standard & Poor’s Ratings Services (“S&P”)and Moody’s Investors Service, Inc. (“Moody’s”); or ii) the “Base Rate” plus1.0%, 1.25%, or 1.5%, again depending on the credit ratings announced byS&P and Moody’s. Base rate is defined as the higher of the rate announcedby Morgan Stanley Senior Funding and the overnight rate charged by the FederalReserve Bank of New York plus 0.5%. Headwaters’ current rate is LIBOR plus2.0%. Headwaters can lock in new LIBOR rates for the first lien loan for one,two, three or six months. The weighted-average interest rate on the first liendebt was approximately 6.4% at June 30, 2007, after giving consideration to theeffect of the interest rate hedge on $150.0 million of this debt, as describedhereafter. Interest on the first lien term loan is generally payable on aquarterly basis.

In January 2007, Headwaters issued $160.0 millionof new convertible senior subordinated notes due 2014. Headwaters used most ofthe net proceeds from these notes and available cash to repay $152.8 million ofthe first lien term loan. As a result of this early repayment (made in thequarter ended March 31, 2007), the remaining balance of the first lien termloan of $262.5 million is repayable as follows: $12.1 million in November 2010,and two payments of $125.2 million each in February 2011 and April 2011, thetermination date. Due to the early repayment, Headwaters accelerated theamortization of related debt issue costs totaling approximately $2.0 million,which amount was charged to interest expense. There are mandatory prepaymentsof the first lien term loan in the event of certain asset sales and debt andequity issuances and from “excess cash flow,” as defined in the agreement.Optional prepayments of the first lien term loan are permitted without penaltyor premium. Once repaid in full or in part, no further reborrowings can bemade.

Borrowings under the revolving credit arrangementare generally subject to the terms of the first lien loan agreement and bearinterest at either LIBOR plus 1.75% to 2.5% (depending on Headwaters’ “totalleverage ratio,” as defined), or the Base Rate plus 0.75% to 1.5%. Borrowingsand reborrowings of any available portion of the $60.0 million revolver can bemade at any time through September 2009, when all loans must be repaid and therevolving credit arrangement terminates. The fees for the unused portion of therevolving credit arrangement range from 0.5% to 0.75% (depending on Headwaters’“total leverage ratio,” as defined). There were no borrowings outstanding underthe revolving credit arrangement as of June 30, 2007, or subsequent thereto.The credit agreement also allows for the issuance of letters of credit, providedthere is capacity under the revolving credit arrangement. As of June 30, 2007,five stand-by letters of credit totaling approximately $4.4 million wereoutstanding, with expiration dates ranging from September 2007 to December2008.

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The credit facility containsrestrictions and covenants common to such agreements, including limitations onthe incurrence of additional debt, investments, merger and acquisitionactivity, asset sales and liens, annual capital expenditures in excess of$100.0 million annually, and the payment of dividends, among others. Inaddition, Headwaters must maintain certain leverage and fixed charge coverageratios, as those terms are defined in the agreements, as follows: i) a totalleverage ratio of 3.75:1.0 or less, declining to 3.5:1.0 in 2010; ii) a maximumratio of consolidated senior funded indebtedness minus subordinatedindebtedness to EBITDA of 2.75:1.0, declining to 2.5:1.0 in 2010; and iii) aminimum ratio of EBITDA plus rent payments for the four preceding fiscal quartersto scheduled payments of principal and interest on all indebtedness for thenext four fiscal quarters of 1.25:1.0.

As required by the senior secured credit facility, Headwaters enteredinto agreements to limit its variable interest rate exposure. The agreementseffectively fix the LIBOR rate at 3.71% for $150.0 million of the first liendebt through September 8, 2007. Headwaters accounts for these agreements ascash flow hedges, with their fair market value reflected in the consolidatedbalance sheet as either other assets or other liabilities. The market value ofthese hedges (and various other cash flow hedges to which Headwaters is adirect or indirect party) at June 30, 2007 was not material. Totalcomprehensive income, considering all cash flow hedge agreements to whichHeadwaters is a party, was not materially different from net income for anyperiod in 2006 or 2007.

2.875% Convertible SeniorSubordinated Notes Due 2016– Headwaters has outstanding $172.5 million of 2.875% convertible seniorsubordinated notes due June 2016, with interest payable semi-annually. Thesenotes are subordinate to the senior secured debt described above and rankequally with the 2.50% convertible senior subordinated notes due 2014 describedbelow, and any future senior subordinated debt. Holders of the notes mayconvert the notes into shares of Headwaters’ common stock at a conversion rateof 33.3333 shares per $1,000 principal amount ($30 conversion price), or 5.75million aggregate shares of common stock, contingent upon certain events. Theconversion rate adjusts for events related to Headwaters’ common stock,including common stock issued as a dividend, rights or warrants to purchasecommon stock issued to all holders of Headwaters’ common stock, and othersimilar rights or events that apply to all holders of common stock.

The notes are convertible if any of the following five criteria aremet: 1) satisfaction of a market price condition which becomes operative if,prior to June 1, 2011, in any calendar quarter the closing price of Headwaters’common stock exceeds $39 per share for at least 20 trading days in the 30consecutive trading days ending on the last trading day of the calendarquarter, or, at any time on or after June 1, 2011 the closing price ofHeadwaters’ common stock exceeds $39 per share; 2) a credit rating, if any,assigned to the notes is three or more rating subcategories below the initialrating; 3) the notes trade at less than 98% of the product of the common stocktrading price and the number of shares of common stock issuable upon conversionof $1,000 principal amount of the notes, except this provision is not availableif the closing common stock price is between 100% and 130% of the currentconversion price of the notes; 4) Headwaters calls the notes for redemption; or5) upon the occurrence of specified corporate transactions.

Headwaters may call the notes for redemption at any time prior to June4, 2011 if the closing common stock price exceeds 130% of the conversion pricefor 20 trading days in any consecutive 30-day trading period (in which caseHeadwaters must provide a “make whole” payment of the present value of allremaining interest payments on the redeemed notes through June 1, 2011).Headwaters may redeem any portion of the notes at any time on or after June 4,2011. In addition, the holder of the notes has the right to require Headwatersto repurchase all or a portion of the notes on June 1, 2011 or if a fundamentalchange in common stock has occurred, including termination of trading. Subsequentto June 1, 2011, the notes require an additional interest payment equal to0.40% of the average trading price of the notes if the trading price equals120% or more of the principal amount of the notes.

Headwaters includes the additional shares of common stock contingentlyissuable under the convertible notes in its diluted EPS calculations on an if-converted basis (see Note 8). In January 2007, Headwaters announced that itwas planning an exchange offer for the 2.875% convertible seniorsubordinated notes due 2016, whereby new notes with similar, but not identical,terms, along with an exchange fee, would be issued upon tender of the existingnotes. The commencement of an exchange offer has been indefinitely postponed.

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2.50% Convertible SeniorSubordinated Notes Due 2014– In January 2007, Headwaters issued $160.0 million of 2.50% convertiblesenior subordinated notes due February 2014, with interest payablesemi-annually. These notes are subordinate to the senior secured debt and rankequally with the 2.875% convertible senior subordinated notes due 2016described above, and any future senior subordinated debt. Total offering costs,including underwriting discounts and commissions, were approximately $5.4million. The conversion rate for the notes is 33.9236 shares per $1,000principal amount ($29.48 conversion price), subject to adjustment. Uponconversion, Headwaters will pay cash up to the principal amount of the notes,and shares of common stock to the extent the price of Headwaters’ common stockexceeds the conversion price during a 20-trading-day observation period. Theconversion rate is adjusted for certain corporate transactions referred to as “fundamentalchanges.”

The notes are convertible at the option of the holder prior to December1, 2013 if any of the following criteria are met:  1) during any fiscal quarter the closingprice of Headwaters’ common stock exceeds $38.32 per share for at least 20trading days during a period of 30 consecutive trading days ending on the lasttrading day of the preceding fiscal quarter; 2) during the five-business-dayperiod after any ten-consecutive-trading-day period, the notes trade at lessthan 98% of the product of the common stock trading price and the number ofshares of common stock issuable upon conversion of $1,000 principal amount ofthe notes; or 3) upon the occurrence of specified corporate transactions. Thenotes are convertible on or after December 1, 2013 regardless of the foregoingcircumstances. Headwaters may not redeem the notes. If Headwaters has a “fundamentalchange,” holders may require Headwaters to repurchase the notes at a priceequal to the principal amount plus any accrued interest. Headwaters filed ashelf registration statement with the SEC to register resales of the notes andthe common stock issuable upon conversion of the notes in April 2007, whichregistration statement was effective upon filing.

In connection with the issuance of the notes, Headwaters entered intoconvertible note hedge and warrant transactions for the purpose of effectivelyincreasing the common stock conversion price for the notes from $29.48 pershare to $35.00 per share. The convertible note hedge terminates upon thematurity of the notes or when none of the notes remain outstanding due toconversion or otherwise. The net pre-tax cost of the hedge and warranttransactions was approximately $11.8 million. Because the contracts are indexedto Headwaters’ common stock and are not considered derivatives, the net costwas accounted for as a decrease in paid-in capital. Headwaters also recorded adeferred tax asset of approximately $16.2 million related to the hedgetransaction.

Interest – During the three months ended June 30, 2006 and 2007, Headwatersincurred total interest costs of approximately $9.1 million and $7.4 million,respectively, including approximately $0.6 million and $0.7 million,respectively, of non-cash interest expense and approximately $0.3 million and$0.2 million, respectively, of interest costs that were capitalized. During thenine months ended June 30, 2006 and 2007, Headwaters incurred total interestcosts of approximately $28.5 million and $26.7 million, respectively, includingapproximately $2.2 million and $4.0 million, respectively, of non-cash interestexpense and approximately $0.7 million and $0.7 million, respectively, ofinterest costs that were capitalized.

Interest income was approximately$0.6 million and $0.5 million during the three months ended June 30, 2006 and2007, respectively, and $2.0 million for both the nine months ended June 30,2006 and 2007. The weighted-average interest rate on the face amount ofoutstanding long-term debt, disregarding amortization of debt issue costs, wasapproximately 5.7% at September 30, 2006 and 4.3% at June 30, 2007.

**7.****              Income Taxes**

Headwaters’ estimated effective income tax rate forthe fiscal year ending September 30, 2007, exclusive of discrete items, is23.0%, which rate was applied to income before income taxes for the nine monthsended June 30, 2007. Headwaters also recognized a net $1.2 million income taxbenefit during the 2007 nine-month period for discrete items that did notaffect the calculation of the estimated effective income tax rate for thefiscal year. The discrete items primarily consisted of additional tax creditsfor 2006 and changes in estimated tax liabilities and in reserves related to anIRS examination. The additional tax credits for 2006 resulted from actualphase-out of Section 45K tax credits for calendar 2006 being lower thanpreviously estimated. After consideration of the effect of the discrete items,income tax expense totaled approximately 22.0% of income before income taxesfor the nine months ended June 30, 2007, compared

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to 30.4% for the nine months ended June 30, 2006. Theincome tax rates for the three months ended June 30, 2006 and 2007 were 34.2%and 23.0%, respectively.

The effective tax rates for 2006 and 2007 are lowerthan statutory rates primarily due to tax credits related to two coal-basedsolid alternative fuel facilities that Headwaters owns and operates, plusHeadwaters’ 19% interest in an entity that owns and operates anotheralternative fuel facility (where Headwaters is not the primary beneficiary).The alternative fuel produced at these three facilities through December 2007qualifies for tax credits pursuant to Section 45K (formerly Section 29) of theInternal Revenue Code, subject to the uncertainties of phase-out, IRS audit andother risks associated with the tax credits, all as more fully described inNote 9.

Headwaters’ 19% interest in the entity that owns andoperates an alternative fuel facility was acquired for payments totaling $15.5million, of which $3.5 million remains to be paid as of June 30, 2007. Thisobligation is recorded in other accrued liabilities in the consolidated balancesheet and bears interest at an 8% rate. Headwaters also agreed to makeadditional payments to the seller based on a pro-rata allocation of the taxcredits generated by the facility through December 2007. These additionalcontractual payments are affected by phase-out and, along with the amortizationof the $15.5 million investment, are recorded in other expense in theconsolidated statements of income, totaling approximately $5.3 million and $9.5million for the nine months ended June 30, 2006 and 2007, respectively.

The alternative fuel produced at the facility through December 2007qualifies for tax credits, and Headwaters is entitled to receive its pro-ratashare of such tax credits generated based upon its ownership percentage.Headwaters has the ability, under certain conditions, to limit its liabilityunder the fixed payment obligations currently totaling approximately $3.5million; therefore, Headwaters’ obligation to make all of the above-describedpayments is effectively limited by the tax benefits Headwaters receives.

As a result of actual and projected oil prices forcalendar 2007, there could be a partial phase-out of Section 45K tax creditsfor the calendar year. In calculating an income tax provision for 2007,Headwaters used an estimated phase-out percentage for Section 45K tax creditsof 25% for calendar 2007. This estimated phase-out percentage was derived byestimating the calendar 2007 reference price for oil using actual oil pricesfor January through April 2007 and published NYMEX oil prices for the monthsMay through December 2007. The monthly NYMEX oil prices were reduced byapproximately 10%, which reduction represents Headwaters’ estimate of therelationship between NYMEX oil prices and the average U.S. wellhead oil pricesactually used to calculate the annual reference price. The reference price forcalendar 2007 was calculated by averaging the 12 months’ actual or estimatedoil prices, which average was compared to the estimated phase-out range forcalendar 2007 of $56.16 to $70.50 to derive an estimated phase-out percentage.

While the calendar 2007 phase-out percentage can notbe finalized at the current time, as of June 30, 2007, the estimated phase-outpercentage represents Headwaters’ best estimate of what the phase-outpercentage would be, using available information as of that date. The effect onincome taxes of any change in the calendar 2007 phase-out percentage from 25%to the actual percentage for the year will be recorded to income tax expense insubsequent periods, when the calendar 2007 actual oil prices and the phase-outrange are known. Any such effect could be material to Headwaters’ 2007 and 2008income tax expense.

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**8.****              Earnings per Share**

Thefollowing table sets forth the computation of basic and diluted EPS for theperiods indicated.
|                                                                                                                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| **(in thousands, except per-share data)**                                                                   | ** ** | **2006**                                        | ** ** | **2007**                                       | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                                                                                                                      |       |                                            |       |                                           |       |   |   |   |   |
| **Numerator:**                                                                                                                  |       |                                            |       |                                           |       |   |   |   |   |
| Numerator for basic  earnings per share – net income                                                                       |       | $                                               | 27,407     |                                           | $          | 46,397 |   | $ | 74,104 |   | $ | 90,592 |   |
| Interest expense  related to convertible senior subordinated notes, net of taxes                                                |       | 892                                             |       | 1,132                                          |       | 3,022 |   | 3,386 |   |
| Numerator for diluted  earnings per share – net income plus interest expense related to convertible  notes, net of taxes   |       | $                                               | 28,299     |                                           | $          | 47,529 |   | $ | 77,126 |   | $ | 93,978 |   |
| ** **                                                                                                                      |       |                                            |       |                                           |       |   |   |   |   |
| **Denominator:**                                                                                                                |       |                                            |       |                                           |       |   |   |   |   |
| Denominator for basic  earnings per share – weighted-average shares outstanding                                            |       | 41,984                                          |       | 42,196                                         |       | 41,813 |   | 42,148 |   |
| Effect of dilutive  securities:                                                                                                 |       |                                            |       |                                           |       |   |   |   |   |
| Shares issuable  upon exercise of options and SARs                                                                              |       | 809                                             |       | 411                                            |       | 1,145 |   | 481 |   |
| Shares issuable  upon conversion of convertible notes                                                                           |       | 5,750                                           |       | 5,750                                          |       | 5,750 |   | 5,750 |   |
| Total potential  dilutive shares                                                                                                |       | 6,559                                           |       | 6,161                                          |       | 6,895 |   | 6,231 |   |
| Denominator for diluted  earnings per share – weighted-average shares outstanding after assumed  exercises and conversions |       | 48,543                                          |       | 48,357                                         |       | 48,708 |   | 48,379 |   |
| ** **                                                                                                                      |       |                                            |       |                                           |       |   |   |   |   |
| **Basic earnings per share**                                                                                                    | ** ** | **$**                                           | **0.65**   | ** **                                     | **$**      | **1.10** | ** ** | **$** | **1.77** | ** ** | **$** | **2.15** | ** ** |
|                                                                                                                            |       |                                            |       |                                           |       |   |   |   |   |
| **Diluted earnings per share**                                                                                                  | ** ** | **$**                                           | **0.58**   | ** **                                     | **$**      | **0.98** | ** ** | **$** | **1.58** | ** ** | **$** | **1.94** | ** ** |
| ** **                                                                                                                      | ** ** | ** **                                      | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Anti-dilutive securities not  considered in diluted EPS calculation:**                                                        | ** ** | ** **                                      | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options                                                                                                                   |       | 280                                             |       | 1,156                                          |       | 140 |   | 1,023 |   |
| SARs                                                                                                                            |       | 3,150                                           |       | 3,365                                          |       | 1,110 |   | 3,212 |   |

 

**9.****              Commitments and Contingencies**

Significantnew commitments and ongoing contingencies as of June 30, 2007 not disclosedpreviously, are as follows.

Acquisitions – During fiscal 2006 and 2007, Headwatersacquired certain assets and assumed certain liabilities of severalprivately-held companies in the construction materials industry. Pursuant tocontractual terms for some of the acquisitions, additional amounts may bepayable in the future, based on the achievement of stipulated revenue orearnings targets for periods ending no later than March 2010. One such periodfor one acquisition ends September 30, 2007, and it is currently expected thatthe additional payment could be in excess of $20 million, which amount would bepayable in fiscal 2008. If it is determined that future earn-out considerationis payable, goodwill will be increased accordingly. 

Property, Plant and Equipment – As of June 30, 2007, Headwaters was committedto spend approximately $27.8 million on capital projects that were in variousstages of completion.

Joint Venture Obligations – Headwaters has entered into variousjoint ventures with Degussa AG, an international chemical company based inGermany. One of these joint ventures purchased a hydrogen peroxide businesslocated in South Korea. Headwaters is a principal obligor with respect to allnon-financial obligations of the joint venture and, with

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respect to financial obligations of the joint venture, 50% of futureplant expansion cost overruns, if any. Headwaters’ investments in its joint ventureswith Degussa AG (in which Degussa and Headwaters have equal ownership, votingrights and control) are accounted for using the equity method of accounting andtotal approximately $18.2 million as of June 30, 2007.

Headwaters owns a 51% interest in a joint venture with Great RiverEnergy, a Minnesota-based power generation and supply cooperative (“GRE”),which was formed to construct, own and operate an ethanol plant in North Dakota(“Blue Flint”). The plant, which commenced operations in February 2007, isexpected to produce more than 50 million gallons of ethanol annually. Costs toconstruct the ethanol plant and fund start-up costs and initial working capitalwere funded primarily by debt secured by all the assets of Blue Flint, alongwith capital contributions from Headwaters and GRE. Headwaters has made itsrequired capital contribution. The Blue Flint joint venture, which is not avariable interest entity, is being accounted for using the equity method ofaccounting because both partners have equal voting rights and control over thejoint venture. Headwaters’ investment in the Blue Flint joint venture isapproximately $11.2 million as of June 30, 2007.

Legal Matters – Headwaters has ongoing litigation andasserted claims which have been incurred during the normal course of business,including the specific matters discussed below. Headwaters intends tovigorously defend or resolve these matters by settlement, as appropriate.Management does not currently believe that the outcome of these matters willhave a material adverse effect on Headwaters’ operations, cash flow orfinancial position.

Historically, costs paid tooutside legal counsel for litigation have generally comprised a majority ofHeadwaters’ litigation-related costs. During the nine months ended June30, 2007, Headwaters incurred approximately $3.0 millionof expense for legal matters, which consisted primarily of costs for outsidelegal counsel. Headwaters currently believes the range of potential loss forall unresolved matters, excluding costs for outside counsel, is from $1.0million up to the amounts sought by claimants and has recorded a totalliability as of June 30, 2007 of $1.0 million. Claims and damages sought byclaimants in excess of this amount are not deemed to be probable. Headwaters’outside counsel currently believe that unfavorable outcomes of outstandinglitigation are neither probable nor remote and declined to express opinionsconcerning the likely outcomes or liability to Headwaters. It is not possible to estimate what litigation-relatedcosts will be in future periods.

The matters discussed below raise difficult andcomplex legal and factual issues, and the resolution of these issues is subjectto many uncertainties, including the facts and circumstances of each case, thejurisdiction in which each case is brought, and the future decisions of juries,judges, and arbitrators. Therefore, although management believes that theclaims asserted against Headwaters in the named cases lack merit, there is apossibility of material losses in excess of the amounts accrued if one or moreof the cases were to be determined adversely against Headwaters for asubstantial amount of the damages asserted. It is possible that a change in the estimates of probable liability couldoccur, and the changes could be material. Additionally, as with any litigation,these proceedings require that Headwaters incur substantial costs, includingattorneys’ fees, managerial time, and other personnel resources and costs inpursuing resolution.

*McEwan*. In 1995, Headwaters granted stock options to a member of its board ofdirectors, Lloyd McEwan. The director resigned from the board in 1996.Headwaters has declined McEwan’s attempts to exercise most of the options ongrounds that the options terminated. In June 2004, McEwan filed a complaint inthe Fourth District Court for the State of Utah against Headwaters allegingbreach of contract, breach of implied covenant of good faith and fair dealing,fraud, and misrepresentation. McEwan seeks declaratory relief as well ascompensatory damages in the approximate amount of $2.8 million and punitivedamages. Headwaters has filed an answer denying McEwan’s claims and hasasserted counterclaims against McEwan. Because resolution of the litigation isuncertain, legal counsel cannot express an opinion as to the ultimate amount ofliability or recovery.

*Boynton*.  In October 1998, Headwaters entered into atechnology purchase agreement with James G. Davidson and Adtech, Inc. Thetransaction transferred certain patent and royalty rights to Headwaters relatedto a synthetic fuel technology invented by Davidson. (This technology isdistinct from the technology developed by Headwaters.) This

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action is factually related to an earlier action brought by certainpurported officers and directors of Adtech, Inc. That action was dismissed bythe United States District Court for the Western District of Tennessee and theDistrict Court’s order of dismissal was affirmed on appeal. In the currentaction, the allegations arise from the same facts, but the claims are assertedby certain purported stockholders of Adtech. In June 2002, Headwaters receiveda summons and complaint from the United States District Court for the WesternDistrict of Tennessee alleging, among other things, fraud, conspiracy,constructive trust, conversion, patent infringement and interference withcontract arising out of the 1998 technology purchase agreement entered intobetween Davidson and Adtech on the one hand, and Headwaters on the other. Theplaintiffs seek declaratory relief and compensatory damages in the approximateamount of between $15.0 million and $25.0 million and punitive damages. InFebruary 2006, the District Court dismissed all claims against Headwaters. Alsoin February 2006, plaintiffs filed an appeal. In July 2007, the United StatesCourt of Appeals for the Federal Circuit vacated the dismissal in favor ofHeadwaters as to the civil conspiracy and constructive trust claims andremanded the case to the District Court for further proceedings. Because theresolution of the litigation is uncertain, legal counsel cannot express anopinion as to the ultimate amount, if any, of Headwaters’ liability.

*HeadwatersConstruction Materials Matters. *There are litigation and pending andthreatened claims made against certain subsidiaries of Headwaters ConstructionMaterials (“HCM”) with respect to several types of exterior finish systemsmanufactured and sold by its subsidiaries for application by contractors onresidential and commercial buildings. Typically, litigation and these claimsare controlled by such subsidiaries’ insurance carriers. The plaintiffs orclaimants in these matters have alleged that the structures have suffereddamage from latent or progressive water penetration due to some alleged failureof the building product or wall system. Some claims involve alleged defectsassociated with components of an Exterior Insulating and Finish System (“EIFS”)which was produced for a limited time (through 1997) by Best Masonry & ToolSupply and Don’s Building Supply. There is a 10-year projected claim periodfollowing discontinuation of the product. Other claims involve allegedliabilities associated with certain stucco products which are still producedand sold by certain subsidiaries of HCM.

Typically, the claimscite damages for alleged personal injuries and punitive damages for allegedunfair business practices in addition to asserting more conventional damageclaims for alleged economic loss and damage to property. To date, claims madeagainst such subsidiaries have been paid by their insurers, with the exceptionof minor deductibles, although such insurance carriers typically have issued “reservationof rights” letters.  None of the caseshas gone to trial. While, to date, none of these proceedings have required thatHCM incur substantial costs, there is no guarantee of insurance coverage orcontinuing coverage. These and future proceedings may result in substantialcosts to HCM, including attorneys’ fees, managerial time and other personnelresources and costs. Adverse resolution of these proceedings could have amaterially negative effect on HCM’s business, financial condition, and resultsof operation, and its ability to meet its financial obligations. Although HCMcarries general and product liability insurance, HCM cannot assure that suchinsurance coverage will remain available, that HCM’s insurance carrier willremain viable, or that the insured amounts will cover all future claims inexcess of HCM’s uninsured retention. Future rate increases may also make suchinsurance uneconomical for HCM to maintain. In addition, the insurance policiesmaintained by HCM exclude claims for damages resulting from exterior insulatingfinish systems, or EIFS, that have manifested after March 2003. Becauseresolution of the litigation and claims is uncertain, legal counsel cannotexpress an opinion as to the ultimate amount, if any, of HCM’s liability.

*Other*. Headwaters and its subsidiaries are also involved in other legalproceedings that have arisen in the normal course of business.

Section 45KMatters – Amaterial amount of Headwaters’ consolidated revenue and net income is derivedfrom license fees and sales of chemical reagents, both of which depend on theability of licensees and other customers to manufacture and sell qualifiedsynthetic fuel that generates tax credits under Section 45K (formerly Section29) of the Internal Revenue Code. Headwaters also claims Section 45K taxcredits for synthetic fuel sales from facilities in which it owns an interest.From time to time, issues arise as to the availability of tax credits and, withthe increased price of oil, the phase-out of credits, including the followingitems.

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*Phase-Out*.  Section 45K tax credits are subject tophase-out after the average annual U.S. wellhead oil price (“reference price”)reaches a beginning phase-out threshold price, and are eliminated entirely ifthe reference price reaches the full phase-out price. In recent periods, thereference price has been approximately 90% of the published market prices foroil. For calendar 2006, the reference price was $59.69 per barrel and thephase-out range began at $55.06 and would have fully phased out tax credits at$69.12 per barrel. Therefore, there was a partial phase-out of tax credits forcalendar 2006 of approximately 33%.

For calendar 2007, Headwaters estimates that the phase-out range(computed by increasing the 2006 inflation adjustment factor by 2%) begins at$56.16 and completes phase-out at $70.50 per barrel. As described in moredetail in Note 7, Headwaters estimated a phase-out percentage for Section 45Ktax credits for calendar 2007 of 25%, using available information as of June30, 2007. It is certain that the estimated phase-out percentage for calendar2007 will change during the year.

In an environment of high oil prices, the risk of phase-out increases.Headwaters’ customers and licensees make their own assessments of phase-outrisk. When customers and licensees have perceived a potential negativefinancial impact from phase-out, they have reduced or stopped synthetic fuelproduction or required Headwaters to share in the costs associated withphase-out. Headwaters makes similar assessments with respect to the continuedoperation of its own synthetic fuel production facilities. As of June 30, 2007,all of Headwaters’ licensees are producing synthetic fuel, but most licenseesstopped production for a period of time in calendar 2006. These events havematerially adversely affected both the amount and timing of recognition ofHeadwaters’ revenue, net income and cash flow, and will likely have a materialadverse effect in future periods as well.

Certain accounting rules limit revenue recognition to amounts that are “fixedor determinable.” The amount of license fee revenue recognized by Headwatersduring fiscal 2006 and thus far in fiscal 2007 has been negatively affected byreduced revenues being recognized for certain licensees whose licenseagreements call for Headwaters to be paid a portion of the tax credits earnedby the licensee. Due to uncertainties related to phase-out for calendar 2006and 2007 and other licensee-specific factors, revenue recognition was deferredfor certain licensees during fiscal 2006. A portion of such revenue is alsocurrently being deferred for certain licensees in 2007. 

Due to publication of the calendar 2006 reference price and thephase-out range for that year, finalization of calendar 2006 phase-out was madepossible during the quarter ended June 30, 2007. As a result of theavailability of this information and the clarification of otherlicensee-specific factors, certain calendar 2006 and prior year license feerevenue totaling approximately $26.5 million and $3.3 million was recognizedduring the quarters ended March 31 and June 30, 2007, respectively. Theseamounts related to periods ending on or prior to December 31, 2006 and wererecognized in 2007 when they met the “fixed or determinable” recognitioncriterion and it was remote that any negative adjustment would be required inthe future. Additionally, applying the same policy, approximately $19.4 millionof license fee revenue was recognized during the quarter ended June 30, 2007for calendar 2007 tax credit-based license fees, approximately $9.7 million ofwhich related to the quarter ended March 31, 2007. As of June 30, 2007, mostlicense fee revenue that has not been recognized relates to the quarters endedMarch 31 and June 30, 2007. This unrecognized revenue, which as of June 30,2007 could total approximately $5.5 million (calculated based onlicensee-reported data and assuming 25% phase-out of Section 45K tax creditsfor calendar 2007), will not be recognized until such time as the amountsbecome “fixed or determinable.”

*Legislation.*  By law, Section 45K tax credits for syntheticfuel produced from coal expire on December 31, 2007. In addition, there havebeen initiatives from time to time to consider the early repeal or modificationof Section 45K, including a bill introduced in January 2007, and there maybe additional initiatives introduced in Congress in calendar 2007. WhenSection 45K expires on December 31, 2007 or if it is repealed or adverselymodified, additional synthetic fuel facilities will probably either close orsubstantially curtail production. Given current prices of coal and the costs ofsynthetic fuel production, Headwaters does not believe that production ofsynthetic fuel will be profitable absent the tax credits. In addition, ifHeadwaters’ licensees close their facilities or materially reduce productionactivities (whether after December 31, 2007, or upon earlier repeal or adversemodification of Section 45K, or for any other reason), it would

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have a further material adverse effect on the revenue, net income andcash flow of Headwaters, in addition to the current material adverse effectcaused by phase-out concerns.

*IRS Audits*.  Licensees are subject to audit by the IRS.The IRS may challenge whether Headwaters’ licensees satisfy the requirements ofSection 45K or applicable Private Letter Rulings, includingplaced-in-service requirements, or may attempt to disallow Section 45K taxcredits for some other reason. The IRS has initiated audits of certainlicensee-taxpayers who claimed Section 45K tax credits and will continuethe audit process in the future. The inability of a licensee to claim Section 45Ktax credits would reduce Headwaters’ future income from the licensee. Inaddition, the IRS may audit Headwaters’ tax credits claimed for synthetic fuelsold from the facilities in which it owns an interest.

*SenatePermanent Subcommittee on Investigations*.  In October2003, the Permanent Subcommittee on Investigations of the Government AffairsCommittee of the United States Senate issued a notification of pendinginvestigations. The notification listed the synthetic fuel tax credit as a newitem. In February 2006, the Subcommittee described its investigation asfollows: “The Subcommittee is continuing its investigation [of] tax creditsclaimed under Section 29 [now Section 45K] of the Internal Revenue Code for thesale of coal-based synthetic fuels. This investigation is examining theutilization of these tax credits, the nature of the technologies and fuelscreated, the use of these fuels, and others [sic] aspects of Section 29. Theinvestigation will also address the IRS’ administration of Section 29 taxcredits.” The Subcommittee conducted numerous interviews and received largevolumes of data between December 2003 and March 2004. Since that time, toHeadwaters’ knowledge, there has been little activity regarding theinvestigation. Headwaters cannot make any assurances as to the timing orultimate outcome of the Subcommittee’s investigation, nor can Headwaterspredict whether Congress or others may conduct investigations ofSection 45K tax credits in the future. Renewed activity in theSubcommittee investigation, if it occurs, may have a material adverse effect onthe willingness of current owners to operate their facilities, and maymaterially adversely affect Headwaters’ revenue, net income and cash flow.

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**ITEM 2.****          MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

Thefollowing discussion and analysis should be read in conjunction with theconsolidated financial statements and related notes included in this Form 10-Q.Our fiscal year ends on September 30 and unless otherwise noted, references to2006 refer to our fiscal quarter and/or nine month period ended June 30, 2006and references to 2007 refer to our fiscal quarter and/or nine month periodended June 30, 2007. Other references to years refer to our fiscal years,unless otherwise noted.

# **Overview**

*Consolidationand Segments*. The consolidated financial statements includethe accounts of Headwaters, all of our subsidiaries and other entities in whichwe have a controlling interest. All significant intercompany transactions andaccounts are eliminated in consolidation. As described in more detail in ourDecember 31, 2006 Form 10-Q, during that quarter, we acquired 100% of theownership interests of a privately-held company in the construction materialsbusiness. Operating results for the acquired business subsequent to theacquisition date have been included in our consolidated results for 2007 andwere not material.

We currently operate in two industries and reportthree business segments, the construction materials and CCPs segments in thebuilding materials industry, and the alternative energy segment in the energyindustry. In the construction materials segment, we design, manufacture, andsell architectural stone and resin-based exterior siding accessories (such as shutters,mounting blocks, and vents) and related products. Revenues consist of sales towholesale and retail distributors, contractors and other users of buildingproducts. We are also a nationwide leader in the management and marketing ofCCPs. Revenues in the CCP segment consist primarily of fly ash and otherproduct sales. In the alternative energy segment, we are focused on reducingwaste and increasing the value of energy feedstocks, primarily in the areas oflow-value coal and oil. Revenue for the alternative energy segment consistsprimarily of sales of chemical reagents and license fees.

*Operations and Strategy.* During the past several years, we have executed our two-fold plan ofmaximizing cash flow from our existing operating business units and diversifyingfrom over-reliance on the legacy alternative energy segment Section 45K(formerly Section 29) business. With the addition and expansion of our CCPmanagement and marketing business through acquisitions in 2002 and in 2004, andthe growth of our construction materials business, through several large andsmall acquisitions in 2004, 2006 and 2007, we have achieved revenue growth anddiversification in three business segments. Because we also incurred increasedindebtedness to make strategic acquisitions, one of our ongoing financialobjectives is to continue to focus on increased cash flows to reduce debt.

A material amount of our 2007 and prior fiscal yearconsolidated revenue and net income has been derived from license fees andsales of chemical reagents, both of which depend on the ability of licenseesand other customers to manufacture and sell qualified synthetic fuel thatgenerates tax credits under Section 45K (formerly Section 29) of the InternalRevenue Code. We have also claimed Section 45K tax credits for synthetic fuelsales from facilities in which we own an interest. From time to time, issuesarise as to the availability of tax credits and, with the increased price ofoil, the phase-out of credits.

By law, Section45K tax credits for synthetic fuel produced from coal expire on December 31,2007. In addition, Section 45K tax credits are subject to phase-out afterthe average annual U.S. wellhead oil price (“reference price”) reaches abeginning phase-out threshold price, and are eliminated entirely if thereference price reaches the full phase-out price. There was no phase-out of taxcredits for calendar 2005; however, as a result of high oil prices in calendar2006, there was a partial phase-out of tax credits for calendar 2006 of approximately33%. In addition, phase-out of Section 45K for calendar 2007 is also possible.As of June 30, 2007, all of our licensees are producing synthetic fuel, butmost licensees stopped production for a period of time in calendar 2006. Theseevents have materially adversely affected both the amount and timing ofrecognition of our revenue, net income and cash flow, and will likely have amaterial adverse effect in future periods as well. Reference is made to notes 7and 9 to the consolidated financial statements where there is more informationon phase-out and other uncertainties related to Section 45K tax credits thathave affected our business in 2007 and that will continue to affect ourbusiness for the remainder of calendar 2007.

Our acquisitionstrategy targets businesses that are leading players in their respectiveindustries and that enjoy healthy operating margins, thus providing additionalcash flow that complements the financial performance of our existingbusinesses. In addition, in fiscal 2006, we began to acquire small companieswith innovative products that can be marketed using our existing distributionchannels. We are also committed to continuing to invest in research anddevelopment activities that are focused on energy-related technologies andnanotechnology. We participate in a joint venture which operates an ethanolplant located in North Dakota, and we are also investing in other alternativeenergy projects such as coal cleaning and

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the use of nanocatalyststo engineer coal for emissions reduction and to enhance the refining of heavycrude oils into lighter transportation fuels.

As a result of our CCPs and construction materialsbusinesses, we are affected by seasonality, with the highest revenue andprofitability produced in the June and September quarters. With CCPs, ourstrategy is to continue to negotiate long-term contracts so that we can investin transportation and storage infrastructure for the marketing and sale ofCCPs. We also intend to continue our efforts to expand usage of high-value CCPsand develop uses for lower-value CCPs, including the expanded use of CCPs inour construction materials businesses and the industry in general.

In fiscal 2005 and 2006, we focused on the integrationof our large 2004 acquisitions, including the marketing of diverse constructionmaterials products through our national distribution network. We became highlyleveraged as a result of those acquisitions, but have reduced our outstandingdebt since that time through cash generated from operations, from anunderwritten public offering of common stock and from proceeds from settlementof litigation. We intend to continue to focus on repaying long-term debt whilecontinuing to look for diversification opportunities within prescribedparameters.

**ThreeMonths Ended June 30, 2007 Compared to Three Months Ended June 30, 2006**

The information set forth below compares our operating results for thequarter ended June 30, 2007 (“2007”) with operating results for the quarterended June 30, 2006 (“2006”).

*Revenue*.  Total revenuefor 2007 increased by $40.4 million or 14% to $336.3 million as compared to$295.9 million for 2006. The major components of revenue are discussed in thesections below.

*Construction Materials Segment*. Sales of construction materials during 2007 were $155.6 million with acorresponding direct cost of $103.3 million. Sales of construction materialsduring 2006 were $162.1 million with a corresponding direct cost of $107.3million. The decrease in sales of construction materials during 2007 was dueprimarily to the effects of a depressed residential housing and remodelingmarket which impacted sales across most of our product lines. We believe thatthe impact of the general industry slowdown has been significantly mitigated byour product categories, geographic diversification, product diversification andthe introduction of new products. Despite the depressed market, gross marginpercentage did not change significantly from 2006 to 2007, due primarily tooperational efficiencies that have been achieved during the past year.Nevertheless, because a substantial amount of our revenues in this segment aredependent on the housing market, we anticipate some impact from marketconditions in future periods until the cycle reverses.

*CCP Segment*.  CCP revenuesfor 2007 were $83.2 million with a corresponding direct cost of $58.4 million.CCP revenues for 2006 were $74.1 million with a corresponding direct cost of$53.7 million. The increase in CCP revenues and in the gross margin percentageduring 2007 were due primarily to a combination of continued strong demand forCCPs and upward pricing trends in most concrete markets. The growth in demandfor CCPs is due in part to certain regional shortages of portland cement forwhich CCPs are a substitute, which can result in an increased percentage ofCCPs being used in concrete. The cement shortages also resulted in increasedprices for CCPs in several markets. 

*Alternative Energy Segment*. Our alternative energy segment revenue consists primarily of chemicalreagent sales, license fee revenue related to our solid alternative fueltechnologies, and to a lesser extent, sales of synthetic fuel from two solidalternative fuel production facilities that we own. The major components ofrevenue for the alternative energy segment are discussed in the sections below.

*Sales of Chemical Reagents*. Chemical reagent sales during 2007 were $50.6 million with acorresponding direct cost of $39.3 million. Chemical reagent sales during 2006were $34.9 million with a corresponding direct cost of $26.5 million. Chemicalreagent sales in 2007 were higher than in 2006 primarily due to increasedsynthetic fuel production by nearly all of our licensees and other customers.We believe there has been less concern in 2007 over phase-out of Section 45Ktax credits than existed in 2006, which has resulted in increased syntheticfuel production. Nevertheless, it is not possible to predict the trend forsales of chemical reagents in future periods because synfuel production by ourlicensees and other customers is subject to decisions based on future oilprices and other customer-specific factors. The gross margin percentage for2007 of 22% was lower than the 2006 gross margin percentage of 24% dueprimarily to increases in the cost of product, which in turn was related toincreases in the costs of petroleum-based materials. Subject to crude oilprices and other factors, we currently believe reagent margins in fiscal 2007will be lower than in 2006.

*LicenseFees*.  During 2007, werecognized license fee revenue totaling $33.6 million, an increase of $21.2million from $12.4 million of license fee revenue recognized during 2006.Certain accounting rules limit revenue recognition to amounts that are “fixedor determinable.” The amount of license fee revenue recognized in 2006 and 2007was negatively affected for certain licensees whose license agreements call forus to be paid a portion of the tax credits earned by the licensee. Due touncertainties related to phase-out for calendar 2006 and 2007 and otherlicensee-specific factors, revenue

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recognition was deferredfor certain licensees during 2006. A portion of such revenue is also currentlybeing deferred for certain licensees in fiscal 2007. 

Due to thepublication of the calendar 2006 reference price and the phase-out range forthat year, finalization of calendar 2006 phase-out was made possible during thequarter ended June 30, 2007. As a result of the availability of thisinformation and the clarification of other licensee-specific factors, certain calendar2006 and prior year license fee revenue totaling approximately $26.5 millionand $3.3 million was recognized during the quarters ended March 31 and June 30,2007, respectively. These amounts related to periods ending on or prior toDecember 31, 2006 and were recognized in 2007 when they met the “fixed ordeterminable” recognition criterion and it was remote that any negativeadjustment would be required in the future. Additionally, applying the samepolicy, approximately $19.4 million of license fee revenue was recognizedduring the quarter ended June 30, 2007 for calendar 2007 tax credit-basedlicense fees, approximately $9.7 million of which related to the quarter endedMarch 31, 2007. As of June 30, 2007, most license fee revenue that has not beenrecognized relates to the quarters ended March 31 and June 30, 2007. Thisunrecognized revenue, which as of June 30, 2007 could total approximately $5.5million (calculated based on licensee-reported data and assuming 25% phase-outof Section 45K tax credits for calendar 2007), will not be recognized untilsuch time as the amounts become “fixed or determinable.” Reference is made toour policy disclosures contained in Note 2 to the consolidated financialstatements and in “*Management’s Discussionand Analysis*” in our Form 10-K, as well as information in Note 9 tothe consolidated financial statements in this Form 10-Q and in the overviewabove.

*Other Alternative Energy Segment Revenues.* The majority of other alternative energysegment revenue is comprised of sales of synthetic fuel, which during 2007 were$10.7 million with a corresponding direct cost of $14.6 million. Sales ofsynthetic fuel during 2006 were $10.5 million with a corresponding direct costof $12.3 million. Revenue from the sale of synthetic fuel has a negative grossmargin, which is more than compensated for by the income tax credits expectedto be earned from the sales of the synthetic fuel.

*Amortization and Research and Development Expenses*. The decrease in amortization expense ($0.5 million) from 2006 to 2007was due primarily to intangible assets that have been fully amortized. Researchand development expense increased by $1.0 million from 2006 to 2007 primarilybecause of increased spending in our joint research efforts with Degussa relatedto hydrogen peroxide (see Note 9) and in developmental efforts related to ournanotechnologies.

*Selling, General and Administrative Expenses*. These expenses increased $2.8 million, or 8% to $38.7 million for 2007from $35.9 million for 2006. Most of the increase represented payroll costsrelated to growth initiatives at the operating business unit level.

*OtherIncome and Expense*. During 2007, we reported net other expense of $9.5 million compared tonet other expense of $7.6 million during 2006. The change of $1.9 million wascomprised of a decrease in net interest expense of $1.5 million and an increasein other expenses of $3.4 million. Net interest expense decreased from $8.2million in 2006 to $6.7 million in 2007, due primarily to a lower interest rate(2.50%) on the $160.0 million of convertible senior subordinated notes issuedin January 2007, the proceeds of which were used primarily to make earlyrepayments of higher-rate debt.

Theincrease in other expenses of $3.4 million consisted primarily of a $3.0million increase in costs related to our investment in the coal-based solidalternative fuel production facility described in Note 7 to the consolidatedfinancial statements.

*IncomeTax Provision*.  Ourestimated effective income tax rate for the fiscal year ending September 30,2007, exclusive of discrete items (none of which affected the quarter endedJune 30, 2007), is 23.0%, which rate was applied to income before income taxesfor the nine months ended June 30, 2007. The income tax rates for the threemonths ended June 30, 2006 and 2007 were 34.2% and 23.0%, respectively. Theeffective tax rates for 2006 and 2007 are lower than statutory rates primarilydue to tax credits related to the alternative fuel facilities that we own orhave an interest in, all as described in Note 7 to the consolidated financialstatements. Excluding the effect of the tax credits, our estimated effectivetax rate for 2007 would be approximately 37.5%. 

Also,as described in Notes 7 and 9 to the consolidated financial statements, whilewe have estimated a phase-out percentage for Section 45K tax credits forcalendar 2007 using available information as of June 30, 2007, it is certainthat our estimated phase-out percentage will change during the year. The effecton income taxes of changes in the estimated phase-out percentage for calendar2007 will be recorded to income tax expense in subsequent periods, when thecalendar 2007 actual oil prices are known. Any such effect could be material toour 2007 and 2008 income tax expense.

Thecalculation of tax liabilities involves uncertainties in the application ofcomplex tax regulations in multiple jurisdictions. For example, we arecurrently under IRS audit for the years 2003 through 2006. We recognizepotential liabilities for anticipated tax audit issues in the U.S. and statetax jurisdictions based on estimates of whether, and the extent to which,additional taxes and interest will be due. If events occur and the payment ofthese amounts ultimately proves to be

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unnecessary, thereversal of the liabilities would result in tax benefits being recognized inthe period when it is determined the liabilities are no longer probable ornecessary. If the estimate of tax liabilities proves to be less than theultimate assessment, a further charge to expense would result.

**NineMonths Ended June 30, 2007 Compared to Nine Months Ended June 30, 2006**

The information set forth below compares our operating results for thenine months ended June 30, 2007 (“2007”) with operating results for the ninemonths ended June 30, 2006 (“2006”).

*Revenue*.  Total revenuefor 2007 increased by $39.2 million or 5% to $885.4 million as compared to$846.2 million for 2006. The major components of revenue are discussed in thesections below.

*Construction Materials Segment*. Sales of construction materials during 2007 were $393.9 million with acorresponding direct cost of $281.1 million. Sales of construction materialsduring 2006 were $423.7 million with a corresponding direct cost of $288.2million. The decrease in sales of construction materials during 2007 was dueprimarily to the effects of a depressed residential housing and remodelingmarket which impacted sales across most of our product lines. The housingmarket slowdown also was the primary reason for the decline in gross marginpercentage from 2006 to 2007.

*CCP Segment*.  CCP revenuesfor 2007 were $214.5 million with a corresponding direct cost of $154.6million. CCP revenues for 2006 were $197.7 million with a corresponding directcost of $149.0 million. The increase in CCP revenues and in the gross marginpercentage during 2007 were due primarily to a combination of continued strongdemand for CCPs and upward pricing trends in most concrete markets. The growthin demand for CCPs is due in part to certain regional shortages of portlandcement for which CCPs are a substitute. The cement shortages also resulted inincreased prices for CCPs in several markets. 

*Alternative Energy Segment*. Our alternative energy segment revenue consists primarily of chemical reagentsales, license fee revenue related to our solid alternative fuel technologies,and to a lesser extent, sales of synthetic fuel from two solid alternative fuelproduction facilities that we own. The major components of revenue for thealternative energy segment are discussed in the sections below.

*Sales of Chemical Reagents*. Chemical reagent sales during 2007 were $141.1 million with acorresponding direct cost of $112.1 million. Chemical reagent sales during 2006were $129.4 million with a corresponding direct cost of $97.5 million. Chemicalreagent sales in 2007 were higher than in 2006 primarily due to increasedsynthetic fuel production by most of our licensees and other customers. Webelieve there has been less concern in 2007 over phase-out of Section 45K taxcredits than existed in 2006, which has resulted in increased synthetic fuelproduction. The gross margin percentage for 2007 of 21% was lower than the 2006gross margin percentage of 25% due primarily to increases in the cost ofproduct, which in turn was related to increases in the costs of petroleum-basedmaterials.

*LicenseFees*.  During 2007, werecognized license fee revenue totaling $98.1 million, an increase of $41.2million from $56.9 million of license fee revenue recognized during 2006. Theamount of license fee revenue recognized in 2006 and 2007 was negativelyaffected for certain licensees whose license agreements call for us to be paida portion of the tax credits earned by the licensee. Due to uncertaintiesrelated to phase-out for calendar 2006 and 2007 and other licensee-specificfactors, revenue recognition was deferred for certain licensees during 2006. Aportion of such revenue is also currently being deferred for certain licenseesin fiscal 2007. 

Due to thepublication of the calendar 2006 reference price and the phase-out range forthat year, finalization of calendar 2006 phase-out was made possible during thequarter ended June 30, 2007. As a result of the availability of thisinformation and the clarification of other licensee-specific factors, certaincalendar 2006 and prior year license fee revenue totaling approximately $26.5million and $3.3 million was recognized during the quarters ended March 31 andJune 30, 2007, respectively. These amounts related to periods ending on orprior to December 31, 2006 and were recognized in 2007 when they met the “fixedor determinable” recognition criterion and it was remote that any negativeadjustment would be required in the future. Additionally, applying this samepolicy, approximately $19.4 million of license fee revenue was recognizedduring 2007 for calendar 2007 tax credit-based license fees.

*Other Alternative Energy Segment Revenues.* The majority of other alternative energysegment revenue is comprised of sales of synthetic fuel, which during 2007 were$32.2 million with a corresponding direct cost of $39.2 million. Sales ofsynthetic fuel during 2006 were $33.9 million with a corresponding direct costof $39.3 million. Revenue from the sale of synthetic fuel has a negative grossmargin, which is more than compensated for by the income tax credits expectedto be earned from the sales of the synthetic fuel. 

*Amortization and Research and Development Expenses*. The decrease in amortization expense ($1.0 million) from 2006 to 2007was due primarily to intangible assets that have been fully amortized. Researchand development expense

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increased by $3.8 million from 2006 to 2007 primarily because ofincreased spending in our joint research efforts with Degussa related tohydrogen peroxide and in developmental efforts related to our nanotechnologies.

*Selling, General and Administrative Expenses*. These expenses increased $9.9 million, or 10% to $113.1 million for 2007from $103.2 million for 2006. The increase in 2007 was due primarily to an $8.6million increase in payroll and long-term incentive pay at the operatingbusiness unit level, a $3.4 million increase in litigation-related costs, and a$2.0 million decrease in marketing and sales-related expenses. A majority ofthe increase in payroll costs relates to growth initiatives at the operatingbusiness unit level, and the increased long-term incentive pay relates toimproved performance at certain operating business units. The increase inlitigation costs was due to a net credit recorded in 2006 because of positivedevelopments in certain legal matters. Those developments resulted in reducedlikelihood of ultimate legal liability and the reversal of previously expensedlitigation costs. The lower marketing and sales-related expenses were a resultof lower sales at certain operating business units.

*Other Income and Expense*. During 2007, we reported net other expense of $33.0 million compared tonet other expense of $30.8 million during 2006. The change of $2.2 million wascomprised of a decrease in net interest expense of $1.8 million and an increasein other expenses of $4.0 million. Net interest expense decreased from $25.8million in 2006 to $24.0 million in 2007, due primarily to the lower interestrate (2.50%) on the $160.0 million of convertible senior subordinated notesissued in January 2007, and lower average levels of long-term debt in 2007 ascompared to 2006. The decrease in interest expense caused by those factors waspartially offset by $2.0 million of accelerated amortization of debt issuecosts related to early repayments of senior debt in 2007, which earlyrepayments were funded primarily by net proceeds from the new lower-rateconvertible notes.

Theincrease in other expenses of $4.0 million consisted primarily of a $4.2million increase in costs related to our investment in the coal-based solidalternative fuel production facility described in Note 7 to the consolidatedfinancial statements.

*IncomeTax Provision*.  Ourestimated effective income tax rate for the fiscal year ending September 30,2007 is 23.0%, which rate was applied to income before income taxes for thenine months ended June 30, 2007. We also recognized a net $1.2 million incometax benefit in 2007 for discrete items that did not affect the calculation ofthe estimated effective income tax rate for the fiscal year. The discrete itemsprimarily consisted of additional tax credits for fiscal 2006 and changes inestimated tax liabilities and in reserves related to an IRS examination. Theadditional tax credits for fiscal 2006 resulted from actual phase-out ofSection 45K tax credits for calendar 2006 being lower than previouslyestimated. After consideration of the effect of the discrete items, income taxexpense totaled approximately 22.0% of income before income taxes for 2007,compared to 30.4% for 2006. The effective tax rates for 2006 and 2007 are lowerthan statutory rates primarily due to tax credits related to the alternativefuel facilities that we own or have an interest in, all as described in Note 7to the consolidated financial statements. 

**Impact ofInflation and Related Matters**

Our operations have been impacted by i) increased cement, polypropyleneand poly-vinyl chloride costs in the construction materials segment; ii) risingcosts for chemical reagents in the alternative energy segment; iii) increasedfuel costs that have affected transportation costs in most of our businessunits; and iv) certain regional shortages of cement and aggregate materials.The increased costs of polypropylene, poly-vinyl chloride, chemical reagentsand fuel are directly related to the increase in prices of natural gas, oil andother petroleum-based materials. The increased costs of cement are causedprimarily by a lack of adequate supplies in some regions of the U.S. 

We have been successful in passing on some, but not all, of theincreased material and transportation costs to customers. It is not possible topredict the future trend of material and transportation costs, nor our abilityto pass on any future price increases to customers. It is also not possible topredict the impact of potential future cement supply shortages on our abilityto procure needed supplies in our construction materials business.

**Liquidityand Capital Resources**

*Summary of Cash Flow Activities*.  Netcash provided by operating activities during the nine months ended June 30,2007 (“2007”) was $75.8 million compared to $172.7 million during the ninemonths ended June 30, 2006 (“2006”).The primary reason for the change in cash provided by operations from 2006 to2007 was the collection in 2006 of a $70.0 million receivable related to thelitigation settlement reached with AJG in 2005, along with other changes inworking capital. In 2006 and 2007, the primary investing activities consistedof payments for acquisitions and the purchase of property, plant and equipment.In 2007 financing activities consisted primarily of the issuance of a newseries of convertible senior subordinated notes and the early repayment of aportion of our senior debt. In 2006, the primary financing activity consistedof repayments of long-term debt. More details about our investing and financingactivities are provided in the following paragraphs.

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*InvestingActivities*.  Totalexpenditures for property, plant and equipment in 2007 were not materiallydifferent from 2006. Most of the capital expenditures in both periods wereincurred by the construction materials segment; however, in 2007, a higherproportion of total capital expenditures were incurred by the alternativeenergy segment as compared to 2006. A significant portion of our planned futurecapital expenditures represent expansion of operations, rather than maintenanceof operating capacity, primarily due togrowth initiatives in the alternative energy segment. Capital expenditures in fiscal 2007 are currentlyexpected to exceed the fiscal 2006 amount. Capital expenditures arelimited by our senior debt covenants to $100.0 million annually; however, thecumulative unused amounts of annual capital expenditures limits can be carriedforward and used in subsequent years. As ofSeptember 30, 2006, we had approximately $25.4 million of unused amounts ofcapital expenditures from prior years and as of June 30, 2007, we werecommitted to spend approximately $27.8 million on capital projects that were invarious stages of completion, primarily in the alternative energy segment. 

We intend tocontinue to expand our business through growth of existing operations,commercialization of technologies currently being developed, and strategicacquisitions of products or entities that expand our current operatingplatform. Acquisitions are an important part of our business strategy and tothat end, we routinely review potential complementary acquisitions, includingthose in the areas of construction materials, CCP marketing, and coal andcatalyst technologies. It is possible that some portion of future cash and cashequivalents and/or proceeds from the issuance of stock or debt will be used tofund acquisitions of complementary businesses in the chemical, energy, buildingproducts and related industries. The senior secured credit agreement limitsacquisitions in the aggregate to $50.0 million of cash consideration and $20.0million of non-cash consideration annually, with no more than $30.0 million ofcash consideration for any one acquisition, unless our “total leverage ratio,”as defined, is less than or equal to 3.50:1.0, after giving effect to anacquisition, in which case the foregoing limitations do not apply. The seniorsecured credit agreement also limits the amount we can invest in joint venturesand other less than 100%-owned entities.

In 2007, weacquired 100% of the ownership interests of a privately-held company in theconstruction materials business. Total consideration paid of approximately$53.0 million consisted primarily of cash. During fiscal 2006, we acquiredcertain assets and assumed certain liabilities of several privately-heldcompanies in the construction materials industry. Pursuant to contractual termsfor some of the acquisitions, additional amounts may be payable in the future,based on the achievement of stipulated revenue or earnings targets for periodsending no later than March 2010. One such period for the 2007 acquisition endsSeptember 30, 2007 and it is currently expected that the additional paymentcould be in excess of $20 million, which amount would be payable in fiscal2008. If it is determined that future earn-out consideration is payable,goodwill will be increased accordingly.

As described in more detail in Note 5 to the consolidated financialstatements and in our Form 10-K, we periodically test for goodwill impairment.We perform our annual impairment testing using a test date of June 30. Due primarily to the depressed residentialhousing and remodeling market, there is risk that one or more of our reportingunits may fail the goodwill impairment test, requiring a write-down ofgoodwill. The goodwill impairment testing is expected to be completed in thequarter ending September 30, 2007, with any necessary non-cash impairmentcharges recorded in that quarter.

Reference is madeto Note 9 to the consolidated financial statements for a discussion of ourinvestments in joint ventures which are accounted for using the equity methodof accounting.

*FinancingActivities*.  In 2006,financing activities consisted primarily of the repayment of long-term debt. In2007, as described in more detail in Note 6 to the consolidated financialstatements, we issued $160.0 million of 2.50% convertible senior subordinatednotes due February 2014. Substantially all of the net proceeds of approximately$154.6 million, along with $5.2 million of available cash, were used to repay$152.8 million of senior debt and the remaining balance (approximately $7.0million) of notes payable to a bank. As of June 30, 2007, we have no long-termdebt repayments that are due prior to fiscal 2011. We may, in the future, makeoptional prepayments of the senior debt depending on actual cash flows, ourcurrent and expected cash requirements and other applicable factors we deem tobe significant.

Due to covenantsassociated with our senior debt, we currently have restrictions on our ability to obtain significant additional amounts oflong-term debt. However, we have historically experienced strong positive cashflow from operations and in fiscal 2005 issued common stock which together hasenabled us to repay a substantial amount of our long-term debt prior toscheduled maturities. We expect our positive cash flow to continue in thefuture and also have the ability to access the equity markets if necessary.

In January 2007, we announced that we were planning an exchange offerfor our 2.875% convertible senior subordinated notes due 2016, wherebynew notes with similar, but not identical, terms, along with an exchange fee,would be issued upon tender of the existing notes. The commencement of anexchange offer has been indefinitely postponed.

Reference is madeto Note 6 to the consolidated financial statements for detailed informationabout our outstanding long-term debt, interest rate hedges, and compliance withdebt covenants, as well as the available $60.0 million revolving

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credit arrangement. Subject to obtaining additional revolving loancommitments, we can increase therevolving credit limit to $100.0 million. The senior credit facility contains restrictions and covenants common tosuch agreements, including limitations on the incurrence of additional debt,investments, merger and acquisition activity, asset sales and liens, annualcapital expenditures in excess of $100.0 million annually, and the payment ofdividends, among others. In addition, we must maintain certain leverage andfixed charge coverage ratios. We are in compliance with all debt covenants asof June 30, 2007.

In 2007, cashproceeds from the exercise of options and employee stock purchases totaled $2.1million, compared to $8.3 million in 2006. Option exercise activity isprimarily dependent on our stock price and is not predictable. To the extentnon-qualified stock options are exercised, or there are disqualifyingdispositions of shares obtained upon the exercise of incentive stock options,we receive an income tax deduction generally equal to the income recognized bythe optionee. Such amounts, reflected in cash flows from financing activitiesin the consolidated statements of cash flows, were not material in 2006 or2007.

*Working Capital*.  As of June30, 2007, our working capital was $184.5 million. Notwithstanding theexpiration of Section 45K tax credits as of December 31, 2007 and the resultingimpact on cash flow, we expect operations to produce positive cash flow infuture periods and believe working capital, along with available borrowingsunder the revolving credit arrangement, will be sufficient for operating needsfor the next 12 months.

*Income Taxes*.  Our cashrequirements for income taxes generally approximate the income tax provision;however, there is usually some lag in paying estimated taxes during a fiscalyear due to the seasonality of our operations and because estimated income taxpayments are typically based on annualizing the fiscal year’s income based onyear-to-date results. There is also some lag in realizing the cash benefitsfrom the utilization of tax credits due to the interaction of our September 30fiscal year end and the different fiscal year ends of the entities throughwhich we receive the tax credits. In 2007, there may be more variability in therelationship between the income tax provision and income tax payments becausethe tax provision calculation is materially dependent upon the estimatedphase-out percentage of Section 45K tax credits (see Notes 7 and 9 to theconsolidated financial statements). The calendar 2007 phase-out percentage issubject to material change because it is dependent on oil prices for all ofcalendar 2007, which are not predictable.

Asdiscussed previously, cash payments for income taxes are reduced for taxdeductions resulting from disqualifying dispositions of incentive stock optionsand from the exercise of non-qualified stock options, which amount was notmaterial in 2007. Option exercise activity is primarily dependent on our stockprice which is not predictable, and likewise, it is not possible to estimatewhat tax benefits may be realized from future option exercises.

*Summaryof Future Cash Requirements*. Significant future cash uses, in addition to operational working capitalrequirements, including income tax payments, are currently expected to consistprimarily of capital expenditures, acquisitions and investments in joint ventures,and debt service payments on outstanding long-term debt. The board of directorsrecently authorized management to develop a stock repurchase program, subjectto legal and financial review, which if carried out, could also result in afuture use of cash.

**LegalMatters**

We have ongoing litigation and asserted claims which have been incurredduring the normal course of business. Reference is made to Note 9 to theconsolidated financial statements for a description of our accounting for legalcosts and other information about legal matters.

**Recent Accounting Pronouncements**

Reference is made to Note 1 to the consolidated financial statements fora discussion of accounting pronouncements that have been recently issuedwhich we have not yet adopted.

**ITEM 3.****                      ****QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

We are exposed tofinancial market risks, primarily related to changes in interest rates. We donot use derivative financial instruments for speculative or trading purposes,but have entered into certain hedge transactions, primarily to limit ourvariable interest rate exposure. The Blue Flint joint venture also has hedgesin place related to variable interest rates and commodities.

As described inmore detail in Note 6 to the consolidated financial statements, our seniordebt, totaling $262.5 million as of June 30, 2007, bears interest at avariable-rate. As required by the senior secured credit facility, we enteredinto agreements to limit our variable interest rate exposure. The agreementseffectively fix the LIBOR rate at 3.71% for $150.0 million of this debt throughSeptember 8, 2007. We account for these agreements as cash flow hedges, withtheir fair market value reflected in the consolidated balance sheet as eitherother assets or other liabilities. The market value of these hedges

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(and various other cashflow hedges to which we are a direct or indirect party) at June 30, 2007 wasnot material. Total comprehensive income, considering all cash flow hedgeagreements to which we are a party, was not materially different from netincome for either 2006 or 2007.

Consideringour current balance of variable-rate debt (reduced by the $150.0 million ofsenior debt that effectively has a fixed interest rate until September 8,2007), a change in the interest rate of 1% would change our interest expense byapproximately $2.3 million during the 12 months ending June 30, 2008.

**ITEM 4.****                     CONTROLSAND PROCEDURES**

*DisclosureControls and Procedures* – We maintain disclosure controls andprocedures that are designed to ensure that information we are required todisclose in the reports that we file or submit under the Securities ExchangeAct of 1934 (the “Exchange Act”), such as this Quarterly Report on Form 10-Q,is recorded, processed, summarized and reported within the time periodsspecified by SEC rules and forms. Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationwe are required to disclose in the reports that we file or submit under theExchange Act is accumulated and communicated to our management, including theChief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”), toallow timely decisions regarding required disclosure.

Our managementevaluated, with the participation of our CEO and CFO, the effectiveness of ourdisclosure controls and procedures as of June 30, 2007, pursuant to paragraph(b) of Rules 13a-15 and 15d-15 under the Exchange Act. This evaluation includeda review of the controls’ objectives and design, the operation of the controls,and the effect of the controls on the information presented in this QuarterlyReport. Our management, including the CEO and CFO, do not expect thatdisclosure controls can or will prevent or detect all errors and all fraud, ifany. A control system, no matter how well designed and operated, can provideonly reasonable, not absolute, assurance that the objectives of the controlsystem are met. Our disclosure controls and procedures are designed to providesuch reasonable assurance of achieving their objectives. Also, the projectionof any evaluation of the disclosure controls and procedures to future periodsis subject to the risk that the disclosure controls and procedures may becomeinadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate.

Based on their review andevaluation, and subject to the inherent limitations described above, our CEOand CFO have concluded that our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the Exchange Act) were effective as of June30, 2007 at the above-described reasonable assurance level. 

*InternalControl over Financial Reporting* – Management is responsiblefor establishing and maintaining adequate internal control over financialreporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act.Our internal control over financial reporting is designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with accountingprinciples generally accepted in the United States of America. 

Because ofinherent limitations, internal control over financial reporting may not preventor detect misstatements. Therefore, even internal controls determined to beeffective can provide only reasonable assurance with respect to financialstatement preparation and presentation. The effectiveness of our internalcontrol over financial reporting is subject to various inherent limitations,including cost limitations, judgments used in decision making, assumptionsabout the likelihood of future events, the possibility of human error, and therisk of fraud. The projection of any evaluation of effectiveness to futureperiods is subject to the risk that controls may become inadequate because ofchanges in conditions, or that the degree of compliance with policies maydeteriorate. Because of these limitations, there can be no assurance that anysystem of internal control over financial reporting will be successful inpreventing all errors or fraud or in making all material information known in atimely manner to the appropriate levels of management.

There has been no change in our internal control over financial reportingduring the quarter ended June 30, 2007 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

###### **PARTII — OTHER INFORMATION**

**ITEM 1.****                             LEGALPROCEEDINGS**

See “*Legal Matters”*in Note 9 to the consolidated financialstatements for a description of current legal proceedings.

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**ITEM 1A.****                 RISK FACTORS**

Risks relating to our business and common stock aredescribed in Item 1A of our Form 10-K and in Item 1A of our December 2006 Form10-Q.

**ITEM 2.****                             UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

None.

**ITEM 3.****                            ****DEFAULTS UPON SENIOR SECURITIES**

None.

**ITEM 4.****                            ****SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

None.

**ITEM 5.****                            ****OTHER INFORMATION**

None.

**ITEM 6.****                            ****EXHIBITS**

Thefollowing exhibits are included herein:

| 12   |   | Computation of ratio of earnings to combined fixed  charges and preferred stock dividends |   | * |
|------|--------|-------------------------------------------------------------------------------------------|--------|---|
| 31.1 |   | Rule  13a-14(a)/15d-14(a) Certification of Chief Executive Officer                        |   | * |
| 31.2 |   | Rule 13a-14(a)/15d-14(a) Certification of Chief  Financial Officer                        |   | * |
| 32   |   | Section 1350 Certifications of Chief Executive  Officer and Chief Financial Officer       |   | * |

 

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*              Filed herewith.

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**SIGNATURES**

Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.
|                             | HEADWATERS INCORPORATED |
|-----------------------------|-------------------------|
|                        |                    |   |
| Date:  August  7, 2007 | By:                     | /s/ Kirk A. Benson |   |
| ** **                  |                    | Kirk A. Benson, Chief Executive Officer |
|                        |                    | (Principal Executive Officer) |
|                        |                    |   |
| Date:  August  7, 2007 | By:                     | /s/ Scott K. Sorensen |   |
|                        |                    | Scott K. Sorensen, Chief Financial Officer |
|                        |                    | (Principal Financial Officer) |
|                             |                         |  |  |  |

 

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