** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**Washington, D.C.20549

**FORM 10-Q**

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

## **For the quarterly period ended December 31,2006**

### **or**

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

## **For the transition period from            to             **

### **Commission file number 1-32459**

**HEADWATERSINCORPORATED**(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’s telephone number, including area code)

**Notapplicable**(Former name, former address and former fiscal year, if changed since lastreport)

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 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 |
|---------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).  Yes o  No x

The number of sharesoutstanding of the Registrant’s common stock as of January 31, 2007 was42,343,767.

 

 

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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 December 31, 2006                                  |       |
|                                    | Condensed Consolidated Statements of Income — For the  three months ended December 31, 2005 and 2006                     |       |
|                                    | Condensed Consolidated Statement of Changes in  Stockholders’ Equity — For the three months ended December 31, 2006 |       |
|                                    | Condensed Consolidated Statements of Cash Flows — For  the three months ended December 31, 2005 and 2006                 |       |
|                                    | 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-lookingStatements**

*ThisQuarterly Report on Form 10-Q contains forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995 regarding futureevents and our future results that are based on current expectations,estimates, forecasts, and projections about the industries in which we operateand the beliefs and assumptions of our management. Actual results may varymaterially from such expectations. Words such as “expects,” “anticipates,” “targets,”“goals,” “projects,” “believes,” “seeks,” “estimates,” or variations of suchwords and similar expressions, are intended to help identify suchforward-looking statements. In addition, any statements that refer toprojections of our future financial performance, our anticipated growth andtrends in our businesses, and other characterizations of future events orcircumstances, are forward-looking. For a discussion of the factors that couldcause actual results to differ from expectations, please see the risk factorsdescribed  in Item 1A of our AnnualReport on Form 10-K for the year ended September 30, 2006  and in Item 1A of this report. There can beno assurance that our results of operations will not be adversely affected bysuch factors. Unless legally required, we undertake no obligation to revise orupdate any forward-looking statements for any reason. Readers are cautioned notto place undue reliance on these forward-looking statements, which speak onlyas of the date of this report.*

Our internetaddress is *www.headwaters.com*.  There we make available, free of charge, ourannual report on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K and any amendments to those reports, as soon asreasonably practicable after we electronically file such material with, orfurnish it to, the Securities and Exchange Commission (“SEC”).  Our reports can be accessed through theinvestor relations section of our web site. The information found on our web site is not part of this or any reportwe file with or furnish to the SEC.

 

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**ITEM1.  FINANCIAL STATEMENTS**

** **

**HEADWATERS INCORPORATED**

###### **CONDENSED CONSOLIDATED BALANCE SHEETS**

(Unaudited)

** **
| ** **                                                                                                                                                                                                                                       | ** ** | **September 30,** | ** **    | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|---------------|-----------------------|------------|
| **(in thousands, except per-share data)**                                                                                                                                                                                    | ** ** | **2006**               | ** **    | **2006**              | ** ** |
|                                                                                                                                                                                                                                             |       |                   |          |                  |       |
| **ASSETS**                                                                                                                                                                                                                                       |       |                   |          |                  |       |
|                                                                                                                                                                                                                                             |       |                   |          |                  |       |
| **Current assets:**                                                                                                                                                                                                                              |       |                   |          |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                        |       | $                      | 79,151        |                  | $          | 54,746 |   |
| Trade  receivables, net                                                                                                                                                                                                                          |       | 131,608                |          | 118,522               |       |
| Inventories                                                                                                                                                                                                                                      |       | 62,519                 |          | 65,510                |       |
| Deferred income  taxes                                                                                                                                                                                                                           |       | 26,465                 |          | 26,614                |       |
| Other                                                                                                                                                                                                                                            |       | 10,294                 |          | 14,177                |       |
| **Total  current assets**                                                                                                                                                                                                                        | ** ** | **310,037**            | ** **    | **279,569**           | ** ** |
|                                                                                                                                                                                                                                             |       |                   |          |                  |       |
| **Property, plant and equipment,  net**                                                                                                                                                                                                          | ** ** | **213,406**            | ** **    | **217,267**           | ** ** |
|                                                                                                                                                                                                                                             |       |                   |          |                  |       |
| **Other assets:**                                                                                                                                                                                                                                |       |                   |          |                  |       |
| Intangible  assets, net                                                                                                                                                                                                                          |       | 251,543                |          | 255,218               |       |
| Goodwill                                                                                                                                                                                                                                         |       | 826,432                |          | 863,161               |       |
| Other                                                                                                                                                                                                                                            |       | 60,311                 |          | 57,788                |       |
| **Total  other assets**                                                                                                                                                                                                                          | ** ** | **1,138,286**          | ** **    | **1,176,167**         | ** ** |
|                                                                                                                                                                                                                                             |       |                   |          |                  |       |
| **Total  assets**                                                                                                                                                                                                                                | ** ** | **$**                  | **1,661,729** | ** **            | **$**      | **1,673,003** | ** ** |
| ** **                                                                                                                                                                                                                                       | ** ** | ** **             | ** **    | ** **            | ** ** |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                   |       |                   |          |                  |       |
|                                                                                                                                                                                                                                             |       |                   |          |                  |       |
| **Current liabilities:**                                                                                                                                                                                                                         |       |                   |          |                  |       |
| Accounts payable                                                                                                                                                                                                                                 |       | $                      | 23,854        |                  | $          | 28,318 |   |
| Accrued  personnel costs                                                                                                                                                                                                                         |       | 32,859                 |          | 23,470                |       |
| Accrued income  taxes                                                                                                                                                                                                                            |       | 16,481                 |          | 16,151                |       |
| Other accrued  liabilities                                                                                                                                                                                                                       |       | 62,190                 |          | 66,155                |       |
| Deferred license  fee revenue                                                                                                                                                                                                                    |       | 22,090                 |          | 22,218                |       |
| Current portion  of long-term debt                                                                                                                                                                                                               |       | 7,267                  |          | 9,884                 |       |
| **Total  current liabilities**                                                                                                                                                                                                                   | ** ** | **164,741**            | ** **    | **166,196**           | ** ** |
|                                                                                                                                                                                                                                             |       |                   |          |                  |       |
| **Long-term liabilities:**                                                                                                                                                                                                                       |       |                   |          |                  |       |
| Long-term debt                                                                                                                                                                                                                                   |       | 587,820                |          | 584,990               |       |
| Deferred income  taxes                                                                                                                                                                                                                           |       | 96,972                 |          | 96,075                |       |
| Other                                                                                                                                                                                                                                            |       | 11,238                 |          | 4,610                 |       |
| **Total  long-term liabilities**                                                                                                                                                                                                                 | ** ** | **696,030**            | ** **    | **685,675**           | ** ** |
| **Total  liabilities**                                                                                                                                                                                                                           | ** ** | **860,771**            | ** **    | **851,871**           | ** ** |
|                                                                                                                                                                                                                                             |       |                   |          |                  |       |
| 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  42,343 shares at December 31, 2006 (including 214 shares held in treasury) |       | 42                     |          | 42                    |       |
| Capital in  excess of par value                                                                                                                                                                                                                  |       | 502,265                |          | 505,188               |       |
| Retained  earnings                                                                                                                                                                                                                               |       | 299,866                |          | 316,857               |       |
| Treasury stock  and other                                                                                                                                                                                                                        |       | (1,215                 | )             | (955                  | )          |
| **Total  stockholders’ equity**                                                                                                                                                                                                             | ** ** | **800,958**            | ** **    | **821,132**           | ** ** |
|                                                                                                                                                                                                                                             |       |                   |          |                  |       |
| **Total liabilities and  stockholders’ equity**                                                                                                                                                                                             | ** ** | **$**                  | **1,661,729** | ** **            | **$**      | **1,673,003** | ** ** |

 

See accompanyingnotes.

3

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**HEADWATERS INCORPORATED**

###### **CONDENSED CONSOLIDATED STATEMENTS OF INCOME**

(Unaudited)

 
| ** **                                                    | ** ** | **Three Months Ended  December 31,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(in thousands, except per-share data)** | ** ** | **2005**                                            | ** ** | **2006** | ** ** |
| ** **                                                    |       |                                                |       |   |   |
| **Revenue:**                                                  |       |                                                |       |   |   |
| Construction materials                                        |       | $                                                   | 129,969    |   | $ | 122,755 |   |
| Coal combustion products                                      |       | 65,165                                              |       | 69,172 |   |
| Alternative energy                                            |       | 85,414                                              |       | 82,997 |   |
| **Total revenue**                                             | ** ** | **280,548**                                         | ** ** | **274,924** | ** ** |
| ** **                                                    |       |                                                |       |   |   |
| **Cost of  revenue:**                                         |       |                                                |       |   |   |
| Construction materials                                        |       | 89,705                                              |       | 90,562 |   |
| Coal combustion products                                      |       | 48,962                                              |       | 49,447 |   |
| Alternative energy                                            |       | 47,658                                              |       | 54,870 |   |
| **Total cost of revenue**                                     | ** ** | **186,325**                                         | ** ** | **194,879** | ** ** |
| ** **                                                    |       |                                                |       |   |   |
| **Gross  profit**                                             | ** ** | **94,223**                                          | ** ** | **80,045** | ** ** |
| ** **                                                    |       |                                                |       |   |   |
| **Operating  expenses:**                                      |       |                                                |       |   |   |
| Amortization                                                  |       | 6,036                                               |       | 5,811 |   |
| Research and development                                      |       | 2,964                                               |       | 3,784 |   |
| Selling, general and administrative                           |       | 34,958                                              |       | 36,561 |   |
| **Total operating expenses**                                  | ** ** | **43,958**                                          | ** ** | **46,156** | ** ** |
| ** **                                                    |       |                                                |       |   |   |
| **Operating  income**                                         | ** ** | **50,265**                                          | ** ** | **33,889** | ** ** |
| ** **                                                    |       |                                                |       |   |   |
| **Other  income (expense):**                                  |       |                                                |       |   |   |
| Net interest expense                                          |       | (8,951                                              | )          | (8,267 | ) |
| Other, net                                                    |       | (3,068                                              | )          | (2,561 | ) |
| **Total other income (expense), net**                         | ** ** | **(12,019**                                         | **)**      | **(10,828** | **)** |
| ** **                                                    |       |                                                |       |   |   |
| **Income  before income taxes**                               | ** ** | **38,246**                                          | ** ** | **23,061** | ** ** |
| ** **                                                    |       |                                                |       |   |   |
| Income tax  provision                                         |       | (9,950                                              | )          | (6,070 | ) |
| ** **                                                    |       |                                                |       |   |   |
| **Net  income**                                               | ** ** | **$**                                               | **28,296** | ** ** | **$** | **16,991** | ** ** |
|                                                          |       |                                                |       |   |   |
| **Basic  earnings per share**                                 | ** ** | **$**                                               | **0.68**   | ** ** | **$** | **0.40** | ** ** |
|                                                          |       |                                                |       |   |   |
| **Diluted earnings per share**                                | ** ** | **$**                                               | **0.60**   | ** ** | **$** | **0.37** | ** ** |

 

See accompanying notes.

4

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**HEADWATERS INCORPORATED**

**CONDENSED CONSOLIDATED STATEMENT OF CHANGES INSTOCKHOLDERS’ EQUITY**(Unaudited)

Forthe Three Months Ended December 31, 2006

 
| ** **                                                                           | ** ** | **Common stock** | ** ** | **Capital in  excess** | ** ** | **Retained**               | ** ** | **Treasury  stock,** | ** ** | ** **       | ** **  | **Total  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 and stock appreciation rights                             |       | 37                    |       | —                      |       | 325                        |       |                 |       |             |        |                          |       | 325 |   |
|                                                                                 |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| 40 shares of  treasury stock transferred to employee stock purchase plan, at cost    |       |                  |       |                        |       | 740                        |       |                 |       | 230              |        |                          |       | 970 |   |
|                                                                                 |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| Stock-based  compensation                                                            |       |                  |       |                        |       | 1,858                      |       |                 |       |             |        |                          |       | 1,858 |   |
|                                                                                 |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| Other  comprehensive income — unrealized gain on cash flow hedges, net of taxes |       |                  |       |                        |       |                       |       |                 |       |             |        | 30                            |       | 30 |   |
|                                                                                 |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| Net income for  the three months ended December 31, 2006                             |       |                  |       |                        |       |                       |       | 16,991               |       |             |        |                          |       | 16,991 |   |
|                                                                                 |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| **Balances as of December 31,  2006**                                                | ** ** | **42,343**            | ** ** | **$**                       | **42**     | ** **                 | **$**      | **505,188**          | ** ** | **$**            | **316,857** | ** **                    | **$**      | **(1,925** | **)** | **$** | **970** | ** ** | **$** | **821,132** | ** ** |

 

See accompanyingnotes.

5

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###### **HEADWATERSINCORPORATED**

###### **CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

###### (Unaudited)

| ** **                                                                         | ** ** | **Three Months Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(in thousands)**                                                            | ** ** | **2005**                                            | ** ** | **2006** | ** ** |
| ** **                                                                         |       |                                                |       |   |   |
| **Cash  flows from operating activities:**                                         |       |                                                |       |   |   |
| Net income                                                                         |       | $                                                   | 28,296     |   | $ | 16,991 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                |       |   |   |
| Depreciation and amortization                                                      |       | 14,963                                              |       | 17,678 |   |
| Stock-based compensation expense                                                   |       | 1,782                                               |       | 1,858 |   |
| Interest expense related to amortization of debt  issue costs                      |       | 630                                                 |       | 619 |   |
| Equity in losses of joint ventures                                                 |       | —                                              |       | 826 |   |
| Amortization of non-refundable license fees                                        |       | (5,519                                              | )          | (5,517 | ) |
| Deferred income taxes                                                              |       | (584                                                | )          | (149 | ) |
| Net loss (gain) on disposition of property, plant  and equipment                   |       | (18                                                 | )          | 190 |   |
| Decrease in trade receivables                                                      |       | 25,072                                              |       | 15,656 |   |
| Increase in inventories                                                            |       | (3,165                                              | )          | (1,568 | ) |
| Decrease in accounts payable and accrued liabilities                               |       | (25,272                                             | )          | (5,105 | ) |
| Other changes in operating assets and liabilities,  net                            |       | (7,966                                              | )          | (6,825 | ) |
| **Net  cash provided by operating activities**                                     | ** ** | **28,219**                                          | ** ** | **34,654** | ** ** |
|                                                                               |       |                                                |       |   |   |
| **Cash  flows from investing activities:**                                         |       |                                                |       |   |   |
| Payments for acquisitions, net of cash acquired                                    |       | (2,432                                              | )          | (50,219 | ) |
| Purchase of property, plant and equipment                                          |       | (13,279                                             | )          | (10,127 | ) |
| Proceeds from disposition of property, plant and  equipment                        |       | 173                                                 |       | 171 |   |
| Investments in joint ventures                                                      |       | (1,544                                              | )          | — |   |
| Net decrease in other assets                                                       |       | 156                                                 |       | 34 |   |
| **Net  cash used in investing activities**                                         | ** ** | **(16,926**                                         | **)**      | **(60,141** | **)** |
| ** **                                                                         |       |                                                |       |   |   |
| **Cash  flows from financing activities:**                                         |       |                                                |       |   |   |
| Payments on long-term debt                                                         |       | (4,274                                              | )          | (213 | ) |
| Proceeds from exercise of stock options                                            |       | 1,002                                               |       | 325 |   |
| Income tax benefit from exercise of stock options  and stock appreciation rights   |       | 1,849                                               |       | — |   |
| Employee stock purchases                                                           |       | 965                                                 |       | 970 |   |
| **Net  cash provided by (used in) financing activities**                           | ** ** | **(458**                                            | **)**      | **1,082** | ** ** |
|                                                                               |       |                                                |       |   |   |
| **Net  increase (decrease) in cash and cash equivalents**                          | ** ** | **10,835**                                          | ** ** | **(24,405** | **)** |
|                                                                               |       |                                                |       |   |   |
| Cash and cash  equivalents, beginning of period                                    |       | 13,666                                              |       | 79,151 |   |
|                                                                               |       |                                                |       |   |   |
| **Cash  and cash equivalents, end of period**                                      | ** ** | **$**                                               | **24,501** | ** ** | **$** | **54,746** | ** ** |
| ** **                                                                         | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| ** **                                                                         | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| **Supplemental  schedule of non-cash investing and financing activities:**         |       |                                                |       |   |   |
| Increase in  accrued liabilities for acquisition-related commitments               |       | $                                                   | —     |   | $ | 2,639 |   |

 

See accompanyingnotes.

 

6

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###### ** **

###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

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

Description of Businessand Organization —Headwaters Incorporated (“Headwaters”) is incorporated in Delaware and is adiversified company providing products, technologies and services in twoindustries: building materials, which includes construction materials and coalcombustion products (“CCPs”), and alternative energy. Headwaters usestechnology to differentiate itself from competitors and to create value in itsbusinesses.

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 relatedproducts. Headwaters is also a nationwide leader in the management andmarketing of CCPs, including fly ash used as a substitute for portland cementHeadwaters believes it is uniquely positioned to manufacture an array of buildingmaterials that use fly ash, such as block, stucco, and mortar and believes thatit has a leading market position in its principal building materialsbusinesses. Revenue from Headwaters’ construction materials and CCPs businessesare diversified geographically and also by market, including the newconstruction, remodeling and home improvement markets.

In the alternative energysector, Headwaters is focused on reducing waste and increasing the value ofenergy feedstocks, primarily in the areas of low-value coal and oil. In coal,Headwaters owns and operates two coal reclamation facilities that remove rock,dirt, and other impurities from waste coal, resulting in higher-value,marketable coal. Headwaters also licenses technology and sells reagents to thecoal-based solid alternative fuel industry. In oil, Headwaters believes thatits heavy oil upgrading technology represents a substantial improvement overcurrent refining technologies. Headwaters’ heavy oil upgrading process uses aliquid catalyst precursor to generate a highly active molecular catalyst toconvert residual oil feedstocks into higher-value distillates that can berefined into gasoline, diesel and other products. In addition, Headwaters is inthe final stages of constructing its first ethanol plant and is proceeding withthe commercialization of multiple catalyst technologies.

Basis ofPresentation —Headwaters’ fiscal year ends on September 30 and unless otherwise noted,references to 2005 refer to Headwaters’ fiscal quarter ended December 31, 2005and references to 2006 refer to Headwaters’ fiscal quarter ended December 31,2006. Other references to years refer to Headwaters’ fiscal years, unlessotherwise noted. The consolidated financial statements include the accounts ofHeadwaters, all of its subsidiaries and other entities in which Headwaters hasa controlling interest. All significant intercompany transactions and accountsare eliminated in consolidation. Due to the seasonality of the operations ofthe building materials businesses and other factors, Headwaters’ consolidatedresults of operations for 2006 are not indicative of the results to be expectedfor the full fiscal 2007 year.

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with the rules and regulations of the Securities and ExchangeCommission (“SEC”) for quarterly reports on Form 10-Q. In the opinion ofmanagement, all adjustments considered necessary for a fair presentation havebeen included, and consist of normal recurring adjustments.Certain information and footnotedisclosures normally included in annual financial statements prepared inaccordance with U.S. generally accepted accounting principles have beencondensed or omitted. These financial statements should be read in conjunctionwith the consolidated financial statements and notes thereto included inHeadwaters’ Annual Report on Form 10-K for the year ended September 30, 2006 (“Form10-K”).

RecentAccounting Pronouncements —In July 2006, the Financial Accounting Standards Board (“FASB”) issuedInterpretation No. 48, “Accounting forUncertainty in Income Taxes — an Interpretation of FASB Statement No. 109 (“FIN48”). This Interpretation prescribes a consistent recognition thresholdand measurement standard, as well as clear criteria for subsequentlyrecognizing, derecognizing and measuring tax positions, for financial reportingpurposes. FIN 48 also requires expanded disclosures with respect to theuncertainty in income taxes. FIN 48 is effective for Headwaters’ fiscal 2008year beginning on October 1, 2007. Management is currently evaluating theimpact of FIN 48. The effect of adopting FIN 48, if material, will be atransition adjustment to beginning retained earnings in the year of adoption.

In September 2006, the FASB issuedSFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”) which addresses howcompanies should measure fair value when they are required to use a fair valuemeasure for recognition or disclosure 

7

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###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

purposes under generally acceptedaccounting principles. Headwaters must adopt SFAS No. 157 no later than in itsfiscal year ending September 30, 2009. Headwaters uses fair value measurementsto determine the reported amounts of assets acquired and liabilities assumed inpurchase transactions, in testing for potential goodwill impairment, fordisclosure of the fair value of financial instruments, as well as in otherinstances. It is therefore possible that the implementation of SFAS No. 157could have a material effect on the reported amounts or disclosures inHeadwaters’ consolidated financial statements 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 been reclassified to conform to thecurrent period’s presentation. The reclassifications had no effect on netincome or total assets.

**2.    SegmentReporting**

Headwaters currently operates in two industries and reports threebusiness segments, the construction materials and CCPs segments in the buildingmaterials industry, and the alternative energy segment in the energy industry. Revenuesfor the construction materials segment consist of product sales to wholesaleand retail distributors, 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 information has been prepared in accordance withSFAS No. 131, “Disclosure about Segments of an Enterprise and RelatedInformation.” Segment performance is evaluated primarily on revenue growth andoperating income, although other factors are also used, such as income taxcredits generated by activities of the alternative energy segment. Intersegmentsales are immaterial.

Segment costs and expenses considered in deriving segment operatingincome include cost of revenue, amortization, research and development, andsegment-specific selling, general and administrative expenses. Amounts includedin the “Corporate” column represent expenses not specifically attributable toany segment and include administrative departmental costs and general corporateoverhead. Segment assets reflect those specifically attributable to individualsegments and primarily include accounts receivable, inventories, property,plant and equipment, intangible assets and goodwill. Cash and cash equivalentsand other assets are included in the “Corporate” column.
| ** **                                  | ** ** | **Three Months Ended December 31, 2005** | ** **    |
|---------------------------------------------|------------|-------------------------------------------------------------------|---------------|
| **(in thousands)**                     | ** ** | **Construction  Materials**                                       | ** **    | **CCPs** | ** ** | **Alternative  Energy** | ** ** | **Corporate** | ** ** | **Totals** | ** ** |
|                                        | ** ** | ** **                                                        | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Segment revenue                             |       | $                                                                 | 129,969       |   | $ | 65,165 |   | $ | 85,414 |   | $ | — |   | $ | 280,548 |   |
|                                        |       |                                                              |          |   |   |   |   |   |   |   |   |
| Depreciation and  amortization              |       | $                                                                 | (9,934        | ) | $ | (3,164 | ) | $ | (1,774 | ) | $ | (91 | ) | $ | (14,963 | ) |
|                                        |       |                                                              |          |   |   |   |   |   |   |   |   |
| Operating income  (loss)                    |       | $                                                                 | 14,949        |   | $ | 9,421 |   | $ | 32,780 |   | $ | (6,885 | ) | $ | 50,265 |   |
| Net interest expense                        |       |                                                              |          |   |   |   |   |   |   | (8,951 | ) |
| Other income (expense), net                 |       |                                                              |          |   |   |   |   |   |   | (3,068 | ) |
| Income tax provision                        |       |                                                              |          |   |   |   |   |   |   | (9,950 | ) |
| Net income                                  |       |                                                              |          |   |   |   |   |   |   | $ | 28,296 |   |
|                                        |       |                                                              |          |   |   |   |   |   |   |   |   |
| Capital  expenditures                       |       | $                                                                 | 8,722         |   | $ | 2,123 |   | $ | 2,051 |   | $ | 383 |   | $ | 13,279 |   |
|                                        |       |                                                              |          |   |   |   |   |   |   |   |   |
| **Segment Assets as of December  31, 2005** | ** ** | **$**                                                             | **1,134,557** | ** ** | **$** | **304,771** | ** ** | **$** | **164,952** | ** ** | **$** | **75,670** | ** ** | **$** | **1,679,950** | ** ** |

 

8

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###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)
| ** **                                  | ** ** | **Three Months Ended December 31, 2006** | ** **    |
|---------------------------------------------|------------|-------------------------------------------------------------------|---------------|
| **(in thousands)**                     | ** ** | **Construction  Materials**                                       | ** **    | **CCPs** | ** ** | **Alternative  Energy** | ** ** | **Corporate** | ** ** | **Totals** | ** ** |
|                                        | ** ** | ** **                                                        | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Segment revenue                             |       | $                                                                 | 122,755       |   | $ | 69,172 |   | $ | 82,997 |   | $ | — |   | $ | 274,924 |   |
|                                        |       |                                                              |          |   |   |   |   |   |   |   |   |
| Depreciation and  amortization              |       | $                                                                 | (12,083       | ) | $ | (3,205 | ) | $ | (2,279 | ) | $ | (111 | ) | $ | (17,678 | ) |
|                                        |       |                                                              |          |   |   |   |   |   |   |   |   |
| Operating income  (loss)                    |       | $                                                                 | 6,454         |   | $ | 12,451 |   | $ | 20,847 |   | $ | (5,863 | ) | $ | 33,889 |   |
| Net interest expense                        |       |                                                              |          |   |   |   |   |   |   | (8,267 | ) |
| Other income (expense), net                 |       |                                                              |          |   |   |   |   |   |   | (2,561 | ) |
| Income tax provision                        |       |                                                              |          |   |   |   |   |   |   | (6,070 | ) |
| Net income                                  |       |                                                              |          |   |   |   |   |   |   | $ | 16,991 |   |
|                                        |       |                                                              |          |   |   |   |   |   |   |   |   |
| Capital  expenditures                       |       | $                                                                 | 6,906         |   | $ | 1,187 |   | $ | 1,999 |   | $ | 35 |   | $ | 10,127 |   |
|                                        |       |                                                              |          |   |   |   |   |   |   |   |   |
| **Segment Assets as of December  31, 2006** | ** ** | **$**                                                             | **1,164,744** | ** ** | **$** | **295,685** | ** ** | **$** | **110,513** | ** ** | **$** | **102,061** | ** ** | **$** | **1,673,003** | ** ** |

 

**3.    Securitiesand Stock-Based Compensation**

SEC Registration Statements —Headwaters has an effective universal shelf registration statement on file withthe Securities and Exchange Commission (“SEC”) that can be used for the sale ofcommon stock, preferred stock, convertible debt and other securities. Approximately $18.0 million remainsavailable for future offerings of securities under this registration statement.A prospectus supplement describing the terms of any additional securities to beissued is required to be filed before any future offering would commence underthe registration statement.

In January 2007, Headwaters filed a registrationstatement on Form S-4 with the SEC to register the exchange of $172.5 millionof new 2.875% convertible senior subordinated notes due 2016 and the commonstock which may be issued upon conversion of the notes, all in connection withthe proposed exchange offer described in Note 6 related to Headwaters’ existing2.875% convertible senior subordinated notes due 2016. Headwaters has beeninformed that the registration statement will be reviewed by the SEC. Also asdescribed in Note 6, in January 2007, Headwaters issued a new series of $160.0million of 2.50% convertible senior subordinated notes due 2014. Headwaters hasagreed to file a registration statement with the SEC to register the resales ofthese notes and the common stock which may be issued upon conversion of thenotes.

Stock-Based Compensation — During2006, Headwaters’ Board of Directors granted 30,000 shares of restricted commonstock to an officer. The restricted common stock vests over a five-year periodcontingent upon stock price performance conditions. Total stock-based compensation expense, none of which involved the expenditureof cash, was approximately $1.8 million and $1.9 million for the three monthsended December 31, 2005 and 2006, respectively. As of December 31, 2006, thereis approximately $10.2 million of total compensation cost related to nonvestedawards not yet recognized, which will be recognized in future periods overapplicable vesting terms.

**4.    Inventories**

Inventoriesconsisted of the following at:

| (in thousands) | ** ** | **September 30, 2006** | ** ** | **December 31, 2006** | ** ** |
|---------------------|------------|----------------------------------|------------|---------------------------------|------------|
|                |       |                             |       |                            |       |
| Raw materials       |       | $                                | 12,831     |                            | $          | 12,363 |   |
| Finished goods      |       | 49,688                           |       | 53,147                          |       |
| ** **          | ** ** | **$**                            | **62,519** | ** **                      | **$**      | **65,510** | ** ** |

 

9

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###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

**5.    IntangibleAssets**

Intangible Assets —All of Headwaters’ identified intangible assets are being amortized. Thefollowing table summarizes the gross carrying amounts and the relatedaccumulated amortization of intangible assets as of:
| ** **                         | ** ** | ** **                       | ** ** | **September 30, 2006** | ** **  | **December 31, 2006** | ** ** |
|------------------------------------|------------|----------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| **(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 |   | $ | 26,670 |   |
| Customer  relationships            |       | 7 1⁄2 - 15 year               | s          | 68,331                           |        | 10,348                          |       | 71,503 |   | 11,646 |   |
| Trade names                        |       | 5 - 20 years                     |       | 63,657                           |        | 7,018                           |       | 68,412 |   | 7,905 |   |
| Patents and  patented technologies |       | 7 1⁄2 - 19 year               | s          | 53,107                           |        | 13,037                          |       | 53,469 |   | 14,334 |   |
| Non-competition  agreements        |       | 2 - 5 years                      |       | 6,852                            |        | 4,717                           |       | 8,048 |   | 5,276 |   |
| Other                              |       | 9 - 15 years                     |       | 3,556                            |        | 1,543                           |       | 3,556 |   | 1,629 |   |
| ** **                         | ** ** | ** **                       | ** ** | **$**                            | **313,193** | ** **                      | **$**      | **61,650** | ** ** | **$** | **322,678** | ** ** | **$** | **67,460** | ** ** |

 

Total amortization expense related to intangible assets wasapproximately $6.0 million in 2005 and $5.8 million in 2006. Total estimatedannual amortization expense for fiscal years 2007 through 2012 is shown in thefollowing 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                    |         |
|                                          |              |                           |              |  |

 

**6.    Long-termDebt**

Long-term debt consisted of the following at:
| **(in thousands)**                | ** ** | **September 30,  2006** | ** **  | **December 31,  2006** | ** ** |
|----------------------------------------|------------|------------------------------|-------------|-----------------------------|------------|
|                                   |       |                         |        |                        |       |
| Senior secured  debt                   |       | $                            | 415,319     |                        | $          | 415,319 |   |
| Convertible  senior subordinated notes |       | 172,500                      |        | 172,500                     |       |
| Notes payable to  a bank               |       | 7,215                        |        | 7,018                       |       |
| Other                                  |       | 53                           |        | 37                          |       |
|                                   |       | 595,087                      |        | 594,874                     |       |
| Less: current  portion                 |       | (7,267                       | )           | (9,884                      | )          |
| **Total long-term debt**               | ** ** | **$**                        | **587,820** | ** **                  | **$**      | **584,990** | ** ** |

 

Senior Secured Credit Agreements — Headwaters’ senior secured credit facilitycurrently consists of a first lien term loan in the amount of $415.3 millionand also provides for up to $60.0 million of borrowings under a revolvingcredit arrangement, along with the ability to increase this amount to $100.0million, subject to obtaining additional revolving loan commitments. Withcertain limited exceptions, the first lien term loan is senior in priority toall other debt and is secured by all assets of Headwaters. The terms of thecredit facility, as currently amended, are described in more detail in thefollowing paragraphs. Headwaters is in compliance with all debt covenants as ofDecember 31, 2006.

The first lien term loan bears interest, at Headwaters’ option, ateither i) the London Interbank Offered Rate (“LIBOR”) plus 2.0%, 2.25%, or2.5%, depending on the credit ratings that have been most recently announcedfor the loans by Standard & Poor’s Ratings Services (“S&P”) and Moody’sInvestors Service, Inc. (“Moody’s”); or ii) the “Base Rate” plus 1.0%, 1.25%,or 1.5%, again depending on the credit ratings announced by S&P and Moody’s.Base rate is defined as the higher 

10

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

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

of the rate announced by Morgan Stanley Senior Funding and the overnightrate charged by the Federal Reserve Bank of New York plus 0.5%. Headwaters’current rate is LIBOR plus 2.0%. Headwaters can lock in new LIBOR rates for thefirst lien loan for one, two, three or six months. The weighted-averageinterest rate on the first lien debt was approximately 6.8% at December 31,2006, after giving consideration to the effect of the interest rate hedge on$150.0 million of this debt, as described below.

As described below, in January 2007, Headwatersissued $160.0 million of new convertible senior subordinated notes due 2014.Headwaters used a portion of the net proceeds from these notes to repay $145.0million of the first lien term loan. As a result of this early repayment, theremaining balance of the first lien term loan of $270.3 million is repayable asfollows: $19.9 million in November 2010, and two payments of $125.2 millioneach in February 2011 and April 2011, the termination date. As a result of theearly repayment, Headwaters has accelerated the amortization of the relateddebt issue costs totaling approximately $1.9 million, which amount will becharged to interest expense in the quarter ending March 31, 2007. Interest onthe first lien term loan is generally payable on a quarterly basis.

There are mandatory prepayments of the first lienterm loan in the event of certain asset sales and debt and equity issuances andfrom “excess cash flow,” as defined in the agreement. Optional prepayments ofthe first lien term loan are permitted without penalty or premium. Once repaidin full or in part, no further reborrowings can be made.

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 December 31, 2006, or subsequentthereto. The credit agreement also allows for the issuance of letters ofcredit, provided there is capacity under the revolving credit arrangement. Asof December 31, 2006, six stand-by letters of credit totaling $6.3 million wereoutstanding, with expiration dates ranging from January 2007 to December 2008.

The credit facility contains restrictions and covenants common to suchagreements, 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, Headwaters must maintain certain leverageand fixed charge coverage ratios, as those terms are defined in the agreements,as follows: i) a total leverage ratio of 3.75:1.0 or less, declining to 3.5:1.0in 2010; ii) a maximum ratio of consolidated senior funded indebtedness minussubordinated indebtedness to EBITDA of 2.75:1.0, declining to 2.5:1.0 in 2010;and iii) a minimum ratio of EBITDA plus rent payments for the four precedingfiscal quarters to scheduled payments of principal and interest on allindebtedness for the next 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 ofthe hedges can fluctuate significantly over a relatively short period of time.The hedges had a market value at December 31, 2006 of approximately $1.6million, which, net of related income taxes, represents other comprehensiveincome. One of the joint ventures Headwaters has invested in (see Note 10) hasalso entered into agreements that are accounted for as cash flow hedges. Totalcomprehensive income, considering all cash flow hedge agreements to whichHeadwaters is a direct or indirect party, was not materially different from netincome for either 2005 or 2006.

2.875% Convertible Senior Subordinated Notes Due 2016 — Headwaters has outstanding $172.5million of 2.875% convertible senior subordinated notes due June 2016, withinterest payable semi-annually. These notes are subordinate to the seniorsecured debt described above and rank equally with the 2.50% convertible seniorsubordinated notes due 2014 described below, and any future senior subordinateddebt. Holders of the notes may convert the notes into shares of Headwaters’common stock at a conversion rate of 33.3333 shares per $1,000 principal amount($30 conversion price), 

11

----

 

###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

or 5.75 millionaggregate 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 on or afterJune 1, 2007 and prior to June 4, 2011 if the closing common stock priceexceeds 130% of the conversion price for 20 trading days in any consecutive30-day trading period (in which case Headwaters must provide a “make whole”payment of the present value of all remaining interest payments on the redeemednotes through June 1, 2011). Headwaters may redeem any portion of the notes atany time on or after June 4, 2011. In addition, the holder of the notes has theright to require Headwaters to repurchase all or a portion of the notes on June1, 2011 or if a fundamental change in common stock has occurred, includingtermination of trading. Subsequent to June 1, 2011, the notes require anadditional interest payment equal to 0.40% of the average trading price of thenotes if the trading price equals 120% or more of the principal amount of thenotes.

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 to commence an exchange offer for the 2.875% convertiblesenior subordinated notes due 2016, whereby new notes with similar terms, alongwith an exchange fee, would be issued upon tender of the existing notes. Theexchange offer has not yet commenced, and until any such offer is consummated,Headwaters will not know whether or what portion of the existing notes will betendered in exchange for new notes. If all existing notes were to be tendered,the exchange fee plus costs of the exchange offer are estimated to beapproximately $1.0 million.

The terms of thenew notes, if issued, will differ from the terms of the existing notes in thefollowing primary ways: i) “net share settlement” upon conversion of the notes,whereby Headwaters will pay cash up to the principal amount of the notes, andshares of common stock to the extent the price of Headwaters’ common stockexceeds the conversion price during a 20-trading-day observation period; ii)payment of a “make whole” premium upon conversion in certain circumstances; andiii) modification of the definition of “fundamental change” in regard tospecified corporate transactions.

2.50% Convertible Senior Subordinated Notes Due 2014 — In January 2007, Headwaters issued$160.0 million of 2.5% convertible senior subordinated notes due February 2014,with interest payable semi-annually. These notes are subordinate to the seniorsecured debt and rank equally with the 2.875% convertible senior subordinatednotes due 2016 described above, and any future senior subordinated debt. Totaloffering costs, including underwriting discounts and commissions, are estimatedto be approximately $5.2 million. The conversion rate for the notes is 33.9236shares per $1,000 principal amount ($29.48 conversion price), subject toadjustment. Upon conversion, Headwaters will pay cash up to the principalamount of the notes, and shares of common stock to the extent the price ofHeadwaters’ common stock exceeds the conversion price during a 20-trading-dayobservation period. The conversion rate is adjusted for certain corporatetransactions referred to as “fundamental changes.”

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 quartercommencing after March 31, 2007, the closing price of Headwaters’ common stockexceeds $38.32 per share for at least 20 trading days during a period of 30consecutive trading days ending on the last trading day

 

12

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###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

of the preceding fiscal quarter; 2) during the five-business-day periodafter any ten-consecutive-trading-day period, the notes trade at less than 98%of the product of the common stock trading price and the number of shares ofcommon stock issuable upon conversion of $1,000 principal amount of the notes;or 3) upon the occurrence of specified corporate transactions. The notes areconvertible 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 has agreedto file a shelf registration statement with the SEC to register resales of thenotes and the common stock issuable upon conversion of the notes.

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 net cost of these transactions was approximately$11.8 million and will be accounted for as a decrease in paid-in capital in thequarter ending March 31, 2007.

Notes Payable to a Bank — The notespayable to a bank, which were collateralized by certain assets of a subsidiary,were repaid in their entirety subsequent to December 31, 2006. The notes boreinterest at variable rates, which as of December 31, 2006, ranged from 5.8% to8.0%. Because the notes were callable by the bank, Headwaters included theentire outstanding balance in current portion of long-term debt in theconsolidated balance sheet.

Interest— During 2005, Headwaters incurred totalinterest costs of approximately $10.0 million, including approximately $0.6million of non-cash interest expense and approximately $0.1 million of interestcosts that were capitalized. During 2006, Headwaters incurred total interestcosts of approximately $9.4 million, including approximately $0.6 million ofnon-cash interest expense and approximately $0.2 million of interest costs thatwere capitalized. Interest income was approximately $0.9 million for both 2005and 2006.

The weighted-average interest rate on the face amount of outstandinglong-term debt, disregarding amortization of debt issue costs, wasapproximately 5.7% at September 30, 2006 and 5.6% at December 31, 2006.

**7.    IncomeTaxes**

Headwaters’estimated effective income tax rate for the fiscal year ending September 30,2007, exclusive of discrete items, is 22.0%, which rate was applied to incomebefore income taxes for the quarter ended December 31, 2006. Headwaters alsorecognized a net $1.0 million income tax expense in 2006 for discrete itemsthat did not affect the calculation of the estimated effective income tax ratefor the fiscal year. The discrete items primarily related to changes inestimated tax liabilities and in reserves related to an IRS examination. Afterconsideration of the effect of the discrete items, income tax expense totaledapproximately 26.3% of income before income taxes in 2006, approximately thesame rate as in 2005 of 26.0%.

The effective taxrates for both 2005 and 2006 are lower than statutory rates primarily due totax credits related to two coal-based solid alternative fuel facilities thatHeadwaters owns and operates, plus Headwaters’ 19% interest in an entity thatowns and operates another alternative fuel facility (where Headwaters is notthe primary beneficiary). The alternative fuel produced at these threefacilities through December 2007 qualifies for tax credits pursuant to Section45K [formerly Section 29] of the Internal Revenue Code, subject to theuncertainties of phase-out, IRS audit and other risks associated with the taxcredits, all as more fully described in Note 10.

Headwaters’ 19%interest in the entity that owns and operates an alternative fuel facility wasacquired in exchange for initial cash payments totaling $0.5 million and anobligation to pay $15.0 million in monthly installments through December 2007.The remaining obligation at December 31, 2006 of $6.9 million is recorded inother accrued liabilities in the consolidated balance sheet, and bears interestat an 8% rate. Headwaters also agreed to make additional payments to the sellerbased on a pro-rata allocation of the tax credits generated by the facility,also through December 2007. These additional contractual payments are affectedby phase-out and, along with the amortization of the $15.5 million 

13

----

 

###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

investment, arerecorded in other expense in the consolidated statements of income, totalingapproximately $3.1 million and $2.7 million for 2005 and 2006, 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 $6.9million; therefore, Headwaters’ obligation to make all of the above-describedpayments is effectively limited by the tax benefits Headwaters receives.

As a result ofhigh oil prices in calendar 2006, there will be a partial phase out of Section45K tax credits for that calendar year. In calculating an income tax provisionfor 2006, Headwaters assumed a phase-out percentage for Section 45K tax creditsof 40% for calendar 2006. This estimated phase-out percentage was derived byestimating the calendar 2006 reference price for oil using actual oil pricesfor the months January through October 2006, and published NYMEX oil prices forNovember and December 2006. The monthly NYMEX oil prices were reduced byapproximately 10%, which reduction represents Headwaters’ estimate of therelationship between NYMEX prices and the average U.S. wellhead oil pricesactually used to calculate the annual reference price. The estimated referenceprice for calendar 2006 was calculated by averaging the 12 months’ actual orestimated oil prices, which average was compared to the estimated phase-outrange for calendar 2006 of $54.27 to $68.12 to derive an estimated phase-outpercentage.

Using availableNYMEX oil prices as of December 31, 2006 for each of the months in 2007, anassumed 2% increase in the phase-out range for calendar 2007 versus calendar2006, and the same methodology as described above, Headwaters estimated aphase-out percentage of 18% for calendar 2007.

While the calendar2006 and 2007 phase-out percentages can not be finalized at the current time,as of December 31, 2006, the estimated phase-out percentages representHeadwaters’ best estimates of what the phase-out percentages would be, usingavailable information as of that date. The effect on income taxes of the changein the phase-out percentages from 40% in calendar 2006 and from 18% in calendar2007 to the actual percentages for the two years will be recorded to income taxexpense in subsequent periods, when all of the calendar 2006 and 2007 actualoil prices are known. Any such effect could be material to Headwaters’ 2007 and2008 income tax expense.

14

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######  

###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

**8.    Earnings perShare**

The following table sets forth the computation of basic and diluted EPSfor the periods indicated.
| ** **                                                                                                                      | ** ** | **Three Months Ended  December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(in thousands, except per-share data)**                                                                   | ** ** | **2005**                                            | ** ** | **2006** | ** ** |
| ** **                                                                                                                      |       |                                                |       |   |   |
| **Numerator:**                                                                                                                  |       |                                                |       |   |   |
| Numerator for  basic earnings per share — net income                                                                       |       | $                                                   | 28,296     |   | $ | 16,991 |   |
| Interest expense  related to convertible senior subordinated notes, net of taxes                                                |       | 1,088                                               |       | 1,133 |   |
| Numerator for  diluted earnings per share — net income plus interest expense related to  convertible notes, net of taxes   |       | $                                                   | 29,384     |   | $ | 18,124 |   |
| ** **                                                                                                                      |       |                                                |       |   |   |
| **Denominator:**                                                                                                                |       |                                                |       |   |   |
| Denominator for  basic earnings per share — weighted-average shares outstanding                                            |       | 41,605                                              |       | 42,078 |   |
| Effect of  dilutive securities:                                                                                                 |       |                                                |       |   |   |
| Shares issuable upon exercise of options and SARs                                                                               |       | 1,271                                               |       | 547 |   |
| Shares issuable upon conversion of convertible notes                                                                            |       | 5,750                                               |       | 5,750 |   |
| Total potential  dilutive shares                                                                                                |       | 7,021                                               |       | 6,297 |   |
| Denominator for  diluted earnings per share — weighted-average shares outstanding after  assumed exercises and conversions |       | 48,626                                              |       | 48,375 |   |
| ** **                                                                                                                      |       |                                                |       |   |   |
| **Basic  earnings per share**                                                                                                   | ** ** | **$**                                               | **0.68**   | ** ** | **$** | **0.40** | ** ** |
|                                                                                                                            |       |                                                |       |   |   |
| **Diluted  earnings per share**                                                                                                 | ** ** | **$**                                               | **0.60**   | ** ** | **$** | **0.37** | ** ** |
| ** **                                                                                                                      | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| **Anti-dilutive  securities not considered in diluted EPS calculation:**                                                        | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Stock options                                                                                                                   |       | 27                                                  |       | 828 |   |
| SARs                                                                                                                            |       | 106                                                 |       | 3,137 |   |

 

**9.    Acquisitions**

In 2006, Headwaters acquired 100% of the ownership interests of aprivately-held company in the construction materials business. Totalconsideration paid of approximately $53.0 million consisted primarily of cash.Pursuant to contractual terms, an additional amount may be payable in thefuture, based on the achievement of a stipulated earnings target for the 12months ending September 30, 2007. Assets acquired and liabilities assumed wererecorded at their estimated fair values as of the acquisition date. Operatingresults for the acquired business subsequent to the acquisition date wereincluded in Headwaters’ consolidated results for 2006 and were not material.

Approximately $8.0 million of the aggregate purchaseprice was allocated to identifiable intangible assets which are being amortizedover estimated useful lives ranging from five to twenty years, and approximately$7.0 million of the purchase price was allocated to net tangible assets. Theremaining purchase price not attributable to tangible and identifiableintangible assets was allocated to goodwill, the tax deductibility of which hasnot yet been determined.

During fiscal 2006, Headwaters acquired certain assetsand assumed certain liabilities of several privately-held companies in theconstruction materials industry, which acquisitions were not materialindividually or in the aggregate. Pursuant to contractual terms for some of theacquisitions, additional amounts may be payable in the future, based on the 

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###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

achievement of stipulated revenue or earnings targetsfor periods ending no later than March 2010. If future earn-out considerationis paid, goodwill will be increased accordingly.

**10.  Commitmentsand Contingencies**

Significantnew commitments and ongoing contingencies as of December 31, 2006 not disclosedpreviously, are as follows.

Property,Plant and Equipment — Asof December 31, 2006, Headwaters was committed to spend approximately $8.8million on capital projects that were in various stages of completion.

Joint Venture Obligations — Headwaters entered into an agreementwith Degussa AG, an international chemical company based in Germany, to jointlydevelop and commercialize a process for the direct synthesis of hydrogenperoxide. Under terms of the joint venture agreement, Headwaters committedto fund 50% of the joint venture’s research and development expendituresthrough September 2007, subject to a stipulated maximum. The amount remainingto be paid under this commitment as of December 31, 2006 is not material.Headwaters may elect to contribute up to €1.5 million in 2007 to fund 50% ofthe continuing expenses of the joint venture. In fiscal 2006, Headwaters andDegussa AG formed another joint venture, Degussa Headwaters Korea Co., Ltd. (“DHK”),which purchased a hydrogen peroxide production business located in South Korea.Headwaters is a principal obligor with respect to all non-financial obligationsof DHK and, with respect to financial obligations of DHK, 50% of future plantexpansion 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 $19.0 million at December 31, 2006.

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 is currently expected to begin operating in earlycalendar 2007 with estimated ethanol production of 50 million gallons annually.Estimated costs to construct the ethanol plant and fund start-up costs andinitial working capital approximate $95.5 million, which is being fundedprimarily by debt secured by all the assets of Blue Flint, along with capitalcontributions from Headwaters and GRE. Headwaters has made its full capitalcontribution. The Blue Flint joint venture, which is not a variable interestentity, is being accounted for using the equity method of accounting becauseboth partners have equal voting rights and control over the joint venture.Headwaters’ investment in the Blue Flint joint venture totals approximately$8.9 million at December 31, 2006.

Legal or Contractual Matters — Headwaters has ongoing litigation and asserted claims which have beenincurred during the normal course of business, including the specific mattersdiscussed below. Headwaters intends to vigorously defend or resolve thesematters by settlement, as appropriate. Management does not currently believethat the outcome of these matters will have a material adverse effect onHeadwaters’ operations, cash flow or financial position.

Historically, costs paid to outside legal counsel for litigation havecomprised a majority of Headwaters’ litigation-related costs. During2006, Headwaters incurred approximately $0.7 millionof expense for legal matters, including costs for outside legal counsel,compared to approximately $1.0 million in 2005. Headwaters currently believesthe range of potential loss for all unresolved matters, excluding costs foroutside counsel, is from $1.0 million up to the amounts sought by claimants andhas recorded a total liability as of December 31, 2006 of $1.0 million. Claimsand damages sought by claimants in excess of this amount are not deemed to beprobable. Headwaters’ outside counsel currently believe that unfavorableoutcomes of outstanding litigation are neither probable nor remote and declinedto express opinions concerning the likely outcomes or liability to Headwaters. It is not possible to estimate whatlitigation-related costs will be in future periods.

The mattersdiscussed below raise difficult and complex legal and factual issues, and theresolution of these issues is subject to many uncertainties, including thefacts and circumstances of each case, the jurisdiction in which each case isbrought, and the future decisions of juries, judges, and arbitrators.Therefore, although management believes that the claims asserted againstHeadwaters in the named cases lack merit, there is a possibility of materiallosses in excess of the 

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###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

amounts accrued ifone or more of the cases were to be determined adversely against Headwaters fora substantial 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 directorresigned from the board in 1996. Headwaters has declined McEwan’s attempts to exercise most of theoptions on grounds that the options terminated. In June 2004, McEwan filed a complaint in the Fourth District Court forthe State of Utah against Headwaters alleging breach of contract, breach ofimplied covenant of good faith and fair dealing, fraud, andmisrepresentation.  McEwan seeksdeclaratory relief as well as compensatory damages in the approximate amount of$2.8 million and punitive damages. Headwaters has filed an answer denying McEwan’s claims and has assertedcounterclaims against McEwan.  Becauseresolution of the litigation is uncertain, legal counsel cannot express anopinion as to the ultimate amount of liability 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 action is factuallyrelated to an earlier action brought by certain purported officers anddirectors of Adtech, Inc. That action was dismissed by the United StatesDistrict Court for the Western District of Tennessee and the District Court’sorder of dismissal was affirmed on appeal. In the current action, the allegations arise from the same facts, butthe claims are asserted by certain purported stockholders of Adtech.  In June 2002, Headwaters received a summonsand complaint from the United States District Court for the Western District ofTennessee alleging, among other things, fraud, conspiracy, constructive trust,conversion, patent infringement and interference with contract arising out ofthe 1998 technology purchase agreement entered into between Davidson and Adtechon the one hand, and Headwaters on the other. The plaintiffs seek declaratory relief and compensatory damages in theapproximate amount of between $15.0 million and $25.0 million and punitivedamages.  In February 2006, the DistrictCourt dismissed all claims against Headwaters. Also in February 2006,plaintiffs filed their notice of appeal to the United States Court of Appealsfor the Sixth Circuit. In June 2006, the appeal was transferred to the UnitedStates Court of Appeals for the Federal Circuit. Because the resolution of thelitigation is uncertain, legal counsel cannot express an opinion as to theultimate 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 systems manufacturedand sold by its subsidiaries for application by contractors on residential andcommercial buildings.  Typically,litigation and these claims are controlled by such subsidiaries’ insurancecarriers.  The plaintiffs or claimants inthese matters have alleged that the structures have suffered damage from latentor progressive water penetration due to some alleged failure of the buildingproduct or wall system. Some claims involve alleged defects associated withcomponents of an Exterior Insulating and Finish System (“EIFS”) which wasproduced for a limited time (through 1997) by Best Masonry & Tool Supplyand Don’s Building Supply.  There is a10-year projected claim period following discontinuation of the product. Otherclaims involve alleged liabilities associated with certain stucco productswhich are still produced and sold by certain subsidiaries of HCM.

Typically, theclaims cite damages for alleged personal injuries and punitive damages foralleged unfair business practices in addition to asserting more conventionaldamage claims for alleged economic loss and damage to property.  To date, claims made against suchsubsidiaries have been paid by their insurers, with the exception of minordeductibles, although such insurance carriers typically have issued “reservationof rights” letters.  None of the caseshas gone to trial.  While, to date, noneof these proceedings have required that HCM incur substantial costs, there isno guarantee of insurance coverage or continuing coverage.  These and future proceedings may result insubstantial costs to HCM, including attorneys’ fees, managerial time and otherpersonnel resources and costs.  Adverseresolution of these proceedings could have a materially negative effect on HCM’sbusiness, financial condition, and results of operation, and its ability tomeet its financial obligations.  AlthoughHCM carries general and product liability insurance, HCM 

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###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

cannot assure thatsuch insurance coverage will remain available, that HCM’s insurance carrierwill remain viable, or that the insured amounts will cover all future claims inexcess of HCM’s uninsured retention. Future rate increases may also make such insurance uneconomical for HCMto maintain.  In addition, the insurancepolicies maintained by HCM exclude claims for damages resulting from exteriorinsulating finish systems, or EIFS, that have manifested after March 2003.  Because resolution of the litigation andclaims is uncertain, legal counsel cannot express an opinion as to the ultimateamount, 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 Headwaters owns aninterest. From time to time, issues arise as to the availability of tax creditsand, with the increased price of oil in calendar 2006, the phase-out ofcredits, including the following items.

*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. Historically, thereference price has trended somewhat lower than published market prices foroil. For calendar 2005, the reference price was $50.26 per barrel and thephase-out range began at $53.20 and would have fully phased out tax credits at$66.78 per barrel. Therefore, there was no phase-out of tax credits forcalendar 2005.

For calendar 2006, Headwaters estimates that the phase-out range(computed by increasing the 2005 inflation adjustment factor by 2%) begins at$54.27 and completes phase-out at $68.12 per barrel. As a result of high oilprices in calendar 2006, there will be partial phase out of Section 45K taxcredits for that calendar year. As described in more detail in Note 7,Headwaters estimated a phase-out percentage for Section 45K tax credits forcalendar 2006 of 40%, using available information as December 31, 2006. Headwatersestimated a phase-out percentage of 18% for calendar 2007, also using availableinformation as of December 31, 2006. Headwaters currently does not believe thephase-out percentage for calendar 2006, when finally determined later in 2007,will vary materially from its December 31, 2006 estimate of 40%; however, it iscertain that the estimated phase-out percentage for calendar 2007 will changeduring calendar 2007 and Headwaters estimates that there would be no phase-outfor calendar 2007, using information as of January 31, 2007.

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 negative financialimpact from phase-out, they have reduced or stopped synthetic fuel productionor required Headwaters to share in the costs associated with phase-out.Headwaters makes similar assessments with respect to the continued operation ofits own synthetic fuel production facilities. As of January 31, 2007,substantially all of Headwaters’ 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 Headwaters’ revenue, net income and cash flow, and will have amaterial adverse 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 Headwaters in2006 was negatively affected by reduced revenues being recognized for certainlicensees whose license agreements call for Headwaters to be paid a portion ofthe tax credits earned by the licensee. Due to current uncertainties related tophase out, including the inability to finalize the calendar 2006 phase-outpercentage for Section 45K tax credits, and other licensee-specific factors,revenue recognition has been deferred for certain licensees. The amountrecognized met the “fixed or determinable” recognition criterion and it isremote that any negative adjustment will be required in the future. Additionalrevenues for licensees, which as of December 31, 2006 could total more than$15.0 million (calculated based on licensee-reported data and assuming 40%phase out of Section 45K tax credits for calendar 2006), will not be recognizeduntil such time as these amounts become “fixed or determinable.”

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###### * *

###### **HEADWATERSINCORPORATED**

###### **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

(Unaudited)

*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 as recently as January 2007,and there may be additional initiatives introduced in Congress in 2007. WhenSection 45K expires at the end of 2007 or if it is repealed or adverselymodified, additional synthetic fuel facilities would probably either close orsubstantially curtail production. Given current prices of coal and 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 2007, or upon earlier repeal or adverse modificationof Section 45K, or for any other reason), it would have a further materialadverse effect on the revenue, net income and cash flow of Headwaters, inaddition to the current material adverse effect caused 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 certain licensee-taxpayerswho claimed Section 45K tax credits and will continue the audit process inthe future. The inability of a licensee to claim Section 45K tax creditswould reduce Headwaters’ future income from the licensee. In addition, the IRSmay audit Headwaters concerning tax credits claimed for synthetic fuel soldfrom 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, to Headwaters’ knowledge,there has been little activity regarding the investigation. Headwaters cannotmake any assurances as to the timing or ultimate outcome of the Subcommitteeinvestigation, nor can Headwaters predict whether Congress or others mayconduct investigations of Section 45K tax credits in the future. Renewedactivity in the Subcommittee investigation, if it occurs, may have a materialadverse effect on the willingness of current owners to operate their facilities,and may materially adversely affect Headwaters’ revenue, net income and cashflow.

License Fees— Pursuant to the terms of an agreement with a certain licensee, this licenseehas set aside substantial amounts for working capital and other operationalcontingencies as provided for in the agreement. These amounts may eventually bepaid out to various parties having an interest in the cash flows from thelicensee’s operations, including Headwaters, if they are not used for workingcapital and other operational contingencies. As a result, Headwaters currentlyexpects to receive at some future date a portion of those reserves, the amountof which is not currently determinable and which constitutes a gain contingencynot recognizable as revenue.

 

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** **

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

The following discussionand analysis should be read in conjunction with the consolidated financialstatements and related notes included in this Form 10-Q. Our fiscal year endson September 30 and unless otherwise noted, references to 2005 refer to ourfiscal quarter ended December 31, 2005 and references to 2006 refer to ourfiscal quarter ended December 31, 2006. Other references to years refer to ourfiscal years, unless otherwise noted.

# **Introduction**

During the past several years, we have executed on our two-fold plan ofmaximizing cash flow from our existing operating business units anddiversifying from over-reliance on the legacy alternative energy segment Section45K [formerly Section 29] business. With the addition and expansion of the CCPmanagement and marketing business through acquisitions in 2002 and in 2004, andthe growth of the construction materials business, culminating in several largeand small acquisitions in 2004, 2006 and 2007, we have achieved revenue growthand diversification into three business segments. Because we also incurredincreased indebtedness to make strategic acquisitions, one of our ongoingfinancial objectives is to continue to focus on increased cash flows forpurposes of reducing debt.

A material amount of ourconsolidated revenue and net income is derived from license fees and sales ofchemical reagents, both of which depend on the ability of licensees and othercustomers to manufacture and sell qualified synthetic fuel that generates taxcredits under Section 45K [formerly Section 29] of the Internal Revenue Code.We also claim Section 45K tax credits for synthetic fuel sales from facilitiesin which we own an interest. From time to time, issues arise as to theavailability of tax credits and, with the increased price of oil in calendar2006, 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 will be partial phase out of Section 45K for that calendar year. Inaddition, phase out of Section 45K for calendar 2007 is also possible. As ofJanuary 31, 2007, substantially all of our licensees are producing syntheticfuel, but most licensees stopped production for a period of time in fiscal2006. These events have materially adversely affected both the amount andtiming of recognition of our revenue, net income and cash flow, and will have amaterial adverse effect in future periods as well. Reference is made to notes 7and 10 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 2006 and that will continue to affect ourbusiness in 2007.

Our acquisitionstrategy targets businesses that are leading players in their respectiveindustries, that enjoy healthy operating margins and that are not overlycapital intensive, thus providing additional cash flow that complements thefinancial performance of our existing businesses. In addition, in fiscal 2006,we began to acquire small companies with innovative products that can bemarketed using our existing distribution channels. We are also committed tocontinuing to invest in research and development activities that are focused onenergy-related technologies and nanotechnology. We have agreed to a jointventure project to construct, own and operate an ethanol plant located in NorthDakota which is currently expected to begin operating in early calendar 2007,and we are also beginning to invest in other alternative energy projects suchas coal cleaning and the use of nanocatalysts to engineer coal for emissionsreduction.

As a result of our CCPs and construction materials businesses, we areaffected by seasonality, with the highest revenue and profitability produced inthe June and September quarters. With CCPs, our strategy is to continue tonegotiate long-term contracts so that we can invest in transportation andstorage infrastructure for the marketing and sale of CCPs. We also intend tocontinue our efforts to expand usage of high-value CCPs and develop uses forlower-value CCPs, including the expanded use of CCPs in our constructionmaterials businesses and the industry in general.

In fiscal 2005 and 2006, we focused on the integration of our 2004acquisitions, including the marketing of diverse construction materials productsthrough our national distribution network. We became highly leveraged as aresult of those acquisitions, but have reduced our outstanding debt since thattime through cash generated from operations, from an underwritten publicoffering of common stock and from proceeds from settlement of litigation. Weintend to continue to focus on repaying long-term debt while continuing to lookfor diversification opportunities within prescribed parameters.

**Consolidation and Segments**

*Consolidation*.The consolidated financial statements include the accounts of Headwaters, allof our subsidiaries and other entities in which we have a controlling interest.All significant intercompany transactions and accounts are eliminated inconsolidation.

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Asdescribed in more detail in Note 9 to the consolidated financial statements, in2006 we acquired 100% of the ownership interests of a privately-held company inthe construction materials business. Operating results for the acquiredbusiness subsequent to the acquisition date have been included in ourconsolidated results for 2006 and were not material.

*Segments*. We currentlyoperate in two industries and report three business segments, the constructionmaterials and CCPs segments in the building materials industry, and the alternativeenergy segment in the energy industry.

In the constructionmaterials segment, we design, manufacture, and sell architectural stone andresin-based exterior siding accessories (such as shutters, mounting blocks, andvents) and related products. Revenues consist of sales to wholesale and retaildistributors, contractors and other users of building products. We are also anationwide leader in the management and marketing of CCPs. Revenues consistprimarily of fly ash and other product sales. In the alternative energysegment, we are focused on reducing waste and increasing the value of energyfeedstocks, primarily in the areas of low-value coal and oil. Revenue for the alternative energy segment consistsprimarily of sales of chemical reagents and license fees.

**ThreeMonths Ended December 31, 2006 Compared to Three Months Ended December 31, 2005**

The information set forthbelow compares our operating results for the quarter ended December 31, 2006 (“2006”)with operating results for the quarter ended December 31, 2005 (“2005”).

*Revenue*. Total revenue for 2006 decreased by $5.6 million or 2% to $274.9 millionas compared to $280.5 million for 2005. The major components of revenue arediscussed in the sections below.

*ConstructionMaterials Segment*.  Sales of construction materials during 2006were $122.8 million with a corresponding direct cost of $90.6 million. Sales ofconstruction materials during 2005 were $130.0 million with a correspondingdirect cost of $89.7 million. The decrease in sales of construction materialsduring 2006 was due primarily to the effects of a depressed residential housingmarket which impacted sales across most of our product lines. The housingmarket slowdown also was the primary reason for the decline in gross marginpercentage from 2005 to 2006.  Because asubstantial amount of our revenues in this segment are dependent on the housingmarket, we anticipate similar impact from the current slowdown in the housingindustry through at least the next quarter.

*CCPSegment*.  CCP revenues for 2006 were $69.2 million witha corresponding direct cost of $49.4 million. CCP revenues for 2005 were $65.2million with a corresponding direct cost of $49.0 million. The increase in CCPrevenues and in the gross margin percentage during 2006 were due primarily to acombination of continued strong demand for CCPs and upward pricing trends inmost concrete markets. In addition, weather conditions in the south centralregion of the United States have generally been favorable in 2006. The growthin demand for CCPs is due in part to certain regional shortages of portlandcement for which CCPs are a substitute, which can result in an increasedpercentage of CCPs being used in concrete. The cement shortages also resultedin increased prices for CCPs in several markets.

*AlternativeEnergy Segment*.  Our alternative energy segment revenueconsists primarily of chemical reagent sales, license fee revenue related toour solid alternative fuel technologies, and to a lesser extent, sales ofsynthetic fuel from two solid alternative fuel production facilities that weown. The major components of revenue for the alternative energy segment arediscussed in the sections below.

*Sales ofChemical Reagents*.  Chemical reagent sales during 2006 were $44.5million with a corresponding direct cost of $35.5 million. Chemical reagentsales during 2005 were $44.5 million with a corresponding direct cost of $33.3million. Despite the partial phase-out of Section 45K tax credits for calendaryear 2006, chemical reagent sales in 2006 were essentially flat as compared to2005. Substantially all of our licensees and other customers operated theirsynfuel facilities in 2006 as oil prices continued to moderate during thequarter. It is not possible to predict the trend for sales of chemical reagentsin future periods. The gross margin percentage for 2006 of 20% was lower than2005’s gross 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. We currently believe reagent margins will decrease further in futureperiods, depending upon crude oil prices and other factors.

*LicenseFees*.  During 2006, werecognized license fee revenue totaling $22.4 million, a decrease of $5.7million or 20% from $28.1 million of license fee revenue recognized during2005. Certain accounting rules limit revenue recognition to amounts that are “fixedor determinable.” The amount of license fee revenue recognized in 2006 wasnegatively affected by reduced revenues being recognized for certain licenseeswhose license agreements call for us to be paid a portion of the tax creditsearned by the licensee. Due to current uncertainties related to phase out,including the inability to finalize the calendar 2006 phase-out percentage forSection 45K tax credits, and other licensee-specific factors, revenuerecognition has been deferred for certain licensees. The amount recognized metthe “fixed or determinable” recognition criterion and it is remote that anynegative adjustment will be required in the future. Additional revenues forlicensees, which as of December 31, 2006 could total more than $15.0 million(calculated based on licensee-reported data and assuming 40% phase out ofSection 45K 

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tax credits for calendar2006), will not be recognized until such time as these amounts become “fixed ordeterminable.” Reference is made to our policy disclosures contained in Note 2to the consolidated financial statements and in “*Management’sDiscussion and Analysis*” in our Form 10-K, as well as information inNote 10 to the consolidated financial statements and the introduction above.

Pursuant to theterms of an agreement with a certain licensee, this licensee has set asidesubstantial amounts for working capital and other operational contingencies asprovided for in the agreement. These amounts, which are in addition to amountsincluded in the $15.0 million amount discussed above, may eventually be paidout to various parties having an interest in the cash flows from the licensee’soperations, including us, if they are not used for working capital and otheroperational contingencies. As a result, we currently expect to receive at somefuture date a portion of those reserves, the amount of which is not currentlydeterminable and which constitutes a gain contingency not recognizable asrevenue.

*OtherAlternative Energy Segment Revenues.* The majority ofother alternative energy segment revenue is comprised of sales of syntheticfuel, which during 2006 were $14.8 million with a corresponding direct cost of$17.3 million. Sales of synthetic fuel during 2005 were $11.5 million with acorresponding direct cost of $13.3 million. The increase in sales of syntheticfuel from 2005 to 2006 was due primarily to our desire to maximize Section 45Ktax credits earned for calendar 2006. Revenue from the sale of synthetic fuelhas a negative gross margin, which is more than compensated for by the incometax credits expected to be earned from the sales of the synthetic fuel.

*Amortization* and *Research and DevelopmentExpenses*.  The changes inamortization expense ($0.2 million) and research and development expenses ($0.8million) from 2005 to 2006 were not material. Both expense categories arecurrently expected to remain near current levels in future periods.

*Selling,General and Administrative Expenses*.  Theseexpenses increased $1.6 million, or 5% to $36.6 million for 2006 from $35.0million for 2005. The increase in 2006 was due primarily to increased payrolland payroll-related costs at the operating business unit level, in turn relatedto growth initiatives in certain of our business units.

*OtherIncome and Expense*. During 2006, we reported net other expense of $10.8 million compared tonet other expense of $12.0 million during 2005. The change of $1.2 million wasattributable to a decrease in net interest expense of $0.7 million and adecrease in other expenses of $0.5 million. Net interest expense decreased from$9.0 million in 2005 to $8.3 million in 2006, due primarily to lower averagelevels of long-term debt in 2006 compared to 2005.

The decrease in otherexpenses of $0.5 million consisted primarily of a decrease in costs ofapproximately $0.4 million related to our investment in the coal-based solidalternative fuel production facility described in Note 7 to the consolidatedfinancial statements. The primary reason for the decreased costs for thisfacility is the partial phase-out of Section 45K tax credits for calendar 2006.Reduced tax benefits from operation of the facility result in reduced costs weare required to pay for operations. The alternative fuel produced at thefacility through December 2007 qualifies for tax credits pursuant to Section45K of the Internal Revenue Code, and we are entitled to receive our pro-ratashare of such tax credits generated based upon our percentage of ownership ofthe facility.

*Income Tax Provision*.  Our estimated effective income tax rate forthe fiscal year ending September 30, 2007 is 22.0%, which rate was applied toincome before income taxes for 2006. We also recognized a net $1.0 millionincome tax expense in 2006 for discrete items that did not affect thecalculation of the estimated effective income tax rate for the fiscal year. Thediscrete items primarily related to changes in estimated tax liabilities and inreserves related to an IRS examination. After consideration of the effect ofthe discrete items, income tax expense totaled approximately 26.3% of incomebefore income taxes in 2006, approximately the same rate as in 2005 of 26.0%.

The effective tax ratesfor both 2005 and 2006 are lower than statutory rates primarily due to taxcredits related to two coal-based solid alternative fuel facilities that we ownand operate, plus our 19% interest in an entity that owns and operates anotheralternative fuel facility (where we are not the primary beneficiary). Thealternative 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 10 to the consolidated financial statements. Excluding the effect of thetax credits, our estimated effective tax rate for 2006 would be approximately39%.

As a result ofhigh oil prices in calendar 2006, there will be a partial phase out of Section45K tax credits for that calendar year. In calculating an income tax provisionfor 2006, we assumed phase-out percentages for Section 45K tax credits of 40%for calendar 2006 and 18% for calendar 2007, all as described in Note 7 to theconsolidated financial statements. While the calendar 2006 and 2007 phase-outpercentages can not be finalized at the current time, as of December 31, 2006,the estimated phase-out percentages represent our best estimates of what thephase-out percentages would be, using available information as of that date.The effect on income taxes of the change in the phase-out percentages from 40%in calendar 2006 and from 18% in calendar 2007 to the actual percentages forthe two years will be recorded to income tax expense in 

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subsequent periods, whenall of the calendar 2006 and 2007 actual oil prices are known. Any such effectcould be material to our 2007 and 2008 income tax expense.

The calculation of taxliabilities involves uncertainties in the application of complex taxregulations in multiple jurisdictions. For example, we are currently under IRSaudit for 2003 and 2004. We recognize potential liabilities for anticipated taxaudit issues in the U.S. and state tax jurisdictions based on estimates ofwhether, and the extent to which, additional taxes and interest will be due. Ifevents occur and the payment of these amounts ultimately proves to beunnecessary, the reversal of the liabilities would result in tax benefits beingrecognized in the period when it is determined the liabilities are no longerprobable or necessary. If the estimate of tax liabilities proves to be lessthan the ultimate assessment, a further charge to expense would result.

**Impact ofInflation and Related Matters**

Our operations have beenimpacted by i) rising costs for chemical reagents in the alternative energysegment; ii) increased cement, polypropylene and poly-vinyl chloride costs inthe construction materials segment; iii) increased fuel costs that haveaffected transportation costs in most of our business units; and iv) certainregional shortages of cement and aggregate materials. The increased costs ofchemical reagents, polypropylene, poly-vinyl chloride and fuel are directlyrelated to the increase in prices of natural gas, oil and other petroleum-basedmaterials. The increased costs of cement are caused primarily by a lack ofadequate supplies in some regions of the U.S.

We have been successfulin passing on some, but not all, of the increased material and transportationcosts to customers. It is not possible to predict the future trend of materialand transportation costs, nor our ability to pass on any future price increasesto customers. It is also not possible to predict the impact of potential futurecement supply shortages on our ability to procure needed supplies in ourconstruction materials business.

**Liquidity and Capital Resources**

*Summaryof Cash Flow Activities*.  Net cash provided by operatingactivities during 2006 was $34.7 million compared to $28.2 million during 2005. In 2006, the primary investing activitiesconsisted of payments for an acquisition and the purchase of property, plantand equipment. Financing activities were not material. In 2005, the primaryinvesting activity consisted of the purchase of property, plant and equipmentand the primary financing activity consisted of repayments of long-term debt.More details about our investing and financing activities are provided in thefollowing paragraphs.

*Investing Activities*.  Expenditures for property, plant andequipment in 2006 were not materially different from the 2005 amount. Most ofthe capital expenditures in both periods were incurred by the constructionmaterials segment; however, in 2006, a higher proportion of total capitalexpenditures were incurred by the alternative energy segment as compared to2005. A significant portion of our planned future capital expendituresrepresent expansion of operations, rather than maintenance of operatingcapacity. Capital expenditures are currently limited by our senior debtcovenants to $100.0 million annually; however, the cumulative unused amounts ofannual capital expenditures limits can be carried forward and used in subsequentyears. As of September 30, 2006, we hadapproximately $25.4 million of unused amounts of capital expenditures fromprior years and as of December 31, 2006, we were committed to spendapproximately $8.8 million on capital projects that were in various stages ofcompletion.

Weintend to continue to expand our business through growth of existingoperations, commercialization of technologies currently being developed, andstrategic acquisitions of products or entities that expand our currentoperating platform. Acquisitions are an important part of our business strategyand to that end, we routinely review potential complementary acquisitions,including those in the areas of construction materials, CCP marketing, and coaland catalyst technologies. It is possible that some portion of future cash andcash equivalents and/or proceeds from the issuance of stock or debt will beused to fund acquisitions of complementary businesses in the chemical, energy,building products and related industries. The senior secured credit agreementlimits acquisitions in the aggregate to $50.0 million of cash consideration and$20.0 million of non-cash consideration annually, with no more than $30.0million of cash consideration for any one acquisition, unless our “totalleverage ratio,” as defined, is less than or equal to 3.50:1.0, after givingeffect to an acquisition, in which case the foregoing limitations do not apply.The senior secured credit agreement also limits the amount we can invest injoint ventures and other less than 100%-owned entities.

In2006, we acquired 100% of the ownership interests of a privately-held companyin the construction materials business. Total consideration paid ofapproximately $53.0 million consisted primarily of cash. Pursuant tocontractual terms, an additional amount may be payable in the future, based onthe achievement of a stipulated earnings target for the 12 months endingSeptember 30, 2007. During fiscal 2006, we acquired certain assets and assumedcertain liabilities of several privately-held companies in the constructionmaterials industry. Pursuant to contractual terms for some of the acquisitions,additional amounts may be payable in the future, based on the achievement ofstipulated revenue or earnings targets for periods ending no later than March2010. If future earn-out consideration is paid, goodwill will be increasedaccordingly.

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Referenceis made to Note 10 to the consolidated financial statements for a discussion ofour investments in joint ventures which are accounted for using the equitymethod of accounting.

*Financing Activities*.  In 2006, financing activities were notmaterial. However, subsequent to December 31, 2006 and as described in moredetail in Note 6 to the consolidated financial statements, we issued $160.0million of 2.5% convertible senior subordinated notes due February 2014.Substantially all of the net proceeds of approximately $154.8 million were usedto repay $145.0 million of senior debt and $7.0 million of notes payable to abank.

Dueto covenants associated with our senior debt, we currently have limitations onour ability to obtain significant additionalamounts of long-term debt. However, we have historically experienced strongpositive cash flow from operations and in fiscal 2005 issued common stock whichtogether has enabled us to repay a substantial amount of our long-term debtprior to the scheduled maturities. We expect our positive cash flow to continuein the future and also have the ability to access the equity markets ifnecessary.

Wehave an effective universal shelf registration statement on file with the SECthat can be used for the sale of common stock, preferred stock, convertibledebt and other securities. Approximately$18.0 million remains available for future offerings of securities under thisregistration statement. A prospectus supplement describing the terms of anyadditional securities to be issued is required to be filed before any futureoffering would commence under the registration statement. In January 2007, wefiled a registration statement on Form S-4 with the SEC to register theexchange of $172.5 million of new 2.875% convertible senior subordinated notesdue 2016 and the common stock which may be issued upon conversion of the notes,all in connection with the proposed exchange offer described in Note 6 to theconsolidated financial statements related to our existing 2.875% convertiblesenior subordinated notes due 2016. We have been informed that the registrationstatement will be reviewed by the SEC.

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. We may, in the future, make optional prepayments of the seniordebt depending on actual cash flows, our current and expected cash requirementsand other applicable factors we deem to be significant.

As provided for in the senior debt agreements, we have available $60.0 million under arevolving credit arrangement, along with theability to increase this amount to $100.0 million, subject to obtainingadditional revolving loan commitments. Borrowingsunder the revolving credit arrangement are generally subject to the terms ofthe first lien loan agreement. Borrowings and reborrowings of any available portionof the $60.0 million revolver can be made at any time through September 2009,when all loans must be repaid and the revolving credit arrangement terminates.There were no borrowings outstanding under the revolving credit arrangement asof December 31, 2006, or subsequent thereto. The credit agreement also allowsfor the issuance of letters of credit, provided there is capacity under therevolving credit arrangement. As of December 31, 2006, six stand-by letters ofcredit totaling $6.3 million were outstanding, with expiration dates rangingfrom January 2007 to December 2008.

The credit facility contains restrictions and covenants common to suchagreements, 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 December 31, 2006.

In2006, cash proceeds from the exercise of options and employee stock purchasestotaled $1.3 million, compared to $2.0 million in 2005. Option exerciseactivity is primarily dependent on our stock price and is not predictable. Tothe extent non-qualified stock options are exercised, or there aredisqualifying dispositions of shares obtained upon the exercise of incentivestock options, we receive an income tax deduction generally equal to the incomerecognized by the optionee. Such amounts, reflected in cash flows fromfinancing activities in the consolidated statements of cash flows, were $0 in2006 and $1.8 million in 2005.

*WorkingCapital*.  During 2006, our working capital decreased by$31.9 million, to $113.4 million as of December 31, 2006. We expect operationsto produce positive cash flow in future periods and believe working capital,along with available borrowings under the revolving credit arrangement, will besufficient for operating needs for the next 12 months.

*IncomeTaxes*.  Our cash requirements for income taxesgenerally approximate the income tax provision; however, there is usually somelag in paying estimated taxes during a fiscal year due to the seasonality ofoperations and because estimated income tax payments are typically based onannualizing the fiscal year’s income based on year-to-date results. There isalso some lag in realizing the cash benefits from the utilization of taxcredits due to the interaction of our September 30 fiscal year end and thedifferent fiscal year ends of the entities through which we receive the taxcredits. In 2007, there may be more variability in the relationship between theincome tax provision and income tax payments because the tax provisioncalculation is materially dependent upon the estimated phase-out percentage ofSection 45K tax credits (see Notes 

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7 and 10 to the consolidated financial statements).The calendar 2007 phase-out percentage is subject to material change at thisdate because it is dependent on oil prices for all of calendar 2007, which arenot predictable. Therefore, the 2006 tax provision reflected in theconsolidated financial statements is also subject to material change.

As discussed previously,cash payments for income taxes are reduced for tax deductions resulting fromdisqualifying dispositions of incentive stock options and from the exercise ofnon-qualified stock options, which amount was $0 in 2006. Option exerciseactivity is primarily dependent on our stock price and is not predictable. Likewise,it is not possible to estimate what tax benefits may be realized from futureoption 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, investments in joint ventures, acquisitionsand debt service payments on outstanding long-term debt.

**Legalor Contractual Matters**

We have ongoing litigation and asserted claims which have been incurredduring the normal course of business, including the specific matters discussedin Note 10 to the consolidated financial statements. We intend to vigorouslydefend or resolve these matters by settlement, as appropriate. We do not currentlybelieve that the outcome of these matters will have a material adverse effecton our operations, cash flow or financial position.

Historically, costs paid to outside legal counsel for litigation havecomprised a majority of our litigation-related costs. During 2006, we incurred approximately $0.7 million of expense for legalmatters, including costs for outside legal counsel, compared to approximately$1.0 million in 2005. We currently believe the range of potential loss for allunresolved matters, excluding costs for outside counsel, is from $1.0 millionup to the amounts sought by claimants and have recorded a total liability as ofDecember 31, 2006 of $1.0 million. Claims and damages sought by claimants inexcess of this amount are not deemed to be probable. Our outside counselcurrently believe that unfavorable outcomes of outstanding litigation areneither probable nor remote and declined to express opinions concerning thelikely outcomes or liability. It is notpossible to estimate what litigation-related costs will be in future periods.

Thematters discussed in Note 10 raise difficult and complex legal and factualissues, and the resolution of these issues is subject to many uncertainties,including the facts and circumstances of each case, the jurisdiction in whicheach case is brought, and the future decisions of juries, judges, andarbitrators. Therefore, although management believes that the claims assertedin the named cases lack merit, there is a possibility of material losses inexcess of the amounts accrued if one or more of the cases were to be determinedadversely against us for a substantial amount of the damages asserted. It is possible that a change in the estimatesof probable liability could occur, and the changes could be material. Additionally,as with any litigation, these proceedings require that we incur substantialcosts, including attorneys’ fees, managerial time, and other personnelresources and costs in pursuing resolution.

**RecentAccounting Pronouncements**

Reference is made to Note 1 to the consolidated financialstatements for a discussion of accounting pronouncements that have been recentlyissued which we have not yet adopted.

**ITEM 3.       QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT 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.

As described inmore detail in Note 6 to the consolidated financial statements, we haveapproximately $422.3 million of variable-rate long-term debt outstanding as ofDecember 31, 2006, consisting of $415.3 million of senior debt and $7.0 millionof notes payable to a bank. There was approximately $422.5 million ofvariable-rate long-term debt outstanding as of September 30, 2006.

As required by thesenior secured credit facility, we entered into agreements to limit ourvariable interest rate exposure. The agreements effectively fix the LIBOR rateat 3.71% for $150.0 million of this debt through September 8, 2007. We accountfor these agreements as cash flow hedges, with their fair market valuereflected in the consolidated balance sheet as either other assets or otherliabilities. The market value of the hedges can fluctuate significantly over arelatively short period of time. The hedges had a market value at December 31,2006 of approximately $1.6 million, which, net of related income taxes,represents other comprehensive income. One of the joint ventures we haveinvested in (see Note 10 to the consolidated financial statements) has alsoentered into agreements that are accounted for as cash flow hedges. Total 

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comprehensive income,considering all cash flow hedge agreements to which we are a direct or indirectparty, was not materially different from net income for either 2005 or 2006.

Considering alloutstanding balances of variable-rate debt (reduced by the $150.0 million ofsenior debt that effectively has a fixed interest rate until September 8,2007), required principal repayments and the early $145.0 million repayment ofsenior debt in January 2007, a change in the interest rate of 1% would changeour interest expense by approximately $1.8 million during the 12 months endingDecember 31, 2007.

**ITEM 4.****                     CONTROLS ANDPROCEDURES**

*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 management evaluated,with the participation of our CEO and CFO, the effectiveness of our disclosurecontrols and procedures as of December 31, 2006, pursuant to paragraph (b) ofRules 13a-15 and 15d-15 under the Exchange Act. This evaluation included areview 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. Also, the projection of any evaluation of the disclosurecontrols and procedures to future periods is subject to the risk that thedisclosure controls and procedures may become inadequate because of changes inconditions, or that the degree of compliance with the policies or proceduresmay deteriorate.

Based on theirreview and evaluation, and subject to the inherent limitations described above,our CEO and CFO have concluded that our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were effectiveas of December 31, 2006.

*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 changein our internal control over financial reporting during the quarter endedDecember 31, 2006 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

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######  

###### **PART II — OTHER INFORMATION**

**ITEM 1.****  LEGAL PROCEEDINGS**

See “*Legal or Contractual Matters”*in Note 10 to the consolidated financial statements for a descriptionof current legal proceedings.

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

Risks relating to our business and common stock aredescribed in Item 1A of the Form 10-K. The following information supplementsthe information contained therein.

**If the EPA were to reclassify CCPs as a hazardouswaste, our ability to sell or dispose of fly ash or other CCPs could suffer.Even if not reclassified, the EPA is expected to impose rules increasing thecost of the disposal of CCPs. Either event could cause a decline in HRI’srevenues and net income.**

Fossil fuelcombustion wastes have been excluded from regulation as “hazardous wastes” undersubtitle C of the Resource Conservation and Recovery Act (“RCRA”). However,CCPs may contain small concentrations of metals or other substances that arehazardous. From time to time the EPA reviews the classification of CCPs and mayat some time in the future conclude that CCPs should be included as a hazardouswaste under subtitle C of RCRA. Under its CCP management contracts withelectric utilities, HRI is obligated to sell or otherwise dispose of CCPsproduced by power plants, and if classified as a hazardous waste, HRI may havelimited or much more expensive options for selling or disposing of CCPs.

EPA has determinedthat national regulations under subtitle D of the Resource Conservation andRecovery Act dealing with state and regional solid waste plans are warrantedfor coal combustion byproducts disposed of in landfills or surfaceimpoundments, or used to fill surface or underground mines. The EPA is planningto publish proposed rules for CCPs generated by commercial electric powerproducers in May 2007 and for management of CCPs at mine facilities in October2008 which will address, among other things, state and regional solid wasteplans for CCPs disposed of in landfills or surface impoundments, or used tofill surface or underground mines. HRI manages a number of landfill and pondoperations that may be affected by EPA’s planned regulations. We believe thatin most of these operations the permitting is contractually retained by theclient and the client would be liable for any costs associated with newpermitting requirements. However, the effect of such regulations on HRI cannotbe completely ascertained at this time.

**ITEM 2.****     UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

None.

**ITEM 3.****     DEFAULTS UPON SENIORSECURITIES**

None.

**ITEM 4.****     SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS**

None.

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

None.

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

The following 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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*                    Filedherewith.

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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: February  2, 2007 | By:                     | /s/ Kirk A. Benson |
| ** **              |                    | Kirk A. Benson, Chief Executive Officer |
|                    |                    | (Principal Executive Officer) |
|                    |                    |   |
| Date: February  2, 2007 | By:                     | /s/ Scott K. Sorensen |
|                    |                    | Scott K. Sorensen, Chief Financial Officer |
|                    |                    | (Principal Financial Officer) |

 

 

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