**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

 

**FORM 10-Q**

 

 

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

**For the quarterly periodended March 31, 2007**

 

**or**

 

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

**For the transition periodfrom             to             **

 

**Commission file number:1-32459**

 

**HEADWATERS INCORPORATED**

(Exact name of registrant as specified in its charter)

 

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

 

**(801) 984-9400**

(Registrant’s telephonenumber, including area code)

 

**Not applicable**

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

 

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

 

Thenumber of shares outstanding of the Registrant’s common stock as of April 30,2007 was 42,378,974.

 

 

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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 March 31, 2007                                      |       |       |       |
|                                    |       | Condensed  Consolidated Statements of Income — For the three and six months ended  March 31, 2006 and 2007           |       |       |       |
|                                    |       | Condensed  Consolidated Statement of Changes in Stockholders’ Equity — For the six  months ended March 31, 2007 |       |       |       |
|                                    |       | Condensed Consolidated Statements of Cash Flows — For  the six months ended March 31, 2006 and 2007                  |       |       |       |
|                                    |       | Notes to  Condensed Consolidated Financial Statements                                                                          |       |       |       |
| ITEM 2.                                 |       | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                                    |       |       |       |
| ITEM 3.                                 |       | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                                    |       |       |       |
| ITEM 4.                                 |       | CONTROLS AND  PROCEDURES                                                                                                       |       |       |       |
|                                    |       |                                                                                                                           |       |       |       |
| **PART II — OTHER  INFORMATION**   |       |                                                                                                                           |       |
|                                    |       |                                                                                                                           |       |       |       |
| ITEM 1.                                 |       | LEGAL PROCEEDINGS                                                                                                              |       |       |       |
| ITEM 1A.                                |       | RISK FACTORS                                                                                                                   |       |       |       |
| ITEM 2.                                 |       | UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                                                   |       |       |       |
| ITEM 3.                                 |       | DEFAULTS UPON  SENIOR SECURITIES                                                                                               |       |       |       |
| ITEM 4.                                 |       | SUBMISSION OF  MATTERS TO A VOTE OF SECURITY HOLDERS                                                                           |       |       |       |
| ITEM 5.                                 |       | OTHER INFORMATION                                                                                                              |       |       |       |
| ITEM 6.                                 |       | EXHIBITS                                                                                                                       |       |       |       |
|                                    |       |                                                                                                                           |       |       |       |
| **SIGNATURES**                          |       |                                                                                                                           |       |       |       |

** **

**Forward-lookingStatements**

*ThisQuarterly Report on Form 10-Q contains forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995 regardingfuture events 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 our Quarterly Report onForm 10-Q for the quarter ended December 31, 2006. There can be no assurancethat our results of operations will not be adversely affected by such factors.Unless legally required, we undertake no obligation to revise or update anyforward-looking statements for any reason. Readers are cautioned not to placeundue reliance on these forward-looking statements, which speak only as of thedate of this report.*

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

2

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**ITEM 1.**                    FINANCIALSTATEMENTS

**HEADWATERSINCORPORATED**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**(Unaudited)
| ** **                                                                                                                                                                                                                                    | ** ** | **September 30,** | ** **    | **March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|---------------|--------------------|------------|
| **(in thousands, except per-share data)**                                                                                                                                                                                 | ** ** | **2006**               | ** **    | **2007**           | ** ** |
|                                                                                                                                                                                                                                          |       |                   |          |               |       |
| **ASSETS**                                                                                                                                                                                                                                    |       |                   |          |               |       |
|                                                                                                                                                                                                                                          |       |                   |          |               |       |
| **Current assets:**                                                                                                                                                                                                                           |       |                   |          |               |       |
| Cash and cash  equivalents                                                                                                                                                                                                                    |       | $                      | 79,151        |               | $          | 29,310 |   |
| Trade  receivables, net                                                                                                                                                                                                                       |       | 131,608                |          | 150,185            |       |
| Inventories                                                                                                                                                                                                                                   |       | 62,519                 |          | 64,714             |       |
| Deferred income  taxes                                                                                                                                                                                                                        |       | 26,465                 |          | 18,182             |       |
| Other                                                                                                                                                                                                                                         |       | 10,294                 |          | 12,223             |       |
| **Total  current assets**                                                                                                                                                                                                                     | ** ** | **310,037**            | ** **    | **274,614**        | ** ** |
|                                                                                                                                                                                                                                          |       |                   |          |               |       |
| **Property, plant and equipment,  net**                                                                                                                                                                                                       | ** ** | **213,406**            | ** **    | **221,709**        | ** ** |
|                                                                                                                                                                                                                                          |       |                   |          |               |       |
| **Other assets:**                                                                                                                                                                                                                             |       |                   |          |               |       |
| Intangible  assets, net                                                                                                                                                                                                                       |       | 251,543                |          | 249,371            |       |
| Goodwill                                                                                                                                                                                                                                      |       | 826,432                |          | 863,161            |       |
| Other                                                                                                                                                                                                                                         |       | 60,311                 |          | 58,376             |       |
| **Total  other assets**                                                                                                                                                                                                                       | ** ** | **1,138,286**          | ** **    | **1,170,908**      | ** ** |
|                                                                                                                                                                                                                                          |       |                   |          |               |       |
| **Total  assets**                                                                                                                                                                                                                             | ** ** | **$**                  | **1,661,729** | ** **         | **$**      | **1,667,231** | ** ** |
| ** **                                                                                                                                                                                                                                    |       |                   |          |               |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                |       |                   |          |               |       |
|                                                                                                                                                                                                                                          |       |                   |          |               |       |
| **Current liabilities:**                                                                                                                                                                                                                      |       |                   |          |               |       |
| Accounts payable                                                                                                                                                                                                                              |       | $                      | 23,854        |               | $          | 31,284 |   |
| Accrued  personnel costs                                                                                                                                                                                                                      |       | 32,859                 |          | 26,070             |       |
| Accrued income  taxes                                                                                                                                                                                                                         |       | 16,481                 |          | 17,009             |       |
| Other accrued  liabilities                                                                                                                                                                                                                    |       | 62,190                 |          | 58,446             |       |
| Deferred license  fee revenue                                                                                                                                                                                                                 |       | 22,090                 |          | 16,552             |       |
| Current portion  of long-term debt                                                                                                                                                                                                            |       | 7,267                  |          | 23                 |       |
| **Total  current liabilities**                                                                                                                                                                                                                | ** ** | **164,741**            | ** **    | **149,384**        | ** ** |
|                                                                                                                                                                                                                                          |       |                   |          |               |       |
| **Long-term liabilities:**                                                                                                                                                                                                                    |       |                   |          |               |       |
| Long-term debt                                                                                                                                                                                                                                |       | 587,820                |          | 595,000            |       |
| Deferred income  taxes                                                                                                                                                                                                                        |       | 96,972                 |          | 63,140             |       |
| Other                                                                                                                                                                                                                                         |       | 11,238                 |          | 5,773              |       |
| **Total  long-term liabilities**                                                                                                                                                                                                              | ** ** | **696,030**            | ** **    | **663,913**        | ** ** |
| **Total  liabilities**                                                                                                                                                                                                                        | ** ** | **860,771**            | ** **    | **813,297**        | ** ** |
|                                                                                                                                                                                                                                          |       |                   |          |               |       |
| 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 42,379 shares at March 31, 2007 (including 195 shares held in treasury) |       | 42                     |          | 42                 |       |
| Capital in  excess of par value                                                                                                                                                                                                               |       | 502,265                |          | 511,334            |       |
| Retained  earnings                                                                                                                                                                                                                            |       | 299,866                |          | 344,061            |       |
| Treasury stock  and other                                                                                                                                                                                                                     |       | (1,215                 | )             | (1,503             | )          |
| **Total  stockholders’ equity**                                                                                                                                                                                                          | ** ** | **800,958**            | ** **    | **853,934**        | ** ** |
|                                                                                                                                                                                                                                          |       |                   |          |               |       |
| **Total liabilities and  stockholders’ equity**                                                                                                                                                                                          | ** ** | **$**                  | **1,661,729** | ** **         | **$**      | **1,667,231** | ** ** |

 

See accompanyingnotes.

3

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**HEADWATERSINCORPORATED**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME**(Unaudited)
| ** **                                                    | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| **(in thousands, except per-share data)** | ** ** | **2006**                                         | ** ** | **2007**                                       | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                                                    |       |                                             |       |                                           |       |   |   |   |   |
| **Revenue:**                                                  |       |                                             |       |                                           |       |   |   |   |   |
| Construction materials                                        |       | $                                                | 131,709    |                                           | $          | 115,547 |   | $ | 261,678 |   | $ | 238,302 |   |
| Coal combustion products                                      |       | 58,491                                           |       | 62,093                                         |       | 123,656 |   | 131,265 |   |
| Alternative energy                                            |       | 79,483                                           |       | 96,465                                         |       | 164,897 |   | 179,462 |   |
| **Total revenue**                                             | ** ** | **269,683**                                      | ** ** | **274,105**                                    | ** ** | **550,231** | ** ** | **549,029** | ** ** |
| ** **                                                    |       |                                             |       |                                           |       |   |   |   |   |
| **Cost of  revenue:**                                         |       |                                             |       |                                           |       |   |   |   |   |
| Construction materials                                        |       | 91,231                                           |       | 87,176                                         |       | 180,936 |   | 177,738 |   |
| Coal combustion products                                      |       | 46,347                                           |       | 46,795                                         |       | 95,309 |   | 96,242 |   |
| Alternative energy                                            |       | 52,590                                           |       | 45,725                                         |       | 100,247 |   | 100,595 |   |
| **Total cost of revenue**                                     | ** ** | **190,168**                                      | ** ** | **179,696**                                    | ** ** | **376,492** | ** ** | **374,575** | ** ** |
| ** **                                                    |       |                                             |       |                                           |       |   |   |   |   |
| **Gross  profit**                                             | ** ** | **79,515**                                       | ** ** | **94,409**                                     | ** ** | **173,739** | ** ** | **174,454** | ** ** |
| ** **                                                    |       |                                             |       |                                           |       |   |   |   |   |
| **Operating  expenses:**                                      |       |                                             |       |                                           |       |   |   |   |   |
| Amortization                                                  |       | 6,105                                            |       | 5,847                                          |       | 12,141 |   | 11,658 |   |
| Research and development                                      |       | 3,355                                            |       | 5,343                                          |       | 6,319 |   | 9,127 |   |
| Selling, general and administrative                           |       | 32,313                                           |       | 37,785                                         |       | 67,272 |   | 74,346 |   |
| **Total operating expenses**                                  | ** ** | **41,773**                                       | ** ** | **48,975**                                     | ** ** | **85,732** | ** ** | **95,131** | ** ** |
| ** **                                                    |       |                                             |       |                                           |       |   |   |   |   |
| **Operating  income**                                         | ** ** | **37,742**                                       | ** ** | **45,434**                                     | ** ** | **88,007** | ** ** | **79,323** | ** ** |
| ** **                                                    |       |                                             |       |                                           |       |   |   |   |   |
| **Other  income (expense):**                                  |       |                                             |       |                                           |       |   |   |   |   |
| Net interest expense                                          |       | (8,709                                           | )          | (9,070                                         | )          | (17,660 | ) | (17,337 | ) |
| Other, net                                                    |       | (2,432                                           | )          | (3,590                                         | )          | (5,501 | ) | (6,151 | ) |
| **Total other income (expense), net**                         | ** ** | **(11,141**                                      | **)**      | **(12,660**                                    | **)**      | **(23,161** | **)** | **(23,488** | **)** |
| ** **                                                    |       |                                             |       |                                           |       |   |   |   |   |
| **Income  before income taxes**                               | ** ** | **26,601**                                       | ** ** | **32,774**                                     | ** ** | **64,846** | ** ** | **55,835** | ** ** |
| ** **                                                    |       |                                             |       |                                           |       |   |   |   |   |
| Income tax  provision                                         |       | (8,200                                           | )          | (5,570                                         | )          | (18,150 | ) | (11,640 | ) |
| ** **                                                    |       |                                             |       |                                           |       |   |   |   |   |
| **Net  income**                                               | ** ** | **$**                                            | **18,401** | ** **                                     | **$**      | **27,204** | ** ** | **$** | **46,696** | ** ** | **$** | **44,195** | ** ** |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Basic earnings  per share                                     | ** ** | **$**                                            | **0.44**   | ** **                                     | **$**      | **0.65** | ** ** | **$** | **1.12** | ** ** | **$** | **1.05** | ** ** |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| **Diluted earnings per share**                                | ** ** | **$**                                            | **0.40**   | ** **                                     | **$**      | **0.59** | ** ** | **$** | **1.00** | ** ** | **$** | **0.96** | ** ** |

 

See accompanyingnotes.

4

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**HEADWATERSINCORPORATED**

**CONDENSEDCONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY** (Unaudited)For the Six MonthsEnded March 31, 2007
| ** **                                                                                                                                    | ** ** | **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                                                                                      |       | 43                    |       | —                      |       | 408                        |       |                 |       |             |        |                          |       | 408 |   |
|                                                                                                                                          |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| Tax benefit from  exercise of stock options                                                                                                   |       |                  |       |                        |       | 16                         |       |                 |       |             |        |                          |       | 16 |   |
|                                                                                                                                          |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| 59 shares of treasury  stock transferred to employee stock purchase plan, at cost                                                             |       |                  |       |                        |       | 860                        |       |                 |       | 376              |        |                          |       | 1,236 |   |
|                                                                                                                                          |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| Stock-based compensation                                                                                                                      |       | 30                    |       |                        |       | 3,428                      |       |                 |       |             |        |                          |       | 3,428 |   |
|                                                                                                                                          |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| Convertible note hedge  and related warrants, net                                                                                             |       |                  |       |                        |       | (11,830                    | )          |                 |       |             |        |                          |       | (11,830 | ) |
|                                                                                                                                          |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| Deferred taxes on  convertible note hedge                                                                                                     |       |                  |       |                        |       | 16,187                     |       |                 |       |             |        |                          |       | 16,187 |   |
|                                                                                                                                          |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| Other comprehensive  income (loss) — net unrealized loss on cash flow hedges and foreign currency  translation adjustments, net of taxes |       |                  |       |                        |       |                       |       |                 |       |             |        | (664                          | )          | (664 | ) |
|                                                                                                                                          |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| Net income for the six  months ended March 31, 2007                                                                                           |       |                  |       |                        |       |                       |       | 44,195               |       |             |        |                          |       | 44,195 |   |
|                                                                                                                                          |       |                  |       |                        |       |                       |       |                 |       |             |        |                          |       |   |   |
| **Balances as of March 31, 2007**                                                                                                             | ** ** | **42,379**            | ** ** | **$**                       | **42**     | ** **                 | **$**      | **511,334**          | ** ** | **$**            | **344,061** | ** **                    | **$**      | **(1,779** | **)** | **$** | **276** | ** ** | **$** | **853,934** | ** ** |

 

See accompanyingnotes.

5

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**HEADWATERSINCORPORATED**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**(Unaudited)
| ** **                                                                                                                       | ** ** | **Six Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| **(in thousands)**                                                                                                          | ** ** | **2006**                                       | ** ** | **2007** | ** ** |
| ** **                                                                                                                       |       |                                           |       |   |   |
| **Cash flows from operating  activities:**                                                                                       |       |                                           |       |   |   |
| Net income                                                                                                                       |       | $                                              | 46,696     |   | $ | 44,195 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                                               |       |                                           |       |   |   |
| Depreciation and  amortization                                                                                                   |       | 30,780                                         |       | 35,750 |   |
| Stock-based compensation  expense                                                                                                |       | 3,625                                          |       | 3,428 |   |
| Interest expense  related to amortization of debt issue costs                                                                    |       | 1,627                                          |       | 3,258 |   |
| Equity in losses  of joint ventures                                                                                              |       | —                                         |       | 1,958 |   |
| Amortization of  non-refundable license fees                                                                                     |       | (11,034                                        | )          | (11,034 | ) |
| Deferred income  taxes                                                                                                           |       | 6,512                                          |       | (8,027 | ) |
| Net loss (gain)  on disposition of property, plant and equipment                                                                 |       | (77                                            | )          | 191 |   |
| Decrease  (increase) in trade receivables                                                                                        |       | 47,296                                         |       | (16,252 | ) |
| Increase in  inventories                                                                                                         |       | (8,098                                         | )          | (773 | ) |
| Decrease in  accounts payable and accrued liabilities                                                                            |       | (47,347                                        | )          | (4,880 | ) |
| Other changes in  operating assets and liabilities, net                                                                          |       | 65,254                                         |       | (5,809 | ) |
| **Net cash provided by operating  activities**                                                                                   | ** ** | **135,234**                                    | ** ** | **42,005** | ** ** |
|                                                                                                                             |       |                                           |       |   |   |
| **Cash flows from investing  activities:**                                                                                       |       |                                           |       |   |   |
| Payments for  acquisitions, net of cash acquired                                                                                 |       | (4,613                                         | )          | (50,219 | ) |
| Purchase of  property, plant and equipment                                                                                       |       | (24,604                                        | )          | (25,469 | ) |
| Proceeds from  disposition of property, plant and equipment                                                                      |       | 787                                            |       | 209 |   |
| Investments in  joint ventures                                                                                                   |       | (6,899                                         | )          | (500 | ) |
| Net increase in  other assets                                                                                                    |       | (1,773                                         | )          | (205 | ) |
| **Net cash used in investing  activities**                                                                                       | ** ** | **(37,102**                                    | **)**      | **(76,184** | **)** |
| ** **                                                                                                                       |       |                                           |       |   |   |
| **Cash flows from financing  activities:**                                                                                       |       |                                           |       |   |   |
| Net proceeds  from issuance of long-term debt                                                                                    |       | —                                         |       | 154,572 |   |
| Payments on  long-term debt                                                                                                      |       | (58,494                                        | )          | (160,064 | ) |
| Convertible note  hedge and related warrants, net                                                                                |       | —                                         |       | (11,830 | ) |
| Proceeds from  exercise of stock options                                                                                         |       | 4,946                                          |       | 408 |   |
| Income tax  benefit from exercise of stock options and stock appreciation rights (net of  reversals pertaining to prior periods) |       | (2,920                                         | )          | 16 |   |
| Employee stock  purchases                                                                                                        |       | 1,445                                          |       | 1,236 |   |
| **Net cash used in financing  activities**                                                                                       | ** ** | **(55,023**                                    | **)**      | **(15,662** | **)** |
|                                                                                                                             |       |                                           |       |   |   |
| **Net increase (decrease) in cash  and cash equivalents**                                                                        | ** ** | **43,109**                                     | ** ** | **(49,841** | **)** |
|                                                                                                                             |       |                                           |       |   |   |
| Cash and cash  equivalents, beginning of period                                                                                  |       | 13,666                                         |       | 79,151 |   |
|                                                                                                                             |       |                                           |       |   |   |
| **Cash and cash equivalents, end  of period**                                                                                    | ** ** | **$**                                          | **56,775** | ** ** | **$** | **29,310** | ** ** |
| ** **                                                                                                                       | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| **Supplemental schedule of  non-cash investing and financing activities:**                                                       |       |                                           |       |   |   |
| Increase in accrued  liabilities for acquisition-related commitments                                                             |       | $                                              | 11,000     |   | $ | 2,639 |   |

 

See accompanyingnotes.

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**HEADWATERSINCORPORATED**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSMarch 31, 2007**(Unaudited)

**1.****              Nature ofOperations 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 other products.Headwaters is also a nationwide leader in the management and marketing of CCPs,including fly ash used as a substitute for portland cement. Headwaters believesit is uniquely positioned to manufacture an array of building materials thatuse fly ash, such as block, stucco, and mortar and believes that it has aleading market position in its principal building materials businesses. Revenuefrom Headwaters’ construction materials and CCPs businesses are diversifiedgeographically and also by market, including the new construction, remodelingand home improvement markets.

In the alternative 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, Headwatersoperates an ethanol plant and is proceeding with the commercialization ofseveral catalyst technologies.

Basis of Presentation — Headwaters’ fiscal year ends onSeptember 30 and unless otherwise noted, references to 2006 refer to Headwaters’fiscal quarter and/or six-month period ended March 31, 2006 and references to2007 refer to Headwaters’ fiscal quarter and/or six-month period ended March31, 2007. 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 2007 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 informationand footnote disclosures normally included in annual financial statementsprepared in accordance with U.S. generally accepted accounting principles havebeen condensed 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”) and in Headwaters’ Quarterly Report on Form 10-Q for the quarter endedDecember 31, 2006.

Recent AccountingPronouncements — In July 2006, the Financial AccountingStandards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASBStatement No. 109 (“FIN 48”). This Interpretation prescribes aconsistent recognition threshold and measurement standard, as well as clearcriteria for subsequently recognizing, derecognizing and measuring taxpositions, for financial reporting purposes. FIN 48 also requires expandeddisclosures with respect to the uncertainty in income taxes. FIN 48 iseffective for Headwaters’ fiscal 2008 year beginning on October 1, 2007.Management is currently evaluating the impact of FIN 48. The effect of adoptingFIN 48, if material, will be a transition adjustment to beginning retainedearnings in the year of adoption.

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

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

Reclassifications— Certain prior period amounts have been reclassified to conform to the currentperiod’s presentation. The reclassifications had no effect on net income ortotal assets.

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

Headwaterscurrently operates in two industries and reports three business segments, theconstruction materials and CCPs segments in the building materials industry,and the alternative energy segment in the energy industry. Revenues for theconstruction materials segment consist of product sales to wholesale and retaildistributors, contractors and other users of building products. CCP revenuesconsist primarily of fly ash and other product sales with a small amount ofservice revenue. Revenue for the alternative energy segment consists primarilyof sales of chemical reagents and license fees.

The followingsegment information has been prepared in accordance with SFAS No. 131, “Disclosureabout Segments of an Enterprise and Related Information.” Segment performanceis evaluated primarily on revenue and operating income, although other factorsare also used, such as income tax credits generated by activities of thealternative energy segment. Intersegment sales are immaterial.

Segment costs andexpenses considered in deriving segment operating income include cost ofrevenue, amortization, research and development, and segment-specific selling,general and administrative expenses. Amounts included in the “Corporate” columnrepresent expenses not specifically attributable to any segment and includeadministrative departmental costs and general corporate overhead. Segmentassets reflect those specifically attributable to individual segments andprimarily include accounts receivable, inventories, property, plant andequipment, intangible assets and goodwill. Cash and cash equivalents and otherassets are included in the “Corporate” column.
|                                | ** ** | **Three Months Ended March 31, 2006** | ** ** |
|--------------------------------|------------|----------------------------------------------------------------|------------|
| **(in thousands)**        | ** ** | **Construction  Materials**                                    | ** ** | **CCPs** | ** ** | **Alternative  Energy** | ** ** | **Corporate** | ** ** | **Totals** | ** ** |
|                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Segment revenue                |       | $                                                              | 131,709    |   | $ | 58,491 |   | $ | 79,483 |   | $ | — |   | $ | 269,683 |   |
|                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Depreciation and  amortization |       | $                                                              | (10,795    | ) | $ | (3,162 | ) | $ | (1,763 | ) | $ | (97 | ) | $ | (15,817 | ) |
|                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Operating income  (loss)       |       | $                                                              | 13,309     |   | $ | 5,320 |   | $ | 20,315 |   | $ | (1,202 | ) | $ | 37,742 |   |
| Net interest expense           |       |                                                           |       |   |   |   |   |   |   | (8,709 | ) |
| Other income (expense), net    |       |                                                           |       |   |   |   |   |   |   | (2,432 | ) |
| Income tax provision           |       |                                                           |       |   |   |   |   |   |   | (8,200 | ) |
| Net income                     |       |                                                           |       |   |   |   |   |   |   | $ | 18,401 |   |
|                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Capital expenditures           |       | $                                                              | 6,856      |   | $ | 2,634 |   | $ | 1,774 |   | $ | 62 |   | $ | 11,326 |   |

 

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|                                | ** ** | **Three Months Ended March 31, 2007** | ** ** |
|--------------------------------|------------|----------------------------------------------------------------|------------|
| **(in thousands)**        | ** ** | **Construction  Materials**                                    | ** ** | **CCPs** | ** ** | **Alternative  Energy** | ** ** | **Corporate** | ** ** | **Totals** | ** ** |
|                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Segment revenue                |       | $                                                              | 115,547    |   | $ | 62,093 |   | $ | 96,465 |   | $ | — |   | $ | 274,105 |   |
|                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Depreciation and  amortization |       | $                                                              | (12,475    | ) | $ | (3,233 | ) | $ | (2,256 | ) | $ | (108 | ) | $ | (18,072 | ) |
|                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Operating income  (loss)       |       | $                                                              | 2,277      |   | $ | 8,202 |   | $ | 41,902 |   | $ | (6,947 | ) | $ | 45,434 |   |
| Net interest expense           |       |                                                           |       |   |   |   |   |   |   | (9,070 | ) |
| Other income (expense), net    |       |                                                           |       |   |   |   |   |   |   | (3,590 | ) |
| Income tax provision           |       |                                                           |       |   |   |   |   |   |   | (5,570 | ) |
| Net income                     |       |                                                           |       |   |   |   |   |   |   | $ | 27,204 |   |
|                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Capital expenditures           |       | $                                                              | 7,442      |   | $ | 2,125 |   | $ | 5,768 |   | $ | 7 |   | $ | 15,342 |   |

 
|                                          | ** ** | **Six Months Ended March 31, 2006** | ** **    |
|------------------------------------------|------------|--------------------------------------------------------------|---------------|
| **(in thousands)**                  | ** ** | **Construction  Materials**                                  | ** **    | **CCPs** | ** ** | **Alternative  Energy** | ** ** | **Corporate** | ** ** | **Totals** | ** ** |
|                                     |       |                                                         |          |   |   |   |   |   |   |   |   |
| Segment revenue                          |       | $                                                            | 261,678       |   | $ | 123,656 |   | $ | 164,897 |   | $ | — |   | $ | 550,231 |   |
|                                     |       |                                                         |          |   |   |   |   |   |   |   |   |
| Depreciation and  amortization           |       | $                                                            | (20,729       | ) | $ | (6,326 | ) | $ | (3,537 | ) | $ | (188 | ) | $ | (30,780 | ) |
|                                     |       |                                                         |          |   |   |   |   |   |   |   |   |
| Operating income  (loss)                 |       | $                                                            | 28,258        |   | $ | 14,741 |   | $ | 53,095 |   | $ | (8,087 | ) | $ | 88,007 |   |
| Net interest expense                     |       |                                                         |          |   |   |   |   |   |   | (17,660 | ) |
| Other income (expense), net              |       |                                                         |          |   |   |   |   |   |   | (5,501 | ) |
| Income tax provision                     |       |                                                         |          |   |   |   |   |   |   | (18,150 | ) |
| Net income                               |       |                                                         |          |   |   |   |   |   |   | $ | 46,696 |   |
|                                     |       |                                                         |          |   |   |   |   |   |   |   |   |
| Capital  expenditures                    |       | $                                                            | 15,577        |   | $ | 4,757 |   | $ | 3,825 |   | $ | 445 |   | $ | 24,604 |   |
|                                     |       |                                                         |          |   |   |   |   |   |   |   |   |
| **Segment Assets as of March 31,  2006** | ** ** | **$**                                                        | **1,143,684** | ** ** | **$** | **302,925** | ** ** | **$** | **70,815** | ** ** | **$** | **98,677** | ** ** | **$** | **1,616,101** | ** ** |

 

|                                          | ** ** | **Six Months Ended March 31, 2007** | ** **    |
|------------------------------------------|------------|--------------------------------------------------------------|---------------|
| **(in thousands)**                  | ** ** | **Construction  Materials**                                  | ** **    | **CCPs** | ** ** | **Alternative  Energy** | ** ** | **Corporate** | ** ** | **Totals** | ** ** |
|                                     |       |                                                         |          |   |   |   |   |   |   |   |   |
| Segment revenue                          |       | $                                                            | 238,302       |   | $ | 131,265 |   | $ | 179,462 |   | $ | — |   | $ | 549,029 |   |
|                                     |       |                                                         |          |   |   |   |   |   |   |   |   |
| Depreciation and  amortization           |       | $                                                            | (24,558       | ) | $ | (6,438 | ) | $ | (4,535 | ) | $ | (219 | ) | $ | (35,750 | ) |
|                                     |       |                                                         |          |   |   |   |   |   |   |   |   |
| Operating income  (loss)                 |       | $                                                            | 8,731         |   | $ | 20,653 |   | $ | 62,749 |   | $ | (12,810 | ) | $ | 79,323 |   |
| Net interest expense                     |       |                                                         |          |   |   |   |   |   |   | (17,337 | ) |
| Other income (expense), net              |       |                                                         |          |   |   |   |   |   |   | (6,151 | ) |
| Income tax provision                     |       |                                                         |          |   |   |   |   |   |   | (11,640 | ) |
| Net income                               |       |                                                         |          |   |   |   |   |   |   | $ | 44,195 |   |
|                                     |       |                                                         |          |   |   |   |   |   |   |   |   |
| Capital  expenditures                    |       | $                                                            | 14,348        |   | $ | 3,312 |   | $ | 7,767 |   | $ | 42 |   | $ | 25,469 |   |
|                                     |       |                                                         |          |   |   |   |   |   |   |   |   |
| **Segment Assets as of March 31,  2007** | ** ** | **$**                                                        | **1,159,045** | ** ** | **$** | **296,605** | ** ** | **$** | **141,876** | ** ** | **$** | **69,705** | ** ** | **$** | **1,667,231** | ** ** |

 

**3.****              Securities andStock-Based Compensation**

SEC Registration Statements — InJanuary 2007, Headwaters filed a registration statement on Form S-4 with theSEC to register the exchange of $172.5 million new 2.875% convertible seniorsubordinated notes due 2016 and the common stock which could be issued uponconversion of the notes, all in connection with a potential exchange offer forHeadwaters’ existing 2.875% convertible senior subordinated notes due 2016 (seeNote 6). The registration statement

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was reviewed by the SEC and was declared effective inApril 2007. Also described in Note 6, in January 2007, Headwaters issued a newseries of $160.0 million 2.50% convertible senior subordinated notes due 2014.Headwaters filed a registration statement with the SEC to register the resalesof these notes and the common stock which may be issued upon conversion of thenotes, which registration statement became effective in April 2007.

Stock-Based Compensation — Totalstock-based compensation expense, none of which involved the expenditure ofcash, was approximately $1.8 million and $1.6 million for the three monthsended March 31, 2006 and 2007, respectively, and $3.6 million and $3.4 millionfor the six months ended March 31, 2006 and 2007, respectively. As of March 31,2007, there is approximately $8.6 million of total compensation cost related tononvested awards not yet recognized, which will be recognized in future periodssubject to applicable vesting terms.

**4.****              Inventories**

Inventories consisted ofthe following at:
| (in thousands) | ** ** | **September 30, 2006** | ** ** | **March 31, 2007** | ** ** |
|---------------------|------------|----------------------------------|------------|------------------------------|------------|
|                |       |                             |       |                         |       |
| Raw materials       |       | $                                | 12,831     |                         | $          | 13,124 |   |
| Finished goods      |       | 49,688                           |       | 51,590                       |       |
| ** **          | ** ** | **$**                            | **62,519** | ** **                   | **$**      | **64,714** | ** ** |

 

**5.****              Intangible Assets**

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** | ** **  | **March 31, 2007**  | ** ** |
|------------------------------------|------------|----------------------------------|------------|----------------------------------|-------------|-------------------------------|------------|
| **(in thousands)**            | ** ** | **Estimated  useful lives** | ** ** | **Gross  Carrying  Amount**      | ** **  | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
|                               |       |                             |       |                             |        |                          |       |   |   |   |   |
| CCP contracts                      |       | 8 - 20 years                     |       | $                                | 117,690     |                          | $          | 24,987 |   | $ | 117,690 |   | $ | 28,353 |   |
| Customer  relationships            |       | 7 1¤2  - 15 years           |       | 68,331                           |        | 10,348                        |       | 71,503 |   | 12,957 |   |
| Trade names                        |       | 5 - 20 years                     |       | 63,657                           |        | 7,018                         |       | 68,412 |   | 8,809 |   |
| Patents and  patented technologies |       | 7 1¤2  - 19 years           |       | 53,107                           |        | 13,037                        |       | 53,469 |   | 15,606 |   |
| Non-competition  agreements        |       | 2 - 5 years                      |       | 6,852                            |        | 4,717                         |       | 8,048 |   | 5,868 |   |
| Other                              |       | 9 - 15 years                     |       | 3,556                            |        | 1,543                         |       | 3,556 |   | 1,714 |   |
| ** **                         | ** ** | ** **                       | ** ** | **$**                            | **313,193** | ** **                    | **$**      | **61,650** | ** ** | **$** | **322,678** | ** ** | **$** | **73,307** | ** ** |

 

Total amortizationexpense related to intangible assets was approximately $6.1 million and $5.8million for the three months ended March 31, 2006 and 2007, respectively, and$12.1 million and $11.7 million for the six months ended March 31, 2006 and 2007,respectively. Total estimated annual amortization expense for fiscal years 2007through 2012 is shown in the following table.
| Year ending September 30: | *** *** | **(in thousands)** | *** *** |
|------------------------------------------|--------------|-------------------------|--------------|
|                                     |         |                    |         |
| 2007                                     |         | $                       | 22,877       |   |
| 2008                                     |         | 21,373                  |         |
| 2009                                     |         | 21,160                  |         |
| 2010                                     |         | 20,760                  |         |
| 2011                                     |         | 20,530                  |         |
| 2012                                     |         | 19,039                  |         |
|                                          |              |                         |              |  |

 

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

Long-term debtconsisted of the following at:
| (in thousands)                    | ** ** | **September 30,  2006** | ** **  | **March 31,  2007** | ** ** |
|----------------------------------------|------------|------------------------------|-------------|--------------------------|------------|
|                                   |       |                         |        |                     |       |
| Senior secured  debt                   |       | $                            | 415,319     |                     | $          | 262,500 |   |
|                                   |       |                         |        |                     |       |
| Convertible senior  subordinated notes |       | 172,500                      |        | 332,500                  |       |
|                                   |       |                         |        |                     |       |
| Notes payable to  a bank               |       | 7,215                        |        | —                   |       |
|                                   |       |                         |        |                     |       |
| Other                                  |       | 53                           |        | 23                       |       |
|                                   |       | 595,087                      |        | 595,023                  |       |
| Less: current  portion                 |       | (7,267                       | )           | (23                      | )          |
| **Total long-term debt**               | ** ** | **$**                        | **587,820** | ** **               | **$**      | **595,000** | ** ** |

 

Senior SecuredCredit Agreements — Headwaters’ senior secured creditfacility currently consists of a first lien term loan in the amount of $262.5million. The credit facility also provides for up to $60.0 million ofborrowings under a revolving credit arrangement, with the ability to increasethis amount to $100.0 million, subject to obtaining additional revolving loancommitments. The first lien term loan is senior in priority to all other debtand is secured by all assets of Headwaters. The terms of the credit facility,as currently amended, are described in more detail in the following paragraphs.Headwaters is in compliance with all debt covenants as of March 31, 2007.

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 of the rate announced by Morgan StanleySenior Funding and the overnight rate charged by the Federal Reserve Bank ofNew York plus 0.5%. Headwaters’ current rate is LIBOR plus 2.0%. Headwaters canlock in new LIBOR rates for the first lien loan for one, two, three or sixmonths. The weighted-average interest rate on the first lien debt wasapproximately 6.4% at March 31, 2007, after giving consideration to the effectof the interest rate hedge on $150.0 million of this debt, as describedhereafter. Interest on the first lien term loan is generally payable on aquarterly basis.

In January 2007, Headwaters issued $160.0 million of new convertiblesenior subordinated notes due 2014. Headwaters used most of the net proceedsfrom these notes and available cash to repay $152.8 million of the first lienterm loan. As a result of this early repayment, the remaining balance of thefirst lien term loan of $262.5 million is repayable as follows: $12.1 millionin November 2010, and two payments of $125.2 million each in February 2011 andApril 2011, the termination date. Due to the early repayment, Headwatersaccelerated the amortization of related debt issue costs totaling approximately$2.0 million, which amount was charged to interest expense. There are mandatoryprepayments of the first lien term loan in the event of certain asset sales anddebt and equity issuances and from “excess cash flow,” as defined in theagreement. Optional prepayments of the first lien term loan are permittedwithout penalty or premium. Once repaid in full or in part, no furtherreborrowings can be made.

Borrowings under the revolving credit arrangement are generally subjectto the terms of the first lien loan agreement and bear interest at either LIBORplus 1.75% to 2.5% (depending on Headwaters’ “total leverage ratio,” asdefined), or the Base Rate plus 0.75% to 1.5%. Borrowings and reborrowings ofany available portion of the $60.0 million revolver can be made at any timethrough September 2009, when all loans must be repaid and the revolving creditarrangement terminates. The fees for the unused portion of the revolving creditarrangement range from 0.5% to 0.75% (depending on Headwaters’ “total leverageratio,” as defined). There were no borrowings outstanding under the revolvingcredit arrangement as of March 31, 2007, or subsequent thereto. The creditagreement also allows for the issuance of letters of credit, provided there iscapacity under the revolving credit arrangement. As of March 31, 2007, fivestand-by letters of credit totaling $4.4 million were outstanding, withexpiration dates ranging from June 2007 to December 2008.

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The creditfacility contains restrictions and covenants common to such agreements,including limitations on the incurrence of additional debt, investments, mergerand acquisition activity, asset sales and liens, annual capital expenditures inexcess of $100.0 million annually, and the payment of dividends, among others.In addition, Headwaters must maintain certain leverage and fixed chargecoverage ratios, as those terms are defined in the agreements, as follows: i) atotal leverage ratio of 3.75:1.0 or less, declining to 3.5:1.0 in 2010; ii) amaximum ratio of consolidated senior funded indebtedness minus subordinatedindebtedness to EBITDA of 2.75:1.0, declining to 2.5:1.0 in 2010; and iii) aminimum ratio of EBITDA plus rent payments for the four preceding fiscalquarters to scheduled payments of principal and interest on all indebtednessfor 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 ofthese hedges (and various other cash flow hedges to which Headwaters is adirect or indirect party) at March 31, 2007 was not material. Totalcomprehensive income, considering all cash flow hedge agreements to whichHeadwaters is a party, was not materially different from net income for either2006 or 2007.

2.875% ConvertibleSenior Subordinated Notes Due 2016 — Headwaters hasoutstanding $172.5 million of 2.875% convertible senior subordinated notes dueJune 2016, with interest payable semi-annually. These notes are subordinate tothe senior secured debt described above and rank equally with the 2.50%convertible senior subordinated notes due 2014 described below, and any futuresenior subordinated debt. Holders of the notes may convert the notes intoshares of Headwaters’ common stock at a conversion rate of 33.3333 shares per$1,000 principal amount ($30 conversion price), or 5.75 million aggregateshares of common stock, contingent upon certain events. The conversion rateadjusts for events related to Headwaters’ common stock, including common stockissued as a dividend, rights or warrants to purchase common stock issued to allholders of Headwaters’ common stock, and other similar rights or events thatapply 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 anif-converted basis (see Note 8). In January 2007, Headwaters announced that itwas planning an exchange offer for the 2.875% convertible senior subordinatednotes due 2016, whereby new notes with similar, but not identical, terms, alongwith an exchange fee, would be issued upon tender of the existing notes. Thecommencement of an exchange offer has been indefinitely postponed.

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2.50% ConvertibleSenior Subordinated Notes Due 2014 — In January 2007,Headwaters issued $160.0 million of 2.50% convertible senior subordinated notesdue February 2014, with interest payable semi-annually. These notes aresubordinate to the senior secured debt and rank equally with the 2.875%convertible senior subordinated notes due 2016 described above, and any futuresenior subordinated debt. Total offering costs, including underwritingdiscounts and commissions, were approximately $5.2 million. The conversion ratefor the notes is 33.9236 shares per $1,000 principal amount ($29.48 conversionprice), subject to adjustment. Upon conversion, Headwaters will pay cash up tothe principal amount of the notes, and shares of common stock to the extent theprice of Headwaters’ common stock exceeds the conversion price during a20-trading-day observation period. The conversion rate is adjusted for certaincorporate transactions 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 quarter commencing afterMarch 31, 2007, the closing price of Headwaters’ common stock exceeds $38.32per share for at least 20 trading days during a period of 30 consecutivetrading days ending on the last trading day of the preceding fiscal quarter; 2)during the five-business-day period after any ten-consecutive-trading-dayperiod, 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; or 3) upon the occurrence of specifiedcorporate transactions. The notes are convertible on or after December 1, 2013regardless of the foregoing circumstances. Headwaters may not redeem the notes.If Headwaters has a “fundamental change,” holders may require Headwaters torepurchase the notes at a price equal to the principal amount plus any accruedinterest. Headwaters filed a shelf registration statement with the SEC toregister resales of the notes and the common stock issuable upon conversion ofthe notes in April 2007, which registration statement was effective uponfiling.

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

Notes Payable to a Bank — The notespayable to a bank, which were collateralized by certain assets of a subsidiary,were repaid in their entirety during 2007.

Interest— During the three months ended March 31, 2006 and 2007, Headwaters incurredtotal interest costs of approximately $9.4 million and $9.9 million,respectively, including approximately $1.0 million and $2.6 million,respectively, of non-cash interest expense and approximately $0.2 million and$0.2 million, respectively, of interest costs that were capitalized. During thesix months ended March 31, 2006 and 2007, Headwaters incurred total interestcosts of approximately $19.4 million and $19.3 million, respectively, includingapproximately $1.6 million and $3.3 million, respectively, of non-cash interestexpense and approximately $0.3 million and $0.5 million, respectively, ofinterest costs that were capitalized.

Interest incomewas approximately $0.5 million and $0.6 million during the three months endedMarch 31, 2006 and 2007, respectively, and $1.4 million and $1.5 million duringthe six months ended March 31, 2006 and 2007, respectively. Theweighted-average interest rate on the face amount of outstanding long-termdebt, disregarding amortization of debt issue costs, was approximately 5.7% atSeptember 30, 2006 and 4.3% at March 31, 2007.

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

Headwaters’estimated effective income tax rate for the fiscal year ending September 30,2007, exclusive of discrete items, is 23.0%, which rate was applied to incomebefore income taxes for the six months ended March 31, 2007. Headwaters alsorecognized a net $1.2 million income tax benefit during the 2007 six-monthperiod for discrete items that did not affect the calculation of the estimatedeffective income tax rate for the fiscal year. The discrete items primarilyconsisted of additional tax credits for 2006 and changes in estimated taxliabilities and in reserves related to an IRS examination. The additional taxcredits for 2006 resulted from actual phase-out of Section 45K tax credits forcalendar 2006 being lower than previously estimated. After consideration of theeffect of the discrete items, income tax

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expense totaledapproximately 20.8% of income before income taxes for the six months endedMarch 31, 2007, compared to 28.0% for the six months ended March 31, 2006. Theincome tax rates for the three months ended March 31, 2006 and 2007 were 30.8%and 17.0%, respectively.

The effective taxrates for 2006 and 2007 are lower than statutory rates primarily due to taxcredits 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 9.

Headwaters’ 19%interest in the entity that owns and operates an alternative fuel facility wasacquired for payments totaling $15.5 million, of which $5.2 million remains tobe paid as of March 31, 2007. This obligation is recorded in other accruedliabilities in the consolidated balance sheet and bears interest at an 8% rate.Headwaters also agreed to make additional payments to the seller based on apro-rata allocation of the tax credits generated by the facility through December2007. These additional contractual payments are affected by phase-out and,along with the amortization of the $15.5 million investment, are recorded inother expense in the consolidated statements of income, totaling approximately$5.6 million and $6.7 million for the six months ended March 31, 2006 and 2007,respectively.

The alternative fuel produced at the facility through December 2007qualifies for tax credits and Headwaters is entitled to receive its pro-ratashare of such tax credits generated based upon its ownership percentage.Headwaters has the ability, under certain conditions, to limit its liabilityunder the fixed payment obligations currently totaling approximately $5.2million; therefore, Headwaters’ obligation to make all of the above-describedpayments is effectively limited by the tax benefits Headwaters receives.

As a result ofactual and projected oil prices for calendar 2007, there could be a partialphase-out of Section 45K tax credits for the calendar year. In calculating anincome tax provision for 2007, Headwaters used an estimated phase-outpercentage for Section 45K tax credits of 21% for calendar 2007. This estimatedphase-out percentage was derived by estimating the calendar 2007 referenceprice for oil using actual oil prices for January 2007 and published NYMEX oilprices for the months February through December 2007. The monthly NYMEX oilprices were reduced by approximately 10%, which reduction represents Headwaters’estimate of the relationship between NYMEX oil prices and the average U.S.wellhead oil prices actually used to calculate the annual reference price. Thereference price for calendar 2007 was calculated by averaging the 12 months’actual or estimated oil prices, which average was compared to the estimated phase-outrange for calendar 2007 of $56.16 to $70.50 to derive an estimated phase-outpercentage.

While the calendar2007 phase-out percentage can not be finalized at the current time, as of March31, 2007, the estimated phase-out percentage represents Headwaters’ bestestimate of what the phase-out percentage would be, using available informationas of that date. The effect on income taxes of any change in the calendar 2007phase-out percentage from 21% to the actual percentage for the year will berecorded to income tax expense in subsequent periods, when the calendar 2007actual oil prices and the phase-out range are known. Any such effect could bematerial to Headwaters’ 2007 and 2008 income tax expense.

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**8.****              Earnings perShare**

The followingtable sets forth the computation of basic and diluted EPS for the periodsindicated.

|                                                                                                                                 | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| **(in thousands, except per-share data)**                                                                   | ** ** | **2006**                                         | ** ** | **2007**                                       | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                                                                                                                      | ** ** | ** **                                       | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Numerator:**                                                                                                                  |       |                                             |       |                                           |       |   |   |   |   |
| Numerator for  basic earnings per share — net income                                                                       |       | $                                                | 18,401     |                                           | $          | 27,204 |   | $ | 46,696 |   | $ | 44,195 |   |
| Interest expense  related to convertible senior subordinated notes, net of taxes                                                |       | 1,042                                            |       | 1,122                                          |       | 2,130 |   | 2,254 |   |
| Numerator for  diluted earnings per share — net income plus interest expense related to  convertible notes, net of taxes   |       | $                                                | 19,443     |                                           | $          | 28,326 |   | $ | 48,826 |   | $ | 46,449 |   |
| ** **                                                                                                                      |       |                                             |       |                                           |       |   |   |   |   |
| **Denominator:**                                                                                                                |       |                                             |       |                                           |       |   |   |   |   |
| Denominator for  basic earnings per share — weighted-average shares outstanding                                            |       | 41,830                                           |       | 42,169                                         |       | 41,717 |   | 42,123 |   |
| Effect of  dilutive securities:                                                                                                 |       |                                             |       |                                           |       |   |   |   |   |
| Shares issuable upon exercise of options and SARs                                                                               |       | 1,354                                            |       | 487                                            |       | 1,313 |   | 517 |   |
| Shares issuable upon conversion of convertible notes                                                                            |       | 5,750                                            |       | 5,750                                          |       | 5,750 |   | 5,750 |   |
| Total potential  dilutive shares                                                                                                |       | 7,104                                            |       | 6,327                                          |       | 7,063 |   | 6,267 |   |
| Denominator for  diluted earnings per share — weighted-average shares outstanding after  assumed exercises and conversions |       | 48,934                                           |       | 48,406                                         |       | 48,780 |   | 48,390 |   |
| ** **                                                                                                                      |       |                                             |       |                                           |       |   |   |   |   |
| **Basic  earnings per share**                                                                                                   | ** ** | **$**                                            | **0.44**   | ** **                                     | **$**      | **0.65** | ** ** | **$** | **1.12** | ** ** | **$** | **1.05** | ** ** |
|                                                                                                                            |       |                                             |       |                                           |       |   |   |   |   |
| **Diluted  earnings per share**                                                                                                 | ** ** | **$**                                            | **0.40**   | ** **                                     | **$**      | **0.59** | ** ** | **$** | **1.00** | ** ** | **$** | **0.96** | ** ** |
| ** **                                                                                                                      | ** ** | ** **                                       | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Anti-dilutive  securities not considered in diluted EPS calculation:**                                                        | ** ** | ** **                                       | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options                                                                                                                   |       | 108                                              |       | 1,086                                          |       | 68 |   | 957 |   |
| SARs                                                                                                                            |       | 106                                              |       | 3,133                                          |       | 64 |   | 3,135 |   |

 

**9.****              Commitments andContingencies**

Significant new commitments and ongoing contingencies as ofMarch 31, 2007 not disclosed previously, are as follows.

Acquisitions — During fiscal 2006and 2007, Headwaters acquired certain assets and assumed certain liabilities ofseveral privately-held companies in the construction materials industry.Pursuant to contractual terms for some of the acquisitions, additional amountsmay be payable in the future, based on the achievement of stipulated revenue orearnings targets for periods ending no later than March 2010. If futureearn-out consideration is paid, goodwill will be increased accordingly.

Property, Plant andEquipment — As of March 31, 2007, Headwaters was committed tospend approximately $24.5 million on capital projects that were in variousstages of completion.

Joint Venture Obligations —Headwaters has entered into various joint ventures with Degussa AG, aninternational chemical company based in Germany. One of these joint venturespurchased a hydrogen peroxide business located in South Korea. Headwaters is aprincipal obligor with respect to all non-financial obligations of the jointventure and, with respect to financial obligations of the joint venture, 50% offuture plant expansion cost overruns, if any. Headwaters’ investments in itsjoint ventures with Degussa AG (in which Degussa and Headwaters have equalownership, voting

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rights and control) are accounted for using the equity method ofaccounting and total approximately $18.5 million as of March 31, 2007.

Headwaters owns a 51% interest in a joint venture with Great RiverEnergy, a Minnesota-based power generation and supply cooperative (“GRE”),which was formed to construct, own and operate an ethanol plant in North Dakota(“Blue Flint”). The plant, which commenced operations in February 2007, isexpected to produce more than 50 million gallons of ethanol annually. Costs toconstruct the ethanol plant and fund start-up costs and initial working capitalwere funded primarily by debt secured by all the assets of Blue Flint, alongwith capital contributions from Headwaters and GRE. Headwaters has made itsrequired capital contribution. The Blue Flint joint venture, which is not avariable interest entity, is being accounted for using the equity method ofaccounting because both partners have equal voting rights and control over thejoint venture. Headwaters’ investment in the Blue Flint joint venture isapproximately $8.6 million as of March 31, 2007.

Legal Matters —Headwaters has ongoing litigation and asserted claims which have been incurredduring the normal course of business, including the specific matters discussedbelow. Headwaters intends to vigorously defend or resolve these matters bysettlement, as appropriate. Management does not currently believe that theoutcome of these matters will have a material adverse effect on Headwaters’operations, cash flow or financial position.

Historically, costs paid to outside legal counsel for litigation havegenerally comprised a majority of Headwaters’ litigation-related costs. Duringthe six months ended March 31, 2007, Headwaters incurredapproximately $1.7 million of expense for legal matters, which consistedprimarily of costs for outside legal counsel. Headwaters currently believes therange of potential loss for all unresolved matters, excluding costs for outsidecounsel, is from $1.0 million up to the amounts sought by claimants and hasrecorded a total liability as of March 31, 2007 of $1.0 million. Claims anddamages 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 amounts accrued if one or more of the cases were to bedetermined adversely against Headwaters for a substantial amount of the damagesasserted. It is possible that a changein the estimates of probable liability could occur, and the changes could bematerial. Additionally, as with any litigation, these proceedings require thatHeadwaters incur substantial costs, including attorneys’ fees, managerial time,and other personnel resources and costs in pursuing resolution.

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

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

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order of dismissalwas affirmed on appeal. In the current action, the allegations arise from thesame facts, but the claims are asserted by certain purported stockholders ofAdtech. In June 2002, Headwaters received a summons and complaint from theUnited States District Court for the Western District of Tennessee alleging,among other things, fraud, conspiracy, constructive trust, conversion, patentinfringement and interference with contract arising out of the 1998 technologypurchase agreement entered into between Davidson and Adtech on the one hand,and Headwaters on the other. The plaintiffs seek declaratory relief andcompensatory damages in the approximate amount of between $15.0 million and$25.0 million and punitive damages. In February 2006, the District Courtdismissed all claims against Headwaters. Also in February 2006, plaintiffsfiled their notice of appeal to the United States Court of Appeals for theSixth Circuit. In June 2006, the appeal was transferred to the United StatesCourt 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 systemsmanufactured and sold by its subsidiaries for application by contractors onresidential and commercial buildings. Typically, litigation and these claimsare controlled by such subsidiaries’ insurance carriers. The plaintiffs orclaimants in these matters have alleged that the structures have suffereddamage from latent or progressive water penetration due to some alleged failureof the building product or wall system. Some claims involve alleged defectsassociated with components of an Exterior Insulating and Finish System (“EIFS”)which was produced for a limited time (through 1997) by Best Masonry & ToolSupply and Don’s Building Supply. There is a 10-year projected claim periodfollowing discontinuation of the product. Other claims involve allegedliabilities associated with certain stucco products which are still producedand sold by certain subsidiaries of HCM.

Typically, 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, claimsmade against such subsidiaries have been paid by their insurers, with theexception of minor deductibles, although such insurance carriers typically haveissued “reservation of rights” letters. None of the cases has gone to trial. While, to date, none of theseproceedings have required that HCM incur substantial costs, there is noguarantee of insurance coverage or continuing coverage. These and futureproceedings may result in substantial costs to HCM, including attorneys’ fees,managerial time and other personnel resources and costs. Adverse resolution ofthese proceedings could have a materially negative effect on HCM’s business,financial condition, and results of operation, and its ability to meet itsfinancial obligations. Although HCM carries general and product liabilityinsurance, HCM cannot assure that such insurance coverage will remainavailable, that HCM’s insurance carrier will remain viable, or that the insuredamounts will cover all future claims in excess of HCM’s uninsured retention.Future rate increases may also make such insurance uneconomical for HCM tomaintain. In addition, the insurance policies maintained by HCM exclude claimsfor damages resulting from exterior insulating finish systems, or EIFS, thathave 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 it owns an interest.From time to time, issues arise as to the availability of tax credits and, withthe increased price of oil, the phase-out of credits, including the followingitems.

*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

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calendar 2006, the reference price was $59.69 per barrel and thephase-out range began at $55.06 and would have fully phased out tax credits at$69.12 per barrel. Therefore, there was a partial phase-out of tax credits forcalendar 2006 of approximately 33%.

For calendar 2007, Headwaters estimates that the phase-out range(computed by increasing the 2006 inflation adjustment factor by 2%) begins at$56.16 and completes phase-out at $70.50 per barrel. As described in moredetail in Note 7, Headwaters estimated a phase-out percentage for Section 45Ktax credits for calendar 2007 of 21%, using available information as of March31, 2007. It is certain that the estimated phase-out percentage for calendar2007 will change during the year.

In an environment of high oil prices, the risk of phase-out increases.Headwaters’ customers and licensees make their own assessments of phase-outrisk. When customers and licensees have perceived a potential negativefinancial impact from phase-out, they have reduced or stopped synthetic fuelproduction or required Headwaters to share in the costs associated withphase-out. Headwaters makes similar assessments with respect to the continuedoperation of its own synthetic fuel production facilities. As of March 31,2007, all of Headwaters’ licensees are producing synthetic fuel, but mostlicensees 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 likelyhave a material 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 Headwatersduring fiscal 2006 and thus far in fiscal 2007 was negatively affected byreduced revenues being recognized for certain licensees whose licenseagreements call for Headwaters to be paid a portion of the tax credits earnedby the licensee. Due to uncertainties related to phase-out for calendar 2006 and2007 and other licensee-specific factors, revenue recognition was deferred forcertain licensees during fiscal 2006 and is also currently being deferred forcertain licensees in 2007. However, due to the recent publication of the 2006reference price and the phase-out range for the year, finalization of calendar2006 phase-out was made possible. Due to the availability of this informationand the clarification of other licensee-specific factors, certain calendar 2006and prior year license fee revenue totaling approximately $26.5 million wasrecognized during the quarter ended March 31, 2007. The amounts recognizedrelated to periods ending on or prior to December 31, 2006 and were recognizedat this time because they met the “fixed or determinable” recognition criterionand it is remote that any negative adjustment will be required in the future.As of March 31, 2007, most license fee revenue that has not been recognizedrelates to the quarter ended March 31, 2007. This unrecognized revenue, whichas of March 31, 2007 could total more than $12.0 million (calculated based onlicensee-reported data and assuming 21% phase-out of Section 45K tax creditsfor calendar 2007), will not be recognized until such time as the amountsbecome “fixed or determinable.”

*Legislation.*  By law, Section 45K tax credits for syntheticfuel produced from coal expire on December 31, 2007. In addition, there havebeen initiatives from time to time to consider the early repeal or modificationof Section 45K, including a bill introduced as recently as January 2007,and there may be additional initiatives introduced in Congress in calendar2007. When Section 45K expires on December 31, 2007 or if it is repealedor adversely modified, additional synthetic fuel facilities will probably eitherclose or substantially curtail production. Given current prices of coal and thecosts of synthetic fuel production, Headwaters does not believe that productionof synthetic fuel will be profitable absent the tax credits. In addition, ifHeadwaters’ licensees close their facilities or materially reduce productionactivities (whether after December 31, 2007, or upon earlier repeal or adversemodification of Section 45K, or for any other reason), it would have afurther material adverse effect on the revenue, net income and cash flow ofHeadwaters, in addition to the current material adverse effect caused byphase-out concerns.

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

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

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**ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL 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 2006 refer to ourfiscal quarter and/or six month period ended March 31, 2006 and references to2007 refer to our fiscal quarter and/or six month period ended March 31, 2007.Other references to years refer to our fiscal years, unless otherwise noted.

# **Overview**

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

We currently operate in two industries and report three business segments,the construction materials and CCPs segments in the building materialsindustry, and the alternative energy segment in the energy industry. In theconstruction materials segment, we design, manufacture, and sell architecturalstone and resin-based exterior siding accessories (such as shutters, mountingblocks, and vents) and related products. Revenues consist of sales to wholesaleand retail distributors, contractors and other users of building products. Weare also a nationwide leader in the management and marketing of CCPs. Revenuesin the CCP segment consist primarily of fly ash and other product sales. In thealternative energy segment, we are focused on reducing waste and increasing thevalue of energy feedstocks, primarily in the areas of low-value coal and oil.Revenue for the alternative energy segment consists primarily of sales ofchemical reagents and license fees.

*Operations and Strategy.* 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 segmentSection 45K (formerly Section 29) business. With the addition and expansion ofour CCP management and marketing business through acquisitions in 2002 and in2004, and the growth of our construction materials business, through severallarge and small acquisitions in 2004, 2006 and 2007, we have achieved revenuegrowth and diversification in 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 to reducedebt.

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, the phase-outof credits.

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

Our acquisitionstrategy targets businesses that are leading players in their respectiveindustries, 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 participate in a jointventure which operates an ethanol plant located in North Dakota, and we arealso investing in other alternative energy projects such as coal cleaning andthe use of nanocatalysts to engineer coal for emissions reduction and toenhance the refining of heavy crude oils into lighter transportation fuels.

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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 to continueour efforts to expand usage of high-value CCPs and develop uses for lower-valueCCPs, including the expanded use of CCPs in our construction materialsbusinesses and the industry in general.

In fiscal 2005 and 2006, we focused on the integration of our large2004 acquisitions, including the marketing of diverse construction materialsproducts through our national distribution network. We became highly leveragedas a result of those acquisitions, but have reduced our outstanding debt sincethat time 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.

**ThreeMonths Ended March 31, 2007 Compared to Three Months Ended March 31, 2006**

Theinformation set forth below compares our operating results for the quarterended March 31, 2007 (“2007”) with operating results for the quarter endedMarch 31, 2006 (“2006”).

*Revenue*. Total revenue for 2007 increased by $4.4 million or 2% to $274.1 millionas compared to $269.7 million for 2006. The major components of revenue arediscussed in the sections below.

*ConstructionMaterials Segment*.  Sales of construction materials during 2007were $115.5 million with a corresponding direct cost of $87.2 million. Sales ofconstruction materials during 2006 were $131.7 million with a correspondingdirect cost of $91.2 million. The decrease in sales of construction materialsduring 2007 was due primarily to the effects of a depressed residential housingand remodeling market which impacted sales across most of our product lines.The housing market slowdown also was the primary reason for the decline in grossmargin percentage from 2006 to 2007. Because a substantial amount of our revenues in this segment aredependent on the housing market, we anticipate similar impact in future periodsuntil the cycle reverses.

*CCPSegment*.  CCP revenues for 2007 were $62.1 million witha corresponding direct cost of $46.8 million. CCP revenues for 2006 were $58.5million with a corresponding direct cost of $46.3 million. The increase in CCPrevenues and in the gross margin percentage during 2007 were due primarily to acombination of continued strong demand for CCPs and upward pricing trends inmost concrete markets. The growth in demand for CCPs is due in part to certainregional shortages of portland cement for which CCPs are a substitute, whichcan result in an increased percentage of CCPs being used in concrete. Thecement shortages also resulted in 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 of Chemical Reagents*. Chemical reagent sales during 2007 were $46.0 million with acorresponding direct cost of $37.3 million. Chemical reagent sales during 2006were $49.9 million with a corresponding direct cost of $37.7 million. Chemicalreagent sales in 2007 were lower than in 2006 primarily due to reducedsynthetic fuel production by two of our licensees. It is not possible topredict the trend for sales of chemical reagents in future periods becausesynfuel production by our licensees and other customers is subject to decisionsbased on future oil prices. The gross margin percentage for 2007 of 19% waslower than the 2006 gross margin percentage of 24% due primarily to increasesin the cost of product, which in turn was related to increases in the costs ofpetroleum-based materials. Subject to crude oil prices and other factors, wecurrently believe reagent margins in fiscal 2007 will be in the 17% range.

*LicenseFees*.  During 2007, werecognized license fee revenue totaling $42.2 million, an increase of $25.9million from $16.3 million of license fee revenue recognized during 2006.Certain accounting rules limit revenue recognition to amounts that are “fixedor determinable.” The amount of license fee revenue recognized in 2006 and 2007was negatively affected by reduced revenues being recognized for certainlicensees whose license agreements call for us to be paid a portion of the taxcredits earned by the licensee. Due to uncertainties related to phase-out forcalendar 2006 and 2007 and other licensee-specific factors, revenue recognitionwas deferred for certain licensees during 2006 and is also currently beingdeferred for certain licensees in fiscal 2007. However, due to the recentpublication of the 2006 reference price and the phase-out range for the year,finalization of calendar 2006 phase-out was made possible. Due to theavailability of this information and the clarification of otherlicensee-specific factors, certain calendar 2006 and prior year license fee revenuetotaling approximately $26.5 million was recognized during 2007. The amountsrecognized related to periods ending on or prior to December 31, 2006 and wererecognized at this time because they met the “fixed or determinable”recognition criterion and it is remote that any negative adjustment will berequired in the future. As of March 31, 2007, most license fee revenue that hasnot been recognized relates to the quarter ended March 31, 2007. Thisunrecognized revenue, which as of March 31, 2007

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could total more than$12.0 million (calculated based on licensee-reported data and assuming 21%phase-out of Section 45K tax credits for calendar 2007), will not be recognizeduntil such time as the amounts become “fixed or determinable.” Reference ismade to our policy disclosures contained in Note 2 to the consolidatedfinancial statements and in “*Management’s Discussionand Analysis*” in our Form 10-K, as well as information in Note 9 tothe consolidated financial statements in this Form 10-Q and in the overviewabove.

*OtherAlternative Energy Segment Revenues.* The majority ofother alternative energy segment revenue is comprised of sales of syntheticfuel, which during 2007 were $6.6 million with a corresponding direct cost of$7.4 million. Sales of synthetic fuel during 2006 were $11.8 million with acorresponding direct cost of $13.8 million. The decrease in sales of syntheticfuel from 2006 to 2007 was due primarily to marketing constraints and highinventory levels at December 31, 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.

*Amortizationand Research and Development Expenses*.  The change inamortization expense ($0.3 million) from 2006 to 2007 was not material.Research and development expense increased by $2.0 million from 2006 to 2007primarily because of increased spending in our joint research efforts withDegussa related to hydrogen peroxide (see Note 9) and in developmental effortsrelated to our nanotechnologies.

*Selling,General and Administrative Expenses*.  Theseexpenses increased $5.5 million, or 17% to $37.8 million for 2007 from $32.3million for 2006. The increase in 2007 was due primarily to a $3.0 millionincrease in litigation-related costs, $1.6 million of increased payroll costs,and $0.8 million of increased incentive pay. The increase in litigation costswas due to a net credit recorded in 2006 because of positive developments incertain legal matters. Those developments resulted in reduced likelihood ofultimate legal liability and the reversal of previously expensed litigationcosts. A majority of the increase in payroll costs relates to growthinitiatives at the operating business unit level, and the increased incentivepay relates to improved overall operating results in 2007 as compared to 2006.

*OtherIncome and Expense*. During 2007, we reported net other expense of $12.7 million compared tonet other expense of $11.1 million during 2006. The change of $1.6 million wasattributable to an increase in net interest expense of $0.4 million and anincrease in other expenses of $1.2 million. Net interest expense increased from$8.7 million in 2006 to $9.1 million in 2007, due primarily to $2.0 million ofaccelerated amortization of debt issue costs related to early repayments ofhigher-rate senior debt, largely offset by the lower interest rate (2.50%) onthe $160.0 million of convertible senior subordinated notes issued in January2007, the proceeds of which were used primarily to make the early senior debtrepayments.

The increase in otherexpenses of $1.2 million consisted primarily of an increase in costs related toour investment in the coal-based solid alternative fuel production facility describedin Note 7 to the consolidated financial statements.

*Income Tax Provision*.  Our estimated effective income tax rate forthe fiscal year ending September 30, 2007 is 23.0%, which rate was applied toincome before income taxes for the six months ended March 31, 2007. We alsorecognized a net $2.2 million income tax benefit in 2007 for discrete itemsthat did not affect the calculation of the estimated effective income tax ratefor the fiscal year. The discrete items primarily consisted of additional taxcredits for fiscal 2006 resulting from actual phase-out of Section 45K taxcredits for calendar 2006 being lower than previously estimated. Afterconsideration of the effect of the discrete items, income tax expense totaledapproximately 17.0% of income before income taxes in 2007, compared to 30.8% in2006. The effective tax rates for 2006 and 2007 are lower than statutory ratesprimarily due to tax credits related to the alternative fuel facilities that weown or have an interest in, all as described in Note 7 to the consolidatedfinancial statements. Excluding the effect of the tax credits, our estimatedeffective tax rate for 2007 would be approximately 38%.

Also as describedin Notes 7 and 9 to the consolidated financial statements, while we have estimateda phase-out percentage for Section 45K tax credits for calendar 2007 usingavailable information as of March 31, 2007, it is certain that our estimatedphase-out percentage will change during the year. The effect on income taxes ofchanges in the estimated phase-out percentage for calendar 2007 will berecorded to income tax expense in subsequent periods, when the calendar 2007actual oil prices are known. Any such effect could be material to our 2007 and2008 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.

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**SixMonths Ended March 31, 2007 Compared to Six Months Ended March 31, 2006**

Theinformation set forth below compares our operating results for the six monthsended March 31, 2007 (“2007”) with operating results for the six months endedMarch 31, 2006 (“2006”).

*Revenue*. Total revenue for 2007 decreased by $1.2 million or less than 1% to$549.0 million as compared to $550.2 million for 2006. The major components ofrevenue are discussed in the sections below.

*ConstructionMaterials Segment*.  Sales of construction materials during 2007were $238.3 million with a corresponding direct cost of $177.7 million. Salesof construction materials during 2006 were $261.7 million with a correspondingdirect cost of $180.9 million. The decrease in sales of construction materialsduring 2007 was due primarily to the effects of a depressed residential housingand remodeling market which impacted sales across most of our product lines.The housing market slowdown also was the primary reason for the decline ingross margin percentage from 2006 to 2007.

*CCP Segment*.  CCP revenues for 2007 were $131.3 millionwith a corresponding direct cost of $96.2 million. CCP revenues for 2006 were$123.7 million with a corresponding direct cost of $95.3 million. The increasein CCP revenues and in the gross margin percentage during 2007 were dueprimarily to a combination of continued strong demand for CCPs and upwardpricing trends in most concrete markets. In addition, weather conditions in thesouth central region of the United States have generally been favorable in2007. The growth in demand for CCPs is due in part to certain regionalshortages of portland cement for which CCPs are a substitute. The cementshortages also resulted in 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 of Chemical Reagents*. Chemical reagent sales during 2007 were $90.5 million with acorresponding direct cost of $72.8 million. Chemical reagent sales during 2006were $94.4 million with a corresponding direct cost of $71.1 million. Chemicalreagent sales in 2007 were lower than in 2006 primarily due to reducedsynthetic fuel production by two of our licensees. The gross margin percentagefor 2007 of 20% was lower than the 2006 gross margin percentage of 25% dueprimarily to increases in the cost of product, which in turn was related toincreases in the costs of petroleum-based materials.

*LicenseFees*.  During 2007, werecognized license fee revenue totaling $64.5 million, an increase of $20.0million from $44.5 million of license fee revenue recognized during 2006. Theamount of license fee revenue recognized in 2006 and 2007 was negativelyaffected by reduced revenues being recognized for certain licensees whoselicense agreements call for us to be paid a portion of the tax credits earnedby the licensee. Due to uncertainties related to phase-out for calendar 2006and 2007 and other licensee-specific factors, revenue recognition was deferredfor certain licensees during 2006 and is also currently being deferred forcertain licensees in fiscal 2007. However, due to the recent publication of the2006 reference price and the phase-out range for the year, finalization ofcalendar 2006 phase-out was made possible. Due to the availability of thisinformation and the clarification of other licensee-specific factors, certainprior period license fee revenue totaling approximately $26.5 million wasrecognized during 2007. The amounts recognized related to periods ending on orprior to December 31, 2006 and were recognized at this time because they metthe “fixed or determinable” recognition criterion and it is remote that anynegative adjustment will be required in the future. Partially offsetting the$26.5 million increase in license fee revenue was a $4.5 million reduction inlicense fees in 2007 related to one of our licensees for which we are currentlydeferring revenue. The license fees from this licensee were not deferred in2006.

*OtherAlternative Energy Segment Revenues.* The majority of other alternative energysegment revenue is comprised of sales of synthetic fuel, which during 2007 were$21.5 million with a corresponding direct cost of $24.7 million. Sales ofsynthetic fuel during 2006 were $23.3 million with a corresponding direct costof $27.0 million. The decrease in sales of synthetic fuel from 2006 to 2007 wasdue primarily to marketing constraints. 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.

*Amortizationand Research and Development Expenses*.  The change inamortization expense ($0.5 million) from 2006 to 2007 was not material.Research and development expense increased by $2.8 million from 2006 to 2007primarily because of increased spending in our joint research efforts withDegussa related to hydrogen peroxide and in developmental efforts related toour nanotechnologies.

*Selling,General and Administrative Expenses*.  Theseexpenses increased $7.0 million, or 10% to $74.3 million for 2007 from $67.3million for 2006. The increase in 2007 was due primarily to a $2.7 millionincrease in litigation-related costs, $3.4 million of increased payroll costs,and $0.9 million of long-term incentive pay expensed in 2007. The increase inlitigation costs was due to a net credit recorded in 2006 because of positivedevelopments in certain legal matters. Those

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developments resulted in reduced likelihood ofultimate legal liability and the reversal of previously expensed litigationcosts. A majority of the increase in payroll costs relates to growthinitiatives at the operating business unit level, and the increased long-termincentive pay relates to improved performance at certain operating businessunits.

*OtherIncome and Expense*.  During 2007, we reported net other expense of$23.5 million compared to net other expense of $23.2 million during 2006. Thechange of $0.3 million was attributable to a decrease in net interest expenseof $0.4 million and an increase in other expenses of $0.7 million. Net interestexpense decreased from $17.7 million in 2006 to $17.3 million in 2007, dueprimarily to the lower interest rate (2.50%) on the $160.0 million ofconvertible senior subordinated notes issued in January 2007, and lower averagelevels of long-term debt in 2007 as compared to 2006. The decrease in interestexpense caused by those factors was largely offset by $2.0 million of acceleratedamortization of debt issue costs related to early repayments of senior debt in2007, which early repayments were funded primarily by net proceeds from the newlower-rate convertible notes.

The increase in otherexpenses of $0.7 million consisted primarily of an increase in costs related toour investment in the coal-based solid alternative fuel production facilitydescribed in Note 7 to the consolidated financial statements.

*Income Tax Provision*.  Our estimated effective income tax rate forthe fiscal year ending September 30, 2007 is 23.0%, which rate was applied toincome before income taxes for the six months ended March 31, 2007. We alsorecognized a net $1.2 million income tax benefit in 2007 for discrete itemsthat did not affect the calculation of the estimated effective income tax ratefor the fiscal year. The discrete items primarily consisted of additional taxcredits for fiscal 2006 and changes in estimated tax liabilities and inreserves related to an IRS examination. The additional tax credits for fiscal2006 resulted from actual phase-out of Section 45K tax credits for calendar2006 being lower than previously estimated. After consideration of the effectof the discrete items, income tax expense totaled approximately 20.8% of incomebefore income taxes for 2007, compared to 28.0% for 2006. The effective taxrates for 2006 and 2007 are lower than statutory rates primarily due to taxcredits related to the alternative fuel facilities that we own or have aninterest in, all as described in Note 7 to the consolidated financialstatements.

**Impact of Inflation and Related Matters**

Ouroperations have been impacted by i) rising costs for chemical reagents in thealternative energy segment; ii) increased cement, polypropylene and poly-vinylchloride costs in the construction materials segment; iii) increased fuel coststhat have affected transportation costs in most of our business units; and iv)certain regional shortages of cement and aggregate materials. The increasedcosts of chemical reagents, polypropylene, poly-vinyl chloride and fuel aredirectly related to the increase in prices of natural gas, oil and otherpetroleum-based materials. The increased costs of cement are caused primarilyby a lack of adequate supplies in some regions of the U.S.

We havebeen successful in passing on some, but not all, of the increased material andtransportation costs to customers. It is not possible to predict the futuretrend of material and transportation costs, nor our ability to pass on anyfuture price increases to customers. It is also not possible to predict theimpact of potential future cement supply shortages on our ability to procureneeded supplies in our construction materials business.

**Liquidity and Capital Resources**

*Summaryof Cash Flow Activities*.  Net cash provided by operatingactivities during the six months ended March 31, 2007 (“2007”) was $42.0million compared to $135.2 million during the six months ended March 31, 2006 (“2006”).The primary reason for the change in cash provided by operations from 2006 to2007 was the collection in 2006 of a $70.0 million receivable related to thelitigation settlement reached with AJG in 2005. In 2007, the primary investingactivities consisted of payments for an acquisition and the purchase ofproperty, plant and equipment. 2007 financing activities consisted primarily ofthe issuance of a new series of convertible senior subordinated notes and theearly repayment of a portion of our senior debt. In 2006, the primary investingactivity consisted of the purchase of property, plant and equipment and theprimary financing activity consisted of repayments of long-term debt. Moredetails about our investing and financing activities are provided in thefollowing paragraphs.

*Investing Activities*.  Total expenditures for property, plant andequipment in 2007 were not materially different from 2006. Most of the capitalexpenditures in both periods were incurred by the construction materialssegment; however, in 2007, a higher proportion of total capital expenditureswere incurred by the alternative energy segment as compared to 2006. Asignificant portion of our planned future capital expenditures representexpansion of operations, rather than maintenance of operating capacity. Capitalexpenditures in fiscal 2007 are currently expected to exceed the fiscal 2006amount, primarily due to growth initiatives in the alternative energy segment.Capital expenditures are limited by our senior debt covenants to $100.0 millionannually; however, the cumulative unused amounts of annual capital expenditureslimits can be carried forward and used in subsequent years. As of September 30,2006, we had approximately $25.4 million of unused amounts of capital

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expenditures from prioryears and as of March 31, 2007, we were committed to spend approximately $24.5million on capital projects that were in various stages of completion,primarily in the alternative energy segment.

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, includingthose in the areas of construction materials, CCP marketing, and coal andcatalyst technologies. It is possible that some portion of future cash and cashequivalents and/or proceeds from the issuance of stock or debt will be used tofund acquisitions of complementary businesses in the chemical, energy, buildingproducts and related industries. The senior secured credit agreement limitsacquisitions in the aggregate to $50.0 million of cash consideration and $20.0million of non-cash consideration annually, with no more than $30.0 million ofcash consideration for any one acquisition, unless our “total leverage ratio,”as defined, is less than or equal to 3.50:1.0, after giving effect to anacquisition, in which case the foregoing limitations do not apply. The seniorsecured credit agreement also limits the amount we can invest in joint venturesand other less than 100%-owned entities.

In2007, 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 ending September30, 2007. During fiscal 2006, we acquired certain assets and assumed certainliabilities of several privately-held companies in the construction materialsindustry. 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.

Referenceis made to Note 9 to the consolidated financial statements for a discussion ofour investments in joint ventures which are accounted for using the equitymethod of accounting.

*FinancingActivities*.  In 2006,financing activities consisted primarily of the repayment of long-term debt. In2007, as described in more detail in Note 6 to the consolidated financialstatements, we issued $160.0 million of 2.50% convertible senior subordinatednotes due February 2014. Substantially all of the net proceeds of approximately$154.8 million, along with $5.0 million of available cash, were used to repay$152.8 million of senior debt and the remaining balance (approximately $7.0million) of notes payable to a bank. We may, in the future, make optionalprepayments of the senior debt depending on actual cash flows, our current andexpected cash requirements and other applicable factors we deem to be  significant.

Dueto covenants associated with our senior debt, we currently have limitations onour ability to obtain significant additional amounts of long-term debt.However, we have historically experienced strong positive cash flow fromoperations and in fiscal 2005 issued common stock which together has enabled usto repay a substantial amount of our long-term debt prior to scheduledmaturities. We expect our positive cash flow to continue in the future and alsohave the ability to access the equity markets if necessary.

InJanuary 2007, we announced that we were planning an exchange offer for our2.875% convertible senior subordinated notes due 2016, whereby new notes withsimilar, but not identical, terms, along with an exchange fee, would be issuedupon tender of the existing notes. The commencement of an exchange offer hasbeen indefinitely postponed.

Reference is madeto Note 6 to the consolidated financial statements for detailed informationabout our outstanding long-term debt, interest rate hedges, and compliance withdebt covenants, as well as the available $60.0 million revolving creditarrangement. Subject to obtaining additional revolving loan commitments, we canincrease the revolving credit limit to $100.0 million. The senior creditfacility contains restrictions and covenants common to such agreements,including limitations on the incurrence of additional debt, investments, mergerand acquisition activity, asset sales and liens, annual capital expenditures inexcess of $100.0 million annually, and the payment of dividends, among others.In addition, we must maintain certain leverage and fixed charge coverageratios. We are in compliance with all debt covenants as of March 31, 2007.

In2007, cash proceeds from the exercise of options and employee stock purchasestotaled $1.6 million, compared to $6.4 million in 2006. 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 notmaterial in 2006 or 2007.

*WorkingCapital*.  As of March 31, 2007, our working capital was$125.2 million. We expect operations to produce positive cash flow in futureperiods and believe working capital, along with available borrowings under therevolving credit arrangement, will be sufficient for operating needs for thenext 12 months.

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*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 ofour operations 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 7 and 9 to the consolidated financialstatements). The calendar 2007 phase-out percentage is subject to materialchange because it is dependent on oil prices for all of calendar 2007, whichare not predictable.

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 not material in 2007. Optionexercise activity is primarily dependent on our stock price and is notpredictable. Likewise, it is not possible to estimate what tax benefits may berealized from future option exercises.

*Summaryof Future Cash Requirements*. Significant future cash uses, in addition to operational working capitalrequirements, including income tax payments, are currently expected to consistprimarily of capital expenditures, acquisitions and investments in jointventures, and debt service payments on outstanding long-term debt.

**LegalMatters**

We have ongoing litigation and asserted claims whichhave been incurred during the normal course of business. Reference is made toNote 9 to the consolidated financial statements for a description of ouraccounting for legal costs and other information about legal matters.

**Recent Accounting Pronouncements**

Referenceis made to Note 1 to the consolidated financial statements for a discussion ofaccounting pronouncements that have been recently issued which we have not yetadopted.

**ITEM 3.**                    QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

As described inmore detail in Note 6 to the consolidated financial statements, our seniordebt, totaling $262.5 million as of March 31, 2007, bears interest at avariable-rate. As required by the senior secured credit facility, we enteredinto agreements to limit our variable interest rate exposure. The agreements effectivelyfix the LIBOR rate at 3.71% for $150.0 million of this debt through September8, 2007. We account for these agreements as cash flow hedges, with their fairmarket value reflected in the consolidated balance sheet as either other assetsor other liabilities. The market value of these hedges (and various other cashflow hedges to which we are a direct or indirect party) at March 31, 2007 wasnot material. Total comprehensive income, considering all cash flow hedgeagreements to which we are a party, was not materially different from netincome for either 2006 or 2007.

Considering ourcurrent balance of variable-rate debt (reduced by the $150.0 million of seniordebt that effectively has a fixed interest rate until September 8, 2007), achange in the interest rate of 1% would change our interest expense byapproximately $2.0 million during the 12 months ending March 31, 2008.

**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 the ExchangeAct is accumulated and communicated to our management, including the ChiefExecutive Officer (“CEO”) and the Chief Financial Officer (“CFO”), to allowtimely decisions regarding required disclosure.

Our management evaluated,with the participation of our CEO and CFO, the effectiveness of our disclosurecontrols and procedures as of March 31, 2007, pursuant to paragraph (b) ofRules 13a-15 and 15d-15 under the Exchange Act. This

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evaluationincluded a review of the controls’ objectives and design, the operation of thecontrols, and the effect of the controls on the information presented in thisQuarterly Report. Our management, including the CEO and CFO, do not expect thatdisclosure controls can or will prevent or detect all errors and all fraud, if any.A control system, no matter how well designed and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. Our disclosure controls and procedures are designed to provide suchreasonable assurance of achieving their objectives. Also, the projection of anyevaluation of the disclosure controls and procedures to future periods issubject to the risk that the disclosure controls and procedures may becomeinadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate.

Based on their review and evaluation, and subject to the inherentlimitations described above, our CEO and CFO have concluded that our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theExchange Act) were effective as of March 31, 2007 at the above-describedreasonable assurance level.

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

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

Therehas been no change in our internal control over financial reporting during thequarter ended March 31, 2007 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

**PART II — OTHERINFORMATION**

**ITEM 1.**                 LEGAL PROCEEDINGS

See “*Legal Matters”*in Note9 to the consolidated financial statements for a description of current legalproceedings.

**ITEM 1A.**        RISK FACTORS

Risksrelating to our business and common stock are described in Item 1A of our Form10-K and in Item 1A of our December 2006 Form 10-Q.

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

None.

**ITEM 3.**                    DEFAULTS UPONSENIOR SECURITIES

None.

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

On February 27, 2007, we held our 2007 AnnualMeeting of Stockholders for the following purposes:

1.                                       Toelect three Class I directors to serve until the 2010 annual meeting, oruntil their successors are duly elected and qualified; and

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2.                                       Toratify the selection by the Board of Directors of Ernst &Young LLP as independent auditors of Headwaters for the fiscal year endingSeptember 30, 2007.

A total of 36,182,567 shares were voted. Bothproposals were approved by the stockholders. The results of voting were asfollows:

1.                                       Toelect Mr. R Sam Christensen as a Class I director: for — 35,887,539;withheld authority — 295,028.

Toelect Mr. William S. Dickinson as a Class I director: for — 35,878,818;withheld authority — 303,749.

To elect Mr. MalynK. Malquist as a Class I director: for — 35,882,064; withheld authority —300,503.

2.                                       Toratify the selection of Ernst & Young LLP as independent auditorsfor the fiscal year ending September 30, 2007: for — 35,993,746; against —126,399; abstain — 62,422.

**ITEM 5.**                    OTHERINFORMATION

None.

**ITEM 6.**                    EXHIBITS

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

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*              Filed herewith.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has duly causedthis report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                         | HEADWATERS INCORPORATED |                                       |
|-------------------------|-------------------------|--------------------------------------------|
|                    |                    |                                       |
| Date:  May 2, 2007 | By:                     | /s/ Kirk A. Benson                         |   |   |   |
|                    |                    | Kirk A. Benson, Chief Executive Officer    |   |
|                    |                    | (Principal Executive Officer)              |   |
|                    |                    |                                       |
| Date:  May 2, 2007 | By:                     | /s/ Scott K. Sorensen                      |   |   |   |
|                    |                    | Scott K. Sorensen, Chief Financial Officer |   |
|                    |                    | (Principal Financial Officer)              |   |

 

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