UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-K

        [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
            EXCHANGE ACT OF 1934

                  For the fiscal year ended September 30, 2004,

                                       or

        [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
            EXCHANGE ACT OF 1934

                  For the transition period from _____ to _____

                         Commission file number 0-27808

                             HEADWATERS INCORPORATED
              -----------------------------------------------------
             (Exact name of registrant as specified in its charter)

             Delaware                                     87-0547337
---------------------------------           ------------------------------------
  (State or other jurisdiction              (I.R.S. Employer Identification No.)
of incorporation or organization)

     10653 South River Front Parkway, Suite 300
                 South Jordan, Utah                         84095
     ------------------------------------------           ----------
      (Address of principal executive offices)            (Zip Code)

                                 (801) 984-9400
               ---------------------------------------------------
              (Registrant's telephone number, including area code)

           Securities registered pursuant to Section 12(b) of the Act:
           -----------------------------------------------------------
                                      None

           Securities registered pursuant to Section 12(g) of the Act:
           -----------------------------------------------------------
                          Common Stock, $.001 par value

         Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

         Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]

         Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes [X] No [ ]

         The aggregate market value of the voting stock held by non-affiliates
of the registrant as of March 31, 2004 was $829,944,861, based upon the closing
price on the Nasdaq National Market reported for such date. This calculation
does not reflect a determination that persons whose shares are excluded from the
computation are affiliates for any other purpose.

         The number of shares outstanding of the registrant's common stock as of
November 30, 2004 was 33,905,043.
                           ___________________________

<PAGE>

                       DOCUMENTS INCORPORATED BY REFERENCE


         Portions of the registrant's definitive proxy statement to be issued in
connection with registrant's annual stockholders' meeting to be held in 2005 are
incorporated by reference into Part III of this report on Form 10-K.

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                                TABLE OF CONTENTS
                                                                            Page
PART I

ITEM 1.    BUSINESS..........................................................  4
ITEM 2.    PROPERTIES........................................................ 21
ITEM 3.    LEGAL PROCEEDINGS................................................. 21
ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............... 23

PART II

ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
             MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES............... 23
ITEM 6.    SELECTED FINANCIAL DATA........................................... 24
ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
             AND RESULTS OF OPERATIONS....................................... 25
ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........ 49
ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................... 50
ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
             AND FINANCIAL DISCLOSURE........................................ 50
ITEM 9A.   CONTROLS AND PROCEDURES........................................... 50
ITEM 9B.   OTHER INFORMATION................................................. 51

PART III

ITEM 10.   DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................ 51
ITEM 11.   EXECUTIVE COMPENSATION............................................ 51
ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.... 51
ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................... 51
ITEM 14.   PRINCIPAL ACCOUNTING FEES AND SERVICES............................ 51

PART IV

ITEM 15.   EXHIBITS, FINANCIAL STATEMENT SCHEDULES........................... 52

SIGNATURES................................................................... 55


Forward-looking Statements

This Annual Report on Form 10-K, contains forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995 regarding future
events and Headwaters' future results that are based on current expectations,
estimates, forecasts, and projections about the industries in which Headwaters
operates and the beliefs and assumptions of its management. Actual results may
vary materially from such expectations. Words such as "expects," "anticipates,"
"targets," "goals," "projects," "believes," "seeks," "estimates," variations of
such words and similar expressions are intended to identify such forward-looking
statements. In addition, any statements that refer to projections of Headwaters'
future financial performance, its anticipated growth and trends in its
businesses, and other characterizations of future events or circumstances, are
forward-looking. For a discussion of the factors that could cause actual results
to differ from expectations, please see the caption entitled "Risk Factors" in
Item 7 hereof. There can be no assurance that Headwaters' results of operations
will not be adversely affected by such factors. Unless legally required,
Headwaters undertakes no obligation to revise or update any forward-looking
statements for any reason. Readers are cautioned not to place undue reliance on
these forward-looking statements, which speak only as of the date of this
report.

Headwaters' Internet address is www.headwaters.com. There Headwaters makes
available, free of charge, its annual report on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K and any amendments to those reports, as
soon as reasonably practicable after Headwaters electronically files such
material with, or furnish it to, the Securities and Exchange Commission ("SEC").
Headwaters' reports can be accessed through the investor relations section of
its web site. The information found on Headwaters' web site is not part of this
or any report it files with or furnishes to the SEC.

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                                     PART I

ITEM 1. BUSINESS

General Development of Business

         Introduction. Headwaters is a diversified growth company providing
products, technologies and services to the energy, construction and home
improvement industries. Headwaters has grown dramatically over the last several
years, both organically and through strategic acquisitions that have allowed it
to diversify and pursue other growth opportunities. Headwaters' revenues have
grown from $27.9 million in 2000 to $892.1 million for the fiscal year ended
September 30, 2004 on a pro forma basis as if all 2004 acquisitions had occurred
as of October 1, 2003. Headwaters' acquisition strategy has concentrated on
opportunities that complement existing business lines, command leading market
positions, are accretive to earnings and generate significant positive cash
flow.

         Headwaters conducts its business primarily through the following
business units:

         Headwaters Energy Services (formerly known as Covol Fuels) is the
market leader in enhancing the value of coal used in power generation through
licensing proprietary technologies and selling chemical reagents that convert
coal into a solid alternative fuel.

         Headwaters Resources (formerly known as ISG) is the largest manager and
marketer of coal combustion products ("CCPs") in the United States. Headwaters
Resources creates commercial value for CCPs using CCPs primarily as a
replacement for portland cement in a variety of concrete products. CCPs, such as
fly ash and bottom ash, are created when coal is burned and have traditionally
been an environmental and economic burden for coal-fueled power generators but,
when properly managed, can result in additional revenue for the utilities.

         Headwaters Technology Innovation Group, known as HTI, develops and
commercializes proprietary technologies to convert or upgrade fossil fuels into
higher-value products and develops nanocatalyst technologies that have multiple
industrial and chemical applications. The energy-related technologies developed
or under development include direct coal liquefaction, the conversion of
gas-to-liquid fuels and the upgrading of heavy oil to lighter materials. HTI has
also developed a proprietary nanocatalyst technology that will allow for the
custom design of catalysts on an atomic scale for multiple industrial
applications, which should reduce costs and increase the efficiency of chemical
reactions.

         Headwaters Construction Materials (formerly known as American
Construction Materials) is a market leader in designing, manufacturing and
marketing architectural stone products under the Eldorado Stone brand acquired
in June 2004 and also holds regional market leadership positions in
manufacturing and marketing concrete blocks, mortar and stucco materials. In
September 2004, Headwaters acquired Tapco Holdings, Inc. ("Tapco"), a leading
manufacturer of building products accessories (such as window shutters, gable
vents and mounting blocks) and professional tools used in exterior residential
remodeling and construction. The acquisitions of the Tapco and Eldorado Stone
businesses in 2004 have significantly transformed the Headwaters Construction
Materials business unit and given Headwaters a national presence in the
commercial and residential improvement market.

         Headwaters' Company History. Headwaters was incorporated in Delaware in
1995 under the name Covol Technologies, Inc. In September 2000, its name was
changed to Headwaters Incorporated. Headwaters' stock trades under the Nasdaq
symbol "HDWR".

         As used herein, "Headwaters," "combined company," "we," "our" and "us"
refer to Headwaters Incorporated and its consolidated subsidiaries, including
Headwaters Energy Services Corp. and its subsidiaries and affiliates; Headwaters
Resources, Inc. and its subsidiaries; Headwaters Technology Innovation Group,
Inc. and its subsidiaries and affiliates; and Headwaters Construction Materials,
Inc. and its subsidiaries and affiliates, including Eldorado Stone LLC and Tapco
Holdings, Inc., unless the context otherwise requires. As used in this report,
"HES" refers to Headwaters Energy Services Corp., together with its consolidated
subsidiaries and affiliates; "HRI" refers to Headwaters Resources, Inc. and its
consolidated subsidiaries; "HTI" refers to Headwaters Technology Innovation
Group, Inc., together with its consolidated subsidiaries and affiliates; and
"HCM" refers to Headwaters Construction Materials, Inc., together with its
consolidated subsidiaries and affiliates, including "Eldorado", which refers to
HCM Stone, LLC and Eldorado Stone LLC and all of their subsidiaries; and
"Tapco," which refers to Tapco Holdings, Inc., and its subsidiaries, unless the
context otherwise requires.

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Headwaters Energy Services

         Principal Products and their Markets. Headwaters Energy Services Corp.,
together with its subsidiaries and affiliates (collectively "HES"), develops and
commercializes technologies that interact with coal-based feedstocks to produce
a solid alternative fuel intended to be eligible for Section 29 tax credits. The
sale of qualified alternative fuel enables facility owners who comply with
certain statutory and regulatory requirements to claim federal tax credits under
Section 29, which currently expires on December 31, 2007. Headwaters has
licensed this technology to owners of solid alternative fuel facilities for
which it receives royalty revenues. Headwaters also sells proprietary chemical
reagents to licensees for use in the production of the coal-based solid
alternative fuel and to other solid alternative fuel facility owners with whom
Headwaters has reagent supply agreements.

         Licensees. Headwaters licenses its technologies to 28 of a
company-estimated total of 75 coal-based solid alternative fuel facilities in
the United States. In addition, during fiscal 2004 Headwaters sold its
proprietary chemical reagents to approximately 32 licensee and other alternative
fuel facilities.

         Current licensees include electric utility companies, coal companies,
financial institutions and other major businesses in the United States. License
agreements contain a quarterly earned royalty fee generally set at a prescribed
dollar amount per ton or a percentage of the tax credits earned by the licensee.
License agreements generally have a term continuing through the later of January
1, 2008 or the date after which tax credits may not be claimed or are otherwise
not available under Section 29.

         Chemical Reagent Sales. The transformation of the feedstock to an
alternative fuel involves the use of a chemical reagent in a qualified facility.
Headwaters primarily markets two proprietary latex-based chemicals, Covol 298
and Covol 298-1, which are widely used for the production of coal-based solid
alternative fuel. The chemical reagent alters the molecular structure of the
feedstock to produce an alternative fuel.

         Headwaters believes the benefits of its proprietary chemical reagents
as compared to competitive materials include clean and efficient combustion
characteristics, ease of application, concentrated form of shipment and lack of
damage to material handling, pulverizing or combustion equipment. Headwaters
believes the chemical reagents used in the HES process are environmentally safe,
possess superior handling characteristics, burn efficiently and are
competitively priced. Additionally, Headwaters' chemical reagents have been
reviewed often by the IRS and tested by independent laboratories. The parameters
of the HES process are consistent with the criteria for future private letter
rulings as outlined by the IRS in Revenue Procedure 2001-30, as modified by
Revenue Procedure 2001-34 and IRS Announcement 2003-70.

         On-site Facility Services. In addition to licensing its technology and
supplying chemical reagents, HES employs chemical, electrical and mechanical
engineers and field personnel with extensive plant and equipment operating
experience to perform on-site facility services and other technical support
functions. HES's engineers have years of experience operating alternative fuel
manufacturing equipment, including mixers, extruders, pellet mills, briquetters
and dryers. HES's employees are experienced in applying its chemical reagents on
multiple types of coal feedstocks. HES has operated alternative fuel facilities
utilizing multiple types of coal feedstocks and has developed and demonstrated
process improvements in commercial facilities. HES has also designed and
constructed reagent mixing and application systems and has retrofitted existing
facilities to use its reagents. For new customers, HES has a mobile,
skid-mounted reagent delivery system that allows for on-site demonstration
testing. HES believes that this full spectrum of services makes it unique in
providing goods and services to the coal-based solid alternative fuel business.

         HES maintains analytical laboratories, including bench-scale equipment
for the production of coal-based solid alternative fuel and comprehensive
analytical testing equipment for performing standard coal analyses. Headwaters
also monitors, documents and substantiates the chemical change process required
to obtain Section 29 tax credits.

         Sources of Available Raw Materials and Inventory Requirements.
Headwaters' chemical reagents are produced by Dow Reichhold Specialty Latex LLC
("Dow Reichhold") under long-term agreements. Headwaters does not maintain or
inventory any chemicals. Instead, Headwaters arranges for the drop shipping of

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the chemical reagents directly from Dow Reichhold's production facilities to the
alternative fuel plants. The chemical reagents can be manufactured in its Dow
Reichhold plants throughout North America assuring short lead-time deliveries
and the ability to meet increasing reagent demand. Separately, the alternative
fuel facility owners have unrelated feedstock agreements that provide a supply
of raw coal for processing at their facilities. These licensees and customers in
turn have production agreements to supply alternative fuel to end users (usually
coal-fueled electricity generating facilities).

Headwaters Resources

         Principal Products and their Markets. Headwaters Resources is currently
the largest manager and marketer of coal combustion products ("CCPs") in the
United States and also manages and markets CCPs in Canada and Puerto Rico. HRI
has long-term exclusive management contracts with coal-fueled electric
generating utilities throughout the United States and provides CCP management
services at more than 110 power plants. HRI markets CCPs in areas where
sufficient demand exists, and manages much of the disposal of the rest of the
CCPs it obtains, typically in landfills. HRI has established long-term
relationships with many of the nation's major utilities and also assists
utilities with their overall CCP management programs.

         HRI markets CCPs as a replacement for manufactured or mined materials
such as portland cement, lime, agricultural gypsum, fired lightweight aggregate,
granite aggregate and limestone. Additionally, HRI provides its affiliate,
Headwaters Construction Materials, CCPs for use in certain construction products
such as mortars, stucco and concrete blocks.

         Utilities produce CCPs year-round, including in the winter when demand
for electricity increases in many regions. In comparison, sales of CCPs and
construction materials produced using CCPs are keyed to construction market
demands that tend to follow national trends in construction with predictable
increases during temperate seasons. CCPs must be stored, usually in terminals,
during the off-peak sales periods as well as transported to where they are
needed for use in construction. In part because of the cost of transportation,
the market for CCPs used in construction is generally regional, although HRI
ships products significant distances to states such as California and Florida
that have limited coal-fueled electric utilities producing high quality CCPs.
HRI enjoys advantages in both logistics and sales from its status as the largest
manager and marketer of CCPs in the United States. HRI maintains more than 30
stand-alone CCP distribution terminals across North America, as well as
approximately 90 plant-site supply facilities. HRI owns or leases approximately
1,300 rail cars and more than 150 trucks, and also contracts with other carriers
so that it can meet its transportation needs for the marketing and disposal of
CCPs. In addition, HRI has more than 50 area managers and technical sales
representatives nationwide to manage customer relations.

         Fly Ash and Other CCPs. The benefits of CCP use in construction
applications include improved product performance, cost savings and positive
environmental impact. Fly ash improves both the chemical and physical
performance of concrete. Chemically, fly ash combines silicon with free lime
created by cement hydration to produce additional binding ability within
concrete - decreasing permeability and enhancing durability. Physically, fly ash
particles are smaller than cement particles, allowing them to effectively fill
voids and create concrete that is denser and more durable. Fly ash particles are
spherical and have a "ball bearing" effect which lubricates the concrete mix and
allows enhanced workability with less water. The requirement of less water also
contributes to decreased permeability and greater durability of concrete.
Because fly ash is also typically less expensive than the cement it replaces,
concrete producers are able to improve profitability while improving concrete
quality.

         When fly ash is used in concrete it provides environmental benefits. In
addition to conserving landfill space, fly ash usage conserves energy and
reduces green house gas emissions. According to the EPA, one ton of fly ash used
as a replacement for portland cement eliminates approximately one ton of carbon
dioxide emissions associated with cement production. This is the equivalent of
retiring an automobile from the road for two months. These benefits are
recognized in major "green building" movements, such as the United States Green
Building Council's LEED classification system. The value of utilizing fly ash in
concrete has been recognized by numerous federal agencies, including the United
States Department of Energy and EPA, which has issued comprehensive procurement
guidelines directing federal agencies to utilize fly ash. The EPA has also
created the Coal Combustion Products Partnership ("C2P2") to nationally promote
CCP utilization. Almost all states specify or recommend the use of fly ash in
state and federal transportation projects. Other government entities that
frequently specify or recommend the utilization of fly ash in concrete include
the Federal Highway Administration, the United States Army Corps of Engineers

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and the United States Bureau of Reclamation. Numerous state departments of
transportation are also increasing their reliance on fly ash as a component for
improving durability in concrete pavements. Several major cement companies have
identified increasing the use of fly ash as a key environmental strategy for the
next two decades.

         Higher quality fly ash and other high value CCPs have the greatest
value to HRI because of the wide variety of higher margin commercial uses. In
fiscal 2004, HRI sold approximately 5.79 million tons of high value CCPs. The
quality of fly ash produced by the combustion process at coal-fueled facilities
varies widely and is affected by the type of coal feedstock used and the boilers
maintained by the utilities. HRI assists its utility clients in their efforts to
improve the production of high value CCPs at their facilities. HRI tests fly ash
to certify compliance with applicable industry standards. A quality control
system ensures that customers have a specific quality of CCPs for various
applications while HRI's extensive investment in transportation equipment and
terminal facilities provides reliability of supply.

         HRI supports its marketing sales program by focusing on customer
desires for quality and reliability. Marketing efforts emphasize the performance
value of CCPs, as well as the attendant environmental benefits.

         HRI undertakes a variety of marketing activities to increase fly ash
sales. These activities include:

         o        Professional Outreach. To promote the acceptance of fly ash in
                  construction projects, all levels of HRI's sales and marketing
                  organization are involved in making regular educational
                  presentations such as continuing professional education
                  seminars to architects, engineers, and others engaged in
                  specifying concrete mix designs.

         o        Technical Publications. HRI publishes technical reference
                  information pertaining to CCPs and CCP applications. HRI also
                  prominently promotes the environmental benefits of CCP use.

         o        Relationships with Industry Organizations. HRI personnel
                  maintain active leadership positions in committees of the
                  American Concrete Institute and the American Society for
                  Testing and Materials, and serve on the boards of the American
                  Coal Ash Association, the Western Region Ash Group, the Texas
                  Coal Ash Utilization Group, the Midwest Coal Ash Association
                  and the American Coal Council. These organizations help
                  establish standards and educate the construction industry and
                  the general public about the benefits of CCP use.

         o        Trade Shows. HRI promotes the use of CCPs at more than 30
                  local and national trade shows and association meetings each
                  year. HRI is also an exhibitor at the nation's leading
                  conferences for utilization of environmentally friendly
                  building products.

         o        Government Affairs. HRI has taken a leadership role in
                  encouraging state and federal legislation and regulations that
                  lead to greater utilization of fly ash by emphasizing its
                  environmental, performance and cost advantages. Legislative
                  recognition of the benefits of fly ash as well as the use of
                  fly ash in governmental projects helps familiarize
                  contractors, architects and engineers with the benefits of the
                  product for other construction uses.

         o        Advertising. HRI advertises for fly ash sales and utilization
                  in a number of publications, including: Architectural Record,
                  Construction Specifier, Concrete Products, Concrete Producer,
                  Concrete International and Environmental Design &
                  Construction.

         o        Creation of Branded Specialty Products. HRI has developed
                  several specialty products that increase market penetration of
                  CCPs and name recognition for HRI's products for road bases,
                  structural fills, industrial fillers and agricultural
                  applications. These include:

                  o        Alsil(R) - Processed fly ash used as an industrial
                           filler;

                  o        C-Stone(TM) - Quality crushed aggregate manufactured
                           from fly ash and used in road base and feedlot
                           applications;

                  o        Flexbase(TM) - Flue Gas Desulphurization (FGD)
                           scrubber sludge, pond ash, and/or lime proportionally
                           mixed for road base or pond liner material;

                  o        Powerlite(R) - Processed fly ash and bottom ash,
                           meeting American Society for Testing and Materials
                           C331 standards, for use as a high quality aggregate
                           in the concrete block industry; and

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                  o        Peanut Maker(R) - A synthetic gypsum used as a land
                           plaster in agricultural applications.

         New Technologies for CCP Utilization. In an effort to maximize the
percentage of CCPs marketed to end users and to minimize the amount of materials
disposed of in landfills, HRI's research and development activities focus on
expanding the use of CCPs by developing new products that utilize high volumes
of CCPs. Through these research and development activities, HRI has developed
FlexCrete(TM), a new commercial and residential building product in its early
commercialization stages. FlexCrete(TM) is an aerated concrete product with 60%
fly ash content that is cured at lower temperatures and ambient pressure. HRI
expects FlexCrete(TM) will offer advantages for construction, including low
cost, ease of use, physical strength, durability, energy efficiency, fire
resistance and environmental sensitivity.

         Technologies to Improve Fly Ash Quality. HRI has also developed
technologies that maintain or improve the quality of CCPs, further expanding and
enhancing their marketability. Utilities are switching fuel sources, changing
boiler operations and introducing ammonia into the exhaust gas stream in an
effort to decrease costs and/or to meet increasingly stringent emissions control
regulations. All of these factors can have a negative effect on fly ash quality,
including an increase in the amount of unburned carbon in fly ash and the
presence of ammonia slip. HRI has addressed these challenges with the
development and/or commercialization of two technologies. Designed to be simple,
economical and highly effective, these technologies can be implemented without
the large capital expenditures often associated with controlling quality
problems.

         Carbon Fixation. Under certain conditions, unburned carbon in fly ash
inhibits the entrainment of air in concrete thereby reducing its resistance to
the effects of freeze-thaw conditions. Technologies designed to remove residual
carbon are often capital intensive and are therefore rarely used. HRI has the
exclusive license in North America to utilize a carbon fixation technology used
to pre-treat fly ash. The technology uses a liquid reagent to coat unburned
carbon particles in the fly ash and hinder the impact on the concrete mix.
Carbon is not removed, but its effects on air entrainment are minimized. The
technology also renders some ash products usable for the first time without
having any adverse effects on the quality of finished concrete. Full scale
carbon fixation units have been installed and are operating at major power
plants.

         Ammonia Slip Mitigation. As electric utilities move to implement
stringent new air pollution controls, many are treating boiler exhaust gases
with ammonia to remove NOx. This can result in unreacted ammonia being deposited
on fly ash. The use of ammonia contaminated fly ash in concrete production can
result in the release of ammonia gas, exposing concrete workers to varying
levels of ammonia. HRI has developed a technology that uses a chemical reagent
to mitigate the ammonia slip effects. When water is added to the concrete mix
containing ammoniated fly ash, the reagent converts ammonia to harmless
compounds. The process allows the reagent to be added and blended with the dry
fly ash at any time from when the fly ash is collected at the power plant to
when the fly ash is used in the production of concrete.

         Sources of Available Raw Materials and Inventory Requirements. Coal is
the largest indigenous fossil fuel resource in the United States. The U.S.
Department of Energy (DOE) estimates that in 2003 annual coal production was in
excess of one billion tons. Almost 92% of all coal consumed in the United States
was for electrical power generation. The DOE further estimates that 2003 U.S.
coal consumption was for electrical power generation was at a record level of
slightly more than one billion tons. Coal serves as a primary resource for
baseline electricity production in the United States and was used to produce
approximately half of the electricity generated in the United States. The
combustion of coal results in a high percentage of residual materials which
serve as the "raw material" for the CCP industry. According to the American Coal
Ash Association, about 37 million tons of CCPs are beneficially used each year
in the United States with more than 81 million tons of CCPs disposed of in
landfills. This provides for opportunities for continuing increases in CCP
utilization. As long as a significant amount of electricity in this country is
generated from coal-fueled generation, HRI believes it will have an adequate
supply of raw materials.

Headwaters Technology Innovation Group

         Headwaters Technology Innovation Group, Inc., together with its
subsidiaries and affiliates (collectively "HTI"), provides research and
development support to Headwaters. HTI maintains a staff of engineers,
scientists and technicians with expertise in the design and operation of
high-pressure and temperature process plants at its Lawrenceville, New Jersey
pilot plant and laboratory facilities. The following are some of the
technologies currently under development.

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<PAGE>

         o        Nanocatalyst Technology. HTI has developed the capability to
                  work at the molecular level in the aligning, spacing and
                  adhering of nano-sized crystals of precious metals on
                  substrate materials. The net effect is higher performance with
                  lower precious metal content, and nearly 100% selectivity for
                  certain chemical reactions (i.e., byproducts and waste are
                  minimized and the desired reaction is maximized). Potential
                  applications for this nanotechnology include new processes for
                  direct synthesis of hydrogen peroxide for the production of
                  chemicals such as propylene oxide. This same technique can
                  also be used to improve existing chemical refining of precious
                  metal catalysts, improve volatile organic compound oxidation,
                  naphtha reforming and the production of high performance
                  catalysts including fuel cell catalysts. In September 2004 HTI
                  entered into a joint venture with Degussa AG, located in
                  Dusseldorf, Germany, to develop and commercialize a process
                  for the direct synthesis of hydrogen peroxide (H2O2). The
                  venture aims to invest in large facilities to produce low-cost
                  hydrogen peroxide for chemical intermediates. High-volume
                  producers will be able to use the H2O2 from these facilities
                  to produce intermediates such as propylene oxide (PO). Subject
                  to terms and conditions of the agreement, the joint venture
                  intends to complete process development by 2007, and will be
                  responsible for any subsequent development and
                  commercialization of manufacturing facilities.

         o        Direct Coal Liquefaction Technology. Headwaters has developed
                  an advanced technology for producing clean liquid fuels
                  directly from coal. Shenhua Group, China's largest coal
                  company, has purchased elements of Headwaters' direct coal
                  liquefaction (DCL) technology for its plant to be built in
                  Majata, China. Although completion of the plant is several
                  years away, it is expected to become the first commercial
                  direct coal liquefaction plant in the world with an ultimate
                  capacity of 50,000 barrels per day. In October 2004, HTI was
                  awarded a contract by Oil India Limited, a government of India
                  enterprise, to study the technical and economic feasibility of
                  applying HTI's direct coal liquefaction technology in India.
                  Oil India is a public sector company engaged in petroleum
                  exploration and production in the Assam region of northeastern
                  India, an area rich in natural resources but distant from
                  established oil refining operations. Under a concurrently
                  signed memorandum of understanding, the companies have agreed
                  that pending a positive result from the feasibility study, if
                  Oil India elects to proceed with a commercial-scale DCL
                  project, HTI will provide the technology license under
                  negotiated commercial terms.

         o        Heavy Oil Upgrading Technology. HTI has obtained the exclusive
                  worldwide license to develop, market and sublicense an
                  innovative catalytic heavy oil upgrading technology known as
                  (HC)3. This technology is a hydrocracking process used for
                  upgrading heavy oil, bitumen or bottom-of-the-barrel residual
                  oil. An upgrading plant using the (HC)3 technologies can
                  produce synthetic crude or clean liquid fuels. The process
                  uses a proprietary, highly active molecular catalyst. There
                  are several heavy oil upgrading plants located around the
                  world that could immediately apply and benefit from the (HC) 3
                  technologies with minimal modification to plant and equipment.

         o        Gas-To-Liquids Technology. Commercialization of slurry-phase
                  Fischer-Tropsch ("FT") technology provides a new source of
                  clean transportation fuels from fossil fuel resources. HTI has
                  developed a skeletal-iron FT catalyst specifically designed
                  for slurry-phase reactors that converts gaseous materials into
                  a range of liquid fuels and chemicals, e.g., propylene. In
                  June 2004, HTI formed a joint venture with Rentech, Inc.
                  called FT Solutions LLC in order to accelerate the development
                  of FT technology. FT Solutions LLC combines the FT
                  technologies of both parties and holds the rights to license
                  the combined technology and supply engineering, technical
                  services and catalysts for FT projects.

Headwaters Construction Materials

         Principal Products and their Markets. Headwaters Construction Materials
is a nation-wide market leader in designing, manufacturing and marketing
shutters, gable vents, mounting blocks and tools (under various Tapco brands),
and architectural manufactured stone (under the Eldorado Stone(R) brand). In
addition, HCM is a regional leader in manufacturing and distributing concrete
blocks and other masonry units (under the Southwest and Palestine brands), as
well as various mortars and stuccos (under the Best Masonry, Magna Wall(R) and
other brands). The acquisitions of Tapco, Eldorado and Southwest in 2004 have
significantly transformed Headwaters Construction Materials business unit and
given Headwaters a national presence in the commercial and residential
improvement market. HCM uses fly ash in the manufacture of its block, mortar and
stucco products and intends to use fly ash in its manufactured stone products.

                                       9
<PAGE>

     Eldorado

         In June 2004, Headwaters acquired Eldorado Stone, LLC, together with
its wholly-owned subsidiaries.

         Principal Products and their Markets. Eldorado offers a wide variety of
high-quality, hand-made manufactured stone products to meet a variety of design
needs. Eldorado's architectural manufactured stone siding incorporates several
key features important to a successful siding product, including: high aesthetic
quality, ease of installation, durability, low maintenance, reasonable cost and
widespread availability. Eldorado's product line has been designed and is
manufactured to be one of the most realistic architectural stone products in the
world. Eldorado's architectural stone siding is a lightweight, adhered siding
product used by national, regional and local architectural firms, real estate
developers, contractors, builders and homeowners. Eldorado Stone(R) is used in
construction projects ranging from large-scale residential housing developments
and commercial projects to do-it-yourself home improvement jobs. In addition to
its use as a primary siding material, the Eldorado product line is used in a
variety of external and internal home applications such as walls, archways,
fireplaces and landscaping. Headwaters believes that Eldorado's focus on product
quality, breadth and innovation, combined with a geographically diversified
manufacturing platform, provides it with significant advantages in leading
architects, builders and end-users to choose Eldorado over traditional materials
such as natural stone, brick or stucco.

         Eldorado Stone(R) is available in 60 distinct stone types, developed
from 12 stone profiles and crafted in a variety of natural colors designed by
Eldorado's artistic staff. Eldorado also offers regional stone products based on
the characteristics of the stone native to the regions. Each stone profile is
manufactured using numerous real stone models, which creates a realistic,
non-repetitive, natural stone look and is crafted in a variety of natural
colors. Eldorado believes its collection developed over the last 30 years of
more than 10,000 natural stones, which are used as models for the profiles, is
not easily replicated.

         Manufacturing. Eldorado manufactures the molds for its stone profiles
as well as the manufactured stone created from these molds. Although Eldorado
does not currently use fly ash in its manufactured stone products, Headwaters
intends to replace a portion of the cement used in the production of Eldorado
Stone(R) with fly ash for greater durability, aesthetic enhancement and
environmental advantages. Headwaters believes that Eldorado's existing plants
may be modified to allow this substitution without material additional expense.
Eldorado has made recent investments in both its manufacturing operations and
sales and marketing capabilities. It has initiated production at its new Rancho
Cucamonga, California facility and has expanded its customer service operations
and staffing. Eldorado currently manufactures its products through a network of
plants strategically situated throughout the U.S. in proximity to its customers.
These locations allow for a high level of customer service, shorter lead times
and lower freight costs. Eldorado has manufacturing facilities at locations
including: Rancho Cucamonga, California; Pueblo, Colorado; Red Bud, Illinois;
Fayetteville, North Carolina; Apple Creek, Ohio; Greencastle, Pennsylvania ;
Carnation, Washington; and Royal City, Washington. In addition, Eldorado has
four distribution centers located at: Stockton, California; Orlando, Florida;
Portland, Oregon; and Arlington, Washington. A new manufacturing facility is
under construction in Dublin, Georgia.

         Sales and Marketing. Eldorado distributes its architectural
manufactured stone products primarily on a wholesale basis through a network of
distributors, including masonry and stone suppliers, roofing and siding
materials distributors, fireplace suppliers and other contractor specialty
stores. Eldorado also has a small direct sales force. Eldorado's sales force
works closely with architects and contractors to provide information concerning
the attributes and ease of installation of its manufactured product and to
promote market acceptance over traditional building materials.

     Southwest Concrete Products

         In July 2004 HCM purchased the assets of Southwest Concrete Products,
LP through HCM's indirect subsidiary, HCM Block & Brick, LP ("Southwest").
Southwest is a leading manufacturer of concrete blocks in South Texas.

         Principal Products and their Markets. Southwest, together with HCM's
existing operations (Palestine Concrete Tile Co., LP), makes HCM one of the
largest manufacturer and seller of concrete block in the Texas market, one of
America's largest block markets. The Southwest acquisition also provides
Headwaters with the opportunity to use fly ash in the manufacturing process for
concrete block, brick and foundation blocks.

                                       10
<PAGE>

         Manufacturing. Southwest operates one of the most modern concrete block
and brick manufacturing facilities in the industry. It has recently launched a
new line of concrete bricks. Southwest has operations in Alleyton, San Antonio
and Houston which complement HCM's similar operations in Dallas and Palestine,
Texas.

         Sales and Marketing. Combining SCP's modern manufacturing facilities
for concrete block and brick with those of HCM provides coverage of all the key
metropolitan areas in Texas, without duplication of facilities. The established
position of the combined block facilities may also provides Eldorado a strategic
location for expansion.

     Tapco

         In September 2004 Headwaters acquired Tapco Holdings, Inc. Tapco is a
leading designer, manufacturer and marketer of building products and
professional tools used in exterior residential home improvement and
construction.

         Principal Products and their Markets. Tapco's building products, which
are either injection-molded from polypropylene or extruded, enhance the
appearance of homes and include window shutters, gable vents, mounting blocks
for exterior fixtures, roof ventilation, exterior decor products and specialty
siding products. Professional tools include portable cutting and shaping tools
used by contractors, on site, to fabricate customized aluminum shapes that
complement the installation of exterior siding.

         Tapco markets its products under the brands "Tapco Products,"
"Mid-America Building Products," "Mid-America Master Series," "Builders Edge,"
"Atlantic Shutter Systems," "Vantage," and "The Foundry." Tapco markets its
injection-molded building product accessories to retailers and mass
merchandisers through its Builders Edge and Vantage brands and to the
manufactured housing market through the Manufactured House Products brand. In
addition, Tapco markets its tools through its Tapco brand, its functional
shutters and storm protection systems through its Atlantic Shutter Systems
brand, and its specialty siding product through its Foundry brand.

         Building Products. Tapco designs, manufactures and markets
injection-molded window shutters, gable vents and exterior fixture mounting
blocks. In addition, Tapco manufactures roof vents, specialty vents, window
mantels, door surrounds, accent windows, functional shutters and specialty vinyl
siding. Tapco's building products serve the needs of the siding, roofing, and
window and door installation industries. Tapco's injection-molded products are
designed to enhance the exterior appearance of the home while delivering
durability at a lower cost compared to similar aluminum, wood and plastic
products while the functional shutters offer storm protection and also enhance
the exterior appearance of the home and can be manufactured to meet certain
hurricane codes. The injection-molded exterior products feature copolymer
construction and U.V. stabilized molded-through color.

         o        Decorative Shutters. Tapco offers the industry's most complete
                  line of standard and custom plastic window shutters, with an
                  extensive number of sizes and colors. Standard shutters, both
                  open louver and raised panel, are available in two widths, 14
                  standard lengths, 16 colors and paintable. Style-a-Shutter,
                  Tapco's line of custom shutters and matching shutter
                  components, is available in up to 13 widths, practically any
                  length, 24 styles, 18 colors and paintable. All of Tapco's
                  shutters feature the patented Shutter-Lok fastening system,
                  which facilitates ease of installation on any siding material
                  including wood, aluminum, vinyl, stucco, hardboard or brick.

         o        Gable Vents. GableMaster gable vents accommodate any
                  architectural style with over 35 size and design variations
                  available in over 220 colors including paintable and
                  stainable. Style-a-Vent, Tapco's line of custom vents, is
                  available in many shapes and sizes and in two colors.
                  GableMaster vents not only provide the needed ventilation, but
                  also add an important aesthetic benefit to a home. Each gable
                  vent features a patented lock-on ring, which significantly
                  reduces installation time by eliminating the need for caulking
                  or channeling and, like Tapco's shutters, can be easily
                  installed on any siding material. The GableMaster product line
                  is screened for insect protection and includes a double baffle
                  system for weather resistance.

         o        Mounting Blocks. Tapco manufactures the industry's most
                  extensive line of mounting blocks, used for the mounting of
                  exterior fixtures such as lights, electrical outlets, faucets,
                  doorbells, and address plates. Each mounting block also
                  features a patented lock-on ring for easy installation and
                  comes in 27 different styles and over 220 colors.

                                       11
<PAGE>

         o        Roof Vents. Tapco produces a line of roof ventilation
                  products, including ridge, hip, and stack covers. Tapco
                  believes that its roof ventilation products are the industry
                  leaders in terms of functionality, durability, and appearance.

         o        Specialty Vents. Tapco manufactures a broad line of specialty
                  vents, including air intake and exhaust vents, dryer vents and
                  foundation vents in over 200 colors including paintable.

         o        Functional Shutters. Tapco manufactures functional shutter
                  systems for storm protection and decorative applications. They
                  are available in numerous styles and almost any size and any
                  color.

         o        Specialty Siding. Tapco manufactures specialty siding (replica
                  cedar and shake siding) under the Foundry brand. Tapco's
                  specialty siding product is available in 10 different profiles
                  and 16 different colors. The siding can be used for accent
                  applications or whole house applications and can be installed
                  easily by a professional siding installer. The Foundry's
                  specialty siding utilizes a proprietary extrusion and in-line
                  forming process for production, as opposed to the
                  injection-molded process utilized by most competitors. The
                  extrusion process allows for changes in profiles and panel
                  dimensions at a lower cost than injection molding. This cost
                  savings has allowed Tapco to sell it at a lower price point
                  than traditional injection molded specialty siding products.
                  In addition, the installation process of Tapco's specialty
                  siding is the same as traditional siding, unlike the
                  specialized installation process required by competitors'
                  specialty siding products. The Foundry siding can be installed
                  faster and with less scrap than its injection-molded specialty
                  siding competitors. These characteristics increase the
                  profitability of using The Foundry's product relative to other
                  types of vinyl siding.

         o        Exterior Decor. Tapco also manufactures a variety of other
                  exterior decor items such as window headers, door surrounds
                  and exterior trim. These items are available in over 30 colors
                  and will fit any window or door.

         o        Professional Tools. Tapco believes it is the largest
                  manufacturer of portable cutting and shaping tools for the
                  professional siding contractor in the United States. These
                  tools enable installers of vinyl and aluminum siding to form
                  virtually any required shape on-site. Tapco's principal
                  installation tool is the bending brake. Brakes hold sheet
                  metal in place for bending and cutting during the installation
                  process. Tapco's MAX II, Pro-14 and Pro-19 brakes feature deep
                  working areas, enabling greater flexibility in making any
                  shape, and strong locking systems. Tapco's Pro-III
                  Port-O-Bender is the best selling portable brake. Tapco also
                  manufactures a brake, the MAX II Port-O-Bender, that is
                  designed to shape heavier gauge metal that is typically used
                  in commercial buildings. Tapco also offers numerous
                  accessories for brakes which include the Pro Cut-Off,
                  Side-Winder and Brake Buddy.

         Distribution. Tapco's products are distributed throughout the United
States and Canada through four primary distribution channels: one-step
distributors that sell directly to contractors, two-step distributors that sell
Tapco's products to lumberyards and one-step distributors, retail home
centers/mass merchandisers, and manufactured housing.

         Tapco distributes is accessory products to the one-step and two-step
distribution channels under the "Master Series(R)" brand and Mid-America
Building Products company name. Tapco distributes its accessory products to the
retail mass merchandiser channel through Builders Edge(R) and Vantage(R) brands.
Tapco distributes its products to the manufactured housing industry through
Manufactured Housing Products ("MHP"), a division of Metamora Products
Corporation. MHP has an exclusive supplier relationship with one of the largest
distributors to the manufactured housing market. Tapco also distributes its
products through all of the major vinyl siding, roofing, and window
distributors. Many competitors, in contrast, manufacture accessory products as
an adjunct to their core siding business.

         Tapco's large number of distribution points is due in large part to the
strong customer "pull thru" demand for its products. Tapco seeks to be the
leader in each meaningful distribution channel by providing the broadest
selection of products coupled with high levels of customer service. Tapco is
able to secure multiple distribution points in local markets because its
products are not limited to any of the major branded roofing, siding, window and
door distributors. Many of Tapco's competitors offer products as an adjunct to
their core roofing, siding, window or door operations. As a result, their
distribution is typically limited to the authorized distributor of their core
branded products.

                                       12
<PAGE>

         Sales and Marketing Organization. Tapco's sales and marketing
organization supports the one-step, two-step distribution, and retail channels
through various networks of sales support that include almost 200 independent
sales representatives and a small group of regional sales managers and sales
executives.

         Tapco maintains relationships with thousands of local contractors,
professional builders, and other end-users by participating in over 1,000 local
shows and six national shows annually. Local shows, sponsored by local
distributors, enable Tapco to promote its products through hands-on comparisons
to competing products. These shows enable Tapco to receive useful feedback from
local contractors, which leads to new product ideas, as well as significant
goodwill within the trade.

         Tapco supports distributors with product literature, displays, videos,
product training programs and showroom merchandising designed to increase
awareness among homeowners and contractors about the benefits of Tapco's
products. In addition, Tapco maintains a large mailing list of active
contractors, which Tapco gathers from warranty registration cards, local and
national shows and requests for CDs and product literature.

         Major Customers. Tapco has a large customer base. Because all of the
one- and two-step distributors have multiple locations and each individual
location has autonomy to stock various products from different suppliers, the
number of ship-to locations is a better measure of the breadth of sales than is
the total number of customers. In the residential home improvement and building
products market, Tapco has over 4,500 non-retail ship-to locations and over
5,200 retail ship-to locations. Sales are broadly diversified across customers
and ship-to locations. For fiscal 2004, two retail home center customers
together represented approximately 25% of Tapco's total sales.

         Manufacturing. Tapco conducts its manufacturing, distribution and sales
operations through 14 facilities, which total approximately 850,000 square feet.
Tapco's manufacturing assets include more than 100 injection molding presses,
almost all of which are automated through robotics or conveyor systems. Robotic
automation has reduced cycle times and helped reduce waste by keeping cycle
times consistent from part to part. Tapco has realized cycle time improvements
on all presses utilizing automation. Tapco's high volume allows it to invest in
multi-cavity tooling, resulting in significantly lower unit costs over single
cavity tooling.

         Tapco follows strict quality control standards in its efforts to
produce products of consistent quality and free of production flaws. Any
nonconforming plastic parts are reused as raw material, further minimizing
waste. Tapco mandates quality control checks at each step of the manufacturing
process.

         Sources of Available Raw Materials. Tapco has long-standing
relationships with its major suppliers. The raw materials Tapco purchases
include polypropylene and styrene pellets, plastic extrusions, and packaging
materials for Tapco's building product lines. Tapco primarily purchases
polypropylene and styrene from single (separate) suppliers. In addition, Tapco
purchases fabricated anodized aluminum, hinges and other components, and
packaging materials for its professional installation tools. Historically, Tapco
has not experienced difficulty in obtaining raw materials or components to meet
its production requirements. From time to time, prices for some of the raw
materials used in Tapco's production/assembly process fluctuate. Although Tapco
does not have any contracts with its suppliers and purchases supplies on a
purchase order basis, Tapco occasionally makes volume purchases of materials to
lock-in pricing.

Major Customers

         Until Headwaters acquired Headwaters Resources in September 2002,
Headwaters operated in and reported as a single industry segment, alternative
energy. Since the acquisition of Headwaters Resources, Headwaters now operates
in three business segments, alternative energy, coal combustion products, and
construction materials. Additional information about segments is presented in
Note 4 to the consolidated financial statements included herein. The following
table presents revenues for all customers that accounted for over 10% of total
revenue during 2002, 2003 or 2004. All of these revenues are attributable to the
alternative energy segment. Most of the named customers are energy companies.
Affiliate relationships are determined for the period in which events are
calculated.

                                       13
<PAGE>
<TABLE>
<CAPTION>
(in thousands)                                     2002            2003             2004
-----------------------------------------------------------------------------------------
<S>                                       <C>             <C>              <C>
Pace Carbon Fuels, L.L.C. affiliates      Less than 10%   Less than 10%          $57,602
DTE Energy Services, Inc. affiliates            $19,660         $42,013    Less than 10%
TECO Coal Corporation affiliates                 20,292   Less than 10%    Less than 10%
Marriott International, Inc. affiliates          19,105   Less than 10%    Less than 10%
AIG Financial Products Corp. affiliates          16,900   Less than 10%    Less than 10%
</TABLE>

Research and Development

         In 2002, Headwaters' research and development expenses were $2.3
million, attributable primarily to activities at HTI. In 2003, research and
development expenses increased to $4.7 million, with the increase primarily
attributable to the inclusion of additional costs relating to HRI's research and
development activities. In 2004, research and development expenses increased to
approximately $7.3 million, with the increase attributable primarily to
activities at HTI.

Headwaters' Business Strategy

Headwaters intends to pursue the following business strategy:

         Enable Customers to Maximize Production and Value of Alternative Fuel
Facilities. In order for Headwaters' customers to maximize the production and
value of their coal-based alternative fuel facilities, Headwaters intends to
continue to assist them in operating their facilities more efficiently, and
Headwaters intends to actively market the benefits of alternative fuel to
electric power generators. Headwaters intends to continue to develop
technologies that improve coal handling, enhance coal combustion characteristics
and reduce air emissions.

         Develop and License New Technologies. Headwaters intends to continue to
develop and commercialize technologies that add value to coal, gas, oil and
other natural resources. These efforts will focus on upgrading heavy oil to
lighter fuel, gas-to-liquid fuels conversion, improving the quality of fly ash,
and converting or upgrading fossil fuels into higher value products. In
addition, HTI's nanocatalyst technologies should provide Headwaters with an
opportunity for commercialization of multiple custom designed catalysts.
Headwaters intends to seek to develop strategic relationships with major
companies in the energy and chemical industries to accelerate commercialization
of its energy and catalyst technologies.

         Leverage Energy and CCP Relationships. HES and HRI maintain
longstanding relationships with many of the largest coal-fueled electricity
producers in the United States. Headwaters believes these relationships will
provide opportunities to expand and strengthen its position among coal-fueled
power generation utilities.

         Expand Commercial Use and Enhance Quality of CCPs. Headwaters intends
to expand its market presence geographically and continue to seek increased
market acceptance of CCPs through targeted marketing of industry decision
makers, such as architects and engineers, and through efforts to increase
governmental recommendations and mandates to use CCPs. An important part of
Headwaters' strategy is to expand alternative uses of CCPs, which allows for
increased sales of CCPs as well as attracting and maintaining utility customers
who value Headwaters' efforts to develop the market for CCPs. Alternative uses
of CCPs include roadbeds, embankments, building products (such as concrete
blocks and manufactured stone) and waste stabilization applications. Headwaters
intends to use fly ash in the production of Eldorado architectural manufactured
stone products as a partial replacement for cement. Headwaters intends to
continue to market the environmental and performance benefits of CCP-based
building products to industry decision makers.

         Leverage Distribution Systems. The Tapco, Eldorado and stucco products
have strong pull-through effect from Headwaters' end customers, primarily
architects, engineers and contractors. Headwaters plans to leverage the
complementary distribution systems of Tapco, Eldorado and its stucco, blocks and
mortar products to accelerate sales of Headwaters' diverse construction
materials product portfolio. For example, Tapco's strong distribution and
marketing presence in the home improvement industry creates a marketing and
sales opportunity for Eldorado Stone that is primarily marketed and distributed
to the new construction market. Headwaters Construction Materials has
relationships with a nationwide distribution network encompassing over 10,000
wholesale distributors as well as leading retail home centers. Further,
Eldorado's strong presence in the Southwest United States and its leading
regional concrete block presence in Texas creates new distribution channels for
Tapco products. Headwaters intends to leverage these complementary distribution
networks to create a national distribution network to market and sell its
diverse portfolio of products to new customers and new segments of the
construction market.

                                       14
<PAGE>

         Leverage Manufacturing Capability. Headwaters is committed to
implementing improvements throughout its manufacturing system. Headwaters
intends to capitalize on Tapco's manufacturing expertise to reduce manufacturing
costs across all of its business units. Through the application of
state-of-the-art manufacturing processes, best practices and economies of scale,
Headwaters intends to optimize its manufacturing processes, increase product
volume, reduce waste and lower costs, all of which should lead to greater
product margins.

         Pursue Complementary and Strategic Acquisitions. Headwaters continually
evaluates the potential acquisition of companies, technologies or products that
will complement its existing business lines, manufacturing and distribution
strengths and build on its leading market positions. Acquisition opportunities
will be evaluated based on strategic fit, accretion to earnings and ability to
generate significant cash flow.

Competition

         Headwaters experiences competition from traditional coal and fuel
suppliers, natural resource producers, and companies that specialize in the use
and upgrading of industrial byproducts. Many of these companies have greater
financial, management and other resources than Headwaters, and may be able to
take advantage of acquisitions and other opportunities more readily.

         Coal-based solid alternative fuels made using Headwaters Energy
Services' technologies, from which Headwaters derives license fee revenues and
revenues from sales of chemical reagents, compete with other alternative fuel
products, as well as traditional fuels. For Headwaters Energy Services,
competition may come in the form of the marketing of competitive chemical
reagents and the marketing of end products qualifying as alternative fuel.
Headwaters Energy Services competes with other companies possessing technologies
to produce coal-based solid alternative fuels and companies that produce
chemical reagents such as Nalco Chemical Company and Accretion Technologies,
LLC.

         Headwaters Energy Services also experiences competition from
traditional coal and fuel suppliers and natural resource producers, in addition
to those companies that specialize in the use and upgrading of industrial
byproducts. These companies may have greater financial, management and other
resources than Headwaters has. Further, many industrial coal users are limited
in the amount of alternative fuel product they can purchase from Headwaters
Energy Services' licensees because they have committed to purchase a substantial
portion of their coal requirements through long-term contracts for standard
coal.

         Generally, the business of marketing traditional CCPs is intensely
competitive. Headwaters Resources has substantial competition in two main areas:
obtaining CCP management contracts with utility and other industrial companies;
and marketing CCPs and related industrial materials. Headwaters Resources has a
presence in every region in the United States but, because the market for the
management of CCPs is highly fragmented and because the costs of transportation
are high relative to sales prices, most of the competition in the CCP management
industry is regional. There are many local, regional and national companies that
compete for market share in these areas with similar products and with numerous
other substitute products. Although Headwaters Resources typically has long-term
CCP management contracts with its clients, some of such contracts provide for
the termination of such contract at the convenience of the utility company upon
a minimum 90-day notice. Moreover, certain of Headwaters Resources' most
significant regional CCP competitors appear to be seeking a broader national
presence. These competitors include Lafarge North America Inc., Boral Material
Technologies Inc. and Cemex. Construction materials are produced and sold
regionally by the numerous owners and operators of concrete ready-mix plants.
Producers with sand and gravel sources near growing metropolitan areas have
important transportation advantages.

         Headwaters Construction Materials has competition from numerous, larger
manufacturers of mortars, stuccos and concrete masonry units. With respect to
concrete masonry units, national and regional competition would include
Oldcastle, Featherlite and Pavestone. In addition, notwithstanding Eldorado's
large market share as a producer of manufactured architectural stone, Eldorado
faces significant competition from other national and regional producers of
similar products, and in particular from Owens Corning. Tapco's primary
competition includes Alcoa and Pinckney in the accessories market, and
CertainTeed and Nailite in the specialty siding market.

         Many of the world's major chemical companies are devoting significant
resources to researching and developing nanocatalysts and catalytic processes.
These companies have greater financial, management and other resources than
Headwaters has. Headwaters' strategy is to pursue complimentary acquisitions or

                                       15
<PAGE>

enter into license agreements or joint ventures with major chemical companies
for the further development and commercialization of Headwaters' nanocatalyst
technologies.

         Positive and Negative Factors. There are positive and negative factors
pertaining to the competitive position of Headwaters and its subsidiaries.
Headwaters Energy Services enjoys the benefits of a leading market position in
the Section 29 licensing and reagent sales businesses, license agreements that
extend through the life of Section 29, and a manufacturing process and reagent
products that have withstood IRS scrutiny. From a broader alternative fuel
industry perspective, Headwaters Energy Services suffers from greater dependence
on United States tax policy and administration than some competitors in
alternative fuels.

         Headwaters Resources competitive position also has positive factors of
a leading market position and long-term contracts. In addition, Headwaters
Resources has built a nationwide CCP distribution system not enjoyed by its
competition. Negatively, Headwaters Resources is sometimes adversely affected by
inclement weather slowing concrete construction (the largest market for CCPs).

         For Headwaters Construction Materials, the block and bagged products
businesses are not national in breadth, although the block business enjoys a
strong regional market position in Texas. Where its market strength is limited,
the HCM block and bagged products businesses do not have strong economies of
scale, price leadership, and have only limited product brand strength.

         Eldorado Stone's competitive position has some identifiable positive
factors. Eldorado is developing a recognized name in the architectural stone
veneer industry and a strong market share. Its product has excellent
authenticity and broad selection alternatives. Negatively, Eldorado Stone has a
limited, albeit growing, distribution network, strong competition from regional
producers that do not have long shipping routes, and financial limitations that
may not be shared by its largest national competitor.

         Tapco has a leading market position in its siding accessories business
because of its strong ability to manufacture and distribute a broad range of
products economically and rapidly. However, Tapco's strong market position
suggests that its future growth will come largely from finding new products to
put into its manufacturing and distribution channels, not from increasing market
share in the siding accessories industry.

Intellectual Property

         Below is a summary of Headwaters' intellectual property. Collectively,
the intellectual property is important to Headwaters, although there is no
single patent or trademark that is itself material to Headwaters at the present
time.

         Headwaters itself has one registered trademark and one pending
trademark application.

         Headwaters Energy Services has nine U.S. patents and one registered
trademark.

         Headwaters Technology Innovation Group has 19 U. S. patents and 18 U.S.
patent applications pending. There are also nine foreign patents applications
pending. Headwaters Technology Innovation Group has six registered trademarks.

         Headwaters Resources has 10 U.S. patents and 7 U.S. patent applications
pending. Headwaters Resources also has three foreign patents with five pending
foreign applications. Headwaters Resources has 15 registered trademarks and two
pending applications.

         Headwaters Construction Materials has 93 U.S. patents and 36 U.S.
patent applications pending (primarily for Tapco). There are eight foreign
patents and 11 foreign patent applications pending. Headwaters Construction
Materials has 37 U.S. registered trademarks, 18 foreign trademarks, and 34
foreign trademark applications pending (primarily for Eldorado).

         There can be no assurance as to the scope of protection afforded by the
patents. In addition, there are other technologies in use and others may
subsequently be developed, which do not, or will not, utilize processes covered
by the patents. There can be no assurance that Headwaters' patents will not be

                                       16
<PAGE>

infringed or challenged by other parties or that Headwaters will not infringe on
patents held by other parties. Because many of these patents represent new
technology, the importance of the patents to Headwaters' business will depend on
its ability to commercialize these technologies successfully, as well as its
ability to protect its technology from infringement or challenge by other
parties.

         In addition to patent protection, Headwaters also relies on trade
secrets, know-how, and confidentiality agreements to protect these technologies.
Despite these safeguards, such methods may not afford complete protection and
there can be no assurance that others will not either independently develop such
know-how or unlawfully obtain access to Headwaters' know-how, concepts, ideas,
and documentation. Since Headwaters' proprietary information is important to its
business, failure to protect ownership of its proprietary information would
likely have a material adverse effect on Headwaters.

Regulations

         Section 29. Headwaters' coal-based solid alternative (or synthetic)
fuel business is subject to compliance with the terms of Section 29 of the
Internal Revenue Code. Under current law, Section 29 tax credits for synthetic
fuel produced from coal expires on December 31, 2007. There have been
initiatives from time to time to consider the early repeal or modification of
Section 29. For example, in 2004, a bill was introduced in the United States
House of Representatives that would repeal the Section 29 credit for synthetic
fuel produced from coal. Headwaters believes that it is unlikely that the bill
will pass Congress, but it could be reintroduced n the future.

         The IRS has suspended the issuance of private letter rulings (PLRs) to
synthetic fuel facility owners several times in the past. Most recently, in June
2003, the IRS stated, in summary, in Announcement 2003-46 that it "has had
reason to question the scientific validity of test procedures and results that
have been presented as evidence that fuel underwent a significant chemical
change, and is currently reviewing information regarding these test procedures
and results," and that pending its review of the issue it was suspending the
issuance of new PLRs regarding significant chemical change.

         The IRS release of Announcement 2003-46 caused certain of Headwaters'
licensees to temporarily reduce or cease synthetic fuel production, which
resulted in a reduction of Headwaters' revenue and net income. In October 2003,
the IRS stated in summary in Announcement 2003-70 that it continues to question
whether processes it had approved under its long-standing ruling practice
produce the necessary level of chemical change required under Section 29 and
Revenue Ruling 86-100. Nonetheless, the IRS indicated that it would continue to
issue PLRs regarding chemical change under the standards set forth in Revenue
Procedures 2001-30 and 2001-34, and that the industry's chemical change test
procedures and results are scientifically valid if applied in a consistent and
unbiased manner. Although the IRS resumed its practice of issuing PLRs, it
expressed continuing concerns regarding the sampling and data/record retention
practices prevalent in the synthetic fuels industry, and PLRs issued following
the release of Announcement 2003-70 have required taxpayers (i) to maintain
sampling and quality control procedures that conform to American Society for
Testing and Materials or other appropriate industry guidelines at the synthetic
fuel facilities, (ii) to obtain regular reports from independent laboratories
that have analyzed the fuel produced in such facilities to verify that the coal
used to produce the fuel undergoes a significant chemical change and (iii) to
maintain records and data underlying the reports that taxpayers obtain from
independent laboratories including raw FTIR data and processed FTIR data
sufficient to document the selection of absorption peaks and integration points.

         Also, in October 2003, the United States Senate Permanent Subcommittee
on Investigations issued a notification of pending investigations. The
notification listed the synthetic fuel tax credit as a new item. In March 2004,
the Subcommittee described its investigation as follows: "The Subcommittee is
continuing its investigation [of] tax credits claimed by Section 29 of the
Internal Revenue Code for the sale of coal-based synthetic fuels. The
investigation is examining the utilization of these tax credits, the nature of
the technologies and fuels created, the use of these fuels, and others [sic]
aspects of Section 29. The investigation will also address the IRS'
administration of Section 29 tax credits."

         The Subcommittee conducted numerous interviews and received large
volumes of data between December 2003 and March 2004. Since then, there has been
little activity on the investigation. The effect that the Senate subcommittee
investigation of synthetic fuel tax credits may have on the industry is unknown.
While the investigation is pending, it may have a material adverse effect on the

                                       17
<PAGE>

willingness of buyers to engage in transactions to purchase synthetic fuel
facilities or on the willingness of current owners to operate their facilities,
and may materially adversely affect Headwaters' revenues and net income. The
Subcommittee has not scheduled a hearing as of the date of this report.
Headwaters cannot make any assurances as to the timing or ultimate outcome of
the Subcommittee investigation, nor can Headwaters predict whether Congress or
others may conduct investigations of Section 29 tax credits in the future.

         Section 29 Phase-Out. In addition, tax credits claimed by a synfuel
plant operator may begin to be phased-out or eliminated prior to the sunset date
of December 31, 2007 if the "reference price" of oil exceeds an annual range of
oil prices, both adjusted annually for inflation. In May 2004, the IRS announced
that the phase-out range for 2003 beginning at $50.14 and ending with a $0 tax
credit at $62.94. Because the calendar year 2003 reference price of oil was
below that range, there was not a phase-out of the credit for qualified fuel
sold in 2003.

         The reference price of oil and the inflation adjustment factor (IAF)
are determined annually (and released in early April for the previous year),
while the predetermined oil price range is fixed, but adjusted annually for
inflation. The reference price of oil is defined as the annual average wellhead
price per barrel for all domestic crude oil not subject to regulation by the
U.S.

         Licensees are subject to audit by the IRS. The IRS may challenge
whether Headwaters' licensees satisfy the requirements of Section 29, or
applicable Private Letter Rulings, including placed-in-service requirements, or
may attempt to disallow Section 29 tax credits for some other reason. The IRS
has initiated audits of certain licensee-taxpayers who claimed Section 29 tax
credits, and the outcome of any such audit is uncertain. Recently, a licensee
announced that IRS field auditors have issued a notice of proposed adjustment
challenging the placed-in-service date of three of its synthetic fuel
facilities. The licensee believes that the facilities meet the placed-in-service
requirement, however, the matter is at an early stage and the timing and final
results of the audit are unknown. The inability of a licensee to claim Section
29 tax credits would reduce Headwaters' future income from the licensee.

         Environmental. Headwaters' operations and those of its suppliers and
customers involved in coal-based energy generation, primarily utilities, are
subject to federal, state and local environmental regulation. The coal-based
solid synthetic fuel operations of Headwaters and its licensees are subject to
federal, state and local environmental regulations that impose limitations on
the discharge of pollutants into the air and water and establish standards for
the treatment, storage and disposal of waste products, which add to the cost of
doing business and expose Headwaters to potential fines for non-compliance.
Moreover, in order to establish and operate the synthetic fuel plants, power
plants and operations to collect and transport CCPs and bottom ash, Headwaters'
and its licensees and customers have obtained various state and local permits
and must comply with processes and procedures that have been approved by
regulatory authorities. Compliance with permits, regulations and the approved
processes and procedures help protect against pollution and contamination and
are critical to Headwaters' business. Any failure to comply could result in the
issuance of substantial fines and penalties and cause us to incur environmental
liabilities.

         Headwaters believes that all required permits to construct and operate
these solid alternative fuel facilities have been or will be obtained and
believe the facilities are in substantial compliance with all relevant laws and
regulations governing alternative fuel operations.

         In spite of safeguards, Headwaters' operations entail risks of
regulatory noncompliance or accidental discharge that could create an
environmental liability because hazardous materials are used or stored during
normal business operations. For example, Headwaters and its subsidiaries use and
share other hazardous chemicals in order to conduct operations involving
distillation to purify products, analysis, packaging of chemicals and the
selling, warehousing and manufacturing of organic chemicals in small research
volumes. Headwaters' subsidiaries also use their facilities to perform research
and development activities involving coal, oil, chemicals and industrial gases
such as hydrogen. As a result, petroleum and other hazardous materials have been
and are present in and on their properties. Headwaters generally hires
independent contractors to transport and dispose of any hazardous materials
generated and send any hazardous wastes only to federally approved, large scale
and reputable off-site waste facilities.

         The federal Clean Air Act of 1970 and subsequent amendments
(particularly the Clean Air Act Amendments of 1990), and corresponding state
laws, which regulate the emissions of materials into the air, affect the coal
industry both directly and indirectly. The coal industry is directly affected by
Clean Air Act permitting requirements and/or emissions control requirements,
including requirements relating to particulate matter (such as, "fugitive
dust"). The coal industry may also be impacted by future regulation of fine
particulate matter measuring 2.5 micrometers in diameter or smaller. In July

                                       18
<PAGE>

1997, the EPA adopted new, more stringent National Ambient Air Quality
Standards, or NAAQS, for particulate matter and ozone. Although the NAAQS were
challenged in litigation, slowing their implementation, the standards were
upheld by the United States Supreme Court, and states will ultimately be
required to revise their existing state implementation plans ("SIPs") to attain
and maintain compliance with the new NAAQS. The new eight-hour ozone
nonattainment designations and classifications were published April 30, 2004,
along with Phase 1 of the final implementation rule for the eight-hour standard.
Both rules took effect June 15, 2004, and both are currently being litigated.
The Phase 2 implementation rule for the eight-hour standard is currently
expected in February or March 2005. The fine particulate matter nonattainment
designations have been projected to be finalized by the end of 2004, with their
implementation rule to follow at some future date. Because electric utilities
emit NOx, which are precursors to ozone and particulate matter, Headwaters
Resources' utility customers are likely to be affected when the new NAAQS are
implemented by the states. State and federal regulations relating to fugitive
dust and the implementation of the new NAAQS may reduce Headwaters Resources'
sources for its products. The extent of the potential impact of the new NAAQS on
the coal industry will depend on the policies and control strategies associated
with the state implementation process under the Clean Air Act.

         The 1990 Clean Air Act Amendments require utilities that are currently
major sources of NOx in moderate or higher ozone non-attainment areas to install
reasonably available control technology for NOx. EPA promulgated a rule (the
"NOx SIP call") in 1998 requiring 22 eastern states to make substantial
reductions in NOx emissions. Court action eliminated one state and portions of
two others from the rule. Under this rule, EPA expects that states will achieve
these reductions by requiring power plants to make substantial reductions in
their NOx emissions. The affected states were required to implement Phase I of
the NOx SIP call by May 31, 2004. On April 21, 2004, EPA published Phase II of
the NOx SIP call, which will require an additional reduction of about 100,000
tons of NOx per year by 2007. In addition to the NOx SIP call, EPA's April 21,
2004 rule also addressed the requirement that it directly regulate NOx emissions
from states upwind of four eastern states that petitioned EPA (pursuant to
section 126 of the Clean Air Act). The section 126 rule will be withdrawn in any
state that submits an approvable NOx SIP. Installation of reasonably available
control technology and additional control measures required under the NOx SIP
call or the section 126 rule will make it more costly to operate coal-fueled
utility power plants and, depending on the requirements of individual SIPs,
could make coal a less attractive fuel alternative in the planning and building
of utility power plants in the future. The effect such regulation or other
requirements that may be imposed in the future could have on the coal industry
in general and on Headwaters Resources in particular cannot be predicted with
certainty. No assurance can be given that the ongoing implementation of the
Clean Air Act (including the 1990 Amendments) or any future regulatory
provisions will not materially adversely affect Headwaters Resources.

         In addition, the 1990 Clean Air Act Amendments require a study of
utility power plant emissions of certain toxic substances, including mercury,
and direct EPA to regulate emissions of these substances, if warranted. EPA has
submitted reports to Congress on Mercury (1997) and Utility Air Toxics (1998).
On December 14, 2000, EPA announced its finding that regulation of hazardous air
pollutant emissions from oil- and coal-fueled electric utility steam generating
units is necessary and appropriate. On January 30, 2004, EPA published the
proposed Utility Mercury Reductions Rule, which sought comments on two
approaches for reducing mercury emissions from coal-burning power plants. EPA is
currently projecting that the rule will be finalized in March of 2005.
Additionally, on January 30, 2004, EPA published a proposal, known as the Clean
Air Interstate Rule, that would require coal-burning power plants to upgrade
their facilities to reduce emissions of sulfur dioxide ("SOx") by 70% and NOx by
65%. EPA currently anticipates finalizing that rule by the end of 2004. Taken
together, these rules, once they are finalized, could result in reduced use of
coal if utilities switch to other sources of fuel.

         The Clear Skies Initiative, announced by the Bush Administration in
February 2002 (S.485 and H.R. 999, and revised by S.1844), seeks to develop
strategies for reducing emissions of SOx, NOx and mercury from power plants.
Because the Initiative must be implemented by legislation that has not yet been
enacted, its effect on Headwaters Resources cannot be determined at this time.
However, in February and April 2003, two four-pollutant bills (S.366 and S.843,
respectively) for power plants were referred to the Senate Environment and
Public Works Committee. In addition to the three pollutants covered under the
Clear Skies Initiative, these bills include the greenhouse gas carbon dioxide.
If enacted as written, these bills could result in reduced use of coal if
utilities switch to other sources of fuel as a means of complying with more
stringent emission limits. It is not likely that any of these bills will be
enacted during 2004, but the Administration intends to make a strong push to
enact Clear Skies in the 109th Congress. Many of the goals of Clear Skies
legislation will be accomplished by the Utility Mercury Rule and the Clean Air
Interstate Rule, once they are finalized (see discussion above).

                                       19
<PAGE>

         Coal-fueled boilers have been impacted by regulations under the 1990
Clean Air Act Amendments, which established specific emissions levels for SOx
and NOx in order to reduce acid rain. These emissions levels have required
utilities to undertake many of the following changes: change their fuel
source(s), add scrubbers to capture SOx, add new boiler burner systems to
control NOx, add or modify fuel pulverizers/air handling systems to control NOx,
introduce flue gas conditioning materials to control particulate emissions in
conjunction with meeting SOx emissions targets and in some very isolated cases
shut down a plant. All of these changes can impact the quantity and quality of
CCPs produced at a power plant and can add to the costs of operating a power
plant. Furthermore, proposed regulations to control mercury emissions could
result in implementation of additional technologies at power plants that could
negatively affect fly ash quality.

         Further, inappropriate use of CCPs can result in faulty end products.
Since most of the products marketed by Headwaters Resources typically consist of
a mixture of client-supplied CCPs, Headwaters Resources does not control the
quality of the final end product, but may share such control with the
manufacturer of the ingredient materials. Therefore, there is a risk of
liability regarding the quality of the materials and end products marketed by
Headwaters Resources. In cases where Headwaters Resources is responsible for
end-product quality, such as a structural fill (where material is used to fill a
cavity or designated area), Headwaters Resources depends solely on its own
quality assurance program.

         Materials sold by Headwaters Resources vary in chemical composition.
Fossil fuel combustion wastes have been excluded from regulation as "hazardous
wastes" under subtitle C of the Resource Conservation and Recovery Act ("RCRA").
However, EPA has determined that national regulations under subtitle D of RCRA
(dealing with state and regional solid waste plans) are warranted for coal
combustion byproducts disposed of in landfills or surface impoundments, or used
to fill surface or underground mines. EPA is planning to publish proposed rules
for CCPs generated by commercial electric power producers in March 2007 and for
management of CCPs at mine facilities in October 2007 which will address, among
other things, state and regional solid waste plans for CCPs disposed of in
landfills or surface impoundments, or used to fill surface or underground mines.
These proposed rules could make coal burning more expensive or less attractive
to Headwaters Resources' utility clients. Headwaters Resources manages a number
of landfill and pond operations that may be affected by EPA's proposed
regulations. In most of these operations the permitting is contractually
retained by the client and the client would be liable for any costs associated
with new permitting requirements. The effect of such regulations on Headwaters
Resources cannot be completely ascertained at this time.

         Headwaters Resources is engaged in providing services at one landfill
operation that is permitted and managed as a hazardous waste landfill.
Headwaters Resources provides the services necessary to landfill the client's
hazardous wastes and operates certain in-plant equipment and systems for the
client. Accordingly, there can be no assurance that Headwaters Resources will
not be named in third-party claims relating to the project.

         CCPs may contain small concentrations of metals that are considered as
"hazardous substances" under the Comprehensive Environmental Response
Compensation and Liability Act ("CERCLA"). Land application of CCPs is regulated
by a variety of federal and state statutes, which impose testing and management
requirements to ensure environmental protection. Under limited circumstances,
mismanagement of CCPs can give rise to CERCLA liability.

         Electric utility deregulation has slowed substantially from previous
years' predictions. Deregulation could negatively impact Headwaters Resources
because it could result in some sources of CCPs being put out of service because
they are not economically competitive. On the other hand, deregulation efforts
have spurred renewed interest in construction of new coal-fueled electricity
generating capacity. Headwaters believes that no significant changes to the
sources of CCPs under contract will occur. However, since this change to the
industry continues to evolve, the impact of deregulation cannot be accurately
projected, and Headwaters could be materially adversely affected if major
changes occur to specific sources.

Employees

         Headwaters employs approximately 3,680 full-time employees. There are
approximately 45 employees in Headwaters' corporate administration. The
following lists the approximate number of employees by business units:

         Headwaters Energy Services, 20

                                       20
<PAGE>

         Headwaters Resources, 710

         Headwaters Technology Innovation Group, 45

         Headwaters Construction Materials, 2,860

Approximately 16 employees work under collective bargaining agreements.

ITEM 2. PROPERTIES

         Headwaters' headquarters are located at 10653 South River Front
Parkway, Suite 300, South Jordan, Utah 84095. The lease for this office space of
approximately 26,500 square feet provides for a six-year term. The monthly rent
is approximately $41,000, with certain adjustments for inflation plus expenses.

         Headwaters Energy Services directs its operations primarily from
Headwaters' South Jordan, Utah location.

         Headwaters Technology Innovation Group owns approximately six acres in
Lawrenceville, New Jersey where it maintains offices and its research
facilities.

         Headwaters Resources owns or leases 16 properties nationwide for its
fly ash storage and distribution operations with East, Central, and West
regional divisions. Headwaters Resources also conducts operations at numerous
other sites via rights granted in various CCP through-put, handling and
marketing contracts (for example, operating a storage or load-out facility
located on utility-owned properties).

         Headwaters Construction Materials owns or leases 51 properties
nationwide for its building products manufacturing distribution, and sales
operations. Tapco is headquartered in Wixom, Michigan and has major
manufacturing facilities in Metamora, Michigan and Elkland, Pennsylvania.
Eldorado is headquartered in San Marcos, California and has major manufacturing
facilities in Rancho Cucamonga, California and Greencastle, Pennsylvania.

ITEM 3. LEGAL PROCEEDINGS

         Headwaters has ongoing litigation and claims incurred during the normal
course of business, including the items discussed below. Headwaters intends to
vigorously defend or resolve these matters by settlement, as appropriate.
Management does not currently believe that the outcome of these matters will
have a material adverse effect on Headwaters' operations, cash flows or
financial position.

         In 2004, Headwaters accrued approximately $1,400,000 of reserves for
legal matters because it concluded that claims and damages sought by claimants
in excess of that amount were not probable. Our outside counsel believe that
unfavorable outcomes are neither probable nor remote and declined to express
opinions concerning the likely outcomes or liability of Headwaters. The reserves
represent the amounts Headwaters would be willing to pay to reach a settlement.
However, these cases raise difficult and complex legal and factual issues, and
the resolution of these issues is subject to many uncertainties, including the
facts and circumstances of each case, the jurisdiction in which each case is
brought, and the future decisions of juries, judges, and arbitrators. Therefore,
although management believes that the claims asserted against Headwaters in the
named cases lack merit, there is a possibility of material losses in excess of
the amounts accrued if one or more of the cases were to be determined adversely
against Headwaters for a substantial amount of the damages asserted. Headwaters
believes the range of potential loss is from $1,400,000 up to the amounts sought
by claimants. It is possible that a change in the estimates of probable
liability could occur, and the changes could be significant. Additionally, as
with any litigation, these proceedings require that Headwaters incur substantial
costs, including attorneys' fees, managerial time, and other personnel resources
and costs in pursuing resolution. Costs paid to outside legal counsel for
litigation, which comprise the majority of Headwaters' litigation-related costs,
totaled approximately $1,700,000 in 2002, $3,000,000 in 2003, and $3,800,000 in
2004. It is not possible to estimate what these costs will be in future periods.

         Boynton. In October 1998, Headwaters entered into a technology purchase
agreement with James G. Davidson and Adtech, Inc. The transaction transferred
certain patent and royalty rights to Headwaters related to a synthetic fuel
technology invented by Davidson. (This technology is distinct from the

                                       21
<PAGE>

technology developed by Headwaters.) This action is factually related to an
earlier action brought by certain purported officers and directors of Adtech,
Inc. That action was dismissed by the United States District Court for the
Western District of Tennessee and the District Court's order of dismissal was
affirmed on appeal. In the current action, the allegations arise from the same
facts, but the claims are asserted by certain purported stockholders of Adtech.
In June 2002, Headwaters received a summons and complaint from the United States
District Court for the Western District of Tennessee alleging, among other
things, fraud, conspiracy, constructive trust, conversion, patent infringement
and interference with contract arising out of the 1998 technology purchase
agreement entered into between Davidson and Adtech on the one hand, and
Headwaters on the other. The plaintiffs seek declaratory relief and compensatory
damages in the approximate amount of between $15,000,000 and $25,000,000 and
punitive damages. The District Court has dismissed all claims against Headwaters
except conspiracy and constructive trust. The Court has scheduled trial for
April 2005. Because the resolution of the litigation is uncertain, legal counsel
cannot express an opinion as to the ultimate amount, if any, of Headwaters'
liability.

         AGTC. In March 1996, Headwaters entered into an agreement with AGTC and
its associates for certain services related to the identification and selection
of alternative fuel projects. In March 2002, AGTC filed an arbitration demand in
Salt Lake City, Utah claiming that it is owed commissions under the 1996
agreement for 8% of the revenues received by Headwaters from the Port Hodder
project. AGTC is seeking approximate damages in the arbitration between $520,000
and $14,300,000. Headwaters asserts that AGTC did not perform under the
agreement and that the agreement was terminated and the disputes were settled in
July 1996. Headwaters filed an answer in the arbitration, denying AGTC's claims
and asserting counterclaims against AGTC. The arbitrator conducted hearings
during July and August of 2004 and has received a post-arbitration briefing but
has not yet issued a decision. Because the resolution of the arbitration is
uncertain, legal counsel cannot express an opinion as to the ultimate amount, if
any, of Headwaters' liability.

         AJG. In December 1996, Headwaters entered into a technology license and
proprietary chemical reagent sale agreement with AJG Financial Services, Inc.
The agreement called for AJG to pay royalties and to purchase proprietary
chemical reagent material from Headwaters. In October 2000, Headwaters filed a
complaint in the Fourth District Court for the State of Utah against AJG
alleging that it had failed to make payments and to perform other obligations
under the agreement. Headwaters asserts claims including breach of contract,
declaratory judgment, unjust enrichment and accounting and seeks money damages
as well as other relief. AJG's answer to the complaint denied Headwaters' claims
and asserted counter-claims based upon allegations of misrepresentation and
breach of contract. AJG seeks compensatory damages in the approximate amount of
$71,000,000 and punitive damages. Headwaters has denied the allegations of AJG's
counter-claims. The court has scheduled trial for January 2005. Because the
resolution of the litigation is uncertain, legal counsel cannot express an
opinion as to the ultimate amount of recovery or liability.

         McEwan. In 1995, Headwaters granted stock options to a member of its
board of directors, Lloyd McEwan. The director resigned from the board in 1996.
Headwaters has declined McEwan's attempts to exercise most of the options on
grounds that the options terminated. In June 2004, McEwan filed a complaint in
the Fourth District Court for the State of Utah against Headwaters alleging
breach of contract, breach of implied covenant of good faith and fair dealing,
fraud, and misrepresentation. McEwan seeks declaratory relief as well as
compensatory damages in the approximate amount of $2,750,000 and punitive
damages. Headwaters has filed an answer denying McEwan's claims and has asserted
counterclaims against McEwan. Because resolution of the litigation is uncertain,
legal counsel cannot express an opinion as to the ultimate amount of liability
or recovery.

         Headwaters Construction Materials Matters. There are litigation and
pending and threatened claims made against certain subsidiaries of Headwaters
Construction Materials with respect to several types of exterior finish systems
manufactured and sold by its subsidiaries for application by contractors on
residential and commercial buildings. Typically, litigation and these claims are
controlled by such subsidiaries' insurance carriers. The plaintiffs or claimants
in these matters have alleged that the structures have suffered damage from
latent or progressive water penetration due to some alleged failure of the
building product or wall system. The most prevalent type of claim involves
alleged defects associated with components of an Exterior Insulation and Finish
System (EIFS) which was produced for a limited time (through 1996) by best
Masonry & Tool Supply. There is a 10-year projected claim period following
discontinuation of the product.

         Typically, the claims cite damages for alleged personal injuries and
punitive damages for alleged unfair business practices in addition to asserting
more conventional damage claims for alleged economic loss and damage to
property. To date, claims made against such subsidiaries have been paid by their
insurers, with the exception of minor deductibles, although such insurance
carriers typically have issued "reservation of rights" letters to Headwaters
Construction Materials. None of the cases has gone to trial, and while two such
cases involve 100 and 800 homes, respectively, none of the cases includes any

                                       22
<PAGE>

claims formally asserted on behalf of a class. While, to date, none of these
proceedings have required that Headwaters Construction Materials incur
substantial costs, there is no guarantee of insurance coverage or continuing
coverage. These and future proceedings may result in substantial costs to
Headwaters Construction Materials, including attorneys' fees, managerial time
and other personnel resources and costs. Adverse resolution of these proceedings
could have a materially negative effect on Headwaters Construction Materials'
business, financial condition, and results of operation, and its ability to meet
its financial obligations. Although Headwaters carries general and product
liability insurance, Headwaters cannot assure that such insurance coverage will
remain available, that the insurance carriers will remain viable, or that the
insured amounts will cover all future claims in excess of the uninsured
retention. Future rate increases may also make such insurance uneconomical for
Headwaters Construction Materials to maintain. In addition, the insurance
policies maintained by Headwaters excludes claims for damages resulting from
exterior insulating finish systems, or EIFS, that have manifested after March
2003. Because resolution of the litigation and claims is uncertain, legal
counsel cannot express an opinion as to the ultimate amount, if any, of
Headwaters Construction Materials' liability.

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


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

         None.


                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
        ISSUER PURCHASES OF EQUITY SECURITIES

         The shares of Headwaters' common stock trade on the Nasdaq National
Market under the symbol "HDWR." Options on Headwaters' common stock are traded
on the Chicago Board Options Exchange under the symbol "HQK." The following
table sets forth for the periods presented, the high and low trading prices of
Headwaters' common stock as reported by Nasdaq.

         Fiscal 2003                                      Low          High
         -----------                                      ---          ----

         Quarter ended December 31, 2002               $12.81        $18.03
         Quarter ended March 31, 2003                   13.50         16.64
         Quarter ended June 30, 2003                    13.25         20.25
         Quarter ended September 30, 2003               12.86         16.30

         Fiscal 2004
         -----------

         Quarter ended December 31, 2003               $14.78        $20.87
         Quarter ended March 31, 2004                   19.50         25.99
         Quarter ended June 30, 2004                    19.50         29.60
         Quarter ended September 30, 2004               23.12         32.02

         As of November 30, 2004, there were 352 stockholders of record of
Headwaters' common stock. Headwaters has not paid dividends on its common stock
to date and does not intend to pay dividends on its common stock in the
foreseeable future. Pursuant to debt agreements Headwaters entered into in
September 2004, Headwaters is prohibited from paying cash dividends so long as
any of the long-term debt is outstanding. Headwaters intends to retain earnings
to finance the development and expansion of its business. Payment of common
stock dividends in the future will depend, among other things, upon Headwaters'
debt covenants, its ability to generate earnings, its need for capital, its
investment opportunities and its overall financial condition. See Note 12 to the
consolidated financial statements for a description of securities authorized for
issuance under equity compensation plans.

                                       23
<PAGE>

Recent Sales of Unregistered Securities

         In June 2004 Headwaters issued $172.5 million in aggregate principal
amount of 2 7/8% Convertible Senior Subordinated Notes due 2016 in a private
placement pursuant to Section 4(2) of the Securities Act of 1933, as amended.
The initial purchasers of the notes were Morgan Stanley & Co. Incorporated; J.P.
Morgan Securities, Inc.; Adams, Harkness & Hill, Inc.; RBC Capital Markets
Corporation; and Stephens Inc. The initial purchasers resold the notes to
"qualified institutional buyers," as defined in Rule 144A under the Securities
Act of 1933, as amended, in reliance of Rule 144A. The net proceeds from the
issuance of notes were $166.3 million after deducting selling discounts and
commissions and offering expenses. The proceeds were used to finance, in part,
Headwaters acquisition of Eldorado Stone. The notes are due on June 1, 2016.
Headwaters pays interest on the notes on June 1 and December 1 of each year,
beginning December 2, 2004. Subject to the terms of the notes, holders may
convert the notes into shares of Headwaters' common stock at a conversion price
of $30.00 per share, which is equivalent to a conversion rate of 33.3333 shares
of Headwaters common stock per $1,000 principal amount of notes. This conversion
rate is subject to adjustment under the terms of the notes. Conversion can occur
only under certain circumstances, including generally when the sale price of
Headwaters common stock exceeds 130% of the conversion price, which would be
$39.00 per share. The notes are general, unsecured obligations that are
subordinated to all existing and future senior indebtedness and Headwaters'
subsidiaries indebtedness and other liabilities. Headwaters may redeem any
portion of the notes at anytime on or after June 4, 2011, and if specific
conditions are satisfied, any time on or after June 1, 2007. On June 1, 2011, or
upon the occurrence of a designated event, holders of the notes may require
Headwaters to repurchase the notes. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity and Capital Resources"
of Item 7 hereof for a more detailed description of the notes.

ITEM 6. SELECTED FINANCIAL DATA

         The following selected financial data are derived from the consolidated
financial statements of Headwaters. This information should be read in
conjunction with the consolidated financial statements, related notes and other
financial information included herein.

         In August 2001, Headwaters acquired HTI, the financial statements of
which have historically been consolidated with Headwaters' financial statements
using a one-month lag. Accordingly, no results of operations of HTI were
included in the consolidated statement of income for 2001. HTI's August 31,
2001, 2002 and 2003 balance sheets were consolidated with Headwaters' September
30, 2001, 2002 and 2003 balance sheets and HTI's results of operations for the
twelve months ended August 31, 2002 and 2003 were consolidated with Headwaters'
2002 and 2003 results. Effective October 1, 2003, Headwaters eliminated the
one-month lag and accordingly, 13 months of HTI's results of operations have
been included in the consolidated statement of income for 2004.

         Also, as more fully described in Note 3 to the consolidated financial
statements, Headwaters acquired HRI on September 19, 2002 and accordingly, HRI's
results of operations for the period from September 19, 2002 through September
30, 2004 have been consolidated with Headwaters' 2002 through 2004 results.
HRI's results of operations up to September 18, 2002 have not been included in
Headwaters' consolidated results for any period. Headwaters acquired VFL on
April 9, 2004, Eldorado Stone on June 2, 2004, SCP on July 2, 2004, and Tapco
Holdings on September 8, 2004. These entities' results of operations for the
periods from the acquisition dates through September 30, 2004 have been
consolidated with Headwaters' 2004 results and their operations up to the dates
of acquisition have not been included in Headwaters' consolidated results for
any period.

         In 2001, Headwaters recorded approximately $7.5 million of income tax
benefit primarily related to the reduction of its deferred tax asset valuation
allowance. In 2004, Headwaters recognized revenue relating to funds deposited in
an escrow account totaling approximately $27.9 million, most of which related to
prior periods (see Note 14 to the consolidated financial statements). In
addition, revenue and net income for 2004 were materially affected by the 2004
acquisitions (see Note 3 to the consolidated financial statements).

         The selected financial data as of and for the years ended September 30,
2000 and 2001 and as of September 30, 2002 are derived from audited financial
statements not included herein. The selected financial data as of September 30,
2003 and 2004 and for the years ended September 30, 2002, 2003, and 2004 were
derived from the audited financial statements of Headwaters included elsewhere
herein.

                                       24
<PAGE>
<TABLE>
<CAPTION>
                                                                      Year ended September 30,
                                                  -----------------------------------------------------------------
(in thousands, except per share data)                2000         2001         2002         2003          2004
-------------------------------------------------------------------------------------------------------------------
<S>                                                   <C>          <C>         <C>          <C>         <C>
OPERATING DATA:
     Total revenue                                    $27,886      $45,464     $119,345     $387,630    $  553,955
     Net income                                         3,682       21,517       24,286       36,631        64,317
     Diluted earnings per share                          0.07         0.87         0.94         1.30          1.95

<CAPTION>
                                                                        As of September 30,
                                                  -----------------------------------------------------------------
(in thousands)                                       2000         2001         2002         2003          2004
-------------------------------------------------------------------------------------------------------------------
<S>                                                   <C>          <C>         <C>          <C>         <C>
BALANCE SHEET DATA:
     Working capital                                  $ 8,393      $ 8,619     $ 15,023     $ 14,176    $   44,387
     Net property, plant and equipment                    552        2,680       50,549       52,743       157,611
     Total assets                                      33,441       55,375      372,857      373,275     1,540,779
     Long-term obligations:
         Long-term debt                                 5,055          149      154,552      104,044       914,641
         Deferred income taxes                             --           --       51,357       50,663       121,469
         Other long-term liabilities                    7,861        8,711        5,442        4,703        10,338
                                                  -----------------------------------------------------------------
     Total long-term obligations                       12,916        8,860      211,351      159,410     1,046,448
     Total stockholders' equity                        10,747       31,086       98,596      140,157       308,155
</TABLE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

         The following discussion and analysis should be read in conjunction
with the information set forth under the caption entitled "ITEM 6. SELECTED
FINANCIAL DATA" and the consolidated financial statements and notes thereto
included elsewhere herein. Headwaters' fiscal year ends on September 30 and
unless otherwise noted, future references to years refer to Headwaters' fiscal
year rather than a calendar year.

Introduction

         Over the last three years, Headwaters has executed on its two-fold plan
of maximizing cash flow from its existing operating business units and
diversifying revenues from reliance on the alternative energy segment. With the
addition of the CCP management and marketing business through the acquisition of
ISG in 2002, and the growth of the construction materials business culminating
in the acquisitions of Eldorado and Tapco in 2004, Headwaters has achieved
revenue growth and diversification into three business segments. Because
Headwaters has also incurred increased indebtedness to make strategic
acquisitions and related capital expenditures, one of management's key financial
objectives is to continue to focus on increased cash flows for purposes of
reducing indebtedness as quickly as possible.

         Headwaters' acquisition strategy targets businesses that are leading
players in their respective industries, enjoy healthy margins from products and
services and are not capital intensive, thus providing additional cash flow that
complements the financial performance of Headwaters' existing business segments.
Headwaters is also committed to the internal development of its energy-related
technologies and nanotechnology through HTI; it has invested in and expects to
continue to maintain its research and development activities.

         As a result of its diversification into CCPs and construction
materials, Headwaters is affected by seasonality, with its highest revenues
produced in the June 30 and September 30 quarters. With CCPs, Headwaters'
strategy is to continue to negotiate long-term contracts so that it may invest
in transport and storage infrastructure for the management and sale of CCPs.
Headwaters also intends to continue to expand usage of high value CCPs, develop
uses for lower value CCPs and expand usage of CCPs both in its construction
products and the industry in general.

         Headwaters' acquisitions of Eldorado and Tapco have created a
concentration in the residential housing market; however, the cyclicality and
interest-rate sensitivity of this business is mitigated by the fact that
approximately 75% of Tapco's products are used in the home improvement and
remodeling market, which is typically counter cyclical to the new construction
market because remodeling is generally less expensive than a new home and is
often required to maintain older homes and preserve their value. As a result,
during economic downturns, Tapco's products have experienced strong growth
rates. In light of Headwaters' leading market shares in Edorado's and Tapco's
markets, Headwaters will need to increase production capacity for Eldorado and
develop and promote new products from Tapco in order to continue the current
growth rate in this segment.

                                       25
<PAGE>

         In fiscal 2005, Headwaters will focus on integration of its new
acquisitions, including the marketing of diverse construction materials products
through its national distribution network, and expansion of the corporate
infrastructure necessary to provide the information and services that the
business segments need to operate at optimal levels. Headwaters is highly
leveraged as a result of the 2004 acquisitions. This leverage makes continued
diversification at historical levels more difficult. Headwaters intends to focus
on repaying its current debt as quickly as possible while continuing to look for
diversification opportunities within prescribed parameters.

Consolidation, Acquisitions and Segments

         Consolidation. The consolidated financial statements include the
accounts of Headwaters, all of its subsidiaries and other entities in which
Headwaters has a controlling financial interest. Headwaters also consolidates
any variable interest entities for which it is the primary beneficiary; however
as of September 30, 2004, there are none. For investments in companies in which
Headwaters has a significant influence over operating and financial decisions
(generally defined as owning a voting or economic interest of 20% to 50%),
Headwaters applies the equity method of accounting. In instances where
Headwaters' investment is less than 20% and significant influence does not
exist, investments are carried at cost. All significant intercompany
transactions and accounts are eliminated in consolidation.

         Headwaters acquired ISG on September 19, 2002 and accordingly, ISG's
results of operations for the period from September 19, 2002 through September
30, 2004 have been consolidated with Headwaters' 2002 through 2004 results.
ISG's results of operations up to September 18, 2002 have not been included in
Headwaters' consolidated results for any period. Headwaters acquired VFL on
April 9, 2004, Eldorado Stone on June 2, 2004, SCP on July 2, 2004, and Tapco on
September 8, 2004. These entities' results of operations for the periods from
the acquisition dates through September 30, 2004 have been consolidated with
Headwaters' 2004 results and their operations up to the dates of acquisition
have not been included in Headwaters' consolidated results for any period.

         Due to the time required to obtain accurate financial information
related to HTI's foreign contracts, for financial reporting purposes HTI's
financial statements have historically been consolidated with Headwaters'
financial statements using a one-month lag. Effective October 1, 2003,
Headwaters eliminated this one-month lag because of the decreased significance
of HTI's foreign contracts. Accordingly, 13 months of HTI's results of
operations have been included in the consolidated statement of income for 2004.

         Acquisitions. As described in the following paragraphs, Headwaters
acquired four companies in 2004 and one company in 2002. Due to the significance
of these acquisitions, in many instances the consolidated financial statements
and components of those financial statements discussed in the following
discussion and analysis are not comparable to prior years' financial statements
or components thereof.

         VFL - On April 9, 2004, Headwaters acquired 100% of the common stock of
VFL Technology Corporation ("VFL") and assumed all of VFL's outstanding debt.
VFL is based in West Chester, Pennsylvania and manages approximately two million
tons of CCPs annually. In addition, VFL has operating knowledge relating to the
use of low quality CCP materials in value-added applications. The acquisition of
VFL broadens the scope of services that Headwaters' CCP segment offers, as well
as its client base, principally on the East coast of the United States and in
the Ohio River Valley. VFL's results of operations have been included in
Headwaters' consolidated statement of income since April 9, 2004.

         The VFL acquisition was accounted for using the purchase method of
accounting as required by SFAS No. 141, "Business Combinations." The
consideration Headwaters paid for VFL was negotiated at arms length and assets
acquired and liabilities assumed were recorded at their estimated fair values as
of April 9, 2004. Approximately $11.3 million of the purchase price was
allocated to identifiable intangible assets consisting of contracts with utility
companies, industrial clients and municipalities. This amount is being amortized
over an estimated average useful life of eight years. The remaining purchase
price not attributable to the tangible and identifiable intangible assets was
allocated to goodwill, all of which is expected to be tax deductible. All of the
intangible assets and goodwill have been allocated to Headwaters' CCP segment.

         Eldorado - On June 2, 2004, Headwaters acquired 100% of the ownership
interests of Eldorado Stone LLC ("Eldorado") and paid off all of Eldorado's
outstanding debt. Eldorado is based in San Marcos, California and is a leading
manufacturer of architectural manufactured stone. With over 700 distributors,
Eldorado provides Headwaters with a national platform for expanded marketing of
"green" building products, such as mortar and stucco, by using higher amounts of
fly ash. Headwaters expects Eldorado, which is included in its construction
materials segment, to provide critical mass and improved margins in Headwaters'
efforts to expand the use of fly ash in building products. Eldorado's results of
operations have been included in Headwaters' consolidated statement of income
since June 2, 2004.

                                       26
<PAGE>

         The Eldorado acquisition was accounted for using the purchase method of
accounting. The consideration Headwaters paid for Eldorado was negotiated at
arms length and assets acquired and liabilities assumed were recorded at their
estimated fair values as of June 2, 2004. Eldorado has experienced significant
growth over the last two years. Eldorado sells its products through an extensive
distribution network. In addition, Eldorado employs a group of talented artists
who create the molds used to produce the manufactured stone product. The quality
of these molds adds significant value to the end product. Eldorado's
manufacturing process, market presence and the quality of its product, including
product design and product breadth, are major elements contributing to
Eldorado's high value and related purchase price. These items, combined with
Eldorado's high growth and extensive distribution network are not separable and,
accordingly, contribute to a significant amount of goodwill. Approximately $9.0
million of the purchase price was allocated to identifiable intangible assets,
consisting primarily of non-compete agreements. The intangible assets are being
amortized over estimated useful lives ranging from three to ten years, with a
combined weighted average life of approximately four years. The remaining
purchase price not attributable to the tangible and identifiable intangible
assets was allocated to goodwill, most of which is expected to be tax
deductible. All of the intangible assets and goodwill have been allocated to
Headwaters' construction materials segment.

         The determination of the final purchase price is subject to potential
adjustments related to the working capital acquired at closing. In addition, the
purchase price allocation will likely differ from that reflected in the
consolidated financial statements after final asset valuation reports are
received and a detailed review of all assets and liabilities, including income
taxes, has been completed. Pre-acquisition contingencies, which are not
material, are included in the value of liabilities assumed as of June 2, 2004
and any change from the recorded amounts is expected to be immaterial. The final
purchase price allocation is expected to be completed by March 31, 2005. Any
changes to the purchase price allocation are not expected to materially increase
or decrease depreciation and amortization expense, but may have a material
effect on the amount of recorded goodwill.

         SCP - On July 2, 2004, Headwaters acquired certain assets of Southwest
Concrete Products, L.P. ("SCP") and assumed all of SCP's outstanding debt. SCP
is based in Alleyton, Texas and is a leading manufacturer of concrete blocks in
South Texas, complementing Headwaters' similar operations in Dallas and East
Texas. SCP provides Headwaters with modern concrete-based manufacturing
facilities and the opportunity to increase the use of CCPs in the manufacture of
block and brick. SCP also has an experienced management team and the president
of SCP subsequently assumed responsibility for all of Headwaters' construction
materials operations other than for Eldorado and Tapco. SCP's results of
operations have been included in Headwaters' consolidated statement of income
since July 2, 2004.

         Headwaters also agreed to pay an earn-out to the sellers if certain
earnings targets are exceeded during the 12 months ending December 31, 2005 (the
"earn-out period"). The additional earn-out consideration will be the product of
5.7 times the amount, if any, that earnings before interest, taxes, depreciation
and amortization ("EBITDA") of SCP exceeds $5.5 million during the earn-out
period. If any earn-out consideration is paid, which will not occur until 2006,
goodwill will be increased accordingly.

         The SCP acquisition was accounted for using the purchase method of
accounting. The consideration Headwaters paid for SCP was negotiated at arms
length and assets acquired and liabilities assumed were recorded at their
estimated fair values as of July 2, 2004. Approximately $6.9 million of the
purchase price was allocated to identifiable intangible assets, consisting
primarily of customer relationships. The intangible assets are being amortized
over estimated useful lives ranging from two to ten years, with a combined
weighted average life of approximately seven years. The remaining purchase price
not attributable to the tangible and identifiable intangible assets was
allocated to goodwill, substantially all of which is expected to be tax
deductible. All of the intangible assets and goodwill have been allocated to
Headwaters' construction materials segment.

         Tapco - On September 8, 2004, Headwaters acquired 100% of the ownership
interests of Tapco Holdings, Inc. ("Tapco") and paid off all of Tapco's
outstanding debt. Tapco is headquartered in Wixom, Michigan and is a leading
designer, manufacturer and marketer of specialty building products and
professional tools used in exterior residential home improvement and
construction throughout the United States and Canada. Headwaters expects the
Tapco acquisition to further diversify Headwaters' cash flow stream away from
its historical reliance on alternative energy. Tapco brings economy of scale and
manufacturing expertise that results in some of the lowest manufacturing costs
in the siding accessory industry, which is expected to improve margins in
Headwaters' construction materials segment. Headwaters may also be able to
leverage Tapco's distribution networks to accelerate sales of Headwaters'
diverse construction materials product portfolio. Tapco's results of operations
have been included in Headwaters' consolidated statement of income beginning
September 8, 2004.

                                       27
<PAGE>

         The Tapco acquisition was accounted for using the purchase method of
accounting. The consideration Headwaters paid for Tapco was negotiated at arms
length and assets acquired and liabilities assumed were recorded at their
estimated fair values as of September 8, 2004. Tapco has a leading market share
in most of its product lines with some lines having a market share greater than
75%. Tapco has the ability to deliver its products within a few days of
receiving the order which is appealing to architects, contractors and end users
of the product. Tapco also offers wide-ranging product choices delivered through
an extensive distribution network throughout the United States. Tapco's
products, manufacturing process and distributors are currently substantially
different than those utilized by Headwaters' other business units and a
substantial amount of sales relate to the remodeling industry. As such, Tapco
may further mitigate the cyclical nature of Headwaters' construction materials
business in the future. Tapco's primary value, therefore, is due to its
significant market presence and manufacturing efficiencies. These values are
largely the result of Tapco's manufacturing and distribution capacities, product
breadth and workforce which are not separable and, accordingly, contribute to a
significant amount of goodwill.

         The final purchase price and the allocation thereof will differ from
that reflected in the consolidated financial statements after final fixed asset
and intangible asset valuation reports are received and a detailed review of all
assets and liabilities, including income taxes, has been completed. The final
purchase price allocation is expected to be completed by June 30, 2005. The
final purchase price allocation is not expected to materially increase or
decrease depreciation and amortization expense from the amounts recorded in 2004
and the amounts expected to be recorded in future periods, nor is it expected to
have a material effect on the identified assets or liabilities, including
goodwill.

         ISG Acquisition - On September 19, 2002, Headwaters acquired 100% of
the common stock of ISG, assumed or paid off all of ISG's outstanding debt and
redeemed all of ISG's outstanding preferred stock. ISG is the leading provider
of high value CCPs to the building products and ready mix concrete industries in
the United States. ISG also develops, manufactures and distributes value-added
bagged concrete, stucco, mortar and block products that utilize fly ash through
its construction materials segment. Headwaters' historical focus has been on
using technology to add value to fossil fuels, particularly coal. The
acquisition of ISG provided Headwaters with a significant position in the last
phase of the coal value chain due to ISG's competencies in managing CCPs. The
acquisition of ISG also brought to Headwaters management depth, corporate
infrastructure and critical mass in revenues and operating income.

         The ISG acquisition was accounted for using the purchase method of
accounting. Assets acquired and liabilities assumed were recorded at their
estimated fair values as of September 19, 2002. Approximately $109.2 million of
the purchase price was allocated to identifiable intangible assets consisting
primarily of contracts with coal-fueled electric power generation plants and
patents. This amount is being amortized over the estimated combined useful life
of approximately 20 years. The remaining purchase price not attributable to the
tangible and identifiable intangible assets was allocated to goodwill, none of
which is tax deductible. All of the intangible assets and all of the goodwill
were allocated to the CCP segment.

         Segments. Until Headwaters acquired ISG in September 2002, Headwaters
operated in and reported as a single industry segment, alternative energy. Since
the acquisition of ISG, Headwaters has operated in three business segments,
alternative energy, CCPs, and construction materials. VFL operates in the CCP
segment and all of the other businesses acquired by Headwaters in 2004 operate
in the construction materials segment. These segments are managed and evaluated
separately by management based on fundamental differences in their operations,
products and services.

         The alternative energy segment includes Headwaters' traditional
coal-based solid alternative fuels business and HTI's business of developing
catalyst technologies to convert coal and heavy oil into
environmentally-friendly, higher-value liquid fuels, as well as nanocatalyst
processes and applications. Revenues for this segment primarily include sales of
chemical reagents and license fees.

         The CCP segment markets coal combustion products such as fly ash and
bottom ash, known as CCPs, to the building products and ready mix concrete
industries. Headwaters markets CCPs to replace manufactured or mined materials,
such as portland cement, lime, agricultural gypsum, fired lightweight aggregate,
granite aggregate and limestone. Headwaters has long-term contracts, primarily
with coal-fueled electric power generation plants pursuant to which it manages
the post-combustion operations for the utilities. CCP revenues consist primarily
of product sales with a smaller amount of service revenue.

         Prior to 2004, the businesses in the construction materials segment
manufactured and distributed value-added bagged concrete, stucco, mortar and
block products. The acquisition of SCP expanded Headwaters' concrete block
business and the acquisition of Eldorado added manufactured architectural stone
to the construction materials product line. Tapco is a leading designer,
manufacturer and marketer of building products used in exterior residential home
improvement and construction. Revenues for the construction materials segment
consist of product sales to wholesale and retail distributors, contractors and
other users of building products and construction materials.

                                       28
<PAGE>

Critical Accounting Policies and Estimates

         Headwaters' significant accounting policies are identified and
described in Note 2 to the consolidated financial statements. The preparation of
consolidated financial statements in conformity with U. S. generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements, and
the reported amounts of revenue and expenses during the reporting period. Actual
results could differ materially from those estimates.

         Headwaters continually evaluates its policies and estimation
procedures. Estimates are often based on historical experience and on
assumptions that are believed to be reasonable under the circumstances, but
which could change in the future. Some of Headwaters' accounting policies and
estimation procedures require the use of substantial judgment, and actual
results could differ materially from the estimates underlying the amounts
reported in the consolidated financial statements. Such policies and estimation
procedures have been reviewed with Headwaters' audit committee. The following is
a discussion of critical accounting policies and estimates.

         License Fee Revenue Recognition. Headwaters currently licenses its
technologies to the owners of 28 coal-based solid alternative fuel facilities in
the United States. Recurring license fees or royalty payments are recognized in
the period when earned, which coincides with the sale of synthetic fuel by
Headwaters' licensees. In most instances, Headwaters receives timely reports
from licensees notifying Headwaters of the amount of solid synthetic fuel sold
and the royalty due Headwaters under the terms of the respective license fee
agreements. Additionally, Headwaters has experienced a regular pattern of
payment by these licensees of the reported amounts.

         Estimates of license fee revenue earned, where required, can be
reliably made based upon historical experience and/or communications from
licensees for whom an established pattern exists. In some cases, however, such
as when a licensee is beginning to produce and sell synthetic fuel or when a
synthetic fuel facility is sold by a licensee to another entity, and for which
there is no pattern or knowledge of past or current production and sales
activity, there may be more limited information upon which to estimate the
license fee revenue earned. In these situations, Headwaters uses such
information as is available and where possible, substantiates the information
through such procedures as observing the levels of chemical reagents purchased
by the licensee and used in the production of the solid synthetic fuel. In
certain limited situations, Headwaters is unable to reliably estimate the
license fee revenues earned during a period, and therefore revenue recognition
is delayed until a future date when sufficient information is known from which
to make a reasonable estimation.

         Pursuant to the contractual terms of an agreement with one licensee,
the license fees owed to Headwaters, which accumulated during a period of
approximately two and a half years, were placed in escrow for the benefit of
Headwaters, pending resolution of an audit of the licensee by the IRS.

         Prior to December 31, 2003, accounting rules governing revenue
recognition, requiring that the seller's price to the buyer be "fixed or
determinable" as well as reasonably certain of collection, appeared to preclude
revenue recognition for the amounts placed in escrow because they were
potentially subject to adjustment based on the outcome of the IRS audit.
Accordingly, none of the escrowed amounts were recognized as revenue in the
consolidated statements of income through December 31, 2003. During the March
2004 quarter, the fieldwork for the tax audit of the licensee was completed and
there were no proposed adjustments to the tax credits claimed by the licensee.
As a result, in March 2004 Headwaters recognized revenue, net of the amount
Headwaters was required to pay to a third party, relating to the funds deposited
in the escrow account totaling approximately $27.9 million. Approximately $3.0
million of this amount related to revenue recorded in the March 2004 quarter and
approximately $25.0 million was recorded as revenue related to prior periods.
Interest income of approximately $0.2 million was also recognized. During the
June 2004 quarter, the IRS completed its administrative review of the licensee's
tax audit and the escrowed amounts were disbursed from the escrow account and
paid to Headwaters.

         In addition to the escrowed amounts, this same licensee has also set
aside substantial amounts for working capital and other operational
contingencies as provided for in the contractual agreements. These amounts may
eventually be paid out to various parties having an interest in the cash flows
from the licensee's operations, including Headwaters, if they are not used for
working capital and other operational contingencies. As a result, Headwaters
currently expects to receive at some future date a portion of those reserves,
the amount of which is not currently determinable and therefore, not
recognizable.

                                       29
<PAGE>

         Realizability of Receivables. Allowances are provided for uncollectible
accounts and notes when deemed necessary. Such allowances are based on an
account-by-account analysis of collectibility or impairment plus a provision for
non-customer specific defaults based upon historical collection experience.
Collateral is not required for trade receivables, but Headwaters performs
periodic credit evaluations of its customers. Collateral is generally required
for notes receivable and has historically consisted of most or all assets of the
debtor.

         With regard to Headwaters' trade receivables from the alternative
energy segment, past allowances have been minimal as have any required
write-offs. Trade receivables from the CCP and construction materials segments
involve substantially more customers, and receivable allowances are required for
discounts, rebates, allowances, and bad debts. Headwaters continually monitors
the collectibility of its trade receivables.

         Net losses recognized on notes receivable were approximately $0.7
million in 2002, $2.1 million in 2003 and $2.6 million in 2004. Such losses were
recorded due to insufficient collateral, or declines in the value of the
underlying collateral which management deemed other than temporary at the time.
Notes receivable generally relate to nonoperating activities and accordingly,
losses are included in other expense in the consolidated statements of income.
Headwaters reviews collectibility of notes receivable at the end of each
reporting period. This collectibility review consists of consideration of
payments of required interest and principal and the sufficiency of the
collateral to support the outstanding note receivable balance. If an impairment
is indicated, Headwaters writes down the note receivable to its estimated net
realizable value.

         Headwaters considers its receivable allowances adequate as of September
30, 2004; however, changes in economic conditions generally or in specific
markets in which Headwaters operates could have a material effect on required
reserve balances.

         Valuation of Long-Lived Assets, including Intangible Assets and
Goodwill. Long-lived assets consist primarily of property, plant and equipment,
intangible assets and goodwill. Intangible assets consist primarily of
identifiable intangible assets obtained in connection with acquisitions. (See
"Acquisitions" above and Note 3 to the consolidated financial statements for a
detailed discussion of the purchase price allocations for the 2004 acquisitions,
including the valuations of intangible assets.) These intangible assets are
being amortized on the straight-line method over their remaining estimated
useful lives. Goodwill consists of the excess of the purchase price for
businesses acquired over the fair value of identified assets acquired, net of
liabilities assumed. In accordance with Statement of Financial Accounting
Standards ("SFAS") No. 142, "Accounting for Goodwill and Intangible Assets,"
goodwill is not amortized, but is tested at least annually for impairment.
Goodwill is normally tested as of June 30, using a two-step process that begins
with an estimation of the fair value of the reporting unit giving rise to the
goodwill.

         In addition to its annual review, Headwaters evaluates the carrying
value of long-lived assets, including intangible assets and goodwill, as well as
the related amortization periods, to determine whether adjustments to these
amounts or to the useful lives are required based on current events and
circumstances. Changes in circumstances such as technological advances, changes
to Headwaters' business model or changes in Headwaters' capital strategy could
result in the actual useful lives differing from Headwaters' current estimates.
In those cases where Headwaters determines that the useful life of property,
plant and equipment or intangible assets should be shortened, Headwaters would
amortize the net book value in excess of salvage value over its revised
remaining useful life, thereby increasing depreciation or amortization expense.

         The carrying value of a long-lived asset is considered impaired when
the anticipated cumulative undiscounted cash flow from that asset is less than
its carrying value. In that event, a loss is recognized based on the amount by
which the carrying value exceeds the fair market value of the long-lived asset.
Indicators of impairment include such things as a significant adverse change in
legal factors or in the general business climate, a decline in operating
performance indicators, a significant change in competition, or an expectation
that significant assets will be sold or otherwise disposed of. There were no
impairment losses recorded for long-lived assets in any of the years presented.

         SFAS No. 142 requires Headwaters to periodically perform tests for
goodwill impairment. Step 1 of the initial impairment test was required to be
performed no later than March 31, 2003; thereafter impairment testing is
required to be performed no less often than annually, or sooner if evidence of
possible impairment arises. Impairment testing is performed at the reporting
unit level and Headwaters has identified four reporting units: (i) Headwaters
Energy Services and (ii) HTI (which together comprise the alternative energy
segment), (iii) CCPs and (iv) construction materials. Currently, goodwill exists
in the HTI, CCPs and construction materials reporting units.

         Step 1 of impairment testing consists of determining and comparing the
fair values of the reporting units to the carrying values of those reporting
units. The fair value of each reporting unit is estimated based on the
application of two approaches. Under the first approach, fair value is estimated
based on the present value of future estimated cash flows. This requires

                                       30
<PAGE>

significant judgments including the estimation of future sales, profit margins,
capital expenditures, future working capital requirements, and the reporting
unit's required rate of return. The second approach estimates fair value based
on the quoted market prices of companies reasonably comparable to the reporting
unit. Based on the application of these two approaches, an estimate of fair
value is determined for each reporting unit. Changes in key estimates and
assumptions employed could materially affect the determination of fair value.

         If step 1 were to be failed for any of the reporting units, indicating
a potential impairment, Headwaters would be required to complete step 2, which
is a more detailed test to calculate the implied fair value of goodwill, and
compare that value to the carrying value of the goodwill. If the carrying value
of the goodwill exceeds the implied fair value of the goodwill, an impairment
loss is required to be recorded.

         Headwaters performed step 1 impairment tests of the recorded goodwill
in the HTI and CCPs reporting units as of October 1, 2002, the beginning of
fiscal year 2003. Headwaters performed its annual, recurring tests for potential
impairment using the dates of June 30, 2003 and 2004. The tests indicated that
the fair values of the reporting units exceeded their carrying values at October
1, 2002, June 30, 2003 and June 30, 2004. Accordingly, step 2 of the impairment
tests was not required to be performed, and no impairment charge was necessary.

         It is possible that some of Headwaters' tangible or intangible
long-lived assets or goodwill could be impaired in the future and that the
resulting write-downs could be material.

         Legal Matters. Headwaters and its subsidiaries are involved in several
legal proceedings and contractual matters that have arisen in the normal course
of business, all as explained in more detail in "ITEM 3. LEGAL PROCEEDINGS" and
Note 14 to the consolidated financial statements. Headwaters intends to
vigorously defend or resolve these matters by settlement, as appropriate.
Management does not currently believe that the outcome of these matters will
have a material adverse effect on Headwaters' operations, cash flows or
financial position.

         In 2004 Headwaters accrued approximately $1.4 million of reserves for
legal matters because it concluded that claims and damages sought by claimants
in that amount were probable. However, these cases raise difficult and complex
legal and factual issues, and the resolution of these issues is subject to many
uncertainties, including the facts and circumstances of each case, the
jurisdiction in which each case is brought, and the future decisions of juries,
judges, and arbitrators. Headwaters' outside counsel believe that unfavorable
outcomes are neither probable nor remote and declined to express opinions
concerning the likely outcomes or liability of Headwaters. Therefore, although
management believes that the claims asserted against Headwaters in the named
cases lack merit, there is a possibility of material losses if one or more of
the cases were to be determined adversely against it for a substantial amount of
the damages asserted. Headwaters believes the range of loss is from $1.4 million
up to the amounts sought by claimants. Additionally, as with any litigation,
these proceedings require that Headwaters incur substantial costs, including
attorneys' fees, managerial time, and other personnel resources and costs in
pursuing resolution. Costs paid to outside legal counsel for litigation, which
comprise the majority of Headwaters' litigation-related costs, totaled
approximately $1.7 million in 2002, $3.0 million in 2003, and $3.8 million in
2004. It is not possible to estimate what these costs will be in future periods.

         In accounting for legal matters and other contingencies, Headwaters
follows the guidance in SFAS No. 5, "Accounting for Contingencies," under which
loss contingencies are accounted for based upon the likelihood of an impairment
of an asset or the incurrence of a liability. If a loss contingency is
"probable" and the amount of loss can be reasonably estimated, it is accrued. If
a loss contingency is "probable," but the amount of loss cannot be reasonably
estimated, disclosure is made. If a loss contingency is "reasonably possible,"
an accrual is made for the most likely amount of loss, if determinable, and
disclosure is made of the potential range of loss. Loss contingencies that are
"remote" are neither accounted for nor disclosed. Gain contingencies are given
no accounting recognition, but are disclosed if material.

Year Ended September 30, 2004 Compared to Year Ended September 30, 2003

         The information set forth below compares Headwaters' operating results
for the year ended September 30, 2004 ("2004") with operating results for the
year ended September 30, 2003 ("2003").

         Revenue. Total revenue for 2004 increased by $166.4 million or 43% to
$554.0 million as compared to $387.6 million for 2003. The major components of
revenue are discussed in the sections below.

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<PAGE>

         Sales of Chemical Reagents. Chemical reagent sales during 2004 were
$132.6 million with a corresponding direct cost of $89.8 million. Chemical
reagent sales during 2003 were $128.4 million with a corresponding direct cost
of $87.4 million. The increase in chemical reagent sales during 2004 was due
primarily to significantly increased synthetic fuel production by Headwaters'
licensees (resulting in increased sales of $13.9 million), largely offset by
decreased synthetic fuel production by customers with which Headwaters does not
have a license agreement (resulting in decreased sales of $9.7 million). It is
not possible to predict the trend of sales of chemical reagents. The gross
margin percentage for 2004 of 32% was approximately the same as for 2003.

         License Fees. During 2004, Headwaters recognized license fee revenue
totaling $72.7 million, an increase of $37.0 million or 104% over $35.7 million
of license fee revenue recognized during 2003. The primary reason for the
increase in license fee revenue in 2004 compared to 2003 was the recognition in
March 2004 of $24.9 million of net revenue relating to funds previously
deposited in an escrow account by one of Headwaters' licensees relating to
alternative fuel sold prior to December 31, 2003, plus approximately $12.2
million of net revenue relating to the March, June and September 2004 quarters.
For more information about the revenue related to this licensee, see "License
Fee Revenue Recognition" in the "Critical Accounting Policies and Estimates"
section above.

         CCP Revenues. CCP revenues for 2004 were $210.2 million with a
corresponding direct cost of $150.1 million. CCP revenues for 2003 were $169.9
million with a corresponding direct cost of $123.1 million. The increase in CCP
revenues during 2004 was due primarily to increased demand for high value CCP
products, the acquisition of VFL in April 2004, and the renegotiation of certain
service agreements. The increased demand for high value fly ash products was the
result of continued strength in the construction market coupled with a tight
market for cement, with cement shortages occurring in some regional markets.
These conditions allowed Headwaters to increase prices in certain CCP markets.
VFL's revenues for 2004 totaled $16.9 million. The gross margin percentage
increased from 2003 to 2004 by approximately 1% due primarily to benefits
realized from the renegotiation of the service agreements.

         Sales of Construction Materials. Sales of construction materials during
2004 were $134.0 million with a corresponding direct cost of $94.6 million.
Sales of construction materials during 2003 were $49.4 million with a
corresponding direct cost of $37.7 million. The increase in sales of
construction materials during 2004 was due primarily to the acquisitions of
Eldorado in June 2004, SCP in July 2004 and Tapco in September 2004. Revenues
for these acquired companies for 2004 totaled $84.1 million. The increase in
gross margin percentage from 2003 to 2004 was due primarily to significantly
higher margins from the operations of the acquired businesses, partially offset
by certain inventory and other balance sheet adjustments, some of which related
to original purchase price allocations, related to the legacy construction
materials businesses.

         Depreciation and Amortization. These costs increased by $4.1 million to
$17.1 million in 2004 from $13.0 million in 2003. The increase was primarily
attributable to the 2004 acquisitions and the resulting increases in depreciable
property, plant and equipment and amortizable intangible assets. For this same
reason, Headwaters expects 2005 depreciation and amortization expense to be
substantially higher than it was for 2004.

         Research and Development. Research and development expenses increased
by $2.6 million to $7.3 million in 2004 from $4.7 million in 2003. The increase
was primarily attributable to increased HTI research and development activities
and an extra month of HTI expenses in 2004. Headwaters remains committed to
HTI's research and development efforts and future expenses are likely to outpace
2004 levels as a result of continuing efforts to commercialize existing
technologies.

         Selling, General and Administrative Expenses. These expenses increased
$26.2 million to $66.9 million for 2004 from $40.7 million for 2003. The
increase in 2004 was due primarily to the 2004 acquisitions ($13.2 million) and
increased incentive pay expenses ($8.4 million), along with certain increases in
various other costs incidental to growth, primarily payroll-related costs. The
increase in incentive pay expenses was the result of obligations under
Headwaters' incentive bonus plans, resulting from improved operating results in
2004, a significant portion of which related to revenue recognized from escrowed
funds in March 2004, as previously discussed. As a result of the 2004
acquisitions, 2005 selling, general and administrative expenses are expected to
be substantially higher than for 2004, but should be more comparable to 2004
levels when viewed as a percentage of revenues.

         Other Income and Expense. During 2004, Headwaters reported net other
expense of $22.7 million compared to net other expense of $17.0 million during
2003. The change of $5.7 million was primarily attributable to an increase in
interest expense of $3.8 million in 2004 and a net increase in other expenses of
$2.1 million in 2004.

         Interest expense increased from $15.7 million in 2003 to $19.5 million
in 2004 due primarily to higher average levels of long-term debt in 2004
compared to 2003, primarily related to the 2004 acquisitions, and accelerated
non-cash interest expense related to the substantial increase in debt repayments
that were made in 2004 compared to 2003. In 2004, debt repayments totaled
approximately $287.2 million, which consisted largely of early repayments. In

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<PAGE>

2003, debt repayments totaled approximately $40.2 million. As a result of the
increase in repayments in 2004, non-cash interest expense, representing
amortization of debt discount and debt issue costs, increased from $3.9 million
in 2003 to $6.0 million in 2004. Due to the substantially higher amounts of
outstanding debt at September 30, 2004 than existed for most of 2004, interest
expense in 2005 is expected to be substantially higher than for 2004.

         The net change in other expenses of $2.1 million consisted primarily of
a write-off of $0.8 million of deferred acquisition costs related to projects
that were abandoned in 2004 and an increase of $1.4 million in losses on
disposition of property, plant and equipment in 2004.

         Income Tax Provision. In 2004, Headwaters recorded an income tax
provision at an effective tax rate of approximately 38.8%. In 2003, the
effective tax rate was approximately the same at 39.0%. As described in more
detail in Note 14 to the consolidated financial statements, in September 2004,
Headwaters purchased a 9% interest in an entity that owns and operates a
coal-based alternative fuel production facility. The solid alternative fuel
produced at the facility qualifies for tax credits pursuant to Section 29 of the
Internal Revenue Code, and Headwaters is entitled to receive its pro-rata share
of such tax credits generated. Headwaters has also agreed to purchase an
additional 10% interest in the entity upon the earlier of receipt of a private
letter ruling for the facility from the IRS, or June 17, 2005. At the time
Headwaters purchases the additional 10% interest, Headwaters' pro-rata share of
the tax credits will also increase. As a result of these tax credits, Headwaters
expects its effective tax rate to decrease several percentage points in 2005.

Year Ended September 30, 2003 Compared to Year Ended September 30, 2002

         The information set forth below compares Headwaters' operating results
for the year ended September 30, 2003 ("2003") with operating results for the
year ended September 30, 2002 ("2002").

         Revenue. Total revenue for 2003 increased by $268.3 million or 225% to
$387.6 million as compared to $119.3 million for 2002. The major components of
revenue are discussed in the sections below.

         Sales of Chemical Reagents. Chemical reagent sales during 2003 were
$128.4 million with a corresponding direct cost of $87.4 million. Chemical
reagent sales during 2002 were $74.4 million with a corresponding direct cost of
$50.1 million. The increase in chemical reagent sales during 2003 was due to
increased synthetic fuel production by Headwaters' licensees (approximately
$33.6 million), as well as sales of chemical reagents to new customers with
which Headwaters does not have a license agreement (approximately $20.4
million).

         License Fees. During 2003, Headwaters recognized license fee revenue
totaling $35.7 million, an increase of $5.2 million or 17% over $30.5 million of
license fee revenue recognized during 2002. License fees in 2003 consisted of
recurring license fees or royalty payments of $34.5 million and deferred revenue
amortization of $1.2 million. License fees in 2002 consisted of recurring
license fees of $29.0 million and deferred revenue amortization of $1.5 million.
The primary reason for the increase in license fee revenue in 2003 compared to
2002 was a major licensee that purchased four facilities from a former licensee
in October 2001, but did not begin operating those facilities until early
calendar 2002. Headwaters earned approximately $11.3 million in license fees
from this licensee in 2003 and $7.4 million in 2002.

         ISG Revenues and Cost of Revenues. CCP revenues and sales of
construction materials and the related cost of revenue captions represent ISG's
revenues and cost of revenues. Because ISG was purchased on September 19, 2002,
there were only 12 days of operations included in 2002 compared to a full year
in 2003.

         Depreciation and Amortization. These costs increased by $11.2 million
to $13.0 million in 2003 from $1.8 million in 2002. The increase was primarily
attributable to depreciation and amortization of ISG's tangible and intangible
assets.

         Research and Development. Research and development expenses increased
by $2.4 million to $4.7 million in 2003 from $2.3 million in 2002. The increase
was primarily attributable to the inclusion of additional costs relating to
ISG's research and development activities. In 2002, research and development
expenses represented primarily costs related to HTI's activities, which remained
relatively unchanged during 2003.

         Selling, General and Administrative Expenses. These expenses increased
$27.0 million to $40.7 million for 2003 from $13.7 million for 2002. The
increase in 2003 was due primarily to the inclusion of ISG's costs, and to a
lesser extent, an increase in professional services expenses of approximately
$1.1 million related to legal actions in which Headwaters is currently involved.

                                       33
<PAGE>

         Other Income and Expense. During 2003, Headwaters reported net other
expense of $17.0 million compared to net other expense of $0.8 million during
2002. The change of $16.2 million was attributable to i) an increase in interest
expense of $15.1 million, ii) a decrease in interest income of $0.7 million, and
iii) an increase in net losses on notes receivable and investments of $1.7
million, substantially offset by an increase in net other income of $1.3
million.

         Interest expense increased in 2003 due to the substantial increase in
debt incurred in September 2002 to finance the acquisition of ISG. Interest
expense in 2003 includes $1.5 million related to accelerated amortization of
debt discount and debt issue costs associated with $25.5 million of early
repayments of senior debt principal. Interest income decreased from 2002 to 2003
primarily due to lower average balances of cash and short-term investments as a
result of Headwaters using a substantial amount of cash to purchase ISG and
applying available cash generated in 2003 to repay long-term debt. Lower
interest rates in 2003 also affected interest income.

         Losses on notes receivable were $1.4 million higher in 2003 as compared
to 2002. In both years, the majority of the losses represented write-downs of a
note receivable which is being accounted for on the cost recovery method. The
write-downs in both years were necessary due to declines in the value of the
underlying collateral. The carrying value of this note receivable at September
30, 2003 was $0.5 million. In 2003, Headwaters also recorded a $0.3 million loss
on an investment.

         Net other income increased by $1.3 million in 2003 compared to 2002
primarily due to two non-recurring transactions in 2002. A $1.3 million gain on
sale of assets resulted from the sale of a 50% interest in one of Headwaters'
original synthetic fuel facilities. Also, Headwaters recorded approximately $2.6
million of losses related to the write-off of deferred project / financing costs
resulting from the abandonment of certain projects or the postponement or
redirection of activities for which costs had previously been deferred.

         Income Tax Provision. In 2003, Headwaters recorded an income tax
provision at an effective tax rate of approximately 39%. In 2002, the effective
tax rate was approximately 40%.

Liquidity and Capital Resources

         Summary of Cash Flow Activities. Net cash provided by operating
activities during 2004 was $91.9 million compared to $56.4 million of net cash
provided by operations during 2003. The change was primarily attributable to an
increase in net income in 2004 compared to 2003.

         In 2004, Headwaters issued 5.0 million shares of common stock under an
effective shelf registration statement for net cash proceeds of $90.3 million.
Headwaters used $50.0 million of the cash generated from the issuance of common
stock to repay debt, and the remaining proceeds were temporarily invested in
short-term trading investments and ultimately used for acquisitions. During
2004, a total of $287.2 million of debt was repaid, approximately $112.8 million
of which was repaid when Headwaters "refinanced" its senior debt in March 2004
and again in September 2004. New debt issuances in 2004 totaled $1,068.1 million
(net of debt issuance costs of approximately $24.4 million), and included $904.0
million of senior debt issued from March through September 2004 and $172.5
million of convertible senior subordinated notes issued in June 2004. Most of
the new debt issuances were in connection with the Eldorado acquisition in June
2004 and the Tapco acquisition in September 2004. During 2004, investing
activities consisted primarily of net payments for acquisitions totaling $952.3
million. More details about Headwaters' investing and financing activities are
provided in the following paragraphs.

         Investing Activities. As described in more detail in Note 3 to the
consolidated financial statements, Headwaters acquired four companies in 2004.
The total purchase price for these acquisitions was approximately $987.8
million, net of cash acquired of $11.8 million. The acquisitions were funded by
net cash payments totaling approximately $952.3 million, along with the
assumption of approximately $16.5 million of debt and the issuance of $19.0
million of notes payable to the previous owners of one company. Most of the
required cash was obtained from the issuance of $904.0 million of new senior
debt in March 2004 through September 2004 and $172.5 million of convertible
senior subordinated notes in June 2004.

         Headwaters intends to continue to expand its business through growth of
existing operations, commercialization of technologies currently being
developed, and strategic acquisitions of entities that operate in adjacent
industries. It is possible that some portion of cash and cash equivalents and
short-term trading investments and/or proceeds from the issuance of stock or
debt will be used to fund acquisitions of complementary businesses in the
chemical, energy, building products and related industries. Acquisitions are an
important part of Headwaters' business strategy and to that end, Headwaters
routinely reviews complementary acquisitions, including those in the areas of
CCP marketing, construction materials, and coal and catalyst technologies. The
new senior secured credit agreement limits acquisitions to $50.0 million each
fiscal year, of which cash consideration may not exceed $30.0 million, unless
Headwaters' "total leverage ratio," as defined, is less than or equal to
3.50:1.0, after giving effect to an acquisition, in which case the foregoing
$30.0 million cash limitation does not apply. In 2004, Headwaters expensed
approximately $0.8 million of deferred acquisition costs related to acquisition
projects that were abandoned.

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<PAGE>

         In 2004, payments for the purchase of property, plant and equipment
totaled $14.0 million. These capital expenditures primarily related to the CCPs
and construction materials segments. Due to the 2004 acquisitions, total capital
expenditures for fiscal year 2005 will be much higher than for fiscal year 2004,
and are currently expected to approximate the limitation on such expenditures
included in the senior debt covenants of $50.0 million. As of September 30,
2004, Headwaters was committed to spend approximately $11.0 million to complete
capital projects that were in various stages of completion.

         As described in more detail in Note 14 to the consolidated financial
statements, in September 2004, Headwaters purchased a 9% interest in an entity
that owns and operates a coal-based alternative fuel production facility.
Headwaters' minority interest was acquired in exchange for an initial cash
payment of $0.3 million and an obligation to pay $7.5 million in monthly
installments from October 2004 through December 2007. Headwaters has also agreed
to purchase an additional 10% interest in the entity upon the earlier of receipt
of a private letter ruling for the facility from the IRS, or June 17, 2005. At
such time, Headwaters will be required to make an additional cash payment of
$0.3 million and pay an additional $7.5 million, plus interest, through December
2007. The total amounts that Headwaters will be required to pay are directly
impacted by the amounts of solid alternative fuel produced at the facility,
including the fixed payment obligations of $7.5 million (increasing to $15.0
million).

         In September 2004, Headwaters entered into an agreement with an
international chemical company, based in Germany, to jointly develop and
commercialize a process for the direct synthesis of hydrogen peroxide. Under
terms of the joint venture agreement, Headwaters paid $1.2 million for its
investment in the joint venture and is further obligated to pay an additional
$1.0 million in 2005 and $1.0 million in 2006. Headwaters has also committed to
fund 50% of the joint venture's research and development expenditures, currently
limited to (euro)3.0 million (approximately $3.7 million at September 30, 2004),
through September 2007. Although there is no legal obligation to do so, the
joint venture partners currently have long-range plans to eventually invest in
large-scale hydrogen peroxide plants using the process for direct synthesis of
hydrogen peroxide.

         Headwaters had two notes receivable with a combined carrying value of
approximately $2.5 million at September 30, 2003. In 2004, Headwaters wrote-off
the balance of these notes plus accrued interest because of declines in the
value of the underlying collateral that management deemed to be other than
temporary. There are no significant note receivable balances as of September 30,
2004.
         Financing Activities. Headwaters has an effective universal shelf
registration statement on file with the SEC that can be used for the sale of
common stock, preferred stock, convertible debt and other securities. In
December 2003, Headwaters filed a prospectus supplement to the shelf
registration statement and issued 4.8 million shares of common stock under this
shelf registration statement in an underwritten public offering. In January
2004, an additional 0.2 million shares of common stock were issued upon exercise
of the underwriters' over-allotment option. In total, proceeds of $90.3 million
were received, net of offering costs of $6.4 million. Following these issuances
of common stock, approximately $53.0 million remains available for future
offerings of securities under the shelf registration statement. A prospectus
supplement describing the terms of any additional securities to be issued is
required to be filed before any future offering would commence under the
registration statement.

         Due to the recent issuance of senior debt and the covenants associated
with that debt, as described below, Headwaters currently has limited ability to
obtain significant additional amounts of long-term debt.

         New 2004 Senior Secured Credit Agreements - In September 2004 and as
amended in October 2004, Headwaters entered into two credit agreements with a
syndication of lenders under which a total of $790.0 million was borrowed under
term loan arrangements and which provide for $60.0 million to be borrowed under
a revolving credit arrangement. The proceeds were used to acquire Tapco and
repay in full the remaining balance due under Headwaters' former 2004 senior
secured credit agreement obtained in March 2004 (see below). The $790.0 million
of term loan borrowings consisted of a first lien term loan in the amount of
$640.0 million and a second lien term loan in the amount of $150.0 million. Both
term loans are secured by all assets of Headwaters and are senior in priority to
all other debt.

         The first lien term loan bears interest, at Headwaters' option, at
either i) the London Interbank Offered Rate ("LIBOR") plus 3.0%, if the "total
leverage ratio," as defined, is less than or equal to 3.75:1.0, and if not, at
LIBOR plus 3.25%, or ii) the "base rate" plus 2.0%, if the total leverage ratio
is less than or equal to 3.75:1.0, and if not, at the base rate plus 2.25%. Base
rate is defined as the higher of the rate announced by Morgan Stanley Senior
Funding and the overnight rate charged by the Federal Reserve Bank of New York

                                       35
<PAGE>

plus 0.5%. The initial interest rate on the first lien debt was set at 6.5%, but
was subsequently reduced to approximately 5.4% in October 2004 pursuant to the
terms of the agreement. The second lien term loan bears interest, also at
Headwaters' option, at either LIBOR plus 5.5%, or the "base rate" plus 4.5%. The
initial interest rate on the second lien debt was set at 9.75%, but was
subsequently reduced to approximately 8.15% in October 2004 pursuant to the
terms of the agreement. Headwaters can lock in new rates for both the first lien
and second lien loans for one, two, three or six months. The next rate change
will occur in January 2005.

         The first lien term loan is repayable in quarterly installments of
principal and interest, with minimum required quarterly principal repayments of
$12.0 million commencing in November 2004 through August 2007, then $4.0 million
through August 2010, with three repayments of approximately $149.3 million
through April 2011, the termination date of the first lien loan agreement. The
second lien term loan is due September 2012, with no required principal
repayments prior to that time. Interest is generally due on a quarterly basis.
There are mandatory prepayments of the first lien term loan in the event of
certain asset sales and debt and equity issuances and from "excess cash flow,"
as defined. Optional prepayments of the first lien term loan are permitted
without penalty or premium. Optional prepayments of the second lien term loan
are permissible only to the extent Headwaters issues new equity securities and
then are further limited to a maximum of $50.0 million, so long as the first
lien term loan remains outstanding. Any optional prepayments of the second lien
term loan bear a penalty of 3% of prepayments made in the first year, 2% of
prepayments made in the second year, and 1% of prepayments made in the third
year. Once repaid in full or in part, no further reborrowings under either of
the term loan arrangements can be made. In October 2004, Headwaters repaid a
total of $24.0 million of the first lien term loan, which amount otherwise would
have been due in November 2004 and February 2005.

         As required by the new senior secured credit facility, Headwaters
entered into certain other agreements to limit its exposure to interest rate
increases. The first set of agreements established the maximum LIBOR rate for
$300.0 million of the senior secured debt at 5.0% through September 8, 2005. The
second set of agreements sets the LIBOR rate at 3.71% for $300.0 million of this
debt for the period commencing September 8, 2005 through September 8, 2007.
Headwaters accounts for these agreements as cash flow hedges, and accordingly,
the fair market value of the hedges is reflected in the consolidated balance
sheet as either other assets or other liabilities. The hedges had a fair market
value of $0 at September 30, 2004.

         Former 2004 Senior Secured Credit Agreement - In March 2004, Headwaters
entered into a credit agreement with a group of banks under which a total of
$50.0 million was borrowed under a term loan arrangement and which, as amended
in June 2004, provided for an additional $75.0 million to be borrowed under a
revolving credit arrangement. The initial $50.0 million of proceeds were used to
repay in full the remaining balance due under Headwaters' former 2002 senior
secured credit agreement (see below). Debt issuance costs of approximately $1.3
million were incurred in issuing this debt, all of which was expensed in 2004.

         The term loan was secured by all assets of Headwaters, bore interest at
a variable rate linked to the Eurodollar rate or the lenders' base rate, both as
defined in the agreement, and was repayable in quarterly installments of $1.25
million through September 2007, with a final payment of $32.5 million due
November 2007. In connection with the purchase of Eldorado in June 2004, a total
of $44.0 million was borrowed under the revolving credit arrangement, all of
which was repaid in June 2004. In connection with the purchase of SCP in July
2004, a total of $20.0 million was borrowed under the revolving credit
arrangement, all of which was repaid in September 2004. Also in September 2004,
the remaining balance outstanding under the term loan was repaid in full using
proceeds from the new 2004 senior secured credit facility described above.

         Convertible Senior Subordinated Notes - In connection with the Eldorado
acquisition, Headwaters issued $172.5 million of 2 ?% convertible senior
subordinated notes due 2016. These notes are subordinate to the new 2004 senior
secured debt described above. Holders of the notes may convert the notes into
shares of Headwaters' common stock at a conversion rate of 33.3333 shares per
$1,000 principal amount ($30 conversion price), or approximately 5.75 million
aggregate shares of common stock, contingent upon certain events. The conversion
rate adjusts for events related to Headwaters' common stock, including common
stock issued as a dividend, rights or warrants to purchase common stock issued
to all holders of Headwaters' common stock, and other similar rights or events
that apply to all holders of common stock.

         The notes are convertible if any of the following five criteria are
met: 1) satisfaction of a market price condition which becomes operative if the
common stock trading price reaches $39 per share for a certain period of time
prior to June 1, 2011 and at any time after that date; 2) a credit rating, if
any, assigned to the notes is three or more rating subcategories below the
initial rating, if any; 3) the notes trade at 98% of the product of the common
stock trading price and the number of shares of common stock issuable upon

                                       36
<PAGE>

conversion of $1,000 principal amount of the notes, except this provision is not
available if the closing common stock price is between 100% and 130% of the
current conversion price of the notes; 4) Headwaters calls the notes for
redemption; and 5) certain corporate transactions occur, including distribution
of rights or warrants to all common stockholders entitling them to purchase
common stock at less than the current market price or distribution of common
stock, cash or other assets, debt securities or certain rights to purchase
securities where the distribution has a per share value exceeding 5% of the
closing common stock price on the day immediately preceding the declaration date
for such distribution. In addition, the notes are convertible if Headwaters
enters into an agreement pursuant to which Headwaters' common stock would be
converted into cash, securities or other property.

         Headwaters may call the notes for redemption at any time on or after
June 1, 2007 and prior to June 4, 2011 if the closing common stock price exceeds
130% of the conversion price for 20 trading days in any consecutive 30-day
trading period (in which case Headwaters must provide a "make whole" payment of
the present value of all remaining interest payments on the redeemed notes
through June 1, 2011). In addition, the holder of the notes has the right to
require Headwaters to repurchase all or a portion of the notes on June 1, 2011
or if a fundamental change in common stock has occurred, including termination
of trading. Subsequent to June 1, 2011, the notes require an additional interest
payment equal to 0.40% of the average trading price of the notes if the trading
price equals 120% or more of the principal amount of the notes.

         Headwaters has not included the additional shares of common stock
contingently issuable under the notes in its 2004 diluted EPS as none of the
contingencies have been met. However, as explained in more detail in Note 13 to
the consolidated financial statements and in the "Risks Relating to Headwaters'
Business" section of this Item 7, implementation of EITF 04-08 in December 2004
will require Headwaters to include in its diluted EPS calculation, on an
if-converted basis, the additional shares issuable under the notes.

         Former 2002 Senior Secured Credit Agreement - In connection with the
ISG acquisition in 2002, Headwaters entered into a $175.0 million senior secured
credit agreement with a syndication of lenders, under which a total of $155.0
million was borrowed as a term loan on the acquisition date. The credit
agreement also allowed up to $20.0 million to be borrowed under a revolving
credit arrangement. The debt was issued at a 3% discount and Headwaters received
net cash proceeds of $150.4 million. The original issue discount was accreted
using the effective interest method and the accretion was recorded as interest
expense. The debt was secured by all assets of Headwaters, bore interest at a
variable rate linked to the Eurodollar rate or the lenders' base rate, both as
defined in the agreement (approximately 5.4% at September 30, 2003) and was
repayable in quarterly installments through August 30, 2007.

         During the December 2003 quarter, principal repayments totaling $39.7
million were made, including $33.5 million of optional prepayments. During the
March 2004 quarter, the remaining balance was repaid in full using available
cash and $50.0 million of proceeds from the former 2004 senior secured credit
facility described above. In connection with the full repayment of this debt,
non cash interest expense totaling approximately $5.0 million was recognized in
the March 2004 quarter, representing amortization of all of the remaining debt
discount and debt issue costs related to this debt.

         Senior Subordinated Debentures - In connection with the ISG
acquisition, Headwaters also entered into a $20.0 million subordinated loan
agreement, under which senior subordinated debentures were issued at a 2%
discount, with Headwaters receiving net cash proceeds of $19.6 million. The
original issue discount was accreted using the effective interest method and the
accretion was recorded as interest expense. ISG management participated in
one-half, or $10.0 million, of the $20.0 million of debt issued. The other half
was issued to a corporation. The debentures bore interest at 18% and were due in
2007; however, in December 2003, the debentures were repaid in full, including a
4%, or $0.4 million, prepayment charge paid to the corporation holding $10.0
million of the debentures. This charge, along with all remaining unamortized
debt discount and debt issue costs, is included in interest expense in the
consolidated statement of income.

         Notes Payable to a Bank - In connection with the acquisition of SCP,
Headwaters assumed SCP's obligations under its notes payable to a bank. The
notes require monthly interest and quarterly principal payments and are
repayable from April 2007 through April 2015. Two of the notes bear interest at
LIBOR plus 0.5%, subject to an interest rate floor of 4.5% (4.5% at September
30, 2004), and the remaining note (in the amount of $1.1 million) bears interest
at 0.5% below the bank's base rate (4.25% at September 30, 2004). Because the
notes are callable by the bank, Headwaters has included the outstanding balance
in current portion of long-term debt in the consolidated balance sheet. The
notes are collateralized by certain assets of SCP and contain financial
covenants, the most restrictive of which specifies a minimum fixed charge
coverage ratio. Headwaters was in compliance with all debt covenants at
September 30, 2004.

         Notes Payable to Former VFL Stockholders - In connection with the VFL
acquisition, Headwaters issued $19.0 million of notes payable to the VFL
stockholders, $13.0 million of which was repaid in June 2004 and $6.0 million of
which was repaid in July 2004. The interest rate on $16.0 million of the notes
was 9% and the interest rate on the remaining $3.0 million of notes was
variable.

                                       37
<PAGE>

         Short-term Borrowings with an Investment Bank - Headwaters had an
arrangement with an investment bank under which Headwaters could borrow up to
90% of the value of the portfolio of Headwaters' short-term investments with the
investment bank, limited to a maximum amount of $20.0 million. Headwaters
borrowed $10.0 million under this arrangement during June 2004, all of which was
repaid in June 2004. In July 2004, Headwaters borrowed $6.0 million under this
arrangement, all of which was repaid in July 2004. This arrangement is no longer
active.

         Options, Warrants, and Employee Stock Purchases - In 2004, cash
proceeds from the exercise of options, warrants and employee stock purchases
totaled $9.1 million, compared to $2.9 million in 2003. Option exercise activity
is largely dependent on Headwaters' stock price and is not predictable. To the
extent non-qualified stock options are exercised, or there are disqualifying
dispositions of shares obtained upon the exercise of incentive stock options,
Headwaters receives an income tax deduction generally equal to the income
recognized by the optionee. Such amounts, reflected in cash flows from
operations in the consolidated statements of cash flows, were $2.1 million in
2003 and $4.1 million in 2004. These income tax deductions do not affect income
tax expense or the effective income tax rate; rather they are reflected as
increases in capital in excess of par value in the consolidated balance sheet.

         Working Capital. In 2004, Headwaters' working capital increased by
$30.2 million, to $44.4 million as of September 30, 2004. Several of the
significant changes in the components of working capital were the result of the
2004 acquisitions, most notably the Eldorado and Tapco acquisitions. Headwaters
expects operations to produce positive cash flows in future periods, which, when
combined with current working capital, is expected to be sufficient for
operating needs for 2005.

         Long-term Debt. Due to the recent issuance of senior debt and the
covenants associated with that debt, as described below, Headwaters currently
has limited ability to obtain significant additional amounts of long-term debt.
However, as provided for in the new 2004 senior debt agreements, Headwaters has
available $60.0 million under a revolving credit arrangement. Borrowings under
this arrangement are generally subject to the terms of the first lien loan
agreement and bear interest at either LIBOR plus 1.75% to 2.5%, or the base rate
plus 0.75% to 1.5%. Borrowings and reborrowings of any available portion of the
$60.0 million revolver can be made at any time through September 2009, at which
time all loans must be repaid and the revolving credit arrangement terminates.
The fees for the unused portion of the revolving credit arrangement range from
0.5% to 0.75%. Finally, the credit agreement allows for the issuance of letters
of credit, provided there is capacity under the revolving credit arrangement. As
of September 30, 2004, three letters of credit totaling $2.1 million were
outstanding, with expiration dates ranging from October 2004 to June 2005.

         Headwaters may, in the future, make optional prepayments of the senior
debt depending on actual cash flows, Headwaters' current and expected cash
requirements and other factors deemed significant by management.

         The senior debt agreements contain restrictions and covenants common to
such agreements, including limitations on the incurrence of additional debt,
investments, merger and acquisition activity, asset sales and liens, capital
expenditures in excess of $50.0 million in any fiscal year (increasing to $60.0
million in 2011) and the payment of dividends, among others. In addition,
Headwaters must maintain certain leverage and fixed charge coverage ratios, as
those terms are defined in the agreements. Under the most restrictive covenants,
contained in the first lien agreement, Headwaters must maintain 1) a total
leverage ratio of 5.0:1.0 or less, declining periodically to 3.5:1.0 in 2010; 2)
a maximum ratio of consolidated senior funded indebtedness minus subordinated
indebtedness to EBITDA of 4.0:1.0, declining periodically to 2.5:1.0 in 2010;
and 3) a minimum ratio of EBITDA plus rent payments for the four preceding
fiscal quarters to scheduled payments of principal and interest on all
indebtedness for the next four fiscal quarters of 1.10:1.0 through September 30,
2006, and 1.25:1.0 thereafter. Headwaters is in compliance with all debt
covenants as of September 30, 2004.

         As described above, Headwaters has approximately $799.8 million of
variable-rate long-term debt outstanding as of September 30, 2004, consisting of
$790.0 million of senior debt and $9.8 million of notes payable to a bank. A
change in the interest rate of 1% would change Headwaters' interest expense by
approximately $7.7 million during the year ending September 30, 2005,
considering all outstanding balances of variable-rate debt and required
principal repayments.

         Income Taxes. As discussed previously, cash payments for income taxes
are reduced for disqualifying dispositions of shares obtained upon the exercise
of stock options, which totaled $4.1 million in 2004. Headwaters' cash
requirements for income taxes in 2005 are expected to approximate the income tax
provision, with some lag due to the seasonality of operations and because
estimated income tax payments are typically based on annualizing the fiscal
year's income based on year-to-date results.

         In 2004, Headwaters recorded an income tax provision at an effective
tax rate of approximately 38.8%. As described in more detail in Note 14 to the
consolidated financial statements, in September 2004, Headwaters purchased a 9%
interest in an entity that owns and operates a coal-based alternative fuel

                                       38
<PAGE>

production facility. The synthetic fuel produced at the facility qualifies for
tax credits pursuant to Section 29 of the Internal Revenue Code, and Headwaters
is entitled to receive its pro-rata share of such tax credits generated.
Headwaters has also agreed to purchase an additional 10% interest in the entity
upon the earlier of receipt of a private letter ruling for the facility from the
IRS, or June 17, 2005. At the time Headwaters purchases the additional 10%
interest, Headwaters' pro-rata share of the tax credits will also increase. As a
result of these tax credits, Headwaters expects its effective tax rate to
decrease several percentage points in 2005.

         Summary of Future Cash Requirements. Significant future cash needs, in
addition to operational working capital requirements, are currently expected to
consist primarily of debt service payments on outstanding long-term debt, income
taxes and capital expenditures.

Off-Balance Sheet Arrangements

         Although Headwaters has operating leases for certain equipment and real
estate, and hedge agreements to limit its exposure to interest rate increases,
Headwaters does not have any off-balance sheet arrangements that have, or are
reasonably likely to have, a current or future effect on its financial
condition, changes in financial condition, revenues or expenses, results of
operations, liquidity, capital expenditures, or capital resources that are
material to investors.

Contractual Obligations and Contingent Liabilities and Commitments

         The following table presents a summary of Headwaters' contractual
obligations by period as of September 30, 2004.
<TABLE>
<CAPTION>
                                                              Payments due by Period
                                            -----------------------------------------------------------
                                                                                                After 5
(in millions)                                   Total       1 Year    2 -3 Years  4 -5 Years     Years
-------------------------------------------------------------------------------------------------------
<S>                                           <C>            <C>        <C>          <C>        <C>
Senior secured debt                           $  790.0       $48.0      $ 96.0       $32.0      $614.0
Convertible senior subordinated notes            172.5          --          --          --       172.5
Other long-term debt                              10.0         9.9         0.1          --          --
                                            -----------------------------------------------------------
     Total long-term debt                        972.5        57.9        96.1        32.0       786.5
Unconditional purchase obligations                65.4        14.0        22.1        14.6        14.7
Operating lease obligations                       47.8        14.8        20.5         8.4         4.1
Investment and joint venture obligations          21.0         5.6        14.0         1.4          --
Capital expenditures                              11.0        11.0          --          --          --
Other long-term obligations                        5.4         3.1         2.3          --          --
                                            -----------------------------------------------------------
     Total contractual cash obligations       $1,123.1      $106.4      $155.0       $56.4      $805.3
                                            ===========================================================
</TABLE>

         As provided for in the senior debt agreements, Headwaters has available
$60.0 million under a revolving credit arrangement. Borrowings and reborrowings
of any available portion of the $60.0 million revolver can be made at any time
through September 2009, at which time all loans must be repaid and the revolving
credit arrangement terminates. The credit agreement allows for the issuance of
letters of credit, provided there is capacity under the revolving credit
arrangement. As of September 30, 2004, three letters of credit totaling $2.1
million were outstanding, with expiration dates ranging from October 2004 to
June 2005. There have been no other letters of credit issued and no funds have
been borrowed under the revolving credit arrangement.

         As indicated previously, Headwaters and its subsidiaries are involved
in several legal proceedings and contractual matters that have arisen in the
normal course of business, all as explained in more detail in "Critical
Accounting Policies and Estimates - Legal Matters," above, "ITEM 3. LEGAL
PROCEEDINGS" and Note 14 to the consolidated financial statements.

Section 29 Matters

         Headwaters Energy Services' license fees and revenues from sales of
chemical reagents depend on the ability of licensees and customers to
manufacture and sell qualified synthetic fuels that generate tax credits under
Section 29 of the Internal Revenue Code. From time to time, issues arise as to
the availability of tax credits, including the items discussed below. Because of
the inherent risks associated with Headwaters' reliance on Section 29,
Headwaters has sought to diversify its sources of revenue, largely through
acquisitions, as described previously.

                                       39
<PAGE>

         Legislation. Under current law, Section 29 tax credits for synthetic
fuel produced from coal expire on December 31, 2007. In addition, there have
been initiatives from time to time to consider the early repeal or modification
of Section 29. For example, during 2004, a bill was introduced in the United
States House of Representatives that would repeal the Section 29 credit for
synthetic fuel produced from coal. Although it is unlikely that the bill will
pass Congress in 2004, the bill could be reintroduced in 2005. If Section 29
expires at the end of 2007 or if it is repealed or adversely modified, synthetic
fuel facilities would probably either close or substantially curtail production.
At this time, given current prices of coal and costs of synthetic fuel
production, Headwaters does not believe that production of synthetic fuel will
be profitable absent the tax credits. In addition, if Headwaters' licensees
close their facilities or materially reduce production activities (whether after
2007, upon earlier repeal or adverse modification of Section 29 or for any other
reason), it would have a material adverse effect on the revenues and net income
of Headwaters.

         Phase-Out. Section 29 tax credits are subject to phase-out after the
average annual wellhead domestic oil price ("reference price") reaches a
beginning phase-out threshold price, and is eliminated entirely if the reference
price reaches the full phase-out price. For 2003, the reference price was $27.56
per barrel and the phase-out range began at $50.14 and would have fully phased
out tax credits at $62.94 per barrel. For 2004, an estimated partial year
reference price through September is $40.48 per barrel, and an estimate of the
phase-out range (using 2% inflation) begins at $51.14 and completes phase-out at
$64.20 per barrel. The NYMEX one-day futures trading price on December 1, 2004
was $45.49 per barrel.

         IRS Audits. Licensees are subject to audit by the IRS. The IRS may
challenge whether Headwaters Energy Services' licensees satisfy the requirements
of Section 29, or applicable Private Letter Rulings, including placed-in-service
requirements, or may attempt to disallow Section 29 tax credits for some other
reason. The IRS has initiated audits of certain licensee-taxpayers who claimed
Section 29 tax credits, and the outcome of any such audit is uncertain. In 2004,
a licensee announced that IRS field auditors had issued a notice of proposed
adjustment challenging the placed-in-service date of three of its synthetic fuel
facilities. The licensee believes that the facilities meet the placed-in-service
requirement, however, the matter is at an early stage and the timing and final
results of the audit are unknown. The inability of a licensee to claim Section
29 tax credits would reduce Headwaters' future income from the licensee.

         Senate Permanent Subcommittee on Investigations. On October 29, 2003,
the Permanent Subcommittee on Investigations of the Government Affairs Committee
of the United States Senate issued a notification of pending investigations. The
notification listed the synthetic fuel tax credit as a new item. In March 2004,
the Subcommittee described its investigation as follows: "The Subcommittee is
continuing its investigation [of] tax credits claimed under Section 29 of the
Internal Revenue Code for the sale of coal-based synthetic fuels. This
investigation is examining the utilization of these tax credits, the nature of
the technologies and fuels created, the use of these fuels, and other aspects of
Section 29. The investigation will also address the IRS' administration of
Section 29 tax credits." The Subcommittee conducted numerous interviews and
received large volumes of data between December 2003 and March 2004. Since that
time, to Headwaters' knowledge, there has been little activity regarding the
investigation. Headwaters cannot make any assurances as to the timing or
ultimate outcome of the Subcommittee investigation, nor can Headwaters predict
whether Congress or others may conduct investigations of Section 29 tax credits
in the future. The Subcommittee investigation may have a material adverse effect
on the willingness of buyers to engage in transactions to purchase synthetic
fuel facilities or on the willingness of current owners to operate their
facilities, and may materially adversely affect Headwaters' revenues and net
income.

Recent Accounting Pronouncements

         In September 2004, the Emerging Issues Task Force ("EITF") reached a
consensus requiring the inclusion of contingently convertible instruments in
diluted EPS calculations. This consensus (EITF Issue 04-08, "The Effect of
Contingently Convertible Debt on Diluted Earnings per Share") will be effective
for periods ending after December 15, 2004 and will require Headwaters to
include in its diluted EPS calculation, on an if-converted basis, the additional
shares issuable under the terms of Headwaters' outstanding convertible senior
subordinated notes described in Note 9. The EITF consensus, when implemented,
must be applied to all applicable prior periods, which for Headwaters will be
the quarters ended June 30, 2004 and September 30, 2004. See Note 13 to the
consolidated financial statements for more information on the expected effect on
Headwaters' EPS of implementing the EITF consensus.

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

Impact of Inflation

         Headwaters' operations were not materially impacted by inflation in
2004.

                                       40
<PAGE>

Risks Relating to Headwaters' Business

If the continued existence of tax credits under Section 29 of the Internal
Revenue Code ("Section 29") is repealed or adversely modified, Headwaters Energy
Services' profitability will be severely affected.

         Headwaters Energy Services' license fees and revenues from sales of
chemical reagents depend on the ability of its licensees and customers to
manufacture and sell qualified synthetic fuels that generate tax credits. Under
current law, Section 29 tax credits are not available for synthetic fuel sold
after December 31, 2007. In addition, there have been initiatives from time to
time to consider the early repeal or modification of Section 29. For example, in
2004 a bill was introduced in the United States House of Representatives that
would repeal the Section 29 credit for synthetic fuel produced from coal. While
passage of the bill appears to be unlikely, the bill could be reintroduced in
Congress in the future. If Section 29 expires at the end of 2007 or if it is
repealed or adversely modified, synthetic fuel facilities would probably either
close or substantially curtail production. At this time, given current prices of
coal and costs of synthetic fuel production, Headwaters does not believe that
production of synthetic fuel will be profitable absent the tax credits. In
addition, if Headwaters' licensees close their facilities or materially reduce
production activities (whether after 2007, upon earlier repeal or adverse
modification of Section 29 or for any other reason), it would have a material
adverse effect on the revenues and net income of Headwaters. Furthermore,
Section 29 tax credits are subject to begin phase-out after the unregulated
average annual oil price reaches $50.14 per barrel, adjusted annually for
inflation (the one day futures trading price on December 1, 2004 was $45.49 per
barrel).

If Headwaters' licensees' demand for Section 29 tax credits decreases,
Headwaters Energy Services' revenues will decrease.

         Headwaters Energy Services' business depends upon the ability of its
licensees and chemical reagent customers to utilize Section 29 tax credits as
payments under its contracts are ultimately based on its customers' production
of synthetic fuels. Their ability to utilize tax credits depends upon their
taxable income. A decline in the profitability of its licensees could reduce
their ability to utilize tax credits, and, in turn, could lead to a reduction in
the production of synthetic fuel at their facilities. Such licensees could sell
their facilities to a taxpayer with more capacity to utilize the tax credits,
but any such transfer could result in short-term or long-term disruption of
operations, and therefore adversely affect Headwaters' revenues and net income.

IRS reviews under Section 29 may adversely affect Headwaters' licensees'
production of synthetic fuel and therefore may adversely affect Headwaters
Energy Services' profitability.

         The issuance of private letter rulings ("PLRs") under Section 29 by the
Internal Revenue Service ("IRS") is important to the willingness of the owners
of synthetic fuel facilities to operate and to their ability to transfer
ownership of those facilities. However, PLRs may be modified or revoked by the
IRS.

         The IRS has suspended the issuance of PLRs to synthetic fuel facility
owners several times in the past, including most recently in 2003, and the IRS
may suspend the issuance of PLRs in the future. In 2003, following an IRS
announcement that it would suspend issuance of PLRs because it questioned the
scientific validity of procedures and tests performed by synthetic fuel facility
operators to determine that the fuel satisfied the requirements of Section 29,
certain of Headwaters' licensees reduced or ceased production, which resulted in
a material impact on Headwaters' revenue and net income. While the IRS later
indicated it would resume the issuance of PLRs, it has continued to express
concerns regarding the sampling and data/record retention practices prevalent in
the synthetic fuels industry. The expression of IRS concern regarding current
practices in the industry may adversely affect the willingness of buyers to
engage in transactions or on the willingness of current owners to operate their
facilities. If current owners are unable to sell their facilities or are
unwilling to operate them, production will not be maximized, thereby materially
decreasing its revenues and net income. Headwaters cannot predict whether the
IRS may conduct reviews or investigations of Section 29 tax credits in the
future, or whether the outcome of IRS audits involving licensees would be
favorable.

Senate investigation of Section 29 tax credits may adversely affect production
by Headwaters' licensees and decrease the profitability of Headwaters Energy
Services.

                                       41
<PAGE>

         On October 30, 2003, the Permanent Subcommittee on Investigations of
the Government Affairs Committee of the United States Senate (the
"Subcommittee") issued a notification of pending investigations. The
notification listed, among others, the synthetic fuel tax credit as a new item
to be reviewed. If the pending investigation or any future Congressional action
results in findings or announcements negative to the industry, it may adversely
affect the willingness of buyers to engage in transactions to purchase synthetic
fuel facilities or the willingness of current owners to operate their
facilities, which would have a direct, negative impact on Headwaters' revenues
and net income.

                  In March 2004, the Subcommittee described its investigation as
                  follows:

                  The Subcommittee is continuing its investigation [of] tax
                  credits claimed under Section 29 of the Internal Revenue Code
                  for the sale of coal-based synthetic fuels. This investigation
                  is examining the utilization of these tax credits, the nature
                  of the technologies and fuels created, the use of these fuels,
                  and others [sic] aspects of Section 29. The investigation will
                  also address the IRS' administration of Section 29 tax
                  credits.

         The Subcommittee conducted numerous interviews and received large
volumes of data between December 2003 and March 2004. Since that time, to
Headwaters' knowledge, there has been little activity regarding the
investigation.

If the IRS challenges or disallows Section 29 tax credits claimed by its
licensees, Headwaters Energy Services' profitability may decrease because future
production by these licensees may decrease.

         Licensees are subject to audit by the IRS. The IRS may challenge
whether Headwaters Energy Services' licensees satisfy the requirements of
Section 29, or applicable PLRs, including placed-in-service requirements, or may
attempt to disallow Section 29 tax credits for some other reason. The IRS has
initiated audits of certain licensee-taxpayers who claimed Section 29 tax
credits, and the outcome of any such audit is uncertain. In 2004, a licensee
announced that IRS field auditors have issued a notice of proposed adjustment
challenging the placed-in-service date of three of its synthetic fuel
facilities. The licensee believes that the facilities meet the placed-in-service
requirement; however, the timing and final results of the audit are unknown. In
the event that tax credits are disallowed, licensees may seek recovery from
Headwaters Energy Services for operational or other reasons, although Headwaters
believes there would be no basis for such claims. The inability of a licensee to
claim Section 29 tax credits also would reduce Headwaters Energy Services'
future revenue from the licensee. In addition, IRS audit activity may have
adversely affected the willingness of buyers to engage in transactions to
purchase synthetic fuel facilities or on the willingness of current owners to
operate their facilities. If current owners are unable to sell their facilities
or are unwilling to operate them at full capacity, production will not be
maximized, which could have a significant effect on Headwaters Energy Services'
revenues and net income.

If Headwaters Energy Services' licensees' demand for Section 29 tax credits is
adversely influenced by negative publicity involving the industry or
transactions principally motivated by the reduction of taxes, Headwaters Energy
Services' profitability will decrease.

         There has been public scrutiny, by the media and by policymakers, of
Section 29. Outside the Section 29 context, there has been increased public
scrutiny of transactions motivated principally by the reduction of federal
income taxes. Headwaters Energy Services' licensees could determine that the
risk of negative publicity or public scrutiny associated with the Section 29 tax
credits exceeds the financial benefits from the utilization of the credits. Such
licensees may seek to mitigate or eliminate such risk by reducing or ceasing
production of synthetic fuel or disposing of their facilities, resulting in
short-term or long-term disruption of operations, in which case Headwaters
Energy Services' revenues and profitability would decrease.

Headwaters Energy Services' revenues result from a small number of licensees and
customers, so that any short-term or long-term decisions by one or a small
number of licensees and customers to decrease or halt production would cause its
profitability to decrease.

         Headwaters Energy Services has licensed its coal-based solid
alternative fuel technology to approximately 20 licensees, from whom license
fees accounted for approximately 9% of Headwaters' aggregate revenues on an
actual basis for fiscal 2004. In addition, HES sells reagent to approximately 30
licensees and additional customers from which reagent sales accounted for
approximately 24% of its aggregate revenues in 2004. Under current law,
facilities must have been placed into service prior to July 1, 1998 to be
eligible for Section 29 tax credits, so Headwaters Energy Services' business
primarily depends on existing licensees and chemical reagent customers. If any
of Headwaters Energy Services' significant licensees or chemical reagent
customers shuts down its facilities, operates its facilities at low production
levels or sells its facilities resulting in short-term or long-term disruption
of operations, Headwaters' revenues and net income could be materially adversely
affected. Headwaters Energy Services' licensees must address all operational

                                       42
<PAGE>

issues including, but not limited to, feedstock availability, cost, moisture
content, British thermal unit content, correct chemical reagent formulation and
application, operability of equipment, product durability and overall costs of
operations. In some cases, licensees may be forced to relocate plants and enter
into new strategic contracts to address marketing and operational issues.
Licensee plant relocations disrupt production and delay generation of license
fees paid to Headwaters.

         The growth of Headwaters Energy Services' revenues has depended in part
on increased production over time of coal-based solid synthetic fuel by its
licensees. While to date efficiencies in production and improvements in
equipment and processes used at facilities have allowed increased production,
capacity is ultimately finite for the specific facilities and could ultimately
limit future growth.

If Headwaters Energy Services is not able to develop and improve alternative
fuel technologies in order to satisfy its customers' requirements, Headwaters
may lose customers and associated licensing and chemical reagent revenues.

         For Headwaters Energy Services to remain competitive, HES must be able
to develop or refine its technologies to keep up with future alternative fuel
requirements. As licensees develop and modify their operations and choices of
coal feedstocks, HES will need to modify existing methods or find new methods,
know-how, additives and other techniques to meet licensee and customer demands,
such as demands for improved efficiencies, lower costs and improvements in
alternative fuel products, including chemical change and improved combustion
characteristics. If Headwaters is unable to develop or refine HES' technologies,
its customers may seek other suppliers or decrease production, thus adversely
affecting licensing and chemical reagent revenues.

Headwaters Resources primarily sells fly ash for use in concrete; if use and
market acceptance of fly ash does not increase, Headwaters Resources will not
grow.

         Headwaters Resources' growth has been and continues to be dependent
upon the increased use of fly ash in the production of concrete. Headwaters
Resources' marketing initiatives emphasize the environmental, cost and
performance advantages of replacing portland cement with fly ash in the
production of concrete. If Headwaters Resources' marketing initiatives are not
successful, Headwaters Resources may not be able to sustain its growth.

If portland cement or competing replacement products are available at lower
prices than fly ash, Headwaters' sales of fly ash as a replacement for portland
cement in concrete products could suffer, causing a decline in Headwaters
Resources' revenues and net income.

         An estimated 60% of Headwaters Resources' revenues for the fiscal year
ended September 30, 2004, which represents 23% of Headwaters aggregate revenues
for the year, were derived from the use of fly ash as a replacement for portland
cement in concrete products. At times, there may be an overcapacity of cement in
the world market, causing potential price decreases. The markets for Headwaters
Resources' products are regional, in part because of the costs of transporting
CCPs, and because Headwaters Resources' business is affected by the availability
and cost of competing products in the specific regions where it conducts
business. If competing products become available at attractive prices and
performance, Headwaters Resources' revenues and net income could decrease.

Because demand for CCPs sold by Headwaters Resources is affected by fluctuations
in weather and construction cycles, Headwaters Resources' revenues and net
income could decrease significantly as a result of unexpected or severe weather
or slowdowns in the construction industry.

         Headwaters Resources manages and markets CCPs and uses CCPs to produce
construction materials. Utilities produce CCPs year-round. In comparison, sales
of CCPs are generally keyed to construction market demands that tend to follow
national trends in construction with predictable increases during temperate
seasons. Headwaters Resources' CCP sales have historically reflected these
seasonal trends, with the largest percentage of total annual revenues being
realized in the quarters ended June 30 and September 30. Low seasonal demand
normally results in reduced shipments and revenues in the quarters ended March
31 and December 31.

         The CCP industry is cyclical because of its dependence on building
construction and highway construction, including infrastructure repair, and is
affected by changes in general and local economic conditions. State construction
budgets are affected adversely by economic downturns. Headwaters Resources'
sales could significantly decrease as a result of a downturn in the economy in
one or more markets that it serves.

If Headwaters Resources' coal-fueled electric utility industry suppliers fail to
provide Headwaters Resources with high value CCPs on a timely basis, Headwaters
Resources' costs could increase and its growth could be hindered.

         Headwaters Resources relies on the production of CCPs by coal-fueled
electric utilities. Headwaters Resources has occasionally experienced delays and
other problems in obtaining high value CCPs from its suppliers and may in the
future be unable to obtain high value CCPs on the scale and within the time

                                       43
<PAGE>

frames required by Headwaters Resources to meet its customers' needs. If
Headwaters Resources is unable to obtain CCPs or if it experiences a delay in
the delivery of high value CCPs, Headwaters Resources may be forced to incur
significant unanticipated expenses to secure alternative sources or to otherwise
maintain supply to its customers. Moreover, its revenues could be adversely
affected if these customers choose to find alternatives to Headwaters Resources
products.

With Headwaters' recent acquisitions of Eldorado and Tapco, Headwaters
Construction Materials has grown to be a significant part of Headwaters'
business and Headwaters' future profitability is therefore increasingly
dependent upon Headwaters' operations in this industry segment.

         In June 2004 Headwaters acquired Eldorado and in September 2004 it
acquired Tapco. With the Eldorado and Tapco acquisitions, Headwaters
Construction Materials has grown to be a significant part of Headwaters'
business. This segment produced $134.0 million in revenues (or approximately 24%
of total revenue) for fiscal year 2004; in combination with Tapco and Eldorado,
on a pro forma basis, revenues for this segment would have been $457.4 million
(or approximately 51% of total pro forma revenues) for fiscal year 2004.
Headwaters' future profitability therefore is highly dependent upon its ability
to operate successfully in this industry segment where its operations to date
have not been as significant to its total revenues.

If Headwaters does not successfully integrate Eldorado and Tapco with its
existing business, Headwaters may not realize the expected benefits of the
acquisitions, and the resources and attention required for successful
integration may interrupt the business activities of Eldorado, Tapco and
Headwaters existing business.

         There is a significant degree of difficulty and management distraction
inherent in the process of integrating Eldorado and Tapco, even though other
senior management continues to operate the businesses. These difficulties
include integrating Eldorado and Tapco with Headwaters' existing construction
materials business, while maintaining the ongoing operations of each business,
coordinating geographically separate organizations and developing new customers
and products. Successful integration will also depend in part on Headwaters'
ability to retain key officers and personnel in each of Headwaters' business
units.

         The combination with Headwaters has resulted in the combined company
having more than 3,680 employees, which substantially increased Headwaters'
previous workforce of approximately 1,000 employees. Integration of these
additional employees, many of whom are manufacturing plant workers, could result
in various issues, including issues related to human resource benefit plans and
an increase in EEOC claims and claims for workers compensation.

         As Headwaters integrates Tapco's and Eldorado's manufacturing and
distribution activities, Headwaters also has increased significantly its sales
and products. Headwaters has limited manufacturing experience and may not be
able to resolve manufacturing issues or increase efficiencies at manufacturing
plants. The integration process requires Headwaters to expand significantly its
operational and financial systems, which increases the operating complexity of
its information technology systems. Implementation of controls, systems and
procedures may be costly and time-consuming and may not be effective.

If Headwaters cannot invest additional capital into Tapco and Eldorado, it may
not be able to sustain or continue Tapco's and Eldorado's growth.

         Current levels of capital expenditures may be insufficient to support
and sustain Tapco's and Eldorado's growth. Headwaters believes that an estimated
$50 million of capital in its fiscal year 2005 will be required for company-wide
growth and other purposes. Headwaters' senior secured credit facilities limit
capital expenditures for the entire business to $50 million for fiscal year
2005.

Because Tapco's and Eldorado's markets are heavily dependent on the residential
construction and remodeling market, Tapco's and Eldorado's revenues could
decrease as a result of declines in construction and remodeling activity due to
unexpected or severe weather, a rise in interest rates, a limit on availability
of credit for homeowners or other events outside Headwaters' control that impact
home construction and home improvement activity.

         Tapco's and Eldorado's construction markets are seasonal and cyclical.
The majority of their sales are in the residential construction market, which
tends to slow down in the winter months. If there is more severe weather than
normal or an increase in interest rates or a limit on availability of credit for
homeowners which results in a slow down in new construction or remodeling and
repair activities, there may be a negative effect on Tapco's and Eldorado's
revenues if they are not able to increase market share.

Interruption of Tapco's ability to immediately ship individual or custom product
orders could harm Tapco's reputation and result in lost revenues if customers
turn to other sources for products.

                                       44
<PAGE>

         Tapco's construction materials business is highly dependent upon
immediate shipments to contractors and distributors throughout the United States
of individual orders, a large portion of which orders are manufactured upon
demand to meet customer specifications. If there is significant interruption of
business at any of Tapco's manufacturing plants or with Tapco's computer systems
that track customer orders and production, Tapco is at risk of harming its
reputation for speed and reliability with important customers and losing
short-term and long-term revenues if these customers turn to other sources.

A significant increase in the price of materials used in the production of
Tapco's products that cannot be passed on to customers could have a significant
adverse effect on net revenue. Further, Tapco depends upon a single source for a
major production material, the interruption of which would materially disrupt
Headwaters' ability to manufacture products and supply products to its
customers, resulting in lost revenues and the potential loss of customers.

         Certain of Tapco's products, which provided approximately 70% of
Tapco's revenues for the fiscal year ended October 31, 2003, are manufactured
from polypropylene which material is sold to Tapco by a single supplier. The
price of polypropylene is primarily a function of manufacturing capacity, demand
and the prices of petrochemical feedstocks, crude oil and natural gas liquids.
Historically, the market price of polypropylene has fluctuated. A significant
increase in the price of polypropylene that cannot be passed on to customers
could have a significant adverse effect on net revenue. There is no long-term
contract with Headwaters' polypropylene supplier. Tapco does not currently
maintain large inventories of polypropylene and alternative sources meeting
Tapco's requirements would be difficult to arrange in the short term. Therefore,
Tapco's manufacturing and ability to provide products to Headwaters' customers
could be materially disrupted if this supply of polypropylene was interrupted
for any reason. Such an interruption and the resulting inability to supply
Tapco's customers with products could adversely impact Tapco's revenues and
potentially Headwaters' relationships with Tapco's customers.

Tapco's revenues would be materially adversely affected if it lost one or both
of its two major customers.

         Two of Tapco's customers together accounted for approximately 25% of
its revenues in its fiscal year ended October 31, 2003. There are no long-term
contracts in place with these customers. Accordingly, any loss of or decrease in
demand from these customers would have a material adverse effect on Tapco's
business.

HTI's technologies may not be commercially developed and marketed profitably,
which could affect HTI's future profitability.

         Although HTI has developed and patented several technologies,
commercialization of these technologies is in initial stages. Market acceptance
of these technologies will depend on HTI's ability to enter into agreements with
licensees or joint venturers to further develop and provide adequate funding to
commercialize the technologies. HTI may not be able to enter into these
agreements and adequate funding may not be available to fully develop and
successfully commercialize its technologies. Further, Headwaters may not be able
to market profitably HTI's technologies.

HTI will conduct business in China, where intellectual property and other laws,
as well as business conditions, may leave Headwaters' intellectual property,
products and technologies vulnerable to duplication by competitors and create
uncertainties as to Headwaters' legal rights against such competitors' actions.

         HTI has and is expected to continue to license or otherwise make its
technology, including its nanotechnology and coal liquefaction technology,
available to entities in China. HTI is also performing a feasibility study that
could lead to licensing of technology in India. There is the risk that foreign
intellectual property laws will not protect Headwaters' intellectual property to
the same extent as under United States laws, leaving us vulnerable to
competitors who may attempt to copy Headwaters' products, processes or
technologies. Further, the legal system of China is based on statutory law.
Under this system, prior court decisions may be cited as persuasive authority
but do not have binding precedential effect. Since 1979, the Chinese government
has been developing a comprehensive system of commercial laws and considerable
progress has been made in the promulgation of laws and regulations dealing with
economic matters, such as corporate organization and governance, foreign
investment, commerce, taxation and trade. As these laws, regulations and legal
requirements are relatively new and because of the limited volume of published
case law and judicial interpretations and the non-binding nature of prior court
decisions, the interpretation and enforcement of these laws, regulations and
legal requirements involve some uncertainty. These uncertainties could limit the
legal protection or recourse available to Headwaters. In addition, dependence on
foreign licenses and conducting foreign operations may subject Headwaters to
increased risk from political change, ownership issues or repatriation or
currency exchange concerns.

                                       45
<PAGE>

Headwaters operates in industries subject to significant environmental
regulation, and compliance with and changes in regulation could add
significantly to the costs of conducting business.

         The coal-based solid synthetic fuel operations of Headwaters and its
licensees are subject to federal, state and local environmental regulations that
impose limitations on the discharge of pollutants into the air and water and
establish standards for the treatment, storage and disposal of waste products,
which add to the costs of doing business and expose Headwaters to potential
fines for non-compliance. If the costs of environmental compliance increase for
any reason, Headwaters may not be able to pass on these costs to customers. In
order to establish and operate the synthetic fuel plants, power plants and
operations to collect and transport CCPs and bottom ash, Headwaters, its
licensees and customers have obtained various state and local permits and must
comply with processes and procedures that have been approved by regulatory
authorities. Any failure to comply could result in the issuance of substantial
fines and penalties and cause Headwaters to incur environmental liabilities.

         Certain Eldorado and Tapco manufacturing operations are also subject to
environmental regulations and permit requirements. If Eldorado and Tapco cannot
obtain additional required environmental permits for their manufacturing
facilities in a timely manner or at all, they may be subject to additional costs
and/or fines.

         HTI's ordinary course of business requires using its facilities to
perform research and development activities involving coal, oil, chemicals and
energy technologies, including liquefaction of coal. As a result, petroleum and
other hazardous materials have been and are present in and on HTI's properties.
Regulatory noncompliance or accidental discharges, in spite of safeguards, could
create an environmental liability. Therefore Headwaters' operations entail risk
of environmental damage, and Headwaters could incur liabilities in the future
arising from the discharge of pollutants into the environment or from waste
disposal practices.

Headwaters is involved in litigation and claims for which Headwaters incurs
significant costs and are exposed to significant liability.

         Headwaters is a party to some significant legal proceedings and is
subject to potential claims regarding operation of its business. These
proceedings will require that Headwaters incur substantial costs, including
attorneys' fees, managerial time and other personnel resources and costs in
pursuing resolution, and adverse resolution of these proceedings could hurt
Headwaters' reputation. With respect to the cases referred to in our "Item 3.
LEGAL PROCEEDINGS" of this Form 10-K, the following amount of damages are being
sought by the counter parties:

         Boynton:        Boynton seeks declaratory relief as well as
                         approximate compensatory damages between $15 million
                         and $25 million and punitive damages;
         AGTC:           AGTC claims approximate damages between $520,000 and
                         $14.3 million;
         AJG:            AJG seeks compensatory damages in the approximate
                         amount of $71 million and punitive damages;
         McEwan:         McEwan seeks declaratory relief as well as
                         compensatory damages in the approximate amount of
                         $2.75 million and punitive damages.

         Headwaters has ongoing litigation and claims incurred during the normal
course of business, including the items referred to above. Headwaters intends to
vigorously defend and/or pursue its rights in these actions. Headwaters does not
currently believe that the outcome of these actions will have a material adverse
effect on Headwaters' operations, cash flows or financial position; however, it
is possible that a change in the estimates of probable liability could occur,
and the change could be significant.

Headwaters has significant competition in its industries which may cause demand
for Headwaters products and services to decrease.

         Headwaters experiences significant competition in all of its segments
and geographic regions. A failure to compete effectively or increased
competition could lead to price cuts, reduced gross margins and loss of market
share, which could hurt profitability. Many of Headwaters' competitors have
greater financial, management and other resources than Headwaters and may be
able to take advantage of acquisitions and other opportunities more readily. In
certain instances Headwaters must compete on the basis of superior products and
services rather than price, thereby increasing the costs of marketing its
services to remain competitive.

         Headwaters Energy Services competes with other companies possessing
technologies to produce coal-based solid alternative fuels and companies that
produce chemical reagents. It also experiences competition from traditional coal
and fuel suppliers and companies involved with natural resources, in addition to
those companies that specialize in the use and upgrading of industrial
byproducts. These companies may have greater financial, management and other
resources than Headwaters has and may develop superior, or more cost-effective
technologies. This could result in a decrease in market share and therefore
revenues.

                                       46
<PAGE>

         Headwaters Resources has substantial competition in two main areas:
obtaining CCP management contracts with utility and other industrial companies;
and marketing CCPs and related industrial materials. There are many local,
regional and national companies that compete for market share in these areas
with similar products and with numerous other substitute products. Although
Headwaters Resources typically has long-term CCP management contracts with its
clients, some of such contracts provide for the termination of such contracts at
the convenience of the utility company upon a minimum 90-day notice. Moreover,
certain of Headwaters Resources' most significant regional CCP competitors
appear to be seeking a broader national presence, and some of these competitors
have substantially greater resources than Headwaters and Headwaters Resources.
If they were to begin to compete in the national market, or in regions where
they currently do not have operations, Headwaters Resources' could lose market
share and associated revenues.

         Headwaters Construction Materials competes against numerous national
and regional manufacturers, some of which are significantly larger than
Headwaters and may have greater financial, manufacturing and distribution
resources than Headwaters.

         For the HTI business, many of the world's major chemical companies are
devoting significant resources to researching and developing nanocatalysts and
catalytic processes. These companies have greater financial, management and
other resources than does Headwaters.

Headwaters' business strategy to diversify through acquisitions may result in
integration costs, failures and dilution to existing stockholders.

         An important business strategy of Headwaters is diversification and
growth through acquisitions. Headwaters' ability to successfully implement
Headwaters' strategy is subject to a number of risks, including difficulties in
identifying acceptable acquisition candidates, consummating acquisitions on
favorable terms and obtaining adequate financing, which may adversely affect its
ability to develop new products and services and to compete in Headwaters
rapidly changing marketplace. In addition, if Headwaters consummates
acquisitions through an exchange of securities, its existing stockholders could
suffer dilution. Successful management and integration of acquisitions are
subject to a number of risks, including difficulties in assimilating acquired
operations, including loss of key employees, diversion of management's attention
from core business operations, assumption of contingent liabilities and
incurrence of potentially significant write-offs. This strategy may not improve
Headwaters' operating results and acquisitions may have a dilutive effect on
existing stockholders.

If Headwaters' internal controls over financial reporting under Section 404 of
the Sarbanes-Oxley Act are not adequate, our reputation could be harmed and we
could be subject to regulatory scrutiny, civil or criminal penalties or
stockholder litigation.

    Section 404 of the Sarbanes-Oxley Act of 2002 requires that Headwaters
evaluates and reports on its system of internal controls beginning with our
Annual Report on Form 10-K for the year ending September 30, 2005. If we fail to
maintain the adequacy of our internal controls, we could be subject to
regulatory scrutiny, civil or criminal penalties or stockholder litigation. Any
inability to provide reliable financial reports could harm our business. Section
404 of the Sarbanes-Oxley Act also requires that our independent auditors report
on management's evaluation of our system of internal controls. Headwaters is in
the process of documenting and testing its system of internal controls to
provide the basis for its report. Further, the growth and diversification of our
business through acquisitions complicates the process of developing, documenting
and testing internal controls. At this time, due to the ongoing evaluation and
testing, no assurance can be given that there may not be significant
deficiencies or material weaknesses that would be required to be reported.

If Headwaters is unable to manage the growth of its business successfully, its
revenues and business prospects could suffer.

         Headwaters has experienced significant growth recently, both internally
and through acquisitions. Headwaters may not be able to successfully manage the
increased scope of its operations or a significantly larger and more
geographically diverse workforce as Headwaters expands. Any failure to
successfully manage growth could harm its business and financial results.
Additionally, growth increases the demands on Headwaters' management,
Headwaters' internal systems, procedures and controls. To successfully manage
growth, Headwaters must add administrative staff and periodically update and
strengthen its operating, financial and other systems, procedures and controls,
which will increase its costs and may reduce its profitability. Headwaters may
be unable to successfully implement improvements to Headwaters' information and
control systems in an efficient or timely manner and may discover deficiencies
in existing systems and controls.

                                       47
<PAGE>

Unauthorized use of or infringement claims regarding Headwaters' proprietary
intellectual property could adversely affect Headwaters' ability to conduct its
business.

         Headwaters has relies primarily on a combination of trade secrets,
patents, copyright and trademark laws and confidentiality procedures to protect
its intellectual property. Despite these precautions, unauthorized third parties
may misappropriate, infringe upon, copy or reverse engineer portions of
Headwaters' technology. Headwaters does not know if current or future patent
applications will be issued with the scope of the claims sought, if at all, or
whether any patents issued will be challenged or invalidated. Headwaters'
business could be harmed if it infringes upon the intellectual property rights
of others. Headwaters has been, and may be in the future, notified that
Headwaters may be infringing intellectual property rights possessed by third
parties. If any such claims are asserted against Headwaters, Headwaters may seek
to enter into royalty or licensing arrangements. There is a risk in these
situations that no license will be available or that a license will not be
available on reasonable terms, precluding use of the applicable technology.
Alternatively, Headwaters may decide to litigate such claims or attempt to
design around the patented technology. To date, while no single patent or
trademark is material to Headwaters' business and the issues described in this
paragraph have not resulted in significant cost or had an adverse impact on
Headwaters' business, future actions could be costly and would divert the
efforts and attention of Headwaters' management and technical personnel.

Headwaters' highly leveraged capital structure affects its flexibility in
responding to changing business and economic conditions and results in high
interest costs.

         As of September 30, 2004, Headwaters had approximately $973 million of
total debt outstanding, including $790 million of senior indebtedness under its
senior secured credit facilities and $172.5 million of its 2 7/8% subordinated
convertible notes ("notes"). Subject to restrictions in Headwaters' senior
secured credit facility, Headwaters may also incur significant amounts of
additional debt for working capital, capital expenditures and other purposes.
Headwaters' combined debt total could have important consequences, including the
following:

         o        Headwaters may have difficulty borrowing money for working
                  capital, capital expenditures, acquisitions or other purposes
                  because of Headwaters' existing debt load and because
                  Headwaters' borrowings are secured by all of its assets;

         o        Headwaters will need to use a large portion of Headwaters'
                  cash flow to pay interest and the required principal payments
                  on its debt, which will reduce the amount of money available
                  to finance Headwaters' operations, capital expenditures and
                  other activities; and

         o        Headwaters' senior secured credit facilities have a variable
                  rate of interest, which exposes Headwaters to the risk of
                  increased interest rates.

         Headwaters' ability to make scheduled payments of the principal of, to
pay interest on or to refinance Headwaters' indebtedness depends on its future
performance, which to a certain extent is subject to economic, financial,
competitive and other factors beyond Headwaters' control. Headwaters' business
may not continue to generate cash flow from operations in the future sufficient
to service Headwaters' debt and make necessary capital expenditures. If unable
to generate such cash flow, Headwaters may be required to adopt one or more
alternatives, such as selling assets, restructuring debt or obtaining additional
equity capital on terms that may be onerous or highly dilutive.

Covenant restrictions under Headwaters' senior secured credit facility may limit
Headwaters' ability to operate its business in a manner required to sustain
profitability and generate growth.

         Headwaters' senior secured credit facilities, contain, among other
things, covenants that may restrict Headwaters' ability to finance future
operations or capital needs, to acquire additional businesses or to engage in
other business activities. The senior secured credit facilities require approval
for new acquisitions funded with aggregate cash consideration in excess of $30
million per year and $50 million in the aggregate until such time as Headwaters'
debt to earnings before interest, taxes, depreciation and amortization
("EBITDA") ratio is reduced to a specified amount. In addition, Headwaters'
senior secured credit facilities set forth covenants requiring us to maintain
specified financial ratios and satisfy certain financial condition tests which
may require that Headwaters take action to reduce its debt or to act in a manner
contrary to its business objectives. A breach of any of these covenants could
result in a default under the senior secured credit facilities, in which event
the lenders could elect to declare all amounts outstanding to be immediately due
and payable. If Headwaters is not able to repay its obligations when they become
due or are accelerated, the lenders could foreclose on Headwaters' assets. The
indenture for the notes does not restrict the amount of indebtedness, including
senior indebtedness, that Headwaters may incur.

                                       48
<PAGE>

Headwaters may not have the ability to raise the funds necessary to finance the
repurchase of Headwaters' notes or may otherwise be restricted from making such
repurchase if required by holders pursuant to the indenture, which would result
in a default under Headwaters' indenture which in turn might constitute a
default under the terms of its other indebtedness, causing much or all of
Headwaters' indebtedness to become due simultaneously when Headwaters is unable
to pay it.

         On June 1, 2011, or in the event of a "designated event" under the
indenture, holders may require Headwaters to repurchase their notes at a price
of 100% of the principal amount of the notes, plus accrued and unpaid interest,
including liquidated damages, if any, to, but excluding, the repurchase date.
However, it is possible that Headwaters will not have sufficient funds available
at such time to make the required repurchase of notes. In addition, any future
credit agreements or other agreements relating to its indebtedness may contain
provisions prohibiting the repurchase of the notes under certain circumstances,
or may provide that a designated event constitutes an event of default under
that agreement. If any agreement governing Headwaters indebtedness prohibits
Headwaters from repurchasing the notes when Headwaters becomes obligated to do
so, Headwaters could seek the consent of the lenders to repurchase the notes or
attempt to refinance this debt. If Headwaters does not obtain such consent or
refinance the debt, it would not be permitted to repurchase the notes.

Headwaters' failure to repurchase tendered notes would constitute an event of
default under the indenture, which might constitute a default under the terms of
Headwaters other indebtedness, causing much or all of Headwaters' indebtedness
to become due simultaneously when Headwaters is unable to pay it.

Delaware law and Headwaters' charter documents may impede or discourage a
takeover, which could cause the market price of Headwaters' shares to decline.

         Headwaters is a Delaware corporation, and the anti-takeover provisions
of Delaware law impose various impediments to the ability of a third party to
acquire control of Headwaters, even if a change in control would be beneficial
to existing stockholders. In addition, Headwaters' board of directors has the
power, without stockholder approval, to designate the terms of one or more
series of preferred stock and issue shares of preferred stock, including the
adoption of a "poison pill," which could be used defensively if a takeover is
threatened. The ability of Headwaters' board of directors to create and issue a
new series of preferred stock and certain provisions of Delaware law and
Headwaters' certificate of incorporation and bylaws could impede a merger,
takeover or other business combination involving Headwaters or discourage a
potential acquirer from making a tender offer for Headwaters' common stock,
which, under certain circumstances, could reduce the market price of Headwaters'
common stock.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

         Headwaters is exposed to financial market risks, primarily related to
changes in interest rates. Headwaters does not use derivative financial
instruments for speculative or trading purposes, but has entered into hedge
transactions to limit its exposure for interest rate movements, as explained
below.

         As described in more detail in Note 9 to the consolidated financial
statements, Headwaters has approximately $799.8 million of variable-rate
long-term debt outstanding as of September 30, 2004, consisting of $790.0
million of senior debt and $9.8 million of notes payable to a bank.

         The $790.0 million of term loan borrowings under the senior debt
agreements consisted of a first lien term loan in the amount of $640.0 million
and a second lien term loan in the amount of $150.0 million. The first lien term
loan bears interest, at Headwaters' option, at either i) the London Interbank
Offered Rate ("LIBOR") plus 3.0%, if the "total leverage ratio," as defined, is
less than or equal to 3.75:1.0, and if not, at LIBOR plus 3.25%, or ii) the
"base rate" plus 2.0%, if the total leverage ratio is less than or equal to
3.75:1.0, and if not, at the base rate plus 2.25%. Base rate is defined as the
higher of the rate announced by Morgan Stanley Senior Funding and the overnight
rate charged by the Federal Reserve Bank of New York plus 0.5%. The interest
rate on the first lien debt at September 30, 2004 was approximately 6.5%, but
was reduced to approximately 5.4% in October 2004. The second lien term loan
bears interest, also at Headwaters' option, at either LIBOR plus 5.5%, or the
"base rate" plus 4.5%. The interest rate on the second lien debt at September
30, 2004 was approximately 9.75%, but was reduced to approximately 8.15% in
October 2004. Headwaters can lock in new rates for both the first lien and
second lien loans for one, two, three or six months. The next rate change will
occur in January 2005.

         In connection with the new senior secured credit facility, Headwaters
entered into certain hedge agreements to limit its exposure to interest rate
increases. The first set of agreements established the maximum LIBOR rate for
$300.0 million of debt at 5.0% through September 8, 2005. The second set of
agreements sets the LIBOR rate at 3.71% for $300.0 million of debt for the
period commencing September 8, 2005 through September 8, 2007. Headwaters
accounts for these agreements as cash flow hedges, and accordingly, the fair
market value of the hedges is reflected in the consolidated balance sheet as
either other assets or other liabilities. The hedges had a fair market value of
$0 at inception and through the period ended September 30, 2004.

                                       49
<PAGE>

         In connection with the acquisition of SCP, Headwaters assumed SCP's
obligations under its notes payable to a bank, totaling $9.8 million. Two of the
notes bear interest at LIBOR plus 0.5%, subject to an interest rate floor of
4.5% (4.5% at September 30, 2004), and the remaining note (in the amount of $1.1
million) bears interest at 0.5% below the bank's base rate (4.25% at September
30, 2004).

         A change in the interest rate of 1% would change Headwaters' interest
expense by approximately $7.7 million during the year ending September 30, 2005,
considering all outstanding balances of variable-rate debt and required
principal repayments.

         The majority of Headwaters' short-term investments, all of which are
classified as trading securities, consist of fixed-rate U.S. government
securities or securities backed by the U.S. government. Changes in interest
rates can affect the market value of these investments, which are carried at
market value in the consolidated balance sheet. The periodic adjustments to
reflect changes in market value are included in interest and net investment
income in the consolidated statements of income. Based on the current amount of
short-term investments and expected near-term changes in the amount of
short-term investments, Headwaters does not expect any material near-term
investment losses to result from changes in interest rates.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         The financial statements and supplementary financial data required by
this Item 8 are set forth in Item 15 of this Form 10-K. All information that has
been omitted is either inapplicable or not required.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

         As described in more detail in the following paragraphs, on October 14,
2002, Headwaters dismissed PricewaterhouseCoopers LLP ("PwC") and appointed
Ernst & Young LLP ("E&Y").

         On September 19, 2002, Headwaters acquired 100% of the common stock of
ISG. E&Y audited ISG since its inception. ISG's revenues comprised approximately
65% of the consolidated revenues of the combined entity and ISG operated in 35
states and Canada. In addition, approximately 85% of Headwaters' employees came
from the ISG acquisition. On October 14, 2002, Headwaters decided to retain E&Y
as its independent accountants for the new combined company and accordingly
dismissed PwC. Headwaters' Audit Committee participated in and approved the
decision to change independent accountants.

         Headwaters did not consult with E&Y on any application of accounting
principles or any other matter during the two fiscal years ended September 30,
2001 or subsequent thereto.

         The reports of PwC on the financial statements for the fiscal years
audited by them contained no adverse opinion or disclaimer of opinion and were
not qualified or modified as to uncertainty, audit scope or accounting
principle.

         In connection with its audits for the two most recent fiscal years and
through October 14, 2002, there were no disagreements with PwC on any matter of
accounting principles or practices, financial statement disclosure, or auditing
scope or procedure, which disagreements if not resolved to the satisfaction of
PwC would have caused them to make reference thereto in their reports on the
financial statements for such years.

         During the two most recent fiscal years and through October 14, 2002,
there were no reportable events (as defined in Regulation S-K Item
304(a)(1)(v)).

         Headwaters requested that PwC furnish it with a letter addressed to the
Securities and Exchange Commission stating whether or not it agrees with the
above statements. A copy of such letter is filed as Exhibit 16.1 to this Form
10-K.

ITEM 9A. CONTROLS AND PROCEDURES

         Disclosure controls are procedures that are designed with an objective
of ensuring that information required to be disclosed in Headwaters' periodic
reports filed with the SEC, such as this Annual Report on Form 10-K, is
recorded, processed, summarized and reported within the time periods specified
by SEC rules, regulations and forms. Disclosure controls include, without
limitation, controls and procedures designed to ensure that such information is
accumulated and communicated to Headwaters' management, including the Chief
Executive Officer ("CEO") and the Chief Financial Officer ("CFO"), in order to
allow timely consideration regarding required disclosures.

                                       50
<PAGE>

         The evaluation of Headwaters' disclosure controls by the CEO and CFO
included a review of the controls' objectives and design, the operation of the
controls, and the effect of the controls on the information presented in this
Annual Report. Headwaters' management, including the CEO and CFO, does not
expect that disclosure 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 only reasonable, not absolute, assurance that the objectives of the
control system are met. Also, projections of any evaluation of the disclosure
controls and procedures to future periods are subject to the risk that the
disclosure controls and procedures may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may
deteriorate.

         Based on their review and evaluation as of September 30, 2004, and
subject to the inherent limitations as described above, Headwaters' CEO and CFO
have concluded that Headwaters' disclosure controls and procedures (as defined
in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are
effective. In addition, they are not aware of any change in Headwaters' internal
control over financial reporting during the quarter ended September 30, 2004
that has materially affected, or is reasonably likely to materially affect,
Headwaters' internal control over financial reporting.

ITEM 9B. OTHER INFORMATION

         None.


                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

         The information to be set forth under the captions "Executive Officers"
and "Proposal No. 1 - Election of Directors" in Headwaters' Proxy Statement to
be filed in January 2005 for the Annual Meeting of Stockholders to be held in
2005 (the "Proxy Statement"), is incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

         The information to be set forth under the caption "Executive
Compensation and Related Information" in the Proxy Statement is incorporated
herein by reference; provided, however, that Headwaters specifically excludes
from such incorporation by reference any information set forth under the
captions "Compensation Committee Report on Executive Compensation" and
"Stockholder Return Performance Graph" in the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         Security ownership of certain beneficial owners and management to be
set forth under the caption "Security Ownership of Certain Beneficial Owners and
Management" in the Proxy Statement is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The information to be set forth under the caption "Transactions with
Related Parties" in the Proxy Statement is incorporated herein by reference.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

         The information to be set forth under the caption "Audit and Non-Audit
Fees" in the Proxy Statement is incorporated herein by reference.

                                       51
<PAGE>

                                     PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

(a)  1.  Financial Statements

         Consolidated Financial Statements of Headwaters Incorporated    Page

         Report of Independent Auditors                                   F-1
         Consolidated Balance Sheets as of September 30, 2003 and 2004    F-2
         Consolidated Statements of Income
              for the years ended September 30, 2002, 2003 and 2004       F-3
         Consolidated Statements of Changes in Stockholders' Equity
              for the years ended September 30, 2002, 2003 and 2004       F-4
         Consolidated Statements of Cash Flows
              for the years ended September 30, 2002, 2003 and 2004       F-6
         Notes to Consolidated Financial Statements                       F-8

     2.  Financial Statement Schedules

         All financial statement schedules for which provision is made in the
applicable accounting regulations of the Securities and Exchange Commission are
not required under the related instructions, are inapplicable, or the required
information has been provided in the consolidated financial statements or notes
thereto.

     3.  Listing of Exhibits

         For convenience, the name Headwaters is used throughout this listing
although in some cases the name Covol was used in the original instrument.
<TABLE>
<CAPTION>
 Exhibit No.                                        Description                                          Location
 -----------                                        -----------                                          --------
<S>              <C>                                                                                      <C>
 3.1.9           Restated Certificate of Incorporation of Headwaters dated August 14, 2001                  (3)
 3.2.4           Restated By-Laws of Headwaters                                                             (7)
10.54            Employment Agreement effective May 1, 1998 with Steven G. Stewart                          (2)
10.60            Employment Agreement dated October 25, 2002 with Kirk A. Benson                            (7)
10.60.1          Amendment to Employment Agreement with Kirk A. Benson dated July 9, 2003                   (9)
10.60.3          ISG Employment Agreement dated October 1, 2001 with Raul Deju                              (7)
10.60.4          Amendment of Employment Agreement dated August 2, 2004 with Raul Deju                       *
10.75            Agreement and Plan of Merger between Headwaters and Industrial Services Group,             (4)
                 Inc. dated July 15, 2002
10.75.2          First Amendment to Agreement and Plan of Merger and Equityholder Agreements among          (5)
                 Headwaters, Industrial Services Group, Inc. and Equityholders of Industrial
                 Services Group, Inc. dated September 19, 2002
10.83            Incentive Agreement between Headwaters and Raul A. Deju dated as of November 12,           (8)
                 2002
10.84            Credit Agreement among Headwaters and various lenders dated March 31, 2004                (11)
                 (terminated)
10.84.1          Pledge and Security Agreement among Headwaters and various lenders dated March            (11)
                 31, 2004 (terminated)
10.84.2          Amendment No. 1, dated as of June 23, 2004, to Credit Agreement among Headwaters          (13)
                 and various lenders as of March 31, 2004 (terminated)
10.85            Agreement and Plan of Merger between Headwaters and VFL Technology Corporation            (11)
                 dated February 10, 2004
10.86            Securities Purchase Agreement by and among Eldorado Stone Holdings Co., LP, et            (12)
                 al. and Headwaters dated April 21, 2004
10.87            Indenture dated as of June 1, 2004 between Headwaters and Wells Fargo Bank, as            (13)
                 Trustee, relating to 2-7/8% Convertible Senior Subordinated Notes due 2016
10.88            Asset Purchase Agreement between Headwaters and Southwest Concrete Products, LP           (13)

                                       52
<PAGE>

10.89            Agreement and Plan of Merger by and among Headwaters Incorporated, Headwaters T           (14)
                 Acquisition Corp., and Tapco Holdings, Inc., dated as of September 8, 2004
10.90            Employment Agreement with John N. Lawless, III dated September 22, 2004                   (15)
10.90.1          Nonstatutory Stock Option Grant effective as of September 22, 2004                        (15)
10.90.2          Executive Change in Control Agreement with John N. Lawless, III effective as of           (15)
                 September 22, 2004
10.91            Credit Agreement among Headwaters and various lenders dated September 8, 2004               *
10.92            Second Lien Credit Agreement among Headwaters and various lenders dated September           *
                 8, 2004
12               Computation of ratio of earnings to combined fixed charges and preferred stock              *
                 dividends
14               Code of Ethics                                                                            (10)
16.1             Letter regarding change in certifying accountant                                           (6)
21               List of Subsidiaries of Headwaters                                                          *
23.1             Consent of Ernst & Young LLP                                                                *
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          *
99.1.1           Amended 2000 Employee Stock Purchase Plan, as further amended                               *
99.2             1995 Stock Option Plan (originally designated as Exhibit No. 10.5)                         (1)
99.2.1           First Amendment to the 1995 Stock Option Plan (originally designated as Exhibit            (1)
                 10.5.1)
99.2.2           1996 Stock Option Agreement                                                                (7)
99.2.3           1998 Stock Option Agreement                                                                (7)
99.2.4           2001 Stock Option Agreement                                                                (7)
99.2.5           2002 Stock Option Agreement                                                                (7)
99.3.1           Incentive Bonus Plan dated 1 October 2004                                                   *
99.4             2002 Stock Incentive Plan                                                                   *
99.7             2003 Stock Incentive Plan                                                                  (8)
99.8             General Employee Bonus Plan dated 1 October 2003                                          (10)
--------------------
</TABLE>
*        Filed herewith.

Unless another exhibit number is indicated as the exhibit number for the exhibit
as "originally filed," the exhibit number in the filing in which any exhibit was
originally filed and to which reference is made hereby is the same as the
exhibit number assigned herein to the exhibit.


(1)      Incorporated by reference to the indicated exhibit filed with
         Headwaters' Registration Statement on Form 10, filed February 26, 1996.
(2)      Incorporated by reference to the indicated exhibit filed with
         Headwaters' Annual Report on Form 10-K, for the fiscal year ended
         September 30, 1998.
(3)      Incorporated by reference to the indicated exhibit filed with
         Headwaters' Current Report on Form 8-K, for events dated August 14,
         2001 and August 28, 2001, filed September 12, 2001.
(4)      Incorporated by reference to the indicated exhibit filed with
         Headwaters' Current Report on Form 8-K, for the event dated July 15,
         2002, filed July 18, 2002.
(5)      Incorporated by reference to the indicated exhibit filed with
         Headwaters' Current Report on Form 8-K, for the event dated September
         19, 2002, filed October 4, 2002.
(6)      Incorporated by reference to the indicated exhibit filed with
         Headwaters' Current Report on Form 8-K, for the event dated October 14,
         2002, filed October 18, 2002.
(7)      Incorporated by reference to the indicated exhibit filed with
         Headwaters' Annual Report on Form 10-K, for the fiscal year ended
         September 30, 2002.
(8)      Incorporated by reference to the indicated exhibit filed with
         Headwaters' Quarterly Report on Form 10-Q, for the quarter ended
         December 31, 2002.

                                       53
<PAGE>

(9)      Incorporated by reference to the indicated exhibit filed with
         Headwaters' Quarterly Report on Form 10-Q, for the quarter ended June
         30, 2003.
(10)     Incorporated by reference to the indicated exhibit filed with
         Headwaters' Annual Report on Form 10-K, for the fiscal year ended
         September 30, 2003.
(11)     Incorporated by reference to the indicated exhibit filed with
         Headwaters' Current Report on Form 8-K/A, for the event dated April 9,
         2004, filed December 7, 2004.
(12)     Incorporated by reference to the indicated exhibit filed with
         Headwaters' Current Report on Form 8-K/A, for the event dated April 21,
         2004, filed December 7, 2004.
(13)     Incorporated by reference to the indicated exhibit filed with
         Headwaters' Current Report on Form 8-K/A, for the event dated July 7,
         2004, filed December 7, 2004.
(14)     Incorporated by reference to the indicated exhibit filed with
         Headwaters' Current Report on Form 8-K/A, for the event dated September
         8, filed December 13, 2004.
(15)     Incorporated by reference to the indicated exhibit filed with
         Headwaters' Current Report on Form 8-K, for the event dated September
         22, 2004, filed September 28, 2004.


Exhibits

         The response to this portion of Item 15 is submitted as a separate
section of this report. See Item 15 (a) 3 above.

Financial Statement Schedules

         The response to this portion of Item 15 is submitted as a separate
section of this report. See Item 15 (a) 2 above.

                                       54
<PAGE>

                                   SIGNATURES

         Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.


                                    HEADWATERS INCORPORATED

                                    By: /s/ Kirk A. Benson
                                       -----------------------------------------
                                    Kirk A. Benson
                                    Chief Executive Officer
                                    (Principal Executive Officer)

                                    By: /s/ Steven G. Stewart
                                       -----------------------------------------
                                    Steven G. Stewart
                                    Chief Financial Officer
                                    (Principal Financial and Accounting Officer)

                                    Date: December 10, 2004


KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Harlan M. Hatfield and Steven G. Stewart, and
each of them, his/her true and lawful attorneys-in-fact and agents, each with
full power of substitution and resubstitution, for him/her and in his/her name,
place and stead, in any and all capacities, to sign any and all amendments to
this report on Form 10-K, and to file the same, with exhibits thereto and other
documents in connection therewith, with the Securities and Exchange Commission,
granting unto said attorneys-in-fact and agents, and each of them, full power
and authority to do and perform each and every act and thing requisite and
necessary to be done, as fully to all intents and purposes as he/she might or
could do in person, hereby ratifying and confirming all that each of said
attorneys-in-fact and agents or their substitute or substitutes may lawfully do
or cause to be done by virtue hereof. Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the Registrant and in the capacities and on the
dates indicated.

       SIGNATURE                          TITLE                      DATE

  /s/ Kirk A. Benson       Director and Chief Executive        December 10, 2004
-----------------------    Officer (Principal Executive
   Kirk A. Benson          Officer)

 /s/ Steven G. Stewart     Chief Financial Officer             December 10, 2004
-----------------------    (Principal Financial and
  Steven G. Stewart        Accounting Officer)

 /s/ James A. Herickhoff   Director                            December 10, 2004
------------------------
James A. Herickhoff

 /s/ Raymond J. Weller     Director                            December 10, 2004
------------------------
 Raymond J. Weller

                                       55
<PAGE>

 /s/ E. J. "Jake" Garn     Director                            December 10, 2004
------------------------
 E. J. "Jake" Garn

/s/ R. Sam Christensen     Director                            December 10, 2004
------------------------
R. Sam Christensen

/s/ William S. Dickinson   Director                            December 10, 2004
-------------------------
William S. Dickinson

 /s/ Malyn K. Malquist     Director                            December 10, 2004
-------------------------
  Malyn K. Malquist

 /s/ Blake O. Fisher, Jr.  Director                            December 10, 2004
-------------------------
Blake O. Fisher, Jr.

                                       56
<PAGE>

             Report of Independent Registered Public Accounting Firm


The Board of Directors and Stockholders
Headwaters Incorporated

We have audited the accompanying consolidated balance sheets of Headwaters
Incorporated as of September 30, 2003 and 2004, and the related consolidated
statements of income, changes in stockholders' equity, and cash flows for each
of the three years in the period ended September 30, 2004. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Headwaters
Incorporated at September 30, 2003 and 2004, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
September 30, 2004, in conformity with U.S. generally accepted accounting
principles.

/s/ Ernst & Young LLP

Salt Lake City, Utah
November 10, 2004

                                      F-1
<PAGE>
<TABLE>
<CAPTION>
                                              HEADWATERS INCORPORATED

                                            CONSOLIDATED BALANCE SHEETS

                                                                                          As of September 30,
                                                                                     ------------------------------
(in thousands, except per-share data)                                                         2003            2004
-------------------------------------------------------------------------------------------------------------------
<S>                                                                                     <C>             <C>
ASSETS

Current assets:
     Cash and cash equivalents                                                          $   18,732      $   20,851
     Short-term trading investments                                                          2,921           6,735
     Trade receivables, net                                                                 52,399         129,899
     Inventories                                                                             7,827          43,812
     Current and deferred income taxes                                                         711          15,933
     Other current assets                                                                    5,294          13,333
                                                                                     ------------------------------
            Total current assets                                                            87,884         230,563
                                                                                     ------------------------------

Property, plant and equipment, net                                                          52,743         157,611
                                                                                     ------------------------------

Other assets:
     Intangible assets, net                                                                112,414         298,803
     Goodwill                                                                              112,131         815,396
     Debt issue costs and other assets                                                       8,103          38,406
                                                                                     ------------------------------
            Total other assets                                                             232,648       1,152,605
                                                                                     ------------------------------

            Total assets                                                                $  373,275      $1,540,779
                                                                                     ==============================


LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
     Accounts payable                                                                   $   17,177      $   29,238
     Accrued personnel costs                                                                 8,669          26,213
     Other accrued liabilities                                                              20,387          72,852
     Current portion of long-term debt                                                      27,475          57,873
                                                                                     ------------------------------
            Total current liabilities                                                       73,708         186,176
                                                                                     ------------------------------

Long-term liabilities:
     Long-term debt                                                                        104,044         914,641
     Deferred income taxes                                                                  50,663         121,469
     Other long-term liabilities                                                             4,703          10,338
                                                                                     ------------------------------
            Total long-term liabilities                                                    159,410       1,046,448
                                                                                     ------------------------------
            Total liabilities                                                              233,118       1,232,624
                                                                                     ------------------------------

Commitments and contingencies

Stockholders' equity:
    Common stock, $0.001 par value; authorized 50,000 shares; issued and
      outstanding: 27,878 shares at September 30, 2003 (including 467 shares
      held in treasury) and 33,775 shares at September 30, 2004 (including 414
      shares held in treasury)                                                                  28              34

    Capital in excess of par value                                                         130,936         235,581
    Retained earnings                                                                       12,213          76,530
    Treasury stock, at cost                                                                 (2,783)         (2,610)
    Other                                                                                     (237)         (1,380)
                                                                                     ------------------------------
            Total stockholders' equity                                                     140,157         308,155
                                                                                     ------------------------------

            Total liabilities and stockholders' equity                                  $  373,275      $1,540,779
                                                                                     ==============================


                                                     See accompanying notes.

                                                              F-2
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
                                              HEADWATERS INCORPORATED

                                         CONSOLIDATED STATEMENTS OF INCOME

                                                                                        Year ended September 30,
                                                                            -------------------------------------------------
(in thousands, except per-share data)                                                  2002            2003             2004
-----------------------------------------------------------------------------------------------------------------------------
<S>                                                                              <C>             <C>              <C>
Revenue:
     Sales of chemical reagents                                                  $   74,419      $  128,375       $  132,603
     License fees                                                                    30,456          35,726           72,721
     Coal combustion products revenues                                                6,818         169,938          210,155
     Sales of construction materials                                                  1,774          49,350          134,027
     Other revenues                                                                   5,878           4,241            4,449
                                                                            -------------------------------------------------
          Total revenue                                                             119,345         387,630          553,955
                                                                            -------------------------------------------------

Operating costs and expenses:
     Cost of chemical reagents sold                                                  50,134          87,386           89,789
     Cost of coal combustion products revenues                                        3,764         123,146          150,080
     Cost of construction materials sold                                              1,388          37,689           94,566
     Other operating costs                                                            5,244           3,919              436
     Depreciation and amortization                                                    1,760          12,982           17,051
     Research and development                                                         2,322           4,674            7,340
     Selling, general and administrative                                             13,699          40,715           66,936
                                                                            -------------------------------------------------
        Total operating costs and expenses                                           78,311         310,511          426,198
                                                                            -------------------------------------------------
Operating income                                                                     41,034          77,119          127,757
                                                                            -------------------------------------------------

Other income (expense):
     Interest and net investment income                                               1,000             310              944
     Interest expense                                                                  (553)        (15,687)         (19,453)
     Losses on notes receivable and investments                                        (743)         (2,436)          (2,842)
     Other, net                                                                        (502)            775           (1,299)
                                                                            -------------------------------------------------
          Total other income (expense), net                                            (798)        (17,038)         (22,650)
                                                                            -------------------------------------------------

Income before income taxes                                                           40,236          60,081          105,107

Income tax provision                                                                (15,950)        (23,450)         (40,790)
                                                                            -------------------------------------------------

Net income                                                                       $   24,286      $   36,631       $   64,317
                                                                            =================================================

Basic earnings per share                                                         $     1.00      $     1.35       $     2.02
                                                                            =================================================

Diluted earnings per share                                                       $     0.94      $     1.30       $     1.95
                                                                            =================================================


                                                     See accompanying notes.

                                                              F-3
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
                                                     HEADWATERS INCORPORATED

                                   CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY


                                                                             Retained
                                       Common stock          Capital in      earnings      Treasury                      Total
                                    --------------------       excess      (accumulated     stock,                   stockholders'
(in thousands)                        Shares     Amount     of par value     deficit)      at cost        Other          equity
----------------------------------------------------------------------------------------------------------------------------------
<S>                                   <C>        <C>         <C>             <C>          <C>            <C>           <C>
Balances as of September 30, 2001     23,807     $  24       $   83,226      $(48,704)    $  (3,038)     $   (422)     $   31,086

Exercise of stock options and
  warrants                             1,315         1            5,383                                                     5,384

Tax benefit from exercise of stock
  options                                                         2,990                                                     2,990

Common stock issued in connection
  with acquisition of Hydrocarbon
  Technologies, Inc.                     178        --            2,823                                                     2,823

Common stock issued in connection
  with acquisition of Industrial
  Services Group, Inc.                 2,100         2           32,716                                                    32,718

Purchase of 83 shares of treasury
  stock, at cost                                                                             (1,188)                       (1,188)

32 shares of treasury stock
  transferred to employee stock
  purchase plan, at cost                                            214                         126                           340

Cancellation of 73 shares of
  treasury stock                         (73)       --           (1,087)                      1,087                            --

Amortization of deferred
  compensation from stock
  options and other                                                                                           157             157

Net income for the year ended
  September 30, 2002                                                           24,286                                      24,286
                                     ---------------------------------------------------------------------------------------------
Balances as of September 30, 2002     27,327        27          126,265       (24,418)       (3,013)         (265)         98,596
                                     ---------------------------------------------------------------------------------------------

Exercise of stock options and
  warrants                               551         1            2,139                                                     2,140

Tax benefit from exercise of
  stock options                                                   2,050                                                     2,050

59 shares of treasury stock
  transferred to employee stock
  purchase plan, at cost                                            482                         230                           712

Amortization of deferred
  compensation from stock
  options and other                                                                                            28              28

Net income for the year ended
  September 30, 2003                                                           36,631                                      36,631
                                     ---------------------------------------------------------------------------------------------
Balances as of September 30, 2003     27,878     $  28       $  130,936      $ 12,213     $  (2,783)     $   (237)     $  140,157
                                     =============================================================================================


                                                     See accompanying notes.

                                                               F-4
<PAGE>
<CAPTION>
                                                     HEADWATERS INCORPORATED

                             CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (continued)


                                                                             Retained
                                       Common stock          Capital in      earnings      Treasury                      Total
                                    --------------------       excess      (accumulated     stock,                   stockholders'
(in thousands)                        Shares     Amount     of par value     deficit)      at cost        Other          equity
----------------------------------------------------------------------------------------------------------------------------------
<S>                                   <C>        <C>         <C>             <C>          <C>            <C>           <C>
Balances as of September 30, 2003     27,878     $  28       $  130,936      $ 12,213     $  (2,783)     $   (237)     $  140,157

Exercise of stock options and
  warrants                               878         1            8,119                                                     8,120

Tax benefit from exercise of stock
  options                                                         4,070                                                     4,070

53 shares of treasury stock
  transferred to employee stock
  purchase plan, at cost                                            771                         173                           944

Common stock issued for cash, net
  of offering costs of $6,432          4,958         5           90,253                                                    90,258

Issuance of restricted stock              61        --            1,432                                    (1,432)             --

Amortization of deferred
  compensation from stock
  options and other                                                                                           289             289

Net income for the year ended
  September 30, 2004                                                           64,317                                      64,317
                                     ---------------------------------------------------------------------------------------------
Balances as of September 30, 2004     33,775     $  34       $  235,581      $ 76,530     $  (2,610)     $ (1,380)     $  308,155
                                     =============================================================================================


                                                     See accompanying notes.

                                                              F-5
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
                                                     HEADWATERS INCORPORATED

                                              CONSOLIDATED STATEMENTS OF CASH FLOWS


                                                                                                   Year ended September 30,
                                                                                        ---------------------------------------
(in thousands)                                                                                  2002         2003         2004
-------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                     <C>            <C>          <C>
Cash flows from operating activities:
Net income                                                                              $   24,286     $   36,631   $   64,317
  Adjustments to reconcile net income to net cash provided by operating activities:
    Depreciation included in cost of products sold                                              --             --        3,497
    Other depreciation and amortization                                                      1,760         12,982       17,051
    Non cash interest expense related to amortization of debt discount and debt
      issue costs                                                                              136          3,857        6,031
    Deferred income taxes                                                                   11,540           (878)      (1,283)
    Income tax benefit from exercise of stock options                                        2,990          2,050        4,070
    Amortization of non-refundable license fees                                             (1,471)        (1,178)      (1,179)
    Net loss (gain) on disposition of property, plant and equipment                         (1,249)          (188)       1,254
    Write-downs of notes receivable and investments                                            986          2,436        2,842
    Other changes in operating assets and liabilities, net of effect of acquisitions:
      Short-term trading investments                                                           141          2,986       (3,814)
      Trade receivables                                                                     (7,742)        (2,068)     (10,620)
      Inventories                                                                              307            615        1,186
      Other current assets                                                                      44         (1,078)      (1,057)
      Accounts payable and accrued liabilities                                              11,175            860        9,671
      Other, net                                                                              (126)          (636)         (35)
                                                                                        ---------------------------------------
            Net cash provided by operating activities                                       42,777         56,391       91,931
                                                                                        ---------------------------------------

Cash flows from investing activities:
  Payments for acquisitions, net of cash acquired of $11,834 in 2004:
    VFL Technology Corporation                                                                  --             --       (4,171)
    Eldorado Stone, LLC                                                                         --             --     (209,770)
    Southwest Concrete Products, L.P.                                                           --             --      (24,691)
    Tapco Holdings, Inc.                                                                        --             --     (713,683)
    Industrial Services Group, Inc.                                                       (205,900)            --           --
    Hydrocarbon Technologies, Inc.                                                            (419)            --           --
  Purchase of property, plant and equipment                                                   (796)        (9,716)     (13,967)
  Proceeds from disposition of property, plant and equipment                                   115          2,685        4,037
  Collections on notes receivable                                                            6,912             54           --
  Net increase in investments and other assets                                                (334)          (594)      (7,794)
                                                                                        ---------------------------------------
            Net cash used in investing activities                                         (200,422)        (7,571)    (970,039)
                                                                                        ---------------------------------------

Cash flows from financing activities:
  Net proceeds from issuance of long-term debt                                             165,806             --    1,068,138
  Payments on long-term debt                                                                (6,412)       (40,224)    (287,233)
  Net proceeds from issuance of common stock                                                    --             --       90,258
  Proceeds from exercise of options and warrants                                             5,384          2,140        8,120
  Employee stock purchases                                                                     340            712          944
  Purchase of common stock for the treasury                                                 (1,188)            --           --
                                                                                        ---------------------------------------
            Net cash provided by (used in) financing activities                            163,930        (37,372)     880,227
                                                                                        ---------------------------------------

Net increase in cash and cash equivalents                                                    6,285         11,448        2,119

Cash and cash equivalents, beginning of year                                                   999          7,284       18,732
                                                                                        ---------------------------------------

Cash and cash equivalents, end of year                                                  $    7,284     $   18,732   $   20,851
                                                                                        =======================================

                                                     See accompanying notes.

                                                               F-6
<PAGE>
<CAPTION>
                                                     HEADWATERS INCORPORATED

                                        CONSOLIDATED STATEMENTS OF CASH FLOWS, continued


                                                                                                   Year ended September 30,
                                                                                        ---------------------------------------
(in thousands)                                                                                  2002         2003         2004
-------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                     <C>            <C>          <C>
Supplemental schedule of non-cash investing and financing activities:
  Purchase of variable interest in solid alternative fuel facility in exchange
    for commitment to make future payments                                              $       --     $       --   $    7,500
  Issuance of restricted stock                                                                  --             --        1,432
  Common stock issued in connection with acquisition of Industrial Services
    Group, Inc.                                                                             32,718             --           --
  Common stock issued in connection with acquisition of Hydrocarbon
    Technologies, Inc.                                                                       2,823             --           --
  Cancellation of treasury stock                                                            (1,087)            --           --

Supplemental disclosure of cash flow information:
  Cash paid for interest                                                                $       39     $   10,054   $   11,063
  Cash paid for income taxes                                                                   322         19,356       35,622


                                                     See accompanying notes.

                                                               F-7
</TABLE>
<PAGE>

                             HEADWATERS INCORPORATED

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                               September 30, 2004
                                   ___________


1.  Organization and Description of Business

    Headwaters Incorporated is incorporated in Delaware. Headwaters owns 100% of
    the following subsidiaries: Headwaters Resources, Inc. and Headwaters
    Construction Materials, Inc. (the two of which combined were formerly
    Industrial Services Group, Inc., a Utah-based company acquired by Headwaters
    in September 2002) ("ISG"); Headwaters Technology Innovation Group, Inc.
    (formerly Hydrocarbon Technologies, Inc., a New Jersey company acquired in
    August 2001) ("HTI"); VFL Technology Corporation, a Pennsylvania company
    acquired in April 2004 ("VFL"); Eldorado Stone, LLC, a Delaware company
    acquired in June 2004 ("Eldorado"); Southwest Concrete Products, L.P., a
    Texas company acquired in July 2004 ("SCP"); and Tapco Holdings, Inc., a
    Michigan company acquired in September 2004 ("Tapco") (see Note 3).
    Headwaters' fiscal year ends on September 30 and unless otherwise noted,
    future references to years refer to Headwaters' fiscal year rather than a
    calendar year.

    Headwaters' focus is on enhancing the value of energy resources in an
    environmentally responsible manner; promoting the expanded use of coal
    combustion products ("CCPs"); and expanding Headwaters' construction
    materials business, including opportunities to utilize products from other
    Headwaters operations in the production of construction materials.
    Headwaters currently generates revenue from licensing its chemical
    technologies to produce solid alternative fuel, from managing CCPs, and from
    the sale of construction materials. Headwaters intends to continue to expand
    its business through growth of existing operations, commercialization of
    technologies currently being developed, and strategic acquisitions of
    entities that operate in adjacent industries.

    Through its proprietary Covol Fuels process, Headwaters adds value to the
    production of coal-based solid alternative fuels primarily for use in
    electric power generation plants. Headwaters currently licenses its
    technologies to the owners of 28 of a company-estimated 75 coal-based solid
    alternative fuel facilities in the United States. Through its wholly-owned
    subsidiary HTI, Headwaters conducts research and development activities
    directed at catalyst technologies to convert coal and heavy oil into
    environmentally-friendly, high-value liquid fuels. In addition, HTI has
    developed a unique process to custom design nanocatalysts that could be used
    in multiple industrial applications.

    ISG's CCP operations and VFL (together referred to as Headwaters' Resources,
    Inc., or "Resources") represent the nation's largest provider of CCP
    management and marketing services to the electric utility industry, serving
    more than 100 coal-fired electric power generation plants nationwide.
    Through its distribution network of over 110 locations, Resources is the
    leading provider of high quality fly ash to the building products and ready
    mix concrete industries in the United States. Resources also develops and
    deploys technologies for maintaining and improving fly ash quality.

    Headwaters' construction materials segment develops, manufactures and
    distributes value-added bagged concrete, stucco, mortar and block products
    that utilize fly ash, and with the acquisitions of Eldorado and SCP,
    manufactured stone and expanded concrete block products. Tapco is a leading
    designer, manufacturer and marketer of building products used in exterior
    residential home improvement and construction.

2.  Summary of Significant Accounting Policies

    Principles of Consolidation - The consolidated financial statements include
    the accounts of Headwaters, all of its subsidiaries and other entities in
    which Headwaters has a controlling financial interest. In accordance with
    Financial Accounting Standards Board Interpretation No. 46, "Consolidation
    of Variable Interest Entities," as revised, Headwaters will consolidate any
    variable interest entities for which it is the primary beneficiary; however
    as of September 30, 2004, there are none. For investments in companies in
    which Headwaters has a significant influence over operating and financial
    decisions (generally defined as owning a voting or economic interest of 20%
    to 50%), Headwaters applies the equity method of accounting. In instances
    where Headwaters' investment is less than 20% and significant influence does
    not exist, investments are carried at cost. All significant intercompany
    transactions and accounts are eliminated in consolidation.

    Headwaters acquired ISG on September 19, 2002 and accordingly, ISG's results
    of operations for the period from September 19, 2002 through September 30,
    2004 have been consolidated with Headwaters' 2002 through 2004 results.
    ISG's results of operations up to September 18, 2002 have not been included

                                      F-8
<PAGE>


                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________

    in Headwaters' consolidated results for any period. Headwaters acquired VFL
    on April 9, 2004, Eldorado Stone on June 2, 2004, SCP on July 2, 2004, and
    Tapco on September 8, 2004. These entities' results of operations for the
    periods from the acquisition dates through September 30, 2004 have been
    consolidated with Headwaters' 2004 results and their operations up to the
    dates of acquisition have not been included in Headwaters' consolidated
    results for any period.

    Due to the time required to obtain accurate financial information related to
    HTI's foreign contracts, for financial reporting purposes HTI's financial
    statements have historically been consolidated with Headwaters' financial
    statements using a one-month lag. Effective October 1, 2003, Headwaters
    eliminated this one-month lag because of the decreased significance of HTI's
    foreign contracts. Accordingly, 13 months of HTI's results of operations
    have been included in the consolidated statement of income for 2004.

    Use of Estimates - The preparation of consolidated financial statements in
    conformity with U.S. generally accepted accounting principles requires
    management to make estimates and assumptions that affect the reported
    amounts of assets and liabilities and disclosures of contingent assets and
    liabilities at the date of the financial statements, and the reported
    amounts of revenue and expenses during the reporting period. Actual results
    could differ materially from those estimates.

    Segment Reporting, Major Customers and Other Concentrations of Risk - Until
    Headwaters acquired ISG in September 2002, Headwaters operated in and
    reported as a single industry segment, alternative energy. Since the
    acquisition of ISG, Headwaters has operated in three business segments,
    alternative energy, CCPs, and construction materials. VFL operates in the
    CCP segment and all of the other businesses acquired by Headwaters in 2004
    operate in the construction materials segment. Additional information about
    segments is presented in Note 4. The following table presents revenues for
    all customers that accounted for over 10% of total revenue during 2002, 2003
    or 2004. All of these revenues are attributable to the alternative energy
    segment.
<TABLE>
<CAPTION>
    (in thousands)                                        2002            2003             2004
    --------------------------------------------------------------------------------------------
    <S>                                          <C>             <C>              <C>
    Pace Carbon Fuels, L.L.C. affiliates         Less than 10%   Less than 10%          $57,602
    DTE Energy Services, Inc. affiliates               $19,660         $42,013    Less than 10%
    TECO Coal Corporation affiliates                    20,292   Less than 10%    Less than 10%
    Marriott International, Inc. affiliates             19,105   Less than 10%    Less than 10%
    AIG Financial Products Corp. affiliates             16,900   Less than 10%    Less than 10%
</TABLE>

    At September 30, 2004, Headwaters had trade receivable balances totaling
    approximately $2,873,000 from Pace Carbon Fuels, L.L.C. affiliates.
    Substantially all of Headwaters' revenues were generated from sales in the
    United States. Headwaters purchases all of the chemical reagent that is sold
    to licensees and other customers from a single large international chemical
    company and Tapco purchases all of the polypropylene used in its building
    products from a single supplier. Management believes that if necessary, the
    chemical reagent and polypropylene could be obtained from other suppliers.
    Headwaters has no other significant unusual credit risks or concentrations.

    Revenue Recognition - Alternative Energy Segment. Headwaters currently
    licenses its technologies to the owners of 28 coal-based solid alternative
    fuel facilities from which Headwaters earns license fees and/or profits from
    the sales of chemical reagents. Non-refundable advance license fees and
    royalty payments have been received from certain licensees under various
    terms and conditions. These non-refundable license fees and royalties have
    been deferred and are being recognized on a straight-line basis through
    December 31, 2007, the period covered by the related license and royalty
    agreements. Recurring license fees or royalty payments are recognized in the
    period when earned, which coincides with the sale of alternative fuel by
    Headwaters' licensees. In certain instances, Headwaters is required to pay
    to third parties a portion of license fees received or cash proceeds from
    the sale of chemical reagents. In such cases, Headwaters records the net
    proceeds as revenue. Revenues from the sales of chemical reagents are
    recognized upon delivery of product and assumption of the risk of loss by
    the licensee or non-licensee customer.

    HTI's revenue consists of license fees, contract services for businesses and
    U.S. government agencies and is included in the caption "Other revenues" in

                                       F-9
<PAGE>


                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    the consolidated statements of income. HTI's costs related to this revenue
    are included in "Other operating costs." In accounting for long-term
    contracts, HTI uses the percentage of completion method of accounting, on
    the basis of the relationship between effort expended and total estimated
    effort for the contract. If estimates of costs to complete a contract
    indicate a loss, a provision is made for the total anticipated loss at that
    time.

    CCP and Construction Materials Segments. Revenue from the sale of CCPs and
    construction materials is recognized upon passage of title to the customer,
    which coincides with physical delivery and assumption of the risk of loss by
    the customer. Estimated sales rebates, discounts and allowances are provided
    for at the time of sale and are based upon established policies and
    historical experience. Revenues include transportation charges and shipping
    and handling fees associated with delivering material and products to
    customers when the transportation or shipping and handling is contractually
    provided for between the customer and Headwaters.

    CCP service revenues include revenues earned under long-term contracts to
    dispose of residual materials created by coal-fired electric power
    generation and revenues earned in connection with certain
    construction-related projects that are incidental to Resources' primary
    business. Service revenues under long-term contracts are recognized
    concurrently with the removal of material and are based on the number of
    tons of material removed at an established price per ton.
    Construction-related projects are billed on a time and materials basis;
    therefore, the revenues and related costs are recognized when the time is
    incurred and the materials are consumed.

    The cost of CCPs sold primarily represents amounts paid to utility companies
    to purchase product together with storage and transportation costs to
    deliver the product to customers. In accordance with certain utility company
    contracts, the cost of CCPs purchased from those utilities is based on a
    percentage of the "net revenues" from the sale of the CCPs purchased. Cost
    of services sold includes landfill fees and transportation charges to
    deliver non-marketable CCPs to the landfill. Cost of construction materials
    sold includes shipping and handling fees.

    Cash and Cash Equivalents - Headwaters considers all short-term highly
    liquid investments with an original maturity of three months or less to be
    cash equivalents. Certain cash and cash equivalents are deposited with
    financial institutions, and at times such amounts may exceed insured
    depository limits.

    Short-term Investments - Short-term investments consist of mortgage- and
    other asset-backed securities, corporate bonds, U.S. government securities
    and equity securities. By policy, Headwaters invests primarily in U.S.
    government securities or securities backed by the U.S. government. All
    investments are defined as trading securities and are stated at market value
    as determined by the most recently traded price of each security at the
    balance sheet date. Unrealized gains and losses are included in earnings.
    Approximately $285,000 of investment gains in 2002, $7,000 of investment
    losses in 2003, and $19,000 of investment gains in 2004 related to
    securities held at September 30, 2002, 2003, and 2004, respectively.

    Receivables - Allowances are provided for uncollectible accounts and notes
    when deemed necessary. Such allowances are based on an account-by-account
    analysis of collectibility or impairment plus a provision for non-customer
    specific defaults based upon historical collection experience. Collateral is
    not required for trade receivables, but Headwaters performs periodic credit
    evaluations of its customers. Collateral is generally required for notes
    receivable.

    Inventories - Inventories are stated at the lower of cost or market (net
    realizable value). Cost includes direct material, direct labor and
    allocations of manufacturing overhead costs and is determined primarily
    using the first-in, first-out method.

    Property, Plant and Equipment - Property, plant and equipment are recorded
    at cost. For significant self-constructed assets, cost includes direct labor
    and interest. Expenditures for major improvements are capitalized;
    expenditures for maintenance, repairs and minor improvements are charged to
    expense as incurred. Assets are depreciated using the straight-line method
    over their estimated useful lives, limited to the lease terms for
    improvements to leased assets. Upon the sale or retirement of property,
    plant and equipment, any gain or loss on disposition is reflected in results
    of operations, and the related asset cost and accumulated depreciation are
    removed from the respective accounts.

                                      F-10
<PAGE>


                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Intangible Assets and Goodwill - Intangible assets consist primarily of
    identifiable intangible assets obtained in connection with acquisitions (see
    Note 3). Intangible assets are amortized using the straight-line method over
    their estimated useful lives. Goodwill consists of the excess of the
    purchase price for businesses acquired over the fair value of identified
    assets acquired, net of liabilities assumed. In accordance with Statement of
    Financial Accounting Standards ("SFAS") No. 142, "Accounting for Goodwill
    and Intangible Assets," goodwill is not amortized, but is tested at least
    annually for impairment. Goodwill is normally tested as of June 30, using a
    two-step process that begins with an estimation of the fair value of the
    reporting unit giving rise to the goodwill (see Note 8).

    Valuation of Long-Lived Assets - Headwaters evaluates the carrying value of
    long-lived assets, including intangible assets and goodwill, as well as the
    related amortization periods, to determine whether adjustments to these
    amounts or to the useful lives are required based on current events and
    circumstances. The carrying value of a long-lived asset is considered
    impaired when the anticipated cumulative undiscounted cash flow from that
    asset is less than its carrying value. In that event, a loss is recognized
    based on the amount by which the carrying value exceeds the fair market
    value of the long-lived asset. There were no impairment losses recorded for
    long-lived assets in any of the years presented.

    Debt Issue Costs - Debt issue costs represent direct costs incurred related
    to the issuance of long-term debt. These costs are amortized to interest
    expense over the lives of the respective debt issues using the effective
    interest method. When debt is repaid early, the portion of unamortized debt
    issue costs related to the early principal repayment is written off and
    included in interest expense in the consolidated statements of income.

    Financial Instruments - Derivatives are recorded in the consolidated balance
    sheets at fair value, as required by SFAS No. 133, "Accounting for
    Derivative Instruments and Hedging Activities," as amended ("SFAS No. 133").
    For all periods presented, the fair value of derivatives is $0. Accounting
    for changes in the fair value of a derivative depends on the intended use of
    the derivative, which is established at inception.

    For derivatives designated as cash flow hedges and which meet the
    effectiveness guidelines of SFAS No. 133, changes in fair value, to the
    extent effective, are recognized in other comprehensive income until the
    hedged item is recognized in earnings. Hedge effectiveness is measured at
    least quarterly based on the relative changes in fair value between the
    derivative contract and the hedged item over time. Any change in fair value
    of a derivative resulting from ineffectiveness, or an excluded component of
    the gain or loss, is recognized immediately and is recorded with interest
    expense in the consolidated statements of income.

    Headwaters formally documents all hedge transactions at inception of the
    contract, including identification of the hedging instruments and the hedged
    items, as well as its risk management objectives and strategies for
    undertaking the hedge transaction. This process includes linking the
    derivatives that are designated as hedges to specific assets, liabilities,
    firm commitments or forecasted transactions. Headwaters also formally
    assesses the effectiveness of its hedging relationships on an ongoing basis.
    As described in more detail in Note 9, Headwaters entered into hedge
    agreements in September 2004 to limit its exposure for interest rate
    movements, but has not entered into any other hedge transactions.

    Income Taxes - Headwaters accounts for income taxes using the asset and
    liability approach. Headwaters recognizes deferred income tax assets or
    liabilities for the expected future tax consequences of events that have
    been recognized in the financial statements or income tax returns. Deferred
    income tax assets or liabilities are determined based upon the differences
    between the financial statement and tax bases of assets and liabilities
    using enacted tax rates expected to apply when the differences are expected
    to be settled or realized. Deferred income tax assets are reviewed
    periodically based on changing events for recoverability and valuation
    allowances are provided as necessary. Headwaters files a consolidated
    federal income tax return with its subsidiaries.

    Research and Development Costs - Research and development costs consist
    primarily of personnel-related costs and are expensed as incurred.

                                      F-11
<PAGE>


                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Advertising Costs - Advertising costs are expensed as incurred, except for
    the cost of certain materials which are capitalized and amortized to expense
    as the materials are distributed.

    Warranty Costs - Provision is made for warranty costs at the time of sale,
    based upon established policies and historical experience.

    Contingencies - In accounting for legal matters and other contingencies,
    Headwaters follows the guidance in SFAS No. 5, "Accounting for
    Contingencies," under which loss contingencies are accounted for based upon
    the likelihood of an impairment of an asset or the incurrence of a
    liability. If a loss contingency is "probable" and the amount of loss can be
    reasonably estimated, it is accrued. If a loss contingency is "probable,"
    but the amount of loss cannot be reasonably estimated, disclosure is made.
    If a loss contingency is "reasonably possible," an accrual is made for the
    most likely amount of loss, if determinable, and disclosure is made of the
    potential range of loss. Loss contingencies that are "remote" are neither
    accounted for nor disclosed. Gain contingencies are given no accounting
    recognition, but are disclosed if material.

    Common Stock Options and Restricted Stock Grants - Headwaters has elected to
    continue to apply the intrinsic value method as prescribed by APB 25 in
    accounting for options and restricted stock grants to employees, officers
    and directors and does not currently plan to change to the fair value method
    unless required by changes in accounting standards. The alternative fair
    value method of accounting prescribed by SFAS No. 123, "Accounting for
    Stock-Based Compensation" ("SFAS No. 123"), requires the use of option
    valuation models that were developed for use in valuing traded stock
    options, as discussed below. Under APB 25, no compensation expense is
    recognized for stock options and restricted stock grants to employees,
    officers and directors when the exercise price of stock options or
    restricted stock equals or exceeds the market price of Headwaters' common
    stock on the date of grant.

    In years prior to 1998, certain options were granted with terms considered
    compensatory. In addition, in 2004, Headwaters issued restricted stock to
    certain officers and employees, also with terms considered compensatory,
    because the restricted stock was issued at no cost to the recipients. In
    such instances, compensation cost is amortized to expense over the
    applicable vesting period on a straight-line basis. If the fair value
    provision of SFAS No. 123 would have been applied to all options and
    restricted stock grants, net income and earnings per share would have been
    changed to the pro forma amounts shown in the following table.
<TABLE>
<CAPTION>
    (in thousands, except per-share data)                                      2002          2003         2004
    ----------------------------------------------------------------------------------------------------------
    <S>                                                                    <C>           <C>          <C>
    Reported net income                                                    $24,286       $36,631      $64,317
    Add actual amortization expense included in reported net income             93            91          289
    Deduct expense  determined under fair value provision of
      SFAS No. 123                                                          (2,479)       (4,097)      (4,090)
                                                                       ---------------------------------------
    Pro forma net income                                                   $21,900       $32,625      $60,516
                                                                       =======================================

    Basic earnings per share - as reported                                 $  1.00       $  1.35      $  2.02
                             - pro forma                                   $  0.90       $  1.20      $  1.90
    Diluted earnings per share - as reported                               $  0.94       $  1.30      $  1.95
                               - pro forma                                 $  0.85       $  1.16      $  1.83
</TABLE>

    The fair values of stock option grants for the years presented were
    determined using the Black-Scholes option pricing model and the following
    assumptions: expected stock price volatility of 40% to 90%, risk-free
    interest rates ranging from 1.3% to 5.0%, weighted average expected option
    lives of 3 to 5 years, and no dividend yield. The Black-Scholes option
    valuation model was developed for use in estimating the fair value of traded
    options that have no vesting restrictions and that are fully transferable.
    In addition, option valuation models require the input of highly subjective
    assumptions including expected stock price volatility. Because Headwaters'
    stock options have characteristics significantly different from those of
    traded options, and because changes in the subjective input assumptions can
    materially affect their fair value, in management's opinion, the existing
    models do not necessarily provide a reliable measure of the fair value of
    stock options and restricted stock.

                                      F-12
<PAGE>


                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Earnings per Share Calculation - Earnings per share ("EPS") has been
    computed based on the weighted-average number of common shares outstanding.
    Diluted EPS computations reflect the increase in weighted-average common
    shares outstanding that would result from the assumed exercise of
    outstanding stock options and warrants, calculated using the treasury stock
    method, and the assumed conversion of convertible securities, using the
    if-converted method, when such options, warrants, and convertible securities
    are dilutive.

    Recent Accounting Pronouncements - In September 2004, the Emerging Issues
    Task Force ("EITF") reached a consensus requiring the inclusion of
    contingently convertible instruments in diluted EPS calculations. This
    consensus (EITF Issue 04-08, "The Effect of Contingently Convertible Debt on
    Diluted Earnings per Share") will be effective for periods ending after
    December 15, 2004 and will require Headwaters to include in its diluted EPS
    calculation, on an if-converted basis, the additional shares issuable under
    the terms of Headwaters' outstanding convertible senior subordinated notes
    described in Note 9. The EITF consensus, when implemented, must be applied
    to all applicable prior periods, which for Headwaters will be the quarters
    ended June 30, 2004 and September 30, 2004. See Note 13 for more information
    on the expected effect on Headwaters' EPS of implementing the EITF
    consensus.

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

    Reclassifications - Certain prior year amounts have been reclassified to
    conform to the current year's presentation. The reclassifications had no
    effect on net income or total assets.

3.  Acquisitions

    As described in the following paragraphs, Headwaters acquired four companies
    in 2004 and one company in 2002.

    VFL - On April 9, 2004, Headwaters acquired 100% of the common stock of VFL
    and assumed all of VFL's outstanding debt. VFL is based in West Chester,
    Pennsylvania and manages approximately two million tons of CCPs annually. In
    addition, VFL has operating knowledge relating to the use of low value CCPs
    in value-added applications. The acquisition of VFL broadens the scope of
    services that Headwaters' CCP segment offers, as well as its client base,
    principally on the East coast of the United States and in the Ohio River
    Valley. VFL's results of operations have been included in Headwaters'
    consolidated statement of income since April 9, 2004. In connection with the
    VFL acquisition, Headwaters issued $19,000,000 of notes payable to the VFL
    stockholders, all of which were repaid in 2004.

    The following table sets forth the total consideration paid to acquire VFL,
    as preliminarily determined and previously reported, and as finally
    determined.
<TABLE>
<CAPTION>
    (in thousands)                                   Preliminary          Final
    ----------------------------------------------------------------------------
    <S>                                                  <C>            <C>
    Cash paid to VFL stockholders                        $ 3,326        $ 3,982
    Notes payable issued to VFL stockholders              19,000         19,000
    VFL debt assumed by Headwaters                         6,749          6,749
    Costs directly related to acquisition                    225            225
                                                  --------------- --------------
                                                         $29,300        $29,956
                                                  =============== ==============
</TABLE>

    The VFL acquisition was accounted for using the purchase method of
    accounting as required by SFAS No. 141, "Business Combinations." The
    consideration Headwaters paid for VFL was negotiated at arms length and
    assets acquired and liabilities assumed were recorded at their estimated
    fair values as of April 9, 2004. Approximately $11,290,000 of the purchase
    price was allocated to identifiable intangible assets consisting of
    contracts with utility companies, industrial clients and municipalities.
    This amount is being amortized over an estimated average useful life of
    eight years. The remaining purchase price not attributable to the tangible
    and identifiable intangible assets was allocated to goodwill, all of which

                                      F-13
<PAGE>

                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    is expected to be tax deductible. All of the intangible assets and goodwill
    have been allocated to Headwaters' CCP segment.

    The following table sets forth the preliminary and final allocations of the
    total consideration to the tangible and intangible assets acquired and
    liabilities assumed.

    (in thousands)                                    Preliminary        Final
    ---------------------------------------------------------------------------
    Cash                                               $       36    $      36
    Trade receivables, net                                  4,287        4,287
    Other assets                                              860          860
    Property, plant and equipment                           8,443        8,808
    Intangible assets acquired - contracts (8 years)       11,290       11,290
    Goodwill                                                7,604        8,125
    Accounts payable and accrued liabilities               (3,220)      (3,450)
                                                     ------------- ------------
         Net assets acquired                           $   29,300    $  29,956
                                                     ============= ============

    Eldorado - On June 2, 2004, Headwaters acquired 100% of the ownership
    interests of Eldorado Stone LLC ("Eldorado") and paid off all of Eldorado's
    outstanding debt. Eldorado is based in San Marcos, California and is a
    leading manufacturer of architectural manufactured stone. With over 700
    distributors, Eldorado provides Headwaters with a national platform for
    expanded marketing of "green" building products, such as mortar and stucco
    made with reclaimed fly ash from coal combustion. Headwaters expects
    Eldorado, which is included in its construction materials segment, to
    provide critical mass and improved margins in Headwaters' efforts to expand
    the use of fly ash in building products. Eldorado's results of operations
    have been included in Headwaters' consolidated statement of income since
    June 2, 2004.

    In connection with the Eldorado acquisition, Headwaters issued $172,500,000
    of convertible senior subordinated debt and also borrowed funds under its
    senior secured revolving credit arrangement and an arrangement with an
    investment company, the latter two of which were repaid in 2004. Headwaters
    incurred approximately $6,200,000 of debt issue costs in connection with the
    issuance of the convertible senior subordinated debt, all of which is
    described in more detail in Note 9.

    The following table sets forth the total consideration paid to acquire
    Eldorado.

        (in thousands)
    --------------------------------------------------------------------------
    Cash paid to Eldorado owners                                     $136,982
    Cash paid to retire Eldorado debt and
      related accrued interest                                         69,650
    Costs directly related to acquisition                               3,800
                                                                --------------
                                                                     $210,432
                                                                ==============

    The Eldorado acquisition was accounted for using the purchase method of
    accounting. The consideration Headwaters paid for Eldorado was negotiated at
    arms length and assets acquired and liabilities assumed were recorded at
    their estimated fair values as of June 2, 2004. Eldorado has experienced
    significant growth over the last two years. Eldorado sells its products
    through an extensive distribution network. In addition, Eldorado employs a
    group of talented artists who create the molds used to produce the
    manufactured stone product. The quality of these molds adds significant
    value to the end product. Eldorado's manufacturing process, market presence
    and the quality of its product, including product design and product
    breadth, are major elements contributing to Eldorado's high value and
    related purchase price. These items, combined with Eldorado's high growth
    and extensive distribution network are not separable and, accordingly,
    contribute to a significant amount of goodwill. Approximately $9,034,000 of
    the purchase price was allocated to identifiable intangible assets,
    consisting primarily of non-compete agreements. The intangible assets are
    being amortized over estimated useful lives ranging from three to ten years,
    with a combined weighted average life of approximately four years. The
    remaining purchase price not attributable to the tangible and identifiable

                                      F-14
<PAGE>

                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    intangible assets was allocated to goodwill, most of which is expected to be
    tax deductible. All of the intangible assets and goodwill have been
    allocated to Headwaters' construction materials segment.

    The following table sets forth the preliminary and most recent allocations
    of the total consideration to the tangible and intangible assets acquired
    and liabilities assumed.

    (in thousands)                                     Preliminary  Most Recent
    ----------------------------------------------------------------------------
    Cash                                                  $    662     $    662
    Trade receivables, net                                  16,051       16,650
    Inventories                                             17,209       16,610
    Other assets                                             3,069        2,553
    Property, plant and equipment                           23,040       23,367
    Intangible assets acquired:
         Non-competition agreements (3 - 3 1/2 years)        6,252        6,252
         Other (5 - 10 years)                                1,901        2,782
    Goodwill                                               160,921      160,263
    Accounts payable and accrued liabilities               (18,673)     (18,707)
                                                      ------------- ------------
         Net assets acquired                              $210,432     $210,432
                                                      ============= ============

    The determination of the final purchase price is subject to potential
    adjustments, including final agreement with the seller of the working
    capital acquired at closing. In addition, the purchase price allocation will
    likely differ from that reflected above after final asset valuation reports
    are received and a detailed review of all assets and liabilities, including
    income taxes, has been completed. Pre-acquisition contingencies, which are
    not material, are included in the value of liabilities assumed as of June 2,
    2004 and any change from the recorded amounts is expected to be immaterial.
    The final purchase price allocation is expected to be completed by March 31,
    2005. Any changes to the purchase price allocation are not expected to
    materially increase or decrease depreciation and amortization expense, but
    may have a material effect on the amount of recorded goodwill.

    SCP - On July 2, 2004, Headwaters acquired certain assets of SCP and assumed
    all of SCP's outstanding debt. SCP is based in Alleyton, Texas and is a
    leading manufacturer of concrete blocks in South Texas, complementing
    Headwaters' similar operations in Dallas and East Texas. SCP provides
    Headwaters with modern concrete-based manufacturing facilities and the
    opportunity to increase the use of CCPs in the manufacture of block and
    brick. SCP also has an experienced management team and the president of SCP
    subsequently assumed responsibility for all of Headwaters' construction
    materials operations other than for Eldorado and Tapco. SCP's results of
    operations have been included in Headwaters' consolidated statement of
    income since July 2, 2004.

    The following table sets forth the total consideration paid to acquire SCP.

    (in thousands)
    ---------------------------------------------------------------------------
    Cash paid to SCP owners                                            $25,210
    SCP debt assumed by Headwaters                                       9,787
    Costs directly related to acquisition                                  300
                                                                 --------------
                                                                       $35,297
                                                                 ==============

    Headwaters also agreed to pay an earn-out to the sellers if certain earnings
    targets are exceeded during the 12 months ending December 31, 2005 (the
    "earn-out period"). The additional earn-out consideration will be the
    product of 5.7 times the amount, if any, that earnings before interest,
    taxes, depreciation and amortization ("EBITDA") of SCP exceeds $5,500,000
    during the earn-out period. If any earn-out consideration is paid, which
    will not occur until 2006, goodwill will be increased accordingly.

    The SCP acquisition was accounted for using the purchase method of
    accounting. The consideration Headwaters paid for SCP was negotiated at arms

                                      F-15
<PAGE>

                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    length and assets acquired and liabilities assumed were recorded at their
    estimated fair values as of July 2, 2004. Approximately $6,890,000 of the
    purchase price was allocated to identifiable intangible assets, consisting
    primarily of customer relationships. The intangible assets are being
    amortized over estimated useful lives ranging from two to ten years, with a
    combined weighted average life of approximately seven years. The remaining
    purchase price not attributable to the tangible and identifiable intangible
    assets was allocated to goodwill, substantially all of which is expected to
    be tax deductible. All of the intangible assets and goodwill have been
    allocated to Headwaters' construction materials segment.

    The following table sets forth the allocation of the total consideration to
    the tangible and intangible assets acquired and liabilities assumed.

    (in thousands)
    --------------------------------------------------------------------------
    Cash                                                            $   819
    Trade receivables, net                                            4,247
    Inventories and other assets                                      3,772
    Property, plant and equipment                                    13,500
    Intangible assets acquired:
         Customer relationships (7 1/2 years)                         5,450
         Other (2 - 10 years)                                         1,440
    Goodwill                                                          7,629
    Accounts payable and accrued liabilities                         (1,560)
                                                                --------------
         Net assets acquired                                        $35,297
                                                                ==============

    Tapco - On September 8, 2004, Headwaters acquired 100% of the ownership
    interests of Tapco and paid off all of Tapco's outstanding debt. Tapco is
    headquartered in Wixom, Michigan and is a leading designer, manufacturer and
    marketer of specialty building products used in exterior residential home
    improvement and construction throughout the United States and Canada.
    Headwaters expects the Tapco acquisition to further diversify Headwaters'
    cash flow stream away from its historical reliance on alternative energy.
    Tapco brings economy of scale and manufacturing expertise that results in
    some of the lowest manufacturing costs in the siding accessory industry,
    which is expected to improve margins in Headwaters' construction materials
    segment. Headwaters may also be able to leverage Tapco's distribution
    networks to accelerate sales of Headwaters' diverse construction materials
    product portfolio. Tapco's results of operations have been included in
    Headwaters' consolidated statement of income beginning September 8, 2004.

    In order to obtain the cash necessary to acquire Tapco, retire the Tapco
    debt and preferred stock, and repay Headwaters' existing senior debt,
    Headwaters borrowed $790,000,000 of debt consisting of $640,000,000 of
    senior secured debt under a first lien with a six and one-half-year term and
    a floating interest rate, and $150,000,000 of senior secured debt under a
    second lien with an eight-year term, also with a floating interest rate. The
    senior secured first lien credit arrangement also includes a $60,000,000
    revolver available to Headwaters which carries a 0.75% commitment fee on
    unused amounts and a floating interest rate on actual borrowings. Headwaters
    incurred approximately $18,000,000 of debt issue costs in connection with
    the issuance of the new senior debt, all of which is described in more
    detail in Note 9.

    The following table sets forth the consideration paid to acquire Tapco.

    (in thousands)
    ---------------------------------------------------------------------------

    Cash paid to Tapco stockholders                                   $388,297
    Cash paid to retire Tapco debt, preferred stock and
      related accrued interest                                         326,703
    Costs directly related to acquisition                                9,000
                                                                  -------------
                                                                      $724,000
                                                                  =============

    The Tapco acquisition was accounted for using the purchase method of
    accounting. The consideration Headwaters paid for Tapco was negotiated at
    arms length and assets acquired and liabilities assumed were recorded at

                                      F-16
<PAGE>

                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    their estimated fair values as of September 8, 2004. Tapco has a leading
    market share in most of its product lines with some lines having a market
    share greater than 75%. Tapco has the ability to deliver its products within
    a few days of receiving the order which is appealing to architects,
    contractors and end users of the product. Tapco also offers wide-ranging
    product choices delivered through an extensive distribution network
    throughout the United States. Tapco's products, manufacturing process and
    distributors are currently substantially different than those utilized by
    Headwaters' other business units and a substantial amount of sales relate to
    the remodeling industry. As such, Tapco may further mitigate the cyclical
    nature of Headwaters' construction materials business in the future. Tapco's
    primary value, therefore, is due to its significant market presence and
    manufacturing efficiencies. These values are largely the result of Tapco's
    manufacturing and distribution capacities, product breadth and workforce
    which are not separable and, accordingly, contribute to a significant amount
    of goodwill.

    Approximately $167,300,000 of the estimated purchase price was allocated to
    estimated identifiable intangible assets consisting primarily of customer
    relationships, trade names, and patents. The estimated intangible assets
    have estimated average useful lives ranging from two to twenty years, with a
    combined weighted average life of approximately 15 years. The remaining
    purchase price not attributable to the tangible and identifiable intangible
    assets was allocated to goodwill, which is not expected to be tax
    deductible. All of the intangible assets and goodwill have been allocated to
    Headwaters' construction materials segment.

    The following table sets forth a preliminary allocation of the total
    consideration to the tangible and intangible assets acquired and liabilities
    assumed.

    (in thousands)
    ----------------------------------------------------------------------------
    Cash                                                             $ 10,317
    Trade receivables, net                                             41,696
    Inventories                                                        16,835
    Other assets                                                        1,232
    Net property, plant and equipment                                  61,376
    Intangible assets acquired:
         Customer relationships (15 years)                             62,000
         Trade names (20 years)                                        62,000
         Patents (10 years)                                            40,000
         Non-competition agreements (2 years)                           3,300
    Goodwill                                                          527,248
    Accounts payable and accrued liabilities                          (33,237)
    Net deferred income tax liabilities                               (68,767)
                                                                   -------------
         Net assets acquired                                         $724,000
                                                                   =============

    The final purchase price and the allocation thereof will differ from that
    reflected above after final fixed asset and intangible asset valuation
    reports are received and a detailed review of all assets and liabilities,
    including income taxes, has been completed. The final purchase price
    allocation is expected to be completed by June 30, 2005. The final purchase
    price allocation is not expected to materially increase or decrease
    depreciation and amortization expense from the amounts recorded in 2004 and
    the amounts expected to be recorded in future periods, nor is it expected to
    have a material effect on the identified assets or liabilities, including
    goodwill.

    Pro Forma Information for 2004 Acquisitions - The following unaudited pro
    forma financial information for 2003 and 2004 assumes the 2004 acquisitions
    occurred as of the beginning of the respective years. The pro forma combined
    results for 2003 combine Headwaters' historical results for the year ended
    September 30, 2003 with VFL's, Eldorado's, and SCP's historical results for
    their respective fiscal years ended December 31, 2003 and Tapco's historical
    results for its fiscal year ended October 31, 2003, after giving effect to
    certain adjustments, including interest expense and the amortization of
    intangible assets.

    The pro forma combined results for 2004 combine Headwaters' historical
    results for the year ended September 30, 2004 with VFL's, Eldorado's, SCP's
    and Tapco's historical results from October 1, 2003 to their respective

                                      F-17
<PAGE>

                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    acquisition dates, after giving effect to necessary adjustments.
    Accordingly, VFL's, Eldorado's and SCP's historical results for the
    three-month period from October 1, 2003 to December 31, 2003 and Tapco's
    historical results for the one-month period from October 1, 2003 to October
    31, 2003 are included in both the pro forma combined results for the year
    ended September 30, 2003 and the pro forma combined results for the year
    ended September 30, 2004. Revenues and net income for VFL, Eldorado, SCP and
    Tapco which are included in both the 2003 and 2004 pro forma results were
    approximately $67,021,000 and $850,000, respectively.


                                                    Unaudited Pro Forma Results
                                                  ------------------------------
    (in thousands, except per-share data)                   2003           2004
    ----------------------------------------------------------------------------

    Total revenue                                       $764,316       $892,140
    Net income                                            38,818         72,876
    Basic earnings per share                                1.43           2.29
    Diluted earnings per share                              1.38           2.21

    The pro forma results have been prepared for illustrative purposes only.
    Such information does not purport to be indicative of the results of
    operations which actually would have resulted had the acquisitions occurred
    on the dates indicated, nor is it indicative of the results that may be
    expected in future periods.

    Deferred Acquisition Costs - In 2004, Headwaters expensed approximately
    $848,000 of deferred acquisition costs related to acquisition projects that
    were abandoned.

    ISG Acquisition - On September 19, 2002, Headwaters acquired 100% of the
    common stock of ISG, assumed or paid off all of ISG's outstanding debt and
    redeemed all of ISG's outstanding preferred stock. ISG is the leading
    provider of high quality fly ash to the building products and ready mix
    concrete industries in the United States. ISG also develops, manufactures
    and distributes value-added bagged concrete, stucco, mortar and block
    products that utilize fly ash through its construction materials segment.
    Headwaters' historical focus has been on using technology to add value to
    fossil fuels, particularly coal. The acquisition of ISG provided Headwaters
    with a significant position in the last phase of the coal value chain due to
    ISG's competencies in managing CCPs. The acquisition of ISG also brought to
    Headwaters substantial management depth, comprehensive corporate
    infrastructure and critical mass in revenues and operating income.

    In order to obtain the cash necessary to acquire ISG and retire the ISG
    debt, Headwaters issued $175,000,000 of new debt consisting of $155,000,000
    of senior secured debt with a five-year term and a variable interest rate
    and $20,000,000 of subordinated debt with an approximate five-year term and
    a fixed interest rate. ISG management participated in one-half, or
    $10,000,000, of the subordinated debt. Total cash proceeds from the issuance
    of new debt, net of debt discounts, was $169,950,000. Headwaters also
    incurred approximately $6,200,000 of debt issue costs to place the new debt,
    which had an initial combined effective weighted-average interest rate of
    approximately 9.0%.

    The following table sets forth the total consideration paid to acquire ISG.

    (in thousands, except per-share amount)
    -------------------------------------------------------------------------
    Fair value of Headwaters stock (2,100 shares at
      $15.58 per share)                                             $ 32,718
    Cash paid to ISG stockholders                                     32,700
    Cash paid to retire ISG debt and related
      accrued interest                                               184,638
    Costs directly related to acquisition                              7,800
                                                                 ------------
                                                                    $257,856
                                                                 ============

    The value of Headwaters' 2,100,000 shares of common stock issued was
    determined using the average market price of Headwaters' stock over a
    five-day period, consisting of the day the terms of acquisition were agreed
    to and announced and two days prior to and two days subsequent to that day.

                                      F-18
<PAGE>

                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    The ISG acquisition was accounted for using the purchase method of
    accounting. Assets acquired and liabilities assumed were recorded at their
    estimated fair values as of September 19, 2002. An adjusted allocation of
    the purchase price, which was not materially different from the preliminary
    allocation, was completed in 2003. The adjustments made related primarily to
    the completion of property, plant and equipment valuations, income tax
    returns for ISG for the period ended September 18, 2002 and certain
    valuations of other liabilities acquired. Approximately $109,164,000 of the
    purchase price was allocated to identifiable intangible assets consisting
    primarily of contracts with coal-fired electric power generation plants and
    patents. This amount is being amortized over the estimated combined useful
    life of approximately 20 years. The remaining purchase price not
    attributable to the tangible and identifiable intangible assets was
    allocated to goodwill, none of which is tax deductible. All of the
    intangible assets and all of the goodwill were allocated to the CCP segment.

    The following table sets forth the allocation of the total consideration to
    the tangible and intangible assets acquired and liabilities assumed.

    (in thousands)
    -------------------------------------------------------------------------
    Cash                                                           $ 19,238
    Trade receivables, net                                           33,820
    Inventories and other assets                                     11,794
    Property, plant and equipment                                    48,981
    Intangible assets acquired:
         Contracts (20 years)                                       106,400
         Patents (7 1/2 years)                                        2,764
    Goodwill                                                        107,873
    Accounts payable and accrued liabilities                        (24,294)
    Net deferred income tax liabilities                             (48,720)
                                                                 ------------
         Net assets acquired                                       $257,856
                                                                 ============

4.  Segment Reporting

    Until Headwaters acquired ISG in September 2002, Headwaters operated in and
    reported as a single industry segment, alternative energy. Since the
    acquisition of ISG, Headwaters has operated in three business segments,
    alternative energy, CCPs, and construction materials. VFL operates in the
    CCP segment and all of the other businesses acquired by Headwaters in 2004
    operate in the construction materials segment. These segments are managed
    and evaluated separately by management based on fundamental differences in
    their operations, products and services.

    The alternative energy segment includes Headwaters' traditional coal-based
    solid alternative fuels business and HTI's business of developing catalyst
    technologies to convert coal and heavy oil into environmentally-friendly,
    higher-value liquid fuels, as well as nanocatalyst processes and
    applications. Revenues for this segment primarily include sales of chemical
    reagents and license fees.

    The CCP segment markets coal combustion products such as fly ash and bottom
    ash, known as CCPs, to the building products and ready mix concrete
    industries. Headwaters markets CCPs to replace manufactured or mined
    materials, such as portland cement, lime, agricultural gypsum, fired
    lightweight aggregate, granite aggregate and limestone. Headwaters has
    long-term contracts, primarily with coal-fired electric power generation
    plants pursuant to which it manages the post-combustion operations for the
    utilities. CCP revenues consist primarily of product sales with a smaller
    amount of service revenue.

    Prior to 2004, the businesses in the construction materials segment
    manufactured and distributed value-added bagged concrete, stucco, mortar and
    block products. The acquisition of SCP expanded Headwaters' concrete block
    business and the acquisition of Eldorado added manufactured architectural
    stone to the construction materials product line. Tapco is a leading
    designer, manufacturer and marketer of building products used in exterior
    residential home improvement and construction. Revenues for the construction
    materials segment consist of product sales to wholesale and retail
    distributors, contractors and other users of building products and
    construction materials.

                                      F-19
<PAGE>

                            HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    The following segment information for has been prepared in accordance with
    SFAS No. 131, "Disclosure about Segments of an Enterprise and Related
    Information." The accounting policies of the segments are the same as those
    described in Note 2. Performance of the segments is evaluated primarily on
    operating income. Intersegment sales are immaterial. Segment costs and
    expenses considered in deriving segment operating income include cost of
    revenues, depreciation and amortization, research and development, and
    segment-specific selling, general and administrative expenses. Amounts
    included in the "Corporate" column represent expenses not specifically
    attributable to any segment and include administrative departmental costs
    and general corporate overhead. Segment assets reflect those specifically
    attributable to individual segments and primarily include accounts
    receivable, inventories, property, plant and equipment, intangible assets
    and goodwill. Other assets are included in the "Corporate" column. Segment
    information for CCPs and construction materials for 2002 represents ISG's
    results for 12 days. Segment information for CCPs for 2004 includes VFL's
    results for six months. Segment information for construction materials for
    2004 includes Eldorado's results for four months, SCP's results for three
    months and Tapco's results for 23 days.
<TABLE>
<CAPTION>
                                                                           2002
                                            --------------------------------------------------------------------
                                              Alternative                 Construction
(in thousands)                                   Energy        CCPs         Materials    Corporate     Totals
----------------------------------------------------------------------------------------------------------------
<S>                                           <C>           <C>            <C>           <C>         <C>
Segment revenue                               $  110,753    $   6,818      $    1,774    $      --   $  119,345
                                            ====================================================================

Depreciation and amortization                 $   (1,265)   $    (380)     $     (32)    $     (83)  $   (1,760)
                                            ====================================================================

Operating income (loss)                       $   48,348    $   1,514      $      118    $  (8,946)  $   41,034
                                            =======================================================
     Net interest income                                                                                    447
     Other income (expense), net                                                                         (1,245)
     Income tax provision                                                                               (15,950)
                                                                                                    ------------
Net income                                                                                           $   24,286
                                                                                                    ============

Capital expenditures                          $      546    $     236      $       --    $      14   $      796
                                            ====================================================================

Segment assets                                $   36,060    $ 286,002      $   21,869    $  28,926   $  372,857
                                            ====================================================================

<CAPTION>
                                                                           2003
                                            --------------------------------------------------------------------
                                              Alternative                 Construction
(in thousands)                                   Energy        CCPs         Materials    Corporate     Totals
----------------------------------------------------------------------------------------------------------------
<S>                                           <C>           <C>            <C>           <C>         <C>
Segment revenue                               $  168,342    $ 169,938      $   49,350    $      --   $  387,630
                                            ====================================================================

Depreciation and amortization                 $   (1,254)   $ (10,822)     $    (624)    $    (282)  $  (12,982)
                                            ====================================================================

Operating income (loss)                       $   65,002    $  21,521      $    4,734    $ (14,138)  $   77,119
                                            =======================================================
     Net interest expense                                                                               (15,377)
     Other income (expense), net                                                                         (1,661)
     Income tax provision                                                                               (23,450)
                                                                                                    ------------
Net income                                                                                           $   36,631
                                                                                                    ============

Capital expenditures                          $      166    $   8,297      $      732    $     521   $    9,716
                                            ====================================================================

Segment assets                                $   34,959    $ 283,916      $   22,341    $  32,059   $  373,275
                                            ====================================================================

                                      F-20
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
                                                    HEADWATERS INCORPORATED

                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                                                       September 30, 2004
                                                           ___________

                                                                           2004
                                            --------------------------------------------------------------------
                                              Alternative                 Construction
(in thousands)                                   Energy        CCPs         Materials    Corporate     Totals
----------------------------------------------------------------------------------------------------------------
<S>                                           <C>           <C>            <C>           <C>         <C>
Segment revenue                               $  209,773    $ 210,155      $  134,027    $      --   $  553,955
                                            ====================================================================

Depreciation and amortization                 $   (1,373)   $ (12,617)     $   (6,227)   $    (331)  $  (20,548)
                                            ====================================================================

Operating income (loss)                       $   98,995    $  30,386      $   17,261    $ (18,885)  $  127,757
                                            =======================================================
     Net interest expense                                                                               (18,509)
     Other income (expense), net                                                                         (4,141)
     Income tax provision                                                                               (40,790)
                                                                                                    ------------
Net income                                                                                           $   64,317
                                                                                                    ============

Capital expenditures                          $      745    $   6,037      $    7,036    $     149   $   13,967
                                            ====================================================================

Segment assets                                $   44,156    $ 316,982      $1,104,980    $  74,661   $1,540,779
                                            ====================================================================

5.  Receivables

    Activity in the trade receivables allowance account was as follows.
<CAPTION>
                                                    Balance at    Charged to    Additions                Balance at
                                                    beginning     expense or      from       Accounts      end of
    (in thousands)                                  of period      revenue    acquisitions  written off    period
    ------------------------------------------- ------------- ------------ ------------- ------------- ------------
    <S>                                              <C>          <C>           <C>          <C>           <C>
    Fiscal year ended September 30, 2002             $     0      $    --       $   412      $    --       $   412
    Fiscal year ended September 30, 2003                 412          516            --         (351)          577
    Fiscal year ended September 30, 2004                 577        2,393         3,131         (998)        5,103
</TABLE>

    Notes receivable generally relate to nonoperating activities and
    accordingly, losses are included in other expense in the consolidated
    statements of income. Net losses recognized on notes receivable were
    approximately $743,000 in 2002, $2,142,000 in 2003 and $2,622,000 in 2004.

6.  Inventories

    Inventories consisted of the following at September 30:

    (in thousands)                                             2003        2004
    ----------------------------------------------------------------------------

    Raw materials                                           $ 1,059    $  8,517
    Work in process                                              --         187
    Finished goods                                            6,768      35,108
                                                         -----------------------
                                                            $ 7,827    $ 43,812
                                                         =======================

7.  Property, Plant and Equipment

    Property, plant and equipment consisted of the following at September 30:
<TABLE>
<CAPTION>
                                              Estimated useful
    (in thousands)                                  lives                 2003        2004
    ---------------------------------------------------------------------------------------
    <S>                                        <C>                    <C>        <C>
    Land and improvements                       8 - 30 years          $ 10,428   $  14,041
    Buildings and improvements                  3 - 40 years            10,128      34,269
    Equipment and vehicles                      2 - 30 years            31,090      88,791
    Dies and molds                             1 1/2 - 10 years             --      28,986
    Construction in progress                                             7,793       8,052
                                                                   ------------------------
                                                                        59,439     174,139
     Less accumulated depreciation                                      (6,696)    (16,528)
                                                                   ------------------------
          Net property, plant and equipment                           $ 52,743   $ 157,611
                                                                   ========================
</TABLE>
                                      F-21
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Depreciation expense was approximately $669,000 in 2002, $6,387,000 in 2003
    and $11,035,000 in 2004.

8.  Intangible Assets and Goodwill

    Intangible Assets - With the exception of certain disclosures that were not
    permitted to be early implemented, Headwaters implemented SFAS No. 142
    effective with the acquisitions of HTI in August 2001 and ISG in September
    2002. Effective October 1, 2002, Headwaters fully implemented SFAS No. 142,
    which mandates the following disclosures. Headwaters has no identified
    intangible assets that are not being amortized.

    The following table summarizes the gross carrying amounts and the related
    accumulated amortization of all amortizable intangible assets as of
    September 30:
<TABLE>
<CAPTION>
                                                                   2003                             2004
                                                  ------------------------------------------------------------------
                                                         Gross                            Gross
                                     Estimated          Carrying        Accumulated      Carrying        Accumulated
    (in thousands)                 useful lives          Amount        Amortization       Amount        Amortization
    ---------------------------------------------------------------------------------------------------------------
    <S>                         <C>                     <C>                <C>           <C>               <C>
    CCP contracts                  8 - 20 years         $106,400           $5,499        $117,690          $11,524
    Customer relationships      7 1/2 - 15 years              --               --          68,331              452
    Trade names                    5 - 20 years               --               --          63,657              268
    Patents and patented
      technologies                7 1/2 - 15 years        12,464            1,666          52,464            2,969
    Non-competition agreements     2 - 3 1/2 years            --               --          10,422              867
    Other                         9 - 17 1/4 years         1,522              807           3,382            1,063
                                                  -----------------------------------------------------------------
                                                        $120,386           $7,972        $315,946          $17,143
                                                  =================================================================
</TABLE>

    Total amortization expense related to intangible assets was approximately
    $998,000 in 2002, $6,504,000 in 2003 and $9,171,000 in 2004. Total estimated
    annual amortization expense for fiscal years 2005 through 2009 is shown in
    the following table.

               Year ending September 30:    (in thousands)
              ---------------------------------------------
                         2005                      $24,449
                         2006                       24,244
                         2007                       21,899
                         2008                       20,350
                         2009                       20,138

    Goodwill - The changes in the carrying amount of goodwill, by segment, are
    as follows.
<TABLE>
<CAPTION>
                                              Alternative                     Construction
    (in thousands)                              Energy            CCPs         Materials          Total
    -----------------------------------------------------------------------------------------------------
    <S>                                          <C>           <C>             <C>              <C>
    Balances as of September 30, 2002            $4,258        $109,109        $     --         $113,367
    Adjustment to previously recorded
      purchase price                                 --          (1,236)             --           (1,236)
                                        -----------------------------------------------------------------
    Balances as of September 30, 2003             4,258         107,873              --          112,131
    Goodwill acquired during the year                --           8,125         695,140          703,265
                                        -----------------------------------------------------------------
    Balances as of September 30, 2004            $4,258        $115,998        $695,140         $815,396
                                        =================================================================
</TABLE>

    In accordance with the requirements of SFAS No. 142, Headwaters does not
    amortize goodwill, all of which relates to acquisitions that occurred from
    2001 through 2004. SFAS No. 142 requires Headwaters to periodically perform
    tests for goodwill impairment. Step 1 of the initial impairment test was
    required to be performed no later than March 31, 2003; thereafter impairment
    testing is required to be performed no less often than annually, or sooner
    if evidence of possible impairment arises. Impairment testing is performed
    at the reporting unit level and Headwaters has identified four reporting
    units: (i) Headwaters Energy Services (formerly Covol Fuels division) and

                                      F-22
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    (ii) HTI (which together comprise the alternative energy segment), (iii)
    CCPs and (iv) construction materials. Currently, goodwill exists in the HTI,
    CCPs and construction materials reporting units.

    Step 1 of impairment testing consists of determining and comparing the fair
    values of the reporting units to the carrying values of those reporting
    units. If step 1 were to be failed for any of the reporting units,
    indicating a potential impairment, Headwaters would be required to complete
    step 2, which is a more detailed test to calculate the implied fair value of
    goodwill, and compare that value to the carrying value of the goodwill. If
    the carrying value of the goodwill exceeds the implied fair value of the
    goodwill, an impairment loss is required to be recorded.

    Headwaters performed step 1 impairment tests of the recorded goodwill in the
    HTI and CCPs reporting units as of October 1, 2002, the beginning of fiscal
    year 2003. Headwaters performed its annual, recurring tests for potential
    impairment using the dates of June 30, 2003 and 2004. The tests indicated
    that the fair values of the reporting units exceeded their carrying values
    at October 1, 2002, June 30, 2003 and June 30, 2004. Accordingly, step 2 of
    the impairment tests was not required to be performed, and no impairment
    charge was necessary.

9.  Liabilities

    Other Accrued Liabilities - Other accrued liabilities consisted of the
    following at September 30:
<TABLE>
<CAPTION>
    (in thousands)                                                             2003           2004
    -----------------------------------------------------------------------------------------------
    <S>                                                                     <C>            <C>
    Acquisition-related accruals                                            $    --        $24,676
    Cost of product not yet invoiced                                          5,520         10,763
    Unamortized non-refundable license fees                                   3,865          7,227
    Other                                                                    11,002         30,186
                                                                    -------------------------------
                                                                            $20,387        $72,852
                                                                    ===============================
<CAPTION>
    Long-term Debt - Long-term debt consisted of the following at September 30:

     (in thousands)                                                            2003           2004
    -----------------------------------------------------------------------------------------------
    <S>                                                                    <C>            <C>
    Senior secured debt                                                    $     --       $790,000

    Convertible senior subordinated notes                                        --        172,500

    Notes payable to a bank                                                      --          9,787

    Senior secured debt with a face amount totaling $114,851                111,766             --

    Senior subordinated debentures with a face amount totaling
      $20,000                                                                19,682             --

    Other                                                                        71            227
                                                                    -------------------------------
                                                                            131,519        972,514
    Less: current portion                                                   (27,475)       (57,873)
                                                                    -------------------------------
    Total long-term debt                                                   $104,044       $914,641
                                                                    ===============================
</TABLE>

    New 2004 Senior Secured Credit Agreements - In September 2004 and as amended
    in October 2004, Headwaters entered into two credit agreements with a
    syndication of lenders under which a total of $790,000,000 was borrowed
    under term loan arrangements and which provide for $60,000,000 to be
    borrowed under a revolving credit arrangement. The proceeds were used to
    acquire Tapco and repay in full the remaining balance due under Headwaters'
    former 2004 senior secured credit agreement obtained in March 2004 (see
    below). The $790,000,000 of term loan borrowings consisted of a first lien
    term loan in the amount of $640,000,000 and a second lien term loan in the
    amount of $150,000,000. Both term loans are secured by all assets of
    Headwaters and are senior in priority to all other debt.

    The first lien term loan bears interest, at Headwaters' option, at either i)
    the London Interbank Offered Rate ("LIBOR") plus 3.0%, if the "total
    leverage ratio," as defined, is less than or equal to 3.75:1.0, and if not,
    at LIBOR plus 3.25%, or ii) the "base rate" plus 2.0%, if the total leverage
    ratio is less than or equal to 3.75:1.0, and if not, at the base rate plus
    2.25%. Base rate is defined as the higher of the rate announced by Morgan

                                      F-23
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Stanley Senior Funding and the overnight rate charged by the Federal Reserve
    Bank of New York plus 0.5%. The initial interest rate on the first lien debt
    was set at 6.5%, but was subsequently reduced to approximately 5.4% in
    October 2004 pursuant to the terms of the agreement. The second lien term
    loan bears interest, also at Headwaters' option, at either LIBOR plus 5.5%,
    or the "base rate" plus 4.5%. The initial interest rate on the second lien
    debt was set at 9.75%, but was subsequently reduced to approximately 8.15%
    in October 2004 pursuant to the terms of the agreement. Headwaters can lock
    in new rates for both the first lien and second lien loans for one, two,
    three or six months. The next rate change will occur in January 2005.

    The first lien term loan is repayable in quarterly installments of principal
    and interest, with minimum required quarterly principal repayments of
    $12,000,000 commencing in November 2004 through August 2007, then $4,000,000
    through August 2010, with three repayments of approximately $149,333,000
    through April 2011, the termination date of the first lien loan agreement.
    The second lien term loan is due September 2012, with no required principal
    repayments prior to that time. Interest is generally due on a quarterly
    basis. There are mandatory prepayments of the first lien term loan in the
    event of certain asset sales and debt and equity issuances and from "excess
    cash flow," as defined. Optional prepayments of the first lien term loan are
    permitted without penalty or premium. Optional prepayments of the second
    lien term loan are permissible only to the extent Headwaters issues new
    equity securities and then are further limited to a maximum of $50,000,000,
    so long as the first lien term loan remains outstanding. Any optional
    prepayments of the second lien term loan bear a penalty of 3% of prepayments
    made in the first year, 2% of prepayments made in the second year, and 1% of
    prepayments made in the third year. Once repaid in full or in part, no
    further reborrowings under either of the term loan arrangements can be made.
    In October 2004, Headwaters repaid a total of $24,000,000 of the first lien
    term loan, which amount otherwise would have been due in November 2004 and
    February 2005.

    Borrowings under the revolving credit arrangement are generally subject to
    the terms of the first lien loan agreement and bear interest at either LIBOR
    plus 1.75% to 2.5%, or the base rate plus 0.75% to 1.5%. Borrowings and
    reborrowings of any available portion of the $60,000,000 revolver can be
    made at any time through September 2009, at which time all loans must be
    repaid and the revolving credit arrangement terminates. The fees for the
    unused portion of the revolving credit arrangement range from 0.5% to 0.75%.
    Finally, the credit agreement allows for the issuance of letters of credit,
    provided there is capacity under the revolving credit arrangement. As of
    September 30, 2004, three letters of credit totaling $2,070,000 were
    outstanding, with expiration dates ranging from October 2004 to June 2005.

    The credit agreements contain restrictions and covenants common to such
    agreements, including limitations on the incurrence of additional debt,
    investments, merger and acquisition activity, asset sales and liens, capital
    expenditures in excess of $50,000,000 in any fiscal year (increasing to
    $60,000,000 in 2011) and the payment of dividends, among others. In
    addition, Headwaters must maintain certain leverage and fixed charge
    coverage ratios, as those terms are defined in the agreements. Under the
    most restrictive covenants, contained in the first lien agreement,
    Headwaters must maintain i) a total leverage ratio of 5.0:1.0 or less,
    declining periodically to 3.5:1.0 in 2010; ii) a maximum ratio of
    consolidated senior funded indebtedness minus subordinated indebtedness to
    EBITDA of 4.0:1.0, declining periodically to 2.5:1.0 in 2010; and iii) a
    minimum ratio of EBITDA plus rent payments for the four preceding fiscal
    quarters to scheduled payments of principal and interest on all indebtedness
    for the next four fiscal quarters of 1.10:1.0 through September 30, 2006,
    and 1.25:1.0 thereafter. Headwaters is in compliance with all debt covenants
    as of September 30, 2004.

    As required by the new senior secured credit facility, Headwaters entered
    into certain other agreements to limit its exposure to interest rate
    increases. The first set of agreements established the maximum LIBOR rate
    for $300,000,000 of the senior secured debt at 5.0% through September 8,
    2005. The second set of agreements sets the LIBOR rate at 3.71% for
    $300,000,000 of this debt for the period commencing September 8, 2005
    through September 8, 2007. Headwaters accounts for these agreements as cash
    flow hedges, and accordingly, the fair market value of the hedges is
    reflected in the consolidated balance sheet as either other assets or other
    liabilities. The hedges had a fair market value of $0 at September 30, 2004.

    Former 2004 Senior Secured Credit Agreement - In March 2004, Headwaters
    entered into a credit agreement with a group of banks under which a total of
    $50,000,000 was borrowed under a term loan arrangement and which, as amended
    in June 2004, provided for an additional $75,000,000 to be borrowed under a
    revolving credit arrangement. The initial $50,000,000 of proceeds were used

                                      F-24
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    to repay in full the remaining balance due under Headwaters' former 2002
    senior secured credit agreement (see below). Debt issuance costs of
    approximately $1,300,000 were incurred in issuing this debt, all of which
    was expensed in 2004.

    The term loan was secured by all assets of Headwaters, bore interest at a
    variable rate linked to the Eurodollar rate or the lenders' base rate, both
    as defined in the agreement, and was repayable in quarterly installments of
    $1,250,000 through September 2007, with a final payment of $32,500,000 due
    November 2007. In connection with the purchase of Eldorado in June 2004, a
    total of $44,000,000 was borrowed under the revolving credit arrangement,
    all of which was repaid in June 2004. In connection with the purchase of SCP
    in July 2004, a total of $20,000,000 was borrowed under the revolving credit
    arrangement, all of which was repaid in September 2004. Also in September
    2004, the remaining balance outstanding under the term loan was repaid in
    full using proceeds from the new 2004 senior secured credit facility
    described above.

    Convertible Senior Subordinated Notes - In connection with the Eldorado
    acquisition, Headwaters issued $172,500,000 of 2 7/8% convertible senior
    subordinated notes due 2016. These notes are subordinate to the new 2004
    senior secured debt described above. Holders of the notes may convert the
    notes into shares of Headwaters' common stock at a conversion rate of
    33.3333 shares per $1,000 principal amount ($30 conversion price), or
    approximately 5,750,000 aggregate shares of common stock, contingent upon
    certain events. The conversion rate adjusts for events related to
    Headwaters' common stock, including common stock issued as a dividend,
    rights or warrants to purchase common stock issued to all holders of
    Headwaters' common stock, and other similar rights or events that apply to
    all holders of common stock.

    The notes are convertible if any of the following five criteria are met: 1)
    satisfaction of a market price condition which becomes operative if the
    common stock trading price reaches $39 per share for a certain period of
    time prior to June 1, 2011 and at any time after that date; 2) a credit
    rating, if any, assigned to the notes is three or more rating subcategories
    below the initial rating, if any; 3) the notes trade at 98% of the product
    of the common stock trading price and the number of shares of common stock
    issuable upon conversion of $1,000 principal amount of the notes, except
    this provision is not available if the closing common stock price is between
    100% and 130% of the current conversion price of the notes; 4) Headwaters
    calls the notes for redemption; and 5) certain corporate transactions occur,
    including distribution of rights or warrants to all common stockholders
    entitling them to purchase common stock at less than the current market
    price or distribution of common stock, cash or other assets, debt securities
    or certain rights to purchase securities where the distribution has a per
    share value exceeding 5% of the closing common stock price on the day
    immediately preceding the declaration date for such distribution. In
    addition, the notes are convertible if Headwaters enters into an agreement
    pursuant to which Headwaters' common stock would be converted into cash,
    securities or other property.

    Headwaters may call the notes for redemption at any time on or after June 1,
    2007 and prior to June 4, 2011 if the closing common stock price exceeds
    130% of the conversion price for 20 trading days in any consecutive 30-day
    trading period (in which case Headwaters must provide a "make whole" payment
    of the present value of all remaining interest payments on the redeemed
    notes through June 1, 2011). In addition, the holder of the notes has the
    right to require Headwaters to repurchase all or a portion of the notes on
    June 1, 2011 or if a fundamental change in common stock has occurred,
    including termination of trading. Subsequent to June 1, 2011, the notes
    require an additional interest payment equal to 0.40% of the average trading
    price of the notes if the trading price equals 120% or more of the principal
    amount of the notes.

    Headwaters has not included the additional shares of common stock
    contingently issuable under the notes in its 2004 diluted EPS as none of the
    contingencies have been met. However, as explained in more detail in Note
    13, implementation of EITF 04-08 in December 2004 will require Headwaters to
    include in its diluted EPS calculation, on an if-converted basis, the
    additional shares issuable under the notes.

    Former 2002 Senior Secured Credit Agreement - In connection with the ISG
    acquisition in 2002, Headwaters entered into a $175,000,000 senior secured
    credit agreement with a syndication of lenders, under which a total of
    $155,000,000 was borrowed as a term loan on the acquisition date. The credit
    agreement also allowed up to $20,000,000 to be borrowed under a revolving

                                      F-25
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    credit arrangement. The debt was issued at a 3% discount and Headwaters
    received net cash proceeds of $150,350,000. The original issue discount was
    accreted using the effective interest method and the accretion was recorded
    as interest expense. The debt was secured by all assets of Headwaters, bore
    interest at a variable rate linked to the Eurodollar rate or the lenders'
    base rate, both as defined in the agreement (approximately 5.4% at September
    30, 2003) and was repayable in quarterly installments through August 30,
    2007.

    During the December 2003 quarter, principal repayments totaling $39,714,000
    were made, including $33,471,000 of optional prepayments. During the March
    2004 quarter, the remaining balance was repaid in full using available cash
    and $50,000,000 of proceeds from the former 2004 senior secured credit
    facility described above. In connection with the full repayment of this
    debt, non cash interest expense totaling approximately $5,023,000 was
    recognized in the March 2004 quarter, representing amortization of all of
    the remaining debt discount and debt issue costs related to this debt.

    Senior Subordinated Debentures - In connection with the ISG acquisition,
    Headwaters also entered into a $20,000,000 subordinated loan agreement,
    under which senior subordinated debentures were issued at a 2% discount,
    with Headwaters receiving net cash proceeds of $19,600,000. The original
    issue discount was accreted using the effective interest method and the
    accretion was recorded as interest expense. ISG management participated in
    one-half, or $10,000,000, of the $20,000,000 of debt issued. The other half
    was issued to a corporation. The debentures bore interest at 18% and were
    due in 2007; however, in December 2003, the debentures were repaid in full,
    including a 4%, or $400,000, prepayment charge paid to the corporation
    holding $10,000,000 of the debentures. This charge, along with all remaining
    unamortized debt discount and debt issue costs, is included in interest
    expense in the consolidated statement of income.

    Notes Payable to a Bank - In connection with the acquisition of SCP,
    Headwaters assumed SCP's obligations under its notes payable to a bank. The
    notes require monthly interest and quarterly principal payments and are
    repayable from April 2007 through April 2015. Two of the notes bear interest
    at LIBOR plus 0.5%, subject to an interest rate floor of 4.5% (4.5% at
    September 30, 2004), and the remaining note (in the amount of $1,100,000)
    bears interest at 0.5% below the bank's base rate (4.25% at September 30,
    2004). Because the notes are callable by the bank, Headwaters has included
    the outstanding balance in current portion of long-term debt in the
    consolidated balance sheet. The notes are collateralized by certain assets
    of SCP and contain financial covenants, the most restrictive of which
    specifies a minimum fixed charge coverage ratio. Headwaters was in
    compliance with all debt covenants at September 30, 2004.

    Notes Payable to Former VFL Stockholders - In connection with the VFL
    acquisition, Headwaters issued $19,000,000 of notes payable to the VFL
    stockholders, $13,000,000 of which was repaid in June 2004 and $6,000,000 of
    which was repaid in July 2004. The interest rate on $16,000,000 of the notes
    was 9% and the interest rate on the remaining $3,000,000 of notes was
    variable.

    Short-term Borrowings with an Investment Bank - Headwaters had an
    arrangement with an investment bank under which Headwaters could borrow up
    to 90% of the value of the portfolio of Headwaters' short-term investments
    with the investment bank, limited to a maximum amount of $20,000,000.
    Headwaters borrowed $10,000,000 under this arrangement during June 2004, all
    of which was repaid in June 2004. In July 2004, Headwaters borrowed
    $6,000,000 under this arrangement, all of which was repaid in July 2004.
    This arrangement is no longer active.

    Interest Rates and Debt Maturities - The weighted-average interest rate on
    the face amount of outstanding long-term debt, disregarding amortization of
    debt issue costs and debt discount, was approximately 7.2% at September 30,
    2003 and 6.3% at September 30, 2004. Future maturities of long-term debt as
    of September 30, 2004 were as follows:

                                                           (in
                     Year ending September 30,          thousands)
                  ------------------------------------------------
                                 2005                    $ 57,873
                                 2006                      48,089
                                 2007                      48,051
                                 2008                      16,001
                                 2009                      16,000
                              Thereafter                  786,500
                                                     -------------
                         Total long-term debt            $972,514
                                                     =============

                                      F-26
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Interest Costs - During 2002, Headwaters incurred total interest costs of
    approximately $553,000, including approximately $136,000 of non-cash
    interest expense. No interest costs were capitalized in 2002. During 2003,
    Headwaters incurred total interest costs of approximately $15,917,000,
    including approximately $3,857,000 of non-cash interest expense and
    approximately $230,000 of interest costs that were capitalized. During 2004,
    Headwaters incurred total interest costs of approximately $19,888,000,
    including approximately $6,031,000 of non-cash interest expense and
    approximately $435,000 of interest costs that were capitalized.

10. Fair Value of Financial Instruments

    Headwaters' financial instruments consist primarily of cash and cash
    equivalents, short-term trading investments, trade and notes receivable,
    accounts payable and long-term debt. All of these financial instruments
    except long-term debt are either carried at fair value in the balance sheet
    or are of a short-term nature. Accordingly, the carrying values for those
    financial instruments as reflected in the consolidated balance sheets
    closely approximated their fair values.

    If all of Headwaters' debt outstanding as of September 30, 2003 carried an
    average interest rate of 7%, management's estimate of the market interest
    rate as of September 30, 2003, the fair value of Headwaters' total long-term
    debt at September 30, 2003 would be approximately $131,500,000. With the
    exception of the 2 7/8% convertible senior subordinated notes due 2016,
    substantially all of Headwaters' debt outstanding as of September 30, 2004
    consisted of variable-rate debt. Using a market interest rate for the
    convertible senior subordinated notes of approximately 2.3%, the fair value
    of all outstanding long-term debt as of September 30, 2004 would be
    approximately $978,892,000. The market interest rate for the convertible
    senior subordinated notes decreased to approximately 2.3% during the period
    June 2004 to September 2004 due primarily to the increase in Headwaters'
    common stock price during the period.

11. Income Taxes

    Headwaters recorded income tax provisions with an effective tax rate of
    approximately 40%, 39% and 39% in 2002, 2003 and 2004, respectively. The
    income tax provision consisted of the following for the years ended
    September 30:
<TABLE>
<CAPTION>
    (in thousands)                                                    2002          2003          2004
    ---------------------------------------------------------------------------------------------------
    <S>                                                            <C>           <C>           <C>
    Current tax provision:
         Federal                                                   $ 3,490       $20,726       $38,374
         State                                                         920         3,602         3,699
                                                              -----------------------------------------
    Total current tax provision                                      4,410        24,328        42,073

    Deferred tax provision (benefit):
         Federal                                                     9,720          (774)       (1,273)
         State                                                       1,820          (104)          (10)
                                                              -----------------------------------------
    Total deferred tax provision (benefit)                          11,540          (878)       (1,283)
                                                              -----------------------------------------
    Total income tax provision                                     $15,950       $23,450       $40,790
                                                              =========================================
</TABLE>

    As of September 30, 2003, Headwaters had deferred tax assets related to
    federal and state net operating loss ("NOL") carryforwards of approximately
    $424,000. During 2004, Headwaters utilized its remaining federal NOL
    carryforwards and as of September 30, 2004, has a deferred tax asset related
    to state NOL carryforwards of approximately $40,000.

    The provision for income taxes differs from the statutory federal income tax
    rate due to the following.
<TABLE>
<CAPTION>
    (in thousands)                                                    2002          2003          2004
    ---------------------------------------------------------------------------------------------------
    <S>                                                            <C>           <C>           <C>
    Tax provision at U.S. statutory rate                           $14,083       $21,028       $36,787
    State income taxes, net of federal tax effect                    1,780         2,352         2,901
    Nondeductible expenses                                              59           302           764
    Other                                                               28          (232)          338
                                                              -----------------------------------------
       Income tax provision                                        $15,950       $23,450       $40,790
                                                              =========================================
</TABLE>
                                      F-27
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Headwaters' deferred income tax assets and liabilities, in particular
    deferred tax liabilities related to intangible assets and property, plant
    and equipment, changed significantly during 2004 due to the 2004
    acquisitions. The components of Headwaters' deferred income tax assets and
    liabilities were as follows as of September 30:
<TABLE>
<CAPTION>
    (in thousands)                                                                  2003          2004
    ---------------------------------------------------------------------------------------------------
    <S>                                                                         <C>          <C>
    Deferred tax assets:

         Estimated liabilities                                                  $  1,430     $   3,933
         Unamortized non-refundable license fees                                   1,885         3,672
         Write-down of notes receivable                                            1,606         2,124
         Trade receivable allowances                                                 224         1,136
         Federal and state net operating loss carryforwards                          424            40
         Other                                                                       225           453
                                                                            ---------------------------
              Total deferred tax assets                                            5,794        11,358
                                                                            ---------------------------

    Deferred tax liabilities:
         Intangible asset basis differences                                      (44,439)     (101,042)
         Property, plant and equipment basis differences                          (7,679)      (21,387)
         Interest on convertible senior subordinated notes                            --        (1,081)
         Other                                                                    (3,628)       (5,284)
                                                                            ---------------------------
              Total deferred tax liabilities                                     (55,746)     (128,794)
                                                                            ---------------------------
    Net deferred tax liability                                                  $(49,952)    $(117,436)
                                                                            ===========================
</TABLE>

12. Stockholders' Equity

    Preferred Stock - Headwaters has 10,000,000 shares of authorized preferred
    stock, none of which was issued or outstanding as of September 30, 2003 or
    2004.

    Issuance of Common Stock - Headwaters has an effective universal shelf
    registration statement on file with the SEC that can be used for the sale of
    common stock, preferred stock, convertible debt and other securities. In
    December 2003, Headwaters filed a prospectus supplement to the shelf
    registration statement and issued 4,750,000 shares of common stock under
    this shelf registration statement in an underwritten public offering. In
    January 2004, an additional 208,457 shares of common stock were issued upon
    exercise of the underwriters' over-allotment option. In total, proceeds of
    $90,258,000 were received, net of offering costs of $6,432,000. Following
    these issuances of common stock, approximately $53,000,000 remains available
    for future offerings of securities under the shelf registration statement. A
    prospectus supplement describing the terms of any additional securities to
    be issued is required to be filed before any future offering would commence
    under the registration statement.

    Restricted Stock Awards - In 2004, Headwaters issued approximately 61,000
    shares of restricted common stock to officers and employees, all under terms
    of the 2003 Stock Incentive Plan. The restricted stock was issued at no cost
    to the recipients and vests over five years. The weighted average grant date
    fair value of the restricted stock awards was $23.57 per share. Headwaters
    amortizes the expense related to the restricted stock awards over the
    vesting period using the straight-line method, which expense totaled
    approximately $136,000 in 2004.

    Stock Incentive Plans - In March 2004, Headwaters' stockholders approved an
    increase in the number of shares available for award grants under
    Headwaters' 2003 Stock Incentive Plan by 1,500,000. As of September 30,
    2004, Headwaters had three stock incentive plans (the "Incentive Plans")
    under which a total of 5,750,000 shares of common stock were reserved for
    ultimate issuance. As of September 30, 2004, options or other awards for
    approximately 1,163,000 shares of common stock could be granted under the
    Plans.

                                      F-28
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    A committee of Headwaters' Board of Directors, or in its absence, the Board
    (the "Committee"), administers and interprets the Incentive Plans. This
    Committee is authorized to grant options and other awards both under the
    Incentive Plans and outside of any Incentive Plan to eligible employees,
    officers, directors, and consultants of Headwaters. Two of the Incentive
    Plans provide for the granting of both incentive stock options and
    non-statutory stock options, as well as other stock awards; the other
    Incentive Plan provides only for the granting of non-statutory stock
    options. Terms of options and other awards granted under the Incentive
    Plans, including vesting requirements, are determined by the Committee.
    Options granted under the Incentive Plans vest over periods ranging up to
    ten years, expire ten years from the date of grant and are not transferable
    other than by will or by the laws of descent and distribution. Incentive
    stock option grants must meet the requirements of the Internal Revenue Code.

    Stock Options - The following table is a summary of activity for all of
    Headwaters' stock options, including options not granted under the Incentive
    Plans, for the years ended September 30:
<TABLE>
<CAPTION>
                                                      2002                   2003                    2004
                                             ----------------------------------------------------------------------
                                                         Weighted-              Weighted-               Weighted-
                                                          average                average                 average
                                                         exercise               exercise                exercise
    (in thousands)                            Shares       price      Shares      price       Shares      price
    ---------------------------------------------------------------------------------------------------------------
    <S>                                          <C>         <C>        <C>         <C>         <C>         <C>
    Outstanding at beginning of year             3,283       $ 5.80     2,990       $ 7.56      3,615       $10.88
       Granted                                     611        13.38     1,188        16.45      1,162        26.07
       Exercised                                  (852)        5.02     (514)         4.05       (826)        9.70
       Canceled                                    (52)        6.60      (49)        14.48       (153)       15.80
                                             ----------------------------------------------------------------------
    Outstanding at end of year                   2,990       $ 7.56     3,615       $10.88      3,798       $15.53
                                             ======================================================================

    Exercisable at end of year                   1,898       $ 6.08     1,992       $ 7.51      1,821       $ 8.90
                                             ======================================================================

    Weighted-average fair value of options
      granted during the year below market                     none                   none                    none

    Weighted-average fair value of options
      granted during the year at market                      $ 7.35                 $ 7.16                  $11.21

    Weighted-average fair value of options
      granted during the year above market                     none                   none                    none


    The following table summarizes information about all stock options
    outstanding at September 30, 2004.

<CAPTION>
    (in thousands)                      Outstanding options                     Exercisable options
    ----------------------------------------------------------------------------------------------------
                         Weighted-average
                               Number          remaining       Weighted-        Number      Weighted-
                           outstanding at   contractual life    average     exercisable at    average
     Range of exercise     September 30,        in years        exercise    September 30,    exercise
           prices               2004                             price           2004          price
    ----------------------------------------------------------------------------------------------------
        <S>                       <C>                  <C>          <C>           <C>            <C>
          $0.01 to $5.88               873               2.7        $ 3.90             858       $ 3.94
         $8.25 to $13.85               838               6.2         12.33             668        12.07
        $14.05 to $16.97               963               8.4         16.35             295        16.17
        $21.29 to $25.76               502               9.6         23.55              --           --
        $28.31 to $28.49               622              10.0         28.40              --           --
                          -----------------                                 ---------------
                                     3,798                                           1,821
                          =================                                 ===============
</TABLE>
                                      F-29
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Stockholder Approval of Options - The following table presents information
    related to stockholder approval of equity compensation plans, which
    information currently represents only stock options, as of September 30,
    2004.
<TABLE>
<CAPTION>
    (in thousands)
     ------------------------------------------------------------------------------------------------------------
                                           Shares to be       Weighted-average     Shares remaining available
                                            issued upon       exercise price of     for future issuance under
              Plan Category             exercise of options  outstanding options  existing equity compensation
                                                                                              plans
    ------------------------------------------------------------------------------------------------------------
    <S>                                               <C>                 <C>                             <C>
    Plans approved by stockholders                    2,559               $14.96                          1,048
    Plans not approved by stockholders                1,239                16.70                            115
                                        ------------------------------------------------------------------------
    Total                                             3,798               $15.53                          1,163
                                        ========================================================================
</TABLE>

    As discussed above, Headwaters has three Incentive Plans under which options
    have been granted. Headwaters has also issued options not covered by any
    Plan. Stockholders have approved two of the three Incentive Plans. The
    amounts included in the caption "not approved by stockholders" in the above
    table represent amounts applicable under the Incentive Plan not approved by
    stockholders plus all stock options granted outside of any Incentive Plan.

    Common Stock Warrants - As of September 30, 2003, there were warrants
    outstanding for the purchase of approximately 56,000 shares of common stock
    at a price of $1.56 per share. The warrants were exercised in 2004 and as of
    September 30, 2004, there were no warrants outstanding.

13. Earnings per Share

    The following table sets forth the computation of basic and diluted EPS for
    the years ended September 30:
<TABLE>
<CAPTION>
    (in thousands, except per-share data)                                     2002        2003        2004
    -------------------------------------------------------------------------------------------------------
    <S>                                                                    <C>         <C>         <C>
    Numerator - net income                                                 $24,286     $36,631     $64,317
                                                                       ====================================

    Denominator:
    Denominator for basic earnings per share - weighted-average
      shares outstanding                                                    24,234      27,083      31,774
    Effect of dilutive securities - shares issuable upon exercise of
      options and warrants                                                   1,491       1,112       1,245
                                                                       ------------------------------------
    Denominator for diluted earnings per share - weighted-average
         shares outstanding after assumed exercises                         25,725      28,195      33,019
                                                                       ====================================

    Basic earnings per share                                               $  1.00     $  1.35     $  2.02
                                                                       ====================================

    Diluted earnings per share                                             $  0.94     $  1.30     $  1.95
                                                                       ====================================
</TABLE>

    During all periods presented, Headwaters' potentially dilutive securities
    consisted of options and warrants for the purchase of common stock.
    Anti-dilutive securities not considered in the diluted EPS calculation
    totaled approximately 210,000 shares in 2002, 655,000 shares in 2003 and
    30,000 shares in 2004. In addition, for 2004, 5,750,000 shares issuable upon
    conversion of Headwaters' convertible senior subordinated notes represent
    potentially dilutive securities; however, these shares were not included in
    the diluted calculation for 2004.

                                      F-30
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    In September 2004, the EITF reached a consensus requiring the inclusion in
    diluted EPS calculations of contingently convertible instruments (EITF Issue
    04-08). This consensus will be effective for periods ending after December
    15, 2004 and will require Headwaters to include in its diluted EPS
    calculation, on an if-converted basis, the additional shares issuable under
    terms of Headwaters' outstanding convertible senior subordinated notes
    described in Note 9. The EITF consensus, when implemented, must be applied
    to all applicable prior periods, which for Headwaters will be the quarters
    ended June 30, 2004 and September 30, 2004. Had Headwaters included the
    shares issuable upon conversion of the convertible senior subordinated notes
    in the 2004 EPS calculation using the if-converted method, for the period
    the notes were outstanding, diluted EPS would have been reduced by $0.07 per
    share to $1.88 per share. The implementation of EITF Issue 04-08 is expected
    to have a more significant effect on 2005 and future years' diluted EPS
    calculations than for 2004 because the convertible senior subordinated notes
    were outstanding for only four months in 2004.

14. Commitments and Contingencies

    Commitments and contingencies as of September 30, 2004 not disclosed
    elsewhere, are as follows.

    Leases - Rental expense was approximately $720,000 in 2002, $11,999,000 in
    2003 and $14,618,000 in 2004. Headwaters has noncancellable operating leases
    for certain facilities and equipment. Most of these leases have renewal
    terms and expire in various years through 2017. As of September 30, 2004,
    minimum rental payments due under these leases are as follows.

                                                   (in
             Year ending September 30:         thousands)
             --------------------------------------------
                         2005                    $14,787
                         2006                     11,210
                         2007                      9,284
                         2008                      5,507
                         2009                      2,904
                      Thereafter                   4,092
                                            -------------
                                                 $47,784
                                            =============

    Sale, Purchase and Royalty Commitments - Certain CCP contracts with its
    customers require Headwaters to make minimum sales. Certain other CCP
    contracts with suppliers require Headwaters to make minimum purchases.
    Actual sales and purchases under contracts with minimum requirements were
    $895,000 and $11,446,000, respectively, for 2003 and $1,021,000 and
    $12,498,000, respectively, for 2004. As of September 30, 2004, these minimum
    requirements are as follows.

                                                (in thousands)
                                        ----------------------------
                                            Minimum        Minimum
          Year ending September 30:           sales       purchases
         -----------------------------------------------------------
                    2005                     $  615       $13,459
                    2006                        515        11,790
                    2007                        375         8,981
                    2008                        375         7,427
                    2009                        375         7,211
                 Thereafter                      63        14,650
                                       ----------------------------
                                             $2,318       $63,518
                                       ============================

    Headwaters currently pays a minimum royalty totaling $500,000 per year on
    certain net sales. If Headwaters terminates the royalty agreement, a
    one-time payment of $500,000 is required.

    Eldorado entered into an agreement with an entity which provides for that
    entity to manufacture and sell product to Eldorado. The agreement contains
    minimum purchase requirements during the initial term, which runs through
    October 2007, which aggregate approximately $1,918,000 at September 30,
    2004. Amounts purchased under this agreement for the four months ended
    September 30, 2004 totaled approximately $105,000. The agreement includes
    both a buy-out option and a put option which become operable under certain
    conditions.

                                      F-31
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Employee Benefit Plans - Headwaters' Board of Directors has approved three
    employee benefit plans that were operative during 2002, 2003 and 2004: the
    Headwaters Incorporated 401(k) Profit Sharing Plan, the 2000 Employee Stock
    Purchase Plan, and the Headwaters Incorporated Incentive Bonus Plan.
    Headwaters' Board of Directors also approved a General Employee Bonus Plan
    that was in place for 2004.

    Substantially all employees of Headwaters are eligible to participate in the
    401(k) and Stock Purchase Plans after meeting length of employment
    requirements. Only designated employees are eligible to participate in the
    Incentive Bonus Plan. The General Employee Bonus Plan covers substantially
    all employees not otherwise eligible to participate in any other
    performance-based bonus compensation arrangement (including the Incentive
    Bonus Plan and sales commission arrangements). Subsequent to September 30,
    2004, Headwaters' Board of Directors also approved a Deferred Compensation
    Plan for certain designated employees, which plan will be effective as of
    January 1, 2005.

    401(k) Plan. Under the terms of the 401(k) Plan, eligible employees may
    elect to make tax-deferred contributions of up to 50% of their compensation,
    subject to statutory limitations. Headwaters matches employee contributions
    up to a designated maximum rate and these matching contributions vest after
    a three-year period. Headwaters is not required to be profitable to make
    matching contributions.

    Stock Purchase Plan. The 2000 Employee Stock Purchase Plan provides eligible
    employees with an opportunity to increase their proprietary interest in
    Headwaters by purchasing Headwaters common stock on favorable terms and to
    pay for such purchases through payroll deductions. A total of 500,000 shares
    of common stock were initially reserved for issuance under the Plan, and
    approximately 307,000 shares are available for future issuance as of
    September 30, 2004. Under the Plan, employees purchase shares of stock
    directly from Headwaters, which shares are made available from treasury
    shares repurchased on the open market. The Plan is intended to comply with
    Section 423 of the Internal Revenue Code, but is not subject to the
    requirements of ERISA. Employees purchase stock through payroll deductions
    of 1% to 10% of cash compensation, subject to certain limitations. The stock
    is purchased in a series of quarterly offerings. The cost per share to the
    employee is 85% of the lesser of the fair market value at the beginning or
    the end of the offering period.

    Incentive Bonus Plan. The Incentive Bonus Plan, approved annually by the
    Compensation Committee of the Board of Directors, provides for annual cash
    bonuses to be paid if Headwaters accomplishes certain financial goals and if
    participating employees meet individual goals. A participant's cash bonus is
    based on Headwaters' success in meeting specified financial performance
    targets approved by the Compensation Committee of the Board of Directors,
    the employee's base pay, and individual performance during the year.
    Headwaters' financial goals are based upon an economic value added concept
    ("EVA") that purports to more closely align with a company's share price
    performance than other measurements of performance.

    General Bonus Plan. Under terms of the General Employee Bonus Plan, a
    participant's cash bonus is based on the employee's base pay, individual
    performance during the year and / or the performance of the employee's work
    unit.

    Acquired Subsidiaries' Benefit Plans. In addition to the plans described
    above, certain of the subsidiaries acquired by Headwaters in 2004 have or
    had employee benefit plan obligations. With the exception of Tapco's 401(k)
    Profit Sharing Plan, which will continue to operate through calendar 2005,
    all of these acquired subsidiaries' employee benefit plans have been or will
    be discontinued in the near future. Under the terms of Tapco's Profit
    Sharing Plan, Tapco has agreed to pay a certain percentage of most
    employees' salary into the Profit Sharing Plan on behalf of those employees.

    Total expense for all of Headwaters' benefit plans combined was
    approximately $3,300,000 in 2002, $5,768,000 in 2003 and $14,862,000 in
    2004.

    Medical Insurance - Effective January 1, 2003, Headwaters adopted a
    self-insured medical insurance plan for its employees and the employees of
    all of its subsidiaries existing at that time. For the plan year ending
    December 31, 2004, there is stop-loss coverage for amounts in excess of
    $100,000 per individual and approximately $7,500,000 in the aggregate.
    Headwaters has contracted with a third-party administrator to assist in the
    payment and administration of claims. Insurance claims are recognized as
    expenses when incurred and include an estimate of costs for claims incurred

                                      F-32
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    but not reported at the balance sheet date. As of September 30, 2004,
    approximately $900,000 is accrued for claims incurred from January through
    September 30, 2004 that have not been paid or reported.

    Tapco also has a self-insured medical insurance plan covering substantially
    all of its employees. This plan is administered by a third party and has
    stop-loss coverage for amounts in excess of $125,000 per individual per
    year. As of September 30, 2004, approximately $662,000 is accrued for claims
    incurred that have not been paid or reported.

    Employment Agreements - Headwaters and its subsidiaries have entered into
    long-term employment agreements with its Chief Executive Officer and 24
    other officers and employees. The agreements have original terms ranging
    from two to five years and are generally renewable by Headwaters, usually
    for one-year terms. They provide for annual salaries currently ranging from
    approximately $67,000 to $400,000 annually per person. The annual commitment
    under all agreements combined is currently approximately $3,715,000.
    Generally, the agreements provide for termination benefits, ranging from six
    months' salary up to a maximum period equal to the remaining term of the
    agreement.

    Incentive Agreements with ISG Principals - In January 2003, Headwaters
    executed incentive agreements with three of the former stockholders and
    officers of ISG, all of whom were officers of either Headwaters or ISG
    following the ISG acquisition. The agreements called for contingent payments
    totaling up to $5,000,000 in the event of (i) a change in control, as
    defined, or (ii) continuing employment through September 2004 and an average
    stock price for Headwaters' common stock for any calendar quarter exceeding
    $20 per share. The maximum payments would have been required if there had
    been a change in control prior to October 2004, or if the officers remained
    employed through September 2004 and the average stock price for any calendar
    quarter reached $25 per share or more. During 2004, two of the three
    officers resigned their positions and Headwaters recorded an expense for
    $1,500,000 related to the obligation to the remaining officer.

    Property, Plant and Equipment - As of September 30, 2004, Headwaters was
    committed to spend approximately $11,000,000 to complete capital projects
    that were in various stages of completion.

    Solid Alternative Fuel Facility - In September 2004, Headwaters purchased a
    9% variable interest in an entity that owns and operates a coal-based solid
    alternative fuel production facility, where Headwaters is not the primary
    beneficiary. Headwaters' minority interest was acquired in exchange for an
    initial cash payment of $250,000 and an obligation to pay $7,500,000 in
    monthly installments from October 2004 through December 2007. This
    obligation, recorded in other accrued liabilities and other long-term
    liabilities in the consolidated balance sheet, bears interest at an 8% rate.
    Headwaters also has agreed to make additional payments to the seller based
    on a pro-rata allocation of the tax credits generated by the facility, and
    its pro-rata share of operating expenses, also through December 2007. The
    alternative fuel produced at the facility through December 2007 qualifies
    for tax credits pursuant to Section 29 of the Internal Revenue Code, and
    Headwaters is entitled to receive its pro-rata share of such tax credits
    generated.

    Headwaters has also agreed to purchase an additional 10% interest in the
    entity upon the earlier of receipt of a private letter ruling for the
    facility from the IRS, or June 17, 2005. At such time, Headwaters will be
    required to make an additional cash payment of $250,000 and pay an
    additional $7,500,000, plus interest, through December 2007, along with
    other related payments, all as described above. At the time Headwaters
    purchases the additional 10% interest, Headwaters' pro-rata share of the tax
    credits will also increase. Headwaters has the ability, under certain
    conditions, to limit its liability under the fixed payment obligations of
    $7,500,000 (increasing to $15,000,000); therefore, Headwaters' obligation to
    support the facility's future operations and make all of the above-described
    payments is effectively limited to the tax benefits Headwaters receives.

    Joint Venture Obligations - In September 2004, Headwaters entered into an
    agreement with an international chemical company, based in Germany, to
    jointly develop and commercialize a process for the direct synthesis of
    hydrogen peroxide. Under terms of the joint venture agreement, Headwaters
    paid $1,245,000 for its investment in the joint venture and is further
    obligated to pay an additional $1,000,000 in 2005 and $1,000,000 in 2006.
    Headwaters has also committed to fund 50% of the joint venture's research
    and development expenditures, currently limited to (euro)3,000,000
    (approximately $3,700,000 at September 30, 2004), through September 2007.

                                      F-33
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Although there is no legal obligation to do so, the joint venture partners
    currently have long-range plans to eventually invest in large-scale hydrogen
    peroxide plants using the process for direct synthesis of hydrogen peroxide.

    Legal or Contractual Matters - Headwaters has ongoing litigation and claims
    incurred during the normal course of business, including the items discussed
    below. Headwaters intends to vigorously defend or resolve these matters by
    settlement, as appropriate. Management does not currently believe that the
    outcome of these matters will have a material adverse effect on Headwaters'
    operations, cash flows or financial position. In 2004, Headwaters accrued
    approximately $1,400,000 of reserves for legal matters because it concluded
    that claims and damages sought by claimants in excess of that amount were
    not probable. Our outside counsel believe that unfavorable outcomes are
    neither probable nor remote and declined to express opinions concerning the
    likely outcomes or liability of Headwaters. The reserves represent the
    amounts Headwaters would be willing to pay to reach a settlement. However,
    these cases raise difficult and complex legal and factual issues, and the
    resolution of these issues is subject to many uncertainties, including the
    facts and circumstances of each case, the jurisdiction in which each case is
    brought, and the future decisions of juries, judges, and arbitrators.
    Therefore, although management believes that the claims asserted against
    Headwaters in the named cases lack merit, there is a possibility of material
    losses in excess of the amounts accrued if one or more of the cases were to
    be determined adversely against Headwaters for a substantial amount of the
    damages asserted. Headwaters believes the range of potential loss is from
    $1,400,000 up to the amounts sought by claimants. It is possible that a
    change in the estimates of probable liability could occur, and the changes
    could be significant. Additionally, as with any litigation, these
    proceedings require that Headwaters incur substantial costs, including
    attorneys' fees, managerial time, and other personnel resources and costs in
    pursuing resolution. Costs paid to outside legal counsel for litigation,
    which comprise the majority of Headwaters' litigation-related costs, totaled
    approximately $1,700,000 in 2002, $3,000,000 in 2003, and $3,800,000 in
    2004. It is not possible to estimate what these costs will be in future
    periods.

    Boynton. In October 1998, Headwaters entered into a technology purchase
    agreement with James G. Davidson and Adtech, Inc. The transaction
    transferred certain patent and royalty rights to Headwaters related to a
    synthetic fuel technology invented by Davidson. (This technology is distinct
    from the technology developed by Headwaters.) This action is factually
    related to an earlier action brought by certain purported officers and
    directors of Adtech, Inc. That action was dismissed by the United States
    District Court for the Western District of Tennessee and the District
    Court's order of dismissal was affirmed on appeal. In the current action,
    the allegations arise from the same facts, but the claims are asserted by
    certain purported stockholders of Adtech. In June 2002, Headwaters received
    a summons and complaint from the United States District Court for the
    Western District of Tennessee alleging, among other things, fraud,
    conspiracy, constructive trust, conversion, patent infringement and
    interference with contract arising out of the 1998 technology purchase
    agreement entered into between Davidson and Adtech on the one hand, and
    Headwaters on the other. The plaintiffs seek declaratory relief and
    compensatory damages in the approximate amount of between $15,000,000 and
    $25,000,000 and punitive damages. The District Court has dismissed all
    claims against Headwaters except conspiracy and constructive trust. The
    Court has scheduled trial for April 2005. Because the resolution of the
    litigation is uncertain, legal counsel cannot express an opinion as to the
    ultimate amount, if any, of Headwaters' liability.

    AGTC. In March 1996, Headwaters entered into an agreement with AGTC and its
    associates for certain services related to the identification and selection
    of synthetic fuel projects. In March 2002, AGTC filed an arbitration demand
    in Salt Lake City, Utah claiming that it is owed commissions under the 1996
    agreement for 8% of the revenues received by Headwaters from the Port Hodder
    project. AGTC is seeking approximate damages in the arbitration between
    $520,000 and $14,300,000. Headwaters asserts that AGTC did not perform under
    the agreement and that the agreement was terminated and the disputes were
    settled in July 1996. Headwaters filed an answer in the arbitration, denying
    AGTC's claims and asserting counterclaims against AGTC. The arbitrator
    conducted hearings during July and August of 2004 and has received a
    post-arbitration briefing but has not yet issued a decision. Because the
    resolution of the arbitration is uncertain, legal counsel cannot express an
    opinion as to the ultimate amount, if any, of Headwaters' liability.

    AJG. In December 1996, Headwaters entered into a technology license and
    proprietary chemical reagent sale agreement with AJG Financial Services,
    Inc. The agreement called for AJG to pay royalties and to purchase

                                      F-34
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    proprietary chemical reagent material from Headwaters. In October 2000,
    Headwaters filed a complaint in the Fourth District Court for the State of
    Utah against AJG alleging that it had failed to make payments and to perform
    other obligations under the agreement. Headwaters asserts claims including
    breach of contract, declaratory judgment, unjust enrichment and accounting
    and seeks money damages as well as other relief. AJG's answer to the
    complaint denied Headwaters' claims and asserted counter-claims based upon
    allegations of misrepresentation and breach of contract. AJG seeks
    compensatory damages in the approximate amount of $71,000,000 and punitive
    damages. Headwaters has denied the allegations of AJG's counter-claims. The
    court has scheduled trial for January 2005. Because the resolution of the
    litigation is uncertain, legal counsel cannot express an opinion as to the
    ultimate amount of recovery or liability. McEwan. In 1995, Headwaters
    granted stock options to a member of its board of directors, Lloyd McEwan.
    The director resigned from the board in 1996. Headwaters has declined
    McEwan's attempts to exercise most of the options on grounds that the
    options terminated. In June 2004, McEwan filed a complaint in the Fourth
    District Court for the State of Utah against Headwaters alleging breach of
    contract, breach of implied covenant of good faith and fair dealing, fraud,
    and misrepresentation. McEwan seeks declaratory relief as well as
    compensatory damages in the approximate amount of $2,750,000 and punitive
    damages. Headwaters has filed an answer denying McEwan's claims and has
    asserted counterclaims against McEwan. Because resolution of the litigation
    is uncertain, legal counsel cannot express an opinion as to the ultimate
    amount of liability or recovery.

    Headwaters Construction Materials Matters. There are litigation and pending
    and threatened claims made against certain subsidiaries of Headwaters
    Construction Materials with respect to several types of exterior finish
    systems manufactured and sold by its subsidiaries for application by
    contractors on residential and commercial buildings. Typically, litigation
    and these claims are controlled by such subsidiaries' insurance carriers.
    The plaintiffs or claimants in these matters have alleged that the
    structures have suffered damage from latent or progressive water penetration
    due to some alleged failure of the building product or wall system. The most
    prevalent type of claim involves alleged defects associated with components
    of an Exterior Insulation and Finish System ("EIFS") which was produced for
    a limited time (through 1997) by Best Masonry & Tool Supply and Don's
    Building Supply. There is a 10-year projected claim period following
    discontinuation of the product.

    Typically, the claims cite damages for alleged personal injuries and
    punitive damages for alleged unfair business practices in addition to
    asserting more conventional damage claims for alleged economic loss and
    damage to property. To date, claims made against such subsidiaries have been
    paid by their insurers, with the exception of minor deductibles, although
    such insurance carriers typically have issued "reservation of rights"
    letters to Headwaters Resources. None of the cases has gone to trial, and
    while two such cases involve 100 and 800 homes, respectively, none of the
    cases includes any claims formally asserted on behalf of a class. While, to
    date, none of these proceedings have required that Headwaters Resources
    incur substantial costs, there is no guarantee of insurance coverage or
    continuing coverage. These and future proceedings may result in substantial
    costs to Headwaters Resources, including attorneys' fees, managerial time
    and other personnel resources and costs. Adverse resolution of these
    proceedings could have a materially negative effect on Headwaters Resources'
    business, financial condition, and results of operation, and its ability to
    meet its financial obligations. Although Headwaters Resources carries
    general and product liability insurance, Headwaters Resources cannot assure
    that such insurance coverage will remain available, that Headwaters
    Resources' insurance carrier will remain viable, or that the insured amounts
    will cover all future claims in excess of Headwaters Resources' uninsured
    retention. Future rate increases may also make such insurance uneconomical
    for Headwaters Resources to maintain. In addition, the insurance policies
    maintained by Headwaters Resources exclude claims for damages resulting from
    exterior insulating finish systems, or EIFS, that have manifested after
    March 2003. Because resolution of the litigation and claims is uncertain,
    legal counsel cannot express an opinion as to the ultimate amount, if any,
    of Headwaters Resources' liability.

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

    Section 29 Matters (Unaudited)- Headwaters Energy Services' license fees and
    revenues from sales of chemical reagents depend on the ability of licensees
    and customers to manufacture and sell qualified synthetic fuels that
    generate tax credits under Section 29 of the Internal Revenue Code. From
    time to time, issues arise as to the availability of tax credits, including
    the items discussed below.

                                      F-35
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    Legislation. Under current law, Section 29 tax credits for synthetic fuel
    produced from coal expire on December 31, 2007. In addition, there have been
    initiatives from time to time to consider the early repeal or modification
    of Section 29. For example, during 2004, a bill was introduced in the United
    States House of Representatives that would repeal the Section 29 credit for
    synthetic fuel produced from coal. Although it is unlikely that the bill
    will pass Congress in 2004, the bill could be reintroduced in 2005. If
    Section 29 expires at the end of 2007 or if it is repealed or adversely
    modified, synthetic fuel facilities would probably either close or
    substantially curtail production. At this time, given current prices of coal
    and costs of synthetic fuel production, Headwaters does not believe that
    production of synthetic fuel will be profitable absent the tax credits. In
    addition, if Headwaters' licensees close their facilities or materially
    reduce production activities (whether after 2007, upon earlier repeal or
    adverse modification of Section 29 or for any other reason), it would have a
    material adverse effect on the revenues and net income of Headwaters.

    Phase-Out. Section 29 tax credits are subject to phase-out after the average
    annual wellhead domestic oil price ("reference price") reaches a beginning
    phase-out threshold price, and is eliminated entirely if the reference price
    reaches the full phase-out price. For 2003, the reference price was $27.56
    per barrel and the phase-out range began at $50.14 and would have fully
    phased out tax credits at $62.94 per barrel. For 2004, an estimated partial
    year reference price (through September) is $40.48 per barrel, and an
    estimate of the phase-out range (using 2% inflation) begins at $51.14 and
    completes phase-out at $64.20 per barrel. The NYMEX one-day futures trading
    price on December 1, 2004 was $45.49 per barrel.

    IRS Audits. Licensees are subject to audit by the IRS. The IRS may challenge
    whether Headwaters Energy Services' licensees satisfy the requirements of
    Section 29, or applicable Private Letter Rulings, including
    placed-in-service requirements, or may attempt to disallow Section 29 tax
    credits for some other reason. The IRS has initiated audits of certain
    licensee-taxpayers who claimed Section 29 tax credits, and the outcome of
    any such audit is uncertain. In 2004, a licensee announced that IRS field
    auditors had issued a notice of proposed adjustment challenging the
    placed-in-service date of three of its synthetic fuel facilities. The
    licensee believes that the facilities meet the placed-in-service
    requirement, however, the timing and final results of the audit are unknown.
    The inability of a licensee to claim Section 29 tax credits would reduce
    Headwaters' future income from the licensee.

    Senate Permanent Subcommittee on Investigations. On October 29, 2003, the
    Permanent Subcommittee on Investigations of the Government Affairs Committee
    of the United States Senate issued a notification of pending investigations.
    The notification listed the synthetic fuel tax credit as a new item. In
    March 2004, the Subcommittee described its investigation as follows: "The
    Subcommittee is continuing its investigation [of] tax credits claimed under
    Section 29 of the Internal Revenue Code for the sale of coal-based synthetic
    fuels. This investigation is examining the utilization of these tax credits,
    the nature of the technologies and fuels created, the use of these fuels,
    and others [sic] aspects of Section 29. The investigation will also address
    the IRS' administration of Section 29 tax credits." The Subcommittee
    conducted numerous interviews and received large volumes of data between
    December 2003 and March 2004. Since that time, to Headwaters' knowledge,
    there has been little activity regarding the investigation. Headwaters
    cannot make any assurances as to the timing or ultimate outcome of the
    Subcommittee investigation, nor can Headwaters predict whether Congress or
    others may conduct investigations of Section 29 tax credits in the future.
    The Subcommittee investigation may have a material adverse effect on the
    willingness of buyers to engage in transactions to purchase synthetic fuel
    facilities or on the willingness of current owners to operate their
    facilities, and may materially adversely affect Headwaters' revenues and net
    income.

    License Fees - Pursuant to the contractual terms of an agreement with a
    certain licensee, the license fees owed to Headwaters, which accumulated
    during a period of approximately two and a half years, were placed in escrow
    for the benefit of Headwaters, pending resolution of an audit of the
    licensee by the IRS.

    Prior to December 31, 2003, certain accounting rules governing revenue
    recognition, requiring that the seller's price to the buyer be "fixed or
    determinable" as well as reasonably certain of collection, appeared to
    preclude revenue recognition for the amounts placed in escrow because they
    were potentially subject to adjustment based on the outcome of the IRS
    audit. Accordingly, none of the escrowed amounts were recognized as revenue
    in the consolidated statements of income through December 31, 2003. During

                                      F-36
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


    the March 2004 quarter, the fieldwork for the tax audit of the licensee was
    completed and there were no proposed adjustments to the tax credits claimed
    by the licensee. As a result, in March 2004 Headwaters recognized revenue,
    net of the amount Headwaters was required to pay to a third party, relating
    to the funds deposited in the escrow account totaling approximately
    $27,900,000. Approximately $3,000,000 of this amount related to revenue
    recorded in the March 2004 quarter and approximately $25,000,000 was
    recorded as revenue related to prior periods. Interest income of
    approximately $164,000 was also recognized. During the June 2004 quarter,
    the IRS completed its administrative review of the licensee's tax audit and
    the escrowed amounts were disbursed from the escrow account and paid to
    Headwaters.

    In addition to the escrowed amounts, this same licensee has also set aside
    substantial amounts for working capital and other operational contingencies
    as provided for in the contractual agreements. These amounts may eventually
    be paid out to various parties having an interest in the cash flows from the
    licensee's operations, including Headwaters, if they are not used for
    working capital and other operational contingencies. As a result, Headwaters
    currently expects to receive at some future date a portion of those
    reserves, the amount of which is not currently determinable and therefore,
    not recognizable.

15. Related Party Transactions

    In addition to transactions disclosed elsewhere, Headwaters was involved in
    the following related party transactions during 2002, 2003 and 2004.
    Headwaters purchases certain insurance benefits for its employees from
    various insurance companies for which a director of Headwaters acts as a
    broker or agent. Gross payments to those insurance companies totaled
    approximately $532,000 in 2002, $510,000 in 2003 and $1,215,000 in 2004.

    Eldorado purchases product from an entity located in Mexico in which an
    officer of Eldorado has a minority ownership interest. Costs incurred for
    materials purchased from this entity were approximately $2,712,000 in 2004.
    A majority of SCP's transportation costs are paid to a company, two of the
    principals of which are related to an officer of SCP. Costs incurred in 2004
    totaled approximately $970,000.

16. Quarterly Financial Data (unaudited)

    Summarized unaudited quarterly financial data for 2003 and 2004 is as
    follows.
<TABLE>
<CAPTION>

                                                                                2003
                                                  -----------------------------------------------------------------
                                                     First       Second        Third        Fourth
    (in thousands, except per-share data)           quarter      quarter      quarter    quarter (2)    Full year
    ---------------------------------------------------------------------------------------------------------------
    <S>                                              <C>          <C>          <C>           <C>          <C>
      Net revenue                                    $ 88,709     $ 86,053     $106,396      $106,472     $387,630
      Gross profit (1)                                 30,733       29,394       34,974        34,284      129,385
      Net income (2)                                    8,052        6,789       10,544        11,246       36,631
      Basic earnings per share                           0.30         0.25         0.39          0.41         1.35
      Diluted earnings per share                         0.29         0.24         0.37          0.40         1.30
<CAPTION>
                                                                                2004
                                                  -----------------------------------------------------------------
                                                     First       Second        Third        Fourth
    (in thousands, except per-share data)           quarter    quarter (3)  quarter (3)  quarter (3)    Full year
    ---------------------------------------------------------------------------------------------------------------
    <S>                                              <C>          <C>          <C>           <C>          <C>
      Net revenue                                    $101,469     $119,521     $134,318      $198,647     $553,955
      Gross profit (1)                                 37,098       57,706       46,446        70,498      211,748
      Net income (3)                                   10,092       18,627       16,060        19,538       64,317
      Basic earnings per share                           0.36         0.57         0.48          0.59         2.02
      Diluted earnings per share                         0.35         0.55         0.47          0.57         1.95
-----------------
</TABLE>
(1)     Gross profit is derived by subtracting cost of revenues and industry
        segment depreciation expense from total revenue.

                                      F-37
<PAGE>

                             HEADWATERS INCORPORATED

              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
                               September 30, 2004
                                   ___________


(2)     In the fourth quarter of 2003, revenue and net income were negatively
        affected by IRS actions which caused certain licensees to temporarily
        reduce or stop solid alternative fuel production, which caused a decline
        in license fees and sales of chemical reagents. Also in the fourth
        quarter of 2003, Headwaters recorded income tax expense at an effective
        income tax rate of approximately 37%, compared to an effective income
        tax rate of approximately 40% for the first nine months of the year. The
        lower rate for the fourth quarter was required to reduce the effective
        income tax rate for the year to approximately 39%. This reduction was
        primarily a result of lower expected state income tax expense.

(3)     In the second quarter of 2004 Headwaters recognized revenue relating to
        funds deposited in an escrow account totaling approximately $27,900,000,
        most of which related to prior periods (see Note 14). In addition,
        revenue and net income for the third and fourth quarters of 2004 were
        materially affected by the 2004 acquisitions (see Note 3).

                                      F-38