# 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, 2006,

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
1-32459

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

|                                                |  |                                         
|----------------------------------------------- |  | ----------------------------------------
|Delaware                                        |  | 87-0547337                              
|(State or other jurisdiction

of incorporation) |  | (I.R.S. Employer

Identification Number)



|                                                             |  |           
|------------------------------------------------------------ |  | ----------
|10653 South River Front Parkway, Suite 300

South Jordan, UT |  | 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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of
the Securities Act.x

Indicate
by check mark if the registrant is not required to file reports pursuant to Section 13 or
Section 15(d) of the Act. ̈

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. YesxNo ̈

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.x

Indicate
by check mark whether the registrant is a large accelerated filer, an accelerated filer,
or a non-accelerated filer.

Large accelerated filer
x Accelerated filer ̈Non-accelerated filer
 ̈

Indicate
by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Act).  Yes  ̈Nox

The
aggregate market value of the voting stock held by non-affiliates of the registrant as of
March 31, 2006 was $1,631,587,796, based upon the closing price on the New York Stock
Exchange 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 15, 2006
was 42,319,651.

_________________

# DOCUMENTS INCORPORATED
BY REFERENCE

Portions
of the registrants definitive proxy statement to be issued in connection with
registrants annual meeting of stockholders to be held in 2007 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                                            | 3 
|-------- | --------------------------------------------------- | --
|ITEM 1A. | RISK FACTORS                                        | 14
|ITEM 1B. | UNRESOLVED STAFF COMMENTS                           | 24
|ITEM 2.  | PROPERTIES                                          | 24
|ITEM 3.  | LEGAL PROCEEDINGS                                   | 25
|ITEM 4.  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS | 26

# PART II

|ITEM 5.  | MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES | 27
|-------- | ------------------------------------------------------------------------------------------------------------ | --
|ITEM 6.  | SELECTED FINANCIAL DATA                                                                                      | 27
|ITEM 7.  | MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                        | 28
|ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                   | 43
|ITEM 8.  | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                  | 43
|ITEM 9.  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                         | 43
|ITEM 9A. | CONTROLS AND PROCEDURES                                                                                      | 43
|ITEM 9B. | OTHER INFORMATION                                                                                            | 45

# PART III

|ITEM 10. | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                             | 46
|-------- | ---------------------------------------------------------------------------------------------- | --
|ITEM 11. | EXECUTIVE COMPENSATION                                                                         | 46
|ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS | 46
|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                 | 46
|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                         | 46

# PART IV

|ITEM 15. | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES | 47
|-------- | ------------------------------------------ | --

| | SIGNATURES | 50
| | ---------- | --

# 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 our future results that are
based on current expectations, estimates, forecasts, and projections about the industries
in which we operate and the beliefs and assumptions of our management. Actual results may
vary materially from such expectations. Words such as expects,
anticipates, targets, goals, projects,
believes, seeks, estimates, or variations of such
words and similar expressions, are intended to identify such forward-looking statements.
In addition, any statements that refer to projections of our future financial performance,
our anticipated growth and trends in our 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 risk factors described in
Item 1A hereof. There can be no assurance that our results of operations will not be
adversely affected by such factors. Unless legally required, we undertake 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.

Our internet address is
www.headwaters.com. There we make available, free of charge, our annual report on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments
to those reports, as soon as reasonably practicable after we electronically file such
material with, or furnish it to, the Securities and Exchange Commission (SEC).
Our reports can be accessed through the investor relations section of our web site. The
information found on our web site is not part of this or any report we file with or
furnish to the SEC.

2

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# PART I

# ITEM 1. BUSINESS

# General Development of
Business

Introduction. Headwaters Incorporated (Headwaters) is a diversified company
          providing products, technologies and services in two industries: construction
          materials, including coal combustion products, and alternative energy.
          Headwaters uses technology to differentiate itself from competitors and to
          create value in its businesses.

In
the construction materials sector, Headwaters designs, manufactures, and sells
architectural stone and resin-based exterior siding accessories (such as shutters,
mounting blocks, and vents) and related products. We believe that we have a leading market
position in our principal construction materials businesses. Headwaters is also a
nationwide leader in the management and marketing of coal combustion products, including
fly ash used as a substitute for portland cement. Headwaters believes it is uniquely
positioned to manufacture an array of construction materials that use fly ash, such as
block, stucco, and mortar. Revenue from our construction materials and coal combustion
products businesses are diversified geographically and also by market, including the new
construction, remodeling and home improvement markets.

In
the alternative energy sector, Headwaters is focused on reducing waste and increasing the
value of energy feedstocks, primarily in the areas of low-value coal and oil. In coal, we
own and operate two coal reclamation facilities that remove rock, dirt, and other
impurities from waste coal, resulting in higher-value, marketable coal. We also license
technology and sell reagents to the coal-based solid alternative fuel industry. In oil, we
believe that Headwaters heavy oil upgrading technology represents a substantial
improvement over current refining technologies. Headwaters heavy oil upgrading
process uses a liquid catalyst precursor to generate a highly active molecular catalyst to
convert residual oil feedstocks into higher-value distillates that can be refined into
gasoline, diesel and other products. In addition, Headwaters is constructing its first
ethanol plant and proceeding with the commercialization of multiple catalyst technologies.

Headwaters
Company History. Headwaters is incorporated in Delaware. Headwaters stock trades
under the New York Stock Exchange symbol HW.

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; Headwaters
Resources, Inc. and its subsidiaries; Headwaters Construction Materials, Inc. and its
subsidiaries (including Eldorado Stone LLC and Tapco International Corporation and their
subsidiaries and affiliates); Headwaters Heavy Oil, LLC; and Headwaters Technology
Innovation, LLC; 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; HCM refers to Headwaters Construction Materials,
Inc., together with its consolidated subsidiaries and affiliates (including
Eldorado, which refers to Eldorado Stone LLC and its subsidiaries and
affiliates; and Tapco, which refers to Tapco International Corporation and its
subsidiaries); HTI refers to Headwaters Technology Innovation, LLC; and
HHO refers to Headwaters Heavy Oil, LLC unless the context otherwise requires.

_________________

# Construction Materials

Headwaters
Construction Materials (HCM) produces construction materials that minimize
waste, conserve natural resources, and/or use less energy in manufacturing or application.
In 2004, we acquired market leading businesses in manufactured architectural stone
products and siding accessories (such as window shutters, gable vents and mounting blocks)
and professional tools used in exterior residential remodeling and construction. Since
that time we have expanded the business organically and through small strategic
acquisitions. Our manufactured stone and building accessories products have a national
presence in commercial, residential and remodeling markets. HCM is also a leading supplier
of concrete blocks in Texas. We believe our traditional building products and new product
offerings position HCM for significant growth. We participate in what we believe to be two
of the highest growth segments within the siding industry, manufactured stone and
specialty siding.

3

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Principal
Products and their Markets

Manufactured
Stone. Under the Eldorado Stone®, StoneCraft, and Dutch Quality Stone
brands, we offer a wide variety of high-quality, hand-made manufactured stone products to
meet a variety of design needs. Our manufactured architectural 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. The Eldorado Stone product line has been designed and is manufactured to be
one of the most realistic architectural stone products in the world. Headwaters
architectural stone siding is a lightweight, adhered siding product used by national,
regional and local architectural firms, real estate developers, contractors, builders and
homeowners. Our stone products are 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 Stone
product line is used in a variety of external and internal home applications such as
walls, archways, fireplaces and landscaping. In 2006, we introduced an architectural brick
veneer product. We also sell Syndecrete®, a light-weight cement-based
composite using natural minerals and recycled materials. It is used primarily in custom
countertops and outdoor tiles. Headwaters believes that our focus on product quality,
breadth and innovation, combined with a geographically diversified manufacturing platform,
provides us with significant marketing advantages over traditional materials such as
natural stone, brick or stucco.

Exterior
Siding Accessories. We are a leading designer, manufacturer and marketer of
resin-based siding accessories and professional tools used in exterior residential home
improvement and construction under the Tapco brands. These products, which are either
injection-molded or extruded, enhance the appearance of homes and include decorative
window shutters, gable vents, and mounting blocks for exterior fixtures, roof ventilation,
window and door trim products, specialty siding products, synthetic roofing tiles, and
window well systems. 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.

The
Tapco brands include Tapco Integrated Tool Systems, Mid-America Siding
Components, Builders Edge, Atlantic Premium Shutters,
Vantage, The Foundry, InSpire, and
WellCraft. We market our injection-molded building product accessories to
retailers and mass merchandisers through our Builders Edge and Vantage brands and to the
manufactured housing market through the MHP brand. In addition, we market tools through
the Tapco brand, functional shutters and storm protection systems through the Atlantic
Premium Shutters brand, specialty siding product through the Foundry brand, specialty
roofing products through the InSpire brand, and window wells under the WellCraft brand.

These
building products serve the needs of the siding, roofing, and window and door installation
industries. Our 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 enhance the exterior appearance of the
home and can be manufactured to meet certain hurricane codes.

Concrete
Block.HCM is one of the largest manufacturers and sellers of concrete block in the
Texas market, one of Americas largest block markets. We use fly ash in the
manufacturing process for concrete block, brick and foundation blocks. We also market
mortar and stucco under the Best Masonry and Magna Wall®brands.

Manufacturing

Headwaters
architectural stone brands are currently manufactured through a network of eight plants
strategically situated in proximity to customers. These locations allow for a high level
of customer service, shorter lead times and lower freight costs. We also have a production
contract with a facility in Tijuana, Mexico.

We
conduct manufacturing, distribution and sales operations for resin-based accessories and
ancillary products through 12 facilities, which total approximately 1.1 million square
feet. Manufacturing assets include more than 100 injection molding presses, almost all of
which are automated through robotics or conveyor systems which has reduced cycle times and
helped reduce waste. Any nonconforming plastic parts are reused as raw material, further
minimizing waste.

We
operate three of the most modern concrete block and brick manufacturing facilities in the
industry. Our block and brick operations are located to provide coverage of all the key
metropolitan areas in Texas.

4

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Distribution

Architectural
stone is distributed throughout the United States and Canada 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. We have three distribution centers for Eldorado Stone branded products.

Resin-based
accessories and our ancillary 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 our products to lumberyards and
one-step distributors, retail home centers/mass merchandisers, and manufactured housing.

We
seek to be a leader in each meaningful distribution channel for our products by providing
the broadest selection coupled with high levels of customer service.

Sales
and Marketing

We
have a small direct sales force for architectural stone products. This 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.

Our
resin-based products 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 business
development managers, regional sales managers and sales executives.

We
maintain relationships with local contractors, professional builders, and other end-users
by participating in over 2,000 local shows and seven national shows annually. Local shows,
sponsored by local distributors, enable us to promote our products through hands-on
comparisons to competing products. These shows enable us to receive useful feedback from
local contractors, which leads to new product ideas, as well as significant goodwill
within the trade.

Major
Customers

We have a large customer base for our construction products. 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, we have
approximately 6,100 non-retail ship-to locations and approximately 7,400 retail ship-to
locations for our products. Sales are broadly diversified across customers and ship-to
locations. For fiscal 2006, three large customers together represented approximately 30%
of total sales of our resin-based accessory products. None of our other construction
materials businesses had a customer representing 10% of its product sales.

Sources
of Available Raw Materials

We purchase
cement, sand and aggregates as primary raw materials for our concrete-based products. We
do not have long-term contracts for the supply of these materials. World wide demand for
these materials has risen in recent years, as well as our costs to purchase raw materials.
However, we have not suffered from any long-term shortages and believe that supplies will
be adequate in the future.

The
raw materials purchased for resin-based products include polypropylene and styrene
pellets, plastic extrusions, and packaging materials. Polypropylene and styrene are
purchased primarily from single (separate) suppliers. From time to time, prices for some
of the raw materials used in production/assembly processes fluctuate significantly.
Although we do not have any contracts with suppliers and purchase supplies on a purchase
order basis, we occasionally make volume purchases of materials to lock in pricing.

# Coal Combustion Products

Principal
Products and their Markets

In
one of our construction materials businesses, we sell coal combustion products
(CCPs), such as fly ash and bottom ash, which are created when coal is burned.
CCPs have traditionally been an environmental and economic burden for power generators
but, when properly managed, can be valuable products. We supply CCPs as a replacement for
portland cement in a variety of concrete infrastructure projects and building products. We
are currently the largest manager and marketer of CCPs in the United States and also
manage and market CCPs in Canada and Puerto Rico. We have a number of long-term exclusive
management contracts with coal-fueled electric generating utilities throughout the United
States and provide CCP management services at more than 110 locations.

5

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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 we ship products
significant distances to states such as California and Florida that have limited
coal-fueled electric utilities producing high quality CCPs. We enjoy advantages in both
logistics and sales from our status as the largest manager and marketer of CCPs in the
United States. We maintain 26 stand-alone CCP distribution terminals across North America,
as well as approximately 100 plant-site supply facilities. We own or lease approximately
1,530 rail cars and more than 200 trucks, and also contract with other carriers so that we
can meet our transportation needs for the marketing and disposal of CCPs. In addition, we
have more than 50 area managers and technical sales representatives nationwide to manage
CCP customer relations.

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, decreasing permeability and enhancing durability. 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 U.S. Environmental Protection Agency (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. The value of utilizing fly ash in concrete
has been recognized by numerous federal agencies, including the United States Department
of Energy (DOE) and the 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.

Higher-quality
fly ash and other high-value CCPs have the greatest value because of the wide variety of
higher-margin commercial uses. 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. We assist our utility clients in their
efforts to improve the production of high-value CCPs at their facilities. A quality
control system ensures that customers have a specific quality of CCPs for various
applications while our investment in transportation equipment and terminal facilities
provides reliability of supply.

Sales
and Marketing

We
support our CCP marketing and 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. We undertake a variety of marketing activities to
increase fly ash sales. These activities include professional outreach, technical
publications, relationships with industry organizations, and involvement in legislative
initiatives leading to greater use of CCPs. In addition, we have developed several
specialty products that increase market penetration of CCPs and name recognition for our
products for road bases, structural fills, industrial fillers and 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,
our 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, we developed FlexCrete, a new commercial and residential building
product in its early commercialization stages. FlexCrete is an aerated concrete product
with approximately 50% fly ash content. We expect FlexCrete will offer advantages for
construction, including ease of use, physical strength, durability, energy efficiency,
fire resistance and environmental sensitivity.

Technologies
to Improve Fly Ash Quality. We have 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. We have addressed these challenges with the development
and/or commercialization of two technologies: carbon fixation, which pre-treats unburned
carbon particles in fly ash in order to minimize the particles adverse effects, and
ammonia slip mitigation, which counteracts the impact of ammonia contaminants in fly ash.
Designed to be simple, economical and highly effective, these technologies can be
implemented without the large capital expenditures often associated with controlling
quality problems.

6

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Sources
of Available Raw Materials

Coal
is the largest indigenous fossil fuel resource in the United States. The DOE estimates
that in 2005 annual coal production was in excess of 1.1 billion tons. About 92% of all
coal consumed in the United States was for electrical power generation. The DOE further
estimates that 2005 U.S. coal consumption for electrical power generation was slightly
more than one billion tons. Coal serves as a primary resource for baseline electricity
production in the United States and is 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, for 2005 about 49.6 million tons
of CCPs were beneficially used in the United States of the approximately 123.1 million
tons generated. 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, we believe we will have an adequate supply of CCP raw
materials.

# Alternative Energy

Headwaters
Energy Services Corp. (HES) is, we believe, the market leader in enhancing the
value of coal used in power generation through licensing technologies and selling chemical
reagents that convert coal into a solid alternative fuel. This solid alternative fuel
qualifies for tax credits under Section 45K of the Internal Revenue Code based upon the
Btu content of the alternative fuel produced and sold. The sale of qualified alternative
fuel enables facility owners who comply with certain statutory and regulatory requirements
to claim federal tax credits under Section 45K, which currently expires on December 31,
2007. We also develop and own coal cleaning facilities. These facilities provide HES with
an opportunity to reduce sulfur oxides (SOx), nitrogen oxides (NOx) and mercury emissions
from coal, greatly increasing coals cleanliness and usability. We also develop and
commercialize technologies to convert or upgrade fossil fuels into higher-value products,
including direct coal liquefaction, and the conversion of gas-to-liquid fuels.

Principal
Products and their Markets

HES
began its business with the development and commercialization of technologies that
interact with coal-based feedstocks to produce a solid alternative fuel intended to be
eligible for Section 45K (formerly Section 29) tax credits. Since the tax credits are
due to expire in 2007 and have been subject to phase out as a result of higher oil prices
(see Risk Factors), our strategy has been to develop new alternative fuel
business by taking advantage of our expertise.

New
Business Opportunities

As
part of our alternative energy strategy, we are developing the following businesses and
technologies:

Coal
Cleaning.HES has acquired an operating waste coal recovery facility and access to
approximately 150 million tons of waste coal material, which we estimate may provide
sufficient coal recovery to support the construction of up to three additional coal
cleaning facilities. HES uses coal cleaning processes that upgrade low value or waste coal
by separating ash from the carbon. The resultant coal product is lower in ash, including
sulfur, mercury and other impurities, and higher in Btu value. We are currently operating
two coal cleaning facilities in Utah and Alabama and are developing plans to build
additional facilities at various locations.

Ethanol. In 2006 HES entered into a joint venture with Great River Energy
          (GRE) of Elk River, Minnesota to develop and construct a 50 million
          gallon-per-year ethanol production facility. The joint venture is named Blue
          Flint Ethanol, LLC and is owned 51% by HES and 49% by GRE. The Blue Flint
          production facility is located at the GRE Coal Creek pulverized coal electric
          power station near Underwood, North Dakota. Coal Creek station will supply
          steam, water and other services to Blue Flint. Headwaters will operate the
          facility. The facility is expected to begin ethanol production in the first
          calendar quarter of 2007.

Coal
Drying. HES and GRE are developing a project to use coal drying technology
developed by GRE at its Coal Creek station. This technology utilizes waste heat from the
power plant to dry high moisture coal which will result in higher boiler efficiencies
during the combustion process. This technology can be utilized with lignite and other
high-moisture coals.

Coal
Liquefaction. We have technology for producing clean liquid fuels from
coal. This technology was evaluated during 2005 in a commercial pre-feasibility study
commissioned by Oil India Limited, a Government of India enterprise. Oil India is a public
sector company engaged in energy services in the Assam Region of northeastern India, an
area rich in natural resources but distant from established oil refining operations. HES
believes that its direct coal liquefaction (DCL) technology may assist Oil
India in converting the Assam regions abundant and soluble coal into transportation
fuels. The technology involved encompasses some of the same elements that the

7

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Shenhua Group, Chinas largest
coal company, purchased from an HES affiliate in 2004 for a DCL project in Majiata,
China. HES also has developed a catalyst specifically designed for application in
slurry-phase Fischer-Tropsch (FT) reactors that convert gaseous materials
into a range of liquid fuels and chemicals, e.g., propylene. When the FT process is
applied to gas derived from coal, the process is referred to as indirect coal
liquefaction (ICL). We have entered into agreements with the government of
the Philippines and with a private company in China, for feasibility and pilot plant
studies related to site-specific applications of our coal-to-liquids technologies,
including both direct and indirect coal liquefaction.

Heavy
Oil Upgrading Technology. We hold an exclusive, worldwide license to
develop, market and sublicense a unique heavy oil upgrading technology for the catalytic
hydrocracking of heavy residual oils such as petroleum vacuum residue (so-called
bottom of the barrel) and tar sand bitumen into lighter, more valuable
petroleum materials. The process uses a proprietary, highly active, molecular-scale
catalyst (HCATTM) to efficiently convert all components of heavy oils,
including the asphaltenic components, which are generally considered the most difficult to
process. In 2007, we plan to continue discussions with operators of several heavy oil
upgrading facilities (in the U.S. and overseas) to explore how the addition of this
technology to their existing refineries could increase product yields and reduce downtime
caused by equipment fouling with minimal modifications to the existing facilities. In
early 2006, we announced the completion of the first commercial scale demonstration of the
heavy oil upgrading technology at a large commercial refinery. Later in 2006,
we completed a second full scale refinery test of this technology. We are negotiating
contracts to sell the HCAT catalyst precursor material and license the associated process
to petroleum refiners.

Hydrogen
Peroxide. In September 2004, we 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, or H2O2. The venture aims to develop
or 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. In October 2005, the joint venture announced the success of pilot plant
operations. In October 2006, a demonstration plant in Germany was completed and began
startup operations. This demonstration plant is intended to prove how the
H2O2process performs on a larger scale, a prerequisite for
engineering a commercial scale H2O2project. In September 2006, we
and Degussa AG acquired a hydrogen peroxide plant in Korea to provide hydrogen peroxide to
SKC Chemicals for use in the manufacture of polypropylene. The joint venture plans to
expand the Korea facility, in part to demonstrate the direct synthesis of hydrogen
peroxide technology on a commercial scale. The joint venture is developing plans and
exploring markets to build additional hydrogen peroxide production facilities in other
strategic locations to help meet the expected world-wide growth in demand for
H2O2 as a chemical intermediate.

Section
45K Business

Licensees. We license technologies to produce solid alternative fuel from coal to 28 of our
          estimated total of 75 coal-based solid alternative fuel facilities in the United
          States. In addition, during fiscal 2006 Headwaters sold its proprietary chemical
          reagents to approximately 35 licensee and other alternative fuel facilities.
          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 45K.

Chemical
Reagent Sales. The transformation of the feedstock to an alternative fuel involves
the use of a chemical reagent in a qualified facility. We primarily market 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.

We
believe the benefits of our 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. We believe 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.

8

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During
2006, industry production of solid alternative fuel was severely curtailed or stopped
during the months of highest oil prices as facility owners evaluated the effect of oil
prices on the availability of Section 45K tax credits. The industrys significant,
albeit temporary, reduction in alternative fuel production during calendar 2006 caused a
material reduction in license fees and chemical reagent sales revenues to HES.

Sources
of Available Raw Materials and Inventory Requirements. Our chemical
reagents are produced by Dow Reichhold Specialty Latex LLC (Dow Reichhold). We
do not maintain or inventory any chemicals. Instead, HES arranges for the drop shipping of
the chemical reagents directly from Dow Reichholds production facilities to the
alternative fuel plants. The chemical reagents can be manufactured in Dow Reichhold plants
throughout North America allowing Headwaters to meet 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).

# Segments and Major
Customers

Headwaters
operates in three business segments, construction materials, CCPs and alternative energy.
Additional information about segments is presented in Note 3 to the consolidated financial
statements. Only one of our customers, Pace Carbon Fuels, L.L.C. and its affiliates, which
is in the alternative energy segment, accounted for more than 10% of total revenue during
2004 ($57.6 million in revenues, constituting 10.4% of total revenue). No customer
accounted for more than 10% of total revenue in 2005 or 2006.

# Research and Development

Headwaters
maintains a staff of engineers, scientists and technicians at HTI with expertise in the
design and operation of high-pressure and temperature process plants at its Lawrenceville,
New Jersey pilot plant and laboratory facilities. Among other technologies under
development, we have the capability to work at the molecular level in the composition,
aligning, spacing and adhering of nano-sized crystals of precious and transition metals on
substrate materials. The net effect is higher performance with lower precious metal
content, nearly 100% selectivity for certain chemical reactions (i.e., the desired
reaction is maximized with byproducts and waste minimized), long life and custom designed
nanocatalysts. Potential applications for this nanotechnology include new processes to
improve existing catalysts for chemical and refining processes. Applications under pilot
scale development include a naphtha reforming catalyst for gasoline blending and synthetic
fibers and plastics.

We
are also conducting laboratory testing on the application of the technology to volatile
organic compound oxidation, high performance catalysts for fuel cells and pharmaceuticals,
and production of nanomaterials and nanofillers such as carbon nanospheres and flame
retardants. We do not necessarily plan to commercially produce all of these products in
their highly competitive and regulated industries but we are exploring partnerships to
develop, manufacture and market nanocatalysts and other products.

The
following table presents Headwaters approximate research and development expenses
for the past three years.

| | 2004 |  | $7.6 million  | 
| | ---- |  | ------------- | 
| | 2005 |  | $12.6 million | 
| | 2006 |  | $13.5 million | 

# Competition

Each
of our business units experiences competition. Many of our competitors have greater
financial, management and other resources and may be able to take advantage of
acquisitions and other opportunities more readily.

Construction
Materials.Notwithstanding our national position as a leading producer of
manufactured architectural stone, we face significant competition from other national and
regional producers of similar products, and in particular from Owens Corning. Our primary
competition for resin-based products includes Alcoa and Pinckney in the accessories
market, and CertainTeed and Nailite in the specialty siding market. HCM has competition
from a number of larger manufacturers of mortars, stuccos and concrete masonry units. With
respect to concrete masonry units, national and regional competition includes Oldcastle,
Featherlite and Pavestone.

CCPs. The business of marketing traditional CCPs is intensely competitive. HRI has
          substantial competition in two main areas: obtaining CCP management contracts
          with utility and other industrial companies and marketing CCPs and related
          industrial materials. HRI has a presence in every region in the United States but, because the

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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 HRI has a number of long-term CCP management
contracts with its           clients, some of these contracts allow for the termination
of the contract at           the convenience of the utility company upon a minimum 90-day
notice. Moreover,           certain of HRIs 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.

Alternative
Fuels.Coal-based solid alternative fuels made using HESs technologies, from
which we derive license fee revenues and revenues from sales of chemical reagents, compete
with other alternative fuel products, as well as traditional fuels. For HES, competition
may come in the form of the marketing of competitive chemical reagents and the marketing
of end products qualifying as alternative fuel. HES 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.

HES
also experiences competition from traditional coal and fuel suppliers and natural resource
producers. Further, many industrial coal users are limited in the amount of alternative
fuel product they can purchase from HESs licensees because they have committed to
purchase a substantial portion of their coal requirements through long-term contracts for
standard coal. Our Blue Flint ethanol plant will experience significant competition from
many producers of ethanol and other biofuels throughout the United States.

Our
new technologies also experience competition from many of the worlds major energy
and chemical companies. Major catalyst developers include Johnson Matthey and Engelhard,
among others. Those companies are devoting significant resources to researching and
developing nanocatalysts and catalytic processes. These companies have greater financial,
management and other resources than we have.

Positive
and Negative Factors. There are positive and negative factors pertaining to our
competitive position.

Construction
Materials.We have developed a recognized name in the manufactured architectural
stone industry and a strong market share. Our products have excellent authenticity and
broad selection alternatives. Our architectural stone business 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. We have a leading market position in our siding accessories business
because of our strong ability to manufacture and distribute a broad range of products
economically and rapidly. However, our resin-based siding accessory business 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. Our block and bagged products business is
not national in breadth, although the block business enjoys a strong regional market
position in Texas. Where its market strength is limited, the bagged products businesses do
not have strong economies of scale or price leadership, and have only limited product
brand strength.

CCPs. Headwaters competitive position has positive factors of a leading
          market position and long-term contracts. In addition, we have built a nationwide
          CCP distribution system not enjoyed by our competition. However, our CCP
          business is sometimes adversely affected by inclement weather slowing concrete
          construction, the largest market for CCPs. We also face increasingly aggressive
          competition in marketing and sales of CCPs.

Alternative
Energy.HES enjoys the benefits of a leading market position in its Section 45K
licensing and reagent sales businesses, license agreements that extend through the life of
Section 45K, and a manufacturing process and reagent products that have withstood IRS
scrutiny. However, Section 45K is due to expire in 2007. From a broader alternative fuel
industry perspective, HES suffers from greater dependence on United States tax policy and
administration than some competitors in alternative fuels, including our coal cleaning and
coal drying businesses.

Most
of our business units are experiencing greater competition for key raw materials including
latex, styrene, polypropylene, cement and aggregates. This competition has contributed to
shortages and price increases for raw materials used by us.

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# Intellectual Property

Headwaters
has 146 U.S. patents and 94 U.S. patents pending. Additionally, Headwaters has 13 foreign
counterpart patents and 51 foreign patents pending. Of these, there are 95 patents and 49
patents pending in our construction products division, and 45 patents and 88 patents
pending which relate to our emerging technologies, including nanotechnology, heavy oil
upgrading and coal liquefaction.

Headwaters
has 98 U.S. trademarks and 36 U.S. trademark applications pending. Additionally,
Headwaters has 51 foreign trademark applications pending. Of these, there are 89
trademarks and 83 trademark applications pending in our construction products division.

Collectively,
the intellectual property is important to us, although there is no single patent or
trademark that is itself material to us at the present time.

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

In
addition to patent protection, we also rely on trade secrets, know-how and confidentiality
agreements to protect 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 our proprietary information is
important to our business, failure to protect ownership of our proprietary information
would likely have a material adverse effect on us.

# Regulation

Section
45K. Our coal-based solid alternative (or synthetic) fuel business is subject to
compliance with the terms of Section 45K (formerly Section 29) of the Internal Revenue
Code. By law, Section 45K tax credits for alternative fuel produced from coal expire on
December 31, 2007.

Tax
credits claimed by an alternative fuel plant operator are phased out prior to their
scheduled expiration date of December 31, 2007, if the reference price of
oil exceeds the lower end of a phase out range, and are eliminated entirely if the
reference price exceeds the higher end of that range, with the beginning and end of the
range being adjusted annually for inflation. Because the calendar year 2004 and 2005
reference prices of oil were below the bottom end of the range, there was no phase-out of
the credit for qualified fuel sold in 2004 or 2005. For calendar 2006, we estimate that
the phase-out range (computed by increasing the 2005 inflation adjustment factor by 2%)
begins at $54.27 and completes phase-out at $68.12 per barrel. While the calendar 2006
phase-out percentage can not be finalized at the current time, as of September 30, 2006,
an estimated phase-out percentage of 42% is our best estimate of what the phase-out
percentage for calendar 2006 would be, using available information as of that date. The
reference price of oil and the inflation adjustment factor are determined annually (and
released in the first week of 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 U.S. Energy Information Agencys estimate of the annual average
wellhead price per barrel for all domestic crude oil not subject to regulation by the U.S.
Tax credits are usually claimed by corporations according to the tax year in which the
alternative fuel is actually produced and sold, which may be different than the calendar
year. There are approximately 24 states/regions that comprise the U.S. average crude oil
price as determined by the United States Energy Information Administration, with western
U.S. crude oil prices often significantly lower than other, more recognized crude oil
types.

The
industry has relied upon the issuance of private letter rulings (PLRs) from the Internal
Revenue Service (IRS) to address various issues relating to Section 45K compliance. IRS
has suspended the issuance of PLRs to alternative fuel facility owners several times in
the past. Most recently, in June 2003, the IRS stated, in summary, 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 private letter rulings
regarding significant chemical change. In October 2003, the IRS stated in summary that it
continued to question whether processes it had approved under its long-standing ruling
practice produced the necessary level of chemical change required under Section 45K and a
related revenue ruling. Nonetheless, the IRS indicated that it would continue to issue
PLRs regarding chemical change under the standards set forth in previous revenue
procedures, and that the industrys chemical change test procedures and results were
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 alternative fuels industry.

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Licensees
are subject to audit by the IRS. The IRS may challenge whether our licensees satisfy the
requirements of Section 45K, or applicable PLRs, including placed-in-service requirements,
or may attempt to disallow Section 45K tax credits for some other reason. The IRS has
initiated audits of certain licensee-taxpayers who claimed Section 45K tax credits, and
the outcome of any such audit is uncertain. The inability of a licensee to claim Section
45K tax credits would reduce our future income from the licensee.

There
have been initiatives from time to time to consider the early repeal or modification of
Section 45K. For example, in 2005, a bill was introduced in the United States House of
Representatives that would have repealed the Section 45K credit for alternative fuel
produced from coal. While this bill did not pass Congress, it or other or similar
legislation could be reintroduced in the future. In addition, in October 2003 the United
States Senate Permanent Subcommittee on Investigations announced an investigation of
Section 45K and collected data in connection with the investigation, but has scheduled no
hearings on the topic.

Environmental. Our operations and those of our suppliers and customers involved in coal-based
          energy generation, primarily utilities, are subject to federal, state and local
          environmental regulation. Our coal-based solid synthetic fuel operations and
          those of our 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 us 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, together with our new coal cleaning businesses, we and our
          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
          our business. Any failure to comply could result in the issuance of substantial
          fines and penalties and cause us to incur environmental liabilities.

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

In
spite of safeguards, our 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, we 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. We also use 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. We generally hire 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.

Our
CCP business is dependent upon the recovery and processing of CCPs from our customers,
typically coal-burning power plants. These entities are highly regulated under federal and
state law, including the federal Clean Air Act of 1970 and subsequent amendments,
particularly the Clean Air Act Amendments of 1990, and corresponding state laws and EPA
rules, which regulate the emissions of materials, such as SOx and
NOx, into the air. 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 EPA has adopted National
Ambient Air Quality Standards, or NAAQS, for particulate matter and ozone, and states will
ultimately be required to revise their existing state implementation plans to attain and
maintain compliance with the NAAQS. Because electric utilities emit NOx, a precursor to
ozone and particulate matter, our utility customers are likely to be affected when the
NAAQS are implemented by the states.

In
addition, the 1990 Clean Air Act Amendments require a study of utility power plant
emissions of certain toxic substances, including mercury, and direct the EPA to regulate
emissions of these substances, if warranted. In 2005, the EPA published the final Clean
Air Mercury Rule, for reducing mercury emissions from new or reconstructed coal-burning
power plants and the Clean Air Interstate Rule, which would require coal-burning power
plants to upgrade their facilities to reduce emissions of sulfur dioxide and
NOx and which, the EPA determined, would also contribute to reduction of
mercury emissions as a co-benefit. Taken together, these rules, if they are implemented in
their current form, could result in reduced use of coal if utilities switch to other
sources of fuel. However, all three rulemakings are currently being challenged in
litigation and since 2005 the EPA has been in the process of reconsidering its rulemaking
in this area. In light of the ongoing litigation and the remaining reconsideration
activities, one or more of these rules ultimately may be revised in ways that cannot
presently be anticipated.

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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 requirements can impact the quantity and quality of CCPs produced at a power plant,
can add to the costs of operating a power plant and, depending on the requirements of
individual state implementation plans, could make coal a less attractive fuel alternative
in the planning and building of utility power plants in the future. Furthermore, the Clean
Air Mercury Rule could result in implementation of additional technologies at power plants
that could negatively affect fly ash quality.

In
an effort to stimulate the use of clean coal, the Energy Policy Act of 2005 provides
funding for the deployment of clean coal technologies. The Act requires the Secretary of
Energy to establish periodic milestones for funded projects, by the year 2020, to remove
at least 97% of sulfur dioxide; to emit no more than .08 lbs of NOx per million
Btu; to achieve at least 90% reductions in mercury emissions; and to achieve a thermal
efficiency of at least 43% for coal of more than 9,000 Btu, 41% for coal of 7,000-9,000
Btu; and 39% for coal of less than 7,000 Btu.

Inappropriate
use of CCPs can result in faulty end products. In some cases the products marketed by HRI
consist of a mixture of client-supplied materials, including CCPs. HRI does not in all
cases 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 HRI. In cases where
HRI is responsible for end-product quality, such as a structural fill (where material is
used to fill a cavity or designated area), HRI depends solely on its own quality assurance
program.

Materials
sold by HRI 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. However, EPA has determined that national regulations under
subtitle D of the Resource Conservation and Recovery Act 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. The EPA is planning to
publish proposed rules for CCPs generated by commercial electric power producers in May
2007 and for management of CCPs at mine facilities in October 2008 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 HRIs utility
clients. HRI 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 HRI cannot
be completely ascertained at this time.

Headwaters
CCP business is engaged in providing services at one landfill operation that is permitted
and managed as a hazardous waste landfill. We provide the services necessary to landfill
the clients hazardous wastes and operate certain in-plant equipment and systems for
the client.

CCPs
may contain small concentrations of metals that are considered as hazardous
substances under the Comprehensive Environmental Response Compensation and Liability
Act. 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 Comprehensive Environmental
Response Compensation and Liability Act liability.

A
number of agencies are studying the issue of nanotechnology, including the National
Toxicology Program, the National Institute for Safety and Health, and the EPA. Many of
these efforts are being coordinated through the interagency Nanoscale Science, Engineering
and Technology subcommittee of the White House Office of Science and Technology Policy,
National Science and Technology Council. Nanoscale materials have been nominated to the
National Toxicology Program for toxicological evaluation. The National Institute for
Safety and Health, the EPA and the National Science Foundation are seeking applications
for research proposals on the potential implications of nanotechnology and manufactured
nanomaterials on human health and the environment. In addition, EPA is studying how
nanomaterials should be approached under existing laws, such as the Toxic Substances
Control Act, and whether new regulations may be needed. One or more of these efforts may
eventually result in regulations which potentially could affect our business in the area
of nanotechnology. At this time, it is not possible to say more precisely what form these
regulations may take.

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We
are constructing an ethanol production facility, Blue Flint Ethanol, LLC, to be located at
the GRE Coal Creek pulverized coal electric power station near Underwood, North Dakota.
The ethanol industry sector manufactures ethanol, principally from industrial corn.
Ethanol production facilities can emit volatile organic compounds and carbon monoxide into
the air. In 2002, the EPA began investigating a suspected pattern of noncompliance with
the Prevention of Significant Deterioration/New Source Review requirements of the Clean
Air Act within the ethanol industry. The Clean Air Acts New Source Review program
requires a source to install pollution controls and undertake other preconstruction
obligations to control air pollution emissions. Subsequent investigations of several
companies in the ethanol industry found them to be in violation for failure to obtain
either Prevention of Significant Deterioration or minor source permits for new
construction and/or modifications made at their facilities. The EPA has negotiated consent
decrees with several companies to bring their ethanol plants into compliance with the air
pollution requirements. Our ethanol production facility is subject to air pollution
permitting and emission control regulatory requirements.

# Employees

Headwaters
employs approximately 4,300 full-time employees. There are approximately 70 employees in
Headwaters corporate administration. Forty-one of Headwaters employees work
under collective bargaining agreements. The following table lists the approximate number
of employees by business unit:

| |    
| | ---
| | HCM
| | HRI
| | HES
| | HTI

# ITEM 1A. RISK FACTORS

# Risks Relating to Our
Business

Section 45K (formerly Section 29)
of the Internal Revenue Code (Section 45K) tax credits are subject to
phase-out if the unregulated average annual oil price reaches the IRS established
phase-out range.

Tax
credits claimed by an alternative fuel facility owner are reduced prior to their scheduled
expiration on December 31, 2007 if the reference price of oil exceeds the
lower end of a phase-out range, and are eliminated entirely if the reference price exceeds
the higher end of that range, with the beginning and end of the range being adjusted
annually for inflation. The reference price of oil is defined as the U.S. Energy
Information Agencys estimate of the annual average wellhead price per barrel for all
domestic crude oil not subject to regulation by the United States. In April of each year,
the IRS announces the reference price and the phase-out range of oil prices for the prior
calendar year. For example, in April 2006, the IRS announced that the reference price for
calendar 2005 was $50.26 per barrel and that the phase-out range for 2005 began at $53.20
per barrel and ended with a $0 tax credit at $66.78 per barrel. Because the calendar year
2005 reference price did not fall within the range, there was not a phase-out of the
credit for qualified fuel sold in 2005.

For
calendar 2006, Headwaters estimates that the phase-out range (computed by increasing the
2005 inflation adjustment factor by 2%) begins at $54.27 and completes phase-out at $68.12
per barrel. While the calendar 2006 phase-out percentage can not be finalized at the
current time, Headwaters estimates that based on actual oil prices for January through
September 2006 and published NYMEX oil prices for October through December 2006, a 42%
phase-out would result. If the Section 45K tax credits are phased out in whole or in
material part, the amounts and timing of recognition of Headwaters revenue, net
income and cash flow will be severely affected.

The
rising price of oil has had a significant impact on the decisions of facility owners
concerning alternative fuel production beginning with the first quarter of calendar year
2006. Headwaters and its licensees and customers closely watch oil price trends and will
continue to consider whether or not to operate facilities depending upon their respective
views of future oil prices. Some facility owners have attempted to protect their positions
by purchasing oil futures hedges and have requested that Headwaters share the cost of such
hedges, while others have considered these actions too risky and expensive, and have
elected to simply curtail or eliminate production based upon an assessment that high oil
prices indicate phase-out likelihood. In 2006, many of Headwaters licensees and
reagent customers temporarily idled production at their alternative

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fuel facilities during the peak
months of oil prices, severely adversely affecting Headwaters revenues from license
fees and reagent sales for the year. During 2007, licensees and reagent customers will
continue to evaluate their particular circumstances in light of volatile oil prices and
anticipated phase-out of credits. Headwaters must also make assessments with respect to
the continued operation of its own synthetic fuel production facilities. Headwaters effective
tax rate for 2006 was increased because of its decision to temporarily stop production at
its own facilities. Additionally, because Headwaters believes that the 2006 reference
price will be within the phase-out range, the effective tax rate was further increased as
a result of the estimated phase-out percentage. Decisions to stop operation of Headwaters own
synthetic fuel production facilities during 2007 will increase its tax rate for the year.
Decisions by Headwaters or our licensees or customers to curtail or eliminate production
during 2007 will severely affect profitability and cash flow, including the timing of
recognition of revenue.

A significant increase in the
price of petrochemical feedstocks used to make latex materials which are in turn used in
the production of HES reagents that cannot be passed on to customers could have a
significant adverse effect on net income. Further, HES depends upon a single supplier for
the production of reagents, the interruption of which would materially disrupt HESs
ability to supply products to its customers, resulting in lost revenues and the potential
loss of customers.

HES
reagents, which provide a majority of HESs revenues, are manufactured from latex by
a single supplier, Dow Reichhold LLC. The price of latex 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 latex has fluctuated, and
significantly increased in 2006. Some contracts allow cost pass through. Further
significant increases in the price of latex that cannot be passed on to customers could
have a significant adverse effect on our net income. HES does not inventory reagents for
sale to customers and alternative sources meeting HESs requirements would be
difficult to arrange. Therefore, HESs ability to provide reagents to its customers
could be materially disrupted if the supply of reagents or feedstock latex materials were
interrupted for any reason. Such an interruption and the resulting inability to supply
HESs customers with reagents could adversely impact HESs revenues and
potentially our relationships with HESs customers.

If the tax credits under Section
45K of the Internal Revenue Code are repealed or adversely modified, HESs
profitability will be severely affected.

HESs
license fees and revenues from sales of chemical reagents depend on the ability of our
licensees and customers to manufacture and sell qualified alternative fuels that generate
tax credits. By law, Section 45K tax credits are not available for alternative 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 45K. For example, in February
2005, a bill was reintroduced in the United States House of Representatives that would
repeal the Section 45K credit for alternative fuel produced from coal. If Section 45K
expires at the end of 2007 or if it is repealed or adversely modified, alternative fuel
facilities would probably either close or substantially curtail production. Given current
prices of coal and costs of alternative fuel production, we do not believe that production
of alternative fuel will be profitable absent the tax credits. In addition, if our
licensees close their facilities or materially reduce production activities (whether after
2007, upon earlier repeal or adverse modification of Section 45K or for any other reason
such as the potential phase out of tax credits described above), it would have a material
adverse effect on the recognition and timing of our revenues and net income.

If our licensees demand for
Section 45K tax credits decreases, HESs revenues will decrease.

HESs
business depends upon the ability of our licensees and chemical reagent customers to
utilize Section 45K tax credits as payments under our contracts are ultimately based on
our customers production of alternative fuels. Their ability to utilize tax credits
depends upon their taxable income. A decline in the profitability of our licensees could
reduce their ability to utilize tax credits, and, in turn, could lead to a reduction in
the production of alternative 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 our revenues and net income.

As
discussed in the first Risk Factor above, in 2006 many of our customers temporarily idled
production at their alternative fuel facilities, with the result that our license fees and
reagent sales have been materially adversely affected.

IRS reviews under Section 45K may
adversely affect our licensees production of alternative fuel and therefore may
adversely affect HESs profitability.

15

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The
issuance of private letter rulings (PLRs) under Section 45K by the IRS is
important to the willingness of the owners of alternative fuel facilities to operate, and
to their ability to transfer ownership, of those facilities. Any issued PLRs may be
modified or revoked by the IRS.

The
IRS has suspended the issuance of PLRs to alternative 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
alternative fuel facility operators to determine that the fuel satisfied the requirements
of Section 45K, certain of our licensees reduced or ceased production, which resulted in a
material adverse impact on our 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 alternative fuels industry
and subsequent PLRs have required taxpayers (i) to maintain sampling and quality control
procedures that conform to the American Society for Testing and Materials or other
appropriate industry guidelines at the alternative 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 Fourier Transform InfraRed
(FTIR) data and processed FTIR data sufficient to document the selection of
absorption peaks and integration points. The expression of IRS concern regarding current
practices in the industry may adversely affect the willingness of buyers to engage in
transactions or 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 our revenues and net income. We
cannot predict whether the IRS may conduct reviews or investigations of Section 45K tax
credits in the future, or whether the outcome of IRS audits involving licensees would be
favorable.

Senate investigation of Section
45K tax credits may adversely affect production by our licensees and decrease the
profitability of HES.

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 alternative 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
alternative fuel facilities or the willingness of current owners to operate their
facilities, which would have a direct, negative impact on our revenues and net income.

In
February 2006, the Subcommittee described its investigation as follows:

| | The
Subcommittee is continuing its investigation [of] tax credits claimed under Section 29
[now Section 45K] 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 our knowledge, there has been little
activity regarding the investigation.

If the IRS challenges or disallows
Section 45K tax credits claimed by our licensees, HESs profitability may decrease
because future production by these licensees may decrease.

Licensees
are subject to audit by the IRS. The IRS may challenge whether HESs licensees
satisfy the requirements of Section 45K, or applicable PLRs, including placed-in-service
requirements, or may attempt to disallow Section 45K tax credits for some other reason.
The IRS has initiated audits of certain licensee-taxpayers who claimed Section 45K tax
credits, and the outcome of any such audit is uncertain. In the event that tax credits are
disallowed, licensees may seek recovery from HES for operational or other reasons,
although we believe there would be no basis for such claims. The inability of a licensee
to claim Section 45K tax credits also would reduce our future revenue from such licensee.
In addition, IRS audit activity may have adversely affected the willingness of buyers to
engage in transactions to purchase alternative fuel facilities or 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 negative effect on our revenues and net income.

If our licensees demand for
Section 45K tax credits is adversely influenced by negative publicity involving the
industry or transactions principally motivated by the reduction of taxes, HESs
profitability will decrease.

16

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There
has been public scrutiny of Section 45K by the media and policymakers. Outside the Section
45K context, there has been public scrutiny of transactions motivated principally by the
reduction of federal income taxes. Our licensees could determine that the risk of negative
publicity or public scrutiny associated with the Section 45K 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 alternative fuel or
disposing of their facilities, resulting in short-term or long-term disruption of
operations, in which case our revenues and profitability would decrease.

HESs revenues are derived
from a small number of licensees and customers; therefore, any short-term or long-term
decisions by one or a small number of such licensees and customers to decrease or halt
production would cause our profitability to decrease.

HES
has 28 licensed facilities using its coal-based synthetic fuel technologies. In addition,
HES sells reagents used at approximately 35 facilities owned by our licensees and other
customers. License fees and reagent sales accounted for approximately 19% of our total
revenues in the fiscal year ended September 30, 2006 and a higher percentage of our
net income. Under law, facilities must have been placed into service prior to July 1,
1998 to be eligible for Section 45K tax credits, so HESs business primarily depends
on existing licensees and chemical reagent customers. If any of HESs 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, our revenues and net income could be materially adversely
affected. HESs licensees must address all operational issues including, but not
limited to, feedstock availability, cost, moisture content, British thermal unit
(Btu) 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 us. As discussed in the first Risk Factor
above, in 2006 some of our customers temporarily idled production at their alternative
fuel facilities, with the result that our license fees and reagent sales were materially
adversely affected.

Headwaters Resources, or HRI,
primarily sells fly ash for use in concrete; if use of fly ash does not increase,
Headwaters Resources may not grow.

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

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

An
estimated 73% of HRIs revenues for the fiscal year ended September 30, 2006
were derived from the sale of fly ash as a replacement for portland cement in concrete
products. At times, there may be an overcapacity of cement in regional markets, causing
potential price decreases. The markets for HRIs products are regional, in part
because of the costs of transporting CCPs, and HRIs 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 prices equal to or less than fly ash,
HRIs revenues and net income could decrease.

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

HRI
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 and decreases during periods of severe weather.
HRIs 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 December 31 and March 31.

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

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If HRIs coal-fueled electric
utility industry suppliers fail to provide HRI with high-value CCPs on a timely basis,
HRIs costs could increase and our growth could be hindered.

HRI
relies on the production of CCPs by coal-fueled electric utilities. HRI 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
frames required by HRI to meet its customers needs. If HRI is unable to obtain CCPs
or if it experiences a delay in the delivery of high-value or quality CCPs, HRI 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 HRIs products.

Because the markets for our
construction materials products are heavily dependent on the residential construction and
remodeling market, our revenues could decrease as a result of events outside our control
that impact home construction and home improvement activity.

With
rising interest rates, there has been a slowing in 2006 of new housing starts and in home
sales generally. While our construction materials business relies upon the home
improvement and remodeling markets as well as new construction, we have experienced a slow
down in sales activity in 2006. If interest rates continue to rise and affect
customers desire or ability to engage in construction or remodeling, or if there is
a limit on availability of credit for homeowners which results in a slowdown in new
construction or remodeling and repair activities, our revenues could be materially
adversely affected,

The
construction markets are seasonal. The majority of our construction materials 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 other events outside of our control, there
may be a negative effect on our revenues if we are not able to increase market share.

A significant increase in the
price of materials used in the production of our construction materials products that
cannot be passed on to customers could have a significant adverse effect on our net
income. Furthermore, we depend upon limited sources for certain key production materials,
the interruption of which would materially disrupt our ability to manufacture and supply
products, resulting in lost revenues and the potential loss of customers.

Eldorados
architectural stone manufacturing processes require key production materials including
cement, oxides, packaging materials, and certain types of rubber-based products. The
suppliers of these materials to Eldorado may experience capacity or supply constraints in
meeting market demand that limit Eldorados ability to obtain needed production
materials on a timely basis or at expected prices. Eldorado has no long-term contracts
with suppliers. Eldorado does not currently maintain large inventories of production
materials and alternative sources meeting Eldorados requirements could be difficult
to arrange in the short term. A significant increase in the price of these materials that
cannot be passed on to customers could have a significant adverse effect on our net
income. Additionally, Eldorados manufacturing and ability to provide products to its
customers could be materially disrupted if this supply of materials was interrupted for
any reason. Such an interruption and the resulting inability to supply Eldorados
customers with products could adversely impact Eldorados revenues and our
relationships with Eldorados customers.

Certain
of Tapcos products, which provide a majority of Tapcos revenues, 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, and significantly increased in 2006. A
significant increase in the price of polypropylene that cannot be passed on to customers
could have a significant adverse effect on our net income. There is no long-term contract
with Tapcos polypropylene supplier. Tapco does not maintain large inventories of
polypropylene and alternative sources meeting Tapcos requirements could be difficult
to arrange in the short term. Therefore, Tapcos manufacturing and ability to provide
products to its 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 our relationships with Tapcos customers.

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.

Tapcos
construction materials business is highly dependent upon rapid 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.

18

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Tapcos revenues would be
materially adversely affected if it lost one or more of its three major customers.

Three
of Tapcos customers together accounted for approximately 30% of its revenues in its
fiscal year ended September 30, 2006. There are no long-term contracts in place with
these customers. Accordingly, a loss of or significant decrease in demand from these
customers would have a material adverse effect on Tapcos business.

Our growth requires continued
investment of capital. If we cannot invest additional capital into new and existing
businesses, we may not be able to sustain or increase ourgrowth.

Our operations
require both maintenance and growth capital. A key part of our business strategy
has been to expand through complementary acquisitions, which has required significant
capital. In addition, commercialization of our energy technologies, such as coal cleaning,
coal drying and heavy oil upgrading, has required and will require significant debt and
equity commitments. In 2006 we entered into joint ventures with Degussa AG for acquiring a
hydrogen peroxide plant and with GRE to develop an ethanol plant, both of which were
financed with equity investments and debt incurred at the project level, and we will
consider making additional such investments in the future. If we do not have sufficient
capital to make equity investments in new projects and/or cannot find acceptable sources
of debt financing, our growth may suffer.

Our
construction materials and CCP businesses also require significant capital expenditures.
Our senior secured credit facilities limit capital expenditures for all of Headwaters to
approximately $100.0 million plus the carryover of $25.4 million from fiscal 2006 and
prior years for fiscal year 2007. We believe that we will need substantially all of this
capital expenditure limitation in fiscal year 2007 for maintenance, growth of existing
businesses and new growth initiatives.

The availability and price of corn
purchased by Blue Flint Ethanol, LLC (BFE) can be affected by weather,
disease, government programs and other factors beyond BFEs control. In addition,
fluctuations in gasoline and diesel fuel prices could adversely affect BFEs ethanol
revenues.

BFE, our joint venture with GRE to
produce ethanol from corn, is expected to begin production in the first quarter of
calendar 2007. The availability and price of corn is subject to wide fluctuations due to
unpredictable factors such as weather, plantings, crop disease, government farm programs
and policies, changes in demand resulting from population growth, and production of
similar and competitive crops. These factors have historically caused volatility in corn
prices and supplies and, consequently, may cause volatility in BFEs operating
results. Reduced supply of corn could adversely affect our profitability by increasing the
cost of raw materials used in BFEs operations.

In addition, the use of ethanol is
closely related to, or may be substituted for, gasoline and diesel fuel. Therefore, the
selling price of ethanol relates to the selling prices of gasoline and diesel fuel. A
significant decrease in the price of gasoline or diesel fuel could result in a significant
decrease in the selling price of BFEs ethanol and could adversely affect BFEs
revenues and operating results. The ethanol and biodiesel industry in the U.S. has
grown rapidly over the last few years and our success will depend on whether demand for
ethanol increases concurrently or if the increased production results in
excess capacity.

Our new businesses, processes and
technologies may not be successfully developed, operated and marketed, which could affect
our future profitability.

Although
we have developed or acquired many new businesses, processes and technologies (e.g.,
ethanol, heavy oil upgrading and coal cleaning), commercialization of these businesses and
technologies are in early stages. Commercial success of these new businesses and
technologies will depend on our ability to enter into agreements with customers, licensees
and/or joint venturers to further develop and provide adequate funding to commercialize
the new businesses and technologies, as well as to develop markets for the products and
technologies. We may not be able to enter into these agreements and adequate funding may
not be available to fully develop and successfully commercialize our new businesses and
technologies. Further, we may not be able to profitably operate our new businesses or
market our technologies or products produced from them.

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Headwaters is conducting business
in China and other foreign countries, where intellectual property and other laws, as well
as business conditions, may leave our intellectual property, products and technologies
vulnerable to duplication by competitors and create uncertainties as to our legal rights
against such competitors actions.

Headwaters
has and is expected to continue to license or otherwise make its technology, including its
nanotechnology, heavy oil upgrading and coal liquefaction technology, available to
entities in China, India and other foreign countries. There is a risk that foreign
intellectual property laws will not protect our intellectual property to the same extent
as under United States laws, leaving us vulnerable to competitors who may attempt to copy
our 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 us. In addition, dependence on foreign
licenses and conducting foreign operations may subject us to increased risk from political
change, ownership issues or repatriation or currency exchange concerns.

Significant increases in energy
and transportation costs that cannot be passed on to customers could have a significant
adverse effect on net income.

We
purchase a significant amount of energy from various sources to conduct our operations,
including fossil fuels and electricity for production of building products and diesel fuel
for distribution of our products and for production-related vehicles. In addition, fuel
cost increases have increased truck and rail carrier transportation costs for our
products. Fuel cost increases have in the past and may in the future adversely affect the
results of our operations and our financial condition. Prices and availability of all
petroleum products are subject to political, economic and market factors that are
generally outside of our control.

We operate 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 alternative fuel operations of HES and the CCP operations of HRI and
their respective customers and licensees, together with new projects such as coal
cleaning, the ethanol plant and the acquisition of a hydrogen peroxide plant in Korea, are
subject to federal, state, local and international 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 us to potential fines for non-compliance. If the costs of
environmental compliance increase for any reason, we may not be able to pass on these
costs to customers. In order to establish and operate the alternative fuel plants, coal
cleaning plants, power plants and operations to collect and transport CCPs and bottom ash,
we, our 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 us to incur environmental liabilities.

Certain
HCM manufacturing operations, including those of Eldorado and Tapco, are also subject to
environmental regulations and permit requirements. If HCM and its subsidiaries and
affiliates cannot obtain or maintain required environmental permits for their existing and
planned manufacturing facilities in a timely manner or at all, they may be subject to
additional costs and/or fines.

The
ethanol industry sector manufactures ethanol, principally from industrial corn. Ethanol
production facilities can emit volatile organic compounds and carbon monoxide into the
air. In 2002, EPA began investigating a suspected pattern of noncompliance with the
Prevention of Significant Deterioration/New Source Review (PSD/NSR) requirements of the
Clean Air Act within the ethanol industry. The Clean Air Acts NSR program requires a
source to install pollution controls and undertake other preconstruction obligations to
control air pollution emissions. Subsequent investigations of several companies in the
ethanol industry found them to be in violation for failure to obtain either PSD or minor
source permits for new construction and/or modifications made at their facilities. EPA has
negotiated consent decrees with several companies to bring their ethanol plants into
compliance with the air pollution requirements. Our ethanol production facility to be
located at the GRE Coal Creek pulverized coal electric power station near Underwood, North
Dakota, may be subject to air pollution permitting and emission control regulatory
requirements. If this facility cannot obtain or maintain required environmental permits or
maintain compliance with environmental regulations, it may be subject to additional costs
and/or fines.

20

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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, fires, or explosions, in spite of safeguards, could create environmental or
safety liabilities. Therefore, our operations entail risk of environmental damage and
injury to people, and we could incur liabilities in the future arising from the discharge
of pollutants into the environment, waste disposal practices, or accidents.

We are involved in litigation and
claims for which we incur significant costs and are exposed to significant liability.

We
are a party to some significant legal proceedings and are subject to potential claims
regarding operation of our business. These proceedings will require that we 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 our reputation. With respect to the cases referred to in Business 
Litigation, the following amount of damages is being sought by the counter parties:

| | McEwan:
McEwan seeks declaratory relief as well as compensatory damages in the approximate amount
of $3 million plus punitive damages.
| | --------------------------------------------------------------------------------------------------------------------------------------

| | Boynton:
Boynton seeks declaratory relief as well as compensatory damages in the approximate amount
of $25 million plus punitive damages.
| | -----------------------------------------------------------------------------------------------------------------------------------------

We have ongoing litigation and claims
incurred during the normal course of business, including the items referred to above. We
intend to vigorously defend and/or pursue our rights in these actions. We do not currently
believe that the outcome of these actions will have a material adverse effect on our
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.

We have significant competition in
our industries which may cause demand for our products and services to decrease.

We
experience significant competition in all of our 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 decrease our profitability. Many of
our competitors have greater financial, management and other resources than us and may be
able to take advantage of acquisitions and other opportunities more readily. In certain
instances we must compete on the basis of superior products and services rather than
price, thereby increasing the costs of marketing our services to remain competitive. See
ITEM 1, Competition, for more information on the competition faced by Headwaters in all of
its segments.

Our business strategy to diversify
and grow through acquisitions may result in integration costs, poor performance and
dilution to existing stockholders.

An
important aspect of our business strategy has been and continues to be diversification and
growth through acquisitions. Our ability to successfully implement our 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 our ability to develop new products and services and to compete
in our markets. In addition, if we consummate acquisitions through an exchange of our
securities, our existing stockholders could suffer dilution.

If
we do not successfully integrate newly acquired businesses with our existing businesses,
we may not realize the expected benefits of the acquisitions, and the resources and
attention required for successful integration may interrupt the business activities of
acquired businesses and our existing businesses. Successful management and integration of
acquisitions are subject to a number of risks, including difficulties in assimilating
acquired operations, loss of key employees, diversion of managements attention from
core business operations, assumption of contingent liabilities, incurrence of potentially
significant write-offs, and various employee issues, such as issues related to human
resource benefit plans, and an increase in employment and discrimination claims and claims
for workers compensation. Each business acquisition also requires us to expand our
operational and financial systems, which increases the complexity of our information
technology systems. Implementation of controls, systems and procedures may be costly and
time-consuming and may not be effective. This strategy may not improve our operating
results and acquisitions may have a dilutive effect on existing stockholders.

21

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If our 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 we evaluate and report on our system
of internal controls. 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. We have documented and
tested our system of internal controls to provide the basis for our report for the year
ended September 30, 2006. The growth and diversification of our business through
acquisitions complicates the process of developing, documenting, maintaining and testing
internal controls. No assurance can be given that in the future there may not be
significant deficiencies or material weaknesses that would be required to be reported in
the future.

If we are unable to manage the
growth of our business successfully, our revenues and business prospects could suffer.

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

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

We
rely primarily on a combination of trade secrets, patents, copyright and trademark laws
and confidentiality procedures to protect our intellectual property. Despite these
precautions, unauthorized third parties may misappropriate, infringe upon, copy or reverse
engineer portions of our technology or products. We do 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. Our business could be harmed
if we infringe upon the intellectual property rights of others. We have been, and may be
in the future, notified that we may be infringing intellectual property rights possessed
by third parties. If any such claims are asserted against us, we 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
our use of the applicable technology. Alternatively, we 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 our business and the issues described in this paragraph have not
resulted in significant cost or had an adverse impact on our business, future actions
could be costly and would divert the efforts and attention of our management and technical
personnel.

Our capital structure affects our
flexibility in responding to changing business and economic conditions and results in high
interest costs.

As
of September 30, 2006, we had approximately $595.1 million of total debt outstanding,
including $415.3 million of senior indebtedness under our senior secured credit facilities
and $172.5 million of our 2.875% convertible senior subordinated notes (the
Convertible Notes). Subject to restrictions in our senior secured credit
facility, we may also incur significant amounts of additional debt for working capital,
capital expenditures and other purposes. Our combined debt total could have important
consequences, including the following:

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

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

22

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| |  | o |  | over
70% of our senior secured credit facilities has a variable rate of
                   interest, which exposes us to the risk of increased interest rates.
| |  | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------

Our
ability to make scheduled payments of the principal of, to pay interest on or to refinance
our indebtedness depends on our future performance, which to a certain extent is subject
to economic, financial, competitive and other factors beyond our control. Our business may
not continue to generate cash flow from operations in the future sufficient to service our
debt and make necessary capital expenditures. If unable to generate such cash flow, we 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 our
senior secured credit facility may limit our ability to operate our business in a manner
required to sustain profitability and generate growth.

Our
senior secured credit facilities, contain, among other things, covenants that may restrict
our ability to finance future operations or capital needs, to acquire additional
businesses or to engage in other business activities. The senior secured credit facilities
impose specified limitations on joint venture investments and new acquisitions. In
addition, our senior secured credit facilities set forth covenants requiring us to
maintain specified financial ratios and to satisfy certain financial condition tests which
may require that we take action to reduce our debt or to act in a manner contrary to our
business objectives. A breach of any of these covenants could result in a default under
our senior secured credit facilities, in which event our lenders could elect to declare
all amounts outstanding to be immediately due and payable. If we are not able to repay our
obligations when they become due or they are accelerated, the lenders could foreclose on
our assets. The indenture for the notes does not restrict the amount of indebtedness,
including senior indebtedness, that we may incur.

# Risks Related to our
Common Stock

The price of our common stock
historically has been volatile. This volatility may affect the price at which you could
sell your common stock, and the sale of substantial amounts of our common stock could
adversely affect the price of our common stock.

The
market price for our common stock has varied between a high of $40.19 in March 2006 and a
low of $20.54 in July 2006 in the twelve month period ended October 31, 2006. This
volatility may affect the price at which you could sell your common stock, and the sale of
substantial amounts of our common stock could adversely affect the price of our common
stock. Our stock price is likely to continue to be volatile and subject to significant
price and volume fluctuations in response to market and other factors, including the other
factors discussed in Risks Relating to Our Business; variations in our
quarterly operating results from our expectations or those of securities analysts or
investors; downward revisions in securities analysts estimates; and announcement by
us or our competitors of significant acquisitions, strategic partnerships, joint ventures
or capital commitments.

In
the past, following periods of volatility in the market price of their stock, many
companies have been the subject of securities class action litigation. If we became
involved in securities class action litigation in the future, it could result in
substantial costs and diversion of our managements attention and resources and could
harm our stock price, business, prospects, results of operations and financial condition.

In
addition, the broader stock market has experienced significant price and volume
fluctuations in recent years. This volatility has affected the market prices of securities
issued by many companies for reasons unrelated to their operating performance and may
adversely affect the price of our common stock. In addition, our announcements of our
quarterly operating results, changes in general conditions in the economy or the financial
markets and other developments affecting us, our affiliates or our competitors could cause
the market price of our common stock to fluctuate substantially.

In
addition, the sale of substantial amounts of our common stock could adversely impact its
price. As of September 30, 2006, we had outstanding approximately 42.3 million shares of
our common stock and options to purchase approximately 2.4 million shares of our common
stock (of which approximately 2.3 million were exercisable as of that date). We also had
outstanding approximately 3.1 million stock appreciation rights as of September 30, 2006,
of which approximately 2.0 million were exercisable. The sale or the availability for sale
of a large number of shares of our common stock in the public market could cause the price
of our common stock to decline.

Conversion of the Convertible
Notes may cause volatility in our stock price and will dilute the ownership interest of
existing stockholders.

23

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Although
our diluted earnings per share calculation treats the Convertible Notes as if they were
already converted into common stock, sales in the public market of the common stock
issuable upon such conversion could adversely affect prevailing market prices of our
common stock. Anticipated conversion of the notes into shares of our common stock could
depress the price of our common stock. In addition, the existence of the Convertible Notes
may encourage short selling by market participants because the conversion of the notes
could be used to satisfy short positions. Conversion of the Convertible Notes will dilute
the ownership interests of existing stockholders, including holders who had previously
converted their notes.

We have never paid dividends and
do not anticipate paying any dividends on our common stock in the future, so any
short-term return on your investment will depend on the market price of our capital stock.

We
currently intend to retain any earnings to finance our operations and growth. The terms
and conditions of our senior secured credit facility restrict and limit payments or
distributions in respect of our capital stock.

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

We
are 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 us, even if a
change in control would be beneficial to our existing stockholders. In addition, our 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 our board of directors to create and issue a new series of preferred stock
and certain provisions of Delaware law and our certificate of incorporation and bylaws
could impede a merger, takeover or other business combination involving us or discourage a
potential acquirer from making a tender offer for our common stock, which, under certain
circumstances, could reduce the market price of our common stock.

# ITEM 1B. UNRESOLVED
STAFF COMMENTS

None.

# 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 39,000 square feet has a term
expiring July 2008. The monthly rent is approximately $60,000, with certain adjustments
for inflation plus expenses.

Construction
Materials. HCM owns or leases 56 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, Greencastle, Pennsylvania and
Dublin, Georgia.

CCPs. HRI owns or leases 12 properties nationwide for its fly ash storage and
          distribution operations with East, Central, and West regional divisions. HRI
          also conducts operations at more than 100 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).

Alternative
Energy. HES directs its operations primarily from Headwaters South
Jordan, Utah location. HES leases a small parcel in Fluvanna County, Virginia for a
synfuel facility. HES also operates coal cleaning facilities on properties near
Wellington, Utah and Adger, Alabama pursuant to a lease and processing agreement,
respectively.

HTI
owns approximately six acres in Lawrenceville, New Jersey where it maintains offices and
its research facilities.

# ITEM 3. LEGAL PROCEEDINGS

Headwaters
has ongoing litigation and asserted claims which have been incurred during the normal
course of business, including the specific matters 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.

24

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Historically,
costs paid to outside legal counsel for litigation have comprised a majority of
Headwaters litigation-related costs. During fiscal 2006, Headwaters incurred
approximately $0.1 million of net expense for legal matters, including costs for outside
legal counsel, compared to approximately $3.8 million in fiscal 2004 and $3.2 million in
fiscal 2005. In 2006, developments in certain legal matters Headwaters is defending
resulted in reduced likelihood of ultimate legal liability and a reduction of expense.
Headwaters currently believes the range of potential loss for all unresolved matters,
excluding costs for outside counsel, is from $1.0 million up to the amounts sought by
claimants and has recorded a total liability as of September 30, 2006 of $1.0 million.
Claims and damages sought by claimants in excess of this amount are not deemed to be
probable. Headwaters outside counsel currently believe that unfavorable outcomes of
outstanding litigation are neither probable nor remote and declined to express opinions
concerning the likely outcomes or liability to Headwaters. It is not possible to estimate
what litigation-related costs will be in future periods.

The
matters discussed below 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. It is possible that a change in the estimates of probable liability
could occur, and the changes could be material. 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.

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 $2.8 million 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.

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 $15.0 million and $25.0 million and
          punitive damages. In February 2006, the District Court dismissed all claims
          against Headwaters. Also in February 2006, plaintiffs filed their notice of
          appeal to the United States Court of Appeals for the Sixth Circuit. In June
          2006, the appeal was transferred to the United States Court of Appeals for the
          Federal Circuit. Because the resolution of the litigation is uncertain, legal
          counsel cannot express an opinion as to the ultimate amount, if any, of
          Headwaters liability.

Headwaters
Construction Materials Matters.There are litigation and pending and threatened claims
made against certain subsidiaries of Headwaters Construction Materials (HCM)
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 Insulating 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.

25

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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. None of the cases has gone to trial. While, to date, none of these proceedings
have required that HCM incur substantial costs, there is no guarantee of insurance
coverage or continuing coverage. These and future proceedings may result in substantial
costs to HCM, including attorneys fees, managerial time and other personnel
resources and costs. Adverse resolution of these proceedings could have a materially
negative effect on HCMs business, financial condition, and results of operation, and
its ability to meet its financial obligations. Although HCM carries general and product
liability insurance, HCM cannot assure that such insurance coverage will remain available,
that HCMs insurance carrier will remain viable, or that the insured amounts will
cover all future claims in excess of HCMs uninsured retention. Future rate increases
may also make such insurance uneconomical for HCM to maintain. In addition, the insurance
policies maintained by HCM 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 HCMs 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.

26

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# PART II

# ITEM 5.  MARKET FOR
REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDERMATTERS AND ISSUER PURCHASES OF
EQUITY SECURITIES

Since
April 6, 2005, the shares of our common stock have traded on the New York Stock Exchange
under the symbol HW. Prior to that time, our shares traded on the Nasdaq
National Market under the symbol HDWR. Options on our 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 our common
stock as reported by the New York Stock Exchange or Nasdaq, as applicable.

|Fiscal 2005                      | Low    |  | High  
|-------------------------------- | ------ |  | ------
|Quarter ended December 31, 2004  | $27.52 |  | $34.96
|Quarter ended March 31, 2005     | 26.31  |  | 34.49 
|Quarter ended June 30, 2005      | 29.08  |  | 35.57 
|Quarter ended September 30, 2005 | 33.90  |  | 45.75 

|Fiscal 2006                     
|--------------------------------
|Quarter ended December 31, 2005 
|Quarter ended March 31, 2006    
|Quarter ended June 30, 2006     
|Quarter ended September 30, 2006

As
of November 15, 2006, there were 347 stockholders of record of our common stock. We have
not paid dividends on our common stock to date and do not intend to pay dividends in the
foreseeable future. Pursuant to the terms of our senior secured credit arrangement (see
Note 8 to the consolidated financial statements), we are prohibited from paying cash
dividends so long as any of the long-term debt is outstanding. We intend to retain
earnings to finance the development and expansion of our business. Payment of common stock
dividends in the future will depend upon, among other things, our debt covenants, our
ability to generate earnings, our need for capital, our investment opportunities and our
overall financial condition.

The
information required by this item regarding equity compensation plans is incorporated by
reference to the information set forth in Item 12 of this Annual Report on Form 10-K. See
Note 11 to the consolidated financial statements for a description of securities
authorized for issuance under equity compensation plans.

We
did not make any unregistered sales of our equity securities during the year ended
September 30, 2006. We did not repurchase any shares of our equity securities during the
fourth quarter of the year ended September 30, 2006.

# ITEM 6. SELECTED
FINANCIAL DATA

The
following selected financial data are derived from our consolidated financial statements.
This information should be read in conjunction with the consolidated financial statements,
related notes and other financial information included in this Form 10-K. The selected
financial data as of and for the years ended September 30, 2002 and 2003 and as of
September 30, 2004 are derived from audited financial statements not included in this Form
10-K. The selected financial data as of September 30, 2005 and 2006 and for the years
ended September 30, 2004, 2005, and 2006 were derived from our audited financial
statements included in this Form 10-K.

As
described in Note 13 to the consolidated financial statements, we acquired several
companies in 2004 and in 2006. The results of operations for these companies for the
periods from the acquisition dates through September 30, 2006 have been consolidated with
our results. None of their results of operations up to the dates of acquisition have been
included in our consolidated results.

In
2004, we recognized revenue relating to funds deposited in an escrow account totaling
approximately $27.9 million, most of which related to prior periods. In 2005, we
successfully settled certain litigation which resulted in increased operating income,
primarily related to prior periods, of approximately $52.4 million. Also in 2005, we early
adopted the fair value method of accounting for stock-based compensation required by SFAS
No. 123R and recorded approximately $33.8 million of stock-based compensation expense,
most of which was of a non-recurring nature (see Note 11 to the consolidated financial
statements).

27

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|                           | Year ended September 30,
|-------------------------- | ------------------------
|
|OPERATING DATA:            |                         
|Total revenue              |                         
|Net income                 |                         
|Diluted earnings per share |                         

|                                  | As of September 30,
|--------------------------------- | -------------------
|
|BALANCE SHEET DATA:               |                    
|Working capital                   |                    
|Net property, plant and equipment |                    
|Total assets                      |                    
|Long-term liabilities:            |                    
|Long-term debt                    |                    
|Deferred income taxes             |                    
|Other                             |                    
|                                 
|Total long-term liabilities       |                    
|Total stockholders' equity        |                    

# 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 related notes included in this Form 10-K.
Our fiscal year ends on September 30 and unless otherwise noted, future references to
years refer to our fiscal year rather than a calendar year.

# Introduction

During
the past several years, we have executed on our two-fold plan of maximizing cash flow from
our existing operating business units and diversifying from over-reliance on the legacy
alternative energy segment Section 45K [formerly Section 29] business. With the addition
and expansion of the CCP management and marketing business through acquisitions in 2002
and in 2004, and the growth of the construction materials business, culminating in several
large and small acquisitions in 2004, 2006 and 2007, we have achieved revenue growth and
diversification into three business segments. Because we also incurred increased
indebtedness to make strategic acquisitions, one of our ongoing financial objectives is to
continue to focus on increased cash flows for purposes of reducing indebtedness.

A
material amount of our consolidated revenue and net income is derived from license fees
and sales of chemical reagents, both of which depend on the ability of licensees and other
customers to manufacture and sell qualified synthetic fuel that generates tax credits
under Section 45K [formerly Section 29] of the Internal Revenue Code. We also claim
Section 45K tax credits based upon synthetic fuel sales from facilities in which we own an
interest. From time to time, issues arise as to the availability of tax credits and, with
the rising price of oil, the phase-out of credits, including the following items.

By
law, Section 45K tax credits for synthetic fuel produced from coal expire on December 31,
2007. In addition, Section 45K tax credits are subject to phase-out after the average
annual U.S. wellhead oil price (reference price) reaches a beginning phase-out
threshold price, and are eliminated entirely if the reference price reaches the full
phase-out price. There was no phase-out of Section 45K tax credits for calendar 2005;
however, we believe that due to higher oil prices in 2006, partial phase-out of tax

28

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credits will occur for calendar
2006. As of the date hereof, substantially all of our licensees are producing synthetic
fuel, but most licensees stopped production for a period of time earlier in the year.
These events have materially adversely affected both the amount and timing of recognition
of our revenue, net income and cash flow, and will have a material adverse effect in
future periods as well. Reference is made to notes 10 and 14 to the consolidated
financial statements where there is more information on phase out and other uncertainties
related to Section 45K tax credits that have affected our business in 2006 and that are
likely to continue to affect our business.

Our
acquisition strategy targets businesses that are leading players in their respective
industries, that enjoy healthy operating margins and that are not overly capital
intensive, thus providing additional cash flow that complements the financial performance
of our existing businesses. In addition, in 2006, we have begun to acquire small companies
with innovative products that can be marketed using our existing distribution channels. We
are also committed to continuing to invest in research and development activities that are
focused on energy-related technologies and nanotechnology. We have agreed to a joint
venture project to construct, own and operate an ethanol plant located in North Dakota
which is currently expected to begin operating in early calendar 2007, and are also
beginning to invest in other alternative energy projects such as coal cleaning and the use
of nanocatalysts to engineer coal for emissions reduction.

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

In
2005 and continuing into 2006, we have focused on the integration of our 2004
acquisitions, including the marketing of diverse construction materials products through
our national distribution network. We became highly leveraged as a result of those
acquisitions, but have reduced our outstanding debt since that time through cash generated
from operations, from an underwritten public offering of common stock and from proceeds
from settlement of litigation. We intend to continue to focus on repaying long-term debt
while continuing to look for diversification opportunities within prescribed parameters.

# Consolidation and
Segments

Consolidation.
          The consolidated financial statements include the accounts of Headwaters, all of
          our subsidiaries and other entities in which we have a controlling interest. We
          are also required to consolidate any variable interest entities for which we are
          the primary beneficiary; however, as of September 30, 2006, there are none. For
          investments in entities in which we have a significant influence over operating
          and financial decisions (generally defined as owning a voting or economic
          interest of 20% to 50%), we apply the equity method of accounting. In instances
          where our 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.

As
described in more detail in Note 13 to the consolidated financial statements, we made
several significant acquisitions in 2004 and several insignificant acquisitions in 2006.
These entities results of operations for the periods from the acquisition dates
through September 30, 2006 have been consolidated with our results; their operations up to
the dates of acquisition have not been included in our consolidated results for any
period.

Segments.
          We currently operate three business segments within two industries, the
          construction materials and CCPs segments in the building materials industry, and
          the alternative energy segment in the energy industry. These segments are
          managed and evaluated separately by management due to differences in their
          operations, products and services.

Prior
to 2004, the businesses in the construction materials segment manufactured and distributed
bagged concrete, stucco, mortar and block products. The 2004 acquisitions expanded our
concrete block business, and added manufactured architectural stone and resin-based siding
accessories and related products used in exterior residential home improvement and
construction to the product line. Revenues for the construction materials segment consist
of product sales to wholesale and retail distributors, contractors and other users of
building products.

The
CCP segment manages and markets coal combustion products such as fly ash and bottom ash,
known as CCPs, to building products and ready mix concrete companies. We purchase CCPs
from coal-fired electric power generation plants under long-term contracts and supply them
to our customers as a replacement for manufactured or mined materials, primarily portland
cement. CCP revenues consist primarily of product sales with a small amount of service
revenue.

29

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The
alternative energy segment includes our legacy coal-based solid alternative fuels business
and several newer initiatives, including coal cleaning, coal drying, ethanol and the
commercialization of catalyst technologies, primarily catalysts that help improve the
yield and quality of petroleum-based fuels. Revenues for this segment consist primarily of
sales of chemical reagents and license fees.

# Critical Accounting
Policies and Estimates

Our
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 us to make estimates and
assumptions that affect i) the reported amounts of assets and liabilities and disclosures
of contingent assets and liabilities at the date of the financial statements, and ii) the
reported amounts of revenue and expenses during the reporting period. Actual results could
differ materially from those estimates.

We
continually evaluate our 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 our 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 our
Audit Committee. The following is a discussion of critical accounting policies and
estimates.

License
Fee Revenue Recognition. We currently license our technologies to the owners of 28
coal-based solid alternative fuel facilities in the U.S. 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. Recurring license fees or royalty
payments are recognized in the period when earned, which coincides with the sale of
alternative fuel by our licensees, provided standard revenue recognition criteria such as
amounts being fixed or determinable are met. In most instances, we receive
timely reports from licensees notifying us of the amount of solid synthetic fuel sold and
the royalty due us under the terms of the respective license fee agreements. Additionally,
we have 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 with 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 available to estimate the license fee revenue
earned. In these situations, we use such information as is available and where possible,
substantiate 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, we are unable to reliably estimate the license fee revenues
earned during a period, and 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 us,
which accumulated during a period of approximately two and a half years ending in 2004,
were placed in escrow for our benefit pending resolution of an audit of the licensee by
the IRS. 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 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 we recognized revenue, net of the amount we were 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. 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 us.

30

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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
agreement. These amounts may eventually be paid out to various parties having an interest
in the cash flows from the licensees operations, including us, if they are not used
for working capital and other operational contingencies. As a result, we currently expect
to receive at some future date a portion of those reserves, the amount of which is not
currently determinable and which constitutes a gain contingency not recognizable as
revenue.

In
1996, we entered into an agreement with AJG Financial Services, Inc. The agreement
provided for AJG to pay royalties and allowed AJG to purchase proprietary chemical reagent
material from us. In October 2000, we 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. We asserted claims including breach of contract and
sought money damages as well as other relief. AJGs answer to the complaint denied
our claims and asserted counter-claims based upon allegations of misrepresentation and
breach of contract.

This
litigation came to the trial phase in January 2005. The jury reached a verdict
substantially in our favor and the court entered a judgment for us against AJG in the
amount of approximately $175.0 million which included approximately $32.0 million in
prejudgment interest. In May 2005, we entered into a settlement agreement with AJG which
provided for payments to us in the amount of $50.0 million at the time of settlement
(which payment was received in May 2005), $70.0 million (related to a contract
modification for use of technology) in January 2006, and certain quarterly payments based
upon tax credits associated with AJGs facilities for calendar years 2005 through
2007. Payments based upon tax credits associated with AJGs facilities for the first
three quarters of calendar year 2005 were received in January 2006, with all other
quarterly payments for 2005 through 2007 payable 45 days after the end of each quarter.
Payments based upon tax credits for 2005 through 2007 are subject to downward adjustment
or elimination if a phase-out of section 29 tax credits occurs due to high oil prices.

We
recognized the $50.0 million contract litigation settlement gain, net of payments due to a
third party, as a reduction in operating costs and expenses in 2005. The $70.0 million,
net of payments due to a third party, is being recognized as revenue over calendar years
2005 through 2007. The ongoing quarterly payments based upon tax credits are being
recognized as revenue in accordance with our revenue recognition policy for license fee
revenue.

In
connection with the settlement of the AJG litigation, we also recognized approximately
$8.2 million of revenue from a licensee with an indirect interest in that litigation, all
of which related to periods prior to January 1, 2005. Ongoing revenue from this licensee
is also being recognized in accordance with our revenue recognition policy for license fee
revenue.

Certain
accounting rules limit revenue recognition to amounts that are fixed or
determinable. The amount of license fee revenue we recognized for 2006 was
materially negatively affected by significantly reduced revenues being recognized for
several licensees whose license agreements call for us to be paid a portion of the tax
credits earned by the licensee. Because the calendar 2006 phase-out percentage for Section
45K tax credits can not be finalized at the current time, only approximately $10.0 million
of revenues for these licensees was recognized for the nine months ended September 30,
2006. The amount recognized met the fixed or determinable recognition
criterion and it is remote that any negative adjustment will be required in the future.
Additional revenues for these licensees, which could total more than $30.0 million
(calculated based on licensee-reported data, which amount ultimately depends on the
calendar 2006 phase-out percentage of Section 45K), will not be recognized until such time
as these amounts become fixed or determinable.

Income
Taxes. Significant estimates and judgments were required in the calculation of our
income tax provisions for the years presented, most particularly for 2006. One of the key
estimates affecting our 2006 tax provision relates to the amount of Section 45K [formerly
Section 29] tax credits that will ultimately be available related to our 19% interest in
an entity that owns and operates a coal-based solid alternative fuel production facility
(see Note 10 to the consolidated financial statements), plus two other smaller alternative
fuel facilities that we own and operate. While the calendar 2006 Section 45K tax credit
phase-out percentage can not be finalized at the current time, as of September 30, 2006,
an estimated phase-out percentage of 42% is our best estimate of what the phase-out
percentage for calendar 2006 would be, using available information as of that date.

The
calculation of our tax liabilities involves uncertainties in the application of complex
tax regulations in multiple jurisdictions. We recognize potential liabilities for
anticipated tax audit issues in the U.S. and state tax jurisdictions based on our estimate
of whether, and the extent to which, additional taxes and interest will be due. If events
occur and the payment of these amounts ultimately proves to be unnecessary, the reversal
of the liabilities would result in tax benefits being recognized in the period when we
determine the liabilities are no longer probable or necessary. If our estimate of tax
liabilities proves to be less than the ultimate assessment, a further charge to expense
would result.

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In
evaluating our ability to recover our recorded deferred tax assets, in full or in part,
all available positive and negative evidence, including our past operating results and our
forecast of future taxable income on a jurisdiction by jurisdiction basis, is considered
and evaluated. In determining future taxable income, we are responsible for assumptions
utilized including the amount of federal, state and international pre-tax operating
income, the reversal of temporary differences and the implementation of feasible and
prudent tax planning strategies. These assumptions require significant judgment about the
forecasts of future taxable income and are consistent with the plans and estimates we are
using to manage our underlying businesses.

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. These intangible assets are being 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 the
requirements of SFAS No. 142, we do not amortize goodwill, all of which relates to
acquisitions that occurred from 2001 through 2006. SFAS No. 142 requires us to
periodically test for goodwill impairment at least annually, or sooner if evidence of
possible impairment arises. We perform our annual impairment testing as of June 30, using
a two-step process that begins with an estimation of the fair values of the reporting
units that have goodwill. Currently, five reporting units have goodwill, three of which
are in the construction materials segment. There is one reporting unit with goodwill in
each of the CCPs and alternative energy segments.

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 is failed for a
reporting unit, indicating a potential impairment, we 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
goodwill exceeds its implied fair value, an impairment loss is required to be recorded. We
have performed step 1 impairment tests of recorded goodwill as of June 30, 2004, 2005 and
2006, all of which indicated that the fair values of the reporting units exceeded their
carrying values. Accordingly, step 2 of the impairment tests was not required to be
performed, and no impairment charges were necessary.

In
addition to the annual review, we evaluate, based on current events and circumstances, 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. Changes in circumstances such as technological advances, or
changes in our business model or capital strategy could result in the actual useful lives
differing from our current estimates. In those cases where we determine that the useful
life of property, plant and equipment or intangible assets should be changed, we would
amortize the net book value in excess of salvage value over its revised remaining useful
life, thereby adjusting depreciation or amortization expense as necessary.

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. In 2006, the
construction materials segment revised downward the estimated useful lives of certain
assets resulting in accelerated depreciation charges in order to fully depreciate the
assets over shorter periods.

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

Stock-Based
Compensation. As described in more detail in Note 11 to the consolidated financial
statements, we early adopted the fair value method of accounting for stock-based
compensation required by SFAS No. 123R, effective as of October 1, 2004, the beginning of
our 2005 fiscal year. SFAS No. 123R revises SFAS No. 123 and supersedes APB 25 and
requires companies to expense the value of employee stock options and other equity-based
awards. Stock-based compensation expense is reported within the same operating expense
line items as used for cash compensation expense. A significant amount of the 2005
stock-based compensation resulted from the expense associated with the grants of
immediate-vested SARs and from the acceleration of vesting of certain stock options. Due
to immateriality, we have not capitalized any compensation cost as part of the cost of any
asset. Tax benefits resulting from exercise of stock options and SARs are reflected in the
consolidated statements of changes in stockholders equity and cash flows.

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We
recognize compensation expense equal to the grant-date fair value of stock-based awards
for all awards expected to vest, over the period during which the related service is
rendered by grantees. The fair value of stock-based awards is determined primarily using
the Black-Scholes-Merton (B-S-M) model, which is the same valuation model used
previously in valuing stock options for the pro forma footnote disclosures under the
requirements of SFAS No. 123 (see Note 2 to the consolidated financial statements). We use
the graded vesting or accelerated method to value awards and to allocate those
values over the requisite service periods, again the same method as used previously in
determining pro forma expense under SFAS No. 123. Our estimated forfeiture rates are based
largely on historical data and ranged from 0% to 5% during 2005 and 2006, depending on the
type of award and the award recipients. As of September 30, 2006, the estimated forfeiture
rate for most unvested awards is 1% per year.

The
fair values of stock options and SARs granted in 2005 and 2006 were estimated using the
B-S-M model, adjusted where necessary to account for specific terms of awards that the
B-S-M model does not have the capability to consider. We use the services of an
independent valuation firm to validate our fair value estimates and assumptions and also
to determine certain necessary adjustments to the B-S-M model output. One such adjustment
was used in determining the fair value of SARs which have a cap on allowed appreciation.
For these SARs, the output determined by the B-S-M model was reduced by an amount
determined by a Quasi-Monte Carlo simulation to reflect the reduction in fair value
associated with the appreciation cap.

Expected
stock price volatility was estimated using historical volatilities of our stock, implied
volatilities of traded options on our stock, volatility predicted by a Generalized
AutoRegressive Conditional Heteroskedasticity model, and an analysis of volatilities
used by other public companies in comparable lines of business. Risk-free interest rates
used were the US Treasury bond yields with terms corresponding to the expected terms of
the awards being valued. In estimating expected lives, we considered the contractual and
vesting terms of awards, along with historical experience; however, due to insufficient
historical data from which to reliably estimate expected lives, we used estimates based on
the simplified method set forth by the SEC in Staff Accounting Bulletin No.
107, where expected life is estimated by summing the awards vesting term and the
contractual term and dividing that result by two. The reduction in value related to
grantee payment for certain immediate-vested SARs was estimated by management based on the
terms of the payment requirements and other factors.

A
significant amount of our outstanding SARs vest over five years and most of these SARs are
exercisable based on the achievement of performance criteria related to our economic
growth during the five-year period. We currently expect the performance criteria to be
achieved and therefore are recording compensation expense over the five-year period, which
also represents the requisite service period. If this expectation changes in the future,
some or all of the compensation expense recognized up to that time would be reversed.

As
a result of the adoption of SFAS No. 123R, we will recognize additional non-cash
compensation expense in future periods. As of September 30, 2006, there was approximately
$11.4 million of total compensation cost related to nonvested awards not yet recognized.
This unrecognized compensation cost is expected to be recognized over a weighted-average
period of approximately 2.0 years.

The
adoption of SFAS No. 123R, combined with the settlement of the AJG litigation described
above, was a contributing factor in our decision to grant employee incentive awards in
2005, in particular to grant fewer options and more SARs, including many that vested
immediately, the granting of performance-based awards, and the acceleration of vesting of
stock options.

# Year Ended September 30,
2006 Compared to Year Ended September 30, 2005

The
information set forth below compares our operating results for the year ended September
30, 2006 (2006) with operating results for the year ended September 30, 2005
(2005).

Revenue.
          Total revenue for 2006 increased by $56 million or 5% to $1.121 billion as
          compared to $1.065 billion for 2005. The major components of revenue are
          discussed in the sections below.

Construction
Materials Segment. Sales of construction materials during 2006 were $573.4 million
with a corresponding direct cost of $394.1 million. Sales of construction materials during
2005 were $519.9 million with a corresponding direct cost of $346.5 million. The increase
in sales of construction materials during 2006 was due primarily to increases in volume,
which occurred across all major product lines, with a lesser impact from price increases
related to passing on to customers a portion of raw material cost

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increases. The primary reasons for
the decline in gross margin percentage from 2005 to 2006 were acceleration of
depreciation charges in order to fully depreciate certain assets over shorter estimated
useful lives, additional operating costs as production levels were managed downward to
account for the downturn in the residential housing market and higher raw material costs,
only a portion of which were passed on to customers. Because a substantial amount of our
revenues in this segment are dependent on the housing market, we anticipate some impact
in 2007 from the current slowdown in the housing industry.

CCP
Segment. CCP revenues for 2006 were $281.2 million with a corresponding direct cost of
$206.4 million. CCP revenues for 2005 were $246.8 million with a corresponding direct cost
of $186.1 million. The increase in CCP revenues and in the gross margin percentage during
2006 were due primarily to a combination of continued strong demand for CCPs, upward
pricing trends in most concrete markets, and increased project revenues. In addition,
weather conditions in the south central region of the United States have generally been
favorable in 2006. The growth in demand for CCPs is due in part to certain regional
shortages of portland cement for which CCPs are a substitute, which can result in an
increased percentage of CCPs being used in concrete. The cement shortages also resulted in
increased prices for CCPs in several markets.

Alternative
Energy Segment. Our alternative energy segment revenue consists primarily of chemical
reagent sales, license fee revenue related to our solid alternative fuel technologies, and
to a lesser extent, sales of synthetic fuel from two solid alternative fuel production
facilities that we own that began operating in 2005. The major components of revenue for
the alternative energy segment are discussed in the sections below.

A
material amount of our consolidated revenue and net income is derived from our license
fees and sales of chemical reagents, both of which depend on the ability of licensees and
other customers to manufacture and sell qualified synthetic fuel that generates tax
credits under Section 45K [formerly Section 29] of the Internal Revenue Code. From time to
time, issues arise as to the availability of tax credits and, with the rising price of
oil, the potential phase-out of credits, as described previously and in Note 14 to the
consolidated financial statements. Due to the significance of these issues, it is not
possible to predict the trend of alternative energy revenue in future periods.

Sales
of Chemical Reagents. Chemical reagent sales during 2006 were $143.0 million with a
corresponding direct cost of $108.1 million. Chemical reagent sales during 2005 were
$170.3 million with a corresponding direct cost of $120.6 million. The decrease in
chemical reagent sales during 2006 was due to decreased synthetic fuel production by our
licensees (resulting in decreased sales of $13.0 million), and by customers with whom we
do not have a license agreement (resulting in decreased sales of $14.3 million). The
primary reason for decreased synthetic fuel production in 2006 was the potential for
significant phase-out of Section 45K tax credits, resulting in licensees and other
customers stopping or significantly curtailing production for a period of time during
2006. It is not possible to predict the trend for sales of chemical reagents in future
periods. The gross margin percentage for 2006 of 24% was lower than 2005s gross
margin percentage of 29% due primarily to increases in the cost of product, which in turn
is related to increases in the costs of petroleum-based materials. We currently believe
reagent margins will decrease further in future periods, depending upon crude oil prices
and other factors.

License
Fees. During 2006, we recognized license fee revenue totaling $74.7 million, a
decrease of $34.6 million or 32% from $109.3 million of license fee revenue recognized
during 2005. The primary reason for the decrease in license fee revenue in 2006 compared
to 2005 relates to significantly reduced revenues being recognized for several licensees
whose license agreements call for us to be paid a portion of the value of the tax credits
earned by the licensee. Certain accounting rules limit revenue recognition to amounts that
are fixed or determinable. Because the calendar 2006 phase-out percentage for
Section 45K tax credits can not be finalized at the current time, only approximately $10.0
million of revenues for these licensees was recognized for the nine months ended September
30, 2006. The amount recognized met the fixed or determinable recognition
criterion and it is remote that any negative adjustment will be required in the future.
Additional revenues for these licensees, which could total more than $30.0 million
(calculated based on licensee-reported data, which amount ultimately depends on the
calendar 2006 phase-out percentage of Section 45K), will not be recognized until such time
as these amounts become fixed or determinable. Reference is made to our policy
disclosures discussed previously.

Pursuant
to the terms of an agreement with a certain licensee, this licensee has set aside
substantial amounts for working capital and other operational contingencies as provided
for in the agreement. These amounts may eventually be paid out to various parties having
an interest in the cash flows from the licensees operations, including us, if they
are not used for working capital and other operational contingencies. As a result, we
currently expect to receive at some future date a portion of those reserves, the amount of
which is not currently determinable and which constitutes a gain contingency not
recognizable as revenue.

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Other
Alternative Energy Segment Revenues. Sales of synthetic fuel during 2006 were $42.5
million with a corresponding direct cost of $49.2 million. Sales of synthetic fuel during
2005 were $16.6 million with a corresponding direct cost of $19.2 million. The increase in
sales of synthetic fuel from 2005 to 2006 was due to the synthetic fuel facilities
starting operations in spring 2005. Revenue from the sale of synthetic fuel has a negative
gross margin, which is more than compensated for by the income tax credits expected to be
earned from the sales of the synthetic fuel.

Amortization
and Research and Development Expenses. There were no material changes in either
amortization or research and development expenses from 2005 to 2006. Both expense
categories are currently expected to remain near historical levels in future periods.

Selling,
General and Administrative Expenses. These expenses decreased $17.3 million, or 11% to
$138.0 million for 2006 from $155.3 million for 2005. The decrease in 2006 was due
primarily to significant one-time stock-based compensation costs in 2005 related to the
implementation in 2005 of SFAS No. 123R ($22.7 million). Offsetting this decrease was a
$3.5 million increase in marketing expense related to efforts in the construction
materials segment to increase awareness and sales of new products.

Contract
Litigation Settlement. In 2005, we settled our litigation with AJG. In connection with
the litigation settlement, a payment of $50.0 million was received in 2005. This amount,
net of payments due to a third party and less the amount recognized as a reimbursement of
legal fees (approximately $6.5 million), was reflected as a reduction in operating costs
and expenses.

Other
Income and Expense. During 2006, we reported net other expense of $44.0 million
compared to net other expense of $73.1 million during 2005. The change of $29.1 million
was attributable to a decrease in net interest expense of $23.4 million and a decrease in
other expenses of $5.7 million. Net interest expense decreased from $57.4 million in 2005
to $34.0 million in 2006, due primarily to significantly lower average levels of long-term
debt in 2006 compared to 2005.

The
decrease in other expenses of $5.7 million consisted primarily of a decrease in costs of
approximately $9.0 million related to our investment in the coal-based solid alternative
fuel production facility described in Note 10 to the consolidated financial statements.
The primary reason for decreased costs for this facility is related to using an estimated
phase-out percentage for Section 45K tax credits for calendar 2006 of approximately 42%,
all as explained in Note 10. The alternative fuel produced at the facility through
December 2007 qualifies for tax credits pursuant to Section 45K of the Internal Revenue
Code, and we are entitled to receive our pro-rata share of such tax credits generated
based upon our percentage of ownership of the facility. Partially offsetting the decrease
in costs related to our investment in the alternative fuel facility was an increase of
$3.3 million in charges primarily related to a joint venture investment and the
disposition of property, plant and equipment.

Income
Tax Provision. Our income tax provision for both 2005 and 2006 resulted in an
effective tax rate of approximately 26%. The low effective tax rate for both years is
primarily due to tax credits related to the two coal-based solid alternative fuel
facilities that we own and operate, plus our 19% interest in an entity that owns and
operates another alternative fuel facility (where we are not the primary beneficiary). The
alternative fuel produced at these three facilities through December 2007 qualifies for
tax credits pursuant to Section 45K [formerly Section 29] of the Internal Revenue Code,
subject to the uncertainties of phase-out, IRS audit and other risks associated with the
tax credits, all as more fully described in Note 14 to the consolidated financial
statements. Excluding the effect of the tax credits, our estimated effective tax rate for
2005 and 2006 would be approximately 38.5% and 40%, respectively.

As
a result of high oil prices in 2006, it appears there will a partial phase out of Section
45K tax credits for calendar 2006. Therefore, in calculating an income tax provision for
fiscal 2006, we assumed a phase-out percentage for Section 45K tax credits for calendar
2006 of 42%. This estimated phase-out percentage was derived by estimating the calendar
2006 reference price for oil using actual oil prices for the months January through July
2006, and published NYMEX oil prices for the months August through December 2006. The
monthly NYMEX oil prices were reduced by approximately 10%, which reduction represents our
estimate of the relationship between NYMEX prices and the average U.S. wellhead oil prices
actually used to calculate the annual reference price. The estimated reference price for
calendar 2006 was calculated by averaging the 12 months actual or estimated oil
prices, which average was compared to the estimated phase-out range for calendar 2006
($54.27 to $68.12) to derive an estimated phase-out percentage.

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While
the calendar 2006 phase-out percentage can not be finalized at the current time, as of
September 30, 2006, an estimated phase-out percentage of 42% is our best estimate of what
the phase-out percentage for calendar 2006 would be, using available information as of
that date. As of March 31, 2006, the estimated phase-out percentage for calendar 2006 was
37% and as of June 30, 2006, the estimated percentage was 69%. The effect on income taxes
of the change in the phase-out percentage from 42% to the actual percentage for the year
will be recorded to income tax expense in subsequent periods, when all of the calendar
2006 actual oil prices are known. Any such effect could be material to our 2007 income tax
expense.

# Year Ended September 30,
2005 Compared to Year Ended September 30, 2004

The
information set forth below compares our operating results for the year ended September
30, 2005 (2005) with operating results for the year ended September 30, 2004
(2004).

Revenue.
          Total revenue for 2005 increased by $511 million or 92% to $1.065 billion as
          compared to $554 million for 2004. The major components of revenue are discussed
          in the sections below.

Construction
Materials Segment. Sales of construction materials during 2005 were $519.9 million
with a corresponding direct cost of $346.5 million. Sales of construction materials during
2004 were $134.0 million with a corresponding direct cost of $95.3 million. The increase
in sales of construction materials during 2005 was due primarily to the 2004 acquisitions.
The increase in gross margin percentage from 2004 to 2005 was due primarily to
significantly higher margins from the operations of the acquired businesses.

CCP
Segment. CCP revenues for 2005 were $246.8 million with a corresponding direct cost of
$186.1 million. CCP revenues for 2004 were $210.2 million with a corresponding direct cost
of $155.8 million. The increase in CCP revenues during 2005 was due primarily to an
acquisition of a CCP company in 2004 and growth in demand for CCPs, partially due to
shortages in portland cement. The cement shortages also resulted in increased prices for
CCPs in several markets. The gross margin percentage decreased from 2004 to 2005 by
approximately 1% due primarily to the acquired company, which typically has lower gross
margins than the legacy CCP business. The acquired companys impact on gross margin
in 2005 was more significant than in 2004 because there was only six months of activity
for the acquired company in 2004.

Alternative
Energy Segment. Our alternative energy segment revenue consists primarily of chemical
reagent sales, license fee revenue related to our solid alternative fuel technologies, and
to a lesser extent, sales of synthetic fuel from two solid alternative fuel production
facilities that we own that began operating in 2005. Revenue from the sale of synthetic
fuel has a negative gross margin, but is more than compensated for by the income tax
credits earned from the sales of the synthetic fuel.

Sales
of Chemical Reagents. Chemical reagent sales during 2005 were $170.3 million with a
corresponding direct cost of $120.6 million. Chemical reagent sales during 2004 were
$132.6 million with a corresponding direct cost of $89.8 million. The increase in chemical
reagent sales during 2005 was due primarily to increased synthetic fuel production by our
licensees (resulting in increased sales of $21.8 million) and by customers with whom we do
not have a license agreement (resulting in increased sales of $15.9 million). Of the
increased sales to customers, $7.4 million represents sales of chemical reagent related to
the coal-based solid alternative fuel production facility in which we are a minority owner
(see Note 10 to the consolidated financial statements). The gross margin percentage for
2005 of 29% was 3% lower than for 2004, due primarily to increases in the cost of product,
which in turn is related to increases in the costs of petroleum-based materials, and to a
lesser extent, changes in customer mix.

License
Fees. During 2005, we recognized license fee revenue totaling $109.3 million, an
increase of $36.6 million or 50% from $72.7 million of license fee revenue recognized
during 2004. The primary reasons for the increase in license fee revenue in 2005 compared
to 2004 relate to the settlement of the AJG litigation described below ($35.1 million in
total). In addition, license fee revenue from licensees not associated with the litigation
increased $1.5 million from 2004 to 2005 as a result of increased production of
alternative fuel by these licensees.

In
2005, we entered into a settlement agreement with AJG which provided for payments to us in
the amount of $50.0 million at the time of settlement (discussed below in the caption
Contract Litigation Settlement), $70.0 million (related to a contract
modification for use of technology) in January 2006, and certain quarterly payments based
upon tax credits associated with AJGs facilities for calendar years 2005 through
2007. The $70.0 million, net of payments due to a third party, is being recognized as
revenue over calendar years 2005 through 2007; however, because the settlement agreement
was not reached until May, six months of revenue covering the period January 1, 2005
through June 30, 2005 was recognized in the quarter ended June 30, 2005. The ongoing
quarterly payments are being recognized as revenue in accordance with our revenue
recognition policy for license fee revenue. In total, we recognized approximately $26.2
million of license fees from AJG in 2005 ($24.8 million of which directly related to the
settlement of litigation), compared to $1.4 million of license fee revenue from AJG in
2004.

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In
connection with the settlement of the AJG litigation, we also recognized approximately
$8.2 million of revenue from a licensee with an indirect interest in that litigation, all
related to periods prior to January 1, 2005. Ongoing revenue from this licensee is also
being recognized in accordance with our revenue recognition policy for license fee revenue
and was approximately $2.3 million in 2005.

Offsetting
these increases, was a $11.1 million decrease in revenue recognized from a licensee for
which we recognized $24.9 million of net revenue in 2004, representing funds previously
deposited in an escrow account pending resolution of certain contingencies, all relating
to alternative fuel sold prior to December 31, 2003. We recognized a total of
approximately $37.1 million of revenue from this licensee in 2004 and $26.0 million of
revenue in 2005. For more information about the revenue related to this licensee, see
License Fee Revenue Recognition in the Critical Accounting Policies and
Estimates section above.

Amortization.
          These costs increased by $15.4 million to $24.5 million in 2005 from $9.1
          million in 2004. The increase was primarily attributable to the fiscal 2004
          acquisitions and the resulting increases in amortizable intangible assets.

Research
and Development. Research and development expenses increased by $5.0 million to $12.6
million in 2005 from $7.6 million in 2004. The increase was primarily attributable to
increased research and development activities and the recognition of approximately $1.9
million of stock-based compensation expense in 2005 related to the adoption of SFAS No.
123R. No such expense was recorded in 2004.

Selling,
General and Administrative Expenses. These expenses increased $87.1 million to $155.3
million for 2005 from $68.2 million for 2004. The increase in 2005 was due primarily to an
increase in stock-based compensation expense of approximately $29.7 million and the 2004
acquisitions (approximately $53.1 million). A substantial portion of the expense related
to stock-based compensation represent the expense associated with the grant of
immediate-vested SARs and the acceleration of vesting of certain stock options ($22.7
million), as explained in more detail in Note 11 to the consolidated financial statements.
These two events are not likely to recur in the foreseeable future. There was only $0.3
million of stock-based compensation included in selling, general, and administrative
expenses in 2004.

Contract
Litigation Settlement. In 2005, we settled our litigation with AJG. In connection with
the litigation settlement, a payment of $50.0 million was received in 2005. This amount,
net of payments due to a third party and less the amount recognized as a reimbursement of
legal fees (approximately $6.5 million), was reflected as a reduction in operating costs
and expenses because it represents a non-recurring litigation settlement that is not
reflective of our revenue components described above, but is directly related to our
operating activities.

Other
Income and Expense. During 2005, we reported net other expense of $73.1 million
compared to net other expense of $22.7 million during 2004. The change of $50.4 million
was attributable to an increase in net interest expense of $38.9 million in 2005 and a net
increase in other expenses of approximately $11.5 million in 2005.

Net
interest expense increased from $18.5 million in 2004 to $57.4 million in 2005 due
primarily to significantly higher average levels of long-term debt in 2005 compared to
2004, as a result of the 2004 acquisitions. We incurred approximately $11.4 million of
interest expense related to the early repayment of senior debt in 2005, consisting of
accelerated amortization of debt issue costs of $7.4 million plus $4.0 million of
prepayment penalties. In connection with the reduction of the amount of senior debt hedged
from $300.0 million to $150.0 million, as allowed under terms of the amended credit
facility, we recognized a gain of approximately $1.0 million, which was recorded as a
reduction in interest expense.

The
net change in other expenses of $11.5 million consisted primarily of a $16.1 million
increase in costs related to our investment in the coal-based solid alternative fuel
production facility described in Note 10 to the consolidated financial statements,
partially reduced by $4.0 million of losses on notes receivable and other asset write-offs
in 2004 that did not recur in 2005 and an increase of $0.8 million in gain on disposition
of property, plant and equipment.

Income
Tax Provision. Our effective income tax rate for 2005 was approximately 26%. This
compares to an effective tax rate of approximately 39% for 2004. The primary reason for
the decrease in the effective tax rate is the federal income tax credits available as a
result of our investment in an entity that owns and operates a coal-based solid

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alternative fuel production facility
(see Note 10 to the consolidated financial statements), as well as our ownership of two
other alternative fuel production facilities that began operating in 2005. The
alternative fuel produced at these three facilities through December 2007 qualifies for
tax credits pursuant to Section 45K of the Internal Revenue Code. Excluding the effect of
the tax credits, our effective tax rate in 2005 would have been approximately 38.5%.

# Impact of Inflation and
Related Matters

Our
operations have been impacted in 2006 by i) rising costs for chemical reagents in the
alternative energy segment; ii) increased cement, polypropylene and poly-vinyl chloride
costs in the construction materials segment; iii) increased fuel costs that have affected
transportation costs in most of our business units; and iv) certain regional shortages of
cement and aggregate materials. The increased costs of chemical reagents, polypropylene,
poly-vinyl chloride and fuel are directly related to the increase in prices of natural
gas, oil and other petroleum-based materials. The increased costs of cement are caused
primarily by a lack of adequate supplies in some regions of the U.S.

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

# Liquidity and Capital
Resources

Summary
of Cash Flow Activities. Net cash provided by operating activities during 2006 was
$222.7 million compared to $151.2 million during 2005. Most of the $71.5 million
difference was due to significant changes in operating assets and liabilities between 2005
and 2006, including in 2006 the receipt of the final $70.0 million payment due from the
litigation settlement reached with AJG in fiscal 2005. In both years, the primary
investing activity consisted of the purchase of property, plant and equipment. In 2006, we
also made investments in joint ventures and incurred payments for acquisitions. The
primary financing activity for both years consisted of repayments of long-term debt. In
2005, proceeds from the issuance of common stock was also a significant financing
activity. More details about our investing and financing activities are provided in the
following paragraphs.

Investing
Activities. Expenditures for property, plant and equipment in 2006 were not materially
different from the 2005 amount. Most of the capital expenditures in both periods were
incurred by the construction materials segment, however in fiscal 2006, a higher
proportion of total capital expenditures were incurred by the CCP and alternative energy
segments, as compared to 2005. A significant portion of our planned future capital
expenditures represent expansion of operations, rather than maintenance of operating
capacity. Capital expenditures for fiscal 2006 were limited to $80.0 million by our senior
debt covenants. The covenants limit capital expenditures to $100.0 million in 2007 and
subsequent years; however, the cumulative unused amounts of annual capital expenditures
limits can be carried forward and used in subsequent years. As of September 30, 2006, we
have approximately $25.4 million of unused amounts of capital expenditures from prior
years and we were committed to spend approximately $7.3 million on capital projects that
were in various stages of completion.

We
intend to continue to expand our business through growth of existing operations,
commercialization of technologies currently being developed, and strategic acquisitions of
products or entities that expand our current operating platform. Acquisitions are an
important part of our business strategy and to that end, we routinely review potential
complementary acquisitions, including those in the areas of construction materials, CCP
marketing, and coal and catalyst technologies. It is possible that some portion of future
cash and cash equivalents 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. The senior secured credit agreement limits acquisitions
in the aggregate to $50.0 million of cash consideration and $20.0 million of non-cash
consideration annually, with no more than $30.0 million of cash consideration for any one
acquisition, unless our total leverage ratio, as defined, is less than or
equal to 3.50:1.0, after giving effect to an acquisition, in which case the foregoing
limitations do not apply. The senior secured credit agreement also limits the amount we
can invest in joint ventures and other less than 100%-owned entities.

We
entered into an agreement with Degussa AG, 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, we committed to fund
50% of the joint ventures research and development expenditures through September
2007, subject to a stipulated maximum. The amount remaining to be paid under this
commitment as of September 30, 2006 is not material. In 2006, we

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formed another joint venture with
Degussa AG, Degussa Headwaters Korea Co., Ltd. (DHK), which purchased a
hydrogen peroxide production business located in South Korea. We are a principal obligor
with respect to all non-financial obligations of DHK and, with respect to financial
obligations of DHK, 50% of future plant expansion cost overruns, if any. Our investments
in joint ventures with Degussa AG (in which Degussa and Headwaters have equal ownership,
voting rights and control) are accounted for using the equity method of accounting and
total approximately $19.3 million at September 30, 2006.

We
also own a 51% interest in a joint venture with Great River Energy, a Minnesota-based
power generation and supply cooperative (GRE), which was formed to construct,
own and operate an ethanol plant in North Dakota (Blue Flint). The plant is
currently expected to begin operating in early calendar 2007 with estimated ethanol
production of 50 million gallons annually. Estimated costs to construct the ethanol plant
and fund start-up costs and initial working capital approximate $95.5 million, which is
being funded primarily by debt secured by all the assets of Blue Flint, along with capital
contributions from us and GRE. We have made our full capital contribution as of September
30, 2006. The Blue Flint joint venture, which is not a variable interest entity, is being
accounted for using the equity method of accounting because both partners have equal
voting rights and control over the joint venture. Our investment in the Blue Flint joint
venture totals approximately $8.9 million at September 30, 2006.

We
agreed to pay an earn-out to the sellers of a subsidiary company acquired in 2004 if a
specified earnings target was exceeded during the 12 months ended December 31, 2005 (the
earn-out period). The earn-out achieved totaled $9.5 million and was recorded as
additional goodwill when it was paid to the former owners of the subsidiary in 2006.
During 2006, we acquired certain assets and assumed certain liabilities of several
privately-held companies in the construction materials industry. Total consideration paid
or accrued for these acquisitions was less than $8.0 million. Pursuant to contractual
terms for some of the acquisitions, additional amounts may be payable in the future, based
on the achievement of stipulated revenue or earnings targets for periods ending no later
than March 2010. If future earn-out consideration is paid, goodwill will be increased
accordingly. Operating results since acquisition dates for all of the businesses combined
were not material.

In
November 2006, we acquired 100% of the ownership interests of a privately-held company in
the construction materials business. Total consideration paid was approximately $49.0
million. Pursuant to contractual terms, an additional amount may be payable in the future,
based on the achievement of a stipulated earnings target for the 12 months ending
September 30, 2007.

Financing
Activities. Due to the issuance of senior debt in September 2004 and the covenants
associated with that debt, we currently have limitations on our ability to obtain
significant additional amounts of long-term debt. However, we have experienced strong
positive cash flow from operations and in fiscal 2005 issued common stock which together
has enabled us to repay a substantial amount of our long-term debt prior to the scheduled
maturities. We expect our positive cash flow to continue in the future and also have the
ability to access the equity markets if necessary.

We
have 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.
Approximately $18.0 million remains available for future offerings of securities under
this 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.

Reference
is made to Note 8 to the consolidated financial statements for detailed information about
our outstanding long-term debt (including 2006 repayments and future maturities), interest
rate hedges, and compliance with debt covenants. We may, in the future, make optional
prepayments of the senior debt depending on actual cash flows, our current and expected
cash requirements and other applicable factors we deem to be significant.

As
provided for in the senior debt agreements, we have available $60.0 million under a
revolving credit arrangement, along with the ability to increase this amount to $100.0
million, subject to obtaining additional revolving loan commitments. Borrowings under the
revolving credit arrangement are generally subject to the terms of the first lien loan
agreement. Borrowings and reborrowings of any available portion of the $60.0 million
revolver can be made at any time through September 2009, when all loans must be repaid and
the revolving credit arrangement terminates. There were no borrowings outstanding under
the revolving credit arrangement as of September 30, 2006, or subsequent thereto. The
credit agreement also allows for the issuance of letters of credit, provided there is
capacity under the revolving credit arrangement. As of September 30, 2006, eight letters
of credit totaling $6.6 million were outstanding, with expiration dates ranging from
October 2006 to December 2008.

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, annual capital expenditures in excess of $80.0 million
for 2006 and $100.0 million thereafter, and the payment of dividends, among others. In
addition, we must maintain certain leverage and fixed charge coverage ratios. We are in
compliance with all debt covenants as of September 30, 2006.

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In
2006, cash proceeds from the exercise of options and employee stock purchases totaled $8.7
million, compared to $14.9 million in 2005. Option exercise activity is primarily
dependent on our 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, we receive an income tax deduction generally equal to
the income recognized by the optionee. Such amounts, reflected in cash flows from
financing activities in the consolidated statements of cash flows, were $(2.8) million in
2006 and $8.1 million in 2005. The negative amount in 2006 was caused by a reversal of
amounts pertaining to prior periods, stemming from adjustments related to an ongoing IRS
audit.

Working
Capital. During 2006, our working capital increased by $28.0 million, to $145.3
million as of September 30, 2006. We expect operations to produce positive cash flow in
future periods and believe working capital, along with available borrowings under the
revolving credit arrangement, will be sufficient for operating needs for the next 12
months.

Income
Taxes. Our cash requirements for income taxes generally approximate the income tax
provision; however, there is usually some lag in paying estimated taxes during a fiscal
year 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. There is also some lag in realizing the cash benefits from the utilization of tax
credits due to the interaction of our September 30 fiscal year end and the different
fiscal year ends of the entities through which we receive the tax credits. In fiscal 2006,
there was more variability in the relationship between the income tax provision and income
tax payments because the tax provision calculation is materially dependent upon the
estimated phase-out percentage of Section 45K tax credits (see Note 10 to the consolidated
financial statements). The phase-out percentage is subject to material change at this date
because it is dependent on oil prices for the remainder of calendar 2006, which are not
predictable. Therefore, the 2006 tax provision reflected in the consolidated financial
statements is also subject to material change.

As
discussed previously, cash payments for income taxes are reduced for tax deductions
resulting from disqualifying dispositions of incentive stock options and from the exercise
of non-qualified stock options, which amount was a negative $2.8 million in 2006. Option
exercise activity is primarily dependent on our stock price and is not predictable.
Likewise, it is not possible to estimate what tax benefits may be realized from future
option exercises.

Summary
of Future Cash Requirements. Significant future cash uses, in addition to operational
working capital requirements, including income tax payments, are currently expected to
consist primarily of capital expenditures, investments in joint ventures, acquisitions and
debt service payments on outstanding long-term debt.

# Off-Balance Sheet
Arrangements

Although
we have operating leases for certain facilities and equipment, and hedge
agreements to limit our exposure to interest rate increases, we do not have any
off-balance sheet arrangements that have, or are reasonably likely to have, a current or
future material effect on our financial condition, results of operations, liquidity,
or capital resources.

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# Contractual Obligations,
Commitments and Contingent Liabilities

The
following table presents a summary of our contractual obligations by period as of
September 30, 2006.

|                                         | Payments due by Fiscal Year
|---------------------------------------- | ---------------------------
|
|
|Senior secured debt                      |                            
|Convertible senior subordinated notes    |                            
|Other long-term debt                     |                            
|                                         |                            
|Total long-term debt                     |                            
|Interest payments on long-term debt      |                            
|Operating lease obligations              |                            
|Unconditional purchase obligations       |                            
|Investment and joint venture obligations |                            
|Capital expenditures                     |                            
|Other long-term obligations              |                            
|                                         |                            
|Total contractual cash obligations       |                            
|                                         |                            

As
described in Note 8 to the consolidated financial statements, our senior debt credit
facility provides for up to $60.0 million of borrowings under a revolving credit
arrangement, along with the ability to increase this amount to $100.0 million, subject to
obtaining additional revolving loan commitments. Borrowings and reborrowings of any
available portion of the $60.0 million revolver can be made at any time through September
2009, when all loans must be repaid and the revolving credit arrangement terminates. There
were no borrowings outstanding under the revolving credit arrangement as of September 30,
2006, or subsequent thereto. The credit agreement also allows for the issuance of letters
of credit, provided there is capacity under the revolving credit arrangement. As of
September 30, 2006, eight letters of credit totaling $6.6 million were outstanding, with
expiration dates ranging from October 2006 to December 2008.

During
2006, we acquired certain assets and assumed certain liabilities of several privately-held
companies in the construction materials industry. Total consideration paid or accrued for
these acquisitions was less than $8.0 million. Pursuant to contractual terms for some of
the acquisitions, additional amounts may be payable in the future, based on the
achievement of stipulated revenue or earnings targets for periods ending no later than
March 2010.

During
2006, the Compensation Committee of our Board of Directors (the Committee)
authorized the grant of long-term incentive cash bonus awards to certain officers and
employees, which awards were granted under our Long Term Incentive Compensation Plan. In
accordance with terms of the awards, cash payments are based on several factors, including
the achievement of stipulated financial goals as measured by economic value added
(EVA) over a three-year period by our operating units. Payments for these
awards may not exceed $30.0 million in the aggregate. No amounts have been expensed for
these awards through September 30, 2006 because it is not yet probable that the financial
goals will be met.

During
2006, the Committee also approved Executive Change in Control Agreements with
12 officers. Upon a change in control, as defined, the agreements provide for immediate
vesting and exercisability of all outstanding stock awards. In addition, if termination of
employment occurs within a specified period of a change in control, the agreements provide
for i) severance pay equal to two times the sum of an officers current annual salary
plus the highest cash bonus paid or payable for any single year in the three-year period
commencing two years prior to the year in which the change in control occurs; and ii)
continuance of health and other benefits and perquisites for a two-year period following
the change in control. If terminations associated with a change in control would have
occurred on September 30, 2006, the severance payments due to the 12 officers would have
aggregated approximately $19.2 million.

During
2005 the Committee authorized the grant of performance unit awards, to be settled in cash,
based on performance criteria tied to the economic value created or preserved by one of
our business units after December 2007. The grants of these performance units were made in
2006 and could result in the payment to employees of a maximum amount of approximately
$3.9 million if all performance criteria are met. No amounts have been expensed for these
awards through September 30, 2006 because it is not yet probable that the performance
criteria will be met.

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In
addition to our standard sales commission arrangements, we have entered into a
contingent commission agreement whereby we have agreed to pay an employee
total sales commissions up to a maximum amount of $4.5 million. The agreement calls for
payments to be made for customer purchase orders of a stipulated size and for a stipulated
period of time to be executed prior to May 2008. No amounts have been expensed under this
agreement through September 30, 2006.

We
have ongoing litigation and asserted claims which have been incurred during the normal
course of business, including the specific matters discussed in Note 14 to the
consolidated financial statements. We intend to vigorously defend or resolve these matters
by settlement, as appropriate. We do not currently believe that the outcome of these
matters will have a material adverse effect on our operations, cash flows or financial
position.

Historically,
costs paid to outside legal counsel for litigation have comprised a majority of our
litigation-related costs. During 2006, we incurred approximately $0.1 million of net
expense for legal matters, including costs for outside legal counsel, compared to
approximately $3.8 million in 2004 and $3.2 million in 2005. In 2006, developments in
certain legal matters we are defending resulted in reduced likelihood of ultimate legal
liability and a reduction of expense. We currently believe the range of potential loss for
all unresolved matters, excluding costs for outside counsel, is from $1.0 million up to
the amounts sought by claimants and has recorded a total liability as of September 30,
2006 of $1.0 million. Claims and damages sought by claimants in excess of this amount are
not deemed to be probable. Our outside counsel currently believe that unfavorable outcomes
of outstanding litigation are neither probable nor remote and declined to express opinions
concerning the likely outcomes or our liability. It is not possible to estimate what
litigation-related costs will be in future periods.

The
matters discussed in Note 14 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 we believe that the
claims asserted against us 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 us for a substantial amount of the damages asserted. It is
possible that a change in the estimates of probable liability could occur, and the changes
could be material. Additionally, as with any litigation, these proceedings require that we
incur substantial costs, including attorneys fees, managerial time, and other
personnel resources and costs in pursuing resolution.

# Recent Accounting
Pronouncements

In
July 2006, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 48, Accounting for Uncertainty in Income Taxes  an
Interpretation of FASB Statement No. 109 (FIN 48). This Interpretation
prescribes a consistent recognition threshold and measurement standard, as well as clear
criteria for subsequently recognizing, derecognizing and measuring tax positions, for
financial reporting purposes. FIN 48 also requires expanded disclosures with respect to
the uncertainty in income taxes. FIN 48 is effective for our fiscal 2008 year beginning on
October 1, 2007. We are currently evaluating the impact of FIN 48. The effect of adopting
FIN 48, if material, will be a transition adjustment to beginning retained earnings in the
year of adoption.

In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements
(SFAS No. 157) which addresses how companies should measure fair value when
they are required to use a fair value measure for recognition or disclosure purposes under
generally accepted accounting principles. We must adopt SFAS No. 157 no later than in our
fiscal year ending September 30, 2009. We use fair value measurements to determine the
reported amounts of assets acquired and liabilities assumed in purchase transactions (see
Note 13 to the consolidated financial statements), in testing for potential goodwill
impairment (see Note 7), for disclosure of the fair value of financial instruments (see
Note 9), as well as in other instances. It is therefore possible that the implementation
of SFAS No. 157 could have a material effect on the reported amounts or disclosures in our
consolidated financial statements in future periods.

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

# ITEM 7A. QUANTITATIVE
AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

We
are exposed to financial market risks, primarily related to changes in interest rates. We
do not use derivative financial instruments for speculative or trading purposes, but have
entered into certain hedge transactions, primarily to limit our variable interest rate
exposure.

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As
described in more detail in Note 8 to the consolidated financial statements, we have
approximately $422.5 million of variable-rate long-term debt outstanding as of September
30, 2006, consisting of $415.3 million of senior debt and $7.2 million of notes payable to
a bank. There was approximately $481.4 million of variable-rate long-term debt outstanding
as of September 30, 2005.

As
required by the senior secured credit facility, we entered into agreements to limit our
variable interest rate exposure. The agreements effectively fix the LIBOR rate at 3.71%
for $150.0 million of this debt through September 8, 2007. We account for these agreements
as cash flow hedges, with their fair market value reflected in the consolidated balance
sheet as either other assets or other liabilities. The market value of the hedges can
fluctuate significantly over a relatively short period of time. The hedges had a market
value at September 30, 2006 of approximately $2.1 million, which, net of related income
taxes, represents other comprehensive income. One of the joint ventures we have invested
in (see Note 14 to the consolidated financial statements) has also entered into agreements
that are accounted for as cash flow hedges. Total comprehensive income, considering all
cash flow hedge agreements to which we are a direct or indirect party, was not materially
different from net income for any period presented.

Considering
all outstanding balances of variable-rate debt (reduced by the $150.0 million of senior
debt that effectively has a fixed interest rate until September 8, 2007) and required
principal repayments, a change in the interest rate of 1% would change our interest
expense by approximately $2.8 million during the 12 months ending September 30, 2007.

# 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

None.

# ITEM 9A. CONTROLS AND
PROCEDURES

Disclosure
Controls and Procedures  We maintain disclosure controls and procedures that are
designed to ensure that information we are required to disclose in the reports that we
file or submit under the Securities Exchange Act of 1934 (the Exchange Act),
such as this Annual Report on Form 10-K, is recorded, processed, summarized and reported
within the time periods specified by SEC rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to ensure that
information we are required to disclose in the reports that we file or submit under the
Exchange Act is accumulated and communicated to our management, including the Chief
Executive Officer (CEO) and the Chief Financial Officer (CFO), to
allow timely decisions regarding required disclosure.

Our
management evaluated, with the participation of our CEO and CFO, the effectiveness of our
disclosure controls and procedures as of September 30, 2006, pursuant to paragraph (b) of
Rules 13a-15 and 15d-15 under the Exchange Act. This evaluation 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. Our management, including the
CEO and CFO, do 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, the projection of any evaluation of the disclosure controls and
procedures to future periods is 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, and subject to the inherent limitations described above,
our CEO and CFO have concluded that our disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were effective as of September 30,
2006.

Internal
Control over Financial Reporting  Management is responsible for establishing and
maintaining adequate internal control over financial reporting, as defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act. Our internal control over financial
reporting is designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in
accordance with accounting principles generally accepted in the United States of America.

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Because
of inherent limitations, internal control over financial reporting may not prevent or
detect misstatements. Therefore, even internal controls determined to be effective can
provide only reasonable assurance with respect to financial statement preparation and
presentation. The effectiveness of our internal control over financial reporting is
subject to various inherent limitations, including cost limitations, judgments used in
decision making, assumptions about the likelihood of future events, the possibility of
human error, and the risk of fraud. The projection of any evaluation of effectiveness to
future periods is subject to the risk that controls may become inadequate because of
changes in conditions, or that the degree of compliance with policies may deteriorate.
Because of these limitations, there can be no assurance that any system of internal
control over financial reporting will be successful in preventing all errors or fraud or
in making all material information known in a timely manner to the appropriate levels of
management.

There
has been no change in our internal control over financial reporting during the quarter
ended September 30, 2006 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.

# Managements
Report on Internal Control over Financial Reporting

Our
management is responsible for establishing and maintaining adequate internal control over
financial reporting. Our internal control system has been designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation and
presentation of our financial statements.

Our
management has assessed the effectiveness of internal control over financial reporting as
of September 30, 2006 using the criteria issued by the Committee of Sponsoring
Organizations of the Treadway Commission in Internal Control  Integrated
Framework. Based on that assessment, management believes that our internal
control over financial reporting was effective as of September 30, 2006.

Ernst
& Young LLP, the independent registered public accounting firm which audits our
consolidated financial statements, has issued the following attestation report on
managements assessment of internal control over financial reporting.

# Report of Independent
Registered Public Accounting Firm

The Board of Directors
and StockholdersHeadwaters Incorporated

We have audited managements
assessment, included in the section entitled Managements Report on Internal
Control over Financial Reporting of Item 9A of Headwaters Incorporateds Form
10-K, that Headwaters Incorporated maintained effective internal control over financial
reporting as of September 30, 2006, based on criteria established in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission (the COSO criteria). Headwaters Incorporateds management is
responsible for maintaining effective internal control over financial reporting and for
its assessment of the effectiveness of internal control over financial reporting. Our
responsibility is to express an opinion on managements assessment and an opinion on
the effectiveness of the Companys internal control over financial reporting based on
our audit.

We conducted our audit 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 effective internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over financial
reporting, evaluating managements assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable
basis for our opinion.

A companys internal control
over financial reporting is a process designed to provide reasonable assurance regarding
the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting principles. A
companys internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and

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dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are being made
only in accordance with authorizations of management and directors of the company; and
(3) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the companys assets that could have a material
effect on the financial statements.

Because of its inherent limitations,
internal control over financial reporting may not prevent or detect misstatements. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk
that controls may become inadequate because of changes in conditions, or that the degree
of compliance with the policies or procedures may deteriorate.

In our opinion, managements
assessment that Headwaters Incorporated maintained effective internal control over
financial reporting as of September 30, 2006, is fairly stated, in all material respects,
based on the COSO criteria. Also, in our opinion, Headwaters Incorporated maintained, in
all material respects, effective internal control over financial reporting as of September
30, 2006, based on the COSO criteria.

We also have audited, in accordance
with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheets of Headwaters Incorporated as of September 30, 2005 and 2006,
and the related consolidated statements of income, stockholders equity, and cash
flows for each of the three years in the period ended September 30, 2006 of Headwaters
Incorporated and our report dated November 17, 2006 expressed an unqualified opinion
thereon.

/s/ Ernst & Young LLP

Salt Lake City, UtahNovember
17, 2006

# ITEM 9B. OTHER
INFORMATION

None.

45

---

# PART III

# ITEM 10. DIRECTORS AND
EXECUTIVE OFFICERS OF THE REGISTRANT

The
applicable information to be set forth under the captions Executive Officers,
Corporate Governance, Section 16(a) Beneficial Ownership Reporting
Compliance and Proposal No. 1  Election of Directors in our Proxy
Statement to be filed in January 2007 for the Annual Meeting of Stockholders to be held in
2007 (the Proxy Statement), is incorporated herein by reference.

# ITEM 11. EXECUTIVE
COMPENSATION

The
applicable information to be set forth under the captions Executive Compensation and
Related Information and Corporate Governance in the Proxy Statement is
incorporated herein by reference; provided, however, that we specifically exclude 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 AND RELATED STOCKHOLDER MATTERS

The
information to be set forth under the captions Summary Information about Equity
Compensation Plans and 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
ACCOUNTANT 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.

46

---

# PART IV

# ITEM 15. EXHIBITS AND
FINANCIAL STATEMENT SCHEDULES

# (a) 1. Financial
Statements

| | Consolidated
Financial Statements of Headwaters Incorporated                                                     | Page
| | ---------------------------------------------------------------------------------------------------------------- | ----
| | Report of Independent
Registered Public Accounting Firm                                                          | F-1 
| | Consolidated Balance Sheets as of September 30,
2005 and 2006                                                    | F-2 
| | Consolidated Statements of Income for the years ended September 30, 2004, 2005 and 2006                          | F-3 
| | Consolidated Statements of Changes in Stockholders Equity for the years ended September 30, 2004, 2005 and 2006 | F-4 
| | Consolidated Statements of Cash Flows for the years ended September 30, 2004, 2005 and 2006                      | F-6 
| | Notes to Consolidated Financial Statements                                                                       | F-7 

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.

|Exhibit No. | Description                                                                                                                                                | Location
|----------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------- | --------
|3.1.9       | Amended and Restated Certificate of Incorporation of Headwaters dated 1 March 2005                                                                         | (12)    
|3.2.5       | Amended and Restated By-Laws of Headwaters                                                                                                                 | *       
|10.60       | Employment Agreement dated August 25, 2005 with Kirk A. Benson                                                                                             | (14)    
|10.86       | Securities Purchase Agreement by and among Eldorado Stone Holdings Co., LP, et al. and Headwaters dated April 21, 2004                                     | (4)     
|10.87       | Indenture dated as of June 1, 2004 between Headwaters and Wells Fargo Bank, as Trustee, relating to 2-7/8% Convertible Senior Subordinated Notes due 2016  | (5)     
|10.89       | Agreement and Plan of Merger by and among Headwaters Incorporated, Headwaters T Acquisition Corp., and Tapco Holdings, Inc., dated as of September 8, 2004 | (6)     
|10.90       | Employment Agreement with John N. Lawless, III dated September 22, 2004                                                                                    | (7)     
|10.90.1     | Nonstatutory Stock Option Grant effective as of September 22, 2004                                                                                         | (7)     
|10.90.2     | Executive Change in Control Agreement with John N. Lawless, III effective as of September 22, 2004                                                         | (7)     
|10.91       | Credit Agreement among Headwaters and various lenders dated September 8, 2004                                                                              | (8)     
|10.93       | Amendment No. 2 to the Credit Agreement among Headwaters and various lenders dated as of March 14, 2005                                                    | (10)    
|10.93.1     | Amendment No. 3 to the Credit Agreement among Headwaters and various lenders dated as of May 19, 2005                                                      | (12)    
|10.93.2     | Amendment No. 4 to the Credit Agreement among Headwaters and various lenders dated as of October 26, 2005                                                  | (16)    
|10.93.3     | Amendment No. 5 to the Credit Agreement among Headwaters and various lenders dated as of June 27, 2006                                                     | (17)    
|10.93.4     | Amendment No. 6 to the Credit Agreement among Headwaters and various lenders dated as of August 30, 2006                                                   | (18)    
|10.95       | Offer of Employment dated September 12, 2005 between Scott K. Sorensen and Headwaters (received September 14, 2005)                                        | (15)    
|10.95.1     | Executive Severance Agreement dated September 20, 2005 between Scott K. Sorensen and Headwaters                                                            | (15)    

47

---

|12     | Computation of ratio of earnings to combined fixed charges and preferred stock dividends                       | *   
|------ | -------------------------------------------------------------------------------------------------------------- | ----
|14     | Code of Ethics                                                                                                 | (11)
|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                                                  | (13)
|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 10.5.1)                        | (1) 
|99.2.2 | 1996 Stock Option Agreement                                                                                    | (2) 
|99.2.3 | 1998 Stock Option Agreement                                                                                    | (2) 
|99.2.4 | 2001 Stock Option Agreement                                                                                    | (2) 
|99.2.5 | 2002 Stock Option Agreement                                                                                    | (2) 
|99.4   | 2002 Stock Incentive Plan                                                                                      | (8) 
|99.7   | 2003 Stock Incentive Plan                                                                                      | (3) 
|99.9   | Short Term Incentive Bonus Plan (Effective 1 October 2005)                                                     | (9) 
|99.10  | Long Term Incentive Compensation Plan (Effective 1 March 2005)                                                 | (9) 
|99.11  | Nominating and Corporate Governance Committee Charter, dated April 25, 2005                                    | (11)
|99.12  | Audit Committee Charter, dated March 9, 2005                                                                   | (11)
|99.13  | Compensation Committee Charter, dated March 9, 2005                                                            | (11)
|99.14  | Form of 2005 Stock Appreciation Right Grant and related Stock Appreciation Right Agreement (vested)            | (11)
|99.15  | Form of 2005 Stock Appreciation Right Grant and related Stock Appreciation Right Agreement (scheduled vesting) | (11)
|99.16  | Form of 2006 Long-Term Incentive Cash Bonus Agreement                                                          | (17)
|99.17  | Form of 2006 Executive Change in Control Agreement                                                             | (17)

---

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, 2002.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Quarterly Report on Form
10-Q, for the quarter          ended December 31, 2002.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) |  | 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.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) |  | 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.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) |  | 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.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) |  | 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.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Annual Report on Form 10-K,
for the fiscal year          ended September 30, 2004.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------

|(9) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated          March 1, 2005, filed March 3, 2005.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(10) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated          March 14, 2005, filed March 17, 2005.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(11) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Quarterly Report on Form
10-Q, for the quarter          ended March 31, 2005.
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

|(12) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated          May 27, 2005, filed June 1, 2005.
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------

48

---

|(13) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Quarterly Report on Form
10-Q, for the quarter          ended June 30, 2005.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

|(14) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated          August 25, 2005, filed August 29, 2005.
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(15) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated          September 14, 2005, filed September 20, 2005.
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(16) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated          November 8, 2005, filed November 8, 2005.
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(17) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Quarterly Report on Form
10-Q, for the quarter          ended June 30, 2006.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

|(18) |  | Incorporated
by reference to the indicated exhibit filed with Headwaters' Current Report on Form 8-K,
for the event dated          August 30, 2006, filed September 1, 2006.
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# (b) Exhibits

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

# (c) 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.

49

---

# 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 INCORPORATEDBY: /s/ Kirk A. Benson  
Kirk A. Benson Chief Executive Officer(Principal Executive Officer)
| |  | ---------------------------------------------------------------------------------------------------------------------------------

| |  | BY: /s/ Scott K. Sorensen 
Scott K. SorensenChief Financial Officer(Principal Financial and Accounting Officer)
| |  | -----------------------------------------------------------------------------------------------------------------------------

| |  | Date: November 22, 2006
| |  | -----------------------

KNOW ALL PERSONS BY THESE PRESENTS,
that each person whose signature appears below constitutes and appoints Harlan M.
Hatfield and Scott K. Sorensen, 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. BensonKirk A. Benson             | Director and Chief Executive Officer (Principal Executive Officer)  | November 22, 2006
|/s/ Scott K. SorensenScott K. Sorensen       | Chief Financial Officer (PrincipalFinancial and Accounting Officer) | November 22, 2006
|/s/ James A. HerickhoffJames A. Herickhoff   | Director                                                            | November 22, 2006
|/s/ Raymond J. WellerRaymond J. Weller       | Director                                                            | November 22, 2006
|/s/ E. J. "Jake" GarnE. J. "Jake" Garn       | Director                                                            | November 22, 2006
|/s/ R. Sam ChristensenR. Sam Christensen     | Director                                                            | November 22, 2006
|/s/ William S. DickinsonWilliam S. Dickinson | Director                                                            | November 22, 2006
|/s/ Malyn K. MalquistMalyn K. Malquist       | Director                                                            | November 22, 2006
|/s/ Blake O. Fisher, Jr.Blake O. Fisher, Jr. | Director                                                            | November 22, 2006

50

---

# Report of Independent Registered Public Accounting Firm

The Board of Directors and StockholdersHeadwaters Incorporated

We have audited the accompanying consolidated balance sheets of Headwaters Incorporated as of September 30, 2005 and 2006, 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, 2006. 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, 2005 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 30, 2006, in conformity with U.S. generally accepted accounting principles.

As discussed in Notes 2 and 11 to the financial statements, in 2005 the Company changed its method of accounting for stock-based compensation.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Headwaters Incorporateds internal control over financial reporting as of September 30, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated November 17, 2006 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Salt Lake City, UtahNovember 17, 2006

F-1

---

# HEADWATERS INCORPORATED

# CONSOLIDATED BALANCE SHEETS

|                                                                         | As of September 30,
|------------------------------------------------------------------------ | -------------------
|
|ASSETS                                                                   |                    
|Current assets:                                                          |                    
|Cash and cash equivalents                                                |                    
|Trade receivables, net                                                   |                    
|Other receivable                                                         |                    
|Inventories                                                              |                    
|Deferred income taxes                                                    |                    
|Other                                                                    |                    
|                                                                         |                    
|Total current assets                                                     |                    
|                                                                         |                    
|Property, plant and equipment, net                                       |                    
|                                                                         |                    
|Other assets:                                                            |                    
|Intangible assets, net                                                   |                    
|Goodwill                                                                 |                    
|Other                                                                    |                    
|                                                                         |                    
|Total other assets                                                       |                    
|                                                                         |                    
|Total assets                                                             |                    
|                                                                         |                    
|LIABILITIES AND STOCKHOLDERS' EQUITY                                     |                    
|Current liabilities:                                                     |                    
|Accounts payable                                                         |                    
|Accrued personnel costs                                                  |                    
|Accrued income taxes                                                     |                    
|Other accrued liabilities                                                |                    
|Deferred license fee revenue                                             |                    
|Current portion of long-term debt                                        |                    
|                                                                         |                    
|Total current liabilities                                                |                    
|                                                                         |                    
|Long-term liabilities:                                                   |                    
|Long-term debt                                                           |                    
|Deferred income taxes                                                    |                    
|Other                                                                    |                    
|                                                                         |                    
|Total long-term liabilities                                              |                    
|                                                                         |                    
|Total liabilities                                                        |                    
|                                                                         |                    
|Commitments and contingencies                                            |                    
|Stockholders' equity:                                                    |                    
|Common stock, $0.001 par value; authorized 100,000 shares; issued and    |                    
|outstanding: 41,842 shares at September 30, 2005 (including 347 shares   |                    
|held in treasury) and 42,306 shares at September 30, 2006 (including 254 |                    
|shares held in treasury)                                                 |                    
|Capital in excess of par value                                           |                    
|Retained earnings                                                        |                    
|Treasury stock and other                                                 |                    
|                                                                         |                    
|Total stockholders' equity                                               |                    
|                                                                         |                    
|Total liabilities and stockholders' equity                               |                    
|                                                                         |                    

See accompanying notes.

F-2

---

# HEADWATERS INCORPORATED

# CONSOLIDATED STATEMENTS OF INCOME

|                                    | Year ended September 30,
|----------------------------------- | ------------------------
|
|Revenue:                            |                         
|Construction materials              |                         
|Coal combustion products            |                         
|Alternative energy                  |                         
|                                    |                         
|Total revenue                       |                         
|Cost of revenue:                    |                         
|Construction materials              |                         
|Coal combustion products            |                         
|Alternative energy                  |                         
|                                    |                         
|Total cost of revenue               |                         
|                                    |                         
|Gross profit                        |                         
|Operating expenses:                 |                         
|Amortization                        |                         
|Research and development            |                         
|Selling, general and administrative |                         
|Contract litigation settlement      |                         
|                                    |                         
|Total operating expenses            |                         
|                                    |                         
|Operating income                    |                         
|Other income (expense):             |                         
|Net interest expense                |                         
|Other, net                          |                         
|                                    |                         
|Total other income (expense), net   |                         
|                                    |                         
|Income before income taxes          |                         
|Income tax provision                |                         
|                                    |                         
|Net income                          |                         
|                                    |                         
|Basic earnings per share            |                         
|                                    |                         
|Diluted earnings per share          |                         
|                                    |                         

See accompanying notes.

F-3

---

# HEADWATERS INCORPORATED

# CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

|                                                        | Common stock | Capital inexcess | Retained | Treasury
stock, |  | Total
stockholders'
|------------------------------------------------------- | ------------ | ---------------- | -------- | --------------- |  | -------------------
|
|Balances as of September 30, 2003                       |              |                  |          | 27,878          |  | $                  
|Exercise of stock options and warrants                  |              |                  |          | 878             |  |                    
|Tax benefit from exercise of stock options              |              |                  |          |                 |  |                    
|53 shares of treasury stock transferred to employee     |              |                 
|stock purchase plan, at cost                            |              |                  |          |                 |  |                    
|Common stock issued for cash, net of commissions and    |              |                 
|other offering costs totaling $6,432                    |              |                  |          | 4,958           |  |                    
|Issuance of restricted stock                            |              |                  |          | 61              |  |                    
|Other                                                   |              |                  |          |                 |  |                    
|Net income for the year ended September 30, 2004        |              |                  |          |                 |  |                    
|                                                        |              |                  |          |                 |  |                    
|Balances as of September 30, 2004                       |              |                  |          | 33,775          |  |                    
|                                                        |              |                  |          |                 |  |                    
|Exercise of stock options and stock appreciation rights |              |                  |          | 1,167           |  |                    
|Tax benefit from exercise of stock options and stock    |              |                 
|appreciation rights                                     |              |                  |          |                 |  |                    
|67 shares of treasury stock transferred to employee     |              |                 
|stock purchase plan, at cost                            |              |                  |          |                 |  |                    
|Common stock issued for cash, net of commissions and    |              |                 
|other offering costs totaling $11,633                   |              |                  |          | 6,900           |  |                    
|Stock-based compensation                                |              |                  |          |                 |  |                    
|Other comprehensive income  unrealized gain on cash    |              |                 
|flow hedges, net of taxes                               |              |                  |          |                 |  |                    
|Net income for the year ended September 30, 2005        |              |                  |          |                 |  |                    
|                                                        |              |                  |          |                 |  |                    
|Balances as of September 30, 2005                       |              |                  |          | 41,842          |  | $                  
|                                                        |              |                  |          |                 |  |                    

See accompanying notes.

F-4

---

# HEADWATERS INCORPORATED

# CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY (continued)

|                                                        | Common stock | Capital in
excess | Retained | Treasury
stock, |  | Total
stockholders'
|------------------------------------------------------- | ------------ | ----------------- | -------- | --------------- |  | -------------------
|
|Balances as of September 30, 2005                       |              |                   |          | 41,842          |  | $                  
|Exercise of stock options and stock appreciation rights |              |                   |          | 462             |  |                    
|Tax benefit from exercise of stock options and stock    |              |                  
|appreciation rights, net of reversals pertaining to     |              |                  
|prior periods                                           |              |                   |          |                 |  |                    
|93 shares of treasury stock transferred to employee     |              |                  
|stock purchase plan, at cost                            |              |                   |          |                 |  |                    
|Stock-based compensation                                |              |                   |          | 2               |  |                    
|Other comprehensive income (loss)  unrealized loss on  |              |                  
|cash flow hedges, net of taxes                          |              |                   |          |                 |  |                    
|Net income for the year ended September 30, 2006        |              |                   |          |                 |  |                    
|                                                        |              |                   |          |                 |  |                    
|Balances as of September 30, 2006                       |              |                   |          | 42,306          |  | $                  
|                                                        |              |                   |          |                 |  |                    

See accompanying notes.

F-5

---

# HEADWATERS INCORPORATED

# CONSOLIDATED STATEMENTS OF CASH FLOWS

|                                                                         | Year ended September 30,
|------------------------------------------------------------------------ | ------------------------
|
|Cash flows from operating activities:                                    |                         
|Net income                                                               |                         
|Adjustments to reconcile net income to net cash provided by operating    |                         
|activities:                                                              |                         
|Depreciation and amortization                                            |                         
|Non-cash stock-based compensation expense                                |                         
|Non-cash interest expense related to amortization of debt issue costs    |                         
|and debt discount                                                        |                         
|Amortization of non-refundable license fees                              |                         
|Deferred income taxes                                                    |                         
|Net loss on disposition of property, plant and equipment                 |                         
|Income tax benefit from exercise of stock options                        |                         
|Decrease (increase) in trade receivables                                 |                         
|Decrease (increase) in inventories                                       |                         
|Increase (decrease) in accounts payable and accrued liabilities          |                         
|Other changes in operating assets and liabilities, net                   |                         
|                                                                         |                         
|Net cash provided by operating activities                                |                         
|                                                                         |                         
|Cash flows from investing activities:                                    |                         
|Purchase of property, plant and equipment                                |                         
|Investments in joint ventures                                            |                         
|Payments for acquisitions, net of cash acquired of $11,834 in 2004       |                         
|Net increase in other assets                                             |                         
|Proceeds from disposition of property, plant and equipment               |                         
|                                                                         |                         
|Net cash used in investing activities                                    |                         
|                                                                         |                         
|Cash flows from financing activities:                                    |                         
|Proceeds from issuance of long-term debt, net of debt issue costs        |                         
|Payments on long-term debt                                               |                         
|Net proceeds from issuance of common stock                               |                         
|Proceeds from exercise of stock options and warrants                     |                         
|Income tax benefit from exercise of stock options and stock appreciation |                         
|rights (net of reversals pertaining to prior periods)                    |                         
|Employee stock purchases                                                 |                         
|                                                                         |                         
|Net cash provided by (used in) financing activities                      |                         
|                                                                         |                         
|Net increase (decrease) in cash and cash equivalents                     |                         
|Cash and cash equivalents, beginning of year                             |                         
|                                                                         |                         
|Cash and cash equivalents, end of year                                   |                         
|                                                                         |                         
|Supplemental schedule of non-cash investing and financing activities:    |                         
|Increase in accrued liabilities for acquisition-related commitments      |                         
|Purchase of interest in solid alternative fuel facility in exchange for  |                         
|commitment to make future payments                                       |                         
|Supplemental disclosure of cash flow information:                        |                         
|Cash paid for interest                                                   |                         
|Cash paid for income taxes                                               |                         

See accompanying notes.

F-6

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS September 30, 2006_________________

# 1.     Description of Business and Organization

| | Headwaters
Incorporated (Headwaters) is a diversified company providing products,
technologies and services in two industries: construction materials, including coal
combustion products, and alternative energy. Headwaters uses technology to differentiate
itself from competitors and to create value in its businesses.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
the construction materials sector, Headwaters designs, manufactures, and sells
architectural stone and resin-based exterior siding accessories (such as shutters,
mounting blocks, and vents) and related products. Headwaters believes that it has a
leading market position in its principal construction materials businesses. Headwaters is
also a nationwide leader in the management and marketing of coal combustion products,
including fly ash used as a substitute for portland cement. Headwaters believes it is
uniquely positioned to manufacture an array of construction materials that use fly ash,
such as block, stucco, and mortar. Revenue from Headwaters construction materials
and coal combustion products businesses are diversified geographically and also by
market, including the new construction, remodeling and home improvement markets.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
the alternative energy sector, Headwaters is focused on reducing waste and increasing the
value of energy feedstocks, primarily in the areas of low-value coal and oil. In coal,
Headwaters owns and operates two coal reclamation facilities that remove rock, dirt, and
other impurities from waste coal, resulting in higher-value, marketable coal. Headwaters
also licenses technology and sells reagents to the coal-based solid alternative fuel
industry. In oil, Headwaters believes that its heavy oil upgrading technology represents
a substantial improvement over current refining technologies. Headwaters heavy oil
upgrading process uses a liquid catalyst precursor to generate a highly active molecular
catalyst to convert residual oil feedstocks into higher-value distillates that can be
refined into gasoline, diesel and other products. In addition, Headwaters is constructing
its first ethanol plant and proceeding with the commercialization of multiple catalyst
technologies.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Headwaters
is incorporated in Delaware. Headwaters fiscal year ends on September 30 and unless
otherwise noted, references to years refer to Headwaters fiscal year rather than a
calendar year.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# 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 interest. In accordance with Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, as revised, Headwaters is required to consolidate any variable interest entities for which it is the primary beneficiary; however as of September 30, 2006, there are none. For investments in entities 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.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As described in more detail in Note 13, Headwaters made several significant acquisitions in 2004 and several insignificant acquisitions in 2006. These entities results of operations for the periods from the acquisition dates through September 30, 2006 have been consolidated with Headwaters results; their operations up to the dates of acquisition have not been included in Headwaters consolidated results for any period.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 i) the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and ii) 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  Headwaters operates in three business segments, construction materials, coal combustion products (CCPs) and alternative energy. Additional information about segments is presented in Note 3. In 2004, one customer of the alternative energy segment accounted for 10.4% of total revenue. No customer accounted for over 10% of total revenue in 2005 or 2006.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Through September 30, 2006, substantially all of Headwaters revenues have been generated from sales in the United States. Headwaters purchases all of the polypropylene used in its building products from a single supplier and purchases all of the chemical reagent that is sold to licensees and other customers from a single large international
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-7

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | chemical company. Management believes that if necessary, the polypropylene could be obtained from other suppliers, although changes in suppliers would be disruptive. Obtaining alternative suppliers of chemical reagent would be disruptive and may not be possible at all because of the expiration of the Section 45K tax credit program on December 31, 2007 (see Note 14).
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Revenue Recognition and Cost of Revenue  Building Materials. Revenue from the sale of construction materials and CCPs is recognized upon passage of title to the customer, which coincides with physical delivery and assumption of 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 products and materials to customers when the transportation or shipping and handling is contractually provided for between the customer and Headwaters. Cost of construction materials and coal combustion products sold includes shipping and handling fees.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | CCP revenues include revenues earned under long-term contracts to dispose of residualmaterials created by coal-fired electric power generation and revenues earned in connection with certain incidental construction-related projects. Revenues under long-term contracts are recognized concurrently with the removal of material and are based on the volume of material removed at established prices per ton. Construction-related projects are billed on a time and materials basis, with revenues and related costs being recognized when time is incurred and 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 product to customers. In compliance with contractual obligations, the cost of CCPs purchased from certain utilities is based on a percentage of the net revenues from sale of the CCPs purchased. Costs also
 include landfill fees and transportation charges to deliver non-marketable CCPs to landfills.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Alternative Energy. Headwaters currently licenses its technologies to the owners of 28 coal-based solid alternative fuel facilities from which Headwaters earns license fees and/or revenue from the sale 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, provided standard revenue recognition criteria such as amounts being fixed or determinable are met. 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. Revenue from the sale of chemical reagents is recognized upon delivery of product and assumption of the risk of loss by the licensee or non-licensee customer.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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, transportation, 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. Except for coal rights, assets are
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-8

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | depreciated using the straight-line method over their estimated useful lives, limited to the lease terms for improvements to leased assets. Coal rights are amortized using the units-of-production method. 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 or amortization are removed from the respective accounts.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Intangible Assets and Goodwill  Intangible assets consist primarily of identifiable intangible assets obtained in connection with acquisitions (see Note 13). 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, as of June 30, using a two-step process that begins with an estimation of the fair values of the reporting units giving rise to the goodwill (see Note 7). No impairment charges have been required for any year presented.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 material impairment losses recorded for long-lived assets in any of the years presented.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Debt Issue Costs  Debt issue costs represent direct costs incurred for 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.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Financial Instruments  Derivatives are recorded in the consolidated balance sheet at fair value, as required by SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (SFAS No. 133). 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 as interest expense.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 instruments on an ongoing basis. Headwaters has entered into hedge agreements to limit its exposure for interest rate movements, but has not entered into any other significant hedge transactions.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Income Taxes  Headwaters accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Headwaters recognizes deferred tax assets or liabilities for the expected future tax consequences of events that have been recognized in the financial statements or in income tax returns. Deferred 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 periodically reviewed for recoverability based on changing events, and valuation allowances are provided as necessary. Headwaters files a consolidated federal income tax return with substantially all of its subsidiaries.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-9

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

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

| | 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. Total advertising costs were approximately $7.8 million in 2005 and $11.4 million in 2006. Advertising costs were not material in 2004.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Warranty Costs  Provision is made for warranty costs at the time of sale, based upon established policies and historical experience. Warranty costs were not material in any of the periods presented.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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, disclosure is made, including the potential range of loss, if determinable. Loss contingencies that are remote are neither accounted for nor disclosed. Gain contingencies are given no accounting recognition until realized, but are disclosed if material.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Stock-Based Compensation  As described in more detail in Note 11, in the quarter ended June 30, 2005 Headwaters early adopted the fair value method of accounting for stock-based compensation required by SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R), effective as of October 1, 2004, the beginning of Headwaters 2005 fiscal year. Accordingly, Headwaters restated its statement of income for the six months ended March 31, 2005 and the restated amounts were used in deriving the statement of income amounts reported for the 2005 fiscal year.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Through March 31, 2005, Headwaters applied the intrinsic value method as prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) in accounting for options, restricted stock and other stock-based compensation to employees, officers and directors, instead of using the fair value method prescribed by SFAS No. 123, Accounting for Stock-Based Compensation (SFAS No. 123). Under APB 25, no compensation expense was recognized for stock-based compensation to employees, officers and directors when the exercise price of the award equaled or exceeded the market price of Headwaters common stock on the date of grant. If the fair value provision of SFAS No. 123 would have been applied to all stock-based compensation for periods prior to 2005, net income and earnings per share would have been changed to the pro forma amounts shown below for 2004.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(in thousands, except per-share data)                           
|----------------------------------------------------------------
|Reported net income                                             
|Add actual stock-based compensation expense included in reported
|net income                                                      
|Deduct expense  determined under fair value provision of        
|SFAS No. 123                                                    
|                                                                
|Pro forma net income                                            
|                                                                
|Basic earnings per share - as reported                          
|- pro forma                                                     
|Diluted earnings per share - as reported                        
|- pro forma                                                     

| | The fair values of stock option grants for 2004 were determined using the Black-Scholes-Merton option pricing model (B-S-M model) and the following assumptions: expected stock price volatility of 40%, risk-free interest rates ranging from 1.5% to 4.5%, weighted average expected option lives of three years beyond vesting dates, and no dividend yield. The B-S-M 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 certain subjective assumptions, including expected stock price volatility.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-10

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | 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-based awards, calculated using the treasury stock method (as modified by SFAS No. 123R), and the assumed conversion of convertible securities, using the if-converted method, when such stock-based awards or convertible securities are dilutive.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Recent Accounting Pronouncements  In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes  an Interpretation of FASB Statement No. 109 (FIN 48). This Interpretation prescribes a consistent recognition threshold and measurement standard, as well as clear criteria for subsequently recognizing, derecognizing and measuring tax positions, for financial reporting purposes. FIN 48 also requires expanded disclosures with respect to the uncertainty in income taxes. FIN 48 is effective for Headwaters fiscal 2008 year beginning on October 1, 2007. Management is currently evaluating the impact of FIN 48. The effect of adopting FIN 48, if material, will be a transition adjustment to beginning retained earnings in the year of adoption.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS No. 157) which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. Headwaters must adopt SFAS No. 157 no later than in its fiscal year ending September 30, 2009. Headwaters uses fair value measurements to determine the reported amounts of assets acquired and liabilities assumed in purchase transactions (see Note 13), in testing for potential goodwill impairment (see Note 7), for disclosure of the fair value of financial instruments (see Note 9), as well as in other instances. It is therefore possible that the implementation of SFAS No. 157 could have a material effect on the reported amounts or disclosures in Headwaters consolidated financial statements in future periods.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 other 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.     Segment Reporting

| | Headwaters currently operates three business segments within two industries, the construction materials and CCPs segments in the building materials industry, and the alternative energy segment in the energy industry. These segments are managed and evaluated separately by management due to differences in their operations, products and services.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Prior to 2004, the businesses in the construction materials segment manufactured and distributed bagged concrete, stucco, mortar and block products. The 2004 acquisitions expanded Headwaters concrete block business, and added manufactured architectural stone and resin-based siding accessories and related products used in exterior residential home improvement and construction to the product line. Revenues for the construction materials segment consist of product sales to wholesale and retail distributors, contractors and other users of building products.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The CCP segment manages and markets coal combustion products such as fly ash and bottom ash, known as CCPs, to building products and ready mix concrete companies. Headwaters purchases CCPs from coal-fired electric power generation plants under long-term contracts and supplies them to Headwaters customers as a replacement for manufactured or mined materials, primarily portland cement. CCP revenues consist primarily of product sales with a small amount of service revenue.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-11

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | The alternative energy segment includes Headwaters legacy coal-based solid alternative fuels business and several newer initiatives, including coal cleaning, ethanol and the commercialization of catalyst technologies, primarily catalysts that help improve the yield and quality of petroleum-based fuels. Revenues for this segment consist primarily of sales of chemical reagents and license fees.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The following segment information 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. Segment performance is evaluated primarily on revenue growth and operating income, although other factors are also used, such as income tax credits generated by activities of the alternative energy segment. Intersegment sales are immaterial.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Segment costs and expenses considered in deriving segment operating income include cost of revenue, 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. Cash and cash equivalents and other assets are included in the Corporate column. Segment information for construction materials and CCPs for 2004 includes four acquired subsidiaries results only for the period of time subsequent to the dates of acquisition, and therefore are not comparable to 2005 and 2006.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                              | 2004
|----------------------------- | ----
|
|Segment revenue               |     
|                              |     
|Depreciation and amortization |     
|                              |     
|Operating income (loss)       |     
|                              |     
|Net interest expense          |     
|Other income (expense), net   |     
|Income tax provision          |     
|                              |     
|Net income                    |     
|                              |     
|Capital expenditures          |     
|                              |     
|Segment assets                |     
|                              |     

|                              | 2005
|----------------------------- | ----
|
|Segment revenue               |     
|                              |     
|Depreciation and amortization |     
|                              |     
|Operating income (loss)       |     
|                              |     
|Net interest expense          |     
|Other income (expense), net   |     
|Income tax provision          |     
|                              |     
|Net income                    |     
|                              |     
|Capital expenditures          |     
|                              |     
|Segment assets                |     
|                              |     

F-12

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

|                              | 2006
|----------------------------- | ----
|
|Segment revenue               |     
|                              |     
|Depreciation and amortization |     
|                              |     
|Operating income (loss)       |     
|                              |     
|Net interest expense          |     
|Other income (expense), net   |     
|Income tax provision          |     
|                              |     
|Net income                    |     
|                              |     
|Capital expenditures          |     
|                              |     
|Segment assets                |     
|                              |     

# 4.     Receivables

Activity in the trade receivables allowance account was as follows.

|(in thousands) | Balance at
beginning
of year | Charged to
expense | Additions
from
acquisitions | Accounts
written off
and other
deductions | Balance at
end of year
|-------------- | ---------------------------- | ------------------ | --------------------------- | ----------------------------------------- | ----------------------
|2004           |                              |                    | $                           | 577                                       |                       
|2005           |                              |                    |                             | 5,777                                     |                       
|2006           |                              |                    |                             | 5,500                                     |                       

# 5.     Inventories

Inventories consisted of the following at September 30:

|(in thousands) | 2005 | 2006
|-------------- | ---- | ----
|Raw materials  |      |     
|Finished goods |      |     
|               |      |     
|               |      |     
|               |      |     

# 6.     Property, Plant and Equipment

Property, plant and equipment consisted of the following at September 30:

|(in thousands)                    | Estimated useful
lives | 2005 | 2006
|--------------------------------- | ---------------------- | ---- | ----
|Land and improvements             |                        |      |     
|Coal rights                       |                        |      |     
|Buildings and improvements        |                        |      |     
|Equipment and vehicles            |                        |      |     
|Dies and molds                    |                        |      |     
|Construction in progress          |                        |      |     
|                                  |                        |      |     
|                                  |                        |      |     
|Less accumulated depreciation     |                        |      |     
|                                  |                        |      |     
|Net property, plant and equipment |                        |      |     
|                                  |                        |      |     

Depreciation expense was approximately $11.0 million in 2004, $27.6 million in 2005 and $35.7 million in 2006.

F-13

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

# 7.     Intangible Assets and Goodwill

| | Intangible Assets  All of Headwaters identified intangible assets are being amortized. The following table summarizes the gross carrying amounts and the related accumulated amortization of intangible assets as of September 30:
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                           |  | 2005 | 2006            
|-------------------------- |  | ---- | ----------------
|
|CCP contracts              |  |      | 8 - 20 years    
|Customer relationships     |  |      | 7 1/2 - 15 years
|Trade names                |  |      | 5 - 20 years    
|Patents and patented       |  |     
|technologies               |  |      | 7 1/2 - 19 years
|Non-competition agreements |  |      | 2 - 5 years     
|Other                      |  |      | 9 - 15 years    
|                           |  |      |                 
|                           |  |      |                 
|                           |  |      |                 

| | Total amortization expense related to intangible assets was approximately $9.1 million in 2004, $24.5 million in 2005 and $24.3 million in 2006. Total estimated annual amortization expense for 2007 through 2011 is shown in the following table.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Year ending September 30: | (in thousands)
|------------------------- | --------------
|2007                      | $22,107       
|2008                      | 20,559        
|2009                      | 20,346        
|2010                      | 19,946        
|2011                      | 19,716        

Goodwill  Changes in the carrying amount of goodwill, by segment, are as follows for 2005 and 2006.

|(in thousands)                     | Construction
Materials | CCPs | Alternative
Energy | Total  
|---------------------------------- | ---------------------- | ---- | ------------------ | -------
|Balances as of September 30, 2004  |                        |      | $                  | 695,140
|Adjustments to previously recorded |                        |     
|purchase price                     |                        |      |                    | (3,851 
|                                   |                        |      |                    |        
|Balances as of September 30, 2005  |                        |      |                    | 691,289
|Goodwill acquired during the year  |                        |      |                    | 5,387  
|Adjustments to previously recorded |                        |     
|purchase price                     |                        |      |                    | 9,500  
|                                   |                        |      |                    |        
|Balances as of September 30, 2006  |                        |      | $                  | 706,176
|                                   |                        |      |                    |        

| | 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 2006. SFAS No. 142 requires Headwaters to periodically test for goodwill impairment at least annually, or sooner if evidence of possible impairment arises. Headwaters performs its annual impairment testing as of June 30, using a two-step process that begins with an estimation of the fair values of the reporting units that have goodwill. Currently, five reporting units have goodwill, three of which are in the construction materials segment. There is one reporting unit with goodwill in each of the CCPs and alternative energy segments.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 is failed for a reporting unit, 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
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-14

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | compare that value to the carrying value of the goodwill. If the carrying value of goodwill exceeds its implied fair value, an impairment loss is required to be recorded. Headwaters has performed step 1 impairment tests of recorded goodwill as of June 30, 2004, 2005 and 2006, all of which indicated that the fair values of the reporting units exceeded their carrying values. Accordingly, step 2 of the impairment tests was not required to be performed, and no impairment charges were necessary.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# 8.     Liabilities

Other Accrued Liabilities  Other accrued liabilities consisted of the following at September 30:

|(in thousands)                                | 2005 | 2006
|--------------------------------------------- | ---- | ----
|Cost of product received but not yet invoiced |      |     
|Refunds due licensees                         |      |     
|Other                                         |      |     
|                                              |      |     
|                                              |      |     
|                                              |      |     

Long-term Debt  Long-term debt consisted of the following at September 30:

|(in thousands)                        | 2005 | 2006
|------------------------------------- | ---- | ----
|Senior secured debt                   |      |     
|Convertible senior subordinated notes |      |     
|Notes payable to a bank               |      |     
|Other                                 |      |     
|                                      |      |     
|                                      |      |     
|Less: current portion                 |      |     
|                                      |      |     
|Total long-term debt                  |      |     
|                                      |      |     

| | Senior Secured Credit Agreements  In 2004, Headwaters entered into two credit agreements with a syndication of lenders. The credit agreements have since been amended, most recently in August 2006. A total of $790.0 million was originally borrowed under the credit facility, which also provides for up to $60.0 million of borrowings under a revolving credit arrangement, along with the ability to increase this amount to $100.0 million, subject to obtaining additional revolving loan commitments. The original $790.0 million of 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. The second lien term loan was repaid in its entirety in 2005. With certain limited exceptions, the first lien term loan is senior in priority to all other debt and is secured by all assets of Headwaters. The terms of the credit facility, as amended, are described in
more detail in the following paragraphs. Headwaters is in compliance with all debt covenants as of September 30, 2006.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The first lien term loan bears interest, at Headwaters option, at either i) the London Interbank Offered Rate (LIBOR) plus 2.0%, 2.25%, or 2.5%, depending on the credit ratings that have been most recently announced for the loans by Standard & Poors Ratings Services (S&P) and Moodys Investors Service, Inc. (Moodys); or ii) the Base Rate plus 1.0%, 1.25%, or 1.5%, again depending on the credit ratings announced by S&P and Moodys. Base rate is defined as the higher of the rate announced by Morgan Stanley Senior Funding and the overnight rate charged by the Federal Reserve Bank of New York plus 0.5%. Headwaters current rate is LIBOR plus 2.0%. The weighted-average interest rate on the first lien debt was approximately 6.8% at September 30, 2006, after giving consideration to the effect of the interest rate hedge on $150.0 million of this debt,
as described below. Headwaters can lock in new LIBOR rates for the first lien loan for one, two, three or six months. The most recent rate change occurred in October 2006.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The first lien term loan ($415.3 million outstanding at September 30, 2006) is repayable in quarterly installments of principal, with minimum required quarterly principal repayments of approximately $3.4 million from November 2007 through August 2010, plus three repayments of approximately $125.2 million each in November 2010, February 2011 and April 2011, the termination date. Interest is generally payable on a quarterly basis.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-15

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | During 2006, Headwaters made one required principal repayment of $3.4 million and one optional repayment of $24.0 million, which satisfied the required principal repayments on the senior debt until November 2007. Acceleration of amortization of debt issue costs related to the 2006 early repayment was not material. During 2005, Headwaters repaid a total of $197.3 million of the first lien term loan and all of the second lien term loan ($150.0 million). As a result of the 2005 early repayments, acceleration of amortization of the related debt issue costs totaling approximately $7.4 million was charged to interest expense. Prepayment penalties totaling $4.0 million were paid related to the early repayment of the second lien term debt, which amount was also charged to interest expense.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 in the agreement. Optional prepayments of the first lien term loan are generally permitted without penalty or premium, except where the proceeds for repayment are obtained from a financing, as defined, consummated for the purpose of lowering the interest rate on the first lien debt, in which case there is a 1% prepayment penalty. Once repaid in full or in part, no further reborrowings under either the first or second lien loan arrangements can be made.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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% (depending on Headwaters total leverage ratio, as defined), 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, when 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% (depending on Headwaters total leverage ratio, as defined). There were no borrowings outstanding under the revolving credit arrangement as of September 30, 2006, or subsequent thereto. The credit agreement also allows for the issuance of letters of credit, provided there is capacity under the revolving credit arrangement. As of September 30,
2006, eight letters of credit totaling $6.6 million were outstanding, with expiration dates ranging from October 2006 to December 2008.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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, annual capital expenditures in excess of $80.0 million for 2006 and $100.0 million thereafter, 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, as follows: i) a total leverage ratio of 4.0:1.0 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 3.0:1.0, 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 as of September 30, 2006, and 1.25:1.0 thereafter.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As required by the senior secured credit facility, Headwaters entered into agreements to limit its variable interest rate exposure. The agreements effectively fix the LIBOR rate at 3.71% for $150.0 million of the first lien debt through September 8, 2007. Headwaters accounts for these agreements as cash flow hedges, with their fair market value reflected in the consolidated balance sheet as either other assets or other liabilities. The market value of the hedges can fluctuate significantly over a relatively short period of time. The hedges had a market value at September 30, 2006 of approximately $2.1 million, which, net of related income taxes, represents other comprehensive income. One of the joint ventures Headwaters has invested in (see Note 14) has also entered into agreements that are accounted for as cash flow hedges. Total comprehensive income, considering all cash flow hedge agreements to which Headwaters is a direct or
indirect party, was not materially different from net income for any period presented.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Convertible Senior Subordinated Notes  Headwaters has outstanding $172.5 million of 2.875% convertible senior subordinated notes due 2016. These notes are subordinate to the 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 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.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-16

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | The notes are convertible if any of the following five criteria are met: 1) satisfaction of a market price condition which becomes operative if, prior to June 1, 2011, in any calendar quarter the closing price of Headwaters common stock exceeds $39 per share for at least 20 trading days in the 30 consecutive trading days ending on the last trading day of the calendar quarter, or, at any time on or after June 1, 2011 the closing price of Headwaters common stock exceeds $39 per share; 2) a credit rating, if any, assigned to the notes is three or more rating subcategories below the initial rating; 3) the notes trade at less than 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). Headwaters may redeem any portion of the notes at any time on or after June 4, 2011. In addition, the holder of the notes has the right to require 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 includes the additional shares of common stock contingently issuable under the notes in its diluted EPS calculations on an if-converted basis (see Note 12).
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Notes Payable to a Bank  In connection with the acquisition of a subsidiary company in 2004, Headwaters assumed that companys note payable obligations to a bank. The notes require monthly interest and quarterly principal payments and bear interest at variable rates, which as of September 30, 2006, ranged from 5.8% to 8.0%. Because the notes are callable by the bank, Headwaters has included the entire outstanding balance in current portion of long-term debt in the consolidated balance sheet. The notes are collateralized by certain assets of the subsidiary and contain financial covenants specific to that subsidiary, including a minimum fixed charge coverage ratio, a leverage ratio requirement, and limitations on capital expenditures. The subsidiary is in compliance with all debt covenants as of September 30, 2006.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Interest and Debt Maturities  During 2004, Headwaters incurred total interest costs related to its long-term debt and other obligations of approximately $19.9 million, including approximately $6.0 million of non-cash interest expense and approximately $0.4 million of interest costs that were capitalized. During 2005, Headwaters incurred total interest costs of approximately $59.7 million, including approximately $10.6 million of non-cash interest expense and approximately $0.5 million of interest costs that were capitalized. During 2006, Headwaters incurred total interest costs of approximately $37.9 million, including approximately $2.8 million of non-cash interest expense and approximately $1.0 million of interest costs that were capitalized. Interest income was approximately $1.0 million, $1.8 million and $2.9 million for 2004, 2005 and 2006, respectively.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The weighted-average interest rate on the face amount of outstanding long-term debt, disregarding amortization of debt issue costs and a gain realized upon reduction of the interest rate hedges in 2005, was approximately 5.2% at September 30, 2005 and 5.7% at September 30, 2006.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-17

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

Future maturities of long-term debt as of September 30, 2006 were as follows:

|Year ending September 30, | (in thousands)
|------------------------- | --------------
|2007                      |               
|2008                      |               
|2009                      |               
|2010                      |               
|2011                      |               
|Thereafter                |               
|                          |               
|Total long-term debt      |               
|                          |               

# 9.     Fair Value of Financial Instruments

| | Headwaters financial instruments consist primarily of cash and cash equivalents, trade receivables, 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 short-term in nature. Accordingly, the carrying values for those financial instruments as reflected in the consolidated balance sheets closely approximate their fair values.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | With the exception of the 2.875% convertible senior subordinated notes due 2016, substantially all of Headwaters outstanding debt as of September 30, 2005 and 2006 consisted of variable-rate debt. However, as a result of the hedge agreements entered into for $150.0 million of the variable-rate senior secured debt described in Note 8, Headwaters has effectively fixed the interest rate on that portion of debt through September 8, 2007.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Using market interest rates of approximately 2.1% in 2005 and 2.8% in 2006 for the convertible senior subordinated notes, and 6.3% in 2005 and 7.5% in 2006 for the $150.0 million hedged portion of senior debt, the fair value of all outstanding long-term debt as of September 30, 2005 and 2006 would be approximately $660.7 million and $600.4 million, respectively. The market interest rates for the convertible senior subordinated notes have decreased from the stated interest rate primarily due to the increase in Headwaters common stock price between the date of issuance and the balance sheet dates.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# 10.   Income Taxes

| | Headwaters recorded income tax provisions with an effective tax rate of approximately 39% in 2004 and 26% in 2005 and 2006. The lower effective tax rate for 2005 and 2006 is primarily due to tax credits related to two coal-based solid alternative fuel facilities that Headwaters owns and operates, plus Headwaters 19% interest in an entity that owns and operates another alternative fuel facility (where Headwaters is not the primary beneficiary). The alternative fuel produced at these three facilities through December 2007 qualifies for tax credits pursuant to Section 45K [formerly Section 29] of the Internal Revenue Code, subject to the uncertainties of phase-out, IRS audit and other risks associated with the tax credits, all as more fully described in Note 14.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Headwaters 19% interest in the entity that owns and operates an alternative fuel facility was acquired in exchange for initial cash payments totaling $0.5 million and an obligation to pay $15.0 million in monthly installments through December 2007. This obligation, recorded in other accrued liabilities and other long-term liabilities in the consolidated balance sheet (totaling approximately $8.5 million at September 30, 2006), bears interest at an 8% rate. Headwaters also agreed to make additional payments to the seller based on a pro-rata allocation of the tax credits generated by the facility, also through December 2007. These additional contractual payments are affected by phase-out and, along with the amortization of the $15.5 million investment, are recorded in other expense in the consolidated statements of income, totaling approximately $16.1 million and $7.0 million for 2005 and 2006, respectively.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The alternative fuel produced at the facility through December 2007 qualifies for tax credits and Headwaters is entitled to receive its pro-rata share of such tax credits generated based upon its ownership percentage. Headwaters has the ability, under certain conditions, to limit its liability under the fixed payment obligations currently totaling approximately $8.5 million; therefore, Headwaters obligation to make all of the above-described payments is effectively limited by the tax benefits Headwaters receives.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-18

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# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | As a result of high oil prices in 2006, it appears there will a partial phase out of Section 45K tax credits for calendar 2006. Therefore, in calculating an income tax provision for fiscal 2006, Headwaters assumed a phase-out percentage for Section 45K tax credits for calendar 2006 of 42%. This estimated phase-out percentage was derived by estimating the calendar 2006 reference price for oil using actual oil prices for the months January through July 2006, and published NYMEX oil prices for the months August through December 2006. The monthly NYMEX oil prices were reduced by approximately 10%, which reduction represents Headwaters estimate of the relationship between NYMEX prices and the average U.S. wellhead oil prices actually used to calculate the annual reference price. The estimated reference price for calendar 2006 was calculated by averaging the 12 months actual or estimated oil prices, which average was compared to
the estimated phase-out range for calendar 2006 ($54.27 to $68.12) to derive an estimated phase-out percentage.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | While the calendar 2006 phase-out
percentage can not be finalized at the current time, as of September 30,
2006, an estimated phase-out percentage of 42% is Headwaters best estimate of what
the phase-out percentage for calendar 2006 would be, using available information as of
that date. As of March 31, 2006, the estimated phase-out percentage for calendar 2006 was
37% and as of June 30, 2006, the estimated percentage was 69%. The effect on income taxes
of the change in the phase-out percentage from 42% to the actual percentage for the year
will be recorded to income tax expense in subsequent periods, when all of the calendar
2006 actual oil prices are known. Any such effect could be material to Headwaters
2007 income tax expense.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The income tax provision consisted of the following for the years ended September 30:

|(in thousands)              | 2004 | 2005 | 2006
|--------------------------- | ---- | ---- | ----
|Current tax provision:      |      |      |     
|Federal                     |      |      | $   
|State                       |      |      |     
|                            |      |      |     
|Total current tax provision |      |      |     
|Deferred tax benefit:       |      |     
|Federal                     |      |      |     
|State                       |      |      |     
|                            |      |      |     
|Total deferred tax benefit  |      |      |     
|                            |      |      |     
|Total income tax provision  |      |      | $   
|                            |      |      |     

The provision for income taxes differs from the amount computed using the statutory federal income tax rate due to the following.

|(in thousands)                                | 2004 | 2005 | 2006
|--------------------------------------------- | ---- | ---- | ----
|Tax provision at U.S. statutory rate          |      |      | $   
|State income taxes, net of federal tax effect |      |      |     
|Estimated tax credits                         |      |      |     
|Tax audit contingencies                       |      |      |     
|Nondeductible expenses                        |      |      |     
|Other                                         |      |      |     
|                                              |      |      |     
|Income tax provision                          |      |      | $   
|                                              |      |      |     

| | The calculation of tax liabilities involves uncertainties in the application of complex tax regulations in multiple jurisdictions. For example, Headwaters is currently under IRS audit for 2003 and 2004. Headwaters recognizes potential liabilities for anticipated tax audit issues in the U.S. and state tax jurisdictions based on estimates of whether, and the extent to which, additional taxes and interest will be due. If events occur and the payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-19

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | period when it is determined the liabilities are no longer probable or necessary. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As of September 30, 2006, Headwaters had deferred tax assets related to U.S., state and non-U.S. net operating loss (NOL) and capital loss carryforwards totaling approximately $4.5 million. Headwaters has established a valuation allowance for substantially all of this amount. A valuation allowance is required when there is significant uncertainty as to the realizability of deferred tax assets. Because the realization of the deferred tax assets related to these NOLs and capital losses is dependent upon future income or capital gains related to domestic and foreign jurisdictional operations that have historically generated losses, management determined that it is not more likely than not that these NOLs and capital losses will be realized and therefore, a valuation allowance is required. The U.S. and state NOLs and capital losses expire from 2010 to 2025. Substantially all of the non-U.S. NOLs do not expire.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The components of Headwaters deferred income tax assets and liabilities were as follows as of September 30:

|(in thousands)                                      | 2005 | 2006
|--------------------------------------------------- | ---- | ----
|Deferred tax assets:                                |      |     
|Stock-based compensation                            |      |     
|Tax credit carryforwards                            |      |     
|Accelerated license fee revenue recognition for tax |      |     
|Estimated liabilities                               |      |     
|Reserves and allowances                             |      |     
|Intangible asset basis differences                  |      |     
|Deferred license fee revenue                        |      |     
|NOL and capital loss carryforwards                  |      |     
|Valuation allowance related to NOL and capital loss |      |     
|carryforwards                                       |      |     
|                                                    |      |     
|Total deferred tax assets                           |      |     
|                                                    |      |     
|Deferred tax liabilities:                           |      |     
|Intangible asset basis differences                  |      |     
|Property, plant and equipment basis differences     |      |     
|Interest on convertible senior subordinated notes   |      |     
|Other                                               |      |     
|                                                    |      |     
|Total deferred tax liabilities                      |      |     
|                                                    |      |     
|Net deferred tax liability                          |      |     
|                                                    |      |     

# 11.   Equity Securities and Stock-Based Compensation

| | Authorized Stock and Exchange Listing  In 2005, Headwaters increased the authorized shares of common stock from 50.0 million to 100.0 million. Headwaters also has 10.0 million shares of authorized preferred stock, none of which was issued or outstanding as of September 30, 2005 or 2006. Headwaters common stock traded on the Nasdaq National Market until April 6, 2005, at which time it began trading on the New York Stock Exchange under the symbol HW.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 2004, Headwaters filed a prospectus supplement to that shelf registration statement and issued approximately 5.0 million shares of common stock in an underwritten public offering. Proceeds of approximately $90.3 million were received, net of commissions and other offering costs totaling $6.4 million.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In 2005, Headwaters filed a Form S-3 shelf registration statement with the SEC, subsequently filed a prospectus supplement to the two effective shelf registration statements and issued 6.9 million shares of common stock in an underwritten public offering. Proceeds of $198.8 million were received, net of commissions and other offering costs totaling $11.6 million. Following this issuance of common stock, approximately $18.0 million remains available for
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-20

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | future offerings of securities under the universal 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.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Grants of Stock Incentive Awards  During 2005, the Compensation Committee of Headwaters Board of Directors (the Committee) granted to certain officers and employees stock incentive awards consisting of approximately 3.0 million stock appreciation rights (SARs) and approximately 0.2 million stock options. Substantially all of these awards were granted during the quarter ended June 30, 2005, the same period that Headwaters early adopted SFAS No. 123R, as explained below. Approximately 2.0 million of the SARs vested at grant date, a majority of which require a payment by grantees of $2.00 per SAR, payable over a 52-month period. Also, the maximum gain that may be received for each of these SARs is limited to the fair market value of one share of Headwaters common stock at the date of grant. The grant of these immediate-vested SARs resulted in approximately $16.2 million of compensation
expense being recorded in 2005, which was calculated in accordance with SFAS No. 123R as described below under Stock-Based Compensation. The remaining SARs which were granted during 2005 (approximately 1.0 million) vest over five years, and approximately 0.9 million of these SARs are exercisable based on the achievement of performance criteria related to the economic growth (EVA) of Headwaters during the five-year period. Currently, Headwaters estimates that the performance criteria will likely be met prior to the end of the five-year vesting period.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | During 2006, the Committee granted i) options for the purchase of approximately 0.1 million shares of common stock to certain directors, and ii) approximately 0.2 million SARs to certain employees. All SAR and stock option awards for the years 2004 through 2006 were granted under existing stock incentive plans, and all have an exercise price equal to the fair market value of Headwaters common stock on the dates of grant and a contractual term of 10 years. When exercised by grantees, SARs are settled in Headwaters common stock.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In 2005, the Committee also approved the acceleration of vesting of options for the purchase of approximately 1.1 million shares for 138 officers, directors and employees which were not fully vested as of the date of acceleration (prior to acceleration, there were in total unvested outstanding options to purchase approximately 1.3 million shares). Options for which vesting was accelerated consisted of all options with an exercise price equal to or greater than $21.29 per share and all but approximately 0.2 million of the accelerated options were in the money at the date of acceleration. Of the options accelerated, options to purchase a total of approximately 0.5 million shares of common stock were granted to directors and executive officers of Headwaters. All of the options for which acceleration of vesting occurred became 100% vested as of the date of acceleration. Total compensation expense of approximately $9.3 million
was recognized related to the acceleration of vesting.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Stock-Based Compensation  During the quarter ended June 30, 2005, Headwaters adopted SFAS No. 123R effective as of October 1, 2004, the beginning of Headwaters 2005 fiscal year (the modified retrospective method, with restatement limited to interim periods in the year of adoption, as permitted by SFAS No. 123R). SFAS No. 123R revises SFAS No. 123 and supersedes APB 25 and requires companies to expense the value of employee stock options and other equity-based awards. The following table summarizes stock-based compensation included in operating costs and expenses for the years indicated.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(in thousands)                         | 2004 | 2005 | 2006
|-------------------------------------- | ---- | ---- | ----
|Construction materials                 |      |      | $   
|Coal combustion products               |      |      |     
|Alternative energy                     |      |      |     
|Research and development               |      |      |     
|Selling, general and administrative    |      |      |     
|                                       |      |      |     
|Total stock-based compensation expense |      |      | $   
|                                       |      |      |     

| | Stock-based compensation expense is reported within the same operating expense line items as used for cash compensation expense. A significant amount of the 2005 stock-based compensation resulted from the expense associated with the grants of immediate-vested SARs and from the acceleration of vesting of certain stock options. Due to immateriality, Headwaters has not capitalized any compensation cost as part of the cost of any asset. The total income tax benefit recognized for stock-
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-21

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | based compensation in the 2005 and 2006 consolidated income statements was approximately $12.2 million and $2.5 million, respectively. Tax benefits resulting from exercise of stock options and SARs are reflected in the consolidated statements of changes in stockholders equity and cash flows.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Headwaters recognizes compensation expense equal to the grant-date fair value of stock-based awards for all awards expected to vest, over the period during which the related service is rendered by grantees. The fair value of stock-based awards is determined primarily using the B-S-M model, which is the same valuation model used previously in valuing stock options for the pro forma footnote disclosures under the requirements of SFAS No. 123 (see Note 2). Headwaters uses the graded vesting or accelerated method to value awards and to allocate those values over the requisite service periods, again the same method as used previously in determining pro forma expense under SFAS No. 123. Headwaters estimated forfeiture rates are based largely on historical data and ranged from 0% to 5% during 2005 and 2006, depending on the type of award and the award recipients. As of September 30, 2006, the estimated forfeiture rate for
most unvested awards is 1% per year.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Valuation Assumptions  The fair values of stock options and SARs granted in 2005 and 2006 were estimated using the B-S-M model, adjusted where necessary to account for specific terms of awards that the B-S-M model does not have the capability to consider. Headwaters used the services of an independent valuation firm to validate its fair value estimates and assumptions and also to determine certain necessary adjustments to the B-S-M model output. One such adjustment was used in determining the fair value of SARs which have a cap on allowed appreciation. For these SARs, the output determined by the B-S-M model was reduced by an amount determined by a Quasi-Monte Carlo simulation to reflect the reduction in fair value associated with the appreciation cap.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
following table summarizes the assumptions used in determining the fair values of the
2005 and 2006 stock-based awards.
| | ---------------------------------------------------------------------------------------------------------------------------

|                                                                     | 2005 | 2006
|-------------------------------------------------------------------- | ---- | ----
|Expected stock volatility                                            |      |     
|Risk-free interest rates                                             |      |     
|Expected lives (beyond vest dates) - 5-year vesting SARs and options |      |     
|Expected lives (beyond vest date) - immediate-vested SARs            |      |     
|Dividend yield                                                       |      |     
|Reductions in value from B-S-M output for SAR appreciation caps      |      |     
|Reduction in value from B-S-M output for grantee payment for SARs    |      |     

| | Expected stock price volatility was estimated using historical volatilities of Headwaters stock, implied volatilities of traded options on Headwaters stock, volatility predicted by a Generalized AutoRegressive Conditional Heteroskedasticity model, and an analysis of volatilities used by other public companies in comparable lines of business to Headwaters. Risk-free interest rates used were the US Treasury bond yields with terms corresponding to the expected terms of the awards being valued. In estimating expected lives, Headwaters considered the contractual and vesting terms of awards, along with historical experience; however, due to insufficient historical data from which to reliably estimate expected lives, Headwaters used estimates based on the simplified method set forth by the SEC in Staff Accounting Bulletin No. 107, where expected life is estimated by summing the awards vesting term and
the contractual term and dividing that result by two. The reduction in value related to grantee payment for certain immediate-vested SARs was estimated by management based on the terms of the payment requirements and other factors.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Stock Incentive Plans  As of September 30, 2006, Headwaters had four stock incentive plans (the Plans), three of which have been approved by stockholders. A total of 7.9 million shares of common stock have been reserved for ultimate issuance under the Plans. One of the Plans has expired and awards can no longer be granted under that plan. As of September 30, 2006, options, SARs and other awards for approximately 0.6 million shares of common stock could be granted under the three remaining plans. Headwaters uses newly issued shares to meet its obligations to issue stock when awards are exercised.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-22

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | The Committee, or in its absence, the full Board, administers and interprets the Plans. This Committee is authorized to grant options and other awards both under the Plans and outside of any Plan to eligible employees, officers, directors, and consultants of Headwaters. Terms of options and other awards granted under the Plans, including vesting requirements, are determined by the Committee and historically have varied significantly. Options and other awards granted under the Plans vest over periods ranging from zero 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 summarizes the activity for all of Headwaters stock options, including options not granted under the Plans, for 2005 and 2006.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(in thousands of shares)          | Shares | Weighted-
average
exercise
price | Weighted-average
remaining
contractual term
in years | Aggregate
intrinsic
value
|--------------------------------- | ------ | -------------------------------- | ---------------------------------------------------- | -------------------------
|Outstanding at September 30, 2004 |        |                                  |                                                      | 3,798                    
|Granted                           |        |                                  |                                                      | 214                      
|Exercised                         |        |                                  |                                                      | (1,166                   
|Forfeited or expired              |        |                                  |                                                      | (53                      
|                                  |        |                                  |                                                      |                          
|Outstanding at September 30, 2005 |        |                                  |                                                      | 2,793                    
|                                  |        |                                  |                                                      |                          
|Granted                           |        |                                  |                                                      | 108                      
|Exercised                         |        |                                  |                                                      | (458                     
|Forfeited or expired              |        |                                  |                                                      | (9                       
|                                  |        |                                  |                                                      |                          
|Outstanding at September 30, 2006 |        |                                  |                                                      | 2,434                    
|                                  |        |                                  |                                                      |                          
|Exercisable at September 30, 2005 |        |                                  |                                                      | 2,465                    
|                                  |        |                                  |                                                      |                          
|Exercisable at September 30, 2006 |        |                                  |                                                      | 2,306                    
|                                  |        |                                  |                                                      |                          

| | The weighted-average grant-date fair value (calculated using the B-S-M model) of options granted during 2005 and 2006 was $13.26 and $11.91, respectively. The total intrinsic value of options exercised during 2005 and 2006 was approximately $27.8 million and $9.7 million, respectively.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
following table summarizes the activity for Headwaters stock options for 2004.
| | -----------------------------------------------------------------------------------

|(in thousands of shares)               | Shares | Weighted-
average
exercise
price
|-------------------------------------- | ------ | --------------------------------
|Outstanding at beginning of year       |        |                                 
|Granted                                |        |                                 
|Exercised                              |        |                                 
|Canceled                               |        |                                 
|                                       |        |                                 
|Outstanding at end of year             |        |                                 
|                                       |        |                                 
|Exercisable at end of year             |        |                                 
|                                       |        |                                 
|Weighted-average fair value of options |        |                                 
|granted during the year below market   |        |                                 
|Weighted-average fair value of options |        |                                 
|granted during the year at market      |        |                                 
|Weighted-average fair value of options |        |                                 
|granted during the year above market   |        |                                 

F-23

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | SARs  The following table summarizes the activity for all of Headwaters SARs for 2005 and 2006. Approximately 2.0 million of the outstanding SARs vested on the date of grant. The remaining SARs vest over five years and most of these SARs are exercisable based on the achievement of performance criteria related to the economic growth of Headwaters during the five-year period. Headwaters currently expects the performance criteria to be achieved and therefore is recording compensation expense over the five-year period, which also represents the requisite service period. If this expectation changes in the future, some of the compensation expense recognized up to that time could be reversed.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(in thousands of shares)          | Shares | Weighted-
average
exercise
price | Weighted-average
remaining
contractual term
in years | Aggregate
intrinsic
value
|--------------------------------- | ------ | -------------------------------- | ---------------------------------------------------- | -------------------------
|Outstanding at September 30, 2004 |        |                                  |                                                      | 0                        
|Granted                           |        |                                  |                                                      | 3,013                    
|Exercised                         |        |                                  |                                                      | (4                       
|Forfeited or expired              |        |                                  |                                                      | (1                       
|                                  |        |                                  |                                                      |                          
|Outstanding at September 30, 2005 |        |                                  |                                                      | 3,008                    
|                                  |        |                                  |                                                      |                          
|Granted                           |        |                                  |                                                      | 197                      
|Exercised                         |        |                                  |                                                      | (40                      
|Forfeited or expired              |        |                                  |                                                      | (24                      
|                                  |        |                                  |                                                      |                          
|Outstanding at September 30, 2006 |        |                                  |                                                      | 3,141                    
|                                  |        |                                  |                                                      |                          
|Exercisable at September 30, 2005 |        |                                  |                                                      | 1,990                    
|                                  |        |                                  |                                                      |                          
|Exercisable at September 30, 2006 |        |                                  |                                                      | 1,971                    
|                                  |        |                                  |                                                      |                          

| | The weighted-average grant-date fair value of SARs granted during 2005 and 2006 was $9.65 and $14.04, respectively. The total intrinsic value of SARs exercised during 2005 and 2006 was approximately $0.1 million for both years.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Other Stock-Based Awards and Unrecognized Compensation Cost  In addition to the stock options and SARs reflected in the tables above, Headwaters has issued less than 0.1 million shares of restricted common stock to officers and employees. The restricted stock was issued at no cost to the recipients and vests over periods ranging from two to five years. Compensation expense equal to the value of the stock on the date of grant is being recognized over the vesting periods which also represent the requisite service periods. In 2005, Headwaters agreed to issue up to 25,000 shares of common stock to the Chief Executive Officer and Chairman of the Board, which shares will vest in March 2010 if the market value of a share of Headwaters common stock meets or exceeds stipulated thresholds. The fair value of this contingent performance stock was estimated by an independent valuation firm by calculating the
probabilities that Headwaters common stock would reach the various market value thresholds. The fair value is being recognized as expense over the requisite service period, or through March 2010. Finally, Headwaters also recognizes compensation expense in connection with its Employee Stock Purchase Plan (ESPP). Compensation expense related to restricted stock, contingent performance stock and the ESPP is not material.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As of September 30, 2006, there is approximately $11.4 million of total compensation cost related to nonvested awards not yet recognized. This unrecognized compensation cost is expected to be recognized over a weighted-average period of approximately 2.0 years.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-24

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | Stockholder Approval of Equity Compensation Plans  The following table presents information related to stockholder approval of equity compensation plans as of September 30, 2006.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(in thousands)                    
|----------------------------------
|
|Plans approved by stockholders    
|Plans not approved by stockholders
|                                  
|Total                             
|                                  

| | As discussed above, Headwaters has four Plans under which options and SARs have been granted. Headwaters has also issued options not covered by any Plan. Stockholders have approved three of the four Plans. The amounts included in the caption not approved by stockholders in the above table represent amounts applicable under the Plan not approved by stockholders plus all awards granted outside of any Plan.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# 12.   Earnings per Share

The following table sets forth the computation of basic and diluted EPS for the years ended September 30:

|(in thousands, except per-share data)                               | 2004 | 2005 | 2006
|------------------------------------------------------------------- | ---- | ---- | ----
|Numerator:                                                          |      |      |     
|Numerator for basic earnings per share - net income                 |      |      | $   
|Interest expense related to convertible senior subordinated         |      |     
|notes, net of taxes                                                 |      |      |     
|                                                                    |      |      |     
|Numerator for diluted earnings per share - net income plus          |      |     
|interest expense related to convertible notes, net of taxes         |      |      | $   
|                                                                    |      |      |     
|Denominator:                                                        |      |     
|Denominator for basic earnings per share - weighted-average         |      |     
|shares outstanding                                                  |      |      |     
|Effect of dilutive securities:                                      |      |     
|Shares issuable upon exercise of options, warrants and SARs         |      |      |     
|Shares issuable upon conversion of convertible notes                |      |      |     
|                                                                    |      |      |     
|Total potential dilutive shares                                     |      |      |     
|                                                                    |      |      |     
|Denominator for diluted earnings per share - weighted-average       |      |     
|shares outstanding after assumed exercises and conversions          |      |      |     
|                                                                    |      |      |     
|Basic earnings per share                                            |      |      | $   
|                                                                    |      |      |     
|Diluted earnings per share                                          |      |      | $   
|                                                                    |      |      |     
|Anti-dilutive securities not considered in diluted EPS calculation: |      |     
|Stock options                                                       |      |      |     
|SARs                                                                |      |      |     

| | SFAS No. 123R changed the method of applying the treasury stock method in determining the potential dilutiveness of stock-based awards for diluted EPS calculations. In accordance with the requirements of SFAS No. 123R, the 2005 and 2006 EPS calculations above considered all of the following as assumed proceeds in using the treasury stock method to calculate whether and to what extent options and SARs were dilutive: i) the amounts employees must pay upon
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-25

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | exercise; plus ii) the average amount of compensation cost during the period, if any, attributed to future service, but not yet recognized; plus iii) the amount of tax benefits, if any, that would be credited to additional paid-in capital if the award were to be exercised.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# 13.   Acquisitions

| | 2004 Acquisitions  Headwaters acquired four companies in 2004. All of the acquisitions were accounted for using the purchase method of accounting as required by SFAS No. 141, Business Combinations. Consideration paid, consisting primarily of cash payments, aggregated over $1.0 billion, and was negotiated at arms length. Assets acquired and liabilities assumed were recorded at their estimated fair values as of the acquisition dates. Results of operations for the acquired companies have been included in Headwaters consolidated statement of income since the acquisition dates.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As reflected in the table below, a significant amount of the aggregate purchase price was allocated to identifiable intangible assets (consisting primarily of customer relationships, trade names, and patents) which are being amortized over estimated useful lives ranging from two to twenty years. The remaining purchase price not attributable to tangible and identifiable intangible assets was allocated to goodwill, most of which is not tax deductible. Substantially all of the intangible assets and goodwill were allocated to Headwaters construction materials segment.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Headwaters agreed to pay an earn-out to the sellers of a subsidiary company acquired in 2004 if a specified earnings target was exceeded during the 12 months ended December 31, 2005 (the earn-out period). The earn-out achieved totaled $9.5 million and was recorded as additional goodwill. It was paid to the former owners of the subsidiary, one of whom is a current officer of Headwaters, in 2006.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The following table sets forth the final allocation of the total consideration paid to the tangible and intangible assets acquired and liabilities assumed for all 2004 acquistions combined.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(in thousands)                     
|-----------------------------------
|Cash                               
|Other current assets               
|Property, plant and equipment      
|Intangible assets                  
|Other assets                       
|Goodwill                           
|Current liabilities                
|Net deferred income tax liabilities
|                                   
|Net assets acquired                
|                                   

| | In 2004, Headwaters expensed approximately $0.9 million of deferred acquisition costs related to acquisition projects that were abandoned. Write-offs of deferred acquisition costs were not material in 2005 or 2006.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2006 Acquisitions  During 2006, Headwaters acquired certain assets and assumed certain liabilities of several privately-held companies in the construction materials industry. Total consideration paid or accrued for these acquisitions was less than $8.0 million. Pursuant to contractual terms for some of the acquisitions, additional amounts may be payable in the future, based on the achievement of stipulated revenue or earnings targets for periods ending no later than March 2010. If future earn-out consideration is paid, goodwill will be increased accordingly. Operating results since acquisition dates for all of the businesses combined were not material.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2007 Acquisition  In November 2006, Headwaters acquired 100% of the ownership interests of a privately-held company in the construction materials business. Total consideration paid was approximately $49.0 million. Pursuant to contractual terms, an additional amount may be payable in the future, based on the achievement of a stipulated earnings target for the 12 months ending September 30, 2007.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-26

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

# 14.   Commitments and Contingencies

Commitments and contingencies as of September 30, 2006 not disclosed elsewhere, are as follows.

| | Leases  Rental expense was approximately $14.6 million in 2004, $24.3 million in 2005 and $30.9 million in 2006. Headwaters has noncancellable operating leases for certain facilities and equipment. Most of these leases have renewal terms and currently are set to expire in various years through 2017. As of September 30, 2006, minimum rental payments due under these leases are as follows.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Year ending September 30: | (in thousands)
|------------------------- | --------------
|2007                      |               
|2008                      |               
|2009                      |               
|2010                      |               
|2011                      |               
|Thereafter                |               
|                          |               
|                          |               
|                          |               

| | Purchase Commitments  Certain CCP segment contracts with suppliers require Headwaters to make minimum purchases. Actual purchases under contracts with minimum requirements were approximately $12.5 million for 2004, $13.2 million for 2005 and $15.4 million for 2006. As of September 30, 2006, minimum future requirements are as follows.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Year ending September 30: | (in thousands)
|------------------------- | --------------
|2007                      |               
|2008                      |               
|2009                      |               
|2010                      |               
|2011                      |               
|Thereafter                |               
|                          |               
|                          |               
|                          |               

| | Compensation Arrangements  Employment Agreements. Headwaters and its subsidiaries have entered into employment agreements with its Chief Executive Officer and several other officers and employees. The agreements have original terms ranging up to five years, many of which are renewable by Headwaters, often for one-year terms. They provide for annual salaries currently ranging from approximately $0.1 million to $0.7 million annually per person. Assuming all agreements set to expire in 2007 are renewed, the annual commitment under all employment agreements combined would currently approximate $4.4 million. The aggregate commitment as of September 30, 2006, assuming no renewals, is approximately $5.4 million. Most agreements provide for termination benefits, which vary widely from agreement to agreement.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Long-Term Incentive Cash Bonus Awards. During 2006, Headwaters Compensation Committee (the Committee) authorized the grant of long-term incentive cash bonus awards to certain officers and employees, which awards were granted under Headwaters Long Term Incentive Compensation Plan. In accordance with terms of the awards, cash payments are based on several factors, including the achievement of stipulated financial goals as measured by economic value added (EVA) over a three-year period by Headwaters and its operating units. Payments for these awards may not exceed $30.0 million in the aggregate. No amounts have been expensed for these awards through September 30, 2006 because it is not yet probable that the financial goals will be met.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Executive Change in Control Agreements. During 2006, the Committee also approved Executive Change in Control Agreements with 12 officers. Upon a change in control, as defined, the agreements provide for immediate vesting and exercisability of all outstanding stock awards. In addition, if termination of employment occurs within a specified period of a change in control, the agreements provide for i) severance pay equal to two times the sum of an officers current annual salary plus the highest cash bonus paid or payable for any single year in the three-year period
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-27

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | commencing two years prior to the year in which the change in control occurs; and ii) continuance of health and other benefits and perquisites for a two-year period following the change in control. If terminations associated with a change in control would have occurred on September 30, 2006, the severance payments due to the 12 officers would have aggregated approximately $19.2 million.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Performance Unit Awards. During 2005 the Committee authorized the grant of performance unit awards, to be settled in cash, based on performance criteria tied to the economic value created or preserved by one of Headwaters business units after December 2007. The grants of these performance units were made in 2006 and could result in the payment to employees of a maximum amount of approximately $3.9 million if all performance criteria are met. No amounts have been expensed for these awards through September 30, 2006 because it is not yet probable that the performance criteria will be met.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Contingent Commission Agreement. In addition to its standard sales commission arrangements, Headwaters has entered into a contingent commission agreement whereby it has agreed to pay an employee total sales commissions up to a maximum amount of $4.5 million. The agreement calls for payments to be made for customer purchase orders of a stipulated size and for a stipulated period of time to be executed prior to May 2008. No amounts have been expensed under this agreement through September 30, 2006.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Employee Benefit Plans  In addition to standard health and life insurance programs, Headwaters has three employee benefit plans that were operative during the three-year period ended September 30, 2006: the 401(k) Profit Sharing Plan (401(k) Plan), the 2000 Employee Stock Purchase Plan (ESPP), and the Incentive Bonus Plan (IBP). During 2005, Headwaters Board approved a Deferred Compensation Plan (DCP) which became effective in January 2005. Also in 2005, Headwaters Board adopted the Long Term Incentive Compensation Plan (LTIP) which was approved by stockholders. Substantially all employees of Headwaters are eligible to participate in the 401(k) Plan and the ESPP after meeting length of employment requirements. Only designated employees are eligible to participate in the IBP, DCP and LTIP.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Certain of the subsidiaries acquired by Headwaters in 2004 had employee benefit plans. All of these acquired subsidiaries employee benefit plans have been discontinued, with the exception of one subsidiarys medical plan and 401(k) Profit Sharing Plan, which are expected to be consolidated with Headwaters plans in 2007. Under the terms of that subsidiarys 401(k) Profit Sharing Plan, it has agreed to pay a certain percentage of most employees salaries into the Profit Sharing Plan on behalf of those employees.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The total expense for all of Headwaters benefit plans combined (excluding standard health and life insurance programs and ESPP expense, which is included in stock-based compensation) was approximately $14.9 million in 2004, $22.8 million in 2005 and $16.4 million in 2006.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 three years. Headwaters is not required to be profitable to make matching contributions.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | ESPP. The ESPP provides eligible employees with an opportunity to purchase 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 148,000 shares remain available for future issuance as of September 30, 2006. In accordance with terms of the ESPP, participating employees purchase shares of stock directly from Headwaters, which shares are made available from treasury shares which have been repurchased on the open market. The ESPP 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 fair market value at the end of each offering period.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-28

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | IBP. The IBP, the specifics of which are approved annually by the Compensation Committee, provides for annual cash bonuses to be paid if Headwaters accomplishes certain financial goals and if participating employees meet individual goals. 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.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | DCP. The DCP is a nonqualified plan that allows eligible employees to make tax-deferred contributions of up to 50% of their base compensation and 100% of their incentive compensation. In certain instances, Headwaters matches employee contributions up to a designated maximum rate and these matching contributions vest after three years. Headwaters is not required to be profitable to make matching contributions.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | LTIP. Other than obligations associated with the long-term incentive cash bonus awards described above and grants of certain of the stock-based awards described in Note 11, Headwaters has no commitments under the LTIP as of September 30, 2006.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Self Insurance  Headwaters has adopted self-insured medical insurance plans that cover substantially all employees. There is stop-loss coverage for amounts in excess of $100,000 to $175,000 per individual per year. Headwaters also self insures for workers compensation claims in most states, limited by stop-loss coverage for amounts in excess of $250,000 per occurrence and approximately $6.0 million in the aggregate annually. Headwaters has contracted with third-party administrators to assist in the payment and administration of claims. Insurance claims are recognized as expense when incurred and include an estimate of costs for claims incurred but not reported at the balance sheet date. As of September 30, 2006, approximately $4.3 million is accrued for medical and workers compensation claims incurred on or before September 30, 2006 that have not been paid or reported.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Property, Plant and Equipment  As of September 30, 2006, Headwaters was committed to spend approximately $7.3 million on capital projects that were in various stages of completion.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Joint Venture Obligations  Headwaters entered into an agreement with Degussa AG, 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 committed to fund 50% of the joint ventures research and development expenditures through September 2007, subject to a stipulated maximum. The amount remaining to be paid under this commitment as of September 30, 2006 is not material. In 2006, Headwaters and Degussa AG formed another joint venture, Degussa Headwaters Korea Co., Ltd. (DHK), which purchased a hydrogen peroxide production business located in South Korea. Headwaters is a principal obligor with respect to all non-financial obligations of DHK and, with respect to financial obligations of DHK, 50% of future plant expansion cost overruns, if any. Headwaters
investments in its joint ventures with Degussa AG (in which Degussa and Headwaters have equal ownership, voting rights and control) are accounted for using the equity method of accounting and total approximately $19.3 million at September 30, 2006.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Headwaters owns a 51% interest in a joint venture with Great River Energy, a Minnesota-based power generation and supply cooperative (GRE), which was formed to construct, own and operate an ethanol plant in North Dakota (Blue Flint). The plant is currently expected to begin operating in early calendar 2007 with estimated ethanol production of 50 million gallons annually. Estimated costs to construct the ethanol plant and fund start-up costs and initial working capital approximate $95.5 million, which is being funded primarily by debt secured by all the assets of Blue Flint, along with capital contributions from Headwaters and GRE. Headwaters has made its full capital contribution as of September 30, 2006. The Blue Flint joint venture, which is not a variable interest entity, is being accounted for using the equity method of accounting because both partners have equal voting rights and control over the joint
venture. Headwaters investment in the Blue Flint joint venture totals approximately $8.9 million at September 30, 2006.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Legal or Contractual Matters  Headwaters has ongoing litigation and asserted claims which have been incurred during the normal course of business, including the specific matters 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.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-29

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | Historically, costs paid to outside legal counsel for litigation have comprised a majority of Headwaters litigation-related costs. During 2006, Headwaters incurred approximately $0.1 million of net expense for legal matters, including costs for outside legal counsel, compared to approximately $3.8 million in 2004 and $3.2 million in 2005. In 2006, developments in certain legal matters Headwaters is defending resulted in reduced likelihood of ultimate legal liability and a reduction of expense. Headwaters currently believes the range of potential loss for all unresolved matters, excluding costs for outside counsel, is from $1.0 million up to the amounts sought by claimants and has recorded a total liability as of September 30, 2006 of $1.0 million. Claims and damages sought by claimants in excess of this amount are not deemed to be probable. Headwaters outside counsel currently believe that unfavorable outcomes of outstanding
litigation are neither probable nor remote and declined to express opinions concerning the likely outcomes or liability to Headwaters. It is not possible to estimate what litigation-related costs will be in future periods.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The matters discussed below 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. It is possible that a change in the estimates of probable liability could occur, and the changes could be material. 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.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 $2.8 million 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.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 $15.0 million and $25.0 million and punitive damages. In February 2006, the District Court dismissed all claims against Headwaters. Also in February 2006, plaintiffs filed their notice of appeal to the United States Court of Appeals for the Sixth Circuit. In June 2006, the appeal was transferred to the United States Court of Appeals for the Federal Circuit. Because the resolution of the litigation is uncertain, legal counsel cannot express an opinion as to the ultimate amount, if any, of Headwaters liability.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Headwaters Construction Materials Matters.There are litigation and pending and threatened claims made against certain subsidiaries of Headwaters Construction Materials (HCM) 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
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-30

---

# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | 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 Insulating 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. None of the cases has gone to trial. While, to date, none of these proceedings have required that HCM incur substantial costs, there is no guarantee of insurance coverage or continuing coverage. These and future proceedings may result in substantial costs to HCM, including attorneys fees, managerial time and other personnel resources and costs. Adverse resolution of these proceedings could have a materially negative effect on HCMs business, financial condition, and results of
operation, and its ability to meet its financial obligations. Although HCM carries general and product liability insurance, HCM cannot assure that such insurance coverage will remain available, that HCMs insurance carrier will remain viable, or that the insured amounts will cover all future claims in excess of HCMs uninsured retention. Future rate increases may also make such insurance uneconomical for HCM to maintain. In addition, the insurance policies maintained by HCM 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 HCMs liability.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

| | Section 45K Matters  A material amount of Headwaters consolidated revenues and net income is derived from license fees and sales of chemical reagents, both of which depend on the ability of licensees and other customers to manufacture and sell qualified synthetic fuels that generate tax credits under Section 45K [formerly Section 29] of the Internal Revenue Code. Headwaters also claims Section 45K tax credits based upon synthetic fuel sales from facilities in which Headwaters owns an interest. From time to time, issues arise as to the availability of tax credits and, with the rising price of oil, the phase-out of credits, including the items discussed below.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Phase-Out. Section 45K tax credits are subject to phase-out after the average annual U.S. wellhead oil price (reference price) reaches a beginning phase-out threshold price, and are eliminated entirely if the reference price reaches the full phase-out price. Historically, the reference price has trended somewhat lower than published market prices for oil. For calendar 2005, the reference price was $50.26 per barrel and the phase-out range began at $53.20 and would have fully phased out tax credits at $66.78 per barrel. Therefore, there was no phase-out of tax credits for calendar 2005.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | For calendar 2006, Headwaters estimates that the phase-out range (computed by increasing the 2005 inflation adjustment factor by 2%) begins at $54.27 and completes phase-out at $68.12 per barrel. As of the date hereof, the reference price for calendar 2006 is not known; however, Headwaters currently estimates partial phase-out will occur for calendar 2006. As described in more detail in Note 10, an estimate of the calendar 2006 phase out percentage calculated as of September 30, 2006, using available information as of that date, resulted in a 42% phase out.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In an environment of high oil prices, the risk of phase-out increases. Headwaters customers and licensees make their own assessments of phase-out risk. When customers and licensees have perceived a potential negative financial impact from phase-out, they have reduced or stopped synthetic fuel production or required Headwaters to share in the costs associated with phase-out. Headwaters makes similar assessments with respect to the continued operation of its own synthetic fuel production facilities. As of the date hereof, substantially all of Headwaters licensees are producing synthetic fuel, but most licensees stopped production for a period of time earlier in the year. These events have materially adversely affected both the amount and timing of recognition of Headwaters revenue, net income and cash flow, and will have a material adverse effect in future periods as well.
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F-31

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# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | Certain accounting rules limit
revenue recognition to amounts that are fixed or determinable. The amount of
license fee revenue recognized by Headwaters for 2006 was materially negatively affected
by significantly reduced revenues being recognized for several licensees whose license
agreements call for Headwaters to be paid a portion of the tax credits earned by the
licensee. Because the calendar 2006 phase-out percentage for Section 45K tax credits can
not be finalized at the current time, only approximately $10.0 million of revenues for
these licensees was recognized for the nine months ended September 30, 2006. The amount
recognized met the fixed or determinable recognition criterion and it is
remote that any negative adjustment will be required in the future. Additional revenues
for these licensees, which could total more than $30.0 million (calculated based on
licensee-reported data, which amount ultimately depends on the calendar 2006 phase-out
percentage of Section 45K), will not be recognized until such time as these amounts become
fixed or determinable.
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| | Legislation. By law, Section 45K 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 45K. If Section 45K expires at the end of 2007 or if it is repealed or adversely modified, additional synthetic fuel facilities would probably either close or substantially curtail production. 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, or upon earlier repeal or adverse modification of Section 45K, or for any other reason), it would have a further material adverse effect on the revenue, net income and cash flow of Headwaters, in
addition to the current material adverse effect caused by phase-out concerns.
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| | IRS Audits. Licensees are subject to audit by the IRS. The IRS may challenge whether Headwaters licensees satisfy the requirements of Section 45K, or applicable Private Letter Rulings, including placed-in-service requirements, or may attempt to disallow Section 45K tax credits for some other reason. The IRS has initiated audits of certain licensee-taxpayers who claimed Section 45K tax credits and will continue the audit process in the future. The inability of a licensee to claim Section 45K tax credits would reduce Headwaters future income from the licensee. In addition, the IRS may audit Headwaters concerning tax credits claimed for synthetic fuel sold from the facilities in which it owns an interest.
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| | Senate Permanent Subcommittee on Investigations. In October 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 February 2006, the Subcommittee described its investigation as follows: The Subcommittee is continuing its investigation [of] tax credits claimed under Section 29 [now Section 45K] 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 45K tax credits in the future. Renewed activity in the Subcommittee investigation, if it occurs, may have a material adverse effect on the willingness of current owners to operate their facilities, and may materially adversely affect Headwaters revenue, net income and cash flow.
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| | License Fees  Pursuant to the terms of an agreement with a certain licensee, this licensee has set aside substantial amounts for working capital and other operational contingencies as provided for in the agreement. 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 which constitutes a gain contingency not recognizable as revenue.
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# 15.   Related Party Transactions

| | In addition to transactions disclosed elsewhere, Headwaters was involved in the following transactions with related parties during 2004, 2005 and 2006. A director of Headwaters is a principal in one of the insurance brokerage
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F-32

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# HEADWATERS INCORPORATED

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS, continued September 30, 2006_________________

| | companies Headwaters uses to purchase certain insurance benefits for its employees. Commissions paid to that company by providers of insurance services to Headwaters totaled approximately $0.1 million in 2004, $0.2 million in 2005 and $0.2 million in 2006.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | One of Headwaters subsidiaries purchases product from an entity located in Mexico in which an officer of Headwaters has a minority ownership interest. Costs incurred for materials purchased from this entity were approximately $2.7 million in 2004, $11.8 million in 2005 and $16.2 million in 2006. A majority of another subsidiarys transportation needs are provided by a company, two of the principals of which are related to an officer of the subsidiary. Costs incurred were approximately $1.0 million in 2004, $4.9 million in 2005 and $5.9 million in 2006.
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# 16.   Quarterly Financial Data (unaudited)

Summarized unaudited quarterly financial data for 2005 and 2006 is as follows.

|                               | 2005
|------------------------------ | ----
|
|Net revenue                    |     
|Gross profit                   |     
|Net income                     |     
|Basic earnings per share (1)   |     
|Diluted earnings per share (1) |     

|                           | 2006
|-------------------------- | ----
|
|Net revenue                |     
|Gross profit               |     
|Net income                 |     
|Basic earnings per share   |     
|Diluted earnings per share |     

---

| | (1) | Because the weighted-average share number used to calculate EPS for the full year is an average of the numbers used for the four quarters, the full year EPS amount does not equal the sum of the EPS amounts for the four quarters of 2005.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) | In the third quarter of 2005, Headwaters settled its litigation with AJG and recognized a significant non-recurring gain of $50.0 million, along with increased recurring revenues beginning in that quarter. Also in the third quarter of 2005, Headwaters adopted SFAS No. 123R (see Note 11) which, combined with the grant of immediate-vested SARs and the acceleration of vesting of certain outstanding options, resulted in the recognition of significant non-recurring stock-based compensation expense totaling approximately $25.5 million. Headwaters adopted SFAS No. 123R using the modified retrospective method, with restatement of the interim periods in the year of adoption. Accordingly, the amounts shown above for the first and second quarters of 2005 were restated to reflect stock-based compensation expense calculated in accordance with the new stock-based compensation accounting rules.
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| | (3) | In the fourth quarter of 2005 and 2006, Headwaters recorded income tax expense at an effective tax rate of approximately 18% and 11%, respectively, compared to an effective income tax rate of approximately 30% for the first nine months of both years. The lower rates for the fourth quarter were required to reduce the effective income tax rate for each year to approximately 26%. The 2005 reduction was primarily a result of Section 45K income tax credits related to alternative fuel facilities in which Headwaters has an ownership interest, and the 2006 reduction was primarily a result of changes in the estimated phase out of Section 45K tax credits (see Note 10).
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F-33

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