I have not been the biggest fan of Headwaters' (HW) twin strategies of growth-by-acquisition and acquisitions-funded-by-debt, but the reality is that this company is doing a pretty good job of growing at a time when many housing-leveraged materials companies have yet to really catch their stride. Better still, there's a chance that the company's architectural stone siding products could grow from rounding error in the overall U.S. siding market to a significant business, a move that would have significant implications for the company's revenue and profits.
Certainly there is a difference between what can happen and what will happen. I nevertheless lean positive on this company, as the housing recovery is still in its early years and just 1% share of the U.S. siding market could mean a 15% shift in revenue from FY2013's base.
Starting The Year Strong
Housing materials companies continue to report a range of results and opinions on the state of the U.S. housing industry, but it looks like conditions have gotten better. To pick two examples, RPM saw more than 9% organic growth in its consumer business, while USG reported 12% revenue growth in its December quarter.
Headwaters compares pretty well. Revenue for the fiscal first quarter (ended December 31) rose 11% as reported. Light Building Products revenue rose 21% as reported, or 9% on an organic basis with stone products leading the way on improving new residential construction. Heavy Construction revenue was also higher, but by a much more modest 5% as iffy fly ash volumes were offset by site service revenue. The small (and volatile) Energy Technology business saw revenue decline about 77% to just over $1 million.
Margins were okay. Gross margin was a little disappointing (down 20bp yoy), but that was due to inventory buybacks from a distribution partner and acquisition-related accounting issues. On an adjusted basis, margins looked fine and Headwaters did reported an 11% increase in adjusted EBITDA with a margin about a point higher than expected.
A Tale Of Multiple Markets
Like other building material companies, Headwaters is exposed to different market conditions across geographies and product types. Headwaters saw better demand in the new residential construction market as opposed to remodeling/renovation, and with that stronger results in the stone business than the vinyl siding accessory and trim lines. Even so, trim board revenue rose 11% and the company added a significant new distributor (Boise Cascade (BCC)).
Fly ash volumes were disappointing this quarter, with weather being the principle cause. Infrastructure construction spending still isn't great, but cement manufacturers are talking about price increases of $3 to $8 per ton (around 3% to 7%), and fly ash prices usually follow pretty closely. While some investors may be worried about the impact of coal-fired generation at electrical utilities, most of the "at risk" coal-fired generation produces a lower quality fly ash that Headwaters doesn't routinely handle.
Can Stone Siding Be A Real Growth Driver For Headwaters?
Of the Light Building Products business, about half of the revenue comes from the Tapco siding and siding accessories business. While the standard vinyl siding market is dominated by companies like Ply Gem (PGEM) and CertainTeed, Headwaters doesn't really compete in this market - its premium Foundry brand and products like shake siding are considered "specialty" and the company has a respectable 25% market share there (though its only about 5% of overall revenue).
The bulk of Tapco's business is focused on various siding accessories (shutters, gable vents, etc.) and trim pieces, and Headwaters has a large market share here (estimated around 75%). With such significant share, Headwaters is going to need underlying market growth (particularly remodel/renovation), improved distribution, and add-on products to really deliver better growth.
Stone siding is a different story.
If you accept industry estimates that the siding market is worth $11 billion a year in normal times, vinyl siding holds about 30% share, while stucco and brick each have about 25% share each. Stone siding ekes out a small remainder after fiber cement and engineered wood and while the business is real (as demonstrated by $100 million-plus in revenue for both Headwaters and Australia's Boral (OTCPK:BOALY)), it's still almost rounding error to Ply Gem or St. Gobain's CertainTeed.
Headwaters is pursuing a reasonable strategy, using a three-prong "good/better/best" branding approach with Dutch Quality, StoneCraft, and Eldorado. Headwaters is also working on improving its distribution and dealing directly with homebuilders to drive increased adoption.
The question is still whether the market will adopt it. Traditional stone siding is far and away the most expensive option, often costing over $2,000 per square (equal to 100 sq ft). The architectural stone (concrete-based materials shaped and colored to look like stone) offered by Headwaters and Boral can offer savings of 50% to 66% relative to natural stone, but that's still triple the cost of vinyl siding and about double the price of brick (where Boral is also a market leader, by the way). Architectural stone siding does have some perks - it doesn't offer the same architectural support as real stone, but it still provides support, and a lot of people prefer its appearance to vinyl siding and brick.
Boral doesn't give detailed information about its Cultured Stone business all that often (it is about 3% of the company's overall revenue base), but U.S. analysts have estimated that Headwaters has about 35% share with Boral somewhere in the 20%'s. Even if the two are closer than that, they still dominate the market and Headwaters has a lot to gain if stone siding (architectural stone) can gain just a few points of market share against vinyl, brick, or stucco.
Good Luck Modeling The Recovery
As I have lamented before, forecasting the pace and magnitude of the U.S. housing recovery is just guesswork at this point. The growth opportunity in stone siding doesn't make it any easier, as just small share shifts would mean significant revenue potential for Headwaters.
Luckily for Headwaters, Boral's US operations are still operating unprofitably and the company arguably has bigger fish to fry than to worry about taking share from Headwaters. That said, Boral and Headwaters compete in multiple markets (architectural stone, roofing tiles, and fly ash) so it is not as though Headwaters operates under their radar.
I'm still looking for high single-digit revenue growth from Headwaters, with improving utilization/operating leverage and (later) better interest leverage leading to free cash flow growth in the teens. Given management's taste for M&A, I would not be surprised to see further deals that broaden the company's product portfolio and/or add new distribution or geographic exposures.
The Bottom Line
My long-term free cash flow model doesn't necessarily suggest that Headwaters is incredibly cheap (particularly after the 20% jump on earnings), but then an extra one percent share of the siding market would mean $1/share in fair value, so there's definitely upside in a bullish scenario. Looking instead at EV/EBTIDA, I still see room for Headwaters to move higher. At 10x 2014 EBITDA (a slight premium to the peer group average of 9.5x), fair value comes in around $13.50 and I would not be surprised if the 2014 estimates head higher if Headwaters continues to execute at a high level (and/or conditions in housing get better).