Why I'm Not Dipping Into Walter Industries

After reviewing Walter Industries, Inc. (WLT) following an email request, I have decided that I will not be adding WLT to my value portfolio, mainly caused by the high amount of debt in relation to the book value. My value scorecard shows only one passing mark in the dividend section with a yield of approximately 0.4% in 2005. In providing a growth assessment of the firm, WLT currently provides some upside opportunity to the current trading levels with the lowest P/S multiple across the industry comparative. This growth upside does have some risk associated with it driven by the P/S industry benchmark of 1.4x vs. WLT's 0.7x.

Company Overview

Description
Walter Industries, Inc., is a diversified company which operates in seven reportable segments: Mueller, Anvil, U.S. Pipe, Natural Resources, Homebuilding, Financing and Other. Through these operating segments, the Company offers a diversified line of products and services including water infrastructure and flow control products, coal, natural gas, home construction and mortgage financing, furnace and foundry coke and slag fiber. On December 3, 2003, the Company completed the sale of AIMCOR, previously a wholly-owned subsidiary of the Company, to Oxbow Carbon and Minerals LLC. The Company also completed the sale of JW Aluminum, previously a wholly-owned subsidiary of the Company, to Wellspring Capital Management LLC on December 5, 2003. As a result of the above sales, the results highlighted below have not been classified into discontinued operations.

5-Year Financial History

In the 5-year historical picture, Walter Industries had two major divestitures in December 2003 and two major acquisitions in October 2005. The 2002 – 2003 annual revenue and income impact is driven by the divestitures. Excluding these one-time impacts, WLT has been showing some nice revenue growth along with going into a profitable position. On a trailing twelve months [TTM], I am anticipating a 78% annual increase in revenue to $3.2 Billion mainly driven by the recent Mueller (MWA) and Anvil (AVM) acquisitions completed on October 3rd, 2005. In the past 5 years years, Walter Industries has maintained operating expenses at historical levels in the face of the divestitures and acquisition activity.

5-Year Stock Performance

If you had invested $10,000 in WLT stock on January 2nd, 2001, your stock would be worth $63,411 representing a +534% return or 36.0% annually. There were only two years that Walter Industries experienced negative price performance, in 2002 and 2006 year to date.

Value Assessment Scorecard

I use an 8 criteria selection grid to help me assess potential value in any equity assessment. These 8 criteria are mainly driven from my readings of Benjamin Graham. The security doesn’t have to pass all of the below criteria to be selected for my portfolio, the more the better. Some of the major items that I focus on are Price to Book ratio (Criteria D.) and the earnings and free cash flow yields metrics (Criteria G.).

The value scorecard illustrates WLT’s significant amount of debt compared to the current book value, currently at 3x on the last reported balance sheet as of Q3 2006. WLT’s price to book ratio has been steadily increasing from 2001-2005, with a correction on the TTM basis coming in at 2.8x. Slightly higher than what I am comfortable with. The company does provide FCF yield’s that are higher than the current 10-year note, but not 2x enough to provide me a safety margin in my investments.

Growth Assessment

With my growth reviews of stock, I use a few different valuation techniques to surround my assumptions.
- 5 Year Discounted Cash Flow model with terminal value
- Industry Price to Earnings multiples
- Industry Price to Sales multiples
- Current Price to Earnings sensitivity

From a growth perspective, there is some potential upside to the current market cap value. This is mainly driven by the Price/Sales ratio that I am using from the Morningstar website at 1.4x. If I use a 0.7x price to sales ratio that the stock is currently trading at, the overall growth market cap is 2,089 or 1.2% upside opportunity to the current trading levels.

DCF Model

In my 5 year discounted cash flow model, I am assuming 10% sales growth with net income margin improving to 4.1% and the free cash flow % to revenue of 6.0%, compared to 2.8% and 4.0% on a TTM basis. With a corresponding 5% terminal value and 10% cost of capital, WLT’s value is worth around $2.0 Billion.


Industry P/E and P/S multiples

With the diversified portfolio of Walter Industries, I have elected to capture the Morningstar.com industry benchmarks for Price to Earnings of 15.9x and 1.4x respectively. As previously mentioned, the 1.4x Price to sales benchmark is creating a potential growth opportunity for WLT. When you hold the 0.7x of Price to Sales the current stock is trading at, the potential growth has disappeared.


Current P/E sensitivity

With the Morningstar.com benchmarks, you will notice the Walter Industries is currently trading at 48.7x to earnings per share with the industry trading at 15.9x. I have selected a P/E of 15.0 to capture the market cap sensitivity on project future earnings growth of 10%.

Comments

[cheapstockhunter]

Elias. Do your homework. You cannot just pull a bunch of numbers off of morningstar and make a thoughtful investment decision, without reading the 10-K and having a true understanding of the financials.

Your analysis is totally flawed. Please read the 10-K and re-evaluate before you continue to spread your wisdom across the internet

1. Debt balance. You need to look at net debt. Secured Mortgage backed debt must be evaluated in tandem with the offsetting mortgage recievables. Mueller Water debt, which will be spun out in 2 weeks should also be properly accounted for when making an estimation of company liabilities, relative to the companies earning power

2. Relative Valuation ratios. Who created the "industry" peer group P/S and P/E ratios you are using as comps? Are they conglomerates? Homebuilders? Coal companies? If this is a coal company universe, are you comparing to conventional steam coal producers or met coal producers? Any idea which has higher margins?

3. How did you arrive at those free cash flow assumptions over the next 5 years? Did you listen to the conference call? Do you know what wall street estimates are? Most folks that follow the company expect them to earn about 250-350mm in cash flow next year. The Kodiak and Mine 7 initiatives over the next 3 years have the ability to add 25-40% increase in production. Based on next years revenue of 1.1B, 300mm in cash flow, and cap-ex estimate of 60mm (discussed on conference call) I arrive at a free cash flow / revenue yield of about 20%. Put that into your model.

4. Book value of equity. Company has a negative equity balance stemming from a transaction with KKR 5 years ago, that skews the amount of accounting book value on the balance sheet. Evaluate the real tangible assets the company relative to its debt, you will find the company has sufficient resources to cover its liabilities. Try looking at the company as an aquirer would? Do you think they care more about the number that morningstar has under "shareholder equity"? Or would they be more concerned with the real world market value and earning power of Walter's assets.

I understand your need to constantly repost this analysis as your short position continues to keep you up at night, but please do your homework before spreading your gibberish all over the internet.

[EliasTsepouridis]

Jonathan -
Thanks for your feedback. First let me start by disclosing that I am not long nor short Walter Industries and that all investors are advised to do their own research. The main basis of this article was that this is my personal analysis/screening criteria to decide if I should include WLT in my portfolio. With that said, the main drivers of my decision were #1. the debt levels (adjusted for the mortgage backed securities) as a % to book value were over 100% for multiple years, something that I am not comfortable with and #2 having the business completing many acquisitions and/or divestitures in the past, I can't get a handle on the historical normalized cash flow trends.
Elias