This has been a rough year for companies hoping to leverage a nascent recovery in residential construction, residential remodel/repair work, and light commercial construction. Ply Gem (PGEM), Louisiana-Pacific (LPX), and James Hardie (JHX) have done worst than most, but even Armstrong World Industries (AWI) and Mohawk (MHK) have done pretty poorly. Against that backdrop, Headwaters' (HW) steep correction from the start of July is still unpleasant to behold, but the stock still has a double-digit gain on a year-to-date basis.
I think a large part of the problem with Headwaters' shares has been inflated expectations, as the company continues to execute reasonably well. I'd like to see better operating leverage, but management is still committed to growing the business and absorbing some inefficiencies along the way. I'm still not as bullish on Headwaters as the ardent supporters who email me, but I do believe the shares have sold off to a point where they once again look like an interesting play on that "when, not if" recovery in residential recovery and a longer-term effort to assemble a collection of quality specialty building materials businesses.
When Good Enough Isn't
Headwaters met most of the numbers that the sell-side cares about, but the Street wanted more both in terms of present-day momentum and forward guidance.
Revenue rose 13% as reported, or 7% on an organic basis, which was just slightly better than expected. The Light Building Products segment saw 19% reported revenue growth and 9% organic growth, as siding sales (about half of the segment's business) were flat, but roofing and stone products rose double digits and concrete block was also up year over year. Heavy Construction Materials saw 7% growth, with good results in fly ash (volume up 7% and price up 4%) offset by weaker results from site service. The small and volatile Energy Technology business saw a 44% decline in revenue.
Gross margin improved about a half-point from last year, coming in a little weaker than expected. Adjusted EBITDA was up 19% as reported (up over 14% including stock comp expense) and was more or less in line with most analysts' expectations. Light Building Products EBITDA rose 14% while Heavy Construction Materials EBITDA rose 22%; LBP profits were limited in part by smaller contributions to the mix from the higher-margin siding operations.
Operating income was up 11% as reported and looked about 15% weak relative to the sell-side. Profit growth was stronger in the LBP business than HCM (up 21% versus 17%), but HCM fared better relative to expectations on margins.
Waiting For The Upturn
Management reiterated guidance of $130 million to $145 million in EBITDA for the fiscal year (this was the third quarter in the company's fiscal year). That implies a pretty strong sequential improvement in EBITDA (around 12%), but sell-side analysts were already a little above the midpoint of that guidance, so investors may be disappointed that the outlook wasn't lifted.
Based on what other companies, including Ply Gem, have been saying, this isn't a total surprise. Earlier this week, Plum Creek announced its intention to reduce its timber harvests due to ongoing weakness in construction demand and price for sawlogs. Housing starts haven't been all that strong (single-family starts down 4% yoy in June and down more than 1% from the January level) and while Headwaters is not overly exposed to the new construction market (repair/remodel is just as important), the Joint Center for Housing Studies of Harvard University's Leading Indicator of Remodeling Activity has been showing an erratic rate of growth (albeit still up 7%-plus yoy in the second quarter).
Headwaters' management isn't just sitting around and waiting for activity levels to improve. Management has been focused on increased cross-selling efforts across existing businesses and building interest in its stone siding products as an alternative to vinyl, brick, and stucco.
M&A is still considered a growth driver as well. The company expanded its roofing product line with the acquisition of the Gerard stone-coated metal roofing business from Reliance Steel & Aluminum (RS) back in May and is almost certainly looking at additional acquisition prospects in key states like Florida, Texas, California, and Arizona. While operating too many disparate businesses can create margin headwinds, Headwaters has the advantage of being a relatively large player in this niche market, with opportunities to increase market share and drive operating leverage with better volumes.
Fly Ash Issues Should Go Away Soon
The EPA has not yet formally published its new rule(s) regarding the handling of coal combustion products (including fly ash), but all indications have been that the agency will deem them non-hazardous waste. It seems that the market participants (cement manufacturers) are already incorporating these expectations into their plans, but it will be a net positive to see this issue resolved once and for all.
Headwaters is still committed to this business, and recently acquired LA Ash Products, a company that collects ash from circulating fluidized-bed boilers. CFB ash isn't the same as the fly ash that Headwaters is more known for - it has too much sulfur to be used in concrete - but it can be used in other applications like soil stabilization and structural fill. Most importantly, this deal should add some balance to Headwaters' existing CFB business, as LA Ash has more demand than it can fill, while Headwaters' existing CFB business has excess supply.
The Bottom Line
Although I think Headwaters bulls get a little too excited about the potential of this business in a few years' time, I am bullish on the company's prospects as housing and light commercial construction and remodeling markets recover. I'm looking for high single-digit growth over the long term, with significant improvements in FCF margin (helped in part by balance sheet leverage and deferred tax assets).
I'm still not completely sold on these shares from a DCF perspective, but a 9.5x multiple to FY 2015 EBITDA suggests a fair value around $13.50, with every $8 million in additional EBITDA supporting another $1/share in fair value. There are more than a few battered and bruised housing recovery plays out there, but after this pull back I think Headwaters is worth another look.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
