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There was a point in time when Headwaters (HW) was an interesting play on clean(er) energy, what with its coal conversion, coal cleaning, and catalyst technologies. As it turns out, most of those energy opportunities really couldn't stand on their own merits and one by one fell to the wayside. Now the company stands as a debt-ridden building products company operating in one of the worst construction markets in living memory. While that sounds bad, and is indeed challenging, it looks like a series of asset sales will keep the company in place to benefit from that eventual rebound in construction activity.

Farewell To Ethanol, Coal Cleaning Next?

Headwaters started the year by announcing the sale of its 51% interest in the Blue Flint Ethanol LLC to its partner Great River Energy for $18.5 million. That was about 20% better than management had led the Street to believe and the added balance sheet flexibility is welcome.

Looking ahead, the company is still intending to sell its coal cleaning business. Already classifying it as a discontinued operation, management is hoping to garner another $20 million or so in cash from this business. Admittedly this won't substantially dent the $500 million or so in debt on the balance sheet, but it is more relevant when compared to the $140 million or so in debt due by 2016.

Trying To Build A Business In Building

Although there are still some energy assets at the company (including technology that can be used in refinery catalysts), Headwaters is now for all intents and purposes a building products company. Unfortunately, it's hardly news that this is a remarkably bad environment for construction. Housing starts have been about 60% below the long-term trend and the environment for commercial construction is scarcely better.

Nevertheless, Headwaters is trying to make a go of it in two separate businesses. The Light Building Products business focuses on resin-based siding products and architectural stone, while the Heavy Construction business is largely built around selling coal-burning utility byproducts like fly ash to concrete makers who can use it to improve the performance of the concrete at a reduced cost.

From Frying Pan To Fire?

Headwaters certainly had its challenges trying to make a go of it in the coal-related businesses, particularly in regards to the significance of tax credits on the economic viability of the business. Unfortunately, it's not as though the building businesses are risk-free ventures in their own right.

In the siding business, for instance, Headwaters is a small player well behind the likes of Ply Gem or Saint Gobain's CertainTeed. Although the architectural stone business is more significant within its market, it is not as though builders like Toll Brothers (TOL) have seen much nascent demand for the McMansions that so often use those stone products. Likewise, there is not much that's proprietary to the fly ash business; plenty of companies are in the business of acting as a go-between for utilities and cement/concrete companies.

Simply put, market share matters. Companies like Masco (MAS), Fortune Brands Home (FBHS) and Owens Corning (OC) are big enough that they have some measure of leverage with home improvement stores like Home Depot (HD)and Lowe's (LOW) and building supply distributors, but that's harder for Headwaters at this point. What's more, these can be brand-driven businesses and Headwaters scarcely has the financial flexibility to invest in brand-building in a big way.

Playing For The Recovery

Management deserves plenty of blame for buying its construction businesses at very nearly peak multiples and then using debt to pay the bills. This collection of decisions has put the very survival of the company into some doubt because of the debt service requirements. At the same time, management has been working hard to drive costs out of the building supply businesses and has used asset sales to buy breathing room.

Sooner or later construction activity will rebound in the United States; construction activity is not keeping up with population growth and that cannot go on forever. When that activity returns, companies like Armstrong World Industries (AWI), Owns Corning, and Simpson Manufacturing (SSD) should see sales rebound in a meaningful way.

Headwaters can certainly play that recovery and there are some signs that the maintenance/repair side of the business is already starting to pick up. Likewise, the eventual recovery in names like Cemex (CX) should improve the business prospects for Headwaters' fly ash operations.

The Bottom Line

Assuming that a recovery in building activity starts in 2014 and hits its stride in 2015-2016, Headwaters could be an interesting stock on both a free cash flow and EV/EBTIDA basis. Certainly there are drawbacks to an EV/EBITDA approach here as Headwaters is in more precarious shape with its balance sheet and has not yet really built a name for itself in light building products outside of the architectural stone business.

If Headwaters can produce about 6% top-line revenue growth (on a compound basis) through 2016 and boost its free cash flow margin up to the average level of building products companies, these shares should be worth something in the $4 range. That's not a bad return, but investors should not kid themselves about the risks here, not the least of which is an even slower-than-expected recovering in construction activity.

Source: Will Exiting Energy Re-Energize Headwaters?