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A longtime friend of mine recently asked me to review the financials of Headwaters, Inc. (HW). This is a company I followed many years ago during it's heyday and which has run up to over $40 a share, from an obscure bulletin board company. I stopped following the company when its technologies related to "clean" coal fizzled and the company went into decline. Therefore, I was not overly shocked when looking at the company again recently, with the stock still in the single digits and the company losing money for several years. The company is now reborn, so to speak, as a building materials company versus the old business model of a clean coal technology company, but also remains involved in the disposal of fly ash, a coal burning byproduct. Today, I will do an analysis of the current state of the company's financials to see what is behind the losses and whether I think the company has a promising future.

The Income Statement

The first thing I always look at when evaluating a company's financial picture is the income statement. Headwaters, like many struggling companies, wishes for us to focus on any number but the bottom line and produces several numbers to distract investors. Of course the company throws in the standard paragraphs about how adjusted EBITDA is not the same as GAAP net income and other standard language. The more numbers a company tries to present as a way to measure income, the more wary I am of the company. What always matters most to me is the bottom line and on Headwaters the bottom line is not improving, nor has it improved in any quarter in the last three fiscal years (except the second quarter of this year which compares to a giant loss on interest expense in 2011). Here are the last several quarters of results:

Year over year comparisons
EPSEPS PreviousSales % change
1st Quarter 2010-0.23-0.02-16.0%
2nd Quarter 2010-0.22-9.92-6.9%
3rd Quarter 20100.030.079.7%
4th Quarter 2010-0.410.056.9%
1st Quarter 2011-0.34-0.23-2.7%
2nd Quarter 2011-2.59-0.22-11.7%
3rd Quarter 2011-0.10.03-16.4%
4th Quarter 2011-0.77-0.4131.9%
1st Quarter 2012-0.39-0.341.2%
2nd Quarter 2012-0.34-2.5914.5%
3rd Quarter 2012-0.21-0.19.3%

Despite the dire past earnings picture, there is definitely light at the end of the tunnel with Headwaters. Many times a company which can't do anything on the bottom line is also having operating problems. Headwaters has actually swung to an operating profit this year, meaning the business itself is improving. In fact, despite all the distracting versions of earnings in the third quarter earnings release (pdf), the CFO says:

We are excited about the underlying improvement in the business and, should end markets maintain their current momentum, would expect to generate a net profit in 2013, which would be our first annual profit since 2007.

With four quarters now of increasing sales and a swing to an operating profit, there is some fuel to think this may be possible. The company need only overcome its balance sheet problems, as discussed in the next section, to transform from positive adjusted EBITDA, to having an actual net income. Before advancing, one last thing must be noted about these projections. This is the first quarterly earnings release where the CFO projects a positive net income, versus an outlook in the previous quarters centering around a positive adjusted EBITDA. From an individual company perspective, this change in language is much the same as a change in language of the Federal Reserve, where small changes in language or the addition of new language will signal something meaningful for investors. In this case, a positive change is occurring in the core business of Headwaters, as reflected in the addition of the new language.

The Balance Sheet

I divide a company's balance sheet into five sections, focusing on five numbers: current assets, current liabilities, total assets, total liabilities, and the bottom line, equity. All five of these categories are shrinking for Headwaters. Although its good to see liabilities shrinking, its not generally a good thing to see equity and assets shrinking.

From there I look at the balance sheet on a line by line basis to see what drove the resulting changes in the five general categories. The first standout was a drop in cash by over $21 million to just under $29 million in the previous nine months. A drop in cash is not always a bad thing and an examination of the Headwaters statement of cash flows reveals in this instance a wise use of cash. Cash flows from operations are positive and the big draw down in cash was due to a pay down of nearly $33 million in long-term debt, without issuing new debt. Hardly ever can I fault a company for using cash to pay down long term debt. With negligible changes in other current assets, I see no big red flags in the current assets category, especially since current assets exceed current liabilities.

Next, the non current assets are examined. The company has $149 million in intangible assets and $116 million in goodwill, with $49 million in other assets and assets held for sale. Included in the third quarter 2012 SEC filing is a clear amortization schedule of the intangible assets, showing a steady decline in the amortization charge over time, leading to a better net income picture in the future. The goodwill line, though many times larger than equity, does not strike me as something about to sink this company, especially since this line has remained roughly the same since the end of fiscal 2009. Only when companies are constantly having to take impairment charges for their goodwill do I consider this line a major concern. In all, the assets of the company have declined, but no major red flags are being raised from my perspective.

Now comes the meat of the Headwaters problem. The company has accumulated more debt than it can handle and the interest expense of nearly $42 million in the last nine months alone makes up the bulk of the difference between a $18.5 million operating profit and a $29.5 million net loss from continuing operations over this period. As stated previously, the company has addressed some of this problem and the reduction in cash is a direct result of paying down debt. Total debt has declined $27 million in the past nine months, but still stands at a whopping $503 million as of June 30, 2012.

Indeed, the bulk of the news out of the company this year has been in regards to its continuing efforts to reduce debt. The first efforts of the company center around selling its non-core assets. In the last nine months, the company gained cash proceeds of over $18 million from the sale of an ethanol plant in January, and potential consideration of $10.4 million from the sale of a coal cleaning facility in June. The company also recorded an impairment charge from its coal cleaning operations in the June quarter, putting the book value of these assets to near $0. Lastly, the company expects to sell all or nearly all of these assets by the end of 2012. The divestiture of these non-core assets bodes well for the future strength of the balance sheet and income statement.

The second initiative of the company to address the debt problem has been centered around the debt itself. As previously mentioned the company used cash to pay down some debt, but it has also restructured its debt to push maturities out further into the future (at the cost of a higher interest rate). As stated by the CFO in the June 11, 2012 press release (pdf):

The maturity extension reduces Headwaters' refinancing risk and creates a debt maturity profile that better fits the cash generation profile of the business should recovery in end markets be slow to develop.

Assuming the remaining core business does not deteriorate, I would have to agree with this statement. Although the company's debt is very large, the debt is manageable and if the company continues to improve upon the debt position, liabilities will not be a cause for worry other than the still large amount of interest expense.

The final section of the balance sheet I examine is equity. Headwaters has little equity to speak of, only $1.2 million as of the end of the third fiscal quarter. If the company does indeed swing to a net operating profit in 2013, while continuing to work on existing debt problems, this number should improve significantly over the course of the next year or so.

Before moving on to the general business side of the company's evaluation I feel I must put one HUGE caveat in place. Many times when a company is looking to dig itself out of a major debt problem and the price of the shares increases significantly, the company decides to issue more shares in order to pay down the debt. Although I see no mention of this in any of the company's filings or releases, most seasoned investors will have been through an episode where a struggling turn around play issues more shares.

For short term traders, this is a huge worry and one which is completely unpredictable. Even much healthier companies than Headwaters are apt to issue shares to improve a balance sheet and I see no reason to stop Headwaters from doing the same with its large amount of indebtedness and a run up in the stock from around $2.25 to over $7.50 this year. Indeed, for this reason alone, I myself will shy away from doing any short term trades in the company until balance sheet and earnings conditions have drastically improved.

The Story of the Company, or Future Expectations

When I began following Headwaters several years ago, the big news of the company was its technology geared towards "clean" coal and other initiatives to deal with industrial waste. The company became a small cap darling in the middle of the last decade, but alas this technology did not pan out as a valid long-term business plan and I stopped following the company as the business went into decline.

Over 90% of the current underlying business of Headwaters is concentrated in two segments, light building products (architectural stone, siding accessories, and concrete block) and heavy construction materials (coal combustion products). The first business segment will rely heavily on the strength of the housing market, which has shown significant improvement this year from a very depressed level in previous years. Interest rates remain low, allowing consumers to more easily purchase homes or use a home equity line of credit to remodel their existing homes. With the latest round of quantitative easing out of the Federal Reserve focusing on the purchase of mortgage backed securities, there is even more fuel for the housing fire and hence a better prospect for the light building products segment of Headwaters.

The second business segment is a holdover from the company's previous efforts to provide technology to the coal burning industry. Headwaters provides services to electric utilities in the disposition of fly ash, including using the fly ash as an additive in concrete. Fly ash strengthens concrete and has become a creative way to make use of an industrial waste product. The company has been trying to get the federal government involved in this waste product, but so far efforts have stalled. At one point favorable language was attached to a bill in the Senate, but was later dropped. Even without the federal government's support it is a fast growing part of the Headwaters business. As electric companies domestically and around the world continue to rely heavily on coal as a fuel, this business segment has plenty of room to grow in the future.

Conclusion

Headwaters is a turn around play, which is divesting its non-core assets and focusing on debt reduction as it tries to grow its business. Although not perfect, the company's balance sheet has no red flags which are not being currently addressed in a very meaningful way. With a reduction in debt and no debt maturing before early 2014, the company has improved its overall financial position and is poised to produce an operating profit for the first time since 2007 in the 2013 fiscal year. Both major operating segments of Headwaters have a promising future and should contribute significantly to the company's value going forward.

As previously mentioned, for short-term investors there is a big caveat related to the possible issuance of more shares to address the large debt burden. Attempting to make a quick trade is exposing one's money to a possible quick drop in the company's stock should the company chose to raise additional capital. From a longer-term perspective, the company looks to be an attractive investment for those looking into turn around plays, although currently there is not a whole lot of value in the company and little equity. I am generally a shorter-term investor and therefore will not look to buy any shares of the company until the debt burden has been further addressed, but if I were a longer-term investor this is a company I would consider looking into.

I hope this write-up proves useful to my friends looking at the company as well as others.

Source: Headwaters: A Turnaround Play Worth A Look For Long-Term Investors