Headwaters Inc. Is Trading Ahead Of Fundamentals

| About: Headwaters Incorporated (HW)
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Headwaters Inc., (NYSE:HW) is a building products company utilizing by-products of coal fired power plants to create innovative building materials. The company has also entered the energy market with an innovative way to utilize bottom of the barrel oil, though this segment is still in the beginning stages, operates at a loss, and accounts for less than 4% of revenue.

In the past, the company generated a lot of hype and promise based on coal cleaning technology. The result of these years of effort was a mountain of debt and little-to-no value created. The company is still connected to this old technology, through the use of fly ash in the building products being produced, but all the assets of the actual coal cleaning operations have been sold.

In my first article on Headwaters, I stated the company is worth a look for long-term investors as a turnaround play, but was dangerous to hold in the short-term, due to continuing share issuance. Since the article, the stock has climbed from $7.22 to a Wednesday close of $10.86, for a 50.4% gain in eight-and-a-half months. This article will now take the opposite view. I now think Headwaters is above a reasonable buy price based on present and future fundamentals.

THE DEBT PROBLEM

A lot of turnaround plays are coming off of a major debt problem, often due to a failed business idea. Headwaters is no exception in this department. Even after paying off a good deal of debt in the last few years, mainly through share issuance and selling off the assets of the old business, the company has a staggering amount of debt. After paying off $39.5 million in face value of debt so far in fiscal 2013, the debt load still comes in at $465 million, as shown in the following table:

Millions Interest Rate Maturity
Senior Secured Notes $ 400.00 7.625% Apr-19
Convertible Senior Subordinated Notes $ 15.60 2.5% Feb-14
Convertible Senior Subordinated Notes $ 49.30 8.75% Feb-16
Total $ 464.90

Source: Company press releases

For shareholders and debt holders, the good news is the company has a small amount of debt due in the next few years. The bad news is the company still has a whole lot of debt, resulting in a whole lot of interest payments. After combing through the company press releases, I created the following table to highlight how heavily the debt problem hurts the bottom line:

Trailing Twelve Months Previous Twelve Months % Change
Revenue $ 656,289 $ 605,999 8.3%
Gross Profit $ 178,716 $ 159,034 12.4%
Operating Income $ 36,704 $ 23,392 56.9%
Interest Expense $ (48,306) $ (52,745) -8.4%
Net Loss $ (32,074) $ (97,386) -67.1%
Gross Profit % 27.2% 26.2%
Operating Income % 5.6% 3.9%

As one can see, the net loss of the company is heavily impacted by interest expense. Although the company has reduced interest expense by 8.4% in the last 12 months, the total expense still far exceeds operating income. In a May 8th press release, the company touts a $1 million reduction in annual interest expense as the result of recent debt reduction efforts. Even with the reduction in interest expense, this still leaves the company with a burdensome amount in annual interest expense.

Even when and if the company should swing to bottom line profitability, there is still over $460 million in debt to pay off. Creating a lean operating company with little debt worries will not be easily achieved through operations alone. Therefore, the company will likely issue additional shares to pay down debt faster, as has been the case over the past several years. Five years ago, the second quarter SEC filing showed 42.3 million shares outstanding. The latest filing shows 73.1 million shares outstanding. Over a five-year period, the company increased shares outstanding by 73%. Another way to look at this number would be to consider this a dilution in one's stake in the company. Going forward, the company is likely to issue more shares to pay off debt, further diluting the stake of shareholders.

A FUTURE EARNINGS PROJECTION

When I evaluate a long-term investment, I tend to project a reasonable scenario for sales and earnings over the next five years. The purpose of this section will be to come up with a sales and earnings projection for those five years.

The company predicts $110-$125 million in adjusted EBITDA for this fiscal year. Using the midpoint of a $117.5 million figure, we can work towards the bottom line number. First subtract $52 million for depreciation and amortization, then subtract $47 million in interest expense. Subtract another $5 million in other expenses, including an early extinguishment of debt. These subtractions leave the company with $13.5 million in profit, before taxes. So far, in the first six months of the fiscal year 2013, the company has recognized a tax benefit on a large loss. If the company were to indeed make a profit, then perhaps there will be taxes paid in the second half of the year, though it's nearly impossible to tell in advance what the company will do with tax loss carry forwards.

The $13.5 million in profit works out to around $0.18 a share in quarterly profit. This is not too far off the average analyst estimate of $0.23 per share. If the company were to recognize around $3 million in tax benefits, after recognizing $2.3 million so far this year, then the average analyst estimate is right in line with my figures. This is good reinforcement for my logic in creating the estimates below.

To get to the $0.23 a share in earnings, one would have to project a 10% increase in sales for the year. The following table illustrates how to get from $0.23 to a revenue figure:

Millions (except EPS)
Sales $ 696.07
Gross profit $ 188.63
Operating expenses $ 128.00
Operating income $ 60.63
Interest Expense $ (47.00)
Tax benefit $ 3.00
Net profit $ 16.63
EPS $ 0.23

The first two quarters of the year featured 8.8% increases in sales in each quarter. Therefore, both the company and analysts are expecting an acceleration in sales for the remainder of the fiscal year. For these numbers, I used a 27.1% gross profit margin, which is consistent with the first half of the year. I also simply doubled operating expenses for the first six months. Either of these numbers could be adjusted up or down to come up with the final figure. The key here, for me, is to establish the projection of an increase of sales. This is consistent with analysts, the company's projection, and a general pick up in the construction market. Given the confidence I can get from being in line with analysts and the company, I created the following table:

In millions 2013 2014 2015 2016 2017
Sales $ 696 $ 780 $ 873 $ 978 $1,095
Gross profit $ 189 $ 218 $ 253 $ 293 $ 329
Operating expenses $ 128 $ 134 $ 141 $ 148 $ 156
Operating income $ 61 $ 84 $ 112 $ 145 $ 173
Interest Expense $ 47 $ 35 $ 30 $ 25 $ 20
Pretax income $ 14 $ 49 $ 82 $ 120 $ 153
Taxes $ 3 $ (19) $ (32) $ (47) $ (60)
Net profit $ 17 $ 30 $ 50 $ 73 $ 93
EPS $0.23 $0.41 $0.69 $1.00 $ 1.28

For this table, I used a 12% increase in sales and a steadily increasing gross profit margin to a 30% level in 2017. I also projected a 5% annual increase in operating expenses and a standard corporate tax rate of 39%. Lastly, I used a steady reduction in interest expense, which may be accelerated if the company should pay down debt faster. Based on the largest chunk of debt, the $400 million at 7.625%, the company would need to pay off $66 million in debt per year to reduce interest expense by $5 million. With cash on hand and positive net earnings on the way, I considered this a possible task without having to issue additional shares. To pay down the debt faster, the company would need to increase sales at a faster rate than my projection, or raise additional money through share issuance, which would then decrease EPS due to dilution.

Therefore, there may be plenty of flaws in this analysis, but I can also see the above table as a reasonable projection of the next five years for Headwaters. Sales may increase faster and margins may be larger, conversely sales may decrease or margins may shrink. For my own analysis of the company, these are the numbers I am using. In the latest report, construction spending grew at 4.8% on a year-over-year basis for March, while climbing 6.2% in February. These numbers give me confidence for the growth of Headwaters on a top line basis going forward.

VALUING THE SHARES

My method for evaluating shares of a company has served me fairly well in predicting advances and declines in share prices, so I have continued to use this method. First, I project the share price as 15 times forward earnings. Second I take current equity per share and add the next five years' projected earnings to get a second number. I then take the average of those two numbers to generate a fair value for the company.

For Headwaters, I project 2014 earnings per share of $0.41. The calculation is then $0.41 X 15 = $6.12 per share. Using the numbers above, plus the $0.85 a share in current equity, the second calculation would be $0.85 + $0.23 + $0.41 + $0.69 + $1.00 + $1.28 = $4.45. This then works out to an average of $5.28.

At a Wednesday close of $10.86 per share, Headwaters is trading over twice what I would consider a fair value. The company is trading at a forward PE of 26 and trading at well over any amount of equity which may be accumulated over the next five years. Sales, earnings and expenses may well improve, but there are just too many factors working against the company for me to justify such a high valuation.

In my last article, I considered Headwaters a company worth looking at for a long-term hold. Now, after the run up in price, the huge problem with interest expense, and the company trading ahead an optimistic projection for five years of improved margins and steady sales, I no longer consider Headwaters an interesting play for long-term investors. For short-term investors, the company is likely to issue more shares, further diluting future earnings and creating more immediately available supply. In sum, I think Headwaters is trading ahead of fundamentals and needs to drop back to the $6-$7.50 range before I would consider the company a buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.