HW: headwaters

[kagame]

This was a recent Motley Fool Rule Breakers pick and the current stock price is looking even more undervalued then when they recommended it a month ago, supposing their thesis about the company's tax credit writeoff loss as a minor problem is credible.

Who likes this alternative energy play? Anyone think its doomed? An absurdly good value?

Thanks for the input, Im glad I bought in thirds for this one!

[Sniper]

Care to post the MF analysis?

[kagame]

"Reduce, reuse, recycle," goes the environmentalist mantra. Even before President Jimmy Carter's famous cardigans of the 1970s, progressives, policymakers, and thrift-minded citizens have looked at ways to reduce our consumption of fossil fuels.

But how about reuse and recycling? Outside of some limited commercial operations that recycle used motor oil, there have been few opportunities to take fossil fuels for a second ride around the block. Refineries get all they can out of crude oil, distilling it into everything from gasoline to heating oil right down to long hydrocarbons used in plastics, with as little as possible left over. And when these fuels are burned, most of the gasses and solids left behind are mere pollutants.

Coal is another matter. By-products of its production and consumption — soot, fly ash, bottom ash, and scrubber sludge — may not sound like big business, but in the ashpits of industry, Headwaters (NYSE: HW) has found gold.

In 1992, Headwaters introduced a latex-based polymer that binds with soot to make a synthetic fuel. You can think of it as a sort of glue that sticks together particles of coal into new chunks of solid fuel, which in turn can be burned for fuel just like regular coal, but with greater efficiency. This reagent put the company on the map and proved to be a great growth driver. By 2002, synthetic fuel chemicals accounted for more than 90% of Headwaters' revenue.

Yet there was a looming threat. Right now, it is cost-effective to make synthetic fuel only because companies that use it qualify for a section 45K (formerly section 29) alternative fuels tax credit. Without this credit, use of synthetic fuel would generally no longer be cost-effective — a real concern for Headwaters, because current tax credits will expire at the end of 2007 unless renewed.

Seeing this, management decided to move along the coal lifecycle from pre-combustion products (soot) to post-combustion (fly ash). In 2002, it acquired a company called ISG Resources, which supplies fly ash for use as a cement substitute in making concrete products. Sensing an opportunity beyond supplying raw materials (a business the company still pursues under its Headwaters Resources division), it moved up the value chain into making its own construction materials. It developed FlexCrete, a fly-ash-rich concrete building material that is as strong as concrete at a fraction of the weight, acts as a natural flame retardant, insulator, and sound dampener, and can be sawn and shaped like wood.

So behind what may look like an odd industrial conglomerate — energy, construction, materials — is the common link of coal waste.

Financial Snapshot
Fast Growth

The success of Headwaters' synthetic fuel business and its subsequent diversification can be seen in the numbers. Its revenues almost doubled between 2004 and 2005, and have increased 152-fold since 1999 (from $7 million to $1.1 billion last year). Operating profits and net income have followed a similar course. Net income nearly doubled in 2005 over the previous year to $121 million, and earnings reached $2.79 per share. That puts the company at a trailing P/E of 13.7. Given that analysts are expecting the company to grow at a 24% annual rate over the next five years, that gives Headwaters a low P/E/G ratio of 0.57.

I should mention that Headwaters was my pick for the Fool's Stocks 2006 report, and it makes sense to add this great company to our Rule Breakers roster. I also want to thank member Westsider2000, who was the first to post about this company after our contest began (although, as he notes, other members have discussed HW in the past). I had more room to talk about valuation in Stocks 2006, but suffice it to say that I believe it is undervalued relative to comparable companies like Eagle Materials (NYSE: EXP) and Nalco Holding (NYSE: NLC), and that even using some pretty conservative estimates on future cash flow, the stock looks underpriced. So unless Headwaters hits a major snag, it looks to me like a company with great growth potential and pretty moderate downside risks.
The Risks

One risk is the high price of oil, since section 45K credits begin to phase out as the wellhead price of oil exceeds a certain level, which Headwaters estimates to be $53.43 in 2006. Based on these assumptions, credits would be phased out entirely if oil hits an average price of $67.07. Given the current price of oil, that could mean at least a partial phase-out of tax credits this year, which would in turn reduce demand for Headwaters' product. I think we should consider this source of revenue under threat, but I also believe a considerable amount of pessimism is already baked into HW stock.

The second scenario would be a major slowdown in the construction industry. With worries that housing may be in a bubble and that the record pace of homebuilding will slow, that sounds like a very real concern. But Headwaters' FlexCrete product has only miniscule penetration into the cement market, despite its merits. HW estimates that fly ash represents only about 11% of the portland cement used in U.S. concrete manufacture at present. The company can achieve strong growth even in a shrinking construction market.
Bright Future

Lest you think Headwaters' energy business is built around the tax code, I want to point you toward some important R&D initiatives at the company that could drive future growth beyond what I've already discussed:

» A dry coal cleaning facility in central Utah is expected to commence commercial operations at the end of March. Dry coal cleaning separates ash and other impurities from low-quality coal, converting it to a clean-burning fuelstock.

» A coal-to-liquid conversion technology would make low-sulfur diesel fuel from coal.

» Its NanoKinetix subsidiary develops nano-scale catalysts and materials for applications including direct synthesis of hydrogen peroxide and other electrocatalysts for fuel cells.

» It's trying to do for oil what it has done for coal: converting low-quality or "heavy" oil (like what's found in tar sands) to high-quality synthetic crude. A heavy oil facility is scheduled to open in 2009.

» It has a joint venture with the private Great River Energy to develop and construct an ethanol production facility.

In short, Headwaters offers a portfolio of technologies for fossil fuel recycling and other alternative energy innovations. I like the mix of proven revenue streams, near-term innovation, and potential.

[kagame]

bump

[Sniper]

I think everyone is focused on taxes; hopefully we can get back to looking at stocks soon! [img]/images/graemlins/smile.gif[/img]

[DesertCat]

I generally avoid energy related investments in my portfolio because of the inherent volatity. I have no way to predict if oil will be $100 per barrel in two years or $30 per barrel. I also try to avoid businesses with big questions about the viability of their core revenue streams.

In this case, to research it more, you need to break down the company's different segments and try to estimate reasonable value for each. Clearly their synthetic fuel products business is a binary case, it's either worth zero, or a much larger number. Their concrete products look like they'll be around, the question is what is a best case and worst case for sales/profits over the next year? Every day the housing market gets worse, and with mortgage rates hitting a four year high, my bet is the worse is yet to come. Then you look at the remainder of their businesses, and do the same.

The problem with the motley fool "analysis", is that it provides no financial analysis, and no guess as to what the value of the business or it's components are. Right now, HW is trading at about a 12x PE, a bit cheaper than the average stock. Their most recent quarterly report (which you can access through the SEC web site under edgar, look for the latest "10Q") reports that synfuels ("alternative energy") provided 60% of their earnings and have much higher margins then the other segments. If synfuels go away, HW is making barely $1 per share and trading for a 35x PE. The construction segment grew about 11% year over year in one of the biggest building booms in history, how does it do in a bad building market?

In short, synfuels is hugely profitable and takes very little capital. The other businesses take huge amounts of capital and are only moderately profitable. Doesn't sound like they are worth 35x PE if synfuels shuts down. Of course they have some cool technologies with lots of potential, but at what price are you chasing a gut-shot with bad pot odds?

In short, they have one great business that might be going away, two crappy businesses, and lots of hope. If you get a thrill chasing gutshots, maybe this is for you. I prefer to look for more sure things. And I think if you make a living from poker, you'd want to limit the volatility of your portfolio as you face enough of that in your daily bankroll.

[kagame]

I really appreciate your candid assessment of MF's stock picking style and also the risk involved in this sort of investment

I am extremely diversified in regards with my stock holdings now so risk taking is the name of the game! Being 21 and also being incredibly fluid is a bizarre state. I find myself constantly trying to find ways to make myself secure yet at the same time lock down extreme returns. Hopefully my current selection process will pan out, its really a bit terrifying jumping into this on my own.

Wow that got a bit sappy. Heres some more. I just dont state how much I appreciate the advice on here very often, as I am aware you guys know alot more than me and any serious sort of response to my ideas is usually going to be at least moderately altruistic.

That said, I think stocks that could be absurdly undervalued are a great addition to any stock portfolio, if the risk is assessed and understood. Hopefully I am aware of what Im getting myself into this time.