Headwaters Still Waiting For The Turn In Construction

By Stephen D. Simpson, CFA | August 03, 2012 AAA

Investors banking on a recovery in construction activity have had to revisit their expectations in recent weeks, and not in a good way. While there is evidence here and there that building trends have improved, companies like Masco (NYSE:MAS) and Armstrong World Industries (NYSE:AWI) have reminded investors that there's still a way to go back to "normal." Headwaters (NYSE:HW) looks considerably more stable right now, but the stock has already recovered significantly on this better operating performance.

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Steady Progress in Fiscal Q3
In taking on massive amounts of debt to enter the construction/building products industries at nearly the peak of the market, Headwaters management dug a deep hole for itself and the shareholders. Encouragingly, the company continues to make progress by eschewing flashy or risky moves and instead just looking to run the business better.

Revenue rose 9% this quarter, with light building product revenue up 6% and heavy construction material revenue up about 20%, despite a lower relative coal combustion product contribution. Against a backdrop of unimpressive trends in residential, light commercial and heavy commercial building, that's not a bad performance.

Margins also continue to improve. Gross margin improved more than two points, with a nearly four-point improvement in the light products segment and more than two points of improvement in heavy materials. Operating income rose 17% this quarter, and though the company reported a GAAP net loss, the company's quarterly operating income is nearly covering the interest expenses.

SEE: Understanding The Income Statement

Still More Restructuring
Headwaters management has been active in trying to monetize assets that it believes are no longer core to the company's future, while also trying to reconfigure its capital structure. To that end, a coal cleaning facility was sold for about $10 million in total potential compensation, and the company restructured some debt to reduce refinancing risks in 2013 and 2014. Nothing comes for free and there is a price to be paid for these restructurings, but it does give the company more breathing room.

When, Not If, But It's Still a Big "When?"
I don't believe anybody seriously doubts that construction activity will rebound in North America at some point. I could cite several papers and reports that talk about the growing "housing deficit," to say nothing of the ongoing need to refurbish and build new commercial buildings.

That's good news for companies like Weyerhaeuser (NYSE:WY), Louisiana-Pacific (NYSE:LPX), Owens Corning (NYSE:OC) and the like, as well as Headwaters, but it doesn't help much in any particular quarter. I do believe that there is an opportunity for Headwaters to gain share with its architectural stone, window/trim and siding products - particularly if they can effectively market their environmental angle (less waste, less energy, etc.).

However, it's just not that simple. For starters, every building products company wants to minimize waste and energy use and there's a long history of using "puffery" to appeal to whatever consumers think they want. What's more, a residential construction rebound in 2015 doesn't do Headwaters any good if debt/liquidity problems asphyxiate it before the rebound.

SEE: Earning Forecasts: A Primer

The Bottom Line
Headwaters' stock has done great already this year, up about 175% to date. Along the way, the sell-side average price target has more than doubled and there seems to be a generally improved sentiment towards the company's odds of surviving long enough to thrive again.

This is going to sound like a cop-out, but building a free cash flow model for Headwaters involves considerably more guesswork than normal. I do believe that revenue growth can jump further as the building rebound comes (whenever that may be), and I see significant margin leverage potential from better capacity utilization and, in time, paying down that debt. So while I see fair value in the mid-to-high single digits today (not especially appealing for a company with this risk profile), I fully acknowledge that the potential upside could be much greater if things go right.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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