Description

Summary

Headwaters Inc. (HW) is a buy. We think HW suffers from a misperception that it is an over-levered, cyclical energy-technology firm. On the contrary, HW has divested its troubled legacy energy tech assets over the last five years and now represents a compelling combination of material upside optionality through its building products group and a strong margin of safety though its flyash business.

The flyash business represents HW’s most valuable but least understood asset. The fly ash segment is levered to a tightening supply-demand dynamic within the US cement industry and is potentially worth the company’s current enterprise value. Our channel checks indicate that the US is entering a cycle where it will be net short cement by the end of 2015. Certain regions such as Texas have already begun importing cement due to shortages. Cement producers are accelerating headline price increases up to +30% for 2015 and will likely push even higher in 2016 as the NESHAP rules exacerbate a structural decline in domestic cement supply. Fly ash is a cheaper, direct substitute of cement used in the production of concrete and is a necessary ingredient that strengthens it. HW controls roughly 50% of the US fly ash supply and will benefit as construction companies seek to lower costs and increase fly ash substitution in lieu of higher-priced, scarcer cement. The business has a strong moat and attractive incremental margins (> 45% with material upside on volumes alone) that will drive earnings growth greater than street expectations.

Headwaters’ core light building products segment includes materials such as siding, roofing, trim-boards, architectural stone and concrete blocks. This has been a steady grower that accounts for 60% of total revenues with 15% operating margins. Admittedly, the majority of products are levered to residential construction and thus very cyclical in nature. However, we like where we are in the housing cycle with housing starts still 40% below the long-term average. Given that HW has significant operating leverage, we see this segment as a significant call option to a mid-cycle housing recovery scenario.

We think there’s at least 50% upside in 12 months based on our FY16 estimates and rolling forward current NTM 10x EBITDA market multiples. We believe the fly ash business could be sold for a premium based on recent transactions (14x NTM EBITDA multiple) or could be spun-off as a separate company. A 14x multiple on the flyash segment (Heavy Construction Materials - “HCM” assets) could provide a total upside of 90%+ from the current stock price.

Heavy Construction Materials Segment – 40% of revenue

Fly Ash Background

Headwaters collects, stores and markets fly ash on behalf of 100+ coal plants across 35 states. Fly ash is a non-combustible byproduct of burning coal and is notably used as a direct substitute for cement. Cement and fly ash are the primary ingredients used to make cementitious material, or the “glue” that binds aggregates to form concrete. Fly ash usage has historically ranged from 10-20% of total cementitious materials and can reach as high as 70-80% in certain applications.

There are substantial benefits of fly ash relative to cement. First, it is a necessary material mixed with cement for concrete production because it increases concrete’s workability, strength, durability and life span. Concrete actually strengthens over time if it contains fly ash. Fly ash is also cheaper than cement given that it is sold as a byproduct of coal combustion, whereas cement must be produced in kilns that heat up to 2,700°F. Portland cement is priced ~$90-95/ton while fly ash is up to 50% cheaper near coal plants that generate high-quality fly ash (Texas) or 10% cheaper in more distant locations from coal plants (N. California). Environmentally-conscious companies consider fly ash a greener product than cement and use it to reduce their carbon footprints due to the fact that cement production creates substantial carbon dioxide emissions. A good description of the relative advantages of flyash v. cement can be found here (http://www.ashgroveresources.com/showcase4.html).

Headwaters has an entrenched 50% share of fly ash market and the next largest players, Lafarge and Boral, capture about 12.5% each. HW signs 5-20 year contracts (7 yr average life) with utilities to transport, store, sell or dispose fly ash. The company has built a national storage infrastructure and rail network with 29 terminals, 850 railcars and 100 trucks. The combination of long-term contracts and network effects from a national footprint leads to high barriers to entry favorable to HW. HW generates 75% of its HCM revenues through fly ash sales and 25% through service (fly ash disposal) contracts. Sales are conducted through revenue sharing agreements (HW receives ~70% of the net revenue after transportation costs).

Industry Tailwinds

There is a significant pricing tailwind for cement that will lead to increased pricing and volume for fly ash given that it is direct substitute for cement. The Portland Cement Association (PCA) estimates that the cement demand will be 86MM/93MM/103MM tons for ‘14/’15/’16. Note that this is still well below peak demand of 130MM tons in 2005/2006. The US currently has ~95 million tons of cement production capacity today. However, the EPA’s NESHAP (National Emission Standards for Hazardous Air Pollutants) rules will lead to closure of older non-compliant cement kilns and could remove as much as 10MM tons of supply by 2016. The PCA estimates 18 of the total 100 US cement plants will close by 2016 and estimates compliance costs could be as high as $25/ton, which make inefficient kilns uneconomical to operate and create a structural decline in supply. The implication is that the US will be net short cement, which will lead to significant cement price increases with imports as the marginal source of supply. Fly ash will be a direct beneficiary from this secular move as construction companies seek to lower costs and substitute more fly ash.

Source: Historical data from US Geological Survey; estimates from PCA September 2014 forecast

Our channel checks indicate that these prices increases are underway and are accelerating. Certain regions such as South Texas are net short cement already. For example, last year Cemex asked for an $8/ton headline price increase for Oct’13 and was only partially successful in capturing half of that request. They pushed for $9/ton increase for Apr’14 and up to $16.50/ton in Oct’14. The Apr’14 increase was broadly accepted around $8/ton while Oct’14 results will be disclosed on their next earnings call. Cement is roughly $90/ton today. Pricing negotiations for 2015 are well underway, and Cemex is negotiating for $16.50/ton increase for Apr’15 and an additional $10/ton increase for Oct’15. The ultimate price will likely be less than the 30% headline increase, but is nonetheless substantial and accelerating. Fly ash is already benefitting from this trend, and HW conservatively estimates a 4-5% net price increase (HW rev-shares with utilities, so HW gets a portion of the total price increase). Volume sales are also expected to accelerate given that fly ash will be comparatively even cheaper and will replace more cement in concrete production.

A simple question we ask the company is why don’t companies use more fly ash if it’s cheaper, strengthens concrete and is more environmentally friendly? There are two answers to that. First, fly ash is produced by coal utilities, and far locations incur substantial rail costs (California, for example, doesn’t allow coal burning plants within its borders and so “imports” fly ash from Nevada and Arizona). Fly ash is only slightly below the price of cement in Northern California, when factoring in freight. Second, concrete manufacturers have a resistance to change mixture recipes – don’t change it if it works – and generally keep fly ash substitution rates the same. However, when cement suppliers are pushing +30% y/y price increases, we believe that will change the dynamics and force buyers to look at increasing fly ash usage.

Another small, but important tailwind is a recent development with the EPA. The EPA proposed a regulatory framework on coal ash in 2010 and would either classify coal combustion residuals under subtitle C (hazardous) vs. subtitle D (non-hazardous). If fly ash were classified under subtitle C (hazardous), that would have a wide range of implications. Fly ash is found in most modern concrete structures today, which would open potential litigation against fly ash producers and immediately reduce demand for fly ash. Headwaters sued the EPA in 2012 to force a deadline on the decision since the prolonged overhang was detrimental to the business. Long story short, the EPA put out a press release earlier in 2014 indicating that it would classify fly ash under subtitle D (non-hazardous), which removes the lingering headwind and potentially increases demand from those waiting on the sidelines for the EPA rule to pass.

Risks

One potential area of concern is that the coal industry is in secular decline and would negatively impact the supply of fly ash. The EPA sponsored MATS (Mercury and Air Toxics Standards) rule focuses on reducing emissions from coal plants and forces less efficient (both in volume and technology) coal fired power plants to retire. Fortunately for HW, it sources its coal from larger, more technologically updated plants (scrubbers, activated-carbon filters, etc.) that produce the highest quality fly ash that is suitable for concrete production. High-quality flyash is defined as low carbon content (carbon that’s mostly burned away). Currently, HW is still selling 30% below its annual supply of high-quality fly ash which provides ample room to the upside and has storage facilities to store the excess capacity. If demand outstrips supply, HW can also mix high-quality fly ash with lower quality-ash to average out the quality and still meet the standards required for concrete production.

There is also macro risk of US construction spending decelerating if the economy slows down. However, the upcoming reduction in supply due to EPA regulations will still cause the US to be net short cement. Certain regions have already begun importing cement today (Houston and SE Texas) and that is likely to continue for the foreseeable future (price increases are accelerating).

Heavy Construction Materials (Fly Ash) Financial Forecast

HW generates over 8M tons of annual fly ash supply and sold over 5M tons in FY14 (peak sales were 6.4M tons in 2007). Assuming the PCA’s forecast is correct and the fly ash substitution trend continues, volumes sold could increase 30% by 2016. HW generated $309.3M in HCM revenues and $66.8M EBITDA (21.6% margin) in FY14 ending September. We estimate fly ash revenues can grow ~15% annually, driven both by price and volume increases, reaching $410M by 2016. The company estimates that incremental margins on product sales are 45%+ (HW achieved 63% incremental EBITDA margin in FY14, somewhat driven by a mix decrease in low-margin service revenues). We estimate 40% incremental margins, bringing EBITDA margins to 26% or $106M in EBITDA by 2016. The fly ash segment has significant upside potential if cement producers accelerate price increases in 2016. Below is a sensitivity table of the HCM’s EBITDA based on gross fly ash price increases and volume growth.

Light Building Products Segment – 60% of revenue

Thoughts on the Housing Cycle

Because Headwaters’ LBP (light building products) segment exposes the investor to the housing cycle, the investor must form an opinion as to the length and curvature of the current cycle and the point on the curve where we currently reside. Admittedly, cycle timing is highly subjective (and deserves a VIC article by itself) but we have reasonable conviction that the US and specifically, the US repair and remodel market, remain currently well below mid-cycle levels of what we think should ultimately result in a more normalized housing cycle. We base our belief on many data points but for the sake of brevity we detail the primary end points below:

• Household formation should continue along historical trends, particularly for the 20-34 old demographic (which have experienced the largest annual increase in employment since 1984).

• Mortgage underwriting standards are loosening and entry-level credit will increasingly return to the market (sub-660 credit score share of Ginnie Mae securitized mortgages is up 470 bps YoY)

• US sales growth for aggregate industry building products YTD (+8%) is materially higher than consumer-retail and GDP growth for the same time period.

• Current US housing starts at 1MM/year still represent a meaningful discount from mid-cycle annual housing starts of 1.4MM and well below the peak annual housing starts of 2.1MM

LBP (Light Building Products) Background:

HW is traditionally known for its light building products (LBP), which is divided into three divisions: siding accessories (45% of LBP), manufactured stone (30% of LBP) and Texas concrete block (25% of LBP). Over 70% of the segment’s revenues are exposed to the residential sector, including repair & remodel and new residential construction. The balance of the revenue comes from the commercial sector, primarily through the Texas concrete block segment. HW is well-positioned to capture the upside in a mid-cycle scenario given that it captures 45% incremental margins (company estimates its current capacity utilization is at 50% vs. peak – implying low cap ex to growth into peak fundamentals). Even if housing remains muted, there are several key advantages that will enable the LBP segment to grow faster than the market.

Siding & Accessories:

Siding and accessories includes specialty siding, trim-boards, vents, shutters and roofing. Over the years, the industry has substantially consolidated, and HW estimates it has a 75% market share in many of its products. The company primarily distributes its products through 5,000 wholesale distributors (10% goes to Home Depot and Lowe’s). This division is primarily levered to the repair and remodel market, which has been flat in 2014. Siding has experienced lackluster growth and the majority of revenue is derived from the Northeast and Midwest, weaker regions in the recovery and negatively impacted by the polar vortex earlier in the year. However, the overall division still grew organically mid-high single digits YTD 2014. Although HW doesn’t break out operating margins by product, Plygem (the largest manufacturer of vinyl siding in the US) reported 15% margins for its siding, fencing and stone segment for YTD 2014.

Vinyl siding offers the most cost effective method to protect your property against inclement weather. On average vinyl siding costs $6-8k for an average 2,500 square foot, two story house, while composite siding (LP SmartSide is a popular brand) costs $10k and concrete/brick on average cost $20k for the same house. While there is some substitution risk for vinyl as consumers choose more expensive and attractive siding, vinyl still remains an attractive option for lower end home owners and continues to grow mid to high single digits (HW doesn’t break out product sales growth but Plygem reported 9% sales growth in Q3 2014).

The siding business is a mature and highly consolidated industry and HW, as one of the top #4 US players, has been acquisitive over the last 3 years by adding trim-board and roofing product companies in order to leverage its large national distribution network. The company expects to make additional accretive bolt-on acquisitions and leverage its distribution network to grow sales.

Other LBPs:

The manufactured stone division sells architectural stone which is used on exterior siding to improve aesthetics. The company has four manufacturing facilities that use stone molds, bake the material and color the stone. Cement and freight are the largest input costs. The product is sold through 500 distributors mostly in California and Texas. Architectural stone is new construction orientated and is used in higher end homes, a subsegment that has been relatively strong in both states. We expect HW to grow architectural stone (AS) sales over time as AS offers homeowners an attractive, popular style at a lower cost than real stone. The company estimates it has a leading 30% market share within this segment.

The Texas concrete block business sells a variety of standard and custom concrete block in Texas and Louisiana for commercial construction. HW produces concrete from ready-mix cement producers (who mixes in HW’s fly ash) and captures 65% of the local market. The business is very localized given that freight is prohibitively expensive for long distance deliveries. One potential tailwind is that a large number of schools are scheduled to be built in TX and LA during 2016 and 2017. HW estimates that it will capture at least 40-50% of the new school builds, which will help drive revenue growth. According to management, the specific revenue bonds financing these schools have already been issued.

Risks

The biggest risk is a stall in the housing recovery. The best way to handicap the risk is by reducing growth assumptions. In a mid-cycle scenario, housing starts would be 40% higher than today. Per our forecasts below, we’re only assuming 10-12% organic growth.

Light Building Products Financial Forecast

The LBP segment generated $472M in revenues and $88.1M in EBITDA (18.6% margin) for FY14. Revenues grew organically by 8% y/y amidst a fairly muted housing construction year. We expect organic revenues to grow 10% in FY15 and 12% in FY16 on the assumption that the housing outlook only slightly improves. The company states that incremental contribution margins are 45%+ for the segment given its significantly underutilized capacity. In the weak 2014 environment, the company achieved 20% incremental EBITDA margins, driven by some mix-shift towards lower margin Texas concrete block. We believe incremental margins can reach 30% if there is any semblance of a recovery that can drive growth in its siding business. We project $595M revenues by FY16 at 21% EBITDA margins or $125M EBITDA.

Energy Technology – 1% of revenue

This segment originally operated coal cleaning facilities that the company has sold and exited in 2013. What remains is its liquid catalyst business, which is used by oil refiners to upgrade bottom-of-the-barrel feedstock. The company is running some trials with customers and ultimately hopes to prove out the technology and sell the business. Analysts estimate that this could fetch 8-10x if the company scales this business to $20M EBITDA. This is not a near-term, high probability event, so the value of this business should be assigned zero.

Capital Structure/Allocation

HW has net debt of $477M or 3.4x LTM EBITDA leverage as of FY14 ending Sep. They have a small $50M convertible bond due 2/16 @ 8.75%. The other two senior notes are $150M and $400M due in 2019 (callable in 2016/2015 at 103.375/103.813) at 7.25% and 7.625%, respectively. Most of the deleveraging will be through EBITDA growth and FCF generation. The company views debt repayment as their primary use of FCF and targets a 2.5-3.0X net debt/EBITDA ratio. We believe HW will pay down/refinance their $50M convertible note and $400M senior note next year to lower their interest expense.

HW has ~ $200M NOLs and $24.8M in tax credits, which is projected to last several years. Headwaters is effectively only paying state taxes which amounts to approximately $4M in FY14 and FY15.

Given that HW is well positioned to capture upside in a mid-cycle housing scenario, the likely scenarios for the use of cash other than debt repayment would be to make accretive bolt-on acquisitions where they can extract some synergies. The company has made several sub-$50M acquisitions that are additive to their product lines and accretive. HW generated $30M in FCF for FY14 (see model below) and is expected to generate $59M/$92M in FY15/FY16.

Valuation Model

This model reflects the forecasting assumptions above in each respective section. One note, the company adds back “cash-based compensation tied to stock price” to EBITDA, but we leave it out since we consider that an expense.

We employ a sum-of-parts analysis since the HCM and LBP are independently run units. Comparable companies for each segment trade in a fairly close range with an average 10x NTM EBITDA multiple. That multiple can expand in a mid-cycle housing scenario, but our base case assumes that the multiple just rolls forward next year. A base case multiple of 10x to FY16 leads to a 12-month target price of $21.33/sh.

An upside scenario is if Headwaters potentially splits or sells a segment to a potential acquirer. We think that the HCM (fly ash) business would be highly attractive to a large cement/concrete producer as it would immediately provide a leading 50% market share within a highly attractive industry. The most comparable comp would be Martin Marietta Materials’ acquisition of Texas Industries in July, 2014, a cement and concrete producer, for 14x forward 12-months EBITDA. We think the fly ash business could sell for more given that it has a much better margin profile, leading market share and high barriers to entry. Management could also unlock value by spinning off the fly ash business. Applying a 14x multiple the HCM segment leads to a value of ~$1.5bn or the entire company’s value today. A SOTP analysis leads to a combined 12-month target price of $26.89/sh.

Comparable Companies Analysis

Additional Risks

The greatest risk the company is an economic recession and slowdown in construction and residential spending. HW is a cyclical play and all bets are off if demand falls off a cliff like it did in ’08-09. However, in a slow growth environment, this idea still works due to the structural supply decline in domestic cement. Fly ash is a cheaper, superior product that is interchangeable with cement. Concrete producers will seek to increase fly ash usage as cement prices rise and its availability dwindles. The light building products segment will continue to be a steady grower in the current muted environment, but has significant operating leverage and would provide a substantial call option if we hit a mid-cycle scenario.

Catalyst

-Cement producers accelerate price increases as US becomes net short cement.  This will increase demand for fly ash, increasing fly ash prices and volume.

-Debt refinancings in 2015.  Capital structure will de-lever through EBITDA growth and FCF generation.  

-Potential sale/spin-off of company's fly ash division

-Housing starts grow faster than expected