I believe that HW is worth about one-fourth its current stock price, and that intrinsic value is rapidly deteriorating. HW shareholders have fallen asleep at the wheel as HW approaches a disastrous and virtually inevitable earnings cliff effective 12/31/07.  70-80% of HW’s earnings stream is set to sunset legislatively after 12/31.  What shareholders will be left with is a deteriorating, hideously-levered construction products company, and a set of money-losing alternative energy schemes.  Applying market multiples to the construction businesses suggests a $7-8 stock.  I believe this idea is timely as shareholders are likely to realize how poorly the construction materials business did when HW reports on the 30^th pre-market.  Based on the prelims management published on the 16^th, I don’t believe that shareholders realize how incredibly well the alternative energy business did given that it benefited from a very large one-time accrual in the quarter.

 

Section 45K has a long and storied history, most of which adds minimal value to the present discussion.  The short of it is that during the energy crisis in the 70s, in order to promote energy self-reliance, Congress created tax credits for utilities to conserve coal resources.  The credits essentially make purchasing ‘waste coal’ a net profitable activity after applying the tax credit.  Waste coal is essentially coal that is sub-optimally small for the most efficient combustion.  A numerical example follows.  In this example a waste coal processor (often electric utilities) buys waste coal at a discount to market, spends the money necessary to process it into standard-sized briquettes, and claims the credit against their taxes.  Processing the waste coal makes the gross cost above-market.  After netting the credit, however, the coal ends up being significantly below market.  Some variations of this scenario exist depending on who processes the coal, but the credit amount is a constant and the only difference is who receives it.

 

Coal Price                   35.00/ton

Processing Cost           10.00

-------------------         -------

Gross Cost                  45.00

Less: Tax Credit          (28.00)

-------------------         -------

Net Cost                      17.00/ton

 

This sounds like a worthy piece of legislation until we consider the potential abuses available (assuming the U.S. had anything less than an infinite supply of coal of course).  As it turns out, given the size of the credit, in many cases processors simply crush standard coal into waste coal-sized briquettes and claim the credit.  HW has been capitalizing on this credit by selling the reagent necessary to bond the waste coal, and by collecting license fees on the reagent formula.  

At any rate, the credit is widely considered a travesty.  Finance departments within the utilities assume that it’s a goner in their internal projections.  I estimate that the credit costs taxpayers $6 billion per year.  Lobbying efforts to renew the credit last year failed.  As this credit is essentially a corporate subsidy in times of staggering deficits, the new Democratic-controlled Congress is even less likely to renew it than their predecessors. 

Section 45K credits are scheduled to sunset after 12/31/07 at the latest.  I believe the odds of a renewal are very low.  Between now and then they are subject to phase-outs.  During 2006 the credits were likely subject to a 35% phase-out.  The phase-out is based on annual average oil prices, retrospectively.  The phase-out for 2007 will likely begin if the 2007 average price of oil exceeds $55.  The credits will be fully phased out if prices average above $69.50.  Regardless, phase-outs aren’t necessary to make this a high-IRR short, it would only be gravy. 

As you might have anticipated the retrospective basis for setting the phase-outs can create some uncertainty regarding the likelihood of realizing any given year’s credits until the end of the year.  It was for this reason that HW deferred as much as $30 million of royalties that were contingent on the customers’ realization of the credits in 2006.  The idea being that for GAAP purposes the revenue has to be reasonably determinable.  The high margin royalties were deferred until calendar Q4.  Let me emphasize that the royalties are very high margin – no direct costs associated with them, i.e. near 100% incremental margin.  However, as recently as 10/31/06 the phase-out was estimated at 35% for 2006.  Since projecting how much of the deferred royalties will be recognized involves daunting calculations I’ve decided to assume that 30% of them will be recognized.  Full disclosure: I have no real basis for this assumption, but I do know it will be more than zero.

As one more nugget of background on the synfuel business, I want to call attention to the fact that Section 45K accounts for more than 100% of the alternative fuel segment’s earnings.  The other alternative fuel businesses (heavy oil upgrading, hydrogen peroxide, coal liquefaction, coal drying, ethanol, and coal cleaning) lose significant money.  Management gives us a rough indication of how much in the 2006 10-K:

 

2006 Reagent Gross Profit      34.9

2006 License Fee GP              74.7

Synfuel Sales Losses               (6.7)

-------------------------------     -----

Subtotal                                   103

Reported 2006 EBIT               80

-------------------------------     -----

Other Alt Fuel Losses             (23)

 

There’s possibly some Section 45K-related overhead not included in corporate overhead which could theoretically be eliminated post-12/31, so let’s assume the other schemes lose $15mm pre-tax per year (again, no real basis).  The upshot of this is that the synfuel business actually earns significantly more than management lets on, preferring to focus on the synfuel earnings net of the other alternative fuel losses.

So, let’s reconcile management’s preliminary report from last week with what we think about the Q1 synfuel picture.  Last time oil prices averaged about $60 as they did in Q1 ‘07, the base alternative fuel business earned $20mm of EBIT (with a lower phase-out range).  Last quarter when oil prices averaged almost $70, it produced $13mm of EBIT (with royalty deferrals).  So let’s use $17mm as a base, and assume that $10mm of deferred royalties will flow through on top of that.

 

Q1 EBT Prelim                       24mm (30% tax rate, consistent w/ recent quarters)

Less: Base Alt Fuel                 17

Less: Deferred Royalties        10

Less: Other Alt Fuel Adj.        4

------------------------------      ---

Q1 Construction/CCP EBT     (7)

Core Q1 EPS                           (.17)

Q1 EPS Prelim                        .37

 

Obviously calendar Q4 is the seasonally worst for the construction business, so I’m not suggesting the construction business is losing money on an annualized business, in fact it is definitely profitable.  The exercise is intended to point out the overwhelming contribution to earnings from the soon-to-be defunct synfuel business.  Management pre-reported what appears to be a seasonably-reasonable set of Street-beating numbers that are actually pumped up with non-recurring gains. 

 

The construction materials segment is essentially a roll-up of various architectural stone businesses and such.  In my view, given the continuing deterioration on residential construction fundamentals, this business doesn’t deserve a valuation dissimilar to any other residential construction-correlated business.  USG for example fetches only 5x TTM earnings. 

As a side note, while I use TTM earnings to value this business, the residential building cycle has yet to bottom.  Additionally, construction materials understandably correlate to new housing starts on a lag basis.  New housing starts began to break in calendar Q1 2006 when they were flattish.  Serious deterioration didn’t began in Q2 when starts were down 9%.  Q3 and Q4 deteriorated in succession by 18% and 24% year over year, respectively.  As HW didn’t exhibit any slowing in the construction materials business until last quarter, it’s reasonable to assume that materials lags starts by 3-6 months.  In other words, we haven’t seen the worst, and starts have yet to visibly bottom out. 

 

The CCP business bears no relation to the synfuel business.  CCP produces a lime substitute for use in concrete mix.  The product is essentially a byproduct of coal burned in the electric generation process.  CCPs are gaining market share from lime and other legacy products.  Because it is gaining market share I believe CCPs deserve a premium valuation to the construction materials business.  However, I would note that it is more commercial construction-correlated, and thus still cyclical.  Commercial construction activity has yet to break however, so we’ll build in a cushion recognizing that we haven’t top-ticked it.

 

To rectify my prior shameless sensationalism, I attempt to value the stock based on TTM earnings ex-synfuel.  Note that the ongoing businesses will be taxed at 40% as HW will no longer generate any synfuel-related tax credits for itself.  Also note that my TTM is inclusive of my Q1 ’07 estimate based on prelims.

 

                        EBIT   Taxed  Mult.    EV

CCP                 52        31        20.0     620

Construction    56        34        7.0       238

Other Alt Fuel (15)     (9)                   0

Corporate        (16)     (10)     13.0     (130)

Net Debt                                              (516)

Equity Value                                        212

Basic Shares                                       42.3

Stock Price                                          5.00

 

I’ve given the other alternative fuels zero value, just as I would any other scam of this variety.  One might argue however that the business has option value.  My counter argument would be that management has been working on these technologies for many years without any tangible results. 

I’ve also given corporate drain a 50% haircut based on the assumption that post-Section 45K we’ll have room for cuts.  I’ve arrived at the corporate multiple by adding the construction and CCP EVs over their combined earnings numbers to come to an objective blended multiple.

We must also acknowledge that the synfuel business will generate cash between now and then of perhaps $60mm after-tax, so we must add $1.50 of per share value for this.  We then arrive at $6.50.  HW will have almost $500mm of debt over less than $100mm of EBITDA at this point – over 5x. 

Even assuming Section 45K is renewed, applying a 12x multiple on the $1.50 of Section 45K earnings puts us at $25.50.  $2 of downside versus $16 of upside.  Another way of looking at it is the market is discounting a 95% probability of Section 45K renewal ((23.50-6.50)/(12 x 1.50)), while management, myself, and anyone on the sell side believes the probability is virtually zero.

HW is liquid and easy to borrow, and you should earn a full positive rebate.  If it is hard to borrow, options are traded, including long-dated ones.