Foolish Forecast: Headwaters' Net Margin May Take a Dunking

Construction materials manufacturer-cum-alternative energy play Headwaters (NYSE: HW  ) has beaten the tar out of earnings estimates in every quarter so far this year. But will Tuesday morning's fiscal 2007 earnings report cement a year of utter outperformance?

What analysts say:

  • Buy, sell, or waffle? Eight analysts follow Headwaters, giving the stock two buy ratings, five holds, and a sell.
  • Revenues. On average, they expect to see sales rise 10.5% to $304.2 million.
  • Earnings. Profits, however, are predicted to fall 12% to $0.54 per share.

What management says:
Oct. 19 was an important day for Headwaters investors; the company filed an 8-K statement with the SEC including not one, not two, but three pieces of material news. Bad news first: You've heard about the difficulties that are plaguing homebuilders like Toll Brothers (NYSE: TOL  ) , right? The ones that get blamed whenever Lowe's or Home Depot report a down quarter? Well, they're doing little good for Headwaters, either. Management's annual goodwill impairment check revealed the need to write down the value of the firm's Tapco construction materials business by $98 million. This charge to earnings will hit Q4 earnings hard. It is not taken into account in the analysts' estimate noted above, as it is an unusual noncash charge, but my guess is that we're going to see a net loss for the quarter under GAAP accounting standards.

The good news is that this is a noncash charge. In the same press release discussing it, Headwaters mentioned that the firm generated "over $100.0 million of cash" over the past four quarters. Headwaters used a portion of these cash profits to prepay "an additional $52.5 million of our senior debt." (Actually, you can consider this bad news, as well, if you like. Prepayment of debt often entails a charge to earnings in its own right.)

Final news installment: Saying that the firm's stock price presents "an opportunity to enhance long-term stockholder value," Headwaters plans to spend $15 million buying back stock. At current prices, if implemented in full, that would knock the share count down by about 2.6%.

What management does:
After falling for quite some time, margins seem to have turned the corner at Headwaters, rising in each of the last two quarters. But if I'm right about the charges mentioned above, we should see the net margin take a significant hit next week.

Margins

3/06

6/06

9/06

12/06

3/07

6/07

Gross

34.7%

32.7%

31.9%

30.8%

32.0%

32.9%

Operating

18.4%

18.4%

16.2%

14.8%

15.5%

16.7%

Net

12.5%

10.2%

9.1%

8.1%

8.9%

10.2%

All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ended in the named months.

One Fool says:
Share buybacks get a lot of attention in the financial press (why, even I have covered a few of the things, such as the $2 billion buyback initiatives at Symantec (Nasdaq: SYMC  ) and United Technologies (NYSE: UTX  ) , or the monster $5.5 billion program at Best Buy (NYSE: BBY  ) .) So I wouldn't blame investors if they feel disappointed that Headwaters is spending so much less on buybacks than on debt repayments.

That said, I suspect the folks over at Motley Fool Rule Breakers are grinning ear to ear over Headwaters' emphasis on debt repayment. In last month's three-year review of all recommendations made by the newsletter, Rule Breakers analyst Karl Thiel called Headwaters "attractively priced" and highlighted its stealth "portfolio of nanotech and alternative energy technologies." The thing that concerned him most, though, was the company's huge pile of debt, which Karl termed Headwaters' "Achilles' heel." Good news, Karl. This firm just took the first step toward heeling itself.


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