Heads-Up for Headwaters

Coal is generally believed to be the remains of plants so old they predate dinosaurs, let alone hominids, but if this guy is right, a few minutes of yesterday's TV time may have been courtesy of some hairy ancestors.

Aside from man-ape fossils in their coal beds, today's coal industry is preoccupied with a host of environmental concerns, not the least of which comes down to the particulate waste left in the wake of this least efficient path to electricity.

On the whole, the coal-fired generation business is a bit like a slaughterhouse: We like its result, but we'd prefer not to think about the process. In this case, the process is more dusty than gory, and the result is half of America's power. While coal usage is only expected to grow as our country -- and the world -- becomes more, well, power-hungry, the demand for a cleaner, reduced-guilt coal process is likely to increase as well.

Stepping up to this plate with an offering that feels as good to the left (brain) as it does to the right is Headwaters Incorporated (NASDAQ:HDWR).

The company has three main divisions. One turns dusty coal-mining waste into burnable fuel; one takes the coal-burning equivalent of fireplace soot and makes construction materials, mainly a cement replacement, out of it; and a newer division, related to the second, makes both artificial stone and cinderblock products that either incorporate coal-burning waste or will incorporate it soon. Finally, a small nanotech division is making at least symbolic headway in high-potential applications.

The stock isn't outright cheap, and we may not be looking at the next Microsoft (NASDAQ:MSFT) here, but I'll wager that the market doesn't see the tidal wave forming on the distant horizon.

Eat my dust, taxpayer
Unlike its cohesive cousin, coal dust -- a mining by-product -- would be uneconomical to transport to coal boilers were it not for a tax credit from Section 29 of the Internal Revenue Code (originally a 1980 effort to support domestic solid, and in this case synthetic, fuel alternatives to foreign oil). Headwaters both licenses its synthetic fuel process know-how (don't ask me about this) and sells a latex-based bonding agent to synfuel customers, which include utilities, coal companies, and other synfuel facility owners like Marriott (NYSE:MAR), Morgan Stanley (NYSE:MWD), and Bank One (NYSE:ONE). This bonding agent clumps left-behind coal dust so it can be transported to be, ironically, pummeled right back into dust (to maximize surface area) before being burned.

Though Section 29 expires in 2007, it has been renewed in the past, and my guess is that it will be renewed again, perhaps in a less generous form. At issue for Headwaters is whether its latex additive creates a substantial-enough chemical change for the latex-bound coal dust to be considered a bona fide synthetic fuel. This has been periodically investigated, with Headwaters emerging victorious thus far. Keep in mind that in spite of the obvious "enviro" feel of salvaging coal dust, Section 29's intent is simply to reduce foreign energy dependence. If Section 29 disappears completely, the market leader in both synfuel technology licensing and bonding agent sales could lose $168 million yearly -- pretty significant for a company whose 2004 revenues will be less than $500 million.

From ash to cash
Perhaps as a precautionary measure in the event of a Section 29 non-renewal, Headwaters has been getting into the business of managing and making things with the otherwise-wasted by-products of coal combustion, and in a big way. Its 2003 acquisition of ISG Resources more than doubled revenues, and the April 2004 acquisition of VFL Technology Corp. should add $30 million more to the company's coal combustion product -- CCP for short -- total. Headwaters is also buying Eldorado Stone, a powerhouse in the fast-growing artificial stone market. Eldorado's products don't use coal waste yet, but they do add a nice $100 million to Headwaters' existing $49 million in yearly sales of refined building products made with CCPs.

CCPs include two kinds of waste ash, as well as scrubber sludge, all of which Headwaters is capable of putting to construction, agricultural, or industrial use, the flagship application being a replacement for portland cement in making concrete. In some cases, Headwaters gets this crud from facilities paying the company to take it, along with less-marketable waste, off their hands. In other instances, Headwaters pays facilities to let it come in and cherry-pick "fly" ash, the best of the worst, so to speak. In still other cases, Headwaters acts mostly as a crud middleman, matchmaking between the haves and the have-nots of the coal crud world.

But here's the best part: When fly ash is used in lieu of portland cement, the resulting concrete is four times stronger and a highway thusly constructed lasts 50 years versus 25 with cement. And using a ton of fly ash versus a ton of cement spares the world more than a ton of carbon dioxide emission, comparable to what's released in powering your house for a month or your car for two, not to mention that this stuff is 20%-60% cheaper than cement as well.

So why isn't everybody using it? Well, usage has been steadily climbing, thanks in part to government-mandated usage of fly ash in public construction projects, along with some aggressive lobbying and capable marketing from Headwaters. Apparently, it's still an unfamiliar thing in the slow-as-cement-to-change (sorry) construction business. But the big reason seems to be that both cement and fly ash are just so cheap that long distance transportation doesn't make sense given the nascent product awareness.

Headwaters controls half the yearly high-quality fly ash produced domestically, and is aggressively expanding its distribution capabilities. Their less-refined CCP side generated $170 million in revenue, and the refined construction materials division added another $49 million, although the latter amount will be at least $100 million higher going forward.

Nano? Not yet
And finally, we have HTI, a small $15 million nanotech and molecular catalyst acquisition from 2001. Although it's contracted to get some coal-to-diesel action in China (coal liquefaction has historically been the cold fusion of the energy world) and is working on converting bottom-of-the-barrel heavy oil to light, useable fuel oil, the nanotech division doesn't seem likely to conquer the world anytime soon, especially with its sub-$5 million yearly R&D budget.

To be fair, HTI does aim to partner with larger outfits in the future and, simply put, its projects are exciting to read about and potentially revolutionary. For now, though, expect under $10 million revenue per year from these guys.

We love models, but they don't always love us back
Besides strong organic growth, Headwaters has been growing in leaps and bounds through acquisitions of varying-margin businesses. While it's great that the company has grown from $7 million in revenues in 1999 to $388 million in 2003, this acquisition-heavy growth makes valuation touchy. I thought I'd try a multiple first -- a simultaneous multiple, as a break from forward and trailing stuff. I started with per-share free cash flow from 2001-2003, which I divided into a simple arithmetic average of stock prices for each of those years.

The logic here was that I'd see how the market, using quarterly data, company/analyst guidance, and intuition, valued those yearly cash flows while they were occurring. The 2001-2003 price/free cash flow (FCF) multiples were surprisingly stable. I extrapolated based on Headwaters' intended 20% earnings per share (EPS) and cash flow growth, which I projected through 2008, and tacked on $1 million per year in additional capital expenditures subsequent to the $10 million 2004 guidance.

* Dollars and shares in millions, except per-share data
* Assumes modest 3% weighted average shares outstanding (WASO) basic growth and slightly generous nine times forward multiple.

Headwaters is around $23 now -- definitely ahead of itself according to this projection. I tried the same thing with EPS, and Headwaters still came in under $20 per share. But while I had the EPS figures in front of me, I figured I'd try a quickie DCF approach.

Those wanting more framework can see a previous DCF exercise, but a CAPM (capital asset pricing model) rundown with 0.736 beta, 4% risk-free rate, 6% market risk premium, and 5% post-2008 growth gives an 8.4% discount rate and a whopping $56.16 valuation. And that's before adding $0.80-per-share cash on hand at the end of 2003.

Yes, to these EPS numbers I should add capital expenditures net of depreciation, as well as non-cash changes in working capital to get free cash flows to equity, but this is just a "quickie DCF," not the kind of detailed analysis you'd expect to find in Motley Fool Stock Advisor or Hidden Gems newsletters.

Returning to the numbers, it seems we've gone from one extreme to the other, value-wise. We don't always have to agree with the market, but it's comforting to know where it's coming from, and it doesn't seem to be coming from either of these extremes. My 20% EPS and cash flow growth might not last more than four years, but then again, things might be even better.

Prior to the ISG acquisition, almost all of Headwaters' revenue came from synfuel, so as Headwaters migrates towards steady growth on the CCP and construction products side, it's possible that such safety is being rewarded with a higher multiple. If you go from my assumed nine-times-FCF multiple to 11.5 times, you get close to the stock price. Paradoxically, speculative investors excited about nanotechnologies could be driving up the multiple by jumping in now in hopes of a monster payoff.

In another vein, beta, which measures historical volatility, probably isn't terribly useful for the stock of a company changing so much by acquisition. The smart money is probably not in using CAPM here, at least in this form. If we jettison the CAPM rate for an uncorrupted 12.5% discount rate, for example, we get a value of $23.70 from the DCF model, close to the current price.

The point here is that the numbers are beckoning us into the subjective realm and away from arbitrary precision. You don't make money in the market by seeing the same future and having the same certainty about it as everyone else. You have to see different events or be more certain about known ones.

My unscientific opinion is that the stock's price just about incorporates the obvious growth in domestic coal waste business. On top of this, you've got two wildcards -- potential international expansion and nanotech applications -- that could take more than five years to show their faces. I thought about modeling these, but felt their mere inclusion would imply a greater degree of certainty than exists. Instead, you can look at the facts yourself and get a feel for the forces at work.

Waste not, want not
Considering Headwaters' tight grasp on the pre- and post-coal combustion market, Section 29 non-renewal risk -- not industry competition -- is probably an investor's biggest concern. One would think, generally, that the eco-friendly, low-waste nature of Headwaters' offering should serve it well as we move towards a future demanding cleaner and less wasteful forms of energy.

I'm not even convinced that good growth in this area is fully priced into the stock, although those less confident in Section 29 renewal would say that the difference consists of that risk. But if you buy the stock for steady core business growth, you get the two wildcards -- potentially huge ones at that. International expansion of Headwaters' strong domestic competencies is one. The other, nanotechnology, is perhaps most exciting because, as Headwaters' glossy promo material rightly states, the future of energy is on a molecular level.

Fool contributor James Early had some hairy ancestors, but he can at least apply sunblock to his back without getting a handful of hair. He owns none of the stocks mentioned in this article and can be reached via email. The Motley Fool is investors writing for investors.