The Motley Fool Rule Breakers growth investing service has been making buy and sell recommendations for members since 2004. Now it's time for those members to help shape the service, through the "Take That!" contest currently under way. Readers nominated the companies they thought were no longer Rule Breakers and that should be sold from the scorecard, and the five best bear cases are now up for a vote. The winning (losing!) stock will be revealed in the next issue of Rule Breakers -- and quite possibly a sell recommendation to go along with it!
This March, Fool co-founder David Gardner recommended Headwaters (NYSE:HW) to subscribers of his Rule Breakers service. Since then, the stock has slipped and stumbled: Picked when it was trading for $38.56, the stock has lost 36% since then.
So is it time to cut our losses and sell, or hunker down and ride the short-term haircut to long-term outperformance?
We're bullish!
In his original write-up, David liked Headwaters because he saw a company helping to produce energy and use its byproducts more efficiently. "Byproducts of [coal] production and consumption -- soot, fly ash, bottom ash, and scrubber sludge -- may not sound like big business, but in the ashpits of industry, Headwaters has found gold," David wrote.
Synthetic fuel chemicals made up more than 90% of Headwaters' revenue by 2002. Because companies that use the fuel qualify for a Section 45K alternative fuels tax credit, Headwaters was in a position to profit. Losing that tax credit -- and it will expire at the end of 2007 unless renewed -- would be a huge blow to Headwaters, but David saw some panic in the streets.
First, he saw a management team that was diversifying its sources of revenue:
Management decided to move along the coal lifecycle from pre-combustion products (soot) to post-combustion (fly ash). In 2002, it acquired a company called ISG Resources, which supplies fly ash for use as a cement substitute in making concrete products. Sensing an opportunity beyond supplying raw materials (a business the company still pursues under its Headwaters Resources division), it moved up the value chain into making its own construction materials. It developed FlexCrete, a fly-ash-rich concrete building material that is as strong as concrete at a fraction of the weight, acts as a natural flame retardant, insulator, and sound dampener, and can be sawn and shaped like wood.
Moreover, Headwaters had a lengthy list of R&D initiatives that could pay off down the road, which meant a growth stock that actually looked cheap. "I like the mix of proven revenue streams, near-term innovation, and potential," David wrote. All this for a potentially cheap price:
Suffice it to say that I believe it is undervalued relative to comparable companies like Eagle Materials (NYSE:EXP) and Nalco Holding (NYSE:NLC), and that even using some pretty conservative estimates on future cash flow, the stock looks underpriced. So unless Headwaters hits a major snag, it looks to me like a company with great growth potential and pretty moderate downside risks.
That that valuation thesis hasn't played out in seven months doesn't mean David was wrong. One of Peter Lynch's pet peeves is when investors assume that because their stock declined, they were wrong (and, vice versa, that because it rose in value, they were right). David preaches a patient, hold-for-years investment approach, and with just seven months on the Rule Breakers scorecard, we'd need a crystal ball to know if Headwaters is headed in the right direction.
No, we're bearish!
In the "Take That" contest, AirForceFool laid out the bear case for Headwaters. While he agrees that "synthetic fuel was Headwaters' main business and is what drove historical growth," he believes those days are gone. Quoting his post on the Rule Breakers board:
- We're stuck in the middle where tax credits aren't fully available, but it isn't profitable to produce synthetic fuel.
- We are looking at the beginning of a serious housing decline.
- Short interest, anyone? I normally don't take too much stock in what the shorts are up to, but with shorts at almost 17%, it causes me to raise an eyebrow.
Kicking Headwaters off the Rule Breakers scorecard, AirForceFool argues, is not about whether you like it as a company. Nor is it about being able to accept risk to get superior long-term gains.
Rather, "The question is: 'Is Headwaters a Rule Breaker?' My answer to that is: It was ... and it may be again, but right now it isn't. Too much has changed, too much is unknown, the risks are way too high for the perceived rewards."
So which one is it?
Community sentiment is largely bullish. According to Motley Fool CAPS data, Headwaters is a three-star stock (out of five possible stars); 191 CAPS players have rated it an "outperform," while 219 have rated it "underperform" vs. the S&P 500. Analysts are neutral to bearish. According to Thomson data, Headwaters has a mean recommendation of 2.7 on a 1-to-5 buy-or-sell scale.
So ... which one is it? For the full bull and bear Headwaters arguments, and to read the cases against each of the five finalists, click on over to Rule Breakers Central. If you're not a member, you can access the service, read all of our recommendations, and cast a vote in our contest -- all with a completely free, no-strings-attached 30-day trial.
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Neither Brian nor Rik owns shares of any company mentioned in this article. The Fool has a disclosure policy.
