Wednesday, 16 November 2011

WaterFurnace Renewable Energy Inc 3Q2011 Results

In September 2010, I reviewed WaterFurnace Renewable Energy Inc (TSX: WFI), a manufacturer of geothermal heat pumps, and decided to buy shares. Four quarters on, how do things look?

Industry Prospects - The business environment remains weak.
  • Residential slump continues - US Housing starts, a prime driver of demand for WFI's residential products, continue at an extremely low rate of about 500,000 - 600,000 starts per year vs historical norms well above 1 million. That situation doesn't look set to improve soon. In the latest conference call and in the published report on Q3 results, company management says it expects 2012 to see an overall industry decline of 10-15% for residential geothermal heat pump sales in the USA. Residential products, according to WFI management, have a higher profit margin than the commercial products that the company has emphasized to fill the sales gap. New housing, in which the substantial initial capital cost of geothermal is embedded and financed by a mortgage for amortization over a long period, overcomes the sticker shock impediment to geothermal's market success.
Financials - The overall picture is that the company is maintaining its financial strength, or even improving it slightly, in the continuing difficult environment.
  • Gross Profit Margin - GPM seems to be staying about the same. This is not so bad considering the shift in product mix from residential to lower margin commercial. But GPM is not improving as management says on page 3 of the Quarterly report - if one adds back the $727k difference for Q1-3 of 2011 that resulted from the change in method of calculating Warranty costs (page 31), then GM is not 37.7% as stated but only 32%, which is at the lower end of those in the last five years according to ADVFN.
  • Net Profit Margin - The same ADVFN page shows that the NPM has stayed quite stable at around 10% through the last five quarters.
  • Cash Flow - Whether it is by simple cash flow from operations or including capital expenditures (or depreciation instead of capex since the relatively new factory doesn't seem to be needing much investment for now), 2011 results are stronger than 2010 which were an improvement over 2009. WFI is thus adding to its cash reserves, probably more than it has an opportunity to spend effectively at the moment. No doubt this has enabled and justified the announced increase this quarter in the dividend from USD$0.22 to $0.24 per share.
  • Dividend - The strong and improving cash flow, along with complete absence of debt on the balance sheet, indicates that the dividend is quite sustainable. The dividend salves the pain of the stock price drop since last year.
  • Warranty Reserves - The rapidly rising warranty reserves, a non-cash liability but one which eventually happens in cash if the estimate is correct, could become an issue down the road. About half the increased liability, according to note 12 on page 31, in the first nine months of 2011 came from increased claim rates, not merely extra sales of units. It does not yet come to a level that is at all a problem but might be something to monitor.
Market Share - In the Q3 report, management states that it is gaining market share but the story is not so clear to me. It may be a question of how one defines the market.
  • WFI's sales increased 2.3% in the first nine months of 2011 while competitor LSB Industries saw a 19% rise (cf its Q3 report).
  • Though the numbers are out of date and have not yet even been released for 2010, WFI's shipments fell from 2008 to 2009 (as indicated by the figures Indiana) while those of LSB rose (cf the numbers for its home base of Oklahoma) according to the US Energy Information Administration website.
Insider Trading - Company insiders are keeping the faith.
  • The only activity in the past six months (see here) consists of stock purchases or dispositions by gift.

Strategy - The theme at WFI seems to be "steady-as-she-goes".
  • The HyperEngineering acquisition earlier this year has not been mentioned in the last two conference calls and is a minor revenue generator ($2.9 million in total with regular WFI international product sales) with a profit margin of around 8% (cf page 26 of the Q3 report), slightly less than the overall company margin.
  • Cash is being given back to shareholders through dividends instead, for instance, being kept in the company to make acquisitions
  • There are no initiatives to address a key issue of the large capital outlay required by a residential homeowner doing a retrofit conversion to geothermal of an existing home. The development of options to allow customers to finance installation costs as well as other strategic challenges and opportunities is laid out in the business school case study on WFI prepared by Charles Shanabruch in 2009.
  • Not much has changed since that date under CEO Tom Huntington who took over from the dynamic former CEO Bruce Ritchey. Perhaps the only glimmer of a new direction is international sales expansion beyond the USA and Canada, where the tiny sales volume tripled despite receiving no focus by management.
Valuation - Somewhere above the low end valuation of $29 per share that I estimated last year seems reasonable.
  • WFI has grown EPS 4.5%, and Free Cash Flow from negative to positive, over 2010; both are positives
  • US housing starts remain flat, a constraining negative that tends to the lower valuation. The guess/assumption last year that it might take two years to get back to normal levels should probably be re-stated as two more years from today in order to be conservative.
  • The stock price of WFI has slumped considerably from the $25-26 range of last year to around $19 nowadays. That makes WFI an even better value. Last year I said that WFI is a good buy, but for the long term. That is still my view.
Disclosure: I still own the shares I bought last year. I even bought more at around $21.

Disclaimer: This post is my opinion only as to how and why I came to my own investment decision. Whether you agree or not, it should not be taken as investment advice.

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