Wednesday, 18 April 2012

WaterFurnace Renewable Energy(WFI): 2011 YE Dilemma

Last month WFI published its annual report of 2011 results. For investors, the report along with the conference call (available on CNW), the annual information form (AIF) and the information circular paint a positive picture on some fronts offset by negatives on others and overall stagnation.

Competition from Natural Gas
When I made my original assessment of WFI 18 months ago, I concluded that the main constraint on the company's renewed growth was US housing starts and that when the US housing market recovered, sales and earnings growth would begin again. Not so certain, it now appears. The success of fracking and the resulting now plentiful natural gas supplies causing low gas prices are providing another big restraint on potential home geothermal heat pump installations. Consumers do the math and conclude that natural gas is cheaper, as the annual information form concedes: " ... very low natural gas prices will put competitive pressure on geothermal heat pumps if availability and low gas prices persist." That's probably why WFI said in the conference call that the residential market was down 9% in 2011.

That something else besides housing starts is affecting WFI's residential sales is seen in the fact that US starts did rise steadily through 2011, a condition about which management said the following in the Q1 report: "Housing starts are forecasted to be 600,000 by the end of 2011, despite the overhang of foreclosures and tighter bank lending practices. The residential replacement market will continue to be the single greatest opportunity for geothermal heat pump installations for the next several years. As residential new construction revives, then this will present a significant upside opportunity for the business." Housing starts reached 700,000 in December yet WFI experienced falling residential sales. The latest AIF still doesn't include natural gas prices amongst risk factors.

The discussion of the economics in the Wikipedia geothermal heat pump article tells us that the economies of scale on capital costs benefit commercial large buildings much more than residential, making systems more cost effective for commercial buildings, which is most likely why WFI's sales in that segment continue to grow.

WFI management says it is also looking more to international markets for growth - in the UK, China and South Korea - and also in the commercial sector. Maybe, but possible success is in the future and not evident now. The Hyper Engineering acquisition of 2011 in Australia is having no discernible effect except that shares issued for the purchase helped dilute earnings per share by 1 cent to $1.14.

Not-so-good Numbers in Financial Statements
Several 2011 numbers aren't good for investors, though not disastrously so.
1) Executive and employee compensation was way up - What justifies executive compensation rising 31% and employee salaries and benefits 13% (while employee headcount dropped from over 300 to 287) in 2011 given that company earnings and sales stagnated and the stock price dropped dramatically? The $1.7 million or so excess increase over what a 3% inflation rise would have been represents $0.14 cents less in earnings per share. Has the Board (whose rise in fees was only 2.6%) been paying attention? It is a dilemma to invest in a virtuous green company only to have management and employees grab an increasing share of the profits.
2) Warranty claim provisions rising faster than sales - Note 12 in the financial statements records another whopping increase (27%) in provisions for warranty claims, a big chunk of which is due to an increase in claim rates, as opposed to more units under warranty from higher sales. How this jives with an assumption stated earlier in the annual report that unit failure rates will remain the same as in the past is not explained ( I sent the company an email asking for an explanation and have not received a reply). Warranties have become a significant part of balance sheet liabilities and of cash flows (as a non-cash item added back). In the future if the reserves are correct or too low, when warranties are honoured/paid out, the warranty cash flow will reverse and become a drag on cash flow. There will be much less leeway to keep up dividends. If the reserves have been too high, earnings will get juiced by one-time upward adjustments. It is getting harder to understand how profitable WFI actually is.

In short, WFI has become much less attractive than before with its current sales geography and product mix, perhaps not to the point of selling, but management needs to deliver on expansion to new regions of the world and/or through new products.


Naveg said...

You should be happy that WFI is directing additional funds to executive and employee compensation. Without good employees, a company has no chance of success, a rule from which WFI is not exempt. As an investor, you should be glad that the company is doing what must be done to retain its talented employees. It is a necessary step for long-term growth.

While WFI's business may not have heated up much this year, the job market has. It follows that compensation must rise, even if it means a dip in short-term profits. Who will build and sell the products otherwise?

CanadianInvestor said...

Naveg, would that it were so. I fear that WFI is giving the reward before the result. The talent is not yet evident. Huntington's performance has been credible since becoming CEO 3 years ago but nowhere near as strong as his predecessor Ritchie. The most talented people leave organizations for lack of challenge or work excitement, a crappy boss, a poisoned work atmosphere, not for pay. Those who merely chase pay are probably not the kind of people who build long term business success.

Anonymous said...

On natural gas price: I agree, but natural gas companies are burning cash like crazy now, which is an indication that such low prices are clearly unsustainable. I am not a great beleiver in the shale gas hype. A bigger worry than natural gas prices is the 30% tax credit that might not be renewed in 2016.
On warranty claims: during Ritchie's tenure as CEO, standard warranty on popular units such as the Envision was increased from 5 to an industry-leading 10 years. This has been potentialy a nice sale driver, but may have a translated in higher probability of claim (just speculating here)
On Huntington: it is unfair to compare him to Ritchie since the latter tenure as CEO took place in the context of the housing boom. I have always thought that one of the best criteria to judge a company or ceo is its ability to remain profitable while capturing market share in a down market. From this perspective, Huntington has done an outstanding job so far. I am looking forward to see their new product pipeline (variable speed unit); it would be great if they manage to increase the efficiency of their units (this is a big factor in making geothermal units more economically attractive ).

Disclosure: I own shares of Waterfurnace right now at an average cost of $20.

SPBrunner said...

Good article. I am linking to it today.

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