Tuesday, 14 August 2012

WaterFurnace Renewable Energy 2Q2012: Worrying Sales Slide

WaterFurnace (TSX: WFI) has just released its second quarter 2012 financial report. The news is not good.
  • Big slide in sales - Sales dropped a big 16.5% vs the same quarter a year ago. Management is now lamenting dropping consumer confidence and belatedly recognizing the competition from low natural gas. Worst news is that CEO's Huntington's claim that WFI is stronger than its competitors and gaining market share looks dubious. LSB Industries reported recently too and its sales drop on the comparable climate control side of the business was only 12.5%.
  • Inventory climbing - Inventory is rising fairly dramatically - from 33.5% of sales in 2Q2011 to 41.1% in 2Q2012. Why are managers downplaying this by saying that inventory remains at "historical levels"? The factors behind the sales slowdown aren't likely to reverse soon.
  • Warranty costs rising - Warranty provisions continue to rise, even as sales decline. Using note 13, net additional accruals for honoring warranty claims rose from 4.3% of sales in the first six months of 2011 to 5.5% in 2012. The biggest portion comes from increasing claim rates not new units covered following sales. As I discussed in my last post about WFI in April, this cannot continue forever without consequences. If the provisions are correct, future cash flow will suffer when claim repairs or replacements occur. If so, the dividend could be in danger. If the provisions are too high, earnings will shoot up when the liability is reversed.
  • Dividend payout looks unsustainably high - Aside from the warranty cost question, the current dividend payout at $0.96 per year looks way too close to the trailing 12-month earnings per share of $1.07 i.e. 90% payout. If sales remain soft and below 2011 in the next few quarters, the ratio will exceed 100%. That 5.8% dividend yield is not sustainable.
  • Manager compensation rising out of line - Both salaries and stock allocation to managers rose considerably (10+%). That doesn't fit very well with relative or absolute business performance, nor with WFI's stock price, which has dropped 22% in the past year.
The only hopeful news was the announcement of the joint venture with a Chinese partner to sell its products into China. However, whether that initiative produces renewed sales growth will only be seen in a year or more. And success is not at all certain.

Revised Stock Valuation - Using much more pessimistic assumptions than in the initial assessment of 2010 (see post here) - earnings fall to $0.85 EPS, dividend cut in half, no growth for six years, followed by 3% growth thereafter, with a required return of 5% - WFI is worth around $23. With no growth at all, dividing the 0.85 EPS by the 0.05 required return gives a value of $17, just above where it trades today. FWIW, one broker tracking WFI, Canaccord Adams, has a target price of $24. According to Thomson Reuters, two un-named brokers have 12 month price targets of $21.90 and $23.90. One rates WFI a Hold, the other a Strong Buy.

Though it doesn't look as though there is a high chance of further big price declines, the last quarter's drop in sales was a surprise - even it seems to management - so it will be interesting to see what happens after the ex-dividend date of August 20th. Some investors might stick around to collect the dividend and then head for the exit. For the moment, I'm holding on.

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