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.

WaterFurnace Renewable Energy Inc 1Q2011 Conference Call

My investment pick (original analysis post here) of the environmental litter, WaterFurnace (WFI) finally issued (delayed by conversion to the IFRS accounting standard) its first quarter report covering the three months up to March 31, 2011 and held the conference call on the results.

Things, in a word, look rosy. President Huntington and Treasurer Andriano provided reasonable explanations and assurances that some quarterly report negatives are one-offs (like the extra taxes that really reduced profits), erring on the cautious side (the rise in warranty reserves despite better reliability of newer products) or taking advantage of an opportunity (the rise in inventories to get 2% price savings on input materials vs only 1.5% return on cash). The company also successfully (sales dollars are up) implemented a price increase to restore margins in the face of rising input costs.

More important for the long term is that despite the continued hapless state of the US residential market, WFI is making sales gains and solid profits. There was lots of talk of expansion in China through a joint venture, sales opportunity in new market segments from the Hyper Engineering acquisition, where they are hiring, and a renewal of sales increases in Canada after the promise of the Conservative government to renew the EcoEnergy retrofit subsidy program.

After the call, WFI's price went up in the broadly declining market yesterday, up to $21.50 (which is still way down from the $26 or so of last September when I bought some stock). Maybe speculators (or investors?) have taken a cue from the closing seconds of the call when Huntington said he was looking forward to a solid second quarter. Looking forward? The end of the second quarter is in two weeks!

I still have confidence in the long term worth of this company and still have my shares.

Budget Restoration of EcoENERGY Program - Good and Bad

Yesterday's federal budget restored the popular EcoENERGY home retrofit program, though the government's heart really isn't in it (apparently this is a sop to bribe, oops, accommodate a demand of, the NDP) since the funding of $400 million is only for the 2011-12 fiscal year.

The temporary short extension of the program is bad but at least the program itself is good for homeowners. Home energy efficiency investment is a one-time cash outflow that replaces future constant regular cash outflow on energy bills. It provides permanent inflation protection against energy price rises (see my original post on my friend's actual geothermal home installation for the financials of his situation). For the retiree especially, a cash flow saving that automatically exactly matches inflation on an essential living expense is a great boon. Consider the difficulty of trying to find an investment that even gets close to doing that.

This budget item is also a good thing for investors (of which I am one) in WaterFurnace Renewable Energy (TSX: WFI), a manufacturer of EcoENERGY-eligible ground source home heating and cooling systems whose Canadian sales dropped 14.3% in 2010 per the annual report after the EcoENERGY program was allowed to lapse last year. For a year at least, WFI's Canadian sales should get a boost, though they are at such a low proportion (12.7% in 2010) of WFI's total sales, that won't make a huge difference.

Waterfurnace Renewable Energy YE2010 - Trudging Along

The 2010 annual report and conference call (on Newswire.ca) for WaterFurnace Renewable Energy (TSX: WFI) are now available. What do they tell us (I do own some) shareholders?

The financial results bring no great surprises. Earnings in the last quarter followed the trend of 2010, being down from 2009, which itself was down from 2008. Sales went up a bit, at much lower profitability, as the company only in late 2010 implemented a price increase to try to recoup some of the input price rises, notably copper.

The company has continued its fairly dramatic shift away from the moribund new US residential housing market to the residential replacement and commercial sectors.

Strangely, given the big drop announced today in US housing starts (to 480k in February from 620k the month before and the analyst forecast of 580k) the tone from management on the conference call (yesterday) was quite positive. They said they expect an upside of 15 to 20% in 2011 from residential new construction.

Apart from the upside uncertainty of housing starts, the major downside risk is that US government cost-cutting may remove the 30% tax credit for geothermal home installation that is supposedly in place till 2016. Management said they feel the tax credit is relatively secure based on their lobbying contact with lawmakers.

Another upside uncertainty that would increase the financial attractiveness of geothermal is how much, if at all, natural gas prices will go up.

The acquisition of Hyper Engineering sounds like a reasonable move. Its technology for limiting the inrush current on startup of electric motors can both be integrated into its own products and continue to be sold, even expanded, as a separate business. WFI managers even said that Hyper is a profitable business right now.

Due to the removal of the federal retrofit rebate program, Canadian sales kept falling through 2010 (now under 15% of total sales) and according to WFI management, have now hit a solid bottom. Some provinces continue to support geothermal for residential.

WFI continues to fly under the radar - only two analysts, one for CIBC and another whose affiliation wasn't stated - took part in the conference call.

One of the Board directors, Thomas Dawson, even bought 100 shares in February at $25.25. There have been no sales by insiders for over 12 months so that is positive.

All in all, maybe things will get better in 2011 as WFI management expects, but at worst it is still a waiting game, perhaps another year or two before growth resumes. Other investors in the last two days seem to like the results - the stock is back up over $26. I am comfortable holding onto my WFI shares.

Perils of Procrastination - Missed Stock Opportunity

Looks like I missed the boat from delaying looking at two companies suggested by a commenter on a post about Waterfurnace Renewable Energy's (TSX: WFI). "Anonymous", also a WFI shareholder, had asked whether I had looked at Computer Modelling Group (TSX: CMG) and 5N Plus (TSX: VNP). Prices of both companies are up considerably since that post. 5N has just announced an acquisition per this GlobeInvestor article, boosting its price 17% in a couple of days, which brings it to c. plus 50% since my post! CMG is up over 40% since October! Got any more stock analysis suggestions, Anon?

WFI has its conference call March 15 and full year results release March 14, which I will be reviewing. The company has already authorized and paid the quarterly dividend at the same rate as the previous one. I'm not expecting much sales or profit rises given the continuing bad state of the US housing market. The rise in energy prices is making the value proposition of its product - geothermal heating - increasingly attractive, however.

Waterfurnace Renewable Energy - Insiders Buying Post Q3 Report

When I did my first post on Waterfurnace Renewable Energy (TSX: WFI) assessing it as a stock to buy, insider trading had been quiet. Now we are getting the encouraging signal from a couple of insiders who have been actively buying shares themselves in the last month or so since the release of the company's 3rd quarter report, which I reviewed in this post. Both Board Member Thomas Dawson and the CFO Fred Andriano have been tangibly demonstrating their faith in the company's future according to this list of recent WFI insider trades from CanadianInsider.com - all purchases and fairly large amounts too, given the size of company. It looks like they took advantage of the recent price dip too, paying pretty much the bottom price.