Value Investors Club / Owens Corning (OC)

Description

Owens Corning

Owens Corning ("OC") has three main business units, and an "other" section. These business units (on a pro-forma basis due to a recent acquisition) are exposed to US & Canada new home sales (29%), US and Canada remodeling (26%), US & Canada Commercial/Industrial (22%), and International Composites and Insulation (23%. Due to a relatively recent emergence from bankruptcy and 55% exposure to US home-related activity, the company's stock trades at a substantial discount to its expected value. The argument for OC's cheapness below rests fundamentally on the notion of mean reversion of the margins of the company's businesses. In each case, I will explain the industry structure and why that justifies the thought that current depressed margins are temporary in nature and not a new steady state.

OC was written up on VIC in January of 2007 as well. Interested readers would be well-served reading that as well.

Debt: $1.85B
Cash: $450mm
PV of NOLs: $700mm

Shares Outstanding: 131mm
Share Px: $20.6
Mkt Cap: $2.7B

Net EV: $3.4B
Normalized EBITDA: $911mm (D&A is $320mm and I estimate the EBIT per business unit below)
EV/Normalized EBITDA: 3.7x

Note on Buffett's early 2001 acquisition of Johns Manville ("JM"): This is a great comp since, when JM was acquired, it was in the same businesses with roughly the same sales mix. Unfortunately for current comps purpose, Buffett bought it out in early 2001 at a low multiple - 4.7x EBITDA and 9.3x earnings. It is worth noting that Buffett was buying peak margins, and it was more likely 6.5x - 7x normalized EBITDA margins. No doubt it was a great deal considering the stability of the aggregate businesses and Berkshire's cost of capital, but I think it was at a price significantly in excess of OC's current value. Note that the discussion below of JM's financials is limited to 1993 - 2000, the period when they were publicly available.

Insulation

OC's insulation business is currently in the midst of the worst downturn it has seen in the last 30 years, largely because the fall-off in housing starts is similarly bad. EBIT margins have been cut in half (from 22.9% to 10.4% for 9M07) as over-capacity has led to tougher price competition and deleveraging of the operating structure. Nevertheless, the insulation industry is concentrated-- OC, Certainteed / St. Gobain, and JM / Berkshire make up 80%+ of North American market share-- and, with OC's dominant position within the industry (majority share in North America), the business unit is well-positioned to weather the current significant downturn in its end markets. Overcapacity will diminish, and, as housing starts flatten and eventually increase, production slack will dissipate and historical margins will return.

Except for brief (1 - 2 year) dips, the margins for OC and JM seem to have varied between 16% and 22% for a long time, as can be seen from the 12 year table below. Due to both firms combining their other building materials businesses with insulation for the years not broken out below, it is impossible to accurately determine margins in the other years. However, looking back at JM's segment EBIT from 1991 it is clear margins probably dipped into the mid-single digits at the last major housing starts stumble.

EBIT margins for insulation companies
          OC      JM
1994              before this point insulation was combined with roofing.
1995              16.9%
1996              17.3% (pre-non-recurring charge)
1997              14.1%
1998              16.1%
1999              22.6%
2000              21.6% (first 9M)
2001 - 2003 not broken out
2004     20.5%
2005     21.5%
2006     22.3%
2007     10.4% (first 9M)

         OC Insulation Sales
2005     $1.98B
2006     $2.10B
2007     $1.76B (9M annualized)

As is apparent from the above numbers, there is strong profitability in the industry at levels above what might be expected in producing a commodity. There are a few reasons this occurs. First, OC has majority share in its industry and its two largest competitors are another 30%+ of the market. This is not a simple competitive market. Management talks about "disciplined" pricing within the industry - this is code for oligopoly pricing, i.e. where the prisoner dilemma of maintaining pricing does not suffer too much in the way of defections. Second, OC has trademarked Pink insulation, the color Pink, and licensed the Pink Panther. Because of their long-time dominant position, the typical consumer thinks of insulation as being pink, and this association strengthens OC's ability to sell insulation at strong prices. Finally, the distribution channels and relationships with retailers are very stable, once again due to the concentrated nature of the industry. Any movement is on the margin, and is less driven by pricing.

Management indicated late in November that capacity utilization is down in the 70% - 75% range, a level where price cutting does occur. According to management, 60% of 2006 sales were exposed to new housing, and new housing sales have been cut in half. How long it takes for sales to recover or for the leaders in the industry to shutter enough plants that capacity rises back to the industry target of low 90s is tough to ascertain. It is likely some mix of housing starts recovering a little (or a lot) and time passing. Nevertheless, this current dip in profitability should be met on the opposite side of the downturn by a fairly rapid snap back to high margins.

Since OC recently emerged from bankruptcy, we have the benefit of fresh-start accounting for the insulation segment assets. At $2.8B, the company's normalized $325mm EBIT (derived below) is not outlandish. This corresponds to an 11.5% ROA - strong, given the stability, but not incredibly so. It is a capital intensive business, and not one easily replicated. While undoubtedly a well-capitalized industrialist could build the necessary plants, supplanting OC's customer relationships and brand image would cost far more (or require cutting prices to a level where the EBIT generated did not generate attractive ROAs).

Insulation is under-penetrated in the US from the company's viewpoint, and this is likely the case. Energy, especially at current levels, is far more expensive as a long-term solution to our heating or cooling needs than insulation. Accordingly, the company continues to believe it can drive incremental sales through both new houses and replacement/remodeling.

While the next year or two will likely trend significantly below long-term averages, eventually margins are likely to recover to a level of 20% or slightly more as capacity recovers to mid 90s. Using a relatively conservative $1.8B normalized sales for insulation, and a 18% long-term average EBIT margin, we have a business generating $325mm EBIT with little to no reinvestment in the business and growing sales at GDP + 2% or so.

Roofing

Roofing is a pretty stable business. Generally, a house needs to replace its roof every 20 - 30 years, and once it needs a replacement economic cycles don't affect the decision to do so very much. In a strong housing market reroofing can go as low as 70% of industry revenues whereas in a slow housing market, reroofing can rise to 85% or more. Also, roofing companies tend to benefit from large hurricanes as that creates a lot of roof shingle demand (these companies did very well in 2005).

The roofing materials industry within the US is almost as concentrated as the insulation industry. The major players in roofing are OC, CertainTeed, JM, and GAF-Elk (private company with public bonds). From BECN's 10-K (a roofing distributor), the estimate of the residential roofing market was about $8.2B in sales at the supplier to distributor level in 2005. This year, we are likely at 85% of that (70% of sales in 2005 were reroofing while 30% new roofs -- new roofing has fallen in half), or $7B. Of that, GAF's annualized sales to residential roofers are running at $1.8B-ish, OC's annualized sales are running at $1.3B, and JM is probably around $800mm. These three make up more than half the residential roofing supply, residential roofing makes up 90% of OC's roofing segment.

OC, historically, has had more volatile and slightly lower margins than GAF and JM. Margins in roofing are primarily based on the price of inputs (asphalt, mostly, which is a petroleum by-product) and the company's ability to pass on price increases in underlying materials. Over the long run, past results imply it is probably conservative to assume a 5% EBIT margin with GAF and JM averaging closer to 7.5%. Obviously, there is an upside case to be made that OC will converge upon GAF and JM.

Sales have likely bottomed at $1.5B this year. I'll use $1.6B as a conservative sales figure for the roofing business to add $80mm EBIT.

Other Building Materials

The primary value in the other building materials segment is their Cultured Stone subsidiary, which creates manufactured stone veneer for the outside of homes. The manufactured stone industry is around $1B and growing at 10% - 20% annually, according to a company slideshow. Due to the cheapness, lighter weight, and design versatility manufactured stone is slowly taking market share from regular stone but still remains less than 4% of all stone veneer. Cultured Stone is a leader in the industry with perhaps $200mm in sales (unknown due to lack of segment breakout). Given the Other Building Materials and Services segment had $78mm in sales and $6mm in EBIT, I estimate annual EBIT at $20mm to $25mm and growing at 15%.

Composites

The composites section manufactures, fabricates and sells glass fiber reinforcements, mat, veil and specialized products worldwide that are used in a wide variety of composite material systems. Primary end uses are in the transportation, building construction, telecommunications and electronics markets. Many of the applications are customer engineered deals for various uses, which adds to customer lock-in and margins. In addition, due to the variety of applications, the globally distributed nature of customers, and OC's leadership position in many markets (especially with its recent acquisition), this business is very stable. In addition, due to the ongoing substitution of composites in for more expensive and less versatile substances (aluminum, steel, glass), this business grows at global GDP + a few percent. Finally, due to the rapid growth of China and India, and OC's strong positions in those markets, there is a portion of the business that will likely grow very quickly in the coming years.

The company announced at the end of October that, rather than creating a JV with Saint-Gobain's Composites business, it instead would acquire their composite business for $640mm. For the purposes of this write-up, I'm not going to include the pro-forma numbers as they haven't been well-disclosed by the company. Instead, I'll assume the value received by OC equals the $640mm cash they paid for it plus 1/3rd of their claimed synergies of $100mm annually (occurring over 4 years).

With above average growth characteristics including lots of international opportunity (global GDP + 1-2%), strong stable rising margins (10%) and $1.7B in sales pre-Saint Gobain purchase, EBIT is $170mm. Including the 1/3rd of claimed synergies, that rises to $203mm.

Corporate Expenses

Over the past few years, corporate expenses have been higher than they will be going forward due to bankruptcy expenses. If we go back a few years, it is easy to see unallocated corporate expenses should average $40mm, or less.

Summary
               Normalized EBIT
Insulation     $325mm
Roofing        $ 80mm
Other Building $ 23mm
Composites     $203mm
Corporate     -$ 40mm

Total EBIT     $591mm
Net debt exp -$108mm
Taxes       -$179mm
Net Income $304mm

16x Multiple $4864mm
NOL NPV        $700mm [I wonder what discount rate is being used for the $700mm number. Does anyone ever get full value for these things?]

Value         $5564mm
Shares out    131mm
Px per share $42.5 target price

Catalyst

Housing starts stabilize
Insulation industry rationalizes
Company post-BK numbers start showing up on screens

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			2007	2008
Price:	20.60	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	2,700	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT