Owens Corning (OC) exited Chapter 11 on October 31, 2006. The reorganization puts it in the hands of a group of extremely sophisticated distressed debt investors and at today’s price, is trading right at their cost basis. This price represents 6.1x trailing EBITDA and 1x post-bankruptcy book value.  What follows is an analysis of another compelling post asbestos bankruptcy idea akin to the GRA and USG writeups of last year.

 

 

At $28.50, OC provides the opportunity to invest alongside a smart list of distressed debt investors and the OC management team at their cost basis.  Having been in bankruptcy for the past 6 years, it emerged less then 3 months ago and has yet to draw the interest of Wall Street.  The company has not filed a clean 10Q, hosted only one conference call providing very little guidance, has no analyst coverage, and recently announced a major merger agreement for one of its divisions but has yet to disclose potential synergies or upside potential.  The company successfully navigated the bankruptcy process and now emerges with a clean balance sheet, completely absolved of its asbestos liabilities.  Owens Corning holds the #1 or #2 positions in the markets it serves, which while facing some short term headwinds, have extremely favorable long term dynamics.

 

For those that are more concerned about the short term dynamics of the housing industry, an alternative investment would be to purchase OC common stock and buy HGX puts.  As the tables at the end of the report show, approximately 40% of OC sales were into the US/Canada new residential construction market and this short position would provide protection against a worse then expected housing starts scenario.

 

In brief, the company entered bankruptcy in 2000 as a result of asbestos liabilities and emerged in October 2006.  Its Asbestos Trust received $4 billion and 28.2 million shares.  Other distributions include $2.4 billion to fully cover bank facility claims, $284 million to other creditors, 27 million shares to bondholders and a total of 25.3 million warrants to equity and other claim holders (with exercise prices in the mid-40s).  Funding was through cash on hand, a rights offering and borrowings.  A couple of interesting points:

 

Rights Offering:  Bondholders, including D.E. Shaw, Plainfield Special Situations, Quadrangle, Citadel to name a few, were offered the right to buy 72.9 million shares at $30.  Only 2.9 million shares were purchased.  However, the offering was backstopped by a JP Morgan syndicate for a fee of $100 million.  If you’re a bondholder and you want to participate, it makes sense to bypass the rights offering and participate in the syndicate because your share cost is reduced by $1.37/share (the $100 million is distributed pro rata).  It seems that this is exactly what happened – these bondholders bypassed the rights offering for the backstop syndicate.  The resultant current shareholder list consists largely of these distressed debt specialists.  At today’s price ($28.50) you can purchase the equity for the same price that they negotiated for during the bankruptcy process.

 

Insider Incentives:  2.7 million restricted shares (3 year vest) were granted to the company of which 2 million went to non-management employees.  Every employee received shares.  Options to purchase 2.1 million shares at $30 were granted as well which are slightly out of the money. 

 

The following post bankruptcy financials represent the valuation of Owens Corning:

 

The enterprise value doesn’t include the 7.8 and 17.5 million warrants exerciseable at $45.25 and $43 or the 2.1 million management options exerciseable at $30 since they are out of the money. 

 

The cumulative average growth rate of Owens Corning EBIT and EBITDA over the last 14 years is 7.4% and 5.4% respectively.  This time period includes both the early 90’s and early 2000’s housing market downturn so it is reflective of the entire cycle.  Of the 14 years, 6 were operated in bankruptcy.  Extremely favorable long term market drivers (detailed later) suggest that going forward, the company will at a minimum continue on this growth trajectory.  These include the trend towards building energy efficient homes due to growing energy concerns, and continued growth in the remodeling market as a result of unprecedented increases in housing starts beginning in 1992. The caveat is that the current housing slowdown will impact near term results negatively so growth will be bumpy.

 

Two hints on the company’s view of future performance.  The Disclosure Statement shows 2006, 2007 and 2008 EBIT forecasts of $600, $649 and $701 million although in its most recent conference call, management indicated those estimates are stale. Management estimated the present value of the $2.9 billion NOL on the latest earnings conference call which assumes a 10% discount rate, 35%-40% tax rate, and a 5-7 year NOL consumption time period.  Using midpoints of these assumptions implies $483 million of net/pretax earnings for the next 6 years or a price/forward 6 yr average earnings multiple of 7.9x.  OC emerges with $2 billion of debt costing 7% = $140 million of interest implying $623 million of EBIT on average, assuming debt stays at $2 billion, over the next 6 years.  Since maintenance capex is equal to or less then D&A you are paying 8x the forward 6 year average free cash flow of the company or a yield of 12.5%.

 

There are few comparables to Owens Corning.  Johns Manville is the company’s largest and most similar competitor and was taken private at an amazing 4.7x EBITDA by Warren Buffett in 2000 (9.3x earnings and 1.9x book value).  This multiple is not a great comparable because ~80% of JM shares were owned by its Asbestos Trust which was extremely motivated to liquidate at the time.  That guy Buffett is smart… imagine how much money he’s made owning this through the current housing boom.   

 

ElkCorp competes directly with OC in its Roofing/Asphalt business (~30% of OC revenue and 25% of EBIT).  The Carlyle Group and Building Materials Corp. of America are in a bidding war for the company and the latest $43.50 offer for the company values it at 13.3X TTM EBIT.  ELK sells higher margin laminate shingles as opposed to the more standard, lower margin 3-tab shingle that Owens Corning primarily produces.  ELK’s EBIT margins average around 8% whereas OC averages <6% for the comparable division and 7.4% for the business overall.  ELK is also much smaller (~$1 billion in sales versus $6.6 billion for OC).  So ELK probably deserves a higher multiple then OC but the gap seems excessive.

 

 

Thermal Insulation:  Their biggest business and most profitable by far.  30% of sales and 60% of profit (including the allocation of corporate overhead) as EBIT margins are over 20%.  They hold the #1 market position in a highly concentrated market.  OC has high brand recognition as they hold exclusive license to the Pink Panther character from MGM studios and are the only company allowed to sell fiberglass insulation that is pink.  Pricing is historically stable (http://data.bls.gov/PDQ/outside.jsp?survey=pc - use Industry # 327993) and volume is driven mainly by new housing starts at a 3-4 month lag since insulation is one of the last items to go into a home.  The slowdown in housing starts starting in the 2006 summer began to hurt volumes in the latter part of Q3.  The housing start slowdown has continued through 2006 although in the short term, for reference, the official NAHB forecast calls for a bottoming out of starts in Q1 2007 and an average housing start figure of a very healthy 1.846 million from 2006-2015 (2006 housing starts were 1.8 million). 

 

The long term trend for housing is extremely favorable and has been discussed in other reports such as the USG writeup by Chris815.  I encourage the reading of this report for more detail.  Production levels over the next decade will exceed the previous decade average according to the long term forecast of the NAHB.  Key factors include the coming of age of the echo boomer population (born in the 80s and 90s) and the continued impact of immigration.  In addition, houses are getting bigger.

 

New housing is definitely the key for this business.  However, another very important growing trend is the use of insulation to offset the rising costs of energy in the home.  Space heating/cooling accounts for 45% of the average homeowners utility bill according to the DOE’s Annual Energy Outlook (http://www.eia.doe.gov/oiaf/aeo/).  In 2005 the US DOE introduced the Energy Policy Act which calls for tax credits for homeowners (up to $500) and builders ($1.80/sf) who use energy efficient products such as insulation.  One of the most cost effective ways to reduce energy consumption in the home is to maintain proper insulation levels (R-value).     

 

Roofing/Asphalt:  ~30% of sales and 20% of profit (including corporate overhead allocation) with EBIT margins in the mid-single digits.  They are #2 in asphalt shingles (behind GAF Materials Corporation).  Volume is driven mainly by remodeling expenditures and natural disaster frequency/severity.  Margins are affected by the price of asphalt which has been extraordinarily high and recently, only partially recovered through price.  Thus Q3 2006 EBIT suffered a bit and the lack of natural disasters in 2006 (the weakest storm season in the last 20 years) has and will make things worse for the next quarter or two as high cost inventory needs to be reduced.  However, roofing replacement occurs every 15-20 years due to wear and tear making the long term prospects of this division very solid.  The near non-stop acceleration in housing starts that began in 1991 grows the stock of aging homes that are candidates for reroofing/remodeling and the roofing/asphalt division will be a direct beneficiary.      

 

Note that remodeling expenditures are much steadier and less volatile then new residential construction/housing starts.  They move together but remodeling exhibits lower amplitude up and down. Remodeling has grown 5.6% annually on average since 1995 according to US Census data (http://www.census.gov/const/www/c50index.html).  This is expected to continue in the long term as a result of record levels of homeowner equity, the continued growth/aging of the housing stock and the rise in homeownership rates.  Again, as a reference I cite the NAHB short and long term forecast for remodeling which calls for 4.3% growth in remodeling expenditures in 2007 (versus a fall in housing starts) and an average annual growth rate of 5% through 2015.  Slow steady growth in remodeling supports this business line over the long term. 

 

Other Building Materials and Services: ~20% of sales and low single digit margins.  This is an assemblage of small business lines such as vinyl siding, manufactured stone veneer, and services.  The company views this entire business segment as a line of incubation businesses that it will experiment with.  It’s relatively small and less important although the stone veneer business seems to show some promise and the company has indicated it expects better results out of the division going forward.

 

Composite Solutions: ~25% of sales and 20% of EBIT (including corporate overhead allocation).  This primarily consists of the sale of fiberglass reinforcement materials that go into composite systems (i.e. car doors, boat hulls, skis, etc.). OC is the market leader.  Volume is driven by global economic activity generally exceeding world GDP by 1%-2%.  This business sells into the commercial/industrial market and is largely international.  Pricing has been affected negatively by capacity increases out of China although the trend is not expected to continue as higher raw material costs have eroded margins.  EBIT Margins in the high single digits are a function of pricing, raw material costs and productivity gains.  The company believes there is ample room for EBIT margin improvement.

 

A large part of this margin improvement plan centers around the Q3 announcement that the composite business is being merged with Saint-Gobain’s Vetrotex division (the #2 player in the market).  This brings synergies that haven’t yet been formally defined but surely will include cost reductions and sales opportunities.  The company is targeting double digit margins but hasn’t been specific about its expectations.  The business will initially be structured as a joint venture where OC will have a call option on the Saint-Gobain share exerciseable in 4 years.  It will be a $1.8 billion company with 10,000 employees (owned 60% by Owens Corning) with operating leverage opportunities.  OC will discuss its outlook for the JV more fully on the next earnings conference call or shortly thereafter (note: no formal agreement has been signed yet).

 

Current prices offer an attractive entry point from an absolute and relative value perspective and allow for investment alongside a sophisticated group of distressed debt investors at their cost basis.  Short term headwinds and Wall Street unfamiliarity create an opportunity to purchase a market leader at inexpensive prices.  OC’s businesses have favorable long term prospects which provide the foundation for solid revenue and profit growth in the years to come.