Description
Thesis
USG Corp. (USG) exited Chapter 11 on June 20 and may be purchased for 5.4 x trailing EBITDA and 8.4x trailing earnings. Despite filing for bankruptcy twice since 1993, USG is an outstanding business. The company is a low cost, dominant wallboard producer with 30% U.S. market share. (USG is the larges of three companies which control 66% of the wallboard market in the US - the other two companies, National Gypsum and Koch Industries, are privately held). USG is also the largest wallboard distributor in the U.S. and the second largest producer of ceiling tiles for commercial buildings. Demand for USG’s products is likely to grow for the foreseeable future driven by demographics. USG’s businesses generate attractive returns on capital (~15% after tax, ~28% EBITDA/ capital) and feature high barriers to entry. In addition, an investment in USG includes a free option on asbestos legislation currently under consideration in the U.S. Senate: if the legislation is enacted by December 31, 2006, USG shares will appreciate by about 65%. This idea was previously written-up in March of this year by Sparky and in March of 2001 by Thomas – I will endeavor to add to their analyses and point out that USG’s shares are about 22% cheaper than they were when Sparky posted the idea last spring.
Valuation
The following shows our calculation of USG’s current market valuation.
|
(000) |
|
|
|
|
Shares outstanding, 8/2/06 |
89,849 |
|
|
|
Options outstanding, 6/30/06 (adjusted for rights offering) |
363 |
0.37% |
WASP= $33.15 |
|
Long-term incentive plan shares, 8/4/06 |
8,200 |
8.33% |
|
|
shares outstanding 8/25/06 |
98,412 |
|
|
|
Share price, 9/20/06 |
50.45 |
|
|
|
Market capitalization less tax refund |
4,964,891 |
|
|
|
Cash, post rights offering |
438,000 |
|
|
|
Debt, post rights offering |
1,650,000 |
|
|
|
Enterprise value, net |
6,176,891 |
|
|
The above enterprise value calculation includes a $1 billion term loan facility (LIBOR + 0.75%) and assumes that USG fully draws its $650 million revolver (LIBOR + 0.6%). USG also has a $1.15 billion tax bridge term loan facility (LIBOR + 0.75%) which will be used to finance a tax receivable from the U.S. government. We omitted the bridge loan from our enterprise value calculation because it will be a temporary component of the company’s capital structure.
USG’s Three Businesses
USG’s primary business is manufacturing wallboard, also known as plaster board or sheetrock. USG is the largest producer of wallboard with 30% of the U.S. market; wallboard represented 75% of USG’s 2005 operating income. Wallboard is made from gypsum and paper and is used in the construction of houses and office buildings.
Wallboard Markets
|
New residential construction |
47% |
|
Repair / remodeling - residential |
33% |
|
Repair / remodeling - non-residential |
6% |
|
New non-residential construction |
8% |
|
Exports & temporary construction |
6% |
|
|
100% |
USG is also the largest distributor of building materials in the U.S; it distributes about 33% of USG’s wallboard production and 12% of all wallboard used in the U.S. This business generates 18% of USG’s earnings. Finally, USG Worldwide Ceilings makes acoustical ceiling tiles used in commercial buildings; this business generates about 7% of the company’s earnings.
High Return on Capital
USG’s businesses feature high returns on capital. For instance, the following table shows that USG’s EBITDA return on assets for the 12 months ending 6/30/06 was 28%.
|
|
|
|
|
|
(000) |
6/30/06 |
|
Assets |
|
|
|
Cash |
663,000 |
|
|
A/R |
579,000 |
|
|
Inventories |
361,000 |
|
|
Other current assets |
156,000 |
|
|
total CA |
1,759,000 |
|
|
|
|
|
|
PP&E, net |
2,035,000 |
|
|
Goodwill |
105,000 |
|
|
Other |
182,000 |
|
|
total assets |
4,081,000 |
|
|
|
|
|
|
EBITDA (TTM) |
1,132,000 |
|
|
EBITDA / assets |
28% |
The company’s after tax returns are also high. Given its current capital structure, i.e., post chapter 11 and 524(g) payment, USG would have earned 15% after tax on invested capital during the twelve months ending 6/30/06. USG’s free cash flow exceeds its earnings. Since 1991 USG’s capital expenditures have totaled $2.56 billion while its depreciation and amortization totaled $2.14 billion – during this period, USG increased its production capacity by 55%. With these excellent returns, the question is: are these returns sustainable? USG’s earnings are cyclical and it generated record earnings over the last twelve months, but consider the following data:
|
|
|
USG wallboard shipments |
USG EBITDA |
|
No. of wallboard |
|
|
Year |
(000 sq ft) |
(000 $) |
EBITDA / sq. ft. |
producers 3 |
|
|
1993 |
7,300,000 |
333,000 |
$0.05 |
18 |
|
|
1994 |
7,700,000 |
384,000 |
$0.05 |
18 |
|
|
1995 |
7,600,000 |
394,000 |
$0.05 |
18 |
|
|
1996 |
8,000,000 |
446,000 |
$0.06 |
15 |
|
|
1997 |
8,400,000 |
574,000 |
$0.07 |
14 |
|
|
1998 |
8,800,000 |
689,000 |
$0.08 |
13 |
|
|
1999 |
9,200,000 |
920,000 |
$0.10 |
13 |
|
|
2000 |
9,300,000 |
700,000 |
$0.08 |
11 |
|
|
2001 |
9,900,000 |
232,000 |
$0.02 |
10 |
|
|
2002 |
10,100,000 |
391,000 |
$0.04 |
10 |
|
|
2003 |
10,400,000 |
342,000 |
$0.03 |
8 |
|
|
2004 |
11,000,000 |
640,000 |
$0.06 |
8 |
|
|
2005 |
11,300,000 |
875,000 |
$0.08 |
8 |
During the thirteen years shown, USG’s average EBITDA was $600 million. Since USG’s current enterprise value is $6 billion, does this mean that we are paying 10x likely future EBITDA? We contend we are paying considerably less than 10x forward EBITDA as follows:
1. USG sold more wallboard each year (with the exception of 1995) while the number of wallboard suppliers shrunk from eighteen to eight. Growing sales and fewer competitors is likely to lead to increased earnings.
2. USG was in Chapter 11 for 5½ of the 13 years in the sample – not the most conducive circumstance for maximizing returns.
To corroborate this line of thought, consider USG’s performance during the most recent business slowdown. Shipments of wallboard dipped from 1999 to 2000, USG’s shipments steadily increased. This happened as the number of wallboard suppliers fell from thirteen to eight. We draw the following two inferences from these data:
1. The amount of wallboard consumed in the U.S. generally increases each year (with occasional exceptions).
2. USG is a low cost supplier (it maintained or increased shipments while other suppliers dropped-out).
If these two inferences are correct, one would expect USG’s profitability to increase as it ships more wallboard and competes with fewer companies, i.e., USG’s future earnings are likely to be greater than its historical earnings.
Attractive Factors of Business
There are five factors which make USG’s wallboard business attractive to investors:
1. There is no viable substitute for wallboard. Wallboard offers excellent fire protection, low cost, ease of application and a smooth finished surface. Wallboard has unique fire protection properties due to the high kindling point of gypsum (it’s a mineral) and the ability of gypsum to store water which evaporates (keeping the board cool) during a fire. Regarding cost, USG’s average realized price for a ½ inch 4’ x 12’ sheet of wallboard was $6.91 during 2005 ($144 per thousand square feet). By comparison, 3/8 inch oriented strand board, generally considered an inexpensive alternative to plywood, averaged more than $300 per thousand square feet FOB mill during 2005. Wallboard also enjoys a cost advantage on an installed basis over all alternatives.
2. Most customers buy wallboard on short notice, precluding long distance shipping. As a result, most wallboard is sold within 500 miles of plant. This means that there is less opportunity for customers to arbitrage regional price differences.
3. Low-value to weight ratio and low-value to bulk ratio make wallboard expensive to ship. Wallboard is heavy and fragile (e.g., it is prone to cracking and, generally speaking, is not waterproof) which complicates shipping. For instance, a ½ inch thick 4’ x 12’ sheet of wallboard which sells for $6.91 and weighs 77 lbs. This works out to $197 per metric ton for finished wallboard. Raw gypsum is much less valuable: the average price for raw gypsum was $7.31 per metric ton during 2005, just slightly more valuable than crushed stone ($6.17 per ton). The combination of bulk, weight, low value and fragility mean that, in order to be competitive, wallboard suppliers need to have manufacturing facilities distributed across the country, close to sources of gypsum as well as customers. USG has such a network of facilities. In this way, the wallboard industry is similar to the construction aggregates (gravel, sand and crushed stone) industry.
4. Customer loyalty. Customers tend to purchase wallboard from local suppliers even when local prices are higher than in other regions in order to ensure supply when demand exceeds supply.
5. Demand for wallboard is likely grow. Much is made about the cyclicality of the wallboard business, the implication being that there is an optimal time to invest in a wallboard business based on where we are in the housing cycle or a forecast of when new wallboard production plants will be built. The problem is we know of no way to determine where we are in the housing cycle. While artificially low short-term interest rates in recent years contributed to real-estate price inflation, U.S. housing starts actually peaked in January 1972.
According the the U.S. Census Bureau, the housing stock in the U.S. grows, year after year. Is there any reason to believe that the housing stock will not continue to grow? The Census Bureau expects the U.S. population to grow from 300 million today to 309 million in 2010 and 336 million by 2020.
Given that population growth is likely to continue, it is reasonable to conclude that housing will continue to be built to meet the demand, not to mention repair and replacement of existing homes. The Joint Center for Housing Studies at Harvard recently published a study which postulates that the U.S. Census Bureau is underestimating the likely population growth due to increased immigration and concludes that net household formation during the next 10 years is likely to be 14.6 million verses 12.6 million over the last 10 years.
On the other hand, crowding in housing, i.e., more people living in less space, has been increasing in the U.S. for the last 25 years, a reversal of the previous 40 years. To the extent crowding increases, one would think that there will be less demand for new housing, ergo less demand for wallboard. Increased crowding since the early 1980s, however, has not seriously impacted the demand for wallboard. To the extent that the crowding trend reverses itself, one would expect even greater demand for wallboard.
We are not the sole observer that wallboard demand is likely to grow in the coming years. The wallboard industry is currently building about 6½ billion square feet per year capacity, a 17% boost to today’s capacity. Here are the mitigating facts:
1. The wallboard industry is currently running at 100% capacity utilization.
2. The new capacity is expected to come online over the next three years.
3. It is not known how much old capacity will be removed as the new capacity is added, i.e., the net new capacity is likely to be less than 6½ billion square feet.
4. During the last capacity expansion (late 1990s), industry capacity increased 30%; although USG had a few painful years, the business remained intact and EBITDA remained positive.
Chapter 22
If USG is such a good business, why has it filed Chapter 11 twice since 1993? The reasons that lead to each reorganization were unique, but in both cases corroborate our hypothesis that USG’s businesses are high quality.
In the first instance, USG’s high returns on capital and high free cash flow allowed management to diworsify into other businesses as well as invest in corporate jets and elaborate corporate headquarters. As a result, Cyril Wagner and Jack Brown bought 10% of USG’s shares and launched a hostile takeover in October 1987. USG outbid Wagner and Brown by offering $42 per share ($37 in cash and $5 in a pay in kind debenture) and spinning-off its A.P. Green Refractories business (valued then at $7 per share). To pay for this, USG management sold several subsidiaries (e.g., DAP, Masonite), sold the corporate jets and the corporate headquarters, levered the balance sheet and fired workers. The new capital structure featured $2.5 billion of debt which cost USG about $300 million per year to service. When the inevitable downturn came, USG was not able to meet its obligations. In March 1993, USG filed for Chapter 11. The company emerged from Chapter 11 on May 6, 1993 with $1.6 billion of debt, a junk rating and a new president, William Foote (currently Chairman and CEO). By 1997 management had paid down about $1 billion, achieved investment grade status while spending about $1 billion to upgrade plants and facilities. Foote has worked for USG for 22 years, as has Richard Fleming, the company’s CFO.
In June 2001, USG again filed chapter 11, this time in response to an avalanche of personal injury cases brought against the company because some of its products contained asbestos prior to 1978. The company emerged from bankruptcy on June 20, 2006 after agreeing to fund a 524(g) trust with $3.95 billion and paying all of its creditors 100 cents on the dollar, including accrued interest. The ability of USG to fund the trust and pay its pre-petition creditors in full is a testament to the quality of the underlying business.
Finally, as detailed in Sparky’s write-up in March, an investment in USG includes a free option on the passage of the FAIR Act, pending legislation designed to address asbestos liabilities currently being considered by the U.S. Senate. In the event the FAIR Act is enacted within 10 days of adjournment of the 109th Congress (roughly December 31, 2006), USG will not need to make the $3.050 billion contingent payment to the 524(g) trust (in effect, the U.S. government will make the payment). Considering that USG’s current equity value is $4.8 billion, one would expect USG’s shares to appreciate 65% if the FAIR is enacted by year-end.
Buffet
As of August 22, 2006 Berkshire Hathaway owned 16 million shares of USG, about 16% (on a fully diluted basis) of its equity. Buffet has been a USG shareholder since at least the fourth quarter of 2000.
During 2000, USG’s asbestos liabilities grew and its share price fell from $45 in January ($90 post rights offering) to less than $15 ($30 post rights offering) in November. Buffet filed a 13G on November 17, 2000 indicating that he had purchased 6.5 million shares, equivalent to 15% of the company at the time.
Having owned the company through its Chapter 11 reorganization, Buffet back-stopped the recent rights offering, agreeing to buy up to 45 million shares (50% of the re-organized company) at $40 per share. Net of the $67 million back-stop payment, his cost would have been $1.73 billion or about $38.50 per share if no one else exercised his rights to purchase shares at $40. As it turned out, almost all of the rights were exercised by their owners. Since the rights offering, Berkshire Hathaway has purchased about $180 million of USG shares. The following table summarizes Buffet’s recent purchases:
Buffet’s Recent USG Purchases
|
Date |
Shares purchased |
Price |
Value |
|
08/23/06 |
734,700 |
$45.90 |
$33,722,730 |
|
08/23/06 |
7,000 |
$46.03 |
$322,210 |
|
08/22/06 |
390,200 |
$45.97 |
$17,937,494 |
|
08/21/06 |
567,218 |
$45.92 |
$26,046,651 |
|
08/11/06 |
23,500 |
$46.03 |
$1,081,705 |
|
08/10/06 |
118,500 |
$46.01 |
$5,452,185 |
|
08/09/06 |
587,100 |
$45.98 |
$26,994,858 |
|
08/08/06 |
1,200 |
$45.81 |
$54,972 |
|
08/07/06 |
82,900 |
$45.80 |
$3,796,820 |
|
08/03/06 |
692,500 |
$45.46 |
$31,481,050 |
|
08/03/06 |
26,900 |
$45.71 |
$1,229,599 |
|
08/02/06 |
692,500 |
$45.46 |
$31,481,050 |
|
|
|
|
$179,601,324 |
While we do not recommend abdicating one’s investment decision-making to anyone, the inference we draw from Buffet’s recent purchases is that he believes that USG represents a good investment at the roughly the current price.
Wallboard Manufacturing Cost Structure
|
Gypsum |
20% |
|
Paper |
20% |
|
Natural Gas (2.2 mil BTU / 1000 ft2) |
25% |
|
Labor |
20% |
|
Overhead |
15% |
|
|
100% |
USG PP&E replacement value
|
25 |
Wallboard plants * |
2,034,000,000 |
|
7 |
Paper mills |
800,000,000 |
|
14 |
Gypsum mines |
irreplaceable |
|
|
|
2,834,000,000 |
|
* |
12 supplied in part or in full by synthetic gypsum. |
USG Wallboard Sales Prices
|
|
USG's average sale price |
Price / |
|
Year |
$ / thousand ft2 |
4 x 12 sheet |
|
1991 |
$72.53 |
$3.48 |
|
1992 |
$71.58 |
$3.44 |
|
1993 |
$79.07 |
$3.80 |
|
1994 |
$100.08 |
$4.80 |
|
1995 |
$110.44 |
$5.30 |
|
1996 |
$110.56 |
$5.31 |
|
1997 |
$122.65 |
$5.89 |
|
1998 |
$129.50 |
$6.22 |
|
1999 |
$153.40 |
$7.36 |
|
2000 |
$130.61 |
$6.27 |
|
2001 |
$85.67 |
$4.11 |
|
2002 |
$100.43 |
$4.82 |
|
2003 |
$101.43 |
$4.87 |
|
2004 |
$122.37 |
$5.87 |
|
2005 |
$143.93 |
$6.91 |
Source of Gypsum Imports
|
Canada |
68% |
|
Mexico |
22% |
|
Spain |
8% |
|
Dominican Republic |
1% |
|
Other |
1% |
|
|
100% |
Catalyst
time