Description

USG

Overview:

USG (USG-NYSE $15.55), previously U.S. Gypsum, is a basic materials holding company at a low point in its stock-price cycle. USG is undervalued at present prices, as investors have priced in a slowing economy with lower wallboard prices and near-fatal asbestos litigation exposure. The company is currently priced low enough that anything short of cataclysmic legal setbacks in the near future ought to allow for developments to unfold “better than expected”.

Background:

 USG Corporation is a leading manufacturer and distributor of building materials producing a wide range of products for use in new residential, new nonresidential and repair and remodel construction, as well as products used in certain industrial processes. USG's operations are organized into three operating segments: North American Gypsum, Worldwide Ceilings and Building Products Distribution.
 USG is the lowest cost producer of wallboard, has the highest market share (30%), and its brands (Sheetrock, Durock) are also recognized as highest in quality.
 USG has asbestos litigation exposure relating to joint compounds (a small part of the business) it manufactured until the early 70’s.

Valuation Metrics:
Ratios Current 5 Yr Range
P/B 1.44 NM-17
P/S 0.19 0.16 - 0.85
P/CF 1.92 1.6 - 8.0
P/E NM NM-9
P/Cash 10 8 - 32
Debt/ Cap 69% 19% -94%
Mkt Cap $668 MIL. $600m -$3b

Fundamental Situation:

 Wallboard prices have fallen about 40% from Q4 ’99 peaks of $150 (per msf) to $90. The company estimates that each $10 drop in prices reduces op. net by $90-100 mil.
 USG has upgraded its production portfolio by bringing online new facilities and retiring older, less-efficient plants. Competitors have also brought on new capacity and not retired some plants. Industry capacity is up 10% vs. a year ago.
 Wallboard production is energy intensive. Higher natural gas and electricity prices (USG has a proportional amount of facilities in California) have squeezed margins, even though they hedge 60-75% of their needs annually.
 USG took an addl. $850 mil. ($19.58/shr) charge for asbestos liabilities in Q4 ‘00.

Recent Developments:

 USG and fellow members of an asbestos producers’ legal consortium agreed to disband a common settlement pool, reasoning it had attracted excessive numbers claimants and was not successful in reducing legal costs.
 Several public companies with asbestos litigation exposure (Armstrong, Owens Corning) have sought Chapter 11 relief and others (W.R. Grace, Federal Mogul) have publicly acknowledged the possibility.
 As the bankruptcy dominoes fall, a “last man standing” mentality has seized investors. As the number of available pockets to litigants is reduced by the filings, those companies remaining are feared to have to shoulder an increasing burden.
 Warren Buffet has filed (11/00) as owning 15% of the outstanding common of USG, with acquisition costs approximating current USG share price levels.

Analysis:

A “perfect storm” of negatives has converged on USG over the last year. Wallboard and energy prices have moved in opposite directions, negatively affecting margins to a degree not seen in years. However, energy prices have steadily receded from January’s levels and an accommodative Fed will eventually spur more demand. USG can handle a low-price environment better than competitors and high cost capacity will be removed. Along with Fed-induced demand, wallboard prices will firm.

Catalyst

The real story on USG valuation is asbestos liability. Make no mistake; improving margins could be ignored by the markets as investors focus on the asbestos liability area. Ironically, this is the one item that I believe offers the single best reason to own USG at these prices. In early 2000, Justice Dept. actions, the legal climate, and sentiment toward the tobacco companies seemed to offer almost no hope and reasoned commentators even discussed bankruptcy for MO and RJR. However, this was the absolute best time to BUY and these issues ended up posting some of the best gains anywhere for 2000!

 Asbestos makes did not conspire to hide evidence of health risks and ceased production entirely in the early to mid 1970s as scientific evidence was established.
 Current plaintiffs like USG did not manufacture large amounts of asbestos, and it was not a meaningful contributor to their profitability.
 The asbestos settlement group has been disbanded, shutting off the spigot of easy money to plaintiffs that in recent years haven’t even had to prove any harm or disability. USG has indicated that it will more actively contest future claims.
 The new Bush administration can be expected to set a more business friendly tone through its regulatory actions and judicial nominations.
 A gradually more-conservative judiciary could be expected to make it more difficult for plaintiffs to win awards out of context from actual harm and damage.
 An economic downturn could also help turn the political tide by forcing the discussion in the public forum to weigh the relative merits of eliminating today’s jobs (and firms!) to pay for ever more dubious asbestos claims.