Description

My sincere thanks to Vincent975 for posting GRA here last week and getting Club Members in the asbestos frame of mind. I believe that US Gypsum, USG, is also a compelling investment, though different in many ways from GRA.

USG is the leading low-cost manufacturer of building materials, especially wallboard and ceilings, via North American Gypsum and Worldwide Ceilings, respectively. USG also has, or rather had, a huge asbestos liability. After long fighting the trial lawyers on their asbestos issues, USG announced on Jan 30th, 2006, that they had settled their asbestos liabilities, via a 524g plan. The settlement was interesting in many ways. First, was it’s two-tier outcome structure. The 524g Trust will be funded with $900M in cash and a Contingent Note for another $3.05B. The contingent payments would be paid as follows: $1.9 billion due 30 days after the adjournment of the current session of Congress, and another $1.15 billion due six months after the adjournment of Congress. However, if before the adjournment of the current session, Congress passes legislation establishing a national asbestos personal injury trust fund, such as the FAIR Act (Senate Bill 852, The Fairness in Asbestos Injury Resolution Act of 2005), the contingent payment note would be cancelled and no additional payments would be made, unless that legislation is later found unconstitutional. The creation and funding of the 524g trust would trigger significant tax refunds. Additionally, if, FAIR does pass, then the fact that USG used the 524g structure means that plaintiffs can’t come back to them later if the FAIR fund falls short. A very clever settlement that gets cleverer.

To fund the settlement, USG will do a Rights Offering for stock at $40, backstopped by their long-time investor and advisor Warren Buffet of BRK. More on WEB and the RO later.

Assuming FAIR does not pass in time to help USG (though there’s about a 10% chance it could pass, but I will assume it won’t for our purposes), I am modeling that USG will exit BK and 2006 with no debt and about 89M shares out, and come up with an EV/EBITDA valuation.

Q4 2005 EBITDA, per 10-K: $264 million, and growing.

2006 EBITDA: $1,100 million (remember no taxes to pay in 2006 because USG did not have enough tax capacity to cover the entire 3.95 billion)

2007 EBITDA $1,100 million (I think it will be higher but let’s assume no improvement due to cyclical slowdown in residential new construction – partially offset by increased commercial construction and continued post hurricane rebuilding).

To determine Value we must look at Enterprise Value and subtract debt, so let’s look at USG’s debt as of 12/06:

Net Cash after all 524g settlements (all figures in millions)

Credits
$1,500 cash at 12/31/05
$1,800 rights issue
$1,100 Tax refunds
$1,100 2006 Cash generated (remember no taxes to pay)
$5,500 Total Cash in

Debits
$ 900 first 524g payment
$1,400 pre-petition creditors + accrued interest
$ 67 BRK underwriting premium
$1,900 second 524g payment
$1,150 third 524g payment
$5,412 Total Cash out

So, assuming no debt, and, if we assume an 8X EV/EBITDA multiple, then a post-rights USG is worth $99 per share. However, we are buying USG stock now WITH RIGHTS. If the rights are worth parity, then they are worth $59, so the current USG should be worth $158 per share.

Well, hold on Sparky, how do you know an 8X multiple is reasonable?? Looking at some multiples for some USG close competitors like Masco, Vulcan etc and they were in the 8-11X range, and USG is a debt-free, low-cost, dominant producer. The St. Gobain/BPB deal was at 9.1X prospective EBITDA, not trailing. Clearly, one can fiddle with the variables and get somewhat different outcomes. Assume there is a little debt and it lowers the equity valuation a little. Assume a higher multiple due to USG’s dominant position and low-cost structure and the valuation will be higher.

Well, ok, but we’re all sick of “valuation as a catalyst” arguments. What else ya got for us? Well, how about Warren Buffett? The USG poison pill was altered to exempt WEB during the Rights backstop period, but not anyone else. WEB has agreed to buy all stock at $40 that is not taken up by the rights offering. In other words, all unexercised rights will mean that Buffett gets to buy stock at $40 that is exempt from the PP. Many of us think that this means Buffett can go buy rights in the open market and simply not exercise them; he’ll buy the stock anyway at $40 and this allows him, and only him, an end-run around the PP. Amazingly, even if FAIR passes, the RO will proceed….. I am very sympathetic to this thesis as management obviously loves WEB and would love to see him as an even larger stakeholder. Imagine the joys of having a huge smart patient shareholder who doesn’t care about your quarterly numbers and allows you to run the firm for the long term; as Buffett has enabled them to do thus far. In fact, this coziness with Buffett is my one real concern. I think mgmt’s guidance is woefully conservative on the EBITDA and CapEx front. This conservatism would certainly play to Mr. Buffett’s favor if he were looking to buy stock on the cheap. I think mgmt, and shareholders generally, feel a great debt to Mr Buffett for standing by them through all this.

For you option aficionados out there, this deal offers some fun. The Rights will be part of the USG options deliverable, but only until the Rights expire. Thus, calls exercised before the rights expire get the rights. Puts exercised afterwards don’t have to deliver them. Check out the option pricing, but take some advil first! In addition to recommending an outright purchase of the common, I am also recommending the purchase of the August calls. We own Aug 100’s and 105’s. If I am correct in my argument that emergence from BK, Buffet’s buying and the impending completion of the recapitalization from the rights offering will drive the stock to an 8X multiple, then these calls will be huge winners. Additionally, I am recommending, for more adventurous Members, the sale of the August 90 puts. If, for some reason the rights expiration is delayed beyond the options expiration, these will be a big winner even if the stock doesn’t scream.

While I am quite confident that longer term USG will prove to be a great investment, my one other concern with the short-term options trade is that the great WSJ sell-side machine will not be engaged. USG and WEB have financed this restructuring entirely alone, without using Wall Street to float a massive secondary. Thus, the machine doesn’t have the usual incentive, as it did with say TYC, to run the stock afterward. I am fairly confident that, even should WEB prove to be passive in buying the rights, that the stock will reprice just from the impending completion of the restructuring alone. This was the case with NTLI a while back. Stock went ex-rights…..and went up. A lot. (A lot of options guys got scorched in that one, as has happened here already, and may still again.) It wouldn’t surprise me if someone made a run for USG soon after their emergence and restructuring. There is a cornucopia of LBO money out there craving a decent return. The corporate bond market is exceedingly favorable right now.

In conclusion, I think that as USG moves closer to the Rights period, the stock will firm up. I think that once it goes Ex-rights it will soar.

Catalyst

Exit from BK
Rights offering/restruct
Buffett Rights buying
Possible take-out