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The Long-Term Approach to USG

Josh Zachariah

Josh Zachariah

38 followers
When asked what stocks I’m invested in I tell people it’s between two; Wells Fargo and USG, with the greater half being in USG. Most people have never heard of the company and when I say sheetrock they become more vexed as to why I have any money in the company. The answer is quite simple though, the business isn’t going anywhere.

I try to contrast the stock with that likes of Apple. Apple, for one, is a great company. It holds an incredible brand, churns our returns on equity well in excess of 20% with profit margins also in excess of 20% and very little debt to show for. However its success is relatively recent. If you dig bag 5 years you see profit margins of 10%, in 2002 it was 1.1%, their best year in the 90’s was an average 9.8%.

The question for Apple shareholders is will the decades of the 2010’s be more like the 2000’s or 1990’s? It’s very difficult to tell as the technology business is highly competitive and market leaders change with haste. I would gladly accept any of the profitable decades USG has had at today’s stock price. There will be cycles in the housing market and many of the problems in the past such as asbestos and leveraged buyouts are unlikely to be repeated again.

The sheetrock business though less exciting and not endowed with incredibly high margins is hardly one that will see such dramatic changes. USG is the market leader in sheetrock and has been so for many decades. It holds about a 30% market share in sheetrock industry and has not seen marked shifts outside that figure. Firms that retain market share over time convey monopoly power. Intel and Microsoft had once held a firm grip on the hardware and software markets for many years as their large market shares changed very little during their reign (they still have a decent grip at the moment).

By contrast the smart phone market in which Apple competes shows a very competitive market. Nokia, which once reigned over the cellular phone market, has seen its market share drop from 40% to just over 10% in a year’s time. Google has catapulted itself up by leveraging the android operation system across many carriers. These kinds of rapid shifts don’t bode well for the underlying competitors. Research in Motion’s dramatic fall is equally indicative.

I feel much more confident projecting where the sheetrock industry will be in 10 years rather than what kind of technology people will be using. Houses are going to be built with sheetrock and new sheetrock companies are not going to sprout up over night. In fact the market has grown consolidated as it has contracted from 20 to 8 companies over the last 20 years.

The main concern is can USG sustain more bloodletting to its checking accounts and make it out of the housing downturn? The free cash flow loss in 2008 was $403 million, there was a gain of $95 million in 2009 and a loss of $133 million in 2010. These figures are more important to its viability than earnings right now because of the non-cash expense of depreciation that is written off earnings. Depreciation is a real expense, but the company has the liberty of idling old factories and ones that may need investment as it only operating at 50% capacity. Capital expenditures which show up in free cash flow will likely be much higher in future years, but that outlay can be deferred at the moment.

The company has in excess of $700 million in cash and guaranteed credit lines available to it. This would sustain losses like it has for a several years. The company could tap bond markets should it need especially if the Fed is going to follow through with lowering long-term rates. But given further idling of plants and other cost-cutting the company is pushing towards profitability whether or not demand returns.

I’m not expecting a quick buck on this stock, time will be the friend of the USG shareholder, hopefully just not too much of it.

Disclosure: Long USG

Josh Zachariah

About the author:

Josh Zachariah
I credit my father and Warren Buffett for molding me into the investor I am today.

Rating: 3.2/5 (25 votes)

Comments

Topwine
Topwine - 3 years ago
Nice article !

Jonathan Poland
Jonathan Poland - 3 years ago
Hope this is a new position. It's brave to get behind it considering the housing market may not come around for 5 years or more.
alleygator
Alleygator - 3 years ago
It's gone bankrupt / insolvent twice in the recent past, and I seem to recall that it needed a Buffett lifeline back in 2008 / 2009. I'm not sure what sort of preferred status Buffett got to protect his investment.

My worry would be another bankruptcy or restructuring. Could you elaborate on these "guaranteed credit lines" that you mentioned.

I want to believe...
Josh Zachariah
Josh Zachariah - 3 years ago
Thanks for your guys' comments. Jonathan, I do think 5 years to be well outside estimates for the housing recovery. From what I've read 2013 appears to be when housing should be recovered. 5 years is certainly a possibility but worse case scenario. The housing market has been in recovery mode as early as 3 years ago when housing starts fell off a cliff. Whatever excess housing was produced in the mid 2000's has since been corrected by a collapse in production. There still is excess inventory, but I think the ails of housing at the moment are more the result of high unemployment and the lack of demand because of it.

Alleygator, the company has gone bankrupt twice in 2005 and 1993. The first was related to a leveraged buyout in which interest payments back then were even higher than they are today. In 2005 they went through bankruptcy to purge the asbestos claims. Berkshire Hathaway had set up a trust of $5 billion to handle all future claims. The guaranteed credit lines is a revolver that would charge 3% above LIBOR. These work by having the company borrow and return money as needed and having the funds secured by receivables. Here's a quote from the CEO in the conference call regarding it:

Josh Zachariah
alleygator
Alleygator - 3 years ago
Thanks for the answers.

The guaranteed credit line makes it sound bullet proof! If so, easy buy. What do the spooks say are the downsides and risks, besides waiting for the housing recovery?

The quote didn't post. What's the gist of it?

Josh Zachariah
Josh Zachariah - 3 years ago
Here's the quote:

“Turning now to cash and debt, we are very satisfied with our liquidity position. You can see the numbers in our financial statement. At June 30 (2011), we had cash, cash equivalents and marketable securities of $725 million, and we had nothing borrowed on our revolving credit facility. When you include the borrowing capacity on our credit line, we had total liquidity of $923 million.”
tonyg34
Tonyg34 - 3 years ago
Josh, food for thought.

Interesting investment thesis, but couldn't you make the exact same arguments for owning Vulcan Materials, Cemex, Masco, or Martin Marietta? I would think that the economic moats around cement and aggregates would be far more sustainable than sheet rock because of the cost of moving materials over large distances. Further, except for CX, these companies pay a dividend while you wait for the recovery.

So there you have my counter point. Using the same investment thesis of a rebound in housing as a catalyst, we can easily identify other companies that are just as depressed due to the downturn in housing. Those other companies have a stronger moat due not to operational efficiencies (which is USG's main advantage) but price barriers, they pay dividends, and they have more pricing power in regards to inflation because the switching costs to truck in materials from a further away supplier is higher than the switching costs of gypsum or floor tiles from another supplier.

Josh Zachariah
Josh Zachariah - 3 years ago


Good point Tony. Those cost advantages are similar for cement and other heavy industries, but in the case of cement it is a much more fragmented industry where the top 10 firms account for 30% of the market (see Eagle Materials (EXP) 10k). In the case of USG the company alone accounts for 30% of the sheetrock market so competition dynamics are certainly different.

I have looked at Eagle Materials (EXP) which is the other publicly held sheetrock producer, but it's primary source of revenue is still cement. The company does appear to have had better margins than USG, but they don't separate out cement from sheetrock. The company has also sustained profitability throughout the recession and perhaps it is worth looking into. I have to say though, having the company of Warren Buffett as a fellow shareholder makes me that much surer about investing in one of the more commoditized businesses.

Josh Zachariah
alleygator
Alleygator - 3 years ago
For what it's worth, Prem Watsa is also a USG shareholder, and the Bill Gates foundation took a recent small position in CX.
luishernadez
Luishernadez premium member - 3 years ago
Hi Josh,

Once the housing market recovers, what are your estimates for Revenues, EBIT and FCF for USG? What would be a conservative estimate for normalized Earnings Power? How about ROE?

Berkshire owns around 16% of common and has convertible debt that is worth around $300 million. Fairfax has around 6,5% of common and has convertible debt worth around $150 million. Prem Watsa has spoken very well about USG in past letters. Buffett has mentioned USG´s moat.

My difficulty is estimating its Earnings Power, due to its inconsistency in the past and the cyclical nature of the business.

Luis
Josh Zachariah
Josh Zachariah - 3 years ago
Hey Luis, its above me to determine a figure for revenues and earnings next year or a couple years down the line. I did assemble a spreadsheet of past income statements dating back to 1993 that can be found here. Their 2005 earnings look very ugly because of the large asbestos expenses, which of course are a one time event. The company did average just under $200 million in earnings before taxes for the past 15 years if you neglect the $3 billion asbestos bankruptcy. I provide earnings before taxes because the company does have some $500 million in tax deferred assets which will alleviate future tax concerns.

I have discussed USG more thoroughly in other articles here. I just find attaching hard figures very difficult for this company as it is highly cyclical.

Josh Zachariah
luishernadez
Luishernadez premium member - 3 years ago
I understand all the potential and positives in the thesis. The could earn around $150-$400 million, which would translate to $1.500-$3.200 million market cap (assuming a PE of 10 and 8), which is an upside of 2-4 times.

What I worry about is the downside, them continuing to lose money (FCF negative) for the next 3-4 years. This would be if the housing market takes longer to turn, of course. I guess with such upside, we could handle some share dilution (common stock issuances) from Berkshire and Fairfax (most probable candidates). Another posibility would be that Berkshire buys it outright, with the risk being the price paid of course (if it is lower than $7/share). Do you have an estimate of how much more could they lose of the next couple years if the environment kept negative?

Another positive are the NOL´s (operating loss carryforwards), which you mentioned are $500 million. At the begining of the year they were $1.200 million. I believe this asset is not on the balance sheet, so as soon as they start making money this asset will go on the balance sheet, impacting positively the Net Income and the Shareholder´s Equity.

Any other ideas?
Josh Zachariah
Josh Zachariah - 3 years ago


Cash Flow Statement (USD)

Annual | Quarterly
FISCAL YEAR ENDING31-DEC

2001
31-DEC

2002
31-DEC

2003
31-DEC

2004
31-DEC

2005
31-DEC

2006
31-DEC

2007
31-DEC

2008
31-DEC

2009
31-DEC

2010
Net Income16.0M-53.0M106M312M-1.45B288M76.0M-463M-787M-405M
Depreciation107M106M112M120M125M138M176M182M203M178M
Deferred Taxes134M67.0M59.0M49.0M-1.26B1.20B4.00M-111M453M-9.00M
Change In Working Capital-53.0M113M-60.0M-63.0M-28.0M-1.10B1.05B-17.0M226M65.0M
Other Non Cash Operating Items33.0M116M16.0M10.0M3.11B-4.22B5.00M244M44.0M77.0M
Cash From Operations237M445M249M428M506M-3.70B1.31B-165M139M-94.0M
Capital Expenditures-109M-100M-111M-138M-198M-393M-460M-238M-44.0M-39.0M


I'm also concerned about free cash flows, more so than earnings. Cash flows will determine whether or not the company will need to shut down. But as you can see, even in 2009 the company did squeeze out a positive free cash flow of $90 million. Most of that is the deferred taxes, but the contracting cap ex and the net loss which is declining are both good signs.
ASTA83
ASTA83 premium member - 2 years ago
Thanks for the article.

As a shareholder at $10.30 in the summer and down to 6 then up to 14 i hade quite a ride.

Sold today at $14.00 will make me sleep better at night.

Cheers.

ASTA

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