Two years ago I wrote on the building materials company USG Corp. (NYSE:USG) and the primary risk facing the company – bankruptcy. The company was losing upwards of $200 million and its cash reserves and credit revolver would only hold up for so long in an environment with such red ink. Fast forward to today and the company is on track to make $100 million for the year.
Today the risk of bankruptcy has been diminished dramatically and other risks are presenting themselves. The company recently announced a joint venture with the Australian building materials company Boral (BLD). The terms of the deal would call for USG to contribute $500 million and an additional $75 million if certain profit benchmarks are hit. Last year the company expanded to Oman to form a joint venture with an Omani company to sell sheet rock to India.
To the Risk of Write-Downs
What really concerns me about this expansion internationally is that it is completely unnecessary. USG’s U.S. operations will likely experience tremendous, if not very good, growth in the coming years and that would be comparable to anything the company could generate in even a fast-growing Asian country (fast-growing yesterday that is).
As the company has noted in press releases, the motivation to expand internationally is to “diversify earnings/revenues.” The motivation to expand internationally should be to earn comparably high returns on capital, especially not less. If this expansion abroad leads to diversified earnings and revenues at the expense of returns to equity (in the long run) it would be a terrible disaster and one in which some portion of that $500 million will be written down, sapping the high-quality earnings in the U.S.
I’m reminded of a story about diversification recanted by Warren Buffett in a shareholder letter (I’m not sure which one, but it is also found in Essays of Warren Buffett):
“The business he grew up in was a fine one, with a long-time record of leadership in its industry. Its main product, however, was distressingly glamorless. So several decades ago the company hired a management consultant who naturally advised diversification, the then-current fad [little has changed apparently]. Before long, the company acquired a number of businesses, each after the consulting firm had gone through a long and expensive acquisition study. And the outcome? Said the executive sadly, ‘When we started, were getting 100% of our earnings from the original business. After ten years we were getting 150%.’”
It could very well be that this foray abroad may turn USG into a multinational building materials company much like Lafarge or even Boral. It could also be a disaster and one that is banking on continued, but questionable, break-neck growth in Asian countries. Brand awareness of USG Sheetrock is likely not as strong abroad as say a Coca-Cola or Ford would be. Nevertheless the quality of wallboard coming from USG is certainly on another level compared to the hazardous wallboard coming out of China. In the conference call, USG executives said the company will bring to the joint venture its technical capabilities. They also hinted that they should be able to grow their joint compound business in this international venture. USG holds a greater market share of joint compound in the U.S. than that of even the sheetrock market share. The company also plans to push its lightweight portfolio of sheetrock which is currently driving more than 50% of its sales in the U.S.
To Hold or Not to Hold
In spite of the company’s moves abroad the U.S. operations are going to continue growing. At today’s valuation of some $3 billion the company is hardly overvalued, but it will have to show some serious profits if it is to go much higher. House prices continue to increase in the U.S. and inventory continues to fall, so it’s increasingly making economic sense to build homes. It’s hard to say what kind of earning power the company will generate when housing starts pick up to 1.2 million, 1.3 million, 1.4 million in a given year, it will depend on pricing. Already sheetrock prices are firming up even though so little sheetrock is getting produced and that’s certainly a good sign for USG shareholders.
But the decisions made at the executive level will impact shareholders just as greatly as any macroeconomic tailwinds. Write-downs are real expenses; you need to go no farther than the HP shareholder to know how devastating they can be.
Disclosure: Long USG