The sheetrock manufacturer USG has recently seen a pop in its share price as Warren Buffett (Trades, Portfolio) exercised his convertible bonds on the company. Buffett’s $300 million loan to the company in 2009 came with a convertible price of $11.40 per share. Confusion has ensued as investors speculators and the media are led to believe Buffett is taking a new stake in the company. The stake is hardly new and there was very little doubt this option would be exercised especially as it was one of the most lucrative deals Buffett had made during the crisis.
While this may bring good PR to USG as Buffett now has ever greater control on the business, financially the transaction is a negative to shareholders. Investors would have been better off had Buffett taken the company’s offer of 105% of the debt he was owed. Instead Buffett was awarded 21 million new shares and along with Prem Watsa (Trades, Portfolio)’s conversion the company now has 137 million shares outstanding.
Ordinarily this kind of share dilution would be followed by a decline in the share price; witness Exco Resources rights offering of $5 a share. The natural gas producer controlled by Wilbur Ross (Trades, Portfolio) subsequently saw its share price decline below $5 a share. The $5 share offering that was offered to shareholders was naturally lower than the price at the time of the press release (it was around $5.5 a share).
Rights offerings to existing shareholders should be lower than the market price otherwise shareholders aren’t made better off. But this rights offering was not well received by Exco investors. Throw in the fact natural gas prices have shot up of late and it becomes clear that Exco shareholders really hate the idea of dilution.
So why should shares of USG take off when the pie is being cut into ever smaller pieces? Part of it will have to do with the reduction in interest expense. The $400 million in bonds that were retired came with a stifling 10% coupon ($40 million annual expense). It was the most expensive capital on USG’s balance sheet so it is good that it’s being retired. The company will reduce its leverage which is also a positive as it took on substantial debt to survive the housing crisis.
Nevertheless the company now has a valuation of $4.3 billion up from $3.2 just a couple weeks ago. At $4.3 billion it becomes a lot more difficult to say USG is a buy or for that matter fairly priced. The company pulled in $53 million in profits the previous 2 quarters, but it is still hundreds of millions of dollars away from filling up that valuation of $4.3 billion.
Had the company not expanded internationally I would be much more excited about its future prospects. But as I wrote in an earlier article, the company made investments in Oman that would cater to the Indian market as well as a partnership with the Australian building products company Boral. The Boral joint venture is intended to cover the East Asian market as well as China.
This aggressive international move could be a success, but I think it’s more likely to be a disaster as I side with Jim Chanos (Trades, Portfolio) on the China housing story. Being that USG was exclusively an American oriented business with the exception of its ceiling products business, I find the move internationally to be totally unnecessary as the American market is really the true “growth market” when it comes to single-family construction.
While I subscribe to the accounting view that share dilution is a bad thing, if in this parallel universe where more shares means higher prices I say shovel another 20 million Warren Buffett (Trades, Portfolio)’s way
Disclosure: Selling USG
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