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USG - Bring the Dilution
Posted by: Josh Zachariah (IP Logged)
Date: January 18, 2014 07:22PM

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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USG - Bring the Dilution
Posted by: Dr. Paul Price (IP Logged)
Date: January 19, 2014 09:43PM

Good article, but with a deceptive title.

"Bring [on] the dilution" makes it sound like a positive.

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USG - Bring the Dilution
Posted by: batbeer2 (IP Logged)
Date: January 20, 2014 04:20AM

In 2009 I wrote:

>> WEB provided capital at a cost of say.... $12 a share. The shares on the open market subsequently dropped to ~5..... Giving investors a chance to buy one of WEBs dollars for less than 50 cts...... hmmm.

From time to time, you could buy $7 worth of shares and get $8-$15 dollars worth of capital provided by Buffett. The range depended on how you valued the interest on those convertible notes.

This range is what I used to buy the dips; I made a point of buying cheaper than Buffett.

Now that the shares have run up a bit, those same notes have become dilutive. Investors buying the shares are paying $30 for the same equity WEB bought at much lower prices.

Some wil argue that convertibles are always dilutive but IMHO if you buy your shares at a lower price than the capital that is provided through the convertibles, that capital adds value to your shares in excess of the value that is lost by increasing the number of shares. 

What happened in 2009 can be compared to USG selling someone a bunch of shares at $50 today and using the cash to retire debt. I would consider this anti-dilutive simply because the per-share value gained is greater than value through the increased share-count.

In short, the notes are a stupidity tax. Investors are being punished for buying at $30 and rewarded for buying in the single digits.


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USG - Bring the Dilution
Posted by: Josh Zachariah (IP Logged)
Date: January 20, 2014 09:54AM

Great point Batbeer and I agree it was certainly advantageous to buy below the conversion price, but I still believe the transaction to be dilutive. In essence what USG got was $400 million in capital at a time when capital was hard to come by at a very manageable price - 10%.  If I remember correctly Carlos Slim charged the New York Time 20% for a loan, but it came with no convertible feature.  

Maybe the company might have found a better deal if they shopped around.  Maybe 15% without having the convertible price, but time was precious and the executives would much rather have a job with a high cost capital base rather than risking their jobs to find cheap capital.  Dick Fuld (of Lehman Brothers) tried hunting down cheap[er] capital and look what happened to him and his company.  

Certainly Buffett would not have done it without the convertible option as that option was terribly valuable for him because it was priced near the nadir of the company's valuation.  In short the company had a choice - pay higher interest or cede a large share of the company at a cheap price



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USG - Bring the Dilution
Posted by: rrurban (IP Logged)
Date: January 27, 2014 10:04AM

For USG, they just do not generate FCF consistently and saying they will in the future is just a guess as they have proven for 10+ years they cannot generate positive FCF on a consistent basis.  Considering the debt load, shareholder's equity is under $100M. There must be hidden assets on the books, otherwise it's not worth even $5/share. Where was the value in this company in 2008-2009 even? Sure, it tripled but based on what fundamental value?  What am I missing here?  

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USG - Bring the Dilution
Posted by: batbeer2 (IP Logged)
Date: January 27, 2014 10:34AM

>> For USG, they just do not generate FCF consistently and saying they will in the future is just a guess as they have proven for 10+ years they cannot generate positive FCF on a consistent basis.... What am I missing here?

Many investors (inclusing myself) sometimes use FCF as a proxy for owner earnings. For some stocks (say PMD or BLL) this is probably OK. For other stocks (BRS, AMZN or WFC) it is a mistake. BRS, AMZN and WFC are of course wildly different companies. The reason why FCF as reported is useless as a proxy for owner earnings is different for each one.

USG is another example where FCF as reported (in the last decade or two) does not begin to approximate owner earnings.

As for the consistency... yes, USG is hugely cyclical.

In short, if you use FCF as a proxy for owner earnings, you should know when it is OK to do so and when it is not. For USG, it is not.

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