A few days ago on ValueWalk, I wrote an article on the state of the U.S. housing market. According to several hedge fund managers, the housing market is currently staring down a huge supply deficit.
A report from the Newgate Absolute Return Fund speculates the natural demand for housing within the United States is approximately 2 million units per annum. The current run-rate is 1.2 million and since 1960, housing starts have averaged 1.5 million per annum. In the run-up to the financial crisis, the number of housing units built across the United States surged to record levels, leading to an overbuild.
Now, this overbuild has been all but eliminated as the average build rate over the past seven years stands at just 850 thousand per annum. According to data from the U.S. Census, this overbuild has been almost completely eliminated and the market has moved into a shortage of 700 thousand houses.
The best way to play the trend
According to Newgate and other fund managers, the best way to play this trend appears to be housing service supply companies. These companies make accessories for buildings such as windows, doors, bricks and building timber. These stocks are preferred over homebuilders due to their operational leverage. Such service sector companies should be able to drive a higher return on equity and invested capital as sales grow, but there is no immediate need to expand capacity.
One such stock, and a favorite of billionaire guru Warren Buffett (Trades, Portfolio), is USG Corp. (USG, Financial).
Plenty of leverage
USG is a manufacturer of sheetrock and other products for interior walls and ceilings. The business is over 100 years old and is a great cyclical play on the U.S. housing market. Buffett remains the company’s largest shareholder; Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) helped the company survive the 2008-2009 recession and housing collapse.
Today, the business is much stronger than it was in the run-up to the financial crisis. Book value per share surged from $1.48 at the end of 2011 to $12.9 at the end of 2016 as net debt has fallen from $1.8 billion to $600 million.
For the last two years, the company reported an operating profit of around $350 million. Free cash flow per share came in at 30 cents for 2014, $1.60 for 2015 and just under $2 for 2016.
USG is an excellent example of how homebuilder service companies will be able to extract operating leverage out of a home building boom to rapidly increase profits.
Since 2011, USG’s net fixed asset base has grown from $2.4 billion to $2.9 billion, but over the same period, operating profit has moved from -$206 million to $357 million. Return on capital employed has risen tenfold from 1% in 2012 to 10.4% for 2016.
Shares in USG are not cheap. The group trades at a forward price-earnings (P/E) ratio of 15.5 and an EV/EBITDA multiple of 10.4. Earnings per share growth of 18.2% is expected for the year ahead, giving a PEG ratio of one.
If the proposed housing boom does materialize, USG’s operating leverage and strong balance sheet will rapidly accelerate the company’s earnings higher. Since the crisis, there is no precedent for which to compare USG’s growth if this does occur.
How much are the shares worth?
Trying to place an exact value on how high shares of USG can go if the company sees a sales increase of 20%, 30% or 40% is tough because it is not yet clear how much more efficient it will be able to make its assets. As management has exceeded all expectations over the past five years by increasing the operating margin from 1% to 11.8%, I would not rule out further margin expansion.
Overall, if you are looking for a play on U.S. housing recovery, USG could be the perfect stock.
Disclosure: The author owns no stock mentioned.
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