USG Corp. (USG): Behind the Sheetrock
USG has gotten a fair deal of press given Warren Buffett’s holding in the company and its emergence from Chapter 11 Reorganization to handle its asbestos liability claims. Plenty of folks are calling it a bargain, and some are itching to keep buying, but to temper myself I took a more in depth look at the company to get a feel for what it’s worth.
First things first. In summary fashion, the plan of reorganization and the company’s own plan to finance it are as follows: The company has paid $3.95 billion to a trust established under section 524(g) of the Bankruptcy Code which will be used to fund all past, present, and future asbestos liabilities. With over 100,000 cases previously brought against the company, at least they won’t have to bother with them again.
The company is financing this large sum with a combination of available cash, the use of an approximately $1.1 billion tax loss carryback expected in 2007 thanks to net operating losses incurred in connection with establishing the original asbestos reserve, and proceeds from a “Rights Offering,” in which shareholders had the right to purchase an additional share at $40 for each share they owned. With Berkshire Hathaway backstopping the offering, almost 45 million shares were sold, for net proceeds to the company of $1.7 billion. Despite the dilutive effect of the rights offering, I believe this combination was an intelligent way to finance the nearly $4 billion liability (of course, it helps that $1.1 billion of the liability is going to be financed by benefits received from the original loss incurred by it).
With this success and Buffett’s purchase and commendation of the company, it’s no wonder many are tempted. So now let’s look at the operating business, independent of the now bygone liabilities. USG is the top producer of gypsum wallboards and boasts a strong brand image (ever heard of Sheetrock?), low-cost producer status, and great economies of scale. It’s qualitative moat, if you will, rests on the fact that anyone, even with tremendous resources, will have difficulty achieving the scale, distribution, and cost structure of USG’s main product lines, and will probably have a tough time replacing Sheetrock’s brand image. Given management’s experience and its top-notch performance in bankruptcy court, you can rest assured that the company is in good hands.
Regular operations (prior to distored earnings from last year) sport a high return on equity and strong cash flows. The company has been successful in expanding its top and bottom lines over the long term. While plenty of pundits predict slowdowns in the residential property sectors and hence USG’s sales, the company draws over half of its revenues from commercial buyers. And regardless, the long-term, big picture is more important than trying to predict the next swing in the housing market. So, what about the valuation.
Before getting too giddy about Buffett’s buying, investors should consider 1) that he originally purchased shares at bargain basement prices in 2001 and 2) that his recent accumulation of shares was done at $40-45 (as opposed to the current $55 pricetag). Also, keep in mind that his costs were partially offset by USG’s $67 million fee to Berkshire Hathaway for backstopping the rights offering. Thus, enthusiasm tempered, we can try to look at a DCF.
Generally speaking, I don’t like quoting anything near precise figures for any DCF, since the output is only as good as the inputs, and because if the analysis doesn’t scream at me as giving a huge margin of safety, I’m not too interested anyway. That said, I estimate the value of the shares to be somewhere between $50 on the low end and $85 on the high end. I know, I know, that’s a wide discrepancy, but like I said, I think seeking a high degree of safety (a margin of error) is paramount to seeking a high degree of precision. Considering the limited downside and potential 60%+ upside, investors looking to coat-tail Mr. Buffett may still do reasonably well in USG, though no one should expect many-fold increases with high probability (though I’m the first to admit it is possible).