Sunday, June 18, 2006

USG Overview

USG is a leading manufacturer anddistributor of building materials, producing a wide range of products for use innew residential, new nonresidential, and repair and remodel construction as wellas products used in certain industrial processes.

USG is a unique company. USG has been operating in bankruptcy protection and still has the shares trading. The company is about to exit bankruptcy and is expected to do so in summer 2006. Warren Buffett is an investor in the company with 15% ownership and has backstopped the secondary offering to raise capital for the company at $40/share. This effectively has put a bottom on the stock price at $40/share.

The questions facing an investor now is the following - what are the prospects for the company moving forward and is it a good investment or not. As Charlie Munger said in his speech called "Practical Thought About Practical Thought?" - it is typically good to answer the following questions.

1. Clear the no brainer questions first.
2. Use math as an essential tool for analysis
3. Think the problem forward and then in reverse.
4. Consider psychological factors
5. How can a confluence of factors help ( or jeopordize ) USG prospects

First the no-brainer questions.

USG is in the low tech business like Coca-Cola, chewing gum manufacturer Wrigley Company where loss of patent is not an issue but brand name, operational efficiency and market share are. People that are not in the housing business are familiar with SheetRock - this includes me and many of my friends. The company gets 11% of its sales through HomeDepot. One may estimate that the company gets a higher percentage of its sales through the retail channel. The brand name, while not as powerful as Coca-Cola, is still a factor for this company.

Secondly, the company is a leading manufacturer of gypsum and has about 1/3rd of the market share in the U.S. The company has adequate supplies of gypsum in its mines for 20+ years and is also using synthetic gypsum. The company operates paper companies to create high quality wallboard. The company has a solid transportation and distribution system that is important in a low tech business that can allow it to make the products available easily. World wide ceilings is a leading supplier of interior ceilingsproducts used primarily in commercial applications.

The demographic trends in the U.S suggest increase in population and wealth in the next fifty years. The population by 2050 is expected to hit around 420 million. The aging of baby boomers in the short term and the increase in population in the longer term will lead to market expansion and more demand for the company's products.

The company's management is superb and is acknowledged as such by Charlie Munger. This solves one more no-brainer question for us.

Technology - such as use of Gypsum as a by-product from coal fired power plants that use de-sulpharization and better, higher quality and cheaper manufacturing of wallboards is likely to aid the company rather than put it out of business.

Let us apply some numerical analysis to USG.

The company has about $24/share in cash. The gross operating profit increased to 24% in Q1 2006 compared to Q1 2005. Some of this undoubtedly came from price increases. The analyst expectation is for the company to earn 7.5 $/share post rights in 2006 and 6.3 $/share post rights in 2007. The decline in earnings next year is going to be primarily because of the decline in housing starts .

The population is going to increase at the rate of 3%/year for the next fifty years. This coupled with increasing wealth of the U.S population leading to second homes, re-modeling ( typical remodeling starts two years after a home has been acquired ) can cause an increase of 2% year over year. International growth, growth in other markets and competitive advantages can add another 3% to USG. In general, the company can grow at the rate of 6-8% on the average at the low end for the next twenty years once the asbestos law suit is behind the company. One also needs to note the cyclical nature of this industry as the great housing boom ebbs, there is likely to be a dip in the earnings per share but one shouldnt see a complete wipe out of the market players as happened in 2000.

Cash flow from operating activities was about 500 million last year. The company can pay out about 150 million in dividends per share or about $1.5/share post rights. Assuming a 2% yield, this puts the stock price post rights at about $75/share. Pre-rights, the company can be valued around $110 using this valuation method.

Think the problem forward and then in reverse:

We did some analysis looking at the problem moving forward. Let us do some math in reverse. Taking a free cash flow of 400 million/year a discount of 100 million from last years values and assuming 8% growth for twenty years, we have a cash flow of about 1.8 billion in twenty years from now. Assuming a one dollar dividend today post rights, growing at a nominal 5% per year for the next twenty years, we will get total dividends of $33/share in the course of 20 years. This should yield a dividend yield of $2.65 in twenty years and a share price of $136.00 using the 2% dividend yield formula used earlier. This is a conservative estimate - increase in market share and entry into other segments can increase this value and the company can have a higher upside than projected here.

Psychological factors:

The competitive advantages in transportation and a recognized brand name should continue to provide competitive advantages for USG once asbestos litigation is behind it. Though people arent accustomed to SheetRock the same way as Coca-Cola, it is a familar brand name. Technological changes are likely help USG rather than play against it.

How can a confluence of factors help ( or jeopordize ) USG prospects

The asbestos lawsuit and the scam around it was a factor in putting the company to bankruptcy. Once this is behind the company, the confluence of factors can help USG. Despite claims that this product can be manufactured cheaply, a lesson from psychology may be described here. "A behavior is followed by a consequence and the nature of the consequence modifies the organism's tendency to repeat the behavior in the future". The lessons of 2000 may echo with people that want to invest in this segment. Consequently, the problems of 2000 are unlikely to return anytime in the near future.

Looking at all aspects of USG, the company is not mis priced, but is cheap compared to its relative valuation. For a long term holder, the rights offering at $40/share is a steal - an opportunity that is unlikely to occur again in the near future. Using the forward P/E of $6.5/share in December 2007 and a P/E of 15, the company's price at end of 2007 is around $95=00 post rights.

I would appreciate comments/feedback on this analysis.


Anonymous said...

Thank you very much. I was wondering whether to exercise the option to buy more USG, and intuitively I got a yes, but I needed the kind of thinking and analysis you've offered. Appreciate it very much.

Bruce said...

Thanks for all your work on this analysis of USG. It is very helpful to me in puzzling out what to do about the stock and the rights..........and now that the link is posted on the USG board, I think your work will benefit many others.........

Anonymous said...

This was very helpful as i have struggled to find any info other than what the company send to shareholders.