USG Corp. (USG)

[Enterprising Investor]

USG Poised to Rise From a Strong Foundation (8/30/14)

North America's biggest gypsum maker had to gut-renovate its operations in the housing crisis.

It typically takes a few months before the sound of shovels hitting dirt at a new housing project leads to pay dirt for wallboard maker USG . The delay, however, bodes well for USG investors, who can expect to see the recent upswing in housing starts reflected in the company's results shortly.

The Chicago-based company (ticker: USG), which also makes ceiling tiles and other building products, has climbed out of a deep hole since the housing market crashed. But its results have been depressed, as builders remain reticent to ramp up construction. That's created an opportunity.

Coming off its best quarter since 2007, USG trades at just 12.5 times next year's expected earnings. A slight gain in housing and better investor sentiment should lift the shares from a recent $29 to $33, says Sterne Agee analyst Todd Vencil. If the wallboard manufacturer received the same valuation as other building-products outfits, such as Masco (MAS) or Armstrong World Industries (AWI), USG could jump 30%, to about $38.

"We're still in the early stages of what's going to be a protracted housing recovery," says Vencil. "At these levels, there's not a lot of downside in the stock."

USG, the largest manufacturer of wallboard in North America, lost a cumulative $2.2 billion from 2008 through 2012, as construction fell to historic lows. But results have returned to the black, with the company earning $49 million, or 42 cents per share, on $3.6 billion in sales in 2013. It's expected to earn $212 million, or $1.41 a share, on $3.8 billion in sales this year. Earnings could jump to $2.31 in 2015, analysts project, a 64% increase.

"We had to create our own recovery," says CEO Jim Metcalf. "We didn't know when housing was coming back, so we lowered our breakeven. We focused on innovation." Photo: USG

USG was founded in 1902 in a merger of 30 independent gypsum, rock, and plaster companies. In 1916, it developed Sheetrock, a trademarked product that has become as synonymous with wallboard as Kleenex is to facial tissues. Since then, USG has expanded into other products—most prominently ceiling tile—and it has also faced several challenges, including a bankruptcy in 2001, after a flood of asbestos-related claims connected to its products.

After selling $1.8 billion in shares guaranteed by Warren Buffett's Berkshire Hathaway (BRKA), it emerged from bankruptcy in 2006. Buffett again came to the rescue when USG's business collapsed in 2008, buying $300 million in convertible notes that carried a 10% annual payout. Berkshire converted them to equity in December, and now owns 30% of the company, making it the biggest shareholder.

Buffett's investment helped buttress the balance sheet when USG was hurting, but the rebound is based more on cost-cutting and innovation. Since 2007, USG has idled or closed about one-third its manufacturing capacity, shut 125 distribution branches, and cut its workforce from 14,650 to 8,900.

By reducing so many costs, USG was able to generate the same earnings in its most recent quarter on $948 million in sales as it did in 2007's second quarter, when sales were $1.4 billion.

At the same time, USG reinvented its signature product. New UltraLight wallboard weighs up to 30% less than standard wallboard, saving the company money on shipping and lowering labor costs for contractors.

"We had to create our own recovery," says CEO Jim Metcalf. "We didn't know when housing was coming back, so we lowered our breakeven. We focused on innovation."

The company reports results for four segments. Its gypsum division, which includes wallboard and other products, accounts for about 55% of sales. Ceiling products, mostly sold to commercial clients, represent another 15%, and its distribution company, L&W Supply, accounts for 30%. USG also sells its wares through retailers such as Home Depot (HD), which accounts for 15% of its net sales. It also recently created a new international segment.

About half of USG's sales come from repair and remodeling projects, which has helped buttress its results in the past couple of years, as new construction remained subdued. A rebound in that market, however, could have a more pronounced effect.

HOUSING STARTS ROSE 18%, to 924,900 in 2013, and reached an annualized rate of 1.09 million in July, their best showing in seven months. But they remain below the about 1.5 million that has been the yearly average since 1959, and is the rate at which analysts say construction keeps up with population growth. "There's still a huge mismatch between construction activity and demographic trends," says Chuck Lieberman, chief investment officer at Advisors Capital Management, a USG shareholder.

Another potential positive is in commercial building. USG pulls in about half of its revenue from commercial clients, a sector that Morningstar believes will rise 40% in the next five years.

The Bottom Line

Gains in new-housing starts and improved investor sentiment could lift the stock from $29 to $33, according to one analysis. A revaluation could put them at $38.

Metcalf concedes that housing starts might not bounce back right away: "We do see positive trends, but it's been choppy." Still, any uptick could have a big impact on the company's bottom line, given the cost reductions it's made.

USG has many opportunities abroad; it recently entered a joint venture with Australia's Boral (BOALY) to distribute USG products in Asia, Australia, and the Middle East (the new international segment).

Long-term debt makes up 73% of USG's capital, double the percentage of some rivals, which means it's overleveraged. Metcalf's goal is to trim debt toward 1.5 to two times earnings before interest, taxes, depreciation, and amortization, from about six times at the end of last year.

USG has laid a strong base. Now's the time to build on it.

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