In addition to being an analyst and a writer, I also dabble at being a freelance magician. For instance, I am now getting a signal from beyond the grave ... that you, the reader, are currently ... sitting at your computer ... in a building. I also can see that there are four walls surrounding you ... and that those walls are made with USG's
Unless you're using wireless Internet at the park, I have a high probability of being right about the first part of my prediction. As for the last part, USG's dominance has grown to the point that the company is controlling about a third of the domestic market for wallboard production. So although 2007 looks to be, at best, a so-so year for USG, I am excited about the company's prospects.
Company snapshot
USG is the largest producer of gypsum wallboard in the United States. It also manufactures other building products, such as ceiling grid and tile, and has a distribution arm that delivers construction materials to work sites. USG's largest customer is Home Depot
You call this a slump?
USG's stock seems to be trading in sympathy with the current housing slump. In 2006, about 46% of the wallboard industry's volume demand -- according to USG's 10-K -- was from new residential construction. Given the recent hiccups in the housing market, it makes sense that investors might be nervous about USG's prospects for 2007.
Despite the impending challenges, however, this is not the worst market the industry has faced. In 2001, the wallboard industry took multiple hits. The reeling post-dot-com economy led to a drop in demand for building supplies. While that was happening, about 30% of new capacity came online into the industry within a short 18-month period. To top things off, a new competitor was entering the market and was basically buying market share by selling below cost. All of these adverse developments combined to wreak havoc on the price of wallboard, which plummeted from $153 per thousand square feet in 1999 to $85 in 2001.
As a result, the industry had a severe shakeout. USG, which was under the gun from asbestos litigation, had no choice but to file for bankruptcy protection.
Rebuilding
However, USG has come back strong, partly backed by major investor Berkshire Hathaway
The past couple of years had been great for USG thanks to the housing boom; wallboard prices per thousand square feet increased from about $101 at the end of 2003 to $144 at the end of 2005. The industry now faces declining demand from the housing slump, but this time around, the down cycle shouldn't be as severe.
Batten down the hatches
USG estimates that about 1 billion net new square feet of capacity will come online in 2007. Although that figure seems high in isolation, it is actually only 3% higher than the amount of industry shipments of 36.2 billion square feet in 2006. According to USG's 10-K, industry capacity utilization rates fell from around 100% to lower than 80% (capacity rates below 90% imply pricing pressure), as industry wallboard shipments declined 15% in the second half of 2006 versus the same period in 2005. However, I'm confident that USG, which ended the year at about 79% capacity utilization, can weather the storm.
Despite the industry's inherent cyclicality, I think wallboard manufacturing is a great business to be in over the long run. Over the course of a cycle, USG can earn very high returns on capital with low maintenance expenditures and a high rate of free cash flow. A big reason why wallboard is a surprisingly profitable business is that transportation costs are very high. Thus, players like USG, which own their own gypsum mines (almost completely vertically integrated) and have proximity to the customer, face little competition.
In fact, USG has a nearly unbroken record of selling wallboard at a profit for more than a century. During the 2001 wallboard crisis, USG's market share actually went up, because the company is a low-cost producer and can keep factories running when others have no choice but to shut down.
What to look for in 2007
It's tough to predict the next year's earnings for USG, given the volatility in wallboard pricing. However, it's not difficult to see that when wallboard pricing nears cyclical peaks, USG is able to rake in the dough. Over the past three years, USG has, on an operating basis, earned about $950 million, $750 million, and $500 million in operating income, and $1.09 billion, $875 million, and $640 million in EBITDA. Because maintenance capital expenditures and interest payments are reasonable relative to the firm's operating cash flow and cash on hand, a high proportion of operating income should translate into free cash flow.
So although it is pretty clear that 2007 will be a tough year for the industry and USG, I would look at a drop in the shares from the current $49-per-share price as an aggressive buying opportunity, given the quality of USG's earnings and its long-term economic moat.
Related Foolishness:
Berkshire Hathaway, Home Depot, and USG are Motley Fool Inside Value recommendations. Try out Inside Value or any one of our investing services free for 30 days.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
