USG: Sturdier Than It Looks

If you're a value investor or a Warren Buffett fan, and you don't already own shares of Inside Value pick USG (NYSE: USG  ) , chances are you've at least thought about it. I've previously mentioned that I'd consider buying its shares if their price ever fell. With USG now trading around $40 per share, the time seemed ripe for another look.

For the uninitiated, USG has three primary businesses:

  • North American Gypsum, the largest U.S. manufacturer of gypsum wallboard, with roughly one-third of the market.
  • Worldwide Ceilings, the largest and second-largest worldwide manufacturer of ceiling grid and acoustical ceiling tile, respectively.
  • L&W Supply, a specialty building-products distributor.

Stiff headwinds
USG's shares and financial results have suffered amid a severely slumping housing market. New residential construction accounts for about 46% of total gypsum wallboard demand, and according to the latest census results, housing starts fell 19% from last year.

Even as demand falls, wallboard capacity is expected to increase. Although USG estimates that wallboard capacity will rise a very manageable 1 billion feet in 2007, capacity should expand by another 3.7 billion square feet in the following year. At present, the industry's total current estimated capacity is about 40 billion square feet.

Although USG manufactures arguably the best wallboard brand, Sheetrock, prices are ultimately set by supply and demand. As a rule of thumb, pricing pressure usually sets in once industry capacity utilization rates fall below 90%; currently, the industry's running at about 80%. In the second quarter of 2007, wallboard prices per thousand square feet fell to $142, compared to $182 a year ago. Clearly, USG faces an uphill climb for at least the next couple of years.

Dead money?
The National Association of Homebuilders' housing index, which measures the sentiment of management teams at builders like Pulte (NYSE: PHM  ) , Ryland (NYSE: RYL  ) , KB Home (NYSE: KBH  ) , and Hovnanian (NYSE: HOV  ) , recently hit its lowest score since 1991. Experts expect the housing market to remain in the doldrums at least through 2008.

USG's suffering from a cyclical low, and it could be dead money for a while. However, I've previously praised USG as a good long-term play, thanks to its low-cost production, excellent management team, and other competitive advantages. My latest round of research turned up several other interesting points as well.

A coiled spring?
USG has spent a ton of money on capital expenditures. In 2005 and 2006, the company respectively poured almost $200 million and $400 million into capex. It's already spent $224 million in the first half of 2007.

Normally, a high rate of capex spending is bad, but in this case, it could pay off. USG's new plants are much more efficient than its older, higher-cost capacity, and the company's relying more heavily on those new plants for its overall production. Management has said that it's running its low-cost plants at more than 90% utilization, with its median cost plants at about industry averages of 80%. Meanwhile, in the first quarter of 2007, its high-cost plants were running at 50%.

As old capacity is replaced and new plants are built, USG will grow ever more efficient. Based on industry averages, management says that its newest plants can produce wallboard at half the cost of its older facilities.

Cash flow is go
In addition, I assume that at some point, USG's capex requirements will drop substantially. Management mentioned in the latest earnings call that its new plants will last for maybe 30-40 years, and the company estimates that only 15% of its current capacity comes from high-cost plants.

Thus, I think USG could be a very tightly wound spring, ready to pop loose once the housing market regains its footing. When that happens, either USG shares will rise to reflect USG's improving profitability, or management will have abundant free cash flow to buy back shares at lower prices. I can't predict when this will happen, but in the long run, I believe that shareholders will come out ahead in either scenario.

Related Foolishness:

USG is a Motley Fool Inside Value recommendation. Discover all of Fool value guru Philip Durell's bargain-priced picks 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's disclosure policy is a load-bearing structure.


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