Valuing companies can be frustrating, even with high-quality businesses. If those firms are also cyclical, such as Motley Fool Inside Value recommendation USG
Emil Lee: How do you value USG?
Peter Supino: We think of USG as a growth/cyclical company. So we try to figure out what the central or normal profitability of the business is, then think about the rate at which that normal profitability is growing, and attempt to estimate a present value.
Lee: So you try to figure out what "normal" returns are, and the growth rate of that?
Supino: Yes. One approach is to look at an average of the past two cycles' worth of ROICs and ROEs, adjusted for bankruptcy expenses and reserves. The second-to-last cycle seems to run from the early/mid '90s to the peak in the late '90s, and the most recent from 2002 to 2006. You can get financials online at EDGAR for the whole period, and my guess is that your averages will be nicely double-digit. Of course, the past doesn't guarantee the future. Recent headwinds to returns are higher energy, paper, and transport costs, while a tailwind is consolidation.
Lee: How do you go about figuring out "normal" wallboard margins?
Supino: The first thing we do is look at historical financial statements, to see what [cycles] those margins have been through ... then we study the changes in the cost inputs over the last few years to determine whether this cycle is likely to be very different from past cycles. We'd do all that with the awareness that a huge driver of profitability is unit pricing. That tends to be wildly cyclical, and so your price assumption through a cycle is at least as important, if not more important, than cost assumptions.
Lee: So things like the knowledge that USG is a low-cost producer come into play here?
Supino: I agree with you that they're generally the lowest-cost producer. It's a very regional market, so in certain markets, [the company] might not be. But the portfolio average is low-cost, and that's important to us, because as prices decline, higher-cost producers will stop making money, and USG will still be profitable at those same prices. So they'll be in a position to gain market share through the lows of the cycle and continue to invest in their business.
Lee: To circle back to your earlier comment, I've noticed that it seems both Eagle Materials
Supino: Eagle's factories are located in places rich in gypsum rock. USG has some regions that rely on gypsum transported over water, and also synthetic gypsum. Both of those sources are more expensive, and that higher level of expense gets passed through (to the customer).
Lee: USG has been replacing a lot of high-cost, older capacity with more efficient, lower-cost capacity. Of course, USG's pricing advantage also depends on the extent to which competitors are following suit. Do you see the competition doing the same, and to what extent?
Supino: Generally speaking, competitors are replacing capacity, but doing so at a lower rate. In 2007, the last we saw was that the industry was going to add 700 million square feet of capacity, and USG would be about 500 million of that. Next year, the industry would add over 3 billion square feet, and USG would be more than half of that. Our point of view is [that USG accounts for] way more than their share of incremental capacity that's coming online, and we're happy about that. We figure the low-cost capacity would be able to help them gain market share at good returns on capital.
Lee: How do you feel about the trend of returns on incremental capital going forward?
Supino: It's also my belief that future returns on capital should be at least as good as those in the past, because the industry has consolidated.
Lee: In calculating free cash flow, it's obviously very important to discriminate between maintenance capital expenditures and growth capex. How do you go about figuring this out when the numbers in the financial statements are lumped together?
Supino: We believe management when they say [the wallboard plants] are very long-lived assets. The accounting treatment of those assets suggests maintenance capex should be about $140 million. Our point of view is that those assets depreciate very slowly, and that depreciation may very well overstate the capital intensity of the business. With that said, it's interesting to note that in the 2001 to 2003 period, the company averaged capital spending of about $110 million per year. While the context of that is important because they were in bankruptcy, it does show the flexibility of the business.
One other thing to note about capital intensity is that the business mix has changed as they have acquired distribution businesses, which doesn't require as much capital, because they lease most of those assets.
Weitz Funds have a great long-term track record, so speaking with Peter Supino was a great learning experience in understanding how cyclical companies like USG should be approached. Fools should note, in particular, how Supino cited historical evidence to see what the precedents are, but also applied insightful analyses of the current situation to come up with a more relevant forward-looking investment thesis.
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 highly valued disclosure policy.