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USG (NYSE:USG)

Q1 2013 Earnings Call

April 24, 2013 11:00 am ET

Executives

Ken Banas

James S. Metcalf - Chairman, Chief Executive Officer and President

Matthew F. Hilzinger - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Michael Jason Rehaut - JP Morgan Chase & Co, Research Division

Stephen Kim - Barclays Capital, Research Division

Trey Grooms - Stephens Inc., Research Division

Daniel Oppenheim - Crédit Suisse AG, Research Division

Robert C. Wetenhall - RBC Capital Markets, LLC, Research Division

Mike Wood - Macquarie Research

Keith B. Hughes - SunTrust Robinson Humphrey, Inc., Research Division

Garik S. Shmois - Longbow Research LLC

Joshua K. Chan - Robert W. Baird & Co. Incorporated, Research Division

Dennis McGill - Zelman & Associates, LLC

Seth B. Yeager - Jefferies & Company, Inc. Fixed Income Research

Daniel Downes

Philip Volpicelli

Operator

Welcome to the USG Corporation First Quarter 2013 Earnings Conference Call. My name is John, and I'll be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded. I will now turn the call over to Mr. Ken Banas. Mr. Banas, you may begin.

Ken Banas

Thank you. Good morning, and welcome to USG Corporation's first quarter 2013 earnings conference call and live webcast. We'll be using a slide presentation in conjunction with our call today. It is available by going to the Investor Information section of our website, www.usg.com, and clicking on the link of the webcast.

Before we proceed, let me remind you that certain statements in this conference call may be forward-looking statements under securities laws. These statements are made on the basis of management's current views and assumptions of our business, market and other condition, and management undertakes no obligation to update these statements. The statements are also subject to a number of factors, including those listed at the end of the press release and actual results may be different from our current expectations.

With me today to discuss our results and our outlook are Jim Metcalf, Chairman, President and Chief Executive Officer; and Matt Hilzinger, Executive Vice President and Chief Financial Officer. Jim will provide a general overview of the quarter plus additional insight into some of our businesses. Matt will review the financial results for the quarter for the corporation and the business segment. We will then open the call for questions and conclude with a few comments from Jim. We would like to ensure that everyone has an opportunity to ask questions, so I ask that when we get to the Q&A session, callers are asked to limit themselves to one question. Jim?

James S. Metcalf

Thank you, Ken, and good morning. I appreciate you joining us this morning, and I look forward to giving you an update on the quarter, as well as how we're seeing the overall market.

I'm very pleased to report we had our first quarter of net income in over 5 years. Despite soft volume, we were able to implement a Plan to Win. We're focused on the controllables to generate earnings as we emerge from the half decade depression that has gripped our overall industry. Volume in Wallboard was down slightly compared to last year, but we don't believe this indicates the recovery is off track. Our wallboard pricing policies have been successful, and our customers were more inclined to prebuy in advance of our annual price increase in the fourth quarter than they were a year prior.

We also had a fairly severe winter across most of the country, very different from the more temperate temperatures we had a year ago. In fact, the entire industry shipped 2% less product in the quarter versus last year for the same reasons. We continue to lower our breakeven. Our first quarter SG&A was down from a year ago. This will allow us to continue to maximize our profitability as we move through the recovery and begin to make some targeted investments in our business.

Now I'd like to turn to our business units. First, in the North American Gypsum segment. Wallboard results continue to be the driver of improved performance. Wallboard price was up over $22 from the first quarter last year, and we're pleased with these results. Our customers had an opportunity to improve their margins as well and also lower their administrative costs using our wallboard pricing model.

Worldwide Ceilings experienced the seasonal recovery that we discussed on the last call, delivering $27 million in operating profit in the quarter on basically flat sales. This was the highest quarter ever of operating profit in the Ceilings business despite lower volume in both tile and grid. The commercial market still remains choppy, and we still don't anticipate the demand landscape changing in the near future.

Turning to our distribution business, L&W Supply. L&W continued to improve their operating results in this slow commercial market, reducing losses by 2/3 from a year ago. L&W's wallboard spread percentage increased by double-digit from last year despite volume being down consistent with the market. L&W's strategic focus remains on the commercial contractor but also taking advantage of the growth we're seeing in multifamily residential. Our contractor customers are seeing stronger backlogs in bidding calendars, and they're even beginning to think about the availability of skilled labor as they're quoting jobs that are going to be let next year and early -- later this year.

We're confident in L&W's value proposition and we believe that the velocity is starting to return to the business as the year unfolds.

Our Plan to Win is working, and it's evident in our results. The 3 legs of our strategy are driving the improved performance. Our commitments to strengthening our core business can be seen in the wallboard price improvement, the improved results in both L&W and Worldwide Ceilings. Our cost management initiatives are working, and we continue to focus on lowering our breakeven. In the first quarter, we launched a company-wide Lean Six Sigma program, taking an initiative that's been very successful across our manufacturing footprint over the last few years, and we expanded it to our corporate functions. Although we've already reduced our cost over $0.5 billion, we continue to look for ways to drive even more efficiency across the entire network.

The second pillar of our strategy is to diversify our earnings. Our joint ventures to serve the growth markets are establishing their operations as we speak. I had the opportunity to participate in the groundbreaking in our Oman quarry. I was very impressed with the progress they've made. This is a very valuable asset that's going to be able to serve a variety of strategic interests in both the Middle East and India.

Our final strategic priority is growing our business through innovation. The most visible example of this continues to be the success of our SHEETROCK brand UltraLight portfolio. Another new product, UltraLight Mold Tough panels were released last quarter, and the response has been impressive. In addition, our SHEETROCK brand UltraLight Joint Treatment was a top 10 finisher in the Home Depot innovation awards in 2012, the same awards our UltraLight panel won the year prior.

Our strategy is comprehensive, strengthen, diversify, differentiate to grow USG.

So now, I'd like to turn the call over to Matt, and he's going to give you greater details on the financials. Matt?

Matthew F. Hilzinger

Thanks, Jim, and good morning to all of you. As Jim mentioned, I'll recap our first quarter results and provide some additional details on each of our business segments. Before I begin, I want to remind everybody that at the end of the fourth quarter, we finalized the sale of our European operations, which had been reported previously and entirely within USG International in our Worldwide Ceilings segment. Prior period amounts have been adjusted to reflect our former European operations as discontinued operations.

Moving on to total corporation results from continuing operations for the first quarter of 2013, net sales were $814 million, up 4% from the first quarter of last year. Our first quarter operating profit was $49 million, which compares to an operating profit of $24 million in the first quarter of 2012. The year-on-year improvement was driven primarily by higher wallboard prices, offset somewhat by higher wallboard costs and lower volume. As Jim mentioned, we had our first quarter of net income and positive earnings per share in over 5 years. For the quarter, our diluted EPS was $0.02 per share. We have included 2.7 million of potential common shares in fully diluted EPS. The 35 million shares related to our 2018 convertible debt would not become dilutive and included in our calculation until we have more net income.

In past cycles, USG has achieved 35% to 55% incremental operating profit margin in the 4 years through after a trough. For all of 2012, we had an incremental operating profit margin of 71%. In the first quarter of 2013, we had a $25 million improvement in operating profit on the $31 million increase in sales, resulting in an incremental operating profit margin of 81%. As we continue to take steps toward our breakeven, we anticipate our operating margin will fluctuate and will be impacted by anticipated costs to serve [indiscernible].

Focusing on SG&A expenses, in the first quarter of 2013, SG&A was $72 million versus $76 million last year. A significant portion of this improvement was the timing of expenses expected to be incurred later in the year. As I said in February, we will continue to work to offset the impacts of inflation and still expect SG&A to be up slightly in 2013 versus 2012.

I'll now provide a little more detail on our first quarter segment results. Net sales for our North American Gypsum segment were $509 million for the quarter and operating profit was $46 million versus an operating profit last year of $32 million despite lower wallboard volume. Primary contribution was due to our wallboard price increase contributing $25 million. This decrease in wallboard volumes lowered operating profit by $3 million compared to the year prior. Labor, energy and materials were the principal drivers of our higher costs.

Our U.S. Wallboard business shipped approximately 1.1 billion square feet in the quarter, a decrease of 4% compared to the first quarter of last year and down 9% from the fourth quarter. We believe the decrease in volumes from the fourth quarter is due to the 2 factors Jim had previously mentioned, a higher level of prebuy in the fourth quarter of 2012 versus '11 and the harsher winter this year compared to the unseasonably warm weather of early 2012.

We had an average realized price of $153.07 for the first quarter of 2013 compared to $130.43 in the first quarter a year ago. As we said in the past, this price may fluctuate throughout the year due to changes in freight and regional demand fluctuations, including exports. We are really pleased with this price. We believe that we have been able to secure this increase because of our high-quality products, strong customer service and our commitment to help our customers improve their product offerings and profitability coming out of a half-decade depression in our industry. We are also very pleased that this increase helps USG's path to an appropriate return on invested capital.

Turning to Worldwide Ceilings. Our Ceilings business saw the typical seasonal rebound from the fourth quarter, delivering first quarter operating profit of $27 million in 2013. This was the highest level of operating profit in the history of our Ceilings business despite demand had dropped in both grid and tile. Our February price increase and the shift in mix to higher-end product helped to offset this lower demand. Longer-term demand appears to be improving slightly, however, commercial demand remains choppy and we expect to see continued choppiness in the near future.

In our Building Products Distribution segment, net sales increased 4% year-on-year for the first quarter, with same-store sales up nearly 9%. The operating loss in this year's first quarter decreased to $2 million from $6 million a year ago as L&W improved their wallboard spread despite lower volumes.

As a point of reference, in the first quarter of 2008, L&W posted a $2 million loss on $490 million in sales compared to a $2 million loss this quarter on $281 million in sales. This is evidence that our strategy of our branch rationalization, lowering our breakeven and focusing on the right jobs with the right customers is working. We achieved the same results with sales that are down over 40% and wallboard volume that's down 60%. We believe L&W is very well-positioned as the commercial market emerges from its half decade depression.

Turning to our cash position. USG has historically used more cash in the first quarter of the year due to low levels of seasonal demand and year end accruals, and this year was no exception and was in line with our expectations. The use of $150 million in cash during the first quarter was for the purchase of our remaining mining rights in Oman, higher accruals at year end, including incentives, and some growth in working capital as our business grows. As of March 31 of this year, we had total liquidity of $767 million, and we believe our liquidity is well positioned to end strong for this point in the cycle.

Lastly, turning to tax benefits. USG has over $2.1 billion in federal net operating loss carryforwards that may be used to offset future taxable income. The utilization of these NOLs equates to roughly $800 million in reduced cash federal taxes, which we intend to use to invest in strategic initiatives and delever the balance sheet over time. Section 382 of the U.S. tax code imposes limitations as to how this asset can be utilized if more than 50% of the shares outstanding owned by 5% shareholders change hands over a rolling 3-year period. Our shareholders who have the opportunity to vote on an amendment to our restated Certificate of Incorporation and an amendment to our Rights Agreement to restrict certain transfers of our common stock in an effort to protect the value of our NOLs.

These amendments would generally expire in the shore of 3 years or when the NOLs have been utilized.

Let me conclude by saying that while we are pleased to have delivered our first quarter of net income in over 5 years, we know this is another very important milestone towards earning the appropriate return on investment capital from each of our businesses. With that, I would like to turn it back to Jim. Thanks.

James S. Metcalf

Thank you, Matt. I'd like to take a few moments to share our thoughts on the overall market for the first part of 2013 and how we're seeing the market unfold this year. I've already touched on wallboard shipments for the first quarter. Housing starts, as everyone has seen in March, topped 1 million for the first time since June of 2008, and it was great to see the continued strength in this end market. Multifamily starts really drove the big part of that increase, up 27%, while single-family starts were down slightly and permits were basically flat.

The Harvard Joint Center for Housing Studies last week projected a mid-single-digit increase in the repair and remodel market this year. The first quarter was basically flat in R&R compared to the fourth quarter, but the projections are for a sizable increase in the second and third quarter before the pace of growth moderates towards the end of the year. Our partnership with large big-box retailers and L&W's footprint positions us well to benefit from the continued recovery in repair and remodel.

Turning to commercial, McGraw-Hill Commercial Construction forecasts a mid single-digit increase for 2013. This includes about a 14% increase in commercial and industrial segments, and those segments include office, retail and hotel, and a 2% decrease in institutional, which includes educational, healthcare and government. This comes on the heels of the low single-digit total increase in 2012, with very similar subsegment characteristics. We are seeing the beginnings of an improved commercial opportunity. However, as Matt just mentioned, we do anticipate the overall opportunity to be choppy as the year unfolds.

So with that, I'd like to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Michael Rehaut from JPMorgan.

Michael Jason Rehaut - JP Morgan Chase & Co, Research Division

My first question is on U.S. Gypsum company margins. There was a little bit of a surprise last quarter in terms of, I guess, some catch-up of your accrued cost throughout the year. How do you see that playing out this year in terms of it potentially being a more normal distribution? And if so, would you expect some further margin improvement in 2Q given perhaps greater volume and continued realization of price?

James S. Metcalf

Thank you, Michael. I think you're on the right track. Really, the biggest impact on the margin in the first quarter was volume. We had a little bit of a raw material natural gas increase, but if you look at the biggest impact, it was on the margin side. As we said, margins were down about 2% -- excuse me, 4% year-on-year. Quite frankly, we're starting to see this thing work out. We started to see some trends up as the quarter unfolded on margins. So we think -- we're not giving you a projection, but we're very focused on our strategic sourcing group, which is focused on all of our raw materials. We're hedged on gas, as you know. It was a cold winter, so the spot market came up during the quarter. But we're very focused on keeping the breakeven low and improving our margins in wallboard.

Michael Jason Rehaut - JP Morgan Chase & Co, Research Division

Did I hear you correctly, did you say that margins were down year-over-year and...

James S. Metcalf

No. No, I said that the margins, no, were up year-on-year. I said that volume was down year-on-year.

Michael Jason Rehaut - JP Morgan Chase & Co, Research Division

Volume. Okay, that's what I -- that's what we saw. And then in terms of the volume, just to get more granular there...

James S. Metcalf

Michael, Michael, excuse me, we have quite a few people in queue. If we could just hold that and we'll come back to you on that.

Operator

Our next question comes from Stephen Kim from Barclays.

Stephen Kim - Barclays Capital, Research Division

I just wanted to follow-up and try to understand a little bit better the prebuying activity that may have occurred in the quarter. Just to get a sense for how we might frame things out quarterly over the next couple of quarters -- several quarters. Can you give us a little bit more color around the nature of prebuying activity, how it trended through the quarter and to what degree you think it's going to affect near-term result?

James S. Metcalf

Yes, Stephen. As I said in my prepared comments, our customers, really, they were serious about prebuy much more this year than they were last year, which indicated to us that the price increase was real to our customers. We really managed the prebuying activity from our standpoint and that really had an impact on our volumes. But I will say, some of our customers did prebuy overall. We saw some of the warehouses very full, and there was as much -- just talking to our customers, maybe as much as 20% increased volume that was pre-bought from the customers we talked to. The good news is we've started to see that work its way through volumes. January and February were quite soft and we started to see some trends up in March. And as we look into the second quarter, things are starting to work through. So I guess the question is, has the material flushed through? We think it has. And it really -- we know some customers that actually rented outside warehouses in December to prebuy material but that is flushed through the system. Also, Stephen, we liked your analogy on housing and your first car, so I thought that was a good article.

Operator

Our next question comes from Trey Grooms from Stephens.

Trey Grooms - Stephens Inc., Research Division

Still kind of on the prebuy, but more as it directs to -- as it relates to L&W, obviously, very nice improvement there on the margins. Did this business, given that it's distribution, did it benefit any from kind of the prebuying ahead of the January price increase in wallboard? Do you think that this kind of margin improvement that we've seen here that it's sustainable and that we could see it progress through the year?

James S. Metcalf

Well, we have a big focus corporately on working capital and really controlling our inventory. And L&W and all of our other independence, we put -- we did some maintenance over in December, and we did not have a huge surge and you saw our volumes in the fourth quarter. We didn't have a huge surge on prebuy, particularly our other customers, our big-box retailers, just don't have the space to take it. So no, they did not take a huge advantage of prebuy as some of their competitors did. So L&W's results really are really focused on gross margin improvement. As we said on the commercial contractor, I think the comparison that Matt used versus 2008 about branch rationalization but also lowering the breakeven. So we aren't there yet with L&W, but we've knocked those losses by 2/3, and we're optimistic we're going to start seeing some good results soon.

Operator

Our next question comes from Daniel Oppenheim from Credit Suisse.

Daniel Oppenheim - Crédit Suisse AG, Research Division

I think you talked about some of the -- what you're seeing in terms of the -- the residential side in terms that prebuying activity and such and then how the trends have evolved. Also, actually on the commercial side, a bit choppy. Can you elaborate a bit in terms of what you're seeing here in the second quarter? You're seeing some improvement coming through in those end markets here, how do you describe that?

James S. Metcalf

You're talking about the commercial end markets?

Daniel Oppenheim - Crédit Suisse AG, Research Division

Right, right.

James S. Metcalf

Yes. It's still a very -- we use the term choppy, but if you look at the architectural billings that have just come out, they've -- we've had 8 consecutive months of improvement. But March went backwards from February. So I think March was like 52, which is positive, but February was 55. So it's very uneven. As we said, some segments are up double digits, other segments are down. So we're still trying to work through some very low numbers that were in the system 18 to 24 months ago and with our products, particularly ceiling, there's an 18-month lag on commercial. So we're still seeing commercial to be the last segment of the 3 that's showing any type of improvement. But as you look forward and as McGraw-Hill looks forward into 2014, the projections for 2014 on overall commercial start getting into double digits. So that is the one segment that is really lagging.

Operator

Our next question comes from Bob Wetenhall from RBC.

Robert C. Wetenhall - RBC Capital Markets, LLC, Research Division

I was just hoping Jim would feel really bold today and I wanted to see if you think this is the year when L&W surpasses breakeven and turns profitable? You've obviously made a lot of progress in terms of rationalizing store count, your losses have shrunk dramatically year-over-year. Do you see this division being in the black this year?

James S. Metcalf

Thanks, Bob, I appreciate the comments and we see some commercial velocity that will really get us there much faster, and I think as we continue to see the commercial market as I said earlier, fairly choppy. And we're going to continue to lower the breakeven and get margin improvement. But our focus is to get L&W profitable ASAP. And if we can build some office buildings, that will surely help.

Operator

Our next question comes from Mike Wood from Macquarie.

Mike Wood - Macquarie Research

I had a question in terms of your wallboard U.S. market share. I noticed that it had been obviously trending down since the peak of the housing market, but in the first half of last year, you had a bit of a spike up in market share back up to about 26%. And it looks like you maintained that level in the first quarter. How should we think about your market share going forward?

James S. Metcalf

That's a great question and as we're -- we're looking at -- we always have been balancing price and volume in the market share. The key we've been focused on, our market share did go backwards the last few years as we focused on profitable segments and really looking at geographic markets where the margins weren't where we wanted to be. So we are not on a market share grab. We gained a little share last year because, quite frankly because of innovation. We had in the first quarter of last year, we had a big conversion of stores in the retail big-box arena, converting from competitive product to UltraLight because UltraLight was outselling in the current stores. So our position on market share is we're going to do it with innovation, not with our -- we're going to do it with our value and we're going to balance margin, price and volume, and whatever market share comes out, we'll be pleased with that.

Mike Wood - Macquarie Research

And also in terms of L&W supply, you mentioned similar results...

James S. Metcalf

Mike, Mike, excuse me, we're trying to -- we have a lot of people...

Mike Wood - Macquarie Research

Okay, just one question, no problem.

James S. Metcalf

Yes. They're very excited about us making net income, and I'd really like to give everyone a chance.

Operator

Our next question comes from Kathryn Thompson from TRG.

Unknown Analyst

This is Chris [ph] calling in for Kathryn. I want to do ask one more question about L&W operating margins. Are you seeing any margin pressure by shifting the pricing negotiation away from the manufacturing level down to the distributor level?

James S. Metcalf

Thank you. What we've done in L&W on pricing is similar to what we did in our manufacturing side as we've centralized our pricing policy making, it's down to 1 or 2 individuals corporately. We've taken pricing authority out of the field. We put in some very specific metrics that we've utilized with looking at profitable customers, focus on the commercial contractor, the entire package. So we operate in a very fragmented market in distribution, and we feel that having pricing centrally gives us the opportunity to maximize our margins.

Operator

Our next question comes from Keith Hughes from SunTrust.

Keith B. Hughes - SunTrust Robinson Humphrey, Inc., Research Division

Within L&W, outside of wallboard, are you generally seeing product -- are your suppliers announcing price increases on products? And if so, what kind of magnitude are those right now?

James S. Metcalf

Thank you. It's interesting, we talk a lot about wallboard at L&W but more than half of their revenue is non-wallboard products, ceiling, tile and grid, commercial steel, commercial installation, exterior heat systems. And we are seeing price increases in practically every category. Ceiling, tile and grid in the first quarter was around 5%. You look at steel stud manufacturing, there was a price increase that was put into effect at the end of the year. So we are seeing inflation in our non-wallboard products and what is really important about that is getting margin improvement when we get cost inflation. What we've also done, I've said in the previous call with centralizing our pricing authority at L&W. What we've also done is we've centralized our strategic sourcing group and utilized the leverage of being part of USG Corporation. So when a steel manufacturer or insulation manufacturer has negotiations, we have those in a very central location here. There are category managers that know the industry that look at the future indexes, and we've tried to really professionalize the way we acquire and lock in some of our commodity cost because it is a big part of the margin improvement. Our focus is really to grow the categories in commercial insulation and steel. We feel that we provide value at L&W in commercial and you think about why -- participating in the residential, that's opportunistic for us. But at L&W, the commercial package, steel studs, commercial insulation, ceiling, tile and grid, eaves and wallboard really provide value to the commercial contractor. We also like it because the amount of competitors in the commercial segment are fewer than in the residential segment. You really know -- have to know what you're doing when you're stocking a high-rise building with these products. We operate in a very unsafe environment, both the roads and construction sites. So we feel -- we've been doing that for 45 years, and it's something that we feel that we have value for our customers. So that's when you talk about commercial construction, focus for that, we have the package, we know how to do it and we think the competitive landscape, that there's fewer competitors for us in that environment.

Operator

Our next question comes from Garik Shmois from Longbow Research.

Garik S. Shmois - Longbow Research LLC

With effective utilizations rates in wallboard high, I was just wondering if you could talk about your plans to add back capacity, whether it's later this year or next year and do you see the need for some capacity to come back whether it's from yourself or other industry players as a potential risk to the price improvement you got?

James S. Metcalf

We look at our network every day, Garik. And what we're looking at now is in our plan that we have for this year, and we may be on the lower end of where a lot of projections are for opportunity. But we feel right now adding shifts is not necessary. If the business improves the rest of the year, there may be some very regional shift additions that are planned. This isn't bringing idle capacity back on. This is instead of running plants, our people over time, we would be adding a shift and it would be very regional. We are not anticipating bringing back any idle capacity. We don't -- you have to remember, the market still at historical low levels. The Industry is going to ship around 20 billion feet. We are still exponentially below multi-decade demand levels. So our intent is, from a regional basis, we're busier in certain regions where we may add a shift, but that would be if volume does surprise us in the back half of the year. And I will say, adding a shift at USG has no impact on our value proposition on pricing. So we're very optimistic. Price for -- a wallboard price for 2013, it's in our customers' programs. They have it in their line items. What's great about that, it's lowering their administrative cost. So if a shift is added to the back half of the year, it has no impact on our price.

Matthew F. Hilzinger

This is Matt. Just to add a little bit of numbers to what Jim just said. Our effective utilization capacity right now is around 83%. So I know we've been talking about around 80s, we'll double a little bit, but that represents about 17% more demand before we really need, across the network, need to add anything. So I hope that's helpful.

Operator

Our next question comes from Peter Lisnic from Robert W. Baird.

Joshua K. Chan - Robert W. Baird & Co. Incorporated, Research Division

This is Josh Chan filling in for Pete. We understand that there were a number of price increases in the Gypsum business other than wallboard that went to effect during the quarter. Would you mind commenting on kind of what traction you're getting on some of those price increases?

James S. Metcalf

Yes. We had price increases in the rest of our businesses, our surfaces business, substrates, DUROCK, FIBEROCK, just that you can put in your model, it was -- each one of those were around 5%.

Joshua K. Chan - Robert W. Baird & Co. Incorporated, Research Division

And you're getting good traction on those still?

James S. Metcalf

Yes, we are.

Operator

Our next question comes from Dennis McGill from Zelman.

Dennis McGill - Zelman & Associates, LLC

I just had 5 questions I was hoping to get through. The first one is just the sustainability of Ceilings margins, you mentioned kind of some timing differences in the first quarter, how should we think about that over the course of the year? And now with the international business divestiture kind of what would you think would be either sustainable margins or kind of your guys just go along on the short run?

James S. Metcalf

Sure. And your other 4, you're going to hold off on, right?

Dennis McGill - Zelman & Associates, LLC

Yes, I'm going to hold off.

Dennis McGill - Zelman & Associates, LLC

Okay, thanks, Dennis. The Ceilings business, I think through this entire recovery, we've been -- each quarter the Street's been surprised. The results have been very -- we've gotten through this recession with some very profitable numbers. We have focused on margin improvement versus market share. We have really focused on -- really the key on ceilings is purchasing steel and staying ahead of any type of steel increases with our grid price increases in the market. And we work with some -- we have a really, really wonderful distribution channel that represents our ceiling tile business well. The divestiture of Europe, when you look at Worldwide Ceilings, they -- Europe averaged between $8 million and $10 million in operating profit over the last few years. And in the first quarter this year, as we said, we had the best quarter ever. And if you look at the -- I would look at the USG Interiors' results and the North American results unpacked. And we think that the Ceilings business, going forward, particularly with any type of wind at our back on commercial over the next year will help. We're very focused on with the repair and remodel segment of commercial, that's showing some positive signs. We have a nice footprint in the big-box retailer, which is a good business for us. So we feel that the Ceilings business is -- will continue to be a profitable business. We're also -- when you look at our CapEx, we're investing back into our Cloquet manufacturing facility in Minnesota, which is manufacturers -- our high-end products. We're very busy on the high-end. As Matt has said, we're shifting to -- our mix has changed, higher end, higher profit products, and it's really what the architects are wanting. We're seeing a lot of the architectural firms are specifying higher end ceiling performance, and we're investing in that business to focus on our margin improvement as well. So we're pleased with the results. I would say, any type of velocity just like we say on ceiling or on L&W, is going to help the Ceilings business. And volume was down in the quarter, sales were relatively flat, and the operating profit was very strong. So, Dennis, I'm still very optimistic about our ceilings performance, and I don't see a big fall off as the year unfolds.

Operator

Our next question comes from Seth Yeager from Jefferies.

Seth B. Yeager - Jefferies & Company, Inc. Fixed Income Research

Talking a lot about prices during the quarter, which is a good thing just maybe looking at cost, of the headwind you guys had in Wallboard division, how much of that was just the lower volumes versus nat gas and other? And how hedged -- can you give us an update on your hedge on nat gas with them being up this year?

James S. Metcalf

Yes, I'll have Matt give you the specifics on the hedge. I would say majority of the cost wins we had in the first quarter were related to volume.

Matthew F. Hilzinger

And, Seth, on nat gas, for 2013 we're 90% hedged. And I think in February, in the fourth quarter call, I talked something about probably around a 4% increase slightly above what we paid in 2012. And our policy, really, as we think about 2014, is we want to be 50% hedged going into the year. And so we continue to kind of look at where gas prices are. We'll manage that effectively through the balance of the year but that's effectively where want to be in 2014.

Operator

Our next question comes from Daniel Downes from B.C. Holdings.

Daniel Downes

Can you just give a little more information about the change in the articles of incorporation that investors are going to be voting on in the next couple of weeks. Why now? Was there any interest from a significant shareholder that could have tripped the test in the change in control? Or if you can just kind of explain the dynamics behind that a bit more.

James S. Metcalf

Absolutely.

Matthew F. Hilzinger

This is Matt Hilzinger, appreciate the question. So our objective is to protect 100% of the NOL. And as I said in my earlier comments, it's about 2.1 million. When you take federal and state, the cash value of that is somewhere around $1 billion. So it was a fair amount of money. And as we really start making that income, and we're not a federal taxpayer, we want to make sure that we had the right provisions in place to protect that asset for all shareholders. And so from a timing standpoint, I think as we started to look at our opportunity to make that income, that's really what drove it. It wasn't any particular interest on the shareholder or anything else, we just -- it's time to really put it in place. And so, as you know, there's 2 amendments. One is a vote on the right to protection plan and the other is a change in the Article of Incorporation. It's very common that those are both done together. So I think what we're proposing is when I think a lot of other folks have proposed and again the intent here is really all around protection of that asset. So we -- and I got to be careful what else I say here because I think you've got to be -- the regulations around soliciting here is -- they're pretty stringent. So that's effectively why we did it.

Operator

Our next question comes from [indiscernible] from JPMorgan.

Unknown Analyst

My question is related to working capital. As we look forward, when would we expect working capital to reverse? And then -- and perhaps if you can comment on why payables are down in the quarter.

Matthew F. Hilzinger

This is Matt Hilzinger again. So as Jim said earlier, we watch working capital very, very carefully. And we've improved our working capital metrics when you think about days payable, days inventory, we improved them dramatically in '11. We improved them again in '12. And we've actually improved them in '13. So not quite to the same extent in the first quarter that we saw in the first year for -- in 2012, but that is a real focus of ours. And look, we're going to continue to do things that we need to do to improve those metrics but as we continue to grow the business, you would expect that working capital would grow as well. And that's not a bad thing. But clearly, we're going to watch it very closely. With payables, the reason that payables is down year-over-year is that year end, we actually had a fair amount of accrued expenses that were expensed in 2012, but just the timing of it moved them into 2013. And that included a number of accrued expenses, including incentive compensation. So it's typical that we see that in -- from the fourth quarter to the first quarter. I think last year was probably a little bit higher than what we've seen in the past. But that was clearly within our expectations and not a surprise to us.

Unknown Analyst

Okay. But it has nothing to do with any sort of changes in payment terms?

Matthew F. Hilzinger

No, no, no. There's nothing to do with any kind of changes in payment terms, just merely the cycle and the timing.

Operator

Our next question comes from Philip Volpicelli from Deutsche Bank.

Philip Volpicelli

With regard to the 10% convertible notes, I believe you are able to force conversion of those into equity in December of this year. Is that your intention and is that what would result in the 35 million share count dilution, what will be the dilution associated with that?

Matthew F. Hilzinger

Yes. We have not made a formal decision on that. When we -- so when we look at our current balance sheet, one of the things that we really want to do is we want to simplify the debt structure and delever the company. We want to get to investment-grade metrics, and we want to do that organically. The one thing out there are the convertibles that would allow us to delever and we obviously have an option to call that in December of 2013. We have not made a formal decision on that. But I would tell you, this is just in the spirit of where we want to go in terms of delevering the balance sheet. But we need to spend some time with the folks that own those converts and make sure that we understand what their point of view is in this as well. But it's costing us $40 million in interest per annum, so it's very expensive capital. So that is something that we're going to clearly look at as we move through the balance of this year. And I think it's not unrelated to partly what we want to do around the 2 amendments that I just talked about earlier, right? I mean, we want to make sure that we factor in the impact of that convert and our ability to protect 100% of NOLs.

Philip Volpicelli

And, I'm sorry, what would be dilution to the share count if you...

Matthew F. Hilzinger

It would be 35 -- the additional 35 million shares.

Operator

[Operator Instructions] We have a question from Dennis McGill from Zelman.

Dennis McGill - Zelman & Associates, LLC

Matt, just a follow-up on that last point, the 35 million shares. When you started the call you said that net income would have to be higher. Do those become dilutive even if they don't convert at some point?

Matthew F. Hilzinger

Even if they don't convert, they do become dilutive at some point, but you got to add net income in a very high amount once they convert.

Dennis McGill - Zelman & Associates, LLC

Is there are threshold that we can look at to determine that?

Matthew F. Hilzinger

You can calculate it. It's probably somewhere around 120 million boxes [ph] where that income would need to be in order to have those be dilutive on an annual basis. So part of this, Dennis, is the calculation you -- without getting into a bunch of details here, you may end up having the 35 million come in a quarter or 2, but on an annual basis, we wouldn't anticipate those 35 million shares being dilutive this year absent a conversion. And then, it would be dilutive absent a conversion if we hit net income, somewhere I would say north of $120 million.

Operator

We have no further questions at this time.

James S. Metcalf

I appreciate all the questions and the interest in USG. As we said, in the first quarter, we achieved our net income for the first time in 5 years, and this is very exciting news for the Corporation and I will say for the morale of our team here. But I want to say, this is an important milestone, but we realize we do have work to do to maximize the value of USG, for our shareholders and by no means are we satisfied with these -- our level of earnings. We believe demand will continue to improve throughout the year. And as I said earlier, that we're starting to see some improvement as we speak. Despite a recovery in residential repair and remodel over the past 1.5 years, we're still below historical levels and we have a long way to go. As we talked about in both Q&A and our prepared comments, the commercial recovery is in very early stages, and we believe it's very uneven as the year unfolds. We are well situated to take advantage of the improvement in all of our core businesses, and I have to say, as the CEO, I'm very optimistic about our road ahead. As we close today, I'd like to congratulate the entire USG team, from the board line to the board room, on getting us to this important milestone. It's a milestone we've been focused on. We've been talking to you about it over the last 1.5 years. We still have work to do. We're very optimistic. And as always, we thank you for your time today and your interest in USG. Thank you.

Matthew F. Hilzinger

Thank you.

Ken Banas

A replay of this call will be available until Friday, May 3. Information is available on usg.com. This concludes our conference call. Thank you.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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