USG Corporation (USG) Management Discusses Q2 2013 Results - Earnings Call Transcript

Jul.25.13 | About: USG Corporation (USG)

USG Corporation (NYSE:USG)

Q2 2013 Earnings Call

July 25, 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

Stephen S. Kim - Barclays Capital, Research Division

Jason Aaron Marcus - JP Morgan Chase & Co, Research Division

Michael Dahl - Crédit Suisse AG, Research Division

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

Kathryn I. Thompson - Thompson Research Group, LLC

Trey Grooms - Stephens Inc., Research Division

Garik S. Shmois - Longbow Research LLC

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

Daniel Downes

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

L. Todd Vencil - Sterne Agee & Leach Inc., Research Division

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

Dennis McGill - Zelman & Associates, LLC

Mike Wood - Macquarie Research

John Coyle

Operator

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

Ken Banas

Thank you. Good morning, and welcome to USG Corporation's Second 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 to 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 conditions, 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 segments. 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 as always, 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. We appreciate your interest in USG, and I'm looking forward to sharing our results from the quarter, as well as discussing our view on the market.

I'm very pleased to report we achieved a net income for the second consecutive quarter, and our distribution business, L&W Supply, generated operating profit for the first time since late in 2008. These are really important trends for our business as we continue to build on the recovery, working to maximize our profitability in all of our segments. This is despite experiencing some very strong macroeconomic headwinds as we emerge from one of the worst downturns in our industry's history. We must continue to implement all elements of our Plan to Win. Our work is not done. We're very pleased with the quarter, but let me get into the business results.

First, on our North American Gypsum business. Our Wallboard results continue to be the primary driver of improved performance. Wallboard price and volume improved during the quarter, and we're pleased with the overall results. Most of our customers continue to embrace our pricing philosophy because they have an opportunity to improve their margins, have certainty on pricing and can lower their administrative costs with a single price for the calendar year.

Additionally, in our North American Gypsum segment, we recorded strong results in our Joint Treatment business with volumes increasing 17% and gross profit growing by $4 million.

Worldwide Ceilings achieved solid results in the quarter, delivering $26 million in operating profit. Sales were up 6%, driven by a shift in mix towards our higher-end products, as well as strong volume and favorable costs on both ceiling tile and grid. Our Ceilings business is performing well despite continued choppiness in the commercial market. While we are not seeing sustained evidence that this choppiness is behind us, we do anticipate a seasonal tick-up in our Ceilings business with the school construction season upon us.

Turning to our Distribution business, L&W Supply. Their trend is positive, earning $1 million in the quarter with same-store sales up 13%. Wallboard's spread percentage also increased by double digits, along with modest growth in Wallboard volume. L&W Supply results in the second quarter illustrate our focus on lowering our breakeven and strengthening our core. In the third quarter of 2008, the last profitable quarter, L&W had the same profit on an additional $200 million in sales, an example of the operating leverage we have at L&W and throughout the company. While L&W has made steady progress, our exposure to the commercial market may lead to continued choppiness in the L&W results over the next few quarters.

Our Plan to Win is working and it's evident in our results. As we've talked in the past, our 3 legs of our strategy are: strengthening our core, diversifying our earnings and differentiating through innovation. And these continue to drive our improved performance. Our commitment to strengthen the core can be seen in the L&W results I just mentioned.

Since the downturn began, we closed over 125 L&W locations, reduced overhead, reduced our delivery cost, and more importantly, we redefined our value proposition and a focus on the commercial contractor. L&W Supply also continues to grow its product portfolio outside of Wallboard with a quarterly operating profit growth of over $5 million compared to last year in non-wallboard products like commercial insulation and steel. The focus on these product categories is an important component of redefining our value proposition to the commercial contractor since commercial projects typically use a larger portfolio of these products.

The second pillar of our strategy is to diversify our earnings. One part of this strategy is to provide geographic diversity to our earnings to help dampen the cyclicality of our U.S. business. Last year, we made an important strategic investment in the Middle East region in Oman. These joint ventures, which includes one of the largest gypsum quarries in the world, enabled us to service the high-rise market in the Middle East and India. These markets support our criteria to strategic international markets. There's growth potential where we can attain a #1 or #2 market position; Western construction practices, which give a demand for USG systems, especially in commercial construction; and our landed assets. During the second half of the year, we expect to begin selling gypsum rock out of our Oman quarry to the regional cement industry and with our wallboard plant coming online next year.

Differentiating our business through innovation is our third element of our strategic focus, and I'm very excited to say that during the quarter, we were recognized by the patent board as one of the top innovators in the industrial materials sector. This recognition is based on the strength and the significance of our patents and the research intensity of our company. We're very proud of this designation as it illustrates the value of our product innovations and our commitment to providing a pipeline of new products to our customers. Our strategy provides clarity to our customers and our employees. Strengthen, diversify and differentiate to grow USG.

Now I'd like to turn the presentation over to Matt, and he'll give us a greater detail on the quarter. Matt?

Matthew F. Hilzinger

Thanks, Jim, and good morning to all of you. As Jim mentioned, I'll recap our second quarter results and provide some additional details on each of our business segments. Net sales for the second quarter were $916 million, up 15% from the second quarter of last year and up 13% versus the first quarter. Our second quarter net income was $25 million, which compares to a net loss of $57 million in the second quarter of 2012. The year-on-year improvement was driven by virtually all of our businesses.

As Jim mentioned, this was our second consecutive quarter of net income and positive earnings per share. For the quarter, our diluted EPS was $0.22 per share. We have included 2.5 million of potential common shares in fully diluted EPS. As a reminder, 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.

Looking at SG&A expenses, in the second quarter of 2013, SG&A was $76 million versus $74 million last year. As stated earlier this year, we will continue to work to offset the effects of inflation but still expect SG&A to be up slightly in 2013 versus 2012, primarily starting in Q3 of this year, as we make investments in the business, particularly in select IT, R&D and marketing projects focused on growth.

I will now provide a little more detail on our second quarter segment results. Net sales for our North American Gypsum segment were $573 million for the quarter, and operating profit was $67 million versus net sales of $473 million and an operating profit of $31 million in last year's second quarter. The primary contribution was our Wallboard price increase, contributing $27 million.

Our U.S. Wallboard business shipped approximately 1.3 billion square feet in the quarter, an increase of 12% compared to the second quarter of last year and an increase of 16% from the first quarter. Our quarterly increase was slightly off the industry pace of 14% because of seasonality in the big-box channel where we have a higher share.

We had an average realized Wallboard sales price of $153.77 for the second quarter of 2013 compared to $132.09 in the second quarter a year ago. As we have previously stated, this price may vary slightly throughout the year due to changes in freight, mix, regional demand fluctuations, including exports. For Q2, our price held steady relative to Q1, and we remain very pleased with the price improvement versus the prior year. We believe that we have realized pricing improvement due to our high-quality products, strong customer service and our commitment to help our customers improve their product offerings and profitability as we build on the recovery. This helps USG's path to generating an appropriate return on invested capital.

Additionally, we are driving strong growth in our surfaces and substrates businesses, which include Joint Compound and DUROCK, respectively. During the quarter, we grew our Joint Compound revenue by $12 million and operating profit by $4 million while also growing our DUROCK revenue by $6 million and operating profit by $1 million. Our offshore shipping business, GTL, generated $5 million in increased operating profit for North American Gypsum, primarily due to timing of shipments this year versus last year.

Turning to Worldwide Ceilings. Our Ceilings business delivered a second quarter operating profit of $26 million in 2013. Absent a $3 million environmental charge related to a property we sold decades ago, this would have been our best quarter of operating profit in history. Improved price, cost and volume for both our ceiling tile and grid products helped drive our results, along with a $2 million improvement in our USG International business.

In our Building Products Distribution segment, L&W earned $1 million in operating profit on $319 million in sales compared with an operating loss of $7 million on $293 million in sales during the second quarter of 2012. L&W's Wallboard volume and price were up during the quarter, contributing $5 million in incremental operating profit versus the second quarter of 2012. Additionally, L&W continues to diversify its product offering beyond Wallboard as non-wallboard sales contributed an additional $5 million in incremental operating profit.

L&W same-store sales growth was 13% year-over-year, evidence of our improved product, volume and price. For all of USG, our second quarter incremental operating profit was about 40%. The occurrence and timing of certain costs impacted our leverage this quarter. Frankly, fluctuations on a quarterly basis are not surprising. Historically, when coming out of a recession, we have had incremental operating margins in the range of 30% to 50%. Over the last 6 quarters, we have averaged about 65%. Again, we are committed to taking steps needed to lower our breakeven, but we do anticipate our operating margins will fluctuate and be impacted by anticipated costs to serve growing demand.

Turning to our cash position. Our cash and marketable securities declined by $123 million in the first 6 months of 2013, as we expected. $45 million was used for normal operations, including seasonal increases in working capital and increases as a result of our growth. We also spent $46 million in CapEx, of which $11 million was spent by our Oman consolidated joint ventures. In addition, we spent $17 million for the acquisition of mining rights in Oman during the first quarter. As of June 30 of this year, we had total liquidity of $846 million, including $550 million of cash. And we believe our liquidity is well positioned and strong for this point in the cycle.

Let me conclude by saying that while we are very pleased to have delivered 2 consecutive quarters of net income, we recognize that this is just another step towards earning the appropriate return on invested capital for each of our businesses.

So with that, I'll turn it back to you, Jim.

James S. Metcalf

Thank you, Matt. Now I'd like to discuss some of the thoughts we have on the first half of 2013 on the market and how we see the balance of the year unfolding.

First up, on the residential market. The residential recovery has experienced some recent headwinds that I'm sure you've all seen, impacted primarily by increased interest rates. In June, housing starts and permits did fall, primarily -- driven primarily by the multifamily construction. Despite the fall in starts, NAHB sentiment index rose by 6% to 57 in July, its third consecutive monthly gain and strongest reading since 2006.

Our estimate of approximately 900,000 housing starts in 2013 is not at risk. We will continue, though, to be cautious, matching our level of investment and our expectations with what the market will provide. We do believe that the residential recovery is intact, and despite the potential unevenness in the rate of improvement, we're still very optimistic in the future.

Our overall expectation is that the growth in Repair and Remodel will continue in the low single-digit range for the remainder of the year. We are very well positioned, as Matt said, to benefit from the growth in R&R with our strong partnerships with the large big-box retailers. And the continued increase in home prices, we think, will add valuable equity to homeowners for future remodeling projects.

In the commercial segment, the key economic indicators continue to fluctuate. McGraw-Hill and EBI both have sent mixed signals for much of this year. We feel this indicates that choppiness in commercial construction we've been talking about will likely persist for the unforeseeable future. We have seen some green shoots, though, in our commercial recovery through the conversations with our commercial customers through L&W and building systems team. But we do have a lag, as we've mentioned to you in the past, on the majority of our products, particularly ceiling tiles. We don't anticipate any sustained traction in commercial until possibly mid-next year.

While we think that recovery is underway, and the opportunities returning to our business, we are cautiously optimistic because of the impact of the overall economy may have on our business. I want to say that we remain very committed to our strategy and continuing to strengthen our North American manufacturing and distribution businesses is going to be absolutely critical as we see improvement in opportunity across all of our segments.

So with that, I'd like to open it up for questions, and then we'll conclude with some closing remarks.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Stephen Kim with Barclays.

Stephen S. Kim - Barclays Capital, Research Division

I just wanted to follow up on your comment about the incremental margin. Totally agree that certainly that's going to fluctuate from quarter-to-quarter, and over the last -- certainly the last year, it's has been quite strong [ph]. I was wondering if you maybe, nevertheless, tell us if there was anything in the quarter that did create any kind of a temporary drag to the incrementals and if you foresee anything that's worth talking about in 3Q that you think that we should just be mindful of as we're modeling out incremental margins.

Matthew F. Hilzinger

Right. Stephen, this is Matt Hilzinger. I'll answer your second quarter -- question. But first, let me just say 40% operating leverage is still impressive. And if you put it in historical perspective, and these were in my remarks, when we come out of a recession, we generally earn between 30% and 50% in incremental operating profit. If you look over the last 6 quarters, we've averaged around 64%, so pretty good numbers. On a quarter-to-quarter basis, the incremental operating profit is sensitive. And so some variation. You shouldn't be surprised in seeing that, and I think the second quarter is not an exception to that. And in fact, if you think about the first quarter, we had very strong incremental operating profit in the first quarter, and part of it is just the numbers, right? We had incremental revenue in the first quarter of $31 million and incremental operating profit of $25 million. And if you look at the second quarter, you had revenue of $118 million and incremental operating profit of $46 million. So there's going to be variations just because of the size of the change in the revenue. But with respect to the second quarter, there were some items in the second quarter, I think to be specific to your question it was a reversal of a mark-to-market for natural gas. So there was about a $7 million swing. We had a $3 million positive mark in the first quarter. It was to a $4 million negative mark in the second quarter. We had an environmental charge that I referenced in my remarks of $3 million. There were changes in some of the restructuring reserves. There was some timing of SG&A in Q1. So as you think about Q3, I don't think there's anything specifically to note or through the balance of the year. I mean, the numbers will be what the numbers are. But I would like to say this, we would like to continue to beat the historical average. That's clearly where we're headed. But we do see some headwinds out there. This year, in the first quarter and in the second quarter, we saw labor cost move up a little bit as we gave people raises. We've seen a little bit of inflation in raw material. You think about natural gas, last year, in '12, we were at historical lows of in the $2 range, and we are now in the high $3s. So there's some changes there. There was a little bit of power in the numbers, right? I mean, if you think about the wallboard price increase, we got the same dollar increase that we got in '12, but it's just smaller as a percentage of sales. So that -- just the way you run the numbers will drive some of the incremental margins down. And then lastly, as I referenced and Jim has talked about in the past, we may need to selectively add back some cost over time to be growing demand. Our effective capacity right now is about 80%. There's room through the year to increase demand without having to add shifts across the network. We might add one here or there. But we're going to see that as we move through. And again, I'll just finish up and just say we're going to continue to lower the breakeven with things that we're doing in terms of shared services, and Lean Six Sigma are all important things that I think will help us continue to keep our leverage where we want it to be.

Operator

Our next question comes from Michael Rehaut with JPMorgan.

Jason Aaron Marcus - JP Morgan Chase & Co, Research Division

This is actually Jason Marcus in for Mike. So just to touch on your comments earlier about the rising interest rates and the impact that it had on the new construction market during the quarter, I was wondering if you could talk a little bit about some of the demand trends that you saw during the quarter and if you actually saw an impact on your new construction piece of the Wallboard business during the quarter. And if so, how much of an impact would you say you saw?

James S. Metcalf

Actually, we did not. The quarter we're quite pleased with on a volume -- if you look at our overall business, about 25% of our business is on new res. Half of our portfolio is on that R&R segment, which the second quarter is -- they go into lawn and garden, the big-box retailers go into lawn and garden. So we saw a little bit of a pause in that segment. But, the residential market, we basically lag housing starts by 3.5 months. So it's pretty keen. If you look at where housing starts are on a monthly basis, you add 3.5 months, that's really our demand. So there may be some -- we may see some things in the third quarter with a little bit of pause there. But what's good about that is that's where our big-box business starts coming back where they go back out of lawn and garden in the fall season. It's very, very important for us there. So that's -- it kind of balances out the new res. So long answer to your question, we did not see an impact in the quarter from res.

Operator

Our next question comes from Dan Oppenheim with Credit Suisse.

Michael Dahl - Crédit Suisse AG, Research Division

This is actually Mike Dahl on for Dan. I was hoping you could drill down a little bit more into L&W and the trends you saw in the quarter. When you talk about volume being up a little, where specifically are you seeing kind of the puts and takes? And on the commercial side, where do you see some of the kind of biggest near-term opportunities if you think the overall market is still about a year away from really inflecting? And remind us what the effective utilization rate is on that business.

James S. Metcalf

The L&W business, as we talked, is very focused on the commercial business, which is still in some pretty low numbers. If you look at total commercial business this year, it's up about 8%. But if you look at a footage basis, it's still some low numbers. L&W is a national business, but what we saw is some regional strength. It's very strong in the Texas markets, very strong in Northern California. We're seeing some strength in commercial business in the middle part of the country. So it's very regional. The backlog will vary by geographic region. What we're doing -- what we're seeing on the incremental -- the comp store sales increase you saw was really expanding the portfolio. We're very focused on the non-wallboard products as well, not just selling wallboard to a customer. It's commercial steel, insulation, ceiling tile, grid, fasteners. It's really providing that bigger share of wallet. So where we've done a nice job in the slow market at L&W is focus on the geographic regions, focus on commercial Repair and Remodel. That has been a strong part of the business, the maintenance side of the business and high-rise construction but also increasing the share of wallet for the non-wallboard products. And you can see the improvement on the numbers that we talked about. If you look at the effective capacity, a typical L&W branch will get 3 turns in a day, delivery turns. And we have a lot of room to go before we start adding staff there as well. Very similar to what Matt talked about on the manufacturing side. We want to continue to keep our breakeven low, and we're going to really -- we think we still have some room to go on a volume basis before we start adding any significant type of overhead to our delivery business as well.

Operator

Our next question comes from Bob Wetenhall with RBC Markets.

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

I wanted to ask you -- great job on SG&A leverage. You saved 100 basis points. SG&A is up $2 million year-over-year, and revenues were up $118 million. That obviously shows a lot of cost control. Just want to understand, is this sustainable? And can you guys find additional areas to reduce costs and drive better margin performance in SG&A?

James S. Metcalf

I'm just going to just make a couple of comments, and I'm going to turn it over to Matt. And as we talked before, focusing on keeping our breakeven very low and having as much leverage, and as Matt said in his previous comments, we want to really beat those historic leverage numbers that we talked about, those leverage percentages. So we work very diligently the last 5 years of strengthening the core of this business, and we have to be a -- we're very focused on cost control, both structural costs and input costs. And we are going -- we have all hands on deck. We want to grow the business. But the tricky thing now is we want to grow the business and keep our breakeven low. So what we've talked about is we need to be an ambidextrous organization to do both. It's not one or the other. So I want to assure you, we're extremely focused and this CEO is very extremely focused on cost control. There are some strategic investments we want to make to grow the business, but we're going to be very diligent about that SG&A number that you talked about.

Matthew F. Hilzinger

Yes. And Jim, I would add this to Bob's question. We're roughly flat year-over-year through the first 6 months. And as I said in my remarks, Bob, we're probably going to see a little bit of a tickup in the second half as we start making some of the strategic investments. And again, some of that stuff in IT, in R&D -- IT, just an example, we're putting in some sales force automation here, which we think is strategic to us and kind of a strategic weapon that will allow us to kind of drive the top line but also drive some efficiencies in our cost side as well. So the way that we think about SG&A is we're driving out the low value added where we can and we're using Lean Six Sigma and those type of processes to do that. And so we're going to add back where we think we can really drive kind of growth and value to the shareholders. So you may see us tick up a little bit, as I said, in the second half, but it's really based on more strategic growth investments than anything else.

Operator

Our next question comes from Kathryn Thompson with Thompson Research.

Kathryn I. Thompson - Thompson Research Group, LLC

Could you discuss your thoughts on potential capacity additions and thinking about 2 different ways? This could include reopening of a production line within a current plant or entirely opening a mothball plant. And what -- how much would volume have to increase before making decision to add workers given the increase in overall demand?

James S. Metcalf

Well, I will say right now, we have absolutely no plans to open up a mothball plant nor a line. We feel that we've taken out all of our high-cost old capacity. We've idled some capacity. And if you remember, the longer you idle capacity, the more expensive it is to bring back, and you're dealing with an old technology. We feel that we have anywhere between 15% and 20% of total volume that we could increase without adding a shift. We're working overtime. We're hiring people here and there. We're very busy in, for example, I mentioned in the Texas market. But we really focus on overtime first, adding a body here and there. Then you would add a shift, and then it would be, as you mentioned, a possible line in a current plant. But I think we're a long way from that. Our capacity utilization effective, as Matt said, is around 80%. And it's really -- that is a national number. There's some areas where it's much below that, and in Texas, it's higher than that. So from a mothball perspective, we -- I think it's historically, we've done that once in the history, and that was a bad idea. And again, that is something that is not in our plans.

Operator

Our next question comes from Trey Grooms with Stephens.

Trey Grooms - Stephens Inc., Research Division

Just real quick on L&W. You guys had touched on the fact that there's going to be some choppiness there. And you made it to profitability, getting in the black there, which is great. But with that choppiness, I mean, should we be thinking about kind of staying around the breakeven mark in that business, give or take a little bit, of just kind of in the near term? Or is the choppiness you were referring to more on kind of the top line there?

James S. Metcalf

Well, I think with the large exposure that we have at L&W with the commercial business, and you see the numbers as we do, it really depends on the commercial segment. I mean, office construction, are we positioned with the contractor that does office construction? Are we positioned in an area where they do retail? Well, retail is quite strong in that segment. But yes, Trey, I would say we're looking from an opportunity really to get some wind at our back from a demand standpoint as we position L&W. We're looking -- 2014 is really when we'll start to see a little bit of traction. But even the 2014 numbers, I know that what we're seeing from McGraw-Hill, they're up 16% but it's from a low level. So we're coming from a very low level. So what we're doing at L&W we're -- as I said earlier, we're getting a larger share of wallet. We're trying to position with commercial contractors that are in segments that are growing, and it's really geographically. There are some areas of L&W from a profitability standpoint in the country that are doing extremely well now. But having that national footprint, there are still some pockets -- you see employment where it is now, there's still some pockets that aren't doing great. So we're very happy. We're in the black in the quarter. And our job is to continue that trend. And we do not want to go backwards. But I just -- we just wanted to reiterate, there is some headwinds in our face, in our distribution business. But we have not -- we are still optimistic. And the other thing with L&W, they don't get a chance to really participate in that Residential R&R that we're talking about, and they have a smaller footprint in residential as well. So this is a long-term play for us. We think the commercial business is better positioned for us at L&W. But it's going to be -- we're going to have some chop here probably for the next 3, 4 quarters.

Operator

Our next question comes from Garik Shmois with Longbow Research.

Garik S. Shmois - Longbow Research LLC

Just wondering if you could provide a little bit more color on the strength in the DUROCK and Joint Compound revenues in the quarter, and then also maybe help us better understand the incremental profitability of those product lines as they impact the Wallboard division, and assuming those continue to recover, what kind of profitability, whether it's margins compared to the prior cycle or incremental margins related to the consolidated average, we should be thinking about? That would be helpful.

James S. Metcalf

I'll just -- I'll touch on -- really, the DUROCK is part of our substrate division, and Joint Treatment is part of our surfaces division. What we did is we got into the recession -- Wallboard casts a long shadow in these businesses. So we put together business units with general managers that focus both on these 2 segments, the substrates business, which includes DUROCK and FIBEROCK, as well as our Industrial Gypsum business and surfaces, which is also Joint Treatment. And we don't talk a lot about our plaster business, which is a strong business for us from a market share standpoint. If you look at the results, a couple of things have happened. First, we've talked a lot about our UltraLight and Wallboard. What we did -- our UltraLight -- our lightweight technology, we started with DUROCK 5 years ago. And we lightened DUROCK, and we really focused on the chemistry of our cement board. And what we did is took the weight out, reduced our cost, and we got price premium in the market because of performance and how it compares against competition. So what you're seeing in our DUROCK, and the last -- the last couple of quarters we've highlighted a little bit is that the lightweight technology really has taken root in the cement -- our cement board, as well as, we've talked in many quarters about what UltraLight has done on the Wallboard side. On Joint Treatment as well, we continue to expand our lightweight technology to Joint Treatment, and this is just not a one-trick-pony play on Wallboard. So if you look at our whole portfolio of products, we are going to continue to make them lighter and perform better in the markets. So we can either have a cost-neutral position on the manufacturing side, if not lower, and get a price premium because it performs better than competition. So from a macro standpoint, that's what's really been happening in those portfolios. And Joint Treatment, for example, and DUROCK are really contractor-preferred products. This is a pull-through strategy. A lot of our work from our field group has been done on the field, getting our shoes dirty, and this really isn't a dealer push. This is a contractor pull. So what you're seeing on the Joint Treatment with the increase in residential markets, that's pulling through more of our Joint Treatment because it is a contractor-preferred product. So you have the product technology side that we've done over the last few years lowering the weight. You also have the focus on the pull strategy of being in the field, as well as the residential market including. One other thing that I would like to add on that is our FIBEROCK business, which is part of that substrates business. We have found a new market. The commercial roofing market is a growing market for us. And FIBEROCK is a product that is in many roofing systems now that we have a focus on the commercial roofing business, which also helps us diversify our earnings to some adjacent products. So I think the long and the short of this is innovation is all the way through why these products are performing better. The numbers are the numbers, and you're going to continue to see solid performance here, but that's why innovation is really, really key to us, because it's what the customers -- it's what the customers want, but also from a financial standpoint, it gives us better performance.

Operator

Our next question comes from Keith Hughes with SunTrust.

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

My question is on the Ceilings business. If you look at your end user markets there, can you give a sort of a flavor of what's working, what's not working in the second quarter?

James S. Metcalf

The -- our Ceilings business, as Matt indicated, if we pull out that one environmental charge, it was a record quarter. We saw a little bit of top line growth, but really, it's been focused. And really what's been working well in the second quarter, it's been working really the last probably 3 years, is our focus on the commercial Repair and Remodel side of the business and the big-box retailers. Along with that, we have shored up our distribution business, not only through L&W, but we have some very strategic key ceiling tile distributors that we've upgraded, not only the network of distribution, but their focus on ceilings. So it has been the market focus on the repair -- or the commercial Repair and Remodel and also a focus on distribution and retail. Along with that is we have a tremendous focus on the architectural side on the higher-end products. These are the high-end, high-performing products that have improved margins. In fact, our plant in Cloquet, Minnesota has basically been sold out. And that is one of our capital investments we're going to be making, is expanding our high-end product line in our Cloquet, Minnesota plant to take care of these products that are being specified at the architectural level. So there hasn't been one soft to our recipe here. It's been hitting it at many angles. The key is we've been really focused on profitability and taking cost out of our manufacturing side of the business. But more importantly, it's focused on the higher-end products where we think the customers are growing architecturally. So we're very pleased with our Ceilings results. And for our Ceilings team, they've done a wonderful job. Through this entire recession, in fact, our Ceilings business has been the shining star as we've navigated through this 4-year, 5-year recession. So we're quite pleased with it, and we expect continued results.

Operator

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

Daniel Downes

Your free cash flow for the first half of the year was negative $85 million. Can you give us some indication of where you expect the second half free cash flow will look like? And I would assume your balance sheet at year-end will be in better shape. Can you kind of address what your plans are to use kind of free cash flow in 2014 and onward?

Matthew F. Hilzinger

Yes. This is Matt. Yes, this is Matthew Hilzinger. So the first half, as I said in my remarks, we did use a fair amount of cash. Part of it was in working capital for growth of the business, and part of it was for just CapEx, as we expected. So there was nothing unusual that we saw in the first half of the year. And quite frankly, we don't expect to see anything unusual in the second half of the year. We're going to make our normal pension contribution this quarter. And we'll use a little bit of cash there as we have done in the past. So as we look at our balance sheet through the balance of the year and what we expect at year end is we expect to be in good shape. As you look back over the last probably 6, 7 quarters, each quarter, the balance sheet has gotten in better shape. A lot of that is being driven by kind of earnings and the cash flow that are coming off of that. We do have an event, a possible event at the end of the year that we're evaluating, and I think we've talked about the converts. We have $400 million of convertible securities. They're held by Fairfax and Berkshire. Those are callable in December. They've got a coupon of 10%, and we've got a couple of objectives as we kind of think about the balance sheet and think about liquidity. One is we want to protect our NOLs. For those that followed us know that we have over $2 billion of NOLs, and we want to delever the balance sheet. And so one of the things that we're going to be looking at is, and we haven't made a decision yet, is to whether we want to call those convertible securities. And it's -- we're going through that analysis now. I think we've had some conversations with shareholders in the past about some of the intertwined issues we have between our NOL and the convertible securities. So not to digress, but I'll just give you a little bit of background. We have this NOL. It's about $2 billion. It's got a cash value worth about $1 billion. Under the federal tax code, Section 382, if there is a change in control as defined by the code, and it's rather complicated, but in simple terms, it basically says that if there's a group of shareholders that have a 5% holders or more, that churn more than 50% of the stock over 3 years, that would deem itself as a change in control. And as we look at the converts and if we converted 100% of converts, we would put about 35 million shares out in the market, and that could negatively impact our NOL. So when the process of working with the IRS, getting some private letter rulings on some things, that can impact our decision about whether and how much we want to do the converts at the end of the year. But that's an event that we're looking at to help delever the balance sheet. So overall, I think we're in good shape.

Operator

Our next question comes from Peter Lisnic with Robert Baird.

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

This is Josh Chan filling in for Pete. You mentioned the movement in natural gas prices. I understand you're mostly hedged in 2013, if I'm not mistaken. But as you look to start to hedge your cost for next year, how do you think about the potential magnitude of impact here with the natural gas prices where they are?

Matthew F. Hilzinger

This is Matt Hilzinger again. So we're about 90% hedged for 2013, and we're about 20% hedged for 2014. One of the things that we've always said is that we like to be at least 50% hedged going into the next year. And so we are in the process of layering in hedges. Clearly, gas prices are higher if you take a look at the forward curve for 2014 than they are right now. I mean, if you look at -- I think the forward curve for natural gas is just under $4. If you look at our kind of all-in hedged price for this year, we're around $3.70. So unless gas prices come down substantially, we would expect to see a little bit of a price increase as we look towards 2014 in our cost structure. So we're going to continue with our hedging strategy. It's been very good for us. We're going to be thoughtful about it. We're going to put it in ratably, and we'll keep you updated.

Operator

Todd Vencil with Sterne Agee is online with a question.

L. Todd Vencil - Sterne Agee & Leach Inc., Research Division

It's Todd Vencil, Sterne Agee. I wanted to ask about incremental margins and just follow up on your comments and then the question that we had earlier. I think you guys are looking at that inclusive of pricing? And if there's a way, can you kind of pull out the pricing and talk about what the incrementals look like on -- just on what kind of incrementals you're getting on additional volume as that starts to come through, how that compares this time with prior cycles and then what you expect to see there going forward?

James S. Metcalf

From a macro level, the way you should look at it is if you look at those last 3 examples we used, the recession of the early '80s, '90s and 2000s, as Matt said, we averaged anywhere between $0.30 and $0.50 of incrementals. Typically, as you come out of those recessions, there was price improvement. So those did include price in there. So we're doing a comparison with price in there. But the way that you should look at it in those 3 recessions, we did not take out the amount of cost that we've taken out in these last 4 years. We've taken out approximately $550 million. We plan to keep as much, if not all of that, out of our cost structures. So the last 3 of the 30% to 50% did not include the tremendous cost reductions that we've done recently at L&W Supply. Those reductions, that 30% to 50%, typically were at the U.S. Gypsum segment. So there's -- I just wanted -- when you look at the comparisons of where we were versus the last cycles, it was Gypsum only. The costs weren't taken out, and pricing was in those segments, the price improvement. If you look at -- obviously, the price improvement currently is very strong. To the bottom line, that contributed probably 3 quarters of the improvement at U.S. Gypsum. But peeling that aside, we do look at costs at the plants, SG&A, structural cost reductions, as Matt said, doing more with less. We're finishing up a program where we're looking at our back offices throughout the company and really leveraging technology. So to give you a quick answer on pricing, what would it look like with price out of it, obviously, the numbers would not be at the level you're talking about. But if you're comparing us to the previous cycles, you'd have to take those out as well. So we feel that our objective, and here's the key, our objective is to maximize that leverage, and that's why we're very focused on keeping our breakeven at some extremely aggressive levels. So when we grow the business, for every dollar, that we have a high percentage going to the bottom line.

Operator

Our next question comes from Al Kaschalk with Wedbush Securities.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

I just wanted to follow up on L&W and a bigger picture question here. If you think about the return to profitability and your goal to increase non-wallboard products, can you share with us maybe what -- if there's a sort of a target on how much as a percentage that non-wallboard products could make up for this business?

James S. Metcalf

Yes. Right now, the non-wallboard products, if you look at the portfolio, are more than half of the sales right now. But those are really in 3 key areas, construction steel, commercial ceilings and grid. Where our main focus would be -- we have 7 core product categories. The other main focus is on commercial insulation. We feel there is a big opportunity to grow our share there. And what we're doing, just from a global perspective, is we feel that our share in the non-wallboard products should be equal to, if not greater than, the share we have in Wallboard. So for example, if we have a 12% or 15% market share as an example in Wallboard, we would want to have those other products equal to, if not greater. So commercial insulation is not there. Exterior finishes, we're largest Dryvit distributor in the United States. We want to continue to grow the exterior part of the business. The fastener business is a key area. So those are areas that when you think about a commercial job, we want to be able to have a one-stop shop on 7 core product areas for our contractors. And what is nice about those products, the margin flexibility as you go forward, the cyclicality is not as great as Wallboard. So it brings more value to our customers, and a lot of it is just asking for that order and being the expert in that product category. So we have some work to do in those areas, but we have some great support with our suppliers, both our insulation and our fastener and our exterior suppliers. But more importantly is we have focused the L&W sales organization to focus on those products, as well as the wallboard products as well.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

If I may, it's a regional business, so I guess the near term, meaning 12, 18 months, you'll be looking to intensify those routes with expanded products as opposed to reopening or adding facilities you may have recently closed, is that fair?

James S. Metcalf

Yes, we -- yes, that's a fair statement. There may be -- you may see a location here or there. But we look at -- we feel that we still have -- there was an earlier question on kind of capacity utilization of L&W. With the commercial market being still relatively choppy, we do not plan on opening up locations. We feel that we can cover geographic areas with our current footprint. You will see maybe -- if there's a void, if we exited a market and we think there's a market that we can make some money, we'll do that. But we're going to be very diligent. There's been a lot of hard work about lowering our breakeven.

Operator

Our next question comes from Dennis McGill with Zelman & Associates.

Dennis McGill - Zelman & Associates, LLC

Just quickly, the comment, Jim, I think from a couple of questions ago on the cost takeout and the volume leverage, what I heard you say was that volume leverage should be stronger this cycle because of all the hard work you've done on the cost side. Is that true? And is that what you've seen so far during the recovery?

James S. Metcalf

Yes.

Operator

Our next question comes from Mike Wood with Macquarie.

Mike Wood - Macquarie Research

Yes. Also on L&W, you talked about the value proposition from the value add that you're bringing there and also the cost takeout. Do you have a sense in terms of normalized non-res starts in MRO activity, what we should expect with operating margins in the segment?

James S. Metcalf

Well, if you look at the -- if you look at over the average, over maybe the last 10 or 15 years, it's been high single digits. And if you -- obviously, we've taken out more cost here, so we -- and our plan would be to have higher operating margin percentages. So you look -- historically, probably 8%, 8.5% has been the average margin through the cycles.

Mike Wood - Macquarie Research

Okay. And the addition, do you have an estimate of that, what you're bringing out with this richer product mix and the cost?

James S. Metcalf

Well, obviously, I don't like to give you a projection right now, but the intent is to maximize that.

Operator

Our next question comes from Stephen Kim from Barclays.

John Coyle

It's John filling in for Steve. I had my line muted, but the question was answered.

James S. Metcalf

Okay. Thank you. Just to wrap up, I'd like to say in the quarter, as we talked about, we achieved our second consecutive quarter of net income, generating $25 million in earnings on over $900 million in sales. For comparison, the last time we achieved a comparable net income was the third quarter of 2007, when we earned $7 million on $1.3 billion in revenue. This is really important because it illustrates the leverage we've been talking about. There were a lot of questions here on the leverage that we have within our business. Since the downturn began, we have become a more nimble and more efficient company, and I'd like to say, a leaner company with a focus on growth. While the trend in our results -- and we're quite pleased with the quarter, but we are no means satisfied with the present level of earnings and we do have still -- we have more work to do to maximize the value of USG. We do believe the recovery has started. And we talked about we may face some headwinds in the commercial business, in our L&W business. But regardless, I want to say we're committed to focus on doing both, lowering our breakeven and growing our business as the recovery strengthens.

As always, I thank you for your time today, your interest in USG, and we'll be looking forward to talking to you next quarter. Thank you.

Ken Banas

A taped replay of this call will be available until Friday, August 2. 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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USG (USG): Q2 EPS of $0.22 beats by $0.03. Revenue of $916M (+15% Y/Y) beats by $34.3M. (PR)