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USG Corporation (NYSE:USG)

Q3 2009 Earnings Call

October 21, 2009 11:00 am ET

Executives

James S. Metcalf - President, Chief Operating Officer, Director

William C. Foote - Chairman of the Board, Chief Executive Officer

Richard H. Fleming - Chief Financial Officer, Executive Vice President

Analysts

Michael Rehaut - JP Morgan

Dan Oppenheim - Credit Suisse

Trey Grooms - Stephens, Inc.

Garik Shmois - Longbow Research

Kenneth Zener - Macquarie Capital Securities

Ivy Zelman - Zelman and Associates

David Wells - Thompson Research Group

Jack Kasprzak - BB&T Capital Markets

Mark Weintraub - Buckingham Research Group

Jim Barrett - CL King & Associates

Presentation

Operator

Good morning ladies and gentlemen and welcome to the USG Corporations third quarter 2009 earnings conference call. At this time all participants are in a listen only mode. Later we will conduct a question and answer session. Please note that this conference is being recorded. I will now turn the call over to Mr. James Bencomo, Director Investor Relations and Pension Investments. Mr. Bencomo, you may begin.

James Bencomo

Thank you. Good morning everyone and welcome to USG Corporations’ third quarter 2009 earnings conference call and live webcast. We will 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.

And 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 about 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 today’s press release and actual results may be different from our current expectations.

With me today to discuss our results and our outlook are Bill Foote, USG’s Chairman and CEO, Jim Metcalf, President and COO, and Rick Fleming, Executive Vice President and CFO.

First Bill will comment on market conditions and the outlook for our businesses. Jim will follow with comments on how our operating bits are performing. And Rick Fleming will comment – will conclude with some additional comments on our results and discuss how we are managing our balance sheet and liquidity. We will then open up the call for questions and conclude with a few comments from Bill. Also present for the Q & A portion of the call will be Rick Lowes, Senior Vice President and Controller.

We would like to ensure that everyone has an opportunity to ask questions, so when we get to the Q & A portion of the call, callers are asked to limit themselves to one question and one follow up question. Bill?

William Foote

Thank you, Jim. Good morning everyone. We appreciate your taking the time to be with us this morning and we certainly value your ongoing interest and support of the company.

Market conditions in the third quarter continued to be very challenging. Residential housing market appears to have stabilized, but it is done so at a very low level of demand. Commercial construction declined in the third quarter. We took action during the quarter to prepare for additional declines in the commercial segment during the remainder of 2009 and 2010. Specifically, we resized our distribution business to reflect our expectations for a weakening commercial markets.

The repair and remodel market is somewhat mixed. The commercial side of the repair and remodel market declined in the quarter while the residential side showed signs of stabilizing.

International markets began showing some modest signs of improvement and our cost control strategies are having a positive impact.

It has now been more than three years since the new residential housing market first started to contract, in August of 2006. Those initial declines were followed by contractions in the repair and remodel market and more recently commercial construction market.

USG is accustomed to market cycles. We’ve been operating for more than 100 years. But this has been a particularly long and difficult road and we are certainly not out of the woods. Despite the longevity and the severity of the economic contraction I would like to emphasize several key thoughts that demonstrate our commitment to manage through the recession and position the company for recovery.

First, we’ve established a reliable track record over the last three years for taking decisive and necessary action to adapt to unprecedented declines in our markets. Second, those actions are succeeding. And third and most importantly, our organization remains vibrant and innovative finding new and creative ways to serve customers and prepare for an eventual repeat.

I’d like to elaborate on each of these points. Those of you that have been following the company’s performance since the residential market first started to decline in mid 2006 know that we’ve been very proactive in adapting to the declining market. We’ve closed manufacturing capacity, optimized their distribution network, cut costs substantially, reduced our workforce, and worked hard to maintain our financial flexibility.

The success of those efforts is evident when you compare our year-to-date performance this year to the first nine months of 2008. For the first nine months of this year, total USG sales are down from 3.6 billion to 2.5 billion of this year. That’s a staggering contraction in demand. Even more so when you consider that 2008 sales were down substantially from the prior year. Yet, despite this $1 billion decline in sales we see significant progress in our operating results.

This year’s operating loss of $174 million includes $92 million of restructuring, good will and asset impairment charges. While last year $131 million loss included $30 million of similar charges.

Netting out those charges, the loss this year of $82 million compared to a loss last year of $101 million. So, despite a substantial decline in sales our operating profit before restructuring is up in the first nine months of this year compared to last.

The benefits of our aggressive cost control disciplines can also be seen in the company’s cash position. For the first nine months of this year, net cash generated by operating activities after interest exceeded cash use for capital spending and other investments by $36 million. That’s a huge improvement over the same timeframe last year when those activities used $350 million in cash.

We’ve been equally aggressive in managing our liquidity. One of the highlights of the quarter, early in the quarter, was our successful $300 million note offering, which was very well received by the market. As a result, as of September 30th of this year, our total liquidity consisting cash, cash equivalent and available borrowing capacity was more than $796 million.

We are not just cutting costs and shrinking the company, though, hoping that a recovery will come. We’re continuing to innovate, invest and serve our customers here and abroad.

Before I turn the call over to Jim, I’d like to highlight just a few examples of the vitality of the company in these very challenging times.

We have been very judicious in our capital spending over the last few years. But we’ve found other ways to grow that don’t require large capital investments. For example, during the third quarter we finalized the strategic alliance in Columbia for the manufacture and sale of SHEETROCK brand wallboard. We are using our manufacturing expertise in USG’s proprietary technology as a currency to build alliances around the globe.

Another example is our new tile backer product, DUROCK next gen. Which is by far the lightest cement poured product on the market. Customers praise the product in test markets and we will be rolling it out nationwide next month. We are very excited about the prospects for this breakthrough next generation product.

And we have not lost sight of the importance in serving our customers. Earlier in the quarter L&W supplier distribution business earned vendor of the year award from one of the largest home builders in the southeast.

And our logistics operations are innovating too. USG’s transportation department recently won the SmartWay Excellence Award from the US EPA, marking the second time this year that the EPA has recognized USG for its environmental efforts. We’re saving money by reducing fuel consumption and improving our environmental profile by reducing emissions. All while continuing to provide excellent customer service.

As I said, this is a deep and prolonged downturn. But it has not dampened our passion for serving customers in our inherent optimism and the future of this company. We are making the necessary and sometimes painful moves to manage through an unprecedented downturn knowing that they are actions that will position the company for the eventual rebound in our key markets.

With that, I’d now like to turn the call over to Jim to discuss our operating results. Jim?

James Metcalf

Thank you, Bill, and good morning. Before I review the third quarter performance of each business I’d like to briefly describe the strategic approach we have implemented to navigate through this difficult market. There are three broad areas that have allowed us to manage through the downturn, and more importantly position for future growth. They are operational excellence, market coverage, and financial flexibility.

When we refer to operational excellence, we are focused on safety, cost performance, and operating efficiencies across our entire network. It’s part of our overall strategy on efficiency throughout the entire corporation.

USG has a unique position of operating a North American network of manufacturing facilities. Throughout this downturn we have used modeling from our ERP investment, which we call Links to optimize our network.

We have closed an idle facilities and reduced operations, all with an eye towards achieving the lowest nationwide delivered cost in the industry.

Bill motioned the positive impact of our cost controls. Much of this success can be attributed to our network optimization. Reliable, consistent service is even more important to our customers in this challenging market. Our North American market coverage continues to lead the industry. Our customer satisfaction has been strong all year and at its highest last month. We are getting the right product in the right quantities to our customer on a timely basis coast to coast.

An important point is that our manufacturing reductions have not had a negative effect to provide our customers with industry leading customer service.

Efficient operations and a national market coverage are keys to success in this market. But equally important is having the financial flexibly to implement our business strategies and navigate through this weak market.

As a market leader, we must continue to invest in new products, innovation and marketing support for our customers.

Our financial flexibility is key these initiatives. Bill mentioned our liquidity and Rick Fleming will review in a few moments our financial performance. But I want to emphasis one important contributor to our financial flexibility, which is working capital. For example, we’ve reduced our inventory by over $100 million throughout our entire network while keeping our best in class customer service.

Now I’d like to review the operating highlights for the third quarter. In the third quarter the highlights are in three areas, operational efficiencies, product margin improvement and financial flexibility.

Under operational efficiencies, our safety performance through the company has been excellent. Our operations continue to peruse the prestigious Ocious Star Certification. Ocious Star sites represent less than 1/2 of 1% of all US work sites. We now have 10 facilities that have achieved this status with 12 more working on it.

In our plants labor productivity, recovery, speed and delay remain at historically high levels. In fact, wallboard costs in the third quarter were the lowest they’ve been in over 18 months.

Our investments in new low cost facilities and our manufacturing leadership have been major factors to these results.

Product margin improvement, with the focus on cost reductions, balancing price and volume and customer satisfaction, all major wallboard and ceiling products show gross margin improvement in the third quarter versus last year. Again, with the major impact of lower demand and volume our strategy is providing a platform for growth.

Financial flexibility, as I mention our focus on working capital it can be seen on our balance sheet. We continue to implement the sales of surplus properties with $10 million already realized. Also our structural cost reduction efforts continued as evidenced by the recent restructuring at L&W. And as Bill just mentioned, our successful bond offering provides more flexibility and liquidity for the future.

Now I’d like to turn to each one of our major business units starting with US Gypsum Company. Wallboard volume of approximately 1.2 billion feet in the third quarter was about even with the prior quarter. This compares to 1.7 billion feet in the third quarter of 2008. These levels are consistent with the dramatic drop in demand led by residential and the recent slowdown in commercial.

Our average wallboard price was approximately $115 in the quarter compared to $114 in last year’s third quarter. This is down about $5.50 compared to the second quarter. This decline reflects some adjustments we made to reflex market conditions and balance price in volume during the quarter.

Let me reiterate that we – our pricing philosophy has not changed. With the value proposition we provide, such as new products, research and development, marketing and our sales coverage, we will continue to market as a premium product brand.

By significantly reducing costs and resizing our operations US Gypsum improved operating performance during the quarter. For nine months the operating loss was reduced by $103 million, with $400 million less revenue.

For the third quarter of 2009, operating losses were reduced from $54 million to $31 million with substantially lower volume.

Now I’d like to turn to our surfaces and sub-straight business which also felt the demand impact, but outperformed the market. In the surfaces business, cost disciplines, pricing and market penetration all had positive effect on margins. And it was a terrific performance in a very tough market. Sales of performance sub-straights, which includes DUROCK and FIBEROCK out performed the market with new product introductions and unit margin improvements.

Now I’d like to discuss our distribution business, L&W Supply. The significant decline in commercial construction which began last year contributed to the impact – it continued to impact the results at L&W. L&W reported an operating loss of $73 million in the quarter, which includes charges for restructuring and asset impairment. After netting out the $49 million the operating loss was $24 million for L&W in the quarter.

Sales declined about 2% in the quarter compared to the second quarter, and for nine months sales were down 35%. This sharp drop in sales reflect dramatically lower demand in commercial products such as steel, insulation and commercial roofing. As well as a decline in wallboard spread. We are projecting additional contraction in commercial construction in 2010. And we’ve announced plans to reduce costs future by closing 30 L&Ws.

There are two important points I’d like to make about the L&W center closures. First, we have the capability to service our customers by expanding the reach of our centers in every market we serve. We are sizing L&W operations to the market opportunity.

Second, it’s important to understand that these closures and the context of the broader market. We estimate that there were 70 specialty dealer closures during the quarter, including the locations we closed. Since the beginning of the recession we estimate about 230 specialty dealer locations have closed, with 100 of those being L&W locations.

The market is contracting as a result of the recession but L&W remains the largest and the only specify dealer with a national footprint. L&W continues to be the market leader. And like all of our other businesses it will be well positioned when the market recovers.

Now, I’d like to turn to our ceilings business. The performance of ceilings was solid during the quarter despite the contract in the commercial markets. This reflects our focus on architectural specification, our big box strategy and sales efforts targeted at the healthiest non-residential segments, which include health care and education.

USG interiors posted an operating profit of $16 million for the third quarter, compared to $20 million last year. This performance reflects the benefits of cost reductions, manufacturing efficiencies and price improvement. Sales were only down modestly during the quarter compared to the second quarter. And for nine months sales declined 20% and operating profit was down 17% reflecting the reduction in commercial and commercial R&R activity.

Now, I’d like to turn to our international business. The global slowdown has effected each market we participate in, but we are seeing signs of improvement. The positive impact of our cost controls, strategic alliances and customer growth enabled all of our international operations to report an operating profit in the third quarter.

Operating profit for our international unit was near 2008 levels. International has adopted the same strategy of focusing on USG fundamentals of safety, customer satisfaction, and quality.

Our emphasis on operational excellence, customer satisfaction and financial stability will continue to be our focus. Our markets have contracted substantially but our efforts to focus on customers, reduce our costs, manage working capital, have had a positive impact on our operating performance.

We are carefully balancing price and volume in each business to improve operating results. Customer satisfaction remains high, operational efficiencies throughout the company are excellent. And overall safety performance is strong.

USG is the leader in building products. And despite this very difficult market our eye is on the future. Innovation, customer satisfaction, and operational efficiencies are as important now as ever before. We are focusing on the controllable factors of our business to position the company for the future.

Now I’d like to turn the call over to Rick Fleming for a more detailed discussion of our financial performance. Rick?

Richard Fleming

Thanks, Jim. And good morning to all of you. As Jim mentioned I’ll recap our third quarter and year-to-date financial results and provide some additional details on overhead, interest expense, taxes, capital expenditures, debt and liquidity.

Third quarter 2009 net sales were $822 million, down 32% from the third quarter of 2008 net sales level of $1.211 billion. Our third quarter operating loss was $92 million, including $22 million in restructuring and long lived asset and impairment charges, and $41 million in goodwill and other intangible asset impairment charges.

The majority of the $22 million in restructuring expenses is related to severance costs associated with salaries and other work force reductions, lease obligation and other costs related to the closure of L&W distribution centers and a write down in the current value of idle to manufacturing assets.

The $41 million of intangible asset impairment charge is a non-cash charge reflecting a determination that all the remaining goodwill and a portion of our intangible assets related to the value of certain local trade names that L&W supply were impaired.

We expected our restructuring actions, including the L&W store closures that occurred in October will generate over $30 million in annualized savings. A portion of which will be realized in the fourth quarter of this year.

In last year’s third quarter, we reported an operating loss of $32 million which included $5 million of restructuring charging. Adding back the $63 million of restructuring and impairment charges I just discussed to the reported third quarter 2009 operating loss, there was a loss of $29 million. The loss in the third quarter of 2008 on the same basis was $27 million. So our loss on that basis was very similar despite a $389 million decline in sales.

The breakdown by core business of the $63 million of pre tax restructuring long lived asset impairment and goodwill and other intangible asset impairment charges is as follows; North American Gypsum $11 million, Building Products Distribution $49 million, Worldwide Ceilings $2 million and Corporate $1 million.

Third quarter 2009 net loss after tax was $94 million or $0.96 per share loss. This compared to a net loss of $36 million or a $0.36 loss per share in last years third quarter. As opposed to third quarter 2009 results included $63 million in restructuring and impairment charges, which is $0.43 per share after tax. The third quarter 2008 results included restructuring charges of $5 million before tax or $0.03 per share after tax.

Now I’ll turn to the year-to-date results, for the first nine months of 2009, net sales were $2.5 billion, compared with $3.6 billion in the first nine months of last year, a 31% decline. Our operating loss to the first nine months of 2009 was $174 million compared to a loss of $131 for the first nine months of last year.

The first nine months of 2009 includes pre tax restructuring and long lived asset impairment charges of $51 million in goodwill and other intangible asset impairment charges of $41 million. On after tax basis these amounts hold to $61 million or $0.61 per share. The operating loss for the first nine months of 2008 included $30 million in restructuring and impairment charges, on an after tax basis this was $19 million or $0.19 per share.

Our net after tax loss for the first nine months of 2009 was $189 million or $1.91 loss per share. This compares to the net loss of $114 million or $1.15 loss per share for last year’s first nine months.

The increase in the 2009 net loss is due primarily to the previously mentioned restructuring and impairment charges. And this year’s higher level of interest expense.

Now I have some details on the rest of the of the P&L and discuss what we have done to manage capital spending and our balance sheet including liquidity. Let me start with overhear. Selling and administrative expenses or SG&A declined by $24 million or 26% in the third quarter of 2009 compared with the same period last year. In total, SG&N expenses were $67 million in the third quarter and $219 million for the first nine months of 2009.

SG&A expenses are down $68 million this year compared to last year’s first nine months. On an annualized basis, SG&A spending is now getting close to 2001 levels. Interest expense is $42 million for the third quarter and $120 million for the first nine months. We currently anticipate that our annual interest expense will be about $164 million for all of 2009 on a P&L basis and about $152 million on a cash basis.

The effective tax benefit rate was 28.3% in the third quarter of 2009 and 32.8% for nine months. This compares to rates of 35% and 39.2% in last year’s third quarter and first nine months respectively.

Looking ahead to the full year, we currently anticipate an annual tax benefit rate of about 34%, depending on the mix of worldwide income and the need for valuation allowances.

Turning to capital spending, capital expenditures total $8 million in the third quarter of 2009, compared to $37 million in the same quarter last year. For the first nine months, CAP ex totaled $36 million and we are still forecasting about $50 million of capital spending the full year. Since we have made substantial investments in our operations of the past several years we are comfortable with this level of spending and we believe that it can be maintained in 2010 as well.

Regarding our cash and debt situation, our September 30th cash balance excluding $2 million of restricted cash was $621 million compared with $302 million at the end of the second quarter and $471 million at the end of 2008.

The increased consumed 30th primarily reflected the receipt of $287 million in net proceeds from the August sale of our 9.75% senior notes.

As Bill mentioned, it is worth noting that in the first nine months of this year, net cash generated by operating activities after interest expense exceeded cash use for capital expenditures and other investing activities by $36 million.

Total debt was $1.963 billion as of September 30th compared to $1.836 billion at the end of last year. The increase in the level of debt is due principally to our August issuance of $300 million of senior notes and $25 million of additional borrowing last May on our ship mortgage, less the payoff of $190 million borrowing on our old credit facility last January.

We currently have nothing borrowed on our secured revolving credit facility. This facility is subject to borrowing base in $147 million is effectively available to us at the end of September. After taking account $87 million in outstanding letters of credit and a minimum availability requirement is $75 billion. This amount combined with our cash on hand and the under drawn CDC credit facility resulted in $796 million of liquidity at the end of the third quarter. This represents a substantial increase from the June 30th level of $495 million.

In addition we expect to add to our liquidity to our continued focus on working capital and future surplus asset sales.

Jim has discussed our working capital initiatives already so I’ll briefly recap our surplus asset sale activity. As Jim mentioned we have sold $10 million in surplus assets through September of this year. We presently have over $20 million of surplus asset sales under contract. And these sales are scheduled to close in the fourth quarter of 2009 and the first quarter of next year.

Finally we still anticipate their surplus asset sale program could total $50-$100 million over the next several years.

In conclusion, we continue to focus on the basic, superb customer service, quality, cost and liquidity. As you’ve heard from Bill and Jim, considerable progress has been made in terms of scaling the company to match reduced market conditions. And we are unwavering in our goal of retiring USG to profitability. Here all the considerable progress has been made, we still have more work to do. But we will continue to be relentless in our efforts to achieve this goal.

Now we will be happy to answer all questions you may have.

Question-and-Answer Session

Operator

(Operator's Instructions) The first question comes from Michael Rehaut from JP Morgan.

Michael Rehaut - JP Morgan

Hi. Good morning, everyone. First question just on gypsum wallboard pricing — as I guess you might expect, last quarter you left us announcing that you had another 10% price increase. Obviously, demand really didn't move much sequentially, I was wondering if you could just walk us through kind of what occurred throughout the quarter that obviously it appears that not only did you not get the increase, but there was some slippage in price, and if you've made any announcements or adjustments with regards to the fourth quarter?

James S. Metcalf

Yes, Michael. Just to reiterate, our pricing philosophy, as I said in my prepared comments, has not changed. As you know, we have been raising prices over the last — really since January of 2008, but realistically our whole philosophy is balancing price and volume to maximize our profitability. Pertaining to the fourth quarter, we don't give forecasts so I can't comment on that, but just to kind of walk you through to answer your questions.

We rescinded our increase that we talked about last quarter and what we saw in the general market is lower input cost, particularly energy, which we felt it moved market pricing down and we made some selective adjustments with our customers.

Michael Rehaut - JP Morgan

So just to followup to that, in terms of the lower input costs, this is something that you expect to benefit as you move into next year. Can you give us a sense of what you're thinking about in terms of if you expect to continue to pass these savings along, given the softer demand environment, and how much might you retain versus pass along? Because excluding the charges, the US Gypsum company did about -15 million loss in the second quarter and -20 million in the third, so it still seems like you're operating at an even slightly worse operating loss. So I was wondering just some more insight in terms of again number one, how you're balancing perhaps incremental savings in natural gas going forward and number two, your striving to get back to positive profits?

James S. Metcalf

Well as we look — and again, we don't give pricing forecasts on the next year, but as we've said in previous calls, our hedges roll off and at the beginning of the year we will be about 28% hedged, in January. As you know we're north of 85% hedged at over $9 gas. So from a cost perspective, that will give us some flexibility from a cost side, but again back to pricing, we have a value proposition to our customers . We're going to continue to get price increases and attempt to get price increases in this market as we have the last 18 months.

Operator

The next question comes from Dan Oppenheim from Credit Suisse. Please go ahead.

Dan Oppenheim - Credit Suisse

Thanks very much. I was wondering if you can talk a bit more about your expectations in terms of the wallboard capacity. If we look there given where the operating rates and subdued demand for commercial and weak stabilization in residential — when do you think we'll get to a point where we can see any better pricing power in terms of margins for the wallboard business?

James S. Metcalf

Well, what we're looking at from an opportunity basis as you look at it next year, we're looking at it — the consensus in Blue Chip and what we're seeing is housing starts around 750, non-res is still going to be weak, and repair and remodels is going to be anywhere between — down to and flat.

But if you look at just to kind of frame-up the commercial business and how it relates — the new commercial business and how it relates to wallboard, only 14% of total wallboard opportunities do commercial. It's still heavily R&R and residential. So even with the big contraction in commercial going forward, the new commercial doesn't have as much of an impact on wallboard.

So if you put those together you're looking at total opportunity which is still going to be fairly weak and to get to capacity utilizations north of 80%, we're still a ways off.

Dan Oppenheim - Credit Suisse

Right. And then what do you think in terms of the chances for more longer term idled capacity or just overall taking capacity out?

James S. Metcalf

Well, if you look at the industry as a whole, and let me just refer to you as she. We've taken out about 3.1 billion feet of capacity. About 1.8 of that is idled and the rest of that is permanent. Looking at our network, 85% of our network is low cost or medium speed plants. So we feel our network is running very efficiently. Even at these lower levels as I said in my prepared comments, our efficiencies are at historically high levels, our wallboard costs have come down even with the hedges. So we will continue to balance price and volume and look at our network depending on the demand.

What competition does, that is something you may have to ask them. We see some high cost plants out there. That could come out, but I think one of the issues competition has is they would be exiting markets.

Dan Oppenheim - Credit Suisse

Okay. Thanks very much.

Operator

The next question comes from Trey Grooms of Stephens, Inc.

Trey Grooms - Stephens, Inc.

Good morning, gentlemen. Thanks for taking my call and my question. Real quickly, just gain just touching on capacity, in terms of capacity in the industry, I guess it's about 35 billion square feet or so now and you just mentioned that you need over 80% to get pricing above just adjusting for energy. So when we do see a return to demand and we get back a more normalized environment, where do you guys think that industry capacity needs to be at that point in the cycle?

James S. Metcalf

Are you referring to price improvement in industry capacity or to service the market? I'm not really clear on your question.

Trey Grooms - Stephens, Inc.

Well, both. You said that you need to get 80% utilization to get pricing and so with that, where do you use capacity and the industry needing to be in a mid cycle environment in order to get back to that level?

James S. Metcalf

Well, when you start trending towards 80 to 85, you start getting some traction. So run your housing, your non res, and your R&R models, and you know the capacity of the industry and you can do your — the demand numbers right now are about 18.5.

William C. Foote

This is Bill Foote. Let me just jump in. As we’ve shared with investors in the past, from where we are today looking forward, you need about a 5 billion foot uptick in demand and a decrease in capacity of about 5 billion feet to get back to that, or permutations thereof is there's less capacity coming out at greater increase in demand, but those are sort of the gross numbers and we would expect a very tough winter and the expectation would be some capacity would come out, but demand is really the issue and we're expecting we've hit the bottom in housing and see some improvement, but it's going to take awhile for it to really kick in. But 10 billion is the aggregate number we'd need to get back to 80%.

Trey Grooms - Stephens, Inc.

Okay, well that's helpful. And then, you guys talked I guess last quarter about if we did see another leg down in the industry to about 17 billion square feet or so that you guys would be prepared to maybe take additional steps. I know we're not there yet and I know you've touched on this, but it sounds like you might be maybe taking a less aggressive approach at that now and may be more comfortable with where you stand given kind of your outlook.

James S. Metcalf

Well, let me reiterate, this isn't about comfort. We have a contingency plan for both up and down and we are assuming nothing in this market. As I gave you the numbers we're getting from Blue Chip and some of the outside agencies, but we will have a plan, like we've had over the last 18 months. We have contingency plans. A recent example is a recent restructuring of L&W Supply, the distribution side of our business, and from a capacity standpoint, we are focused on the lowest delivered cost in markets. And when demand moves up or down, we are prepared to make those adjustments. So we aren't going to sit on our hands here.

Trey Grooms - Stephens, Inc.

Okay. That's helpful. Thanks.

Operator

The next question comes from Garik Shmois from Longbow Research. Please go ahead.

Garik Shmois - Longbow Research

Hi. Thanks for taking my questions. First one is can you talk about your wallboard margin spread sequentially during the quarter, recognizing that energy prices might have been low for you, but also your knowing that prices came down sequentially. If you could just identify that for us.

James S. Metcalf

Well we don't disclose our wallboard spread, but I will say that as I mentioned in my prepared comments, our wallboard costs during the quarter were the best they've been in 18 months.

Garik Shmois - Longbow Research

Okay. You can't say directionally whether or not (inaudible) second or third?

James S. Metcalf

No. We don't disclose that.

Garik Shmois - Longbow Research

Okay. And just moving on, just a point of clarification on the L&W, Jim. I wasn't sure, and maybe I misheard this, did you say that you're closing an additional 30 L&W facilities? First off, did I hear that correctly?

James S. Metcalf

Yeah. We've announced 30. We're down to about approximately 160 locations so we announced about 2.5 weeks ago. Part of those are closed in September. A majority of them will be closing this month so just 30.

Garik Shmois - Longbow Research

Okay. That's in line I guess with the 22 that you outlined in the press release, it's part of those moves, okay. And the last question on that, with you taking out L&W facilities, can you just talk about your confidence in still maintaining the lowest delivered cost to market.

James S. Metcalf

From an L&W perspective or a manufacturing perspective?

Garik Shmois - Longbow Research

From a manufacturing perspective.

James S. Metcalf

Well, from a manufacturing perspective, we ship to many customers in addition to L&W and we run models as I mentioned in my prepared comments, through our network optimization, and we look at all of our customers' ship to locations and we have quite a few customers and we look at major markets. So each of our plants compete against each other for lowest delivered cost and we model that every week so we know where we're red, yellow, and green. And if a customer closes, one being L&W or another customer closes, we run that into the model. And primarily we run that into the model from a demand standpoint.

Garik Shmois - Longbow Research

Okay. All right, thank you.

Operator

The next question comes from Kenneth Zener from Macquarie Capital Securities.

Kenneth Zener - Macquarie Capital Securities

Good morning. In the ceiling business, steel is a big part of the cost. Given that revenue's fell down 50 million, I know you guys kind of restated a profit year over year for FIFO LIFO, but can you talk about why the margins were so good, how much of that was related to the lower steel input cost given that grid is a bigger share of that business than it is the ceilings? And what's your outlook as relative to the change in the cost structure for steel?

William C. Foote

Appreciate your comment on ceilings. We're very pleased with the results and it's been a focus on our ceilings business. I thin one of the main factors is we established the business unit a year and a half ago with tremendous amount of focus on cost reductions, manufacturing efficiencies, and top line specifications and our focus on big box. So it's really been two or three different areas that have impacted the positive results on margins.

Steel prices are very volatile. I mean, we follow that through our strategic sourcing. We have a global sourcing group that looks at total steel costs throughout the world, but a lot of our positive impact has been great performance from our ceiling tile side of lowering costs and getting price improvements. So it's been a plan that's been working well and I think it comes down to focus on the business.

Kenneth Zener - Macquarie Capital Securities

Okay. And then same question to wallboard, the way we model, it looks like your fixed costs have been stable kind of the last two quarters more or less, so are you guys at current levels going to be taking out more fixed cost A, and then B, how many, if any, contracts did you guys take down on gas now that it appears to have troughed and moved into the other direction?

James S. Metcalf

Well, let me refer to the cost structure and I'll turn the gas over to Rich Fleming, but as we have looked at our structural cost not only at our plants, but throughout the organization so we have lean manufacturing philosophies in our manufacturing side. Safety is first and foremost, but we have figured out a great way to run these high speed low-cost plants and really focus on our fixed cost. So conversion has been very good if you look at our cost structure. We've been running the plants in this terrible environment at 50% capacity. We've been able to have efficiencies at these plants similar to when we were on allocations. So the fixed cost side is always a focus on all parts of the business and that's something that we're going to stay on even now and when the market returns.

I'll have Rich talk about our contracts and our hedging because there will be some changes as we get into 2010 on our hedge ratios.

Richard H. Fleming

Good morning, Ken. As Jim mentioned, we have entered the year at about 80% hedge at these effective production levels. Actually, the original hedge was at a lower hedge ratio, but as production declined it came in at about an 80% hedge for the full year. And I think we shared with you in the past that those hedges were done at $9.64 so that's a considerable disadvantage compared to the current market price.

You are correct, the spot rates have actually moved up pretty dramatically since the end of August. You might recall spot gas at the end of August is about $2.85 a dekatherm. Today's quote's about $5.16, so that's not really affecting us given the hedge situation, but it clearly will be impacting some of our competition who are un-hedged.

Relative to the ratio going into the next year, the hedge ratio drops dramatically to about 23%, once again hedged at about $9.20. But as you can tell from that, over 80% of our gas at that point will be un-hedged. We have not, at this juncture, put on any additional hedges for 2010. The hedge committee that manages this area of the corporation is working on a recommendation right now that will be presented to both Jim and Bill and then vetted with our appropriate decision makers. But the long and short is we may do something.

We're thinking through it. One issue that is impacting our thinking clearly is that the volatility and the increase in gas costs has been largely at the front end of the curve and the back end of the curve still remains fairly steep, although less steep than it was at the end of August. One option we may be considering would be not to do swaps, but to do basically options that would provide some protection in the event gas spikes, but gives us he benefit of what probably will still be a weak market at the front end of the curve.

Kenneth Zener - Macquarie Capital Securities

So there hasn't been a chance in risk or some of the deleterious effects from hedging at a much higher rate. Your approach necessarily hasn't changed as the curve basically for the outcome?

Richard H. Fleming

No. Our approach hasn't changed which has been a takeout volatility. Clearly this year was a negative in terms of the corporate performance. The hedging activity this year will cost us about $50 million. The good news is next year that isn't in the P&L. But if you look at our hedging activity since '01, the total of all the benefits, including this year's negative, is about $122 million positive to the corporation. So we still think it makes sense to take that volatility out when we can with our dollar cost averaging approach.

Kenneth Zener - Macquarie Capital Securities

Thank you.

Operator

The next question comes from Ivy Zelman of Zelman and Associates.

Ivy Zelman - Zelman and Associates

Good afternoon, everyone. Jim, you mentioned the profitability of ceilings and you've done an outstanding job there. I just want to get a sense from you with the non-res marketing market continuing to be under pressure, if you were modeling and you're looking at that type of margin, do you expect it sustainable even with all the challenges because of your cost initiative sand pricing that you've been able to achieve?

James S. Metcalf

Yes, Ivy. Obviously the non-res is going to have an impact on the ceilings business. Our ceilings business, a large percentage of it is commercial R&R so that will be less of an impact, but yes, we are expecting some pressure with the lower demand.

Ivy Zelman - Zelman and Associates

So modeling wise we should be a little bit more cautious then. In terms of L&W, obviously you're ahead of the curve shutting down 30 more facilities and realizing that you need to get back in the black. Will that you back in the black? Should we be modeling that you return to profitability even with demand as weak as it is because of those closures?

James S. Metcalf

Well, Ivy, you know we don't give projections, but as L&W and anyone of our businesses, we are focused on profitability as soon as we can get there.

Ivy Zelman - Zelman and Associates

So I guess I don't get an answer there. Okay, I tried.

James S. Metcalf

You did, good try.

Operator

Your next question comes from David Wells of Thompson Research Group.

David Wells - Thompson Research Group

Yes. Hi, good morning. First off, maybe if you could just walk us through some of the dynamics that happen when a price increase goes into the marketplace. For the distributor that's receiving that price increase then, are they then required to reopen contracts that they've negotiated with their customers, and is that how some of that — you end up giving up around when you've attempted to push pricing through?

James S. Metcalf

Well, the pricing dynamics sometimes are more of an art than a science. Every specialty dealer handles their individual business differently, but I can't comment on what each individual dealer does on contracts, but typically when you commit to a job as a dealer to a contractor, you commit to that contractor at a price. The next job you quote with the new pricing is typically when you put in the additional increase.

David Wells - Thompson Research Group

Okay. So it wouldn't be then that if you would then — where you referenced earlier in the call where you go back and would choose to give up some pricing to balance that pricing volume kind of conundrum that as a result you’re kind of cutting the legs out from under yourself in the marketplace already.

James S. Metcalf

No. You are not. That's typically for future work and the work that your dealers have currently are jobs that have already been let on pricing that's previously been quoted. But again, every situation can be very different. Each individual contractor varies differently.

David Wells - Thompson Research Group

All right. And then lastly, I'm curious as well how internally within the organization you balance pricing? Because presumably if the distribution side continues to see volumes under pressure, there may be an incentive to help their results out by being more flexible on pricing. And something we keep hearing gin the channel is that pricing at L&W continues to be difficult and not supporting the price increases that are coming out of corporate. And I'm curious how you manage that dichotomy.

James S. Metcalf

Well first of all it ends up all being managed here by the heads of the business unit, and L&W, as I reiterated last quarter, is a profit center. And L&W will quote prices and maximize profitability for L&W Supply. They are not a cost center.

David Wells - Thompson Research Group

Okay. Thank you.

Operator

The next question comes from Jack Kasprzak of BB&T Capital Markets.

Jack Kasprzak - BB&T Capital Markets

Thanks and good morning, everyone. The $67 million of SG&A in the third quarter, just for modeling purposes, is that a good run rate for future quarters, give or take, or could it be materially lower based on recent cost cutting moves?

James S. Metcalf

We're always lowering our costs and I think for your modeling purposes it's a good run rate right now that you've got there.

Jack Kasprzak - BB&T Capital Markets

Okay. Thanks very much. That's all I had.

James S. Metcalf

Operator, why don't we take two more questions.

Operator

Thank you. The next question comes from Mark Weintraub of Buckingham Research Group.

Mark Weintraub - Buckingham Research Group

Thank you. First, are you seeing any significant demand and/or pricing difference regionally at this point, or did basically the market feel pretty similar region to region?

James S. Metcalf

No. It is still a regional market. The southeast is still incredibly weak. The Midwest is fairly stable, solid in relative terms, as well as the intermountain area and Texas, and then obviously there's weak pockets in Arizona, Vegas, and California. So it is a regional demand scenario and then you'll see differences in regional prices as well.

Mark Weintraub - Buckingham Research Group

Which presumably are correlating with the demand?

James S. Metcalf

Correct.

Mark Weintraub - Buckingham Research Group

And I'm sorry, did you throw Texas into the Midwest or the southeast in that —

James S. Metcalf

I actually did it separately because if you're from Texas you think you're separate from everyone else (laughter), but Texas would be with the Midwest, fairly stable.

Mark Weintraub - Buckingham Research Group

Okay. And then I know not necessarily a huge driver for you, but what are you seeing in the facing paper markets and there have been some reports that there could be some changes capacity wise and how people are going to be providing and using their own paper. Could you update us on what you are seeing and hearing there?

James S. Metcalf

Are you talking about the paper as a raw material or as we run our paper mills?

Mark Weintraub - Buckingham Research Group

The gypsum facing paper.

James S. Metcalf

Well, we're totally integrated. We have taken out paper mill closures and we haven't talked about that in recent calls. We've taken out about 17 billion feet of high cost paper capacity, and the reason we did that and we invested in a state of the art paper mill in Kalamazoo, Michigan which is a Ford near machine. So from a paper supply basis, we will be able to service US Gypsum needs up to 12 billion feet of demand.

Mark Weintraub - Buckingham Research Group

And have you been selling paper to third parties?

James S. Metcalf

No. We have not, but if anyone’s interested, we'd be willing to do that.

Operator

The final question today comes from Jim Barrett from CL King & Associates.

Jim Barrett - CL King & Associates

Good morning, everyone. Bill, a question for you. As we look out through this downturn, is it sacrosanct that USG will maintain a national manufacturing network, or could you envision a scenario where you would temporarily exit a market?

William C. Foote

Jim, being a regional business we're very attuned to local demand and our cost position in those markets. But USG, the basic structure of the company is to serve all markets in North America, not just the United States, but Canada and Mexico. And we, importantly, serve some major retailers who have a nationwide presence and locations both north and south of the border.

So fundamentally, we're going to serve all markets to serve our key customers. But as we balance price and volume, our local market shares may ebb and flow. And we're here to make money so we adjust that way. So in Florida as an example, we've pulled back from some very unprofitable business, but would serve our customers there and across the country. So the bottom line is we're a North American enterprise and serving customers in all parts of the continent.

Jim Barrett - CL King & Associates

Good. Well, thank you very much.

James S. Metcalf

Well thank you, I think that concludes our questions. So Bill, would you like to finish up with some concluding comments?

William C. Foote

Thank you, Jim. I'd be delighted. As you've heard, our approach throughout the downturn has been very consistent. We focused on the key factors that we can control; our values, notably safety, serving our customers, managing our costs very aggressively, and ensuring the liquidity of the company. That focus is paying off.

And very importantly, our employees remain very engaged and committed to getting through this downturn. They're serving our customers, managing our operations day to day, but all of that is done with an eye to the future. The team and I remain very confident that we’re on the right path to navigate through this recession and position the company for the eventual rebound in the economy and our key markets.

So with that I say thank you again for joining us today. We appreciate your ongoing support of USG.

James S. Metcalf

Thank you, Bill. I'd like to mention that there will be a replay of this call available. You may dial 1-888-843-8996 and enter the pass code 25577591. Replay will be available until Friday, October 30th. That concludes our call. Thank you very much.

Operator

Thank you for participating in the USG Corporation's third quarter 2009 earnings conference call. This concludes the conference for today.

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