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Matthew Hilzinger - CFO & EVP

Analysts

Jim Barrett - CL King

USG Corporation (USG) CL King & Associates Inc Best Ideas Conference September 12, 2013 10:00 AM ET

Jim Barrett - CL King

Good morning everyone. I'm Jim Barrett. I'm the building material analyst at CL King and I've been following USG since 2004. So we're happy to have them back. We have Matt Hilzinger, who is the CFO, Matt Ackley, who is the Director of Investor Relations and Ken Banas, who is the Treasurer. So welcome and now your turn.

Matt Hilzinger

Thank you, Jim and thanks for the CL King team. We appreciate everybody being here and clearly those that are listening on the phone, thank you for your interest as well.

You know, when you look back over the last few years, we've really been focused on creating our own recovery of USG. And clearly things are getting better for the company and the economy and the thing now for the company is building on a recovery. We've done a lot of work and we're now in a position that we can play some offence and not just defense.

But before I get into the balance of my presentation I just want to have everybody read the cautionary statements. So everybody is clear, the actual conditions may differ from management’s expectations. So please read these fully for all the necessary details, thanks.

USG is a 111-year-old company. We're not just a (inaudible) company. We're not just a building products company. We provide shelter where people work with and play. That's how we think of ourselves. We have 75 production facilities throughout the world. We’re an international company focused on select parts of the world China, the Middle East and India, in particular. And I'll spend a little bit of time talking about those initiatives late around in the presentation.

We have very strong positions in Canada, Mexico and the U.S. We're number one or number two in North America, in ceilings and grid, wallboard surfaces and substrates as well.

While USG not only manufactures product, we distribute product as well. L&W is the largest building products distribution company in the United States with coverage coast to coast with 145 locations. USG plays in both the residential and the commercial markets split about 50-50.

Just a few comments on our financial performance and I know this is a little bit dated but it -- these are the financial results at the end of our second quarter. So I hope everybody had a chance to at least listen in or take a look at the transcript from our second quarter earnings call at the end of July.

In the second quarter, we marked our second quarter of net income earning $26 million of adjusted net earnings that is two quarters in a row of net earnings. We’d like to think that is a trend considering the last five years before that.

We've improved the top-line over the quarter by almost $120 million and improved our gross profit percentage by 400 basis points. We had a $75 million swing in net income quarter-over-quarter and each segment had a very positive operating profit and each business segment improved earnings from the prior year in the last quarter. So we're seeing improvement in our businesses and we're seeing improved demand from last year in residential repair, remodel and commercial as well.

On residential clearly, we've seen some wind in our back. We think that's reasonably durable and I'll talk a little bit more about that in a second. Repair and remodel is starting to come back. We're starting to see some green shoots in that area and then commercial is improving, all be at its still very choppy. I mean I think what I would say is, clearly this year is better than last year in those three segments and we expect next year to be better than this year in those three segments. But each one is moving at a slightly different pace.

This slide is a very interesting slide and it really shows mid cycles of residential repair, remodel and commercial compared to the historical means. So if you look back over the last three or four decades, want is the means in terms of building activity in these three sectors and where are we now? And I'll start with residential and housing which is about 25% of our business, that's new residential.

We expect in 2013 somewhere between call it 900,000 and 1.1 million. I think we're probably going to be somewhere in the 900,000, somewhere in that lower end. But if you look at that and you look at the historical mid-cycle, it's about 1.5 million starts and we're not yet at a million starts. So there's still potential room to move up and our view is residential will continue to improve. If you think about birth rate exceeds death rate, net immigration policy is still positive in this country, we're still at historical lows in terms of housing inventory. Our sense is that new residential will continue to improve.

If you look at commercial, so new commercial is about 25% of our business and the latest forecast from McGraw Hill is about 800 million square feet versus kind of a historical mean of 1.3 billion. So again, there's still a very large amount of room to move back to the mean.

Again, we believe that there' still going to be some choppiness here both geographically and in terms of the segments within commercial, clearly we're seeing hotel and retail do pretty well and I think governmental and educational are still lagging and struggling a little bit.

The last category here is repair and remodel, which is about 50% of our business and split equally between housing and commercial. And repair remodel is also well below its historical mean. And if you think about housing and commercial, the average age of a house in the U.S. is about 40 years old and that's the same for commercial buildings as well.

And our products did extraordinarily well in the R&R sector. When you think about wall boarding, ceilings and the steel studs and the stuff that L&W distributes. And one of the reasons we're starting to see a little bit of green shoot in repair and remodel and part of it is, we see consumer confidence moving up. Consumer confidence is at its highest that it's been in almost five years. One small data point is over the past 18 months home owners have added almost 2.7 trillion hours of paper net worth as home prices have continued to improve and that's expected to grow.

So as people believe and their confidence moves up and they believe they have more wealth, clearly that translates into -- your better performance on repair and remodel.

One data point considered here, if you look back historically at USG's performance over the last call it three or four decades and we'll take housing as an example. The mid-cycle housing number is about 1.5 million starts and our average EBIDTA during that same time for 1.5 million starts is around $425 million. Through the first half of 2013, our EBIDTA is about $200 million. And that's not even a million starts.

So there's a lot of things that we've done and I'll talk and touch on here in terms of improving the operating leverage of the company. And so, I think as you think about USG and you think about the prospects in the future, it's important to consider the improved operating leverage that we demonstrated clearly over the last six months, but how much will that carry forward into the future and that's not a projection, its just something I think evokes me to consider in terms of the earnings power of the company.

I want to touch a little bit on our strategy and our progress has and continues to be driven by three strategic priorities. They're pretty simple but extraordinarily powerful. First is strengthen the core and over the last five, six years we focused heavily on North American manufacturing and distribution (willing) the breakeven and I'll touch on that in a little bit in a couple of minutes.

The second is diversifying our earnings and we're really focused on two areas there, growing adjacent products and select international investments and then the third is differentiation through innovation. It's very important from us, from our perceptive to differentiate ourselves in the marketplace with our customers. It's very important to our customers and it clearly gives us a competitive edge and we can spend some time in the Q&A session, if you'd like talking about UltraLight and the impact that's had for our company and in the industry. So it's through these three strategic priorities that we are building on the recovery.

Kind of getting into strengthening the core in a little bit more detail, there was great effort on getting through the great recession and in fact, sometimes we refer to it as a small d-depression, I mean it was pretty tough. And the company spent an extraordinary amount of time and resources, focusing on lowering the breakeven across the company and they did it in all areas, manufacturing, distribution, corporate. We have taken $3.8 billion of capacity out. We have closed 125 L&W branches. We recommissioned ships that use to transport rock from Nova Scotia down to the Eastern Seaboard, we recommissioned those to Africa from a loss to a profitable venture and nearly 5000 employees have been transitioned from the organization and we haven’t stop. We are still doing things over the breakeven, even as the environment is getting better.

As an example, we are finishing our shared services. This year we had IT finance supply and HR functions out in the field those are being consolidated into a center of excellence where we expect and see -- and are beginning to see lower cost and improved service to our operations.

Another area that we are focused on right now, we’ll continue to work on as Lean Six Sigma. We have been using Lean Six Sigma in our manufacturing for the last four or five years with very good results and we are now expanding that corporate wide, driving productivity across the company, including in my areas of finance and IT.

As an example, of kind of the power of this, prior to the great recession, the industry breakeven was around 26 billion square feet. It’s now just under 18 billion square feet as an industry. And this year, the industry expects to ship somewhere around 20 billion square feet of wallboard and we are profitable. So that really does show from an evidential standpoint what we have been able to do in terms of lowering our breakeven. And we clearly have more operating leverage now than we have had in the past. So it’s really -- it is nice that we can be in a position now to play offense and not just defense.

We are going to continue as I said to focus on keeping our cost low and growing organically. And one of the ways that we are going to focus and grow organically is to diversify our earnings, kind of the second pillar of our strategic (tenant). And one of those components is product adjacencies. It’s about finding products that we currently make and positioning them differently and in a different market. And a great example is SECUROCK, which came out of our fiber rock and glass-mat technologies. With a little bit of modest investment in innovation, we developed a product for commercial working.

And this is a new business for us and that business really had one prior supplier which obviously was not us, but we now can compete in that business. And we see that market just as an example, about $500 million, how much we will take of that is yet to be seen. But we are encouraged with what we have seen so far, but that’s an example of a product adjacency. And the things that we are working on kind of low capital, where we can take products that we currently have and extend those.

The second is, select international growth. We are not a global company. We are focused on select international areas where we can be number one or number two in a particular market. And we have a focus right now on the Middle East and India. Many know that we sold our European operation about a year ago. We reinvested that capital in the Middle East and in India.

Over the past 12 months, we have been investing with a joint venture partner on a quarry, we believe it's the world’s largest gypsum quarry in the small plant in Oman. The idea is that we’ll service both the Middle East and India. We expect the quarry to be functional by the end of the year and we expect the plant to be functional sometime in the middle of 2014.

India has very little gypsum sources, it’s basically at the northern part of the country. And so, this gives us a strategic resource that we think is pretty powerful as we look to enter the Indian market.

Gypsum is also used in the cement industry and we would expect to use that quarry to also supply some cement customers in India as well. So we are very happy with the progress of that venture. We are not taking our eye of the ball of the U.S. and the North American market clearly, those are incredibly important to us.

The third tenant to our strategic priorities is innovation. We have a long, long history of great innovation here at USG. And we are really developing products that customers want. And there has been a shift in our R&D and how we think about R&D from just creating products to creating products that are really built upon customer needs and demand. And we’ve got some great (deal) in changing our products.

We have in the last year introduced a co-branded LED lighting system with GE as more and more companies move or as more and more building moves to kind of lead certification and green, LED lighting is becoming more important as are our ceiling tiles within our high-end RC ratings and we have jointly developed this with GE and is off to a very good start.

We have also like joint compound, which is now 40% lighter than kind of classic joint compound. And clearly, the crown jewel of our innovation over the last few years is our SECUROCK UltraLight. And when people think of UltraLight, they kind of think of it in terms of kind of the half inch. Well, we do UltraLight in 5/8, we do in FIRECODE 30, we do in Type X, which is 60 minute rated FIRECODE, a product we have introduced this year, UltraLight in our more tough product line.

So we continue to take the technology and move it into other parts of our product line. And it's been incredibly well-received by our customers, it’s the contractor preferred brand. When you think about wallboard, weight is the number one complaint. We have obviously reduced that about 30% and we have improved the performance characteristics as well in terms of scoring and snapping and being able to put it up in a highly efficient manner.

When you think about our customers, labor is an important component of their cost. And they are willing to pay a premium and they do pay a premium for this product as they benefit really from productivity on the labor side. And we can produce UltraLight virtually at a cost neutral basis. And in our view -- and again, I'm a little biased but if you go out and take a look at the other products, clearly our product is superior in almost every way.

When you think about innovation at USG, we have got the list of things that we have done. But we did get a recognition here not too long ago from the patent board. We were recognized as one of the top innovators in the industrial material sector and it’s really a testament to our commitment to innovation. It’s based on the strength of our patents and our research intensity.

We use an open innovation culture. So it’s not just R&D, but it is R&D talking with customers, it is R&D talking with and working with our employees. We also have collaborative arrangements with outside universities and independent laboratories that help us in our product development as well. So, three tenants for our strategy, which has really been fundamental to what we have been able to do and where we are going.

I want to switch gears just a little bit and talk a little bit about our balance sheet and capital structure. Clearly, as we look out over the next few years, we have two principal goals. The first is to delever organically to investment grade metrics and the second is to protect our $2.2 billion U.S. net operating loss carry forwards, which if you include the state benefits is worth about $1 billion in cash for us.

So let me start a little bit with delevering organically, if you look at our balance sheet on an S&P, Standard & Poor's defined basis, we have about $3 billion of debt and about a $100 million of equity. That is way too much leverage for a cyclical business, including one that requires some capital.

We are paying over $200 million in interest annually. We have done a ton of work internally to take a look at our capital structure can balance, has lead a lot of that work and we have determined that our optimal capital structure to be investment grade. And I say to be investment grade metrics, it is up to the agencies as to whether we ever get to investment grade but clearly we want to operate the business with investment grade metrics.

And what is that mean? That means, we need to be somewhere at one-and-a-half to two times that to EBITDA at the mid-cycle, which now if you look at it equates to roughly about a 1.5 billion plus in terms of debt reduction in order to get to the right capital structure. This is very doable, when you look at our prospects. I spent a lot of time talking about the operations and the improved leverage, talked a little bit about the improving economy. So, we would expect that our performance would improve as the economy improves and as we continue to work on some of our organic growth opportunities and that’s clearly going to drive cash flow.

Secondly, we’ve got our net operating loss which is worth about $1 billion in terms of cash yield. And lastly, we have our converts. We’ve got $400 million of convertible securities held by Berkshire and Fairfax up in Montreal. Those securities are callable by us in December of this year. Right now, we’ve got about a 10% coupon on those. It’s costing us about $40 million a year. If a 100% is called it equates to an additional kind of 35 million shares -- 35 million shares outstanding.

The primary objective for us is to delever the balance sheet but we will not risk the NOLs to do so. And converting all of the $400 million of bonds could create, some put into risk to our NOL. We’re clearly, we’re managing the risk but let me just give a little bit of background on this. There is nothing inherent about calling the debt that puts the NOLs at risk but there is a very specific IRS code called section 382 around change of control that would limit the amount and the timing of NOLs. And it has to do with 5% shareholders and how much they churn the stock over a three year rolling average.

If they churn stock greater than 50% that can significantly limit the NOL and that could cost us somewhere around $300 million on a NPV basis. So it’s not inconsequential, I would say it’s material and so we are exploring a number of options right now about how we manage the convert is that our option to call it. We can call all of it or we can call portion of it. Those are the things that clearly we are taking a look at and there is more to come on the convert as we move through the balance of the year.

So, over the planning horizon, clearly as we generate cash, it’s going to really go to two areas. We’re going to reinvest in the business where we think it makes absolute sense and we’re going to delever the balance sheet. Those are the two principle areas where we’re going to focus on putting our cash.

Right now, we have ample liquidity and we have lots of flexibilities and some options for our balance sheet and I started off my remarks really talking about being able to build on the recovery and play a little bit of offense and I think our balance sheet and our capital structure now clearly provides the ability to do that.

So, let me briefly wrap up and then we can get into some Q&A. But just again, we’re the industry leader. We’re a 111-year-old company. We’re doing things differently. We’re doing things a lot more efficiently and faster. We are going to continue to get lean. We’re going to continue to focus on ways to lower our breakeven. We’re going to look at organic growth and we have some terrific organic growth ideas. We’re going to look at innovation as currency as way to grow domestically and abroad.

We strongly believe that there is a lot of upside in residential repair and remodel and commercial particularly as you look at those areas moving back and reverting back to kind of historical mid-cycles. So we’re very excited about where we are today. We’re very excited about our position in the industry and our prospects. And we really do like what we do which is building shelter where people work with and play.

So with that, I will conclude my remarks and see if there is any questions.

Question-and-Answer Session

Matt Hilzinger

Yes, sir.

Unidentified Analyst

Can you talk about your outlook, I see a couple of years in good price increase, can you talk about your outlook for 2014?

Matt Hilzinger

Yes. So those on the phone, if you didn’t pick up the question, the question was, can we provide some more information clearly around 2014 pricing? Can we have as a matter of practice, first let me say that we are very pleased with our new pricing methodology that we put in at the beginning of 2012. We had a 17% price increase in 2012 or 17% price increase in 2013. We will have a price increase in 2014. We have not disclosed what that is.

Our practice has been to have personal kind of one on one dialogs with our customers whether it’s the Home Depot or other customers that we have but we do that late November, early December. We like to see what’s happening in the market. We like to see what’s happening with our cost structure but clearly it would be a price increase next year just a matter of how much and just can’t be in a position to really disclose what that is.

Unidentified Analyst

Matt speaking a little bit, dialogs between the big box channel and I guess people (inaudible)?

Matt Hilzinger

I would to say that in general across the country, it’s general, there has been a price increase everywhere sometimes, there are some regionality depending upon kind of a cost through wall board and the regional sector. But in some areas we’ve had price increases above are 17 and below are 17 that’s kind of the average but it’s generally been healthy almost every sector.

Unidentified Analyst

Just talk about how much of capacity has been pulled out in the industry --

Matt Hilzinger

Yes.

Unidentified Analyst

How much is completely 200 versus (inaudible)?

Matt Hilzinger

Yes. The question is how much capacity we pulled out, how much capacity the industry pulled out and how much could come back. And I will answer this and then I’ll ask Ken to jump in. We’ve taken -- we started the research with around 12 billion of feet capacity. That’s somewhere around kind of 9.5. Now we’ve taken about a net 2.5 out, took 3.8 that we started. Then we added a 1.5 that we started with our Washington plant before the recession.

The total industry is taking about 8 billion square feet out and from our perspective, we are going to be very, very thoughtful and very careful about adding capacity. And we’re going to be -- we’re even as we look right now about adding shifts and if you look at, we take to look at the industry. And we take to look at our capacity on an effective capacity basis right now, we are running at about 80%, which basically means that we can across the network add about 20% more throughput before we need to add a labor shift.

We’re going to be very, very careful about where we add a labor shift, let alone bringing back any kind of idle capacity and certainly building any kind of new capacity. So and the nameplate capacity right now around 55%, I think the industry is at 60%. I can’t speak for others out in the industry but I can speak for us, we just don't plan to add capacity in the near term.

Unidentified Analyst

Matt, can you give us -- even a general sense of how big the opportunity is Oman, India, if we look out when that’s being fully (inaudible)?

Matt Hilzinger

Yes. We’ve got a great business in the Middle East and clearly the plan that we’re going to do there is going to – it’s going to augment that business but let me speak specifically to India. When we look out by kind of (inaudible) by 2020, we think that the India business could be about 2 billion square feet. So to give you a perspective right now, the U.S. total industry shipping about 20. So it’s about 10% of the U.S. market.

It’s a very similar, it could be a very similar market to what we have in Canada and Mexico which are great businesses for us but it’s kind of a new market. There is not really a dominant player in India. It’s very focused primarily on commercial, not residential and when you think about commercial sector, it’s primarily around kind of big metropolitan areas, a lot of the commercial buildings that are being built, our western style architecture, right there either western style -- influenced by western style architects who are been trained in the west. And so a lot of the buildings and the building look like that we’ve never seen it, right or as you walk around they have – they look like that. And so, there is a -- what we believe a growing need for a wallboard in that country. And again, we don’t believe if there is a dominant player there, we believe that we can capture the number one or number two role there. And when you think I talked a little bit about this earlier. When you think about gypsum and that is the key thing, you got to have gypsum to make wallboard.

There is not a really good strategic source within India, there is a little bit at the northern part of the country but that’s really why we opened Oman is to really be able to provide a source to that rock for us in India. And we are going to be paced and thoughtful as we go into that market before we put hard assets in the ground. But we’re excited about the prospects in India.

And the market is growing, I mean it’s a – I know there is some ups and downs in India but when you take a look at that market growth particularly compared to North American markets, we see that is an attractive place to grow. Yes, sir.

Unidentified Analyst

Based on your comments about leverage seem to suggest your goal in part of the mid-cycle it’s about (750 in EBITDA)?

Matt Hilzinger

I can’t comment on your downwards.

Unidentified Analyst

Just as you were indicating --

Matt Hilzinger

Yes.

Unidentified Analyst

And that’s like comment but if that was your goal let’s say, is that going to be – how much of that more about hitting the average on residential starts under a remodel or how much of it more about on the new price increase?

Matt Hilzinger

I think we --

Unidentified Analyst

Which one in particular?

Matt Hilzinger

I think there is a (call) of both the things, right. And clearly on a volume basis, I don’t think there is one particular sector here that could grow so far beyond housing for instance, right I mean it’s hard to think that you are going to be 1.7 million housing starts and have an anemic repairable remodel market and an anemic commercial market, right. So I think all three markets have to revert back to the mean in some form of fashion. So clearly that’s a big piece of it on the volume piece.

On the price piece, we’re going to continue to look at price as a way to drive the right return on invested capital. One thing, data point here is, if you look back over the last 41 years, price has moved in the same direction as housing starts. So as housing starts move up you generally get price appreciation. So one of the questions that we often get is how do you get a price increase when you’re at a mean play capacity of 55% and the industry is at 60%.

If you look back historically, you generally get a price increase when the economy is improving and housing starts move up. So I think it’s a combination of both, we’re excited about it. And our expectation not a projection but our expectation is that we would outperform our historical numbers when we move back to and we would do it now, right and we would expect to outperform in the future.

Unidentified Analyst

Do you think pricing overall in the energy coming of leadership but if the leadership is much more rational today, it hasn’t come out assuming that you are (trying) to rational like you have in general. Would you assume that pricing should be much higher than the prior cycle?

Matt Hilzinger

So good question, I forgot to introduce the questions before. The question is our – is pricing going to kind of maintain and is there ability to continue to move our pricing. Our senses is what – we take it year-by-year but as demand improves we’re seeing a little bit of cost creep in right, those things lend themselves to price increases. So our view is that we like to see price increases, these are dialogs that we need to have with our customers as time goes on.

But we’re going to continue to manage the business in a certain way, right. I mean we’re going to continue to – that’s why we need to continue to lower our breakeven, why we’re so focused on keeping our cost levels because some of the stuff is -- you want your desire but we need to make sure that we’re driving our cost low, we will keep our margins right to get to the right return on invested capital.

Jim Barrett - CL King

On that note I think we are --

Matt Hilzinger

Jim, thank you very much.

Jim Barrett - CL King

Well, thanks very much Matt. And thanks everyone for coming.

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