Warren Buffett is considered one of the best long-term investors. His company, Berkshire Hathaway (BRK.B), is a holding company that maintains large positions in several well-known American companies, such as Coca-Cola and American Express and wholly owns several large businesses, such as Geico and Burlington Northern Santa Fe Railroad.
Buffett's long-term record of outperforming the market makes both retail and professional investors pay close attention to the positions Berkshire accumulates and the acquisitions the company is likely to make. Given Berkshire's increased stake in USG Corporation (USG), it appears likely that other investors will soon follow Buffet into the company, and that Berkshire will eventually absorb it.
A Brief History of USG
USG Corporation, which was formerly known as Unites States Gypsum Corporation, is the nation's largest producer of wallboard, or drywall, and the producer of several other homebuilding products. USG's wallboard is sold under the trademarked brand name of Sheetrock, which is synonymous with the product itself, much to the extent that Kleenex, Coke or Band-Aid are to their respective products. USG is also a leading provider of ceiling tile that is primarily used mostly in commercial construction.
As a construction products company, you can probably imagine that USG had a rough time following the collapse in real estate construction following the sub-prime crisis. The company actually had a highly problematic past decade. In 2001, the company began Chapter 11 bankruptcy proceedings in order to resolve legacy asbestos liability that stemmed from the use of the carcinogen in some specialty products that stopped selling decades earlier.
Despite the asbestos and related bankruptcy overhang, and thanks to the bubbling of real estate in the following five years, USG's operations were highly profitable throughout its Chapter 11 proceedings. The company completed its bankruptcy in 2006, with all creditors repaid in full and its shareholders retaining equity in the company. USG also permanently resolved its asbestos liability by establishing a $3.95 billion trust to handle all existing and potential future claims.
Upon exiting Chapter 11, Warren Buffett praised the company, claiming it was "the most successful managerial performance in bankruptcy that I've ever seen." Buffett was not then just a keen observer, but also an interested party. Berkshire acquired 6.5 million shares of USG in the fourth quarter of 2000, which was an especially volatile quarter, with the equity trading between about $14 and $32 per share.
As part of the Chapter 11 settlement arranged by the bankruptcy court, USG raised cash for the asbestos trust by selling stock through an offering. Buffett then showed his faith in the company, with Berkshire Hathaway agreeing to buy any necessary stock that was not otherwise purchased through the offering. Through that offering Berkshire Hathaway purchased an additional 6,969,274 shares of USG, and then acquired even more USG stock in the open market for about $45 per share, until Buffett raised Berkshire's ownership to about 17 million shares, or about 15% of the company.
Post Chapter 11 and Into A Real Estate Collapse
USG performed exceedingly well through most of the first half of 2006, but shares rapidly fell off the table once housing began to soften, falling from a peak of over $114 in April, to about $45 by mid July. USG stabilized in share price over the next year, but then resumed their decline though the second half of 2008 and the first quarter of 2009, until bottoming along with the broader market.
When USG exited bankruptcy, it retained $1.065 billion in short-term debt and $1.439 billion in long-term debt. That debt did not then seem so sizable, as wallboard demand was never stronger and pricing was never higher. By the end of 2009, the USG paid off its short-term debt, but increased its long-term debt to about $2 billion. A large part of this transfer from short to long-term debt was because in late 2008, it sold $400 million in ten-year notes to Berkshire and Fairfax Financial.
Berkshire purchased $300 million of the 10% convertible senior notes that would mature in 2018, where non-callable until December of 2013, and which could be converted into 26.4 million shares at $11.40. USG also sold $100 million of notes with the same terms to Fairfax, which is run by Prem Watsa, who has been referred to as the Canadian Warren Buffett. Fairfax, like Berkshire, holds large positions in many publicly-traded companies, but also collects a substantial share of its revenue through its primary property and casualty insurance business.
Last November, USG announced that it issued a notice of redemption to redeem $325 million in aggregate principal amount of USG's outstanding $400 million on December 16, 2013, for a price equal to 5% more than the principal amount. This triggered the conversion of some of the notes. It is not entirely clear why USG only redeemed $325 million and not the entire $400, but it may be because the company sought to only redeem that which it could comfortably refinance, despite wishing to eliminate them entirely, and that it will redeem the remainder in 2014. Any pre-emptive conversion would indicate an acquisition attempt is imminent.
Berkshire's Current Position
On January 2, Berkshire Hathaway filed a Schedule 13D/A, updating its total position in USG to 30.5% of USG's common stock, roughly doubling its ownership percentage from 15.71% reported at the end of the third quarter of 2013. It is certainly rare that Berkshire gets to such a high stake within a company without later wholly acquiring it, and it is the highest percentage stake Berkshire holds in any publicly-traded companies.
Though this most recent conversion price of $11.40 was far below the current market price for USG, Berkshire did buy several million USG shares at prices roughly 50% higher than the current market price. In the meanwhile, Berkshire is unlikely to divest itself of any of its shares. Similarly, Fairfax is likely to maintain its position for the probable endgame of a Berkshire acquisition.
Berkshire has many housing related investments, and USG would fit right in. Berkshire acquired Jenkins Brick after the sub-prime crisis, merging it within its already wholly-owned Acme Brick subsidiary. Berkshire also owns Clayton Homes, a leading producer and financier of manufactured homes, and holds other housing investments such as Shaw (carpet), Johns Manville (insulation) and MiTek (building products). Several of Berkshire's insurance entities also insure real estate.
Berkshire has also made several other private investments in advance of an anticipated eventual U.S. housing turnaround, including entering a joint venture with Leucadia (LUK) called Berkadia Commercial Mortgage LLC. Berkadia is at least partially composed of assets purchased out of bankruptcy in 2009, but formerly related to GM (GM). Companies like Leucadia and Fairfax will continue to enter further deals with Berkshire when the opportunities arise.
Buffett does have a history of acquiring positions over several years before acquiring them. For example, Buffett bought shares in Geico for decades, increasing Berkshire's stake in the insurer at opportunistic dips until eventually wholly acquiring it in 1996. Berkshire's stake in Burlington Northern Santa Fe also increased over several years, and Buffett owned 22.6% of the railroad when it made a bid for BNSF in late 2009. Berkshire's consolidated and increasing position in USG may have a similar outcome.
USG Corporation was already the industry leader before the recent housing correction, and it should emerge an even more dominant producer of wallboard in a true housing recovery, after some of the weaker competitors fail and/or have a more difficult time expanding capacity to meet any demand increase.
The Sheetrock name is already the premium brand, which is an intangible asset that Buffett does value, as it did with Coca-Cola (KO), and USG is continuing to expand its Sheetrock brand's value through the release of new and differentiating products. In the last few years, USG introduced UltraLight, which is a lighter and thinner wallboard that is of comparable strength to the traditional product. The lighter and thinner UltraLight is advantageous because more of it can fit in the same size mode of transport, the same number of walls would cost less in gas to move and workers installing wallboard should be less tired by the installation process, allowing them to install wallboard faster and/or fatigue at a slower rate. Other benefits likely exist, including possibly being considered a greener alternative.
If construction continues to turn around, and especially if commercial construction accelerates, the demand for USG's products should increase over the next few years. If this occurs, wallboard suppliers should be able to continue increasing prices. USG just returned to profitability in 2013, and its potential for earnings growth in the coming several years appears significant.
Though the recent note conversion did increase the share count, which will put pressure on earnings per share due to dilution, the balance sheet of the company has become far stronger through the removal of some high yield long-term debt. The elimination of 10% notes will result in a significant reduction to interest expenses, which should help the company retain more of its growing revenue stream as profit. Further, those new shares are in the hands of shareholders that are unlikely to sell, and which should be expected to only increase their stake over time, if not only due to the future conversion of the remaining notes.
Additionally, despite the fact that Berkshire was forced to telegraph its increased stake via the Schedule 13D/A it filed earlier this month, it should be expected that there will be further coverage of the increase upon the filing of its quarterly 13F-HR in mid-February. All of this indicates that USG should have strong tailwinds coming over the next few quarters, including greater coverage, and likely become a Berkshire acquisition target in the next few years.