- USG is redeeming the remaining convertible notes owned by Berkshire Hathaway and Fairfax.
- The notes will be converted.
- Berkshire is already the largest shareholder and an eventual acquisition appears increasingly likely as the position grows.
I have previously proposed that USG Corporation (NYSE:USG) is likely to eventually get acquired by Warren Buffett's Berkshire Hathaway (NYSE:BRK.A), (NYSE:BRK.B). I based this on Berkshire's long-term record of accumulating shares of the wallboard behemoth, including that Berkshire had recently reported an increased position after the conversion of some convertible senior notes into USG shares. It now appears probable that Berkshire shall soon convert the remaining notes of this type, taking another big step towards this apparent outcome.
The premise for the eventual acquisition continues to appear on course. The most recent dot on the time line occurred on March 18, when USG announced that it issued a notice of redemption on the remaining $75 million in aggregate principal amount of USG's outstanding 10% contingent convertible senior notes. It redeemed $325 million of the same notes in late 2013.
Berkshire holds most of the outstanding notes, and it is a virtual certainty that the notes shall be converted to shares of USG, because they convert at a price of $11.40 per share. A SEC 13D/A filing is likely to follow this highly probable conversion, and it will probably occur some time in April or May. Berkshire is already the largest USG shareholder, with about one quarter of the equity.
USG Corporation, which was formerly known as Unites States Gypsum Corporation, is the nation's largest producer of wallboard, or drywall, and a producer of several other homebuilding products. USG's wallboard is sold under the trademarked brand name of Sheetrock, which is synonymous with drywall and used much like Kleenex is for tissues or Band-Aid is for adhesive bandages. USG is also a provider of ceiling tile for commercial construction and other home and building construction materials.
USG started this century with some serious issues, and the company began Chapter 11 bankruptcy proceedings in 2001 in order to resolve legacy asbestos liability from products sold decades earlier. Berkshire acquired 6.5 million shares of USG in the fourth quarter of 2000, or shortly before the Chapter 11 filing. USG completed its bankruptcy in 2006 with all creditors fully repaid and the shareholders retaining equity in the company. USG also resolved its asbestos liability by establishing a $3.95 billion trust within the proceedings.
When USG exited Chapter 11, Warren Buffett praised the company's performance, stating that it was "the most successful managerial performance in bankruptcy that I've ever seen." As part of the Chapter 11 settlement, USG raised some of the cash needed for the asbestos trust by selling stock through an offering. There, Berkshire Hathaway contracted to buy any necessary stock that was not otherwise purchased through the offering. Berkshire ended up purchasing 6,969,274 shares in the offering, and also acquired some more USG stock in the open market for about $45 per share.
After the bankruptcy auction and market purchases, Berkshire's ownership of USG reached roughly 17 million shares, or 15% of the company. Shortly after that, the sub-prime crisis began and USG had a rough road to walk as product pricing and demand both plummeted. The reduced rate of construction forced USG to shutter production and incur losses due to the cost of s overcapacity.
Additionally, USG exited bankruptcy with $1.065 billion in short-term debt and $1.439 billion in long-term debt. The debt was a major concern to the market after subprime, which saw significant risk of housing and construction related bankruptcies. By the end 2009, the USG finished paying off its short-term obligations and increased long-term debt to about $2 billion. A large part of this refinancing and reduced total debt was because in late 2008, USG sold $400 million in ten-year notes to Berkshire and Fairfax Financial.
The terms were not great, but this was financing when it was hardest to get. Berkshire purchased $300 million of the 10% convertible senior notes that would mature in 2018, were non-callable until December of 2013, and which could be converted into 26.4 million shares of USG at a price of $11.40 per share. USG also sold $100 million of the same notes to Fairfax.
Last November, USG announced that it issued a notice of redemption for $325 million of these notes in December. This triggered the conversion of those notes. The holders were happy to collect the 10% until forced to convert. Now, the remaining $75 million in notes are to be redeemed, which means that they will also get converted.
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 similar strength to traditional drywall. UltraLight is advantageous because the boards take less space, cost less to transport and can be installed with less effort. According to USG's 2013 annual report, UltraLight accounted for 55% of USG's domestic wallboard shipments in 2013, up from 45% in 2012. The growth of UltraLight will likely continue this year.
USG also recently moved to expand its global reach through the formation of a joint venture with Boral Limited. Boral is an Australia-based cement and construction materials company. The joint venture, USG Boral Building Products, aims to offer their complementary product lines throughout Asia and the Middle East. The combining of manufacturing, distributing and selling locations should result in cost savings for the businesses, and possibly also their customers.
This joint venture seeks to capitalize on each entity's already existing book of business and reputation for quality with clients. By increasing the spectrum of products offered to customers, some existing customers may be more inclined to try the vendor over a new and unfamiliar distributor. Additionally, customers may be more inclined to buy products from more comprehensive vendors, where doing so results in reduced transportation costs.
If construction continues to turn around, and especially if commercial construction accelerates, demand for USG products should increase. USG and other wallboard suppliers have been able to increase prices over the last few years, and further demand growth should allow for additional price increases in the coming years. This potential demand growth accompanied by price increases should make the business of growing appeal, and it is likely that Berkshire will continue to increase its ownership as permitted and in a manner that will not limit the future use of USG's accumulated net operating losses.
The recent note conversion did increase the share count, which puts pressure on per share earnings and related results due to dilution, and the coming conversion will further increase the share count. Nonetheless, the balance sheet of the company has become substantially stronger through the removal of 10% notes. This will result in a reduction to interest expenses, as 10% on $400 million in notes is $40 million in interest per year.
Freeing up the cash that would have otherwise been paid upon these notes should help the company retain more of its growing revenue stream as profit. The interest on those notes was roughly 20% of USG's total 2013 interest expense, or about 85% of net income. If just ten percent of the interest savings were to reach the bottom line, that would result in about a 4-cent increase in annual earnings per share. Nonetheless, a continuing housing turnaround and USG's price increases should both be more significant drivers of earnings strength.
Berkshire Hathaway and USG
USG would fit well within Berkshire, which has many housing related investments. Berkshire 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). Berkshire also acquired Jenkins Brick in 2011, and merged Jenkins with Acme Brick, an already wholly owned subsidiary on Berkshire.
Additionally, Berkshire's 8.8% stake in Wells Fargo (NYSE:WFC) includes substantial exposure to residential real estate activity from mortgages, refinancing, and home equity lines of credit. Berkshire's Nebraska Furniture Mart is also a derivative housing allocation, and the core business of many Berkshire holdings, such as Procter & Gamble (NYSE:PG), Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST), involves supplying products to domestic homes.
Berkshire has also made several other private investments in a housing turnaround, including entering a joint venture with Leucadia (NYSE:LUK) called Berkadia Commercial Mortgage LLC. Berkadia owns some General Motors (NYSE:GM) financial assets that were purchased out of GM's bankruptcy reorganization in 2009. Berkshire's massive insurance empire also insures many properties.
Buffett has a history of slowly acquiring some of its now wholly owned businesses. Buffett bought Geico shares for decades before Berkshire eventually wholly acquiring it in 1996. Berkshire's stake in Burlington Northern Santa Fe also grew over several years, and owned 22.6% of the railroad when Berkshire bid for BNSF in late 2009.
Berkshire is already the largest holder of USG, with about a quarter of the equity and the only other significant shareholder is Knauf, which is a German supplier of building materials and one of the largest global suppliers of gypsum boards. The two companies have a joint venture to produce innovative wall products, including exterior walls that offer a lightness advantage in building construction that is similar to the UltraLight advantage for interior walls.
Buffett accumulated most of his prior position at a price well above where these notes convert. Berkshire had paid as much as 30% more than current prices for some of the shares it acquired before the subprime crisis. The most recent shares acquired in December through the note conversion and likely to be acquired in this coming conversion do so at $11.40 per share, or about one-third of the current market price. Despite the ability to sell the shares and harvest a quick 200% gain, Berkshire is unlikely to sell shares in the entity and especially not while USG's turnaround is still in the early stages.
It is also possible that USG will end up merging with one of its foreign partners, like Knauf or Boral. Berkshire might be interested in participating in the development of a larger materials entity, including possibly providing financing in the form of a preferred.
In the coming months, it is likely that there will be news coverage of Berkshire's increased position, including both the filing of a Schedule 13D/A and then the filing of its quarterly 13F-HR in mid-May. Both of these events will likely be a news bump for USG, and a point at which some further discussion about Buffett's interest in acquiring USG may occur. This spring will also be an important season for the business, as construction activity is used as a key indicator of housing strength and demand for USG's products.