USG, Asbestos and Berkshire Hathaway

USG (USG) shares shot up Thursday on an upgrade, so I guess it is time I got around to writing about this company.

US Gypsum, or USG as the parent company is now called, manufactures home building products such as wallboard, floor tiles, ceiling panels and the like. It is a manufacturing company that is just about as simple and understandable as they come. Unfortunately, in addition to making these products, years ago the company also manufactured, well, asbestos.

As I indicated earlier in my general discussion of bankruptcy, firms emerging from Chapter 11 can make great investments for value investors. The stock in the new company, although the old shareholders may no longer own it, is less burdened by the heavy liabilities that led the company to file in the first place. Meanwhile investor sentiment is often highly negative and can result in undervaluation – who wants to own stock in a bankrupt company anyhow?

But the USG case is in a special subset of bankruptcies. Its bankruptcy is the direct result of asbestos litigation, a trigger that has caused a superfluity of Chapter 11 cases in recent years. Other companies in similar situations to USG (and that may warrant blog postings all their own) include Owens Corning, Armstrong and Federal-Mogul.

In the early seventies, when the dangers of asbestos became widely recognized, a key ruling by a federal Appeals Court declared that victims of asbestos can sue on a product liability basis, rather than a workers compensation basis. This meant that cases could be heard by a jury which could award plaintiffs virtually unlimited damages. And so the lawsuits began. The decision was appealed to the U.S. Supreme Court and upheld, making it applicable to courts throughout the nation.

Over the years legislators tried unsuccessfully to pass various versions of what would have been the Fairness in Asbestos Litigation Injury [FAIR] Act. Such an act would create a national fund from which all future asbestos claims could be paid and which would be funded by those companies subject to asbestos litigation as well as their insurers. Additionally, the act would all but prevent any individual from filing subsequent lawsuits. For one reason or another this bill has never been passed, although a newer version still sits before the Senate.

Instead, the Bankruptcy Code was amended in 1994 to provide for alternative protection for firms. The provision is Section 524(g) and allows Chapter 11 firms to create their own private trust funds from which future liability will be paid. Thus, a firm that has emerged from bankruptcy and created such a fund will not be exposed to any additional, unforeseen asbestos liability. This has encouraged as many as sixty firms to file bankruptcy primarily for the 524(g) benefits. USG is among them.

Warren Buffett began buying USG back in 2001, shortly after the company had filed Chapter 11. He is very familiar with the economics of asbestos-litigation-plagued firms, both through his experience writing insurance policies and with companies Berkshire owns such as Shaw Industries and John Mansfield. In typical fashion, he has stuck with the stock throughout its bankruptcy, obviously aware of the prospects for the firm’s stock. He saw it rise over $100 and then fall back to the mid-$40s. Importantly, the stock survived and creditors will be repaid in full. In fact, the only real consequence of the entire five year bankruptcy is the creation of a large 524(g) fund and the relief from future asbestos liability. Clearly not a prototypical bankruptcy case.

The 524(g) trust is large, though. The company made a $900 million payment in June as it emerged from bankruptcy protection and will contribute $1.8 billion more over the next two years. This was disastrous to the company’s earnings, of course, as USG was forced to take a huge charge. At the same time, the housing industry was in a substantial downturn and makers of building materials were dragged down with it.

So the stock looked cheap back in June as the company emerged from bankruptcy protection, which is likely why Berkshire, already a large shareholder, agreed to help finance the reorganization plan by “backstopping” a stockholder rights offering. This means that, in order to raise the cash to fund the trust, shares were offered for sale to existing shareholders at $40/share and if those shareholders didn't contribute the $1.8 billion needed, Berkshire would buy the difference itself. As a result Berkshire has amassed an 18% stake in the company. Since the rights offering, the stock has risen to $54.

It will remain interesting to watch events unfold, particularly the performance of the company which by all metrics looks very good. But also how other companies with asbestos burdens fare. Perhaps we will even see the passage of a FAIR act sometime soon. Stay tuned, this should be an fun ride.

Disclosure: I own shares of USG and Berkshire, but none of the other companies mentioned in this posting.