USG's (USG) CEO James Metcalf on Q2 2014 Results - Earnings Call Transcript

Jul.24.14 | About: USG Corporation (USG)

USG (NYSE:USG)

Q2 2014 Earnings Call

July 24, 2014 11:00 am ET

Executives

Ken Banas -

James S. Metcalf - Chairman, Chief Executive Officer and President

Matthew F. Hilzinger - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Robert C. Wetenhall - RBC Capital Markets, LLC, Research Division

Stephen S. Kim - Barclays Capital, Research Division

James Barrett - CL King & Associates, Inc., Research Division

Mike Wood - Macquarie Research

Dennis McGill - Zelman & Associates, LLC

Eli Hackel - Goldman Sachs Group Inc., Research Division

Philip Ng - Jefferies LLC, Research Division

Michael Dahl - Crédit Suisse AG, Research Division

Wenjun Xu - Thompson Research Group, LLC

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

Garik S. Shmois - Longbow Research LLC

Keith B. Hughes - SunTrust Robinson Humphrey, Inc., Research Division

Mark A. Weintraub - The Buckingham Research Group Incorporated

Operator

Welcome to the USG Second Quarter 2014 Earnings Conference Call Webcast. My name is Christine, and I will be the operator for today's call. [Operator Instructions] Please note that this conference is being recorded. I will now turn the call over to Mr. Ken Banas. You may begin.

Ken Banas

Thank you. Good morning, and welcome to USG Corporation's Second Quarter 2014 Earnings Conference Call and Live Webcast. We'll 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.

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 of our 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 the press release, and actual results may be different from our current expectations. In addition, please refer to our earnings press release and presentation slides for disclosures and reconciliations of non-GAAP measures used when discussing our results and outlook.

With me today to discuss our results are Jim Metcalf, Chairman, President and Chief Executive Officer; and Matt Hilzinger, Executive Vice President and Chief Financial Officer. Jim will provide a general overview of the quarter, plus additional insight into some of our businesses. Matt will review the financial results for the quarter, for the corporation and the business segments. We will then open the call for questions and conclude with a few comments from Jim. [Operator Instructions] Jim?

James S. Metcalf

Thank you, and good morning. We appreciate everyone joining us this morning, and I look forward to giving you an update on our business, as well as an insight on our overall market. I'm happy to report that during the second quarter, we delivered the strongest net income in the -- since the second quarter of 2007, when we generated the same earnings on $1.4 billion in sales compared to $948 million this quarter. While demand was not where we expected, it has increased compared to last year, and we believe it will improve in the second half of this year. It's important to note that in spite of ongoing choppiness in the macroeconomic environment, we continue to improve our performance. I'm confident in our strategy and believe our business is positioned to benefit from improvements in our end-use markets regardless of the pace of the recovery.

So what I'd like to do now is turn to our business segments. In our Gypsum segment, wallboard volume improved from the first quarter and year-on-year despite softness in the overall opportunity during the quarter. As a reminder, our wallboard shipments typically lag housing starts by 90 to 120 days, so the year-on-year increase in starts that we saw in the quarter is not yet evident in our shipments. Our wallboard pricing policy continues to work for our customers and for us. Our price during the quarter was relatively flat compared to the first quarter.

The other half of the Gypsum business is our surfaces and substrates business units. These businesses also saw improvement and combined to contribute $2 million in operating profit, led by our DUROCK product line, which improved margins by 9%.

In our Ceilings business, we had a very strong quarter despite not outperforming last year's record second quarter. We saw steady improvement in volume each month during the quarter as weather improved, and we had price improvement in both tile and grid. Our costs were up slightly during the quarter from some carryover we had in the first quarter, but has now stabilized. Our Ceilings business is levered to the persistently choppy commercial market. And while we expect this to continue, Ceilings is very well-positioned to benefit as the market improves.

In our Distribution segment, we recorded our 10th consecutive quarter of improved year-over-year operating profit. This was our strongest second quarter since 2008, when wallboard industry shipments were 6.7 billion square feet compared to 5.4 billion shipped in the quarter this year. L&W continues to make operational improvements, and we remain focused on keeping our breakeven low while positioning the business for growth as the commercial opportunity rebounds.

Now turning to USG Boral. I'm very excited to report our first full quarter of operating results. The joint venture is off to a wonderful start. We have already secured several large commercial jobs with our full suite of products: plasterboard, as they refer to drywall in that part of the world; ceilings; joint compound; and FIBEROCK. Our customers in these emerging markets are seeing the value in working with USG Boral that not only supplies a superior plasterboard, but one that also provides system integrity with other industry-leading products.

Now let me shift and touch briefly on the USG strategy. We are extremely focused on our 3 pillars of our Plan to Win: strengthening our core, diversifying our earnings and differentiating through innovation. And I'm going to touch on each one of these.

Our commitment to strengthening the core can be seen in L&W's improved results. During the downturn, we significantly rationalized our footprint by closing over 125 locations. However, we didn't simply focus on branch reductions. We refocused L&W on the commercial contractor where we add significant value. We also injected initiatives to better leverage our scale through strategic sourcing and category management in areas like insulation and steel. We streamlined our operations by elevating the P&L and pricing accountability. With our new strategy in place, we have lowered our breakeven in L&W from about $500 million in quarterly sales before the recession to about $300 million today.

With our improved leverage, we expect L&W, which has generated low-single-digit margins over the past 20 years, to outperform historical operating margins at similar points over the cycle. As I've said before, L&W is a key part of USG's portfolio. L&W provides a nationwide footprint for USG product launches; supports our pricing policies; has growth in product adjacencies, which represent over 50% of L&W sales; and most importantly, has 30,000 contractor customers, which gives us a better insight into the market.

The second pillar of our strategy is diversify our earnings through product adjacencies and strategic geographic extensions. Diversifying our earnings will better position USG at all points in the cycle. USG Boral is obviously a big part of our strategy, and we're very excited about the growth potential of this business. As we mentioned last quarter, USG Boral operates in 12 countries that have GDP growth that are expected to outperform the U.S. market. They have improving adoption rates around construction practices, and we are #1 or #2 in most markets we serve. The 2 teams at USG and Boral have really gelled well together and quickly have embraced the new technologies and processes that we are putting in. The technology rollout is progressing better than expected, and as a result, we are months ahead of schedule. While the preexisting Boral business performed very well, we believe that leveraging USG technologies across all of the products and throughout this emerging region will drive additional revenue for USG in the future.

The third pillar of our strategy is differentiating through innovation. At USG, our focus on differentiating is aimed at inventing value-added technologies that improve our products and systems and, most importantly, provide our customers with better solutions. As we continue to expand our UltraLight platform and portfolio, we had a national rollout of our new SHEETROCK UltraLight Mold Tough. UltraLight Mold Tough is contractor-preferred and performs very well in high humidity and coastal growth areas. We are excited about this new extension and will be a very important product in our new Asian and Australasian markets.

Now I'd like to turn it over to Matt Hilzinger, to give you a greater review of our financial results in the quarter. Matt?

Matthew F. Hilzinger

Thank you, Jim, and good morning, everyone. This morning, I'll take you through the changes to our reportable segments and provide some additional details on our consolidated second quarter results and business segment performances.

First, I'd like to discuss the changes to our reportable segments. Due in part to the contribution of our entities from USG International into our USG Boral joint venture, we wanted to better align our reportable segments with the structural focus of our operations.

So new to this quarter, we have 4 reportable segments: Gypsum, Ceilings, Distribution and USG Boral Building Products. We believe that our new segment structure is aligned with how we strategically approach these businesses. We have also issued an 8-K with recast results this morning back to the beginning of 2013 to illustrate these changes. I would recommend that you take a look at that 8-K strongly.

Our reportable segments will continue to be structured around our key products and business units. Our Gypsum segment includes sales of our wallboard, surfaces, substrates and related building products. The operating segments within our Gypsum segment are structured geographically, and our other operating segment is still only comprised of our shipping business, GTL and mining. Our Ceiling segment is comprised of the sales of ceiling tile, grid, specialty ceilings and other ceilings-related products with the operating segments structured geographically. There are no changes to our distribution segment other than a slightly shorter name. Our fourth segment is USG Boral Building Products. While for GAAP reporting, its results are not consolidated as it's reported as income from equity method investments, we view this business on equal ground with our other businesses. And we will continue to include our portion of the joint venture's net income in our adjusted operating profit.

Now turning to our consolidated results. During the second quarter, net sales were $948 million, up 3% from the second quarter of last year. We recorded GAAP net income of $57 million compared to GAAP net income of $25 million in the second quarter of 2013. On an adjusted basis, our net income was $48 million, and we recorded positive earnings per diluted share of $0.32, with a fully diluted share count of about 147 million shares.

As a reminder, we have called the full $400 million of convertible notes, and the new shares associated with the convertible notes should be included in the share count going forward. Our adjusted earnings excludes, among other items, a $12 million gain on the sale of real estate for our formerly closed Clark, New Jersey paper mill, and our share of a restructuring charge at USG Boral for $2 million, which I'll discuss in more detail in a few minutes.

Adjusted operating profit for the second quarter this year, including our share of the adjusted income from USG Boral Building Products, was $93 million compared to adjusted operating profit of $76 million last year. Our adjusted EBITDA of $145 million during the quarter was 18% higher than the second quarter of last year.

Now shifting to our quarterly business performances. In our Gypsum segment, sales increased by 6% to $612 million for the quarter, with adjusted operating profit of $83 million compared to $68 million in the second quarter of 2013. Wallboard results were a primary driver of our year-on-year improvement, with pricing contributing $18 million and volume adding an additional $2 million.

Our wallboard cost increased by $2 million compared to the second quarter of last year, partially related to higher natural gas costs. As I mentioned on our last earnings call, we expected to pay a higher cost on natural gas for most of the quarter, with our cost normalizing as the quarter closed. For the quarter, our natural gas cost was about $0.50 per decatherm higher than the second quarter last year. But as expected, our gas costs are now within the range of our annual plan, and we expect them to remain there for the balance of the year.

Looking at pricing. Our quarterly blended wallboard price was flat sequentially at $167.31 per thousand square feet, 9% higher than the second quarter last year. As we have previously stated, our price can fluctuate slightly due to regionality, mix, freight and channel differences. Last quarter, we also introduced our new U.S. domestic price, which excluded lower-priced sales to our foreign subsidiaries. Based on feedback that we received from our investors during the quarter, we are amending this disclosure to exclude all shipments to our customers outside of the U.S. and not just our sales to our foreign subsidiaries. While the delta between the 2 methods is small, we believe that this disclosure will be more meaningful related to our domestic sales price, and we will use this methodology going forward. With that said, our domestic price for the second quarter this year was $174.32, an increase of 9% compared to our domestic price of $159.62 a year ago.

In our U.S. Wallboard business during the second quarter, we shipped 1.3 billion square feet, an increase of 3% compared to the prior year. Our quarterly volumes lagged the industry growth, primarily due to customer makeup and geographical exposure to markets that grew more slowly in the second quarter.

Additionally, we didn't see the expected uptick in the states that were impacted by weather in the first quarter, which grew at the same 3% rate as the non-weather-affected states. Our market share through 6 months remained flat year-on-year. It's clear our strategy to drive profitability and return on invested capital is working.

Turning to capacity. Our wallboard effective capacity utilization rate was 77% during the quarter. At this time, we have the right staffing levels at our plants to meet current and near-term demand. I also want to take a moment to restate our views on physical capacity. With our current active network of plants, we have just over 4 billion square feet in total excess annual capacity. In fact, we have sufficient excess capacity to run up to and well beyond the historical mid-cycle averages of about 1.5 million housing starts and 1.3 billion square feet of commercial starts without adding additional physical capacity. As I said last quarter, and as our shareholders would expect, we will be financially disciplined in any decision to add further physical capacity, and we will also be diligent as we evaluate the need for incremental shifts.

Turning to our Ceilings business. We had a strong second quarter with a terrific snapback from the first quarter. Adjusted operating profit was $24 million on $130 million in sales this year, compared to $26 million on $144 million in sales last year. But last year's recast sales of $144 million also includes about $12 million in sales associated with our entities that were contributed to the USG Boral JV, which makes our comp store sales in Ceilings virtually flat year-on-year. Pricing improvement for both tile and grid contributed $5 million year-over-year, which was offset by $2 million due to softer volume and $3 million in higher cost. A large portion of our higher Ceilings costs are attributable to some carryover of higher cost for natural gas from the cold winter, which we anticipated. But as we've said, I believe these costs are now normalized. Our Ceilings business is about 85% commercial. And while we expect an uneven improvement in our results to continue, we believe that there is still headroom for margin and volume expansion as the commercial recovery grinds forward.

Moving to Distribution. Net sales in the second quarter were $344 million, with same-store sales up 6%. Given that Distribution is 75% leveraged to commercial activity, we see this as a positive signal that commercial market continues to recover. In addition, we recorded our fifth consecutive quarter of positive operating profit, recording $4 million during the second quarter compared to an operating profit of $1 million a year ago.

As Jim said earlier, we are very excited to report our first full quarter of operating results for our USG Boral joint venture. Total sales for USG Boral were $280 million in the second quarter, and we generated $23 million in total adjusted operating profit, which excludes a $7 million pretax restructuring charge associated with cost reduction initiatives aimed at eliminating redundant positions and processes. Although there is an upfront charge, we do expect to see the benefit of these cost reductions beginning in calendar year 2015, which should help drive improved performance. Our portion of the JV's adjusted net income was $6 million and included a nonoperational charge of $3 million for weather damage at one of our facilities in Asia. We do, however, expect to recoup the full amount of the damages through insurance before the end of the calendar year, and we expect our full year results for the JV to be within our prior guidance of adjusted -- for adjusted net income. Please remember that we closed on the JV at the end of February, so you'll need to adjust our guidance to 10 months.

Shifting to liquidity. As of June 30, we had total liquidity of $637 million compared to $846 million a year ago. While our current level is lower than last year, our cash and liquidity position continues to build, and I feel that our liquidity position is acceptable given the investment that we made into USG Boral and where we are in the recovery.

With regards to capital expenditures, we gave you an estimate at the beginning of the year for CapEx to be about $145 million. However, as you would expect, we manage our CapEx with some flexibility so that we can adjust these investments based on market conditions. Because the market has lagged our expectations over the first 6 months, we are being disciplined with our capital allocation and are adjusting our annual plan for capital expenditures downward by about $15 million. We remain committed to organically delevering our balance sheet. We have a $59 million bullet payment due in August of this year, which we will pay off with cash on our balance sheet. I believe that the cash generation capabilities of this business are strong, especially as we get further into the cycle, and I believe that we will generate more than enough cash to pay down our debt obligations and organically delever the balance sheet as we work towards our target leverage ratio of 1.5 to 2x debt-to-EBITDA at the mid-cycle.

At this time, I'll turn the call back to you, Jim.

James S. Metcalf

Thank you, Matt. I know there was a lot of information on the segments but, hopefully, that clarified some of the questions you may have on it. And obviously, we'll be able to answer your questions in a few minutes. But before we do that, I would like to take a couple of minutes and give you our point of view of the market going forward and kind of where we are at this point.

During the second quarter, as I mentioned, the pace of the industry shipments lagged our expectations. However, we do believe the overall opportunity is going to improve as the year in 2014 unfolds and going to be better obviously than last year, but at a slightly slower pace than we expected really early this year. We project demand to increase in the second half and into 2015 as our end-use markets will continue to improve. If you look at the individual markets. First, on the residential side, we did see some slight signs of improvement as the quarter unfolded. Each month during the quarter, the rate of housing starts increased compared to prior year. We do remain confident in the residential recovery and believe the overall demographics, like population growth and pent-up demand, point to a more robust but longer-term recovery in residential.

If you look at repair and remodel, which we've talked about in the past, is about 50% of our sales and a key contributor to our performance. We start -- residential R&R in the quarter improved despite normal seasonal softness that we see from a lot of our large home center customers. We expect a pickup in residential R&R in the third quarter. This will be driven by positive seasonality in our customer base and continued improvement in the market. The other side of R&R is commercial R&R, which is especially important to both L&W and our Ceilings business. The macros show signs of modest improvement. While the commercial R&R continues to deliver positive growth, this improvement we're seeing is very uneven.

Turning to new commercial. We see some very modest second half recovery, but with uneven improvement both by commercial segment and geographics. The Architectural Billing Index continues to be very mixed. During the quarter, 2 out of 3 months were positive. But if you look at the last 8 months, only 4 of those have been positive. This is one indication of the choppiness in the market, but we still believe the commercial business is still going to have some choppiness through the remainder of the year. The first part of the year, the opportunity we saw it as basically flat, but I will say we're seeing some slight green shoots in our business on the commercial business -- on the commercial segment. Notably, during the second quarter, we saw an 11%, 11% sequential increase in our steel sales at L&W. And this is really an important leading indicator for us because steel is shipped very early in a commercial job, and we feel that this indicates improvement for some of the other USG products, wallboard, particularly ceiling tile, which has about an 18-month lag, but we're starting to see some slight signs in this market. While we expect uneven improvement in the commercial opportunity, we expect it to continue for at least the balance of the year, but we believe the modest strengthening that we'll see there will lead to a better market in 2015 in the commercial segment.

I want to reiterate, we remain confident that the overall long-term recovery is intact, but at a slower pace of shipments through the 6 months, it's going to make it difficult for us to reach our overall wallboard expectations that we set at the beginning of the year for 2014. We feel that our volume is going to continue to improve on wallboard as the year unfolds, and the overall U.S. wallboard industry, we feel, is still going to reach an annual run rate -- and I want to reiterate the run rate of 23 billion feet in shipments in the second half of the year.

So with that, I'd like to -- that's kind of a recap of the market and where the quarter ended up and our look for the rest of the year. And I'd like to open up the call for questions for our team.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Robert Wetenhall from RBC Capital Markets.

Robert C. Wetenhall - RBC Capital Markets, LLC, Research Division

Could you give us a little bit more granularity on what's going on in the Ceiling business from a volume perspective? It looks like you have some negative volumes in ceilings. And why there is such a big disparity between wallboard shipments and ceiling trends.

James S. Metcalf

Yes, thanks, Bob. Obviously, as Matt said on the Ceilings business, we're heavily weighted to the commercial business. 80%, 85% is either new commercial or commercial repair and remodel. So that market's been very choppy where the wallboard business obviously has a bigger footprint in residential. The Ceilings business, if you look at volumes from the first quarter, both grid and tile volumes were up. Grid volumes were up almost 15%. So we did see some great sequential volume from a very -- we had a terrible first quarter because of winter. So we think the Ceilings business is going to continue to have a great return. The top line is still going to be a little spotty because of this choppiness we see in the commercial business. We're focused on the high end of ceilings. We just put an expansion in our Cloquet, Minnesota plant, which focuses on high-margin products. And we feel that with our industry-leading grid, we're going to continue to deliver the results that we have through this recession. They're really unrelated on what we look at the end of the year or the second half of the year because of the lag. I talked about the steel sales that we're seeing an increase at L&W, which gives us a leading indicator that there's some green shoots. But ceilings won't be hitting those jobs for maybe 18 months because they come in very late in the season. So we think, Bob, the second half for wallboard opportunity is going to be better than the first half. It's going to be better than last year. And we feel 2015 from an opportunity for wallboard is -- 2015 is going to be better than 2014. It's a slow grind up, but we're very positive. For every 100,000 housing starts, there's about 800 million feet of wallboard opportunity. And if you look at commercial, for every 10% change in commercial is about 1% on demand. So they're very unrelated, but we think what's great about having ceilings and wallboard, we package that solution together so we can get an entire USG job. Turning to ceilings, also the USG Boral team is really excited about having ceilings in that portfolio. This will allow us to continue to grow that portfolio in that part of the world, as I said, with not only plasterboard, but having ceilings along with those commercial jobs. So we are cautiously optimistic in the second half, but the volumes are going to be better. And I think we're going to end up the year much better than we did in the first half.

Operator

Our next question comes from Stephen Kim from Barclays.

Stephen S. Kim - Barclays Capital, Research Division

I have a question regarding your commentary about the -- about your wallboard sales. I think you indicated in your prepared remarks that they were -- volumes were up 3%, and you sort of gave some geographic and channel mix factors, which you think caused you to -- I thought you said underperform the industry. But then you also said that you felt your market share was pretty flat over the last 6 months. So I was just wondering if you could comment a little bit more in detail about the different channel segmentation, how they performed and your overall comment -- how you feel about market share.

James S. Metcalf

Yes, if you look at -- our wallboard volume from the first quarter, which we talked about it last -- 3 months ago, was weather-related. Our volume was up from the first quarter about 15%. We feel that we're in good shape. It's very similar to what happened last year, if you look at where we are versus the industry. We're very heavily weighted on the segments to the big-box retailers, the home improvement. They typically go into lawn and garden in the second quarter. They go back into building materials mid-third quarter, after Labor Day. Also Matt had mentioned some of the geographic areas where we have a bigger footprint with our customers. Those regions did not come back as quickly as -- it wasn't as strong as some of the other regions. So really, if you look at where we were last year, it really follows the same trend. And we're always balancing. We're balancing price and volume. And market share, we're very comfortable with. This is about maximizing our profitability with our customers, and we're growing with them. So we're very happy where we are this quarter on wallboard volume.

Operator

Our next question comes from Jim Barrett from CL King & Associates.

James Barrett - CL King & Associates, Inc., Research Division

Jim, can you give us some sense -- and I may have missed it, the USG Boral JV, it sounds like you're making some good progress there. Can you give us a sense as to what the year-over-year delta has been for revenues and operating income for that business?

James S. Metcalf

We -- if you look at it historically, they've been growing about 7% on the top line. And we gave some guidance, which, as you know, we typically don't do, when we came -- when we introduced the JV that we feel that our share of the earnings this year will be anywhere between $35 million and $40 million. And we're on -- as Matt said, we're on pace to do that. We expect about $50 million in synergies within the next 3 years of our technology rollout. And if you just -- directionally, if you want to look at that, about 40% of that will come from revenue growth and another, say, 30%, 35% will come from cost savings, and then the remainder will come from putting the adjacent products like DUROCK and ceiling tile into the mix. So Jim, we're really excited about the rollout of our technology and putting the USG production systems in. And just to remind everyone, you're talking about 12 countries, but you're also looking at 24, 25 manufacturing plants. And our team, our USG technical team, has just done a remarkable job level setting those plants. As I said, we're months ahead of schedule. The exception -- the acceptance of the USG system into the Boral plants has been unbelievable. In fact, we were with the teams this week. And we're really pleased with where we are at this point. It's very early and -- but I think this is a really important part of the USG portfolio. We're talking about -- here in the United States, commercial business is going to be choppy. Residential is growing, but everyone has a different opinion on where that's going to be. And you put this fast-growing business, and you hook this into the USG portfolio. This really helps us diversify the earnings, and it will really assist us going forward when there's different points to the cycle geographically. So we're very excited about it, Jim. It's something we've done before. This isn't new for us, the technology rollout. And they have a really strong market share in that part of the world. If you look at their overall market share, it's about 40%. So they've been doing things really well and everything we put in there is going to be additive. So we're very excited.

Operator

Our next question comes from Mike Wood from Macquarie.

Mike Wood - Macquarie Research

On L&W supply, you've done a good job restructuring the business this cycle. However, given the same-store sales growth you mentioned, the 6%, plus I would think there'd be a positive mix from the commercial growth that you called out, I'm surprised that the incrementals were only 12%. Can you give us some color in terms of what impacted that and what we should expect longer term in terms of the incremental margins in this business?

Matthew F. Hilzinger

Yes. This is Matt Hilzinger. Look, we've been very pleased with what Brendan and his team have been able to do on L&W. When you think about -- and I think Jim has talked about this in the past. We've been able to lower the breakeven of that business. Back in '07 or '08, it took about $500 million of sales a quarter to break even. We can do it in about $300 million now. So there's been a substantial improvement in terms of the leverage that, that business has. I think we do need to get more commercial to drive -- we need to get more throughput through those centers in order to really drive profitability. We really believe that when you look at -- as commercial comes back, that we will be able to outperform the historical margin performance of that business at all points in the cycle. And so we're obviously outperforming that cycle now given the sales that we had, and we would expect that to continue as we see commercial come back.

Operator

Our next caller is from Dennis McGill from Zelman & Associates.

Dennis McGill - Zelman & Associates, LLC

My question is on the regional variances that you talked about. I think everyone was in agreement in the first quarter that weather was a big overhang on demand and being able to ship and different factors you guys spent a lot of time on in the first quarter. And I think you said you didn't really see the acceleration in activity, particularly in the northern regions in the second quarter. And just wondering as you talk to customers, if you have any thoughts as to why that might be given that it was seemingly a pretty clear impact in the first quarter.

Matthew F. Hilzinger

Yes. It's Matt Hilzinger. Clearly, the Northeast has been a big part of our business. We have great customers up there, but it's just been a little bit slower, both on kind of the resi and on the nonresi side. And we just haven't seen it. And we were a little surprised that we didn't see the snapback in the weather-affected states. I think a lot of people were. But clearly, that was something that we were expecting to come back, and it just -- it didn't come back as clearly as we thought it would. But if you take a look at some of the -- even the housing data now, each month over the last quarter, it's gotten a little better. And as Jim said, we're starting to see some leading indicators in commercial. And the Northeast continues to be a really strong area for us, and we would expect that to bounce back. So we're going to continue to do the things that we need to do here and control the things that we can control. And I think we had, as Jim said, just a great quarter. It's the most profitable quarter we've had since 2007. We feel very good about the performance this year.

James S. Metcalf

And just to add on Matt's comments, we saw the regional business very strong in Texas, California and Florida. Those were very strong areas. We have different positions in each one of those areas as we're lined up with our strategic customers. So those were -- some of our customers in some of the busy areas weren't -- they were not as busy. They just did not get the work. And not every one of our customers gets every job. If you look of the Mid-Atlantic states, those were sluggish. There was a lot of -- a lot of rain affected our business there and our customers' business. And what's -- this is really the first time that we've looked at the geographics in the United States, and there aren't any weak areas. We have some sluggish areas, but if you -- as Matt said, if you look at year-on-year, and we have to keep this in perspective. This is not a quarter-by-quarter business. This is -- we're looking at relative improvement in all categories. And still a gypsum industry shipment that they are shipping at very -- we're still shipping -- we're talking about a run rate at 23 billion. That's a run rate. And we're still shipping at some -- at a very low demand. So we're crawling back from this. We're very pleased with the results. And we're going to still see a lot of regional differences here. This is a regional business. And it's really where we're partnered up with customers. We think we have some of the best customers in the industry. And some of them, right now, it's not their season. So we are very optimistic that we're on the right track, and we just need a little more help from overall demand.

Dennis McGill - Zelman & Associates, LLC

And just to clarify Jim, on that last point for California, Texas, Florida. Did you say that it was accelerating and it was strong there or that it wasn't? I'm a little confused.

James S. Metcalf

Strong, strong. California, Texas, Florida, strong.

Operator

Our next question comes from Eli Hackel from Goldman Sachs.

Eli Hackel - Goldman Sachs Group Inc., Research Division

I just wanted to touch on ceilings for a second and pricing power in the segment, which historically has been very strong. Do you think pricing power remains as strong as it was? You've put a bunch of price increases in the past couple of years. Are you getting any more pushback on recent price increases? And then just on the steel, just a -- steel volume, just a clarification, is that 11% dollars or is it volume? And if it's sequentially, can you just give what the year-over-year volume change was?

James S. Metcalf

Yes. On -- you slipped 2 questions in there. I thought that was pretty good. Those are 2 good questions. The first on ceilings. What we really do on -- the key on ceilings is really the grid business. We look at the overall futures of raw steel, and we have a wonderful strategic sourcing group that we have a look on steel 6 to 12 months ahead. So we have done a pretty good job over the last couple of years of -- where we see the steel -- the overall Steel Index going up is getting our price increase to our customers in the market so we don't have margin compression. There have been a couple of quarters that we didn't do that good of a job, but we're getting pretty good at that. On ceilings, it's really selling the value add of the higher end of the ceilings. Right now, about 35% to 40% of our portfolio is at the higher-end, higher-margin, higher-performing ceilings, which tends to get a higher price in the market. So a lot of what you'll see is product mix and where you see the price is going up. So it's -- on ceilings, a lot of it has to do with steel and your steel purchases. Turning to L&W, that 11% was dollars. And that was a year-on-year comparison. And we're also seeing some sequential increases from the first quarter. Actually, the 11% was from the first quarter. But we're also seeing year-on-year. Also on L&W, commercial insulation, commercial EIFS, which is the exterior, interior -- exterior insulation finish system, a la stucco, we're seeing double-digit increases sequentially from the first quarter there as well. So as I said, the commercial market is still choppy. But what's great about having L&W, it gives us some early, kind of early signs of what's coming. And we're starting to see a little bit of green shoots there. So to summarize, ceilings price improvement, we still are going to stay ahead of any type of steel increases. We're going to get value for our high-end products. And we had, as I said in my prepared comments, we had price increases in ceiling tile and grid in the second quarter.

Operator

Our next question comes from Philip Ng from Jefferies.

Philip Ng - Jefferies LLC, Research Division

Your wallboard prices were up sequentially, which is quite encouraging. But there's been chatter there's capacity coming back online in some of the market -- in California and Texas and price competition has picked up. Are you seeing any of that in the marketplace?

James S. Metcalf

On the pricing, it was -- basically, yes. I think what's good about having our one price for the year, it didn't really change that much from the first quarter. As we said in the past, it may change a little because of shipping and freight rates. But we're very happy. And our customers are very happy with our pricing strategy. And it clarifies a lot of things for them. And it has -- it allows them to go out and get additional work. We are not, as Matt said, we're still running -- overall capacity utilization is still in the high-50s for us. Effective capacity is 75-ish. We have no plans to add capacity. And we have not heard of any capacity being added in the market.

Philip Ng - Jefferies LLC, Research Division

Okay. But your pricing is pretty stable as what you see right now in the marketplace.

James S. Metcalf

Yes.

Operator

Our next question comes from Michael Dahl from Crédit Suisse.

Michael Dahl - Crédit Suisse AG, Research Division

I wanted to ask about the comments in the prepared remarks about dialing back the CapEx spend for the year. And wondering if you could give a little more color on what specific projects that would be and how we should think about the impact to operations as a result.

Matthew F. Hilzinger

This is Matt Hilzinger. Yes, so you would expect as we just -- as we saw things lag a little bit, we've dialed back a little bit on CapEx. And we didn't point it out, but our SG&A number is almost flat with last year so -- or last quarter. So we feel pretty good about how we're managing kind of capital and expenses of the business. In fact, we feel very good about it. But on capital, there's always some discretionary items that we look at each year. And there's some projects specifically that we think are good projects, but they require a little bit more work on it, a little bit more engineering work and some things in the plants that we just felt that was best to defer into next year. And so there's some deferral on that. There's also some things that, as we looked at, that we thought were important at the beginning of the year that we just don't need to do. There's some IT projects, some discretionary things that we've pulled back. So there's not anything here that we think impacts our ability to continue to invest and grow in the business. These are just some discretionary things that we think are prudent to kind of pull back. And some of them we've canceled. And some of them we deferred. But as you would expect, we're going to manage the capital pretty tightly.

Operator

Our next question comes from Kathryn Thompson from Thompson Research.

Wenjun Xu - Thompson Research Group, LLC

This is Wenjun sitting in for Kathryn. So our survey work has consistently pointed to bottlenecks with logistics that slow volumes, so for long-haul trucks to rails. Have you seen a similar impact to your business? And if yes, what are you doing to counterbalance this situation?

James S. Metcalf

Can you -- I wasn't sure if you came through as clear as possible, your microphone. Could you please repeat the first part of that? I wasn't sure if I got it, and I want to make sure I answer your question accurately.

Wenjun Xu - Thompson Research Group, LLC

Sure, sure. So our survey work has pointed to bottlenecks with logistics, which slow up some volume that transport to customers. So if you have -- my question is, if you have seen a similar impact to your business from the logistic part, the difficulties? If yes, what are you doing to counterbalance this situation?

James S. Metcalf

No, we have not. And let me just elaborate on that. We haven't seen any bottlenecks. We did see some in the first quarter, which I think the entire industry did because of the terrible weather we had. A lot of the truck traffic had -- was not been able to bring raw materials or ship products. Then it went to the rail. The rail was then overburdened because of everyone moving to truck traffic. But that was a severe winter weather. We have a very extensive network optimization program. We have a program that we have contract carriers that are dedicated to supporting our products. Our typical shipping area is 350 miles, and we have no bottlenecks nor see any.

Operator

Our next question comes from Al Kaschalk from Wedbush Securities.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

Jim, you talked quite a bit about the choppiness in commercial. I was hoping you could give us some insight on maybe some of the puts and takes of where you've seen some improvements or maybe some declines on specific either industry or customers from the beginning of this year to, say, current. You did comment about steel and that benefit would be in '15. But I was hoping that you could maybe bridge from the earlier comments in 2014 to where we stand today that support the growth going forward.

James S. Metcalf

Yes. Thank you. On the commercial market, it's -- there's been a lot of work, I think, by everyone looking at housing starts and how low they went. But it's just -- if you look at the commercial opportunity, you had some very significant downdrafts of commercial being down 35% and 40%. If you look at going forward -- and really the best areas, the highest-growth areas that we have seen for commercial have been education, retail and office. Now those are coming from some very low base, but those are the areas that we're seeing over the last couple of years, but more importantly as we see going forward are going to have a little bit of growth. If you look at retail, that's the largest segment of nonresidential for our business. Education would be the second-largest and office would be third. If you look at health facilities, very anemic. Obviously, public government is really anemic. And you're seeing a little bit of growth in hotels. So again, it's -- we look at -- vacancy rates is one thing we look at. Vacancy rates have improved slightly in the last 12 months. I think they've come down about 1 point. You look at jobs. There's a lot of things. The architectural index has been spotty. So it's still a very choppy area. And just to remind you, the overall new commercial business for USG is about 25%. If you look at the entire portfolio, it's about 25% of our business. 25% plus or minus is residential and then 50% is broken down on the repair and remodel. So those are -- that's kind of -- we still are -- we're still coming from a low base. We think that the second half in commercial is going to be still single digit. First half was flat, and it's still a very, very choppy and uneven market.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

Did -- have you commented -- sorry, just a follow-up on this.

James S. Metcalf

You know what, we have a few people in queue. And I don't mean to cut you off, Al, but I'm trying to get to everybody here. And there's a lot of interest today to hear about our wonderful results. So if we can come back to you, that would be great.

Operator

Our next question comes from Garik Shmois from Longbow Research.

Garik S. Shmois - Longbow Research LLC

I'm just wondering if you could provide a bit more context around your comment that you expect the wallboard industry to get to a 23 billion square foot run rate sometime in the second half of the year. Can you provide a little bit more color? Do you think this could be a third quarter or fourth quarter event? And maybe what kind of housing demand is embedded in this assumption?

James S. Metcalf

Yes. If you look at -- we're looking at this, Garik, more in the third quarter. As I said earlier, this is where a lot of our large home center customers come back into the market. They get out of lawn and garden, building materials becomes a focus. We have really -- historically, we've looked at from about late August, Labor Day through really Thanksgiving is a really busy time. So we're really focused on the residential repair and remodel. We also -- we don't have any crazy housing numbers. I mean, we have the lag of some solid year-on-year increases in this quarter. So we had 3 to 3.5 months on that. We're still at a housing start number for the year of 1 million and change. So nothing -- no big change there. And a little bit of this commercial coming back from flat market in the first quarter or first half up to some single digits in the second half. But it's really going to be driven by the repair and remodel. That's what we're working on. And again, I just want to reiterate. That's a run rate of 23 billion for the industry. We are not projecting that's where we're going to end up at the year. Beginning of the year, we thought that's where it was going to be. But we're still in probably at the 22-ish billion -- 22.5 billion end of the year range.

Operator

Our next question comes from Keith Hughes from SunTrust.

Keith B. Hughes - SunTrust Robinson Humphrey, Inc., Research Division

Kind of building on the last question. Your discussion of the 23 billion run rate would imply some pretty healthy volume increases year-over-year in the second half in wallboard. My question more is on inventory. Have you built inventory in expectation of that? Or is that something you could hit with normal production?

James S. Metcalf

Yes. No, we can hit it with normal production. Our plants are running really well. Our efficiencies are at all-time levels. And my hat's off to our manufacturing team that has really just run this network like a well-oiled machine. As you know, we're a nationwide player, so we have to -- we run our network as one, but there are different regional differences. So no inventory buildup. We have a great forecasting system with both L&W and our customers. We're tied in from a forecasting with some of our large retail customers. So we have a pretty good view of what's coming. And we really want to balance our working capital as well. And we do focus on inventory. So we aren't seeing any build, and we think we'll be able to service our customers. One of the things that we do track is on-time delivery. And our on-time delivery with our customers has been at historical highs. And we'll be able to -- we do have some regions that were extremely busy. I mentioned some of the regions in the earlier question. The Texas market is very busy. And our capacity utilization is extremely high there. But what's great about being a nationwide player is we can balance our network, so you don't have to add capacity somewhere. We can use capacity from other plants. So no inventory build, and we want to balance -- we want to keep an eye on our working capital.

Operator

Our last question comes from Mark Weintraub from Buckingham Research.

Mark A. Weintraub - The Buckingham Research Group Incorporated

Could you give us a little color on gypsum usage you're seeing in the multifamily versus the single-family on the residential side?

James S. Metcalf

Well, the multifamily over the last year has really been the shining star there. And we think -- we do -- we look at housing starts as a whole. It doesn't really mean a big difference to us. There's a little bit of less consumption on the multifamily. But what it also does, multifamily helps us with L&W. L&W has a fairly large footprint when you look at multifamily and high-rise residential construction because there's fewer dealers and distributors that can stock a 30-story condominium building. So it does use a little less product on wallboard, but it could use steel, which L&W sells. It probably has some acoustical tile in the lobbies of the building. So we look at housing starts as a whole. As I said earlier, for every 100,000 additional housing starts is about 800 million feet of wallboard. And when we say that, multifamily is in that calculation.

Mark A. Weintraub - The Buckingham Research Group Incorporated

Okay. And so it's close to a 1:1 relationship?

James S. Metcalf

Yes it's not anything significant that's going to change your model.

Okay. We appreciate your questions, and I know there were quite a few people that were interested in the results, and I appreciate everyone keeping it to one question so we can get through most of the interest that we had this morning. As we said earlier, for the second quarter, we had our best operating results in 7 years. And I think that's a big accomplishment for all the men and women throughout USG and USG Boral. This has been a phenomenal run that we have. We still have a lot of work to do. But just to put it in perspective, it's been 7 long years. And we did this on 2/3 of the market opportunity. I just want to reiterate that. Best operating results in 7 years on 2/3 of the opportunity. And as we've talked in previous calls, we've done this in areas -- in focus areas that we can control. It's continuing, as we like to say, our best-in-class initiatives in our safety performance, our customer satisfaction, our innovation, and as we've been weaving into the comments today, and we will continue to do this is, is focusing on lowering our breakeven. We are very confident that the recovery is intact, but we do feel that it will be a longer, slower recovery than we've seen in previous cycles. While we can't control the pace of the recovery, we can remain and we will remain focused on maximizing the leverage we've driven into this business and continuing to execute on the 3 pillars we talked about this morning of our strategy. As always, we really appreciate your time and your interest in USG, and we thank you for spending the last hour with us. Thank you.

Operator

Thank you. And thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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