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USG (NYSE:USG)

Q2 2011 Earnings Call

July 22, 2011 11:00 am ET

Executives

Brian Moore - President and CEO

Richard Fleming - Chief Financial Officer and Executive Vice President

James Metcalf - Chief Executive Officer, President and Director

William Kelley - Principal Accounting Officer, Vice President and Controller

Analysts

Daniel Oppenheim - Crédit Suisse AG

Rodny Nacier - KeyBanc Capital Markets Inc.

B.G. Dickey - Stephens Inc.

Angela Uttaro - Oppenheimer Funds

Kathryn Thompson - Thompson Research Group, LLC.

Michael Rehaut - JP Morgan Chase & Co

James Barrett - CL King & Associates, Inc.

Robert Wetenhall - RBC Capital Markets, LLC

Joshua Borstein - Longbow Research LLC

Ivan Marcuse - Northcoast Research

Joshua Pollard - Goldman Sachs Group Inc.

John Baugh - Stifel, Nicolaus & Co., Inc.

Mark Weintraub - Buckingham Research Group, Inc.

Operator

Welcome to the USG Corporation's Second Quarter 2011 Earnings Conference Call. My name is John, and I'll be your operator for today's call. [Operator Instructions] Please note this conference is being recorded. I will now turn the call over to Mr. Brian Moore. Mr. Moore, you may begin.

Brian Moore

Thank you. Good morning, and welcome to USG Corporation's second quarter 2011 earnings conference call and live webcast.

We will be using a slide presentation in conjunction with our call today. It is available by going to the Investor Relations 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 about business, market and other conditions, and management undertakes no obligation to update these statements. The statements are also subject to another -- a number of factors, including those listed at the end of today's press release, and actual results may be different from our current expectations.

With me today to discuss our results and our outlook are Jim Metcalf, President and CEO; and Rick Fleming, Executive Vice President and CFO.

Jim will provide a general overview of the quarter plus additional insight into some of our businesses. Rick will review the financial results for the quarter for the corporation and the business segments. We will then open up the call for questions and conclude with a few comments from Jim. Also present for the Q&A portion of the call is Bill Kelley, Vice President and Controller. Jim?

James Metcalf

Thank you, Brian, and good morning. Thank you for joining us, and I appreciate your time and interest in USG. Last month, I had the opportunity to travel in various locations in North America to meet our employees. In every location I visited, our team exhibited a high degree of commitment and optimism about our company's long-term prospects. While it can be discouraging to battle through this very lengthy and severe market contraction the way we have, our employees can see that we are making progress.

Total sales for the second quarter for the corporation were relatively flat, down 1% versus last year, but the progress we continue to make can be seen in the fact that our operating loss was reduced by 16%. This is a significant improvement, especially when you consider that last year's second quarter included the benefit of the government housing tax credit. Regardless, it's still loss, and that's unacceptable to all of us. Our #1 focus continues to be our path to profitability.

As we manage through this recession, I can tell you that our employees are very aligned, and we are pursuing 3 strategic objectives: First, strengthening our core business. Next, diversifying the source of our earnings; and third, differentiating through product innovation. What I'd like to do is spend a couple of minutes and talk about each one of our objectives.

First, strengthening the core. Our core businesses, North American Manufacturing and Distribution are solid. They're all affected by the recession and low volume throughout our network. The actions we've taken, which you've heard in previous calls, is to streamline our operations, reduce our costs and eliminate functions that have strengthened all of our core products. Wallboard, Joint Treatment and Ceilings, as well as improving our Distribution business. These actions are producing tangible benefits right now on exceptionally low demand. We expect that those benefits and the performance of each one of these businesses will be amplified as demand improves, and we can realize the operating leverage in each one of the businesses.

Our second objective is diversifying earnings. One of the most unusual characteristics of this recession besides the severity of it and the duration is the fact that all of our U.S. market segments have declined roughly at the same time. It's been very unusual that residential, commercial and Repair and Remodel segments had been in recession simultaneously. These segments have historically been contracyclical, which have helped us to diversify our earnings in the past.

But this is not what we're dealing with in this recession, and it's had a significant impact on our results. Our plan is to further diversify our earnings, and doing it through international growth and new product adjacencies. We have successful operations outside the United States, including Canada, Mexico, and most recently, China. Unfortunately, these operations don't have the impact to counterbalance the downturn in the United States.

We are growing our joint ventures throughout the world and have technology agreements as examples of how we're going to add to our geographic diversity. We are also expanding in product adjacencies that further diversify our earnings. One example of this is commercial roofing. Our SECUROCK roofing product is relatively new, but has wonderful growth potential. This is one example of expanding a current product into a new growth segment for USG.

Our third objective pertains to innovation. USG is and always has been the leader in innovation. Many breakthroughs that you know in construction are attributable to USG, including the invention of wallboard itself, almost 100 years ago. Our customers tell us that leadership in innovation differentiates us from competition and it's truly a value add for our customers' business. We have continued to pursue and extend our innovation leadership despite resource limitations that have resulted from this recession that we're in. Last year, we created an entirely new product category, lightweight wallboard panels, when we introduced SHEETROCK Brand UltraLight Panels. The customer response to this has been wonderful. It's now available in more than 2,000 locations in the United States and now in Canada.

Our next phase is adding to the lightweight wallboard portfolio with the introduction of the industry's first 5/8 product. It's new to the market and it provides a long requested solution for our commercial contractors. We will continue to expand our advantage in the lightweight category, and more broadly, the innovation leadership that differentiates USG in the market.

Now before I turn it over to Rick Fleming, I'd like to mention a few highlights from the second quarter.

In our U.S. operations, Wallboard volume was down 8% compared to the second quarter of 2010. The Ceilings business performed well this year, despite weak economic conditions. Our Substrates business had a solid quarter as well. Adoption of new specialty panels in our Substrates business, SECUROCK glass-matt sheathing, SECUROCK roof board and DUROCK Next Gen, all outperformed the market.

Outside of the United States, our plant in Monterrey, Mexico started the production of DUROCK Next Generation. Our improved, lighter, stronger DUROCK that is used extensively in the exterior sheathing in Mexico and Latin America. In Canada, as I just mentioned, SHEETROCK UltraLight Panels have been launched and have been extremely well-received by our customers. We've also begun shipping SHEETROCK UltraLight Panels to our Latin American customers with rave reviews.

Our Distribution business L&W Supply launched a new national brand to connect the identities of the 27 local brands and demonstrate our national -- nationwide strength. This is all part of a broader and a fundamental change that is taking place at L&W as we speak. Also, L&W has been informed that we received a Vendor of the Year award from one of our largest customers, emphasizing the focus we have on our strategic customers in this market.

In conclusion, we are focused on our plan to win, strengthen our core business, diversify our earnings and differentiate through innovation. Some of our key U.S. market segments are moving sideways or, quite frankly, treading water, but we are continuing to move ahead aggressively with our strategic plan in our road to profitability.

Now I'd like to turn it over to Rick Fleming for a deeper dive of our financials. Rick?

Richard Fleming

Thanks, Jim, and good morning to all of you. Thank you for joining us. As Jim mentioned, I'll recap our second quarter financial performance and provide some additional details on the operating highlights that Jim just covered. I'll also provide some comments on overhead, interest expense, taxes, capital expenditures, debt and liquidity.

As you heard from Jim, the major headline for the second quarter is that our top line remains challenged by the weak U.S. housing and construction market fundamentals. But we're continuing to make progress towards profitability through our operating initiatives and controlling the controllables.

Now turning to the results. Second quarter 2011 net sales were $761 million, down 1% from the second quarter of 2010 net sales level of $769 million. Our second quarter operating loss was $21 million compared to a loss of $25 million in last year's second quarter. These results included $2 million of restructuring and other charges this year and $7 million last year.

In addition, our sequential improvement was notable as the $21 million operating loss for this quarter compares to a $58 million operating loss in the first quarter of 2011, which included $9 million of restructuring charges.

Second quarter 2011 net loss after tax was $70 million or $0.69 per share based on average shares outstanding of $103.6 million. This compared to a net loss of $74 million or $0.74 per share on 99.5 million shares outstanding in last year's second quarter.

In the interest of time, I will not recap the 6-month results, which are delineated in our press release and its attachment other than to note that the effectiveness of our cost-reduction efforts were evident here, too. Sales were essentially flat for the first 6 months of 2011 compared to the first half of 2010, but our operating loss improved by 26% and our net loss also improved.

Jim previously discussed our operating focus areas, I will now provide a little more detail on our second quarter segment results. The softness in the U.S. market continues to impact all 3 of our business segments: North American Gypsum, Building Products Distribution and Worldwide Ceilings. When comparing this year's second quarter to the comparable period last year, it is important to keep in mind that last year's second quarter included a positive impact of the housing tax credit.

In our North American Gypsum unit, net sales declined 2% to $420 million for the quarter, while its operating loss increased $5 million to $16 million versus $11 million last year. This increased loss reflected lower volumes and margins for both wallboard and joint treatment. A 5% price increase for joint treatment was announced in July, effective August 1.

On U.S. Wallboard business, a key driver of North American Gypsum results, it shipped 986 million square feet in the quarter, down from 1.07 billion square feet a year ago. Industry shipments declined about 270 million feet or 6% from last year's second quarter levels. And they were essentially flat with the first quarter of 2011. As I mentioned, these unfavorable comparisons reflect the fact that second quarter last year included the temporary boost in demand from the housing tax credit.

Our average wallboard price was $111.55 per 1,000 square feet. For the second quarter, this is down about 2% versus same period last year, but up sequentially by $2.40 per MSF versus the first quarter of 2011. In Building Products Distribution, the fundamental restructuring at L&W Supply that Jim described is clearly improving results. In fact, the second quarter of 2011 represented the fifth consecutive quarter in which L&W Supply posted improved operating losses over the comparable period in the prior year.

The changes that have taken place at L&W are substantial from supply chain initiatives to a heightened focus on the commercial contractor to the way we have separated the sales function from the operations at the branches. We are pleased with this progress and we expect to see further improvements. Net sales from our Building Products Distribution business decreased $12 million or 4% to $207 million in the second quarter this year compared to second quarter of last year and same-store sales were down 4% as well for the quarter versus last year. However, operating losses improved by $8 million from a year ago to $14 million loss in this year's second quarter as our efforts to reduce costs and improve operating results continue to take hold. L&W wallboard volumes year-over-year for the quarter were down 24%, while the average wallboard price increased over 8% versus the same period last year. L&W's wallboard margin was up 31% for the quarter versus the second quarter of 2010. In addition, sales from construction metal products and [indiscernible] products were up 8% and 7%, respectively during this year's second quarter, which helped in part to offset the wallboard volume decline.

As of June 30, L&W operated 163 branches, the same level we had at the end of the first quarter of this year. Our Ceilings business has performed very well throughout the great recession and that trend continued in the second quarter. Both sales and operating profit in Worldwide Ceilings were about even with last year despite weak market conditions.

Second quarter net sales from Worldwide Ceilings increased $1 million to $173 million and the second quarter segment operating profit was $1 million less than last year at $22 million. USG Interiors, the largest business unit in the segment, experienced a $3 million decline in operating profit in this year's second quarter, versus the second quarter of 2010 due to slightly lower tile and grid volumes and some raw material cost pressures. I should note that a 5% price increase for tile and grid was announced in June of this year, effective August 1.

Now I have some additional details on the rest of the P&L and discuss what we've been doing to manage capital spending and our balance sheet, including liquidity. I will start with overhead. We have continued to contain our selling and administrative expenses. In fact, our current annualized SG&A spending is at 2002 levels. In the quarter, SG&A expenses were $72 million, down $1 million from the same period last year. For the first six months of 2011, total SG&A was flat with the first half of 2010 at $157 million.

Interest expense was $52 million for the second quarter and $104 million for the first 6 months. And it's higher than last year due to our November 2010 bond offering. We currently anticipate that interest expense will be about $209 million for all of 2011 on a P&L basis and about $195 million on a cash basis, offset in part by about $7 million of projected interest income.

As you may recall, we currently have a full valuation allowance on the deferred tax assets of the majority of our operations, and as a result, our effective book tax rate continues to be minimal. The effective tax provision rate was 1.6% for the second quarter of 2011, resulting in a 6-month tax benefit rate of 1.1%. Looking ahead to the full year, we anticipate an annual tax provision rate of approximately 0%, depending on the mix of worldwide income.

Turning to capital spending, we continue to benefit from the substantial investments in our operations that we made prior to the downturn, and this has allowed us to keep annual capital expenditures at the $50 million level. Capital expenditures totaled $12 million in the second quarter of 2011, compared to $5 million in the same quarter of last year. For the first 6 months, CapEx totaled $25 million, and we are currently forecasting about $50 million of capital spending for the full year.

By the way, the majority of this year's capital budget is focused on converting a number of our wallboard plants to be able to manufacture SHEETROCK Brand UltraLight Panels. We are channeling these capital dollars to UltraLight Panels to accommodate the strong customer demand we are experiencing for these lightweight products.

Turning now to cash and debt, we are very satisfied with our liquidity position. You can see the numbers in our financial statement. At June 30, we had cash, cash equivalents and marketable securities of $725 million, and we had nothing borrowed on our revolving credit facility. When you include the borrowing capacity on our credit line, we had total liquidity of $923 million.

Total debt as of June 30 was $2.3 billion, essentially the same as the balance at the end of the first quarter, as well as year end 2010. In addition, we have a number of liquidity initiatives around working capital management and further surplus asset sales. We presently have about $70 million of asset sales under contract and we expect that these sales will be completed in 2011.

Let me conclude by emphasizing that we continue to have intense focus on improving our profitability. We do see our cost and managing our balance sheet and liquidity. And despite the weak demand levels that we are expensing, we are encouraged that our restructuring efforts are bearing fruit as evidenced by the progress we are -- continue to see both in the United States Gypsum Company and L&W Supply. But we still have more work to do, so our intense focus on profit margins, cost and cash continues.

Now we will be happy to answer any questions you may have. Brian?

Brian Moore

Thank you, Rick. We are now going to open up the call for questions. [Operator Instructions] Operator, please open up the phone lines for participants to ask questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Michael Rehaut from JPMorgan.

Michael Rehaut - JP Morgan Chase & Co

First question, just on the United States Gypsum Company margins, I was just trying to get a sense, with obviously, still staying in the loss position, and obviously, pricing is still very, very challenged. Given the restructuring actions that you've taken year-to-date and perhaps also thinking about if there's any impact as the natural gas futures roll off, if things weren't to change in terms of pricing or volumes, what type of benefit would that or impact would that have on the current level of operating margins in the U.S. Gypsum segment, again everything else equal, except incremental flow-through from restructuring activities and changes in the natural gas pricing?

Richard Fleming

Mike, that's a great question. It's Rick Fleming. Let me cover natural gas first and then we can talk about the broader issue of the cost trends. But just to re-emphasize, we do have a hedge program in place. And as you know, some of the legacy swaps, as we call them, put in place before 2008 have been a bit of a drag on our natural gas cost, although, that's been abating. To put it in perspective, for 2011, about 23% of our buy is legacy swaps. The good news is by the time you get to 2012, it's down to 8%. We've been using the options since then, so whenever gas goes down, we get the benefit with an option. We just cap the potential spike in gas if there was a supply chain disruption or hurricane type of event. In that regard, for 2011, we benefit from about 77% of our buy right now if the gas prices go down. In 2012, it will be 92%. So that's a positive trend there. Right now, with the blended cost of the current spot at the 458, as well as the legacy swaps for 2011, we have a blended cost of roughly $1 above the market. So spot's 458, call it 558. And when you get into next year, that should drop about $0.50 or so and just by the roll-off of the old swaps. To put that in sort of a dollar perspective, our buy this year is about $90 million, including our USG Interiors. Next year, it could be at $5 million or so less, roughly. Of course, that takes -- that assumes gas stays where it is right now on the spot level. Does that answer the question on the gas side?

Michael Rehaut - JP Morgan Chase & Co

Yes. So you're saying the $5 million benefit all else equal?

Richard Fleming

All else equal at spot prices of today's level. Now more powerful trend we're expensing is an improvement in our fixed-cost structure. And if you look at wallboard costs were, a quarter this year versus last year, we had an improvement of about 2% or so. And what happened was paper went up about 11%, but we were able to offset that both with lower rock costs, but most importantly, lower fixed cost of almost 17%. So the positive trends are sort of offsetting any inflation pressures in the Gypsum Company are evident in the numbers. Paper, by the way, is trending to abate right now, and so that looks like a -- it may be going a little bit the other way, positive. But the fixed-cost reduction, 17%, as I mentioned, will continue and could actually be substantially improving if we get more volumes in the systems as well, because of fixed-cost absorption. So hopefully, that gives you a sense of that side of the coin as well.

Michael Rehaut - JP Morgan Chase & Co

So in terms of just incremental benefit from cost savings from any type of restructuring activities, is it mostly in the numbers today?

Richard Fleming

It would be certainly in the numbers relative to the fact that we haven't done major restructuring so far after the first quarter. And any of those benefits are starting to show up in the numbers. But they'll play out a little bit more over the course of the year.

Michael Rehaut - JP Morgan Chase & Co

Okay. Second question...

Richard Fleming

By the way that comment related to the manufacturing footprint for the United States Gypsum Company.

Operator

Our next question comes from Garik Shmois from Longbow Research.

Joshua Borstein - Longbow Research LLC

This is Josh Borstein in for Garik. I was wondering if you could just talk a little about pricing, wallboard prices in the quarter. I think, the prices may have come in a bit below what many were expecting, considering the March and May price increase.

James Metcalf

Yes, this is Jim Metcalf. As Rick talked about in his prepared comments, our price improved about $2 for the quarter. We did have a little bit of pressure from freight, but that wasn't a big impact. And the industry is still in a 50% plus or minus capacity utilization, and there is some low demand. So we got to a point, we've talked about balancing price and volume in previous calls, and that's what we continue to do. And we have been very aggressive, as you know, on price increases over the last 18 months. And during the quarter, we felt that we wanted to protect some of our share and our customers' position. So we are pleased, though, in this environment, at the low capacity rates that -- utilization rates that we are getting price improvement. So kind of stepping back from it, we'd always like to get more, but we're still seeing some positive trends in pricing.

Joshua Borstein - Longbow Research LLC

Okay. And just one follow-up question staying with pricing. If you can talk about -- a little bit about securing additional price increases in the future, what strategy that may be. And a lot of manufacturers have an August price increase out there, having come across any letters from USG. Also some manufacturers now announced a September price increase? Are you going to support either of those attempts, do you think?

James Metcalf

Well, just kind of stepping back, when we look at price improvement as I just mentioned, we've historically and will continue to be pricing on our value. We look at the market of where we will have the higher probability of success of realizing a price increase. It sends our customers to a lot of administrative tasks if we just put an increase letter out, and we don't think we can get it. So we feel that August was not an appropriate time. We thought it wasn't right for our customers, and we're going to continue to monitor demand. We look at our market share. We have a new product rollout. And we'll put a price increase announcement when we feel we have a high realization factor to get it. So you never have to worry about us being aggressive on price. But we want to do it when it's the right time for our customers, and we think it's the right time for the market.

Operator

Our next question comes from Trey Grooms from Stephens Inc.

B.G. Dickey - Stephens Inc.

This is actually B.G. Dickey in for Trey. My question is just around volumes actually in wallboard. I think previously, you guys stated that you were expecting kind of modest growth for the full year in terms of volumes, but -- and I know that you got probably a bit easier comps in the back half of the year. But do you still think that you guys can get positive growth there?

James Metcalf

Yes, we have taken a little different approach on the year, looking at total wallboard opportunity. We think opportunity's probably going to be as we ended the year probably flat versus 2010. The second quarter did take a pause in demand. It comped last year as we talked about, the housing credit. But we have backed off a little bit from our demand for this year. I guess, the good news is it hasn't gone down year-on-year. It's just, we aren't expecting an uptick. Everyone saw the housing start numbers this week, but that's only one month. So we are going to be very conservative on the outlook on demand and we think it's going to be around flat versus 2010.

Operator

Our next question comes from Kathryn Thompson from Thompson Research.

Kathryn Thompson - Thompson Research Group, LLC.

The first question is on your Ceilings segment. And the ceiling sales increased momentum on a percentage basis load in Q2 versus the prior 2 quarters. Question is why the relative slowdown? And how much visibility do you have with your Ceilings business? And how is this different versus your Wallboard segment?

James Metcalf

Yes, Kathryn. The Ceilings business, it did take a slight pause in the quarter, but we're still pleased with the results. Really, what impacted the Ceilings results in the quarter, as Rick talked about, was we had some raw material inflation that our price just lagged behind it slightly. Steel costs increased tremendously in May and June. But as Rick indicated, we have a grid increase for the 1st of August, which we're very optimistic on. The Ceilings business does track very differently than the Wallboard business. Our Ceilings business is heavily weighted to commercial repair and remodel. I think, that's why we've seen the strength of the Ceilings business over the last 2 years surprise some people because of the very low comps we've had on new commercial. So they do operate in different demand factors. For example, housing starts have nothing to do with our Ceilings business. We really track with commercial repair and remodel and we also track architectural billings, because that's very important on new commercial. We're starting to see some modest improvements in the outlook on our commercial, new commercial construction. And our point of view, it's low single digits improvement year-on-year. But we do have about, on Ceilings, you have about an 18-month lag on the demand factor. On wallboard, it's about a 12-month lag. So that's kind of another difference there. But we're really -- we're still -- we're very optimistic on our Ceilings results. We're going to continue to stick to our plan that we've been implementing in the last 3 years. And I'm optimistic that we're going to have a solid year.

Kathryn Thompson - Thompson Research Group, LLC.

I think with that, my first question, I was really focusing more on the top line as opposed to the margins. So raw material fluctuations wouldn't necessarily impact the top line, so really it's more on the top line.

James Metcalf

Well top line quarter, sequential quarter-on-quarter we were up. And if you -- the top line USG Interiors, if you look at, it was $112 million second quarter this year, basically, flat for 2010. So top line growth has -- sequentially, is up slightly from the first quarter, flat versus the second quarter last year. So the top line is important for us, but we've been focused over the last 3 years on Ceilings is a return on investment in our margin improvement. So the top line is not a concern for us, and we think that the rest of the year, it should be some positive top line growth.

Richard Fleming

And Kathryn just add to what Jim said, remember commercial, new commercial, is down 15% last year with the lag that is in the market this year. So that's part of what you see. As Jim mentioned, 2/3 of Ceilings is Repair and Remodel, but 1/3 is still in new commercial.

Operator

Our next question comes from Bob Wetenhall from RBC.

Robert Wetenhall - RBC Capital Markets, LLC

It sounds like it's a very difficult demand environment. And my question is for Jim. If results on an EBITDA basis in 2011 are similar to 2010, would you be comfortable with that? Are you expecting better EBITDA performance? And I want to couch this with the caveat that you guys have been generous in saying that there's pretty limited visibility. So I'm just trying to gauge, I think, you were $45 million of EBITDA last year. Is that a bogey you would like to see this year? Would you be pleased with that? And is that something we can look forward to?

James Metcalf

Bob, thanks for your question. Absolutely, I would not be pleased with that. We've put a lot of effort in reducing cost, introducing new products, balancing price and volume, really focused on our customers. And it is our job not to be pleased on anything that we did last year. We want to continue to improve. I'm not giving a projection, but I would not be pleased with a $45 million EBITDA for 2011.

Robert Wetenhall - RBC Capital Markets, LLC

Is that another way of saying we might expect for better performance in the back half of the year to beat that number in 2011?

James Metcalf

Well, I'm not going to -- I can't give you a projection. But you know me well enough, I would not be pleased.

Operator

Our next question comes from Rodny Nacier from KeyBanc Capital Markets.

Rodny Nacier - KeyBanc Capital Markets Inc.

You had commented earlier on the international expansion opportunities and adjacent products that you're looking to get into. Can we get a sense of maybe timing of those investments, and if you're looking to expand it to new geographies and what products you'd be focusing on, in your business?

James Metcalf

Sure. Thanks for the question. Great question. As we talked about our 3 strategic objectives, we spend a lot of time on these calls talking about strengthening the core, and that is extremely important. That's really been job #1 over the last 3 years. That's strengthening our North American Gypsum business, our Ceilings business, as well as what we've been doing on L&W Supply. So to talk about our second objective, about diversifying our earnings, I really welcome that. And we're going to hopefully get some questions on UltraLight, because this is a very exciting product that I'd like to say, is our iPod for the industry. But on international business, we have taken a very strategic approach that we are going to focus on markets, where we can have critical mass, and I like to use the example markets that are similar to our success we've had at USG Mexico, where we have landed assets, we have business leaders in that markets running the business, and we have a full product line. We are looking at the Latin American market. It's a market, as we move down from North America down into Central and Latin America, with our AIS acquisition we made 3 years ago. It gave us a great platform for growth in the northern cone of South America. And we are looking, as I mentioned in my prepared comments, we've made an investment in Beijing, with our ceiling tile plant. And I don't think anyone can ignore the growth that everyone sees in China. So our ceiling tile plant is past start-up phase. We are in optimization of our ceiling tile plant. We have great partners in Beijing. We have a very active board over there, and we're very optimistic about growing our business in China. When you talk about product adjacencies, I used the example of our commercial SECUROCK board, and this is a product that has been growing exponentially, really started from 0, 12 months ago. It's a product we already make, basically our FIBEROCK product that we have commercial roof systems. And the reason we like this is this is in the repair versus the remodel segment of the market. When a commercial building needs their commercial roof repaired, this isn't something a company or owner would defer, considering even in the midst of the recession. We're also looking at products that our customers currently have but would prefer us to distribute. So the product adjacencies can also be in our distribution. One great example of that is our commercial exterior system that L&W Supply distributes. We are the largest distributor of the Dryvit exterior system. And we view that as a product adjacency. We don't have to manufacture it. We can also distribute it as well. So we put some internal targets for our business units on expanding or diversifying our earnings through geography, with products that we currently make, as well as adjacent products that may be new to USG, but in markets that we are the leader in. So we're really excited about it. We'll continue to update you as the results, as we get some successes here. But these investments are going, at this point, will be minimal, considering where we are in the market. But we have put together a 5-year plan, and have lined up where we are going in some of our opportunities. So we're really excited about it, and I really appreciate you asking the question.

Rodny Nacier - KeyBanc Capital Markets Inc.

And on the current quarter, in your Ceilings business, I'm trying to understand the margins.

James Metcalf

I'm trying, we have some people in queue and I don't want to be rude, but we're trying to keep this to one question. If you we could just -- if you can just hang in there with this, we have some time, we'd be more than happy to answer the Ceilings. And if not, we'll do it on a follow-up call.

Operator

Our next question comes from Dennis McGill from Zelman & Associates.

Dennis McGill

I promise, I'll keep it to one. [indiscernible] as well. I guess, my question on UltraLight is you guys have talked about this, obviously. It's a big innovation for the industry. But at the same time when you look at the volumes, you mentioned that you're down a little bit more than the industry on a year-over-year basis, and it looks like sort of similar to the industry, sequentially. And based on our numbers, price is probably a little bit weaker than the industry year-over-year. So when will -- when do you expect to start to see the market share opportunity come through from UltraLight either in the form of stronger volumes or better price? Is that something we could look forward to in the second half of the year?

James Metcalf

Dennis, that's an excellent question. If I can just frame it in 2 ways. First, on the volume, and let's put UltraLight aside. We have been really, as you've heard in the last, probably 24 months, are keen on balance of price versus volume, market share versus price improvement. And really, the last 6 months, we have focused, honed that down on the L&W Supply piece as well. So when L&W has reengineered and changed their strategy to focus on profitability and key customers, it has had an impact of overall volume, obviously, in our system. So the first impact has been L&W's focus on the commercial contractor and key strategic customers. L&W has had a price improvement, believe it or not, in this environment. We don't show that a lot in our results or highlight that as much as we do at the Gypsum company. But L&W has had very good price improvement with their customers, and quite frankly, have moved away from some either unprofitable customers or some unprofitable regions. So that has impacted the overall volume of U.S. Gypsum and the volume for L&W. But we believe this has been a sea change to reengineer both the Distribution business and balance price and volume. So we aren't concerned about our share basically the last probably 3 to 5 quarters has been relatively flat, tenths of points up or down, and we're at a point now that we think with UltraLight, coming to your question on UltraLight, we think this is a great opportunity to strategically grow our market share in a way that is new to the industry. We're very excited about expanding our footprint in UltraLight and 5/8. This is really the big step change. 1/2 inch was a very big challenge for us. Having the lightest weight product in the industry, by far, is something that's great. But along with that, the performance is critical. Passing a sag test when you have something that light, that does not sag, passing the ASTM nail pull is actually critical that we will not go backwards on. And then on 5/8, having the appropriate UL fire testing is a big challenge, which we check marked all 3 of those. So we currently have the lightest board in the market. We passed all the critical industry tests. But really, the 1/2 inch category that you're seeing, and we've just rolled out a 1/2 inch nationwide. So really in the last month, we're nationwide with 1/2 inch. We just started our 5/8 last month. We'll have 5/8 FIRECODE very, very soon. We have 5/8 30. This is a 30-minute assembly, which about half of commercial construction buildings do not need a 1-hour rated wall. They need a 5/8 assembly. So we're getting some great traction there. So I'm very optimistic about this. And I think, you're going to start seeing some great results as we roll out our 5/8. And I think the proof will be in the numbers, and hopefully next quarter the numbers will jump off the page, and you'll see what UltraLight's doing. But this is truly a new product for the industry, getting into the 5/8 FIRECODE, passing that 1-hour assembly. We have passed all the appropriate tests. And now they'll just be rolling it out to our plants. So we're staying ahead of where we think we need to be, and really, the big areas in commercial construction, where labor rates are so high. So we have our commercial contractors very excited about the 5/8 category. So I'm optimistic about it. So we have 2 things, you have the UltraLight rollout and then you have the reengineering of L&W, I think, would be a backstop for those numbers that you see.

Operator

Our next question comes from John Baugh from Stifel.

John Baugh - Stifel, Nicolaus & Co., Inc.

My question is on Ceilings, and you mentioned the new construction and the lag being down 15%. Trying to get a feel for what pricing did in the second quarter versus volume. And did you not have price increases in place year-over-year? I know, you've got one coming on August 1st. But was pricing up? And then was the volume decline, assuming that was the case, because you had flat revenue, what did remodel activity do? Or was all the volume decline driven by new commercial construction being down?

James Metcalf

Yes, we did get price improvement from the second quarter, first quarter versus second quarter, both on tile and grid. The only thing, what really impacted the results -- the result at the bottom line wasn't a huge variance, was raw materials went up a little faster. So I think, we have a timing issue, particularly on grid, as Rick indicated. We have a tile and grid increase for August 1. So I think that's more of a timing. Yes to answer your question, there was price improvement on both tile and grid in the quarter. And when we talk about 15%, that was 15% in opportunity, which with the lag, that was last year, we're kind of in the midst of feeling that now with that 18-month lag. The numbers for 2011 are anywhere from, say, 2% to 4% improvement. So we won't see that 2% to 4% until back half of next year. So the R&R side of the business has still been pretty solid, particularly in areas, where the vacancy rates have come down, office buildings are getting remodeled. So that's the bigger component. But we still do watch that new construction.

John Baugh - Stifel, Nicolaus & Co., Inc.

So is the R&R volume up in the second quarter, year-over-year, flat? My impression is public spend is tough but corporate's good?

James Metcalf

Yes, it's low single digits. I mean, maybe 1% to 2%. It is up but nothing to write home about.

Richard Fleming

When I gave my remarks, I mentioned volume was down in both categories year-on-year. But if you look sequentially, first quarter, second quarter, pretty flat on grid and up a little bit on tile.

Operator

Our next question comes from Ivan Marcuse from Northcoast Research.

Ivan Marcuse - Northcoast Research

I just have one question. CapEx continues to be fairly low, how long can you keep it at this level? How sustainable is it? And at what point do you have to start increasing your capital expenditures?

Richard Fleming

Sure. A great question. If we need to, we could keep it at this level. We're thinking 2012 as well. We are in the process right now of doing our annual strategic planning, and we're looking at all the opportunities that we have in front of us as you can appreciate. We have many more opportunities than $50 million would allow. So we're going to be going through the capital budget and setting the number in the balance of the year. We'll certainly share that with you once we've done it. But a lot would depend on the overall environment as we enter 2012 in terms of how much of an increase we put in the capital budget. Right now, we don't have a number for 2012. But if necessary, if we had a double-dip recession, something of that type, we could keep it at $50 million for 1 more year.

Ivan Marcuse - Northcoast Research

Okay. Great. My second question is on the Ceilings business.

James Metcalf

Excuse me. I hate to be the Sergeant at Arms again. We're trying to keep this to 1 question, and we still have quite a few people who've not been able to ask. So if I could ask you to just defer that, please.

Operator

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

James Barrett - CL King & Associates, Inc.

Jim, in terms of wallboard pricing, could you discuss as to whether there's any material regional differences in the pricing trend you're seeing over the quarter and the first half and discuss the Southeast specifically?

James Metcalf

Yes, and there are regional differences that the Southeast is the most challenged market. Obviously, with Florida probably being our worst demand market. Everyone, I'm sure, knows what's going on there from a housing standpoint. But if you look at Florida, up through the true Southeast, we're starting to see some positive, a little bit of life in the Carolinas, better. The mid-Atlantic area is a little stronger. So I would say mid-Atlantic to the Northeast is better pricing dynamics. And as you go over into the Midwest, the Midwest down to Texas, our scenario is that we would have better pricing dynamics there. But the Southwest is still very weak, Phoenix, Vegas, Southern California. Pacific Northwest is an area that is trending and showing some signs of life as well. So it is very regional. When numbers get quoted, there's a national realized price. So I would say, if you step back from the whole United States from an improvement standpoint, it would, the Midwest, Mid-Atlantic and Texas areas would be -- would stand out.

Operator

Our next question comes from Joshua Pollard from Goldman Sachs.

Joshua Pollard - Goldman Sachs Group Inc.

I would like to know how much higher should your incremental margins be in a recovery. A number of quarters ago, you guys pretty consistently talked about the 80 to 100 range. So I wanted to figure out what your thoughts were now as you guys outlined your initiatives and potentially if you could focus one part on you guys fixing the core of the business, and the other part on what portion of your gypsum contracts are actually already set. So you guys sort of talked about gas and 2011 and 2012 sort of where you guys are already locked in. I'm trying to understand on the pricing front, what number of your contracts really don't allow for much price improvement or somewhat locked?

James Metcalf

You're pretty good. You weaved in 2 questions into one. So I'm going to have Bill Kelly. Our Controller is going to answer your dual question.

William Kelley

Let me take the first half. This is Bill. To the point of the operating leverage over the historical cycle of our U.S. Gypsum business, I'd say the numbers reported in the past have been in the 30% to 60% range. You go back to the 80 to 85 range, it's around 35%. 2001, 2004 about 33%, and between 92 and 95 it was up almost 60%. I'm not sure I understood the second half of the question, but that's the first one.

Joshua Pollard - Goldman Sachs Group Inc.

I will call it 1B, not second part of the question, was whether around your pricing and I'm trying to understand what portion of your production right now is already under contract today for 2011 and how we could potentially look at that for 2012. Are we talking 25%, 50% of your contracts are already sort of long-term contracts, sort of thinking the Freedom Tower and things of that nature?

James Metcalf

Okay. We typically have job quotes. For example, the Freedom Tower is a great example. And we don't disclose that number, but it is a -- we keep that percentage very tight on what pricing is locked in versus pricing that is market. For example, at midyear, July 1, a lot of the job quotes either expire or job quotes have escalators. So typically, if we have a large job, we quote that job with a set price, but with time or volume price escalators. So it's not a huge percentage of our business. Most of our business is on a daily market price scenario. So we don't tie up a lot of our production on locked-in jobs.

Operator

Our next question comes from Dan Oppenheim from Credit Suisse.

Daniel Oppenheim - Crédit Suisse AG

Getting back to some of your initial comments in terms of the, again, working towards cutting cost in the retro profitability. Overall, you're fairly cautious on the demand environment, and describing this downturn as being much greater in terms of magnitude than we've generally seen. Aside from the demand, there's clearly the ability to work on the supply side, if you look at the UltraLight product now, does that enable you to ship greater distances? If so, does it offer any opportunities in terms of looking at capacity and thinking about getting to higher pricing that way?

James Metcalf

Yes, UltraLight is a wonderful product from an environmental sustainability point of view, because you can get more on a truck. You can ship it further distances, and that helps you when you're supplying products that are lead-qualified jobs. So absolutely, when you're 30% lighter, just as you get 1/3 more products on the truck. That also is very good for our distribution customers, because at the end of the day, the more product, the more UltraLight they buy from USG, the more product they buy from us that is UltraLight, they quite frankly won't need as much equipment. And in this environment, our dealers are under tremendous amount of pressure. And for them not either having to have as much equipment or be able to turn some equipment back helps our customers be more profitable. From a production standpoint, as Rick indicated on our capital, our capital has been, primarily for UltraLight conversions. The good news is it doesn't, it isn't a huge capital expenditure to convert UltraLight. 5/8 is relatively, there's really relatively minimal capital. But this will provide additional volume, because, quite frankly, this is a product that contractors want over any competition. It's lighter. It performs well. And particularly getting a 5/8 product the last caller brought up the Freedom Tower job in, for example, New York City, a fully loaded drywall hangers labor rate is over $100 an hour. So you can imagine having a product that's 1/3 lighter, the productivity increases that will have on the job site and the impact the contractor could have on his labor rate, sets USG UltraLight Panels apart from whatever one can do. So we're extremely excited from an environmental standpoint, from what it does for our customers, either our distribution customers on equipment or our contractor customers on productivity, our workmen comp claims, things of that nature. But at the end of the day, it will be additional business for USG.

Operator

Our next question comes from Mark Weintraub from Buckingham Research.

Mark Weintraub - Buckingham Research Group, Inc.

You had spoken in your presentation about wanting to diversify, and you talked about growth overseas, you talked about product adjacencies. To make a meaningful difference, I imagine, that would take some meaningful dollars, and I was curious how, given the environment we're in, given the balance sheet, et cetera, how would you think about financing that?

Richard Fleming

Sure. Well, first of all, we're thinking a multi-year time horizon. So our strategic plan would not be a plan just for 1 or 2 years. But I think, in terms of the next cycle. So having said all that, clearly, right now, the cash flows would not support substantial opportunities being pursued unless you went to market, and we do think we can do that, if we had great opportunities, both in the volume market, as well as in the equity market. But we are very much aware that if you ever go to the equity market, the opportunity has to well exceed the cost of capital. And that's embedded in our thinking and embedded in the way we look at things. But having said all that even with today's capital spending budget as we proved with UltraLight, we can make select investments, and we think we can do more over time. In some of these emerging markets, Jim shared the past. We're targeting South America, particularly Brazil, India and China as opportunities, and we think we can do things there. On the adjacency side, we have both organic, as well as opportunities that will be external that we'll be considering over time as well. So everything has to be done in its own pace, given the market realities, but having said that, we think, over time, we can make a meaningful difference.

Mark Weintraub - Buckingham Research Group, Inc.

I don't want to get too theoretical here, but how do you think about your cost of capital or cost of equity in particular, and how dependent is it on where your stock price is?

Richard Fleming

Well, clearly, the stock price is one of the factors when you look at your cost of equity. And we also take a long-term view on cost of capital, which is that you can't just use today's low interest rate as the input in the model. You have to look at something more normalized. Having said all that, our cost of capital a day, we might be a little bit on the high side, probably in the area of about 12% after-tax.

Operator

Our final question comes from Angela Uttaro from OppenheimerFunds.

Angela Uttaro - Oppenheimer Funds

Question for you regarding your capacity utilization. You talked about a 30% utilization rate and coupling that with your focus on your core business. Do you think that there are any potentially further reductions in your fixed capacity? Or alternatively, could you joint venture or outsource any of your manufacturing in order to kind of get the supply demand equation maybe a little bit more in sync?

James Metcalf

We look at scenario planning both up and down. And right now, we're really pleased the way the network is running at these very, very low rates. We focus on our low-cost plants, really filling the low cost plants up first and then our medium plants, we use for some of our specialty and commercial products. But as always, if there is another down leg, we do have a plan. We know what plants would come out. But it would not significantly what we would do. We'd not significantly move total industry capacity utilization that much. Your question on joint venture is quite intriguing, because we are currently -- the previous question was how we're going to grow internationally. Well, one of the ways we are doing it and the way we got a very successful venture in Beijing, China is to joint venture. So we have very successful joint ventures throughout the world. We have them in Europe. We have an alliance in Canada. We have joint ventures in China and the Middle East, as well as a few others. And having joint ventures in North America isn't anything that is out of the realm of possibilities. So we are open to those. We've done joint ventures for many years, and every joint -- not every joint venture is the same. So we're keeping our mind wide open on that. It's a great question.

Brian Moore

That concludes our questions. Jim? I think you have some concluding comments.

James Metcalf

Yes. I really appreciate the questions, and the good news is we had more questions than time. So for those of you that had follow-up questions and second questions, we were trying to get as many people represented. So hopefully, that was accommodating for you.

But just to wrap up, as we're talking about the expectations for the U.S. market 2011, our expectations have been pretty modest. The market was weak again in the second quarter. I don't think that was any surprise to anyone here. We were disappointed. We didn't see any significant signs of recovery. But we were basically planning for it. We continue to believe the recovery will become evident in 2012, and we think it's going to pick up some speed in 2013. The overall demographics that you look at in the United States in particular, we feel it's not a matter of if, it's when. But more importantly, we are pursuing our strategic objectives. As I said in my prepared comments, and I really appreciate the questions, on some of the other areas is we're strengthening the core of our business that is critical. We are not taking our eye off the ball of our North American manufacturing and distribution. We're going to diversify our earnings as we have in the past. We're going to diversify them more to add to strengthening our core. And then the third area, which you're seeing during the year is differentiation through innovation. For example, our product like UltraLight Panels. So strengthen, diversify and differentiate, really, that is our strategy. We're working through all of our employees, all of our resources, our capital. They're aligned behind those 3 broad objectives. We're starting to see some positive contributions now. And we expect to see more as the market improves, and as we continue to focus on our operations in our path to profitability.

So I appreciate your time today. We look forward to touching base with you next quarter, and we appreciate your interest in USG Corporation.

Brian Moore

A taped replay of this call will be available until Friday, July 29. Information is available on our website. That concludes our conference call. Thank you.

Operator

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

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