USG Corporation - Rapid Margin Expansion Tells The Story

| About: USG Corporation (USG)

Summary

Q1 2016 revenues grew 7.7% over 2015 results, but expenses actually fall nominally y/y.

Analysts didn't expect this margin beat, and further gains are likely given wallboard price increases.

Significant deleveraging to take place by the end of the year; cutting 25% of debt through free cash flow.

USG Corporation (NYSE:USG) is one of those turnaround plays I've been willing to take a gamble on. I first initiated coverage back in May 2015 when I first bought in, and the equity has had its ups and downs since then. While you'll rarely find me dabbling in investments that don't have a history of generating substantial amounts of free cash flow, USG Corporation is one of those exceptions.

USG is really a tough nut to swallow for most value investors. While value investors are likely comforted by Buffett's continued involvement (the company held more than a quarter of shares outstanding as of their last reporting), the company has been plagued by missteps and honestly barely survived the fallout of the housing crisis. Make no mistake that USG is a leveraged play on the housing market, and if you don't have faith in new build construction domestically, there are other places for you to put your money.

To me, however, the company's Q1 2016 results showcase the rapid turnaround in the company's business, and I believe the market has missed the real story here giving the muted reaction to earnings. USG Corporation, in my opinion, has started off 2016 well.

Margins, Margins, Margins

The company posted earnings per share of $0.46, besting estimates by $0.17/share. That's a hefty beat, especially given that revenue (up 6.7% y/y) was relatively in-line with estimates. Predicting top-line here isn't difficult, and it remains wholly attached to the health of the housing market. Given the mild winter weather and improving new home builds, revenue being up y/y isn't surprising. The story here is massive margin expansion.

Gross margins were 20.1%, up from 16.8% in Q1 2015 and 18.3% for all of 2015. Margin expansion at the cost of sales level was driven primarily by pricing improvement at USG. Capacity in the gypsum market can be constrained in times of growing demand, and the collapse of the housing market saw a lot of domestic capacity fall offline. Pricing for wallboard has continued to rise, with National Gypsum alerting distributors of a 10% price increase in the middle of March and another 10% hike to follow in August. While USG has not announced direct figures beyond price increases, these two have hiked together in the past. Expect further gross margin expansions to come as we head through the rest of 2016.

Beyond this, the bigger story for me was operating margin expansion. Despite the top line 6.7% increase, SG&A expenses fell 11% sequentially from Q4 2015. As the company noted on its conference call, this is the lowest level of SG&A in the first quarter in fifteen years. That's big, and much better than prior guidance of "under 2015 levels". Management did take a cautionary done and guided to not extrapolate this as a run-rate through the rest of the year, but the company is well under way to a solid year when it comes to controlling costs. It is highly likely that all the revenue gains for fiscal 2016 (Up 5.6% according to analysts; understated in my opinion) will flow directly to operating income given the controls on the expense side. Who doesn't love to see 560bps (or more) of operating margin improvement year/year?

Analysts have been quick to up EPS estimates from the strong first quarter; the current consensus estimate for 2016 is $1.72/share, up from $1.54/share just a week ago. 2017 has moved up as well, up from $2.00/share just a week ago to $2.22/share. These are big moves by analysts that have largely gone unnoticed by the market. I think the company has room to beat those estimates handily, which should be a big boost to the stock price eventually once the market realizes what this company is beginning to do. 12.7x beatable consensus 2017 earnings estimates is dirt cheap in my opinion for this company.

Deleveraging

If you asked investors what their number one issue was with USG Corporation, they'd likely quickly point out the balance sheet debt. USG has never had access to cheap funding given its weak financial position that only just began to moderate, and carrying the $2B debt load has been cumbersome.

USG retired $110M of its $500M of 2016 6.3% senior notes wholly through Q1 cash flow. Why bother rolling over that debt when you can simply pay it off through free cash flow? That is exactly what the CFO plans to do by the November due date. Knocking off $500M, or roughly one quarter, of total debt load will go a long way to deleveraging this company.

This move shows a lot about company direction in my opinion. The CFO, Matthew Hilzinger, is relatively new, joining USG Corporation in 2012 after leaving Exelon. This is the first time we've seen what he is prone to do when he's got substantial free cash flow in his hands. He could have instead retired some of the higher interest obligations with later maturity expirations; there would have been some marginally better gains by doing so. By attacking recent expirations first, it shows that the CFO, and the company, simply wants to skip the hassle of raising funds in the capital markets. Debt-free appears to be the end goal here, or at least (by management commentary) cutting the debt load by a little more than half. If management wants to deleverage to that point, it marks a substantial shift of capital allocation policy, as USG Corporation has always been more aggressive when it comes to balance sheet management than many peers.

Berkshire Hathaway Buyout?

This has always been a big "what if" with this play in the minds of shareholders. USG Corporation is small, but it does fit right in the wheelhouse of assets that Buffett would like to own. If Buffett does want to eventually pull the trigger here, he (or another party) is much more likely to do so once the $1.7B in federal tax loss carryforwards are exhausted and the debt obligations are brought down. A potential buyout is still years away in my opinion.

Takeaway

Overall, there was so much here to celebrate, and I think the market is being a little slow on the uptake on this one. There might be a bit of a "wait and see" approach to this one as the company enters a stronger selling season in Q2 and Q3, but given the confidence from the price hikes on wallboard products, I think there is solid opportunity for further margin gains. USG Corporation remains a solid buy.

Disclosure: I am/we are long USG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.