USG (USG) James S. Metcalf on Q2 2016 Results - Earnings Call Transcript

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USG Corp. (NYSE:USG)

Q2 2016 Earnings Call

July 26, 2016 9:00 am ET

Executives

Ryan Flanagan - Senior Director-Investor Relations

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

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

Analysts

Keith Hughes - SunTrust Robinson Humphrey, Inc.

Michael Jason Rehaut - JPMorgan Securities LLC

Mike Wood - Macquarie Capital (NYSE:USA), Inc.

Robert Wetenhall - RBC Capital Markets LLC

Garik S. Shmois - Longbow Research LLC

Dennis Patrick McGill - Zelman Partners LLC

Jerry Revich - Goldman Sachs & Co.

Matthew Scott McCall - BB&T Capital Markets

Michael G. Dahl - Credit Suisse Securities (USA) LLC (Broker)

Philip Ng - Jefferies LLC

Mark A. Weintraub - The Buckingham Research Group, Inc.

Jim Barrett - C.L. King & Associates, Inc.

Operator

Welcome to the Second Quarter 2016 USG Corporation Earnings Conference Call. My name is Christine, and I will be the operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note that this conference is being recorded.

I'll now turn the call over to Ryan Flanagan. You may begin.

Ryan Flanagan - Senior Director-Investor Relations

Thank you. Good morning and welcome to USG Corporation's second quarter 2016 earnings conference call and live webcast. We'll be using a slide presentation in conjunction with our call today. It's 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 assumption of our business, market and other conditions, and management undertakes no obligation to update these statements. These 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 on non-GAAP measures used when discussing our results and outlook.

With me today to discuss the second quarter 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 our businesses. Matt will review the financial results for the corporation and the business segments. We'll then open the call for questions and conclude with a few comments from Jim. We'll try to give as many folks as possible an opportunity to ask questions, so when we get to the Q&A session, callers are asked to limit themselves to just one question. Jim?

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

Thank you, Ryan, and good morning. On our call last quarter, I outlined four operating priorities for our business in 2016: the first one was expanding operating margins in all of our businesses; next, keeping our costs at or below 2015 levels; third, selectively investing in growth initiatives or introducing new products and expanding our very successful lightweight platform; and finally, organically retiring our 2016 debt obligations, and as we have talked in the past, we have a long-term target of debt to EBITDA, 1.5 times to 2 times.

I'm really happy to report that through mid-year, we are meeting or exceeding these objectives in all areas. I'm particularly proud that during the second quarter, we actually improved operating margins in all of our businesses: Gypsum, Ceilings, L&W and USG Boral with record operating margins in our Ceilings business. Now, we did this despite some cost inflation, some currency throughout the world and operating in a very competitive landscape. What I'd like to say, it's proved that our plan to win is working.

Now let me briefly touch on the second quarter, and as Ryan said, I'll turn it over to Matt, and he will get into the details of our business. First, turning to our U.S. wallboard business. We continue to see improved volume with shipments up 3% for the quarter. Volume increased despite some surge buying and a mild winter in the first quarter. If you look at industry shipments, they increased approximately 6%. As we often see in any individual quarter, customer makeup or regional pricing, but more importantly, our strategy of balancing price and volume to maximize profitability can drive volume differences. But you can see the success of our strategies reflected in our improved profitability through the first half of the year.

Now turning to our surfaces and substrates businesses, which continues to have very strong performance with incremental profit over $8 million in the quarter. These businesses are realizing higher prices. We have cost management and strong volume with improving market penetration. It's been very, very successful growing these businesses. We had improved performance in all product categories with joint treatment, our commercial roofing products, and Levelrock leading the way.

Now, let's move to Ceilings. And as I mentioned, the second quarter operating margins climbed to a new record of over 24%. As you know, this business has performed throughout the recession and it's now positioned for the commercial market recovery. Our customers continue to demand more value and performance from their ceiling systems and we've given them that. They want high acoustical performance, they want smooth monolithic look, and a high recycle content. Now these are all attributes that you'll find in our high-performance ceilings. We're also seeing a shift in the high-performance ceilings and this shift, as well as a very focused strategic sourcing initiative we have on steel costs, contributed to our recent strong performance. As we talk to the architectural community, we feel that this trend of higher end products is going to continue and our focus on strategic sourcing is very important for the ceilings business.

Now let's move to L&W. We had a terrific operating performance in the quarter, which drove continued margin expansion. Comp store sales and wallboard volume were both up 8%. We had strong volume growth from steel studs, which were up roughly 15% from last year, and we believe that's a early indicator of the recovering commercial market. Our focus at L&W on operating proven initiatives along with a stronger commercial demand were primary drivers in our improved operating profit of $15 million, which was up from $9 million last year.

USG Borals business continues to make a positive impact to our portfolio, with second quarter margins of almost 16%. These are the highest margins we've realized in the joint venture to-date. Plasterboard volume, price improvement and market conversion from standard plasterboard to Sheetrock NextGen all increased at USG Boral. Joint compound and steel stud volumes were up 11% and 13%, respectfully (sic) [respectively] (6:37). And our geographic regions of Australia and South Korea continue to be the big drivers of the improved results, and these markets have exceeded our expectations.

So, with that, I'm going to turn it over to Matt, and he will get into the financials of the quarter in more detail.

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

Thanks, Jim, and good morning, everyone. Let me start by saying overall we had a really solid quarter. We improved operating margin in each of our businesses, we improved EBITDA and free cash flow and we continue to make great progress on our deleveraging plan. As I usually do, I'll begin with a few administrative items, starting with a quick but important reminder that we're recording a tax provision on our U.S. earnings this year, unlike last year or many years. So while we're not paying cash taxes on U.S. earnings, our net income and EPS look like apples-to-bananas on a comparative basis to last year. For this year, I'd suggest you look at measures like adjusted operating profit or adjusted EBITDA to give you more of an apples-to-apples view.

And a few thoughts on our bridge from our GAAP to adjusted results, which are listed in the detail of our press release and earnings slides. There are two adjustments during the quarter. The first item relates to our delevering actions, specifically the extinguishment costs incurred this quarter related to buying back $75 million of our $500 million bullet bonds that are due in November. And the second item is an $11 million pre-tax gain associated with the sale of some surplus property in Nevada, which also generated $11 million in cash proceeds.

Now let's get into the numbers for the quarter. Net sales were up 3% to just over $1 billion, adjusted operating profit increased 17% to $138 million and adjusted EBITDA was up almost 15% to $194 million, which makes our trailing 12-month adjusted EBITDA in the ballpark of around $700 million. In addition, foreign currency was a headwind again this quarter, with a hit to sales of $10 million and a hit to net income of $5 million.

With that, let's move and get into some more detail in the segment results. In the Gypsum segment, net sales for the second quarter were up 3% from last year to $635 million, with foreign exchange headwinds of $9 million to revenues. Adjusted operating profit increased 40 basis points to 16.1% and our performance was even better when you factor in $3 million of unfavorable foreign exchange.

As Jim mentioned, volumes in the U.S. were up 3% and that drove $3 million of profit improvement in wallboard. Our domestic wallboard price was up 3% sequentially from the first quarter. Overall price was down slightly on a year-over-year basis. You may recall that we saw wallboard pricing move downward throughout 2015, so seeing wallboard price move down year-over-year this quarter really was not unexpected. And as you'd expect, product mix and regional pricing differences also impacted the year-over-year price from a quarter ago.

Costs for the second quarter were $2 million higher year-over-year, as we had slight headwind with some inflation in labor, paper and other input costs. We offset some, but not all, of this inflation with lean manufacturing. And some lower natural gas pricing is expected. In fact, regarding natural gas, we saw a tailwind of around $3 million this quarter. On an all-in basis, gas prices for the second quarter were down about 15% year-on-year. And I expect gas prices to be down around the same amount for the full year, provided that spot prices stay about where they are right now.

Moving to surfaces and substrates. We continue to see really strong growth, with revenues up 8% in the second quarter and $8 million of improved profit, driven by a combination of higher price and lower cost, always a good thing, with increased volumes across the entire product portfolio.

Moving to Ceilings. Second quarter net sales were $137 million in the quarter, up 5% from $131 million a year ago. Operating margins expanded 500 basis points to 24.1%. Price was up in both our tile and grid products, with stronger pricing in tile relative to grid. Volumes were up in the low-single digits and costs were slightly favorable, primarily due to steel costs.

In fact, steel provided a tailwind of around $2 million due to advanced purchases we made in the first quarter, which lowered our average inventory cost for the second quarter. And given that we've seen really steep price increases in steel in April, I really don't expect to see the trend that we saw in the first half continue in the second half of the year. In fact, I expect steel cost to be above last year's as we move through the balance of the year. And as we've done in the past, we expect to manage these costs and these headwinds by passing along appropriate pricing, just as we did with our June price increase on grid.

Moving to the Distribution business, L&W's net sales for the second quarter were up 6% over last year to $386 million. We saw margin expansion in L&W as well with 140 basis points of expansion to 3.9%. L&W's improved performance was driven across the entire portfolio, in both our wallboard and adjacent product categories. Delivery cost also helped our performance as they were only up about $1 million against the 6% increase in net sales. SG&A spend was up slightly in L&W, as we continued to implement our operational improvement initiatives around truck utilization, inventory management, and price optimization.

So, overall, I'd say we're working rather smartly to increase the performance at L&W and we're moving in the right direction with margin expansion both year-over-year and sequentially. So, job well done.

Moving on to USG Boral, we saw some really nice acceleration in the second quarter with margins up 250 basis points to 15.8%. The total JV's net sales were up $9 million to $273 million, generating net income of $32 million, up $6 million from last year. Of course USG's portion of the JV's adjusted net income increased to $16 million from $13 million. We saw improvement even though there were headwinds from foreign currency this quarter. If you strip out the negative effects of foreign exchange and just view the results for the second quarter on a constant currency basis, revenues increased 8% to $286 million and total JV adjusted net income increased over 30% to $34 million.

Shifting to SG&A, our second quarter SG&A of $75 million was flat with the prior year and is expected up sequentially from the first quarter. On our last earnings call, I mentioned that our SG&A run rate for the second quarter would increase due to some cost deferrals in the first quarter and general timing of spending. And that's exactly what happened, with the second quarter spending right in line with our expectations. Through the first six months of the year, our SG&A spending is running favorable to last year by $6 million, and here's what's most important, we now expect our full year SG&A to be slightly higher than $300 million, which is favorable to our original guidance and well under our last year's spend of $317 million. So, despite no year-over-year improvement in this second quarter, we're driving real reductions in SG&A throughout the year.

A brief update on our outlook of foreign exchange. Based on currency movements in the second quarter, I now expect that the second half of our consolidated net income for the year to be unfavorably impacted by about $5 million as a result of foreign exchange and that's assuming that rates stay the same as they were at the end of June.

Moving to the balance sheet, I'm really pleased to say that we continued our open market purchases of our $500 million bond series that matures in November. We purchased a $137 million in the second quarter and another $40 million this month in July; that gives us a total of $177 million in early debt retirements this year. And I'm really confident now that we'll pay out the rest of these notes organically in November through normal operating cash flows, and this would just be another huge step towards hitting our leverage target of 1.5 times to 2 times net debt to EBITDA. So, I'm really pleased with the progress we're making there.

One other quick, but very important note, I'd have you reference slide number 25 in our earnings deck where we've provided some new details on how we calculate our net debt to EBITDA leverage ratio. As we get closer to our target range, I think it's really important that you know how we think about it, and how we calculate it. So, hopefully you'll find this helpful as you think about modeling our net debt to EBITDA going forward.

In closing, just to summarize, I'm really pleased with our performance in the second quarter across all of our businesses as we improved profitability, we expanded our operating margins, we grew quick free cash flow, we're really in a terrific position right now, and I'm encouraged about the rest of the year. We have a terrific opportunity in front of us, as we work towards our targeted capital structure, reinvest in the business, and grow our return on invested capital in all of our businesses.

So, with that, Jim, I'll turn it back to you.

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

Thanks, Matt. Before Matt and I open it up to questions, I'd like to give you a few thoughts on the outlook in the balance of 2016. As Matt said, and I really echo his encouragement, we are very encouraged about the continued solid demand trends and expect this strength to continue the back half of the year, really in all of our markets, in North America, in Asia and Australasia. And what's great about the USG Boral business, it does help us differentiate and diversify our earnings stream outside of North America. So all these markets, we feel very good about.

We believe demand in the U.S. end markets support wallboard growth for the year slightly more than 8%, and if you recall, that's better than what we thought at the beginning of the year. So, we're projecting a high single-digit growth for the overall year for U.S. wallboard. In the U.S., if you look at the segments, we're expecting housing to be up about 10% to 1.2 million starts, I think that's the numbers everyone is probably looking at in the same way. But we also see continued improvement in the commercial markets, with new commercial up 3% to 4% this year and our repair and remodel, up mid-single digits.

Finally, as I mentioned USG Boral, you saw the numbers half way through the year and we're on pace to hit our target of increasing our net income by 10% for 2016. There is strong growth in that market, great market penetration, and we're really getting some wonderful traction there. And really this is being supported by our first half performance, but on the outlook of the markets that I just mentioned. USG Boral, it's about two-and-a-half years since we entered into this joint venture, and we continue to be very pleased with this business that it delivers growth for USG Corporation, and as I mentioned it diversifies our earnings stream.

So, as I wrap up, I just wanted to make a couple of comments before we go into questions, and you've heard me talk over the past quarters and a couple of years about our plan and our plan to win: And we have three pillars: it's strengthen, it's diversify and it's differentiate our businesses. First on strengthening our core businesses. We're strengthening but we're also profitably growing our businesses. I think you see this in our results for the quarter and halfway through the year, but also you're going to see it in our commitment to reinvest in our core, our core businesses. Our advanced manufacturing initiatives in our plants are going to make us more efficient, it's going to lower our cost structure and further strengthen our network.

So, that's an initiative that's very, very important for us and it's right under the roof of our factories, we know how to do it. And these are great initiatives as we grow our business. We're also investing in key growth initiatives. I talked about high performance ceilings, we're going to continue to grow that portfolio, there is a great customer need as I mentioned earlier about that and we're just finishing a rebuild of our Plaster City, California plant to grow our specialty high-end business and our glass mat business on the West Coast.

As we diversify our earnings, step number two of our pillar, both home and abroad, the growth – we talked about the growth in our substrates businesses that serve the commercial roofing business, flooring, and the general building envelope has tremendous upside potential. It's early, you are starting to see some nice results in the quarter, and we're very excited about the market penetration, but also the products that are new to USG and new to our customers. As I mentioned, USG Boral has exceeded expectations and it provides us with additional growth opportunities in specialty panels and product adjacencies in high-growth areas of the world, it's just not a plasterboard play, we really think there are some great opportunities in new markets for products that are a proven success here in the United States.

In our third pillar, we talk about the innovation. We're differentiating our products through innovation. We're expanding our lightweight platform, as I mentioned. UltraLight was the pioneer of this, we're going to continue to expand that platform and give customers products that they need and really help their success and we are introducing new products like Securock ExoAir 430, which this product was recently named a winner in the Edison Awards for innovation. We were the first to market, to provide our customers also, with a lightweight 5/8-inch glass-mat panel, which filled a key customer need.

So both of these are examples of the traction we're getting in the market. And we continue – and I want to share with everyone here, we're continuing to fill the innovation pipeline with system solutions for our customers and giving them a better way.

So, with that, I'd like to open it up for questions. And we'd really be interested in your comments. And then, we'll wrap up with some brief closing comments around 9 o'clock.

Operator

Thank you.

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

So, operator, do you want to open it up?

Question-and-Answer Session

Operator

Yes. We will now begin the question-and-answer session. Our first question comes from Keith Hughes from SunTrust. Please go ahead.

Keith Hughes - SunTrust Robinson Humphrey, Inc.

Thank you. Questions on wallboard volume. You've given us the details. It was interesting that L&W's volume was up more than USG, if you could just talk regionally areas you saw strength, weakness, and why you think the deflection from the industry numbers on your numbers this quarter.

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

Yeah. I'll take that Keith. L&W numbers as we said that the comps stores and wallboard volume was up about 8%. L&W didn't do any surge buying in the first quarter. So, that had a big reason that their numbers were strong. So, really the numbers you saw for L&W in the second quarter were basically their organic growth in the market. Also, if you look at U.S. Gypsum, the second quarter is a slower quarter because of our large footprint with retail customers and they typically go into lawn and garden.

So, when you look at really sequentially the last few years going from the first quarter to the second quarter, volumes typically do dip. So, L&W also is starting to see some nice tailwinds on the commercial market. If you go back two years ago, the commercial opportunity was up double digits and there is about an 18-month lag there. So, with L&W's heavy focus on commercial, they started to see some nice traction on demand. So, it was surge buying, it was the U.S. Gypsum, the second quarter typically is a lower quarter for them, lower volume, and the commercial business going to L&W.

Keith Hughes - SunTrust Robinson Humphrey, Inc.

Thank you.

Operator

Thank you. Our next question comes from Michael Rehaut from JPMorgan. Please go ahead.

Michael Jason Rehaut - JPMorgan Securities LLC

Hi. Thanks. Good morning, everyone. Had a question also on around wallboard volumes. First quarter and second quarter it appears that – and I'm sorry if this is a little bit duplicative from your first Q&A, but maybe I'm not fully getting all the nuances. It appears that your own shipments, if I have this correct, trailed the industry in the first quarter and the second quarter by a single-digit amount. Is that something that we should expect to persist in the back half? And is the reason for that due to more regional exposure or certain lower profit business that you are choosing not to pursue?

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

Yes, Michael, this is Jim again. A couple things. First, a lot of it has to do with managing price and volume. That's really key and that's been part of our strategy of really maximizing the profitability of the business. So, we're doing that every day in the market is managing price and volume. The regionality you touched on, if you look at the Southeast region, in the second quarter was the strongest region. The market was up almost 21%. And our footprint is not as large there. So, you have some regionality as well.

If you look at the back half of the year, on your question, as I said in my comments, we're anticipating volume growth to be in the high-single digits, around 8% for the year. So if you recall in the first quarter, 20% was a big jump. You had weather, you had some surge buying in organic. I think it was like broken out a third, a third, a third. So we're going to continue to balance price and volume as we have. We want to maximize the bottom line, but growth is very important for us too.

So the addition of our high-end glass mat panels and really growing the higher-end wallboard side of the businesses is really part of our strategy as well. That's why that Plaster City expansion out West was really important. We had a void out there. We were having to ship products from the Midwest. And from a profitability standpoint, it really wasn't attractive for us. So we needed to put a foothold out there.

So you're hitting on two or three of the key items. And we're going to continue to expand our margins. I mean, that's one of our initiatives, as I said. And we think that the growth in the back half is going to be high-single digits.

Operator

Thank you. Our next question comes from Mike Wood from Macquarie. Please go ahead.

Mike Wood - Macquarie Capital (USA), Inc.

Hi. Thank you. Question on the – you'd called out the wallboard price trended lower during 2015. Is it feasible within your framework of the one guarantee price per year for it to trend back upwards if wallboard demand remains strong? Or would it be relatively fixed versus the 3% sequential increase you called out? And was that increase consistent nationally, or if you can call out any regional pockets? Thank you.

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

Pricing is always regional. So it's by segment, it's by geographic region. So you don't have one price for a whole geographic area. So, yes, it is a very regional price. And obviously, with demand stronger, you get better price improvement.

Our pricing strategy is not to exceed. We have guidance with our customers for the year and we aren't (28:28) the year, it's all related to demand. So we have, one, not to exceed one price for the year and we're going to continue to balance price and volume, as I mentioned with the last question.

Mike Wood - Macquarie Capital (USA), Inc.

Got it. But safe to say you're not bouncing on that high end of the not to exceed price. Is that fair?

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

I'm sorry, what was your question again?

Mike Wood - Macquarie Capital (USA), Inc.

Just wanted to confirm, there would be room left in your not to exceed price theoretically. Is that correct?

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

We have one price for the year not to exceed. So theoretically, yes.

Operator

Thank you. Our next question comes from Bob Wetenhall from RBC Capital Markets. Please go ahead.

Robert Wetenhall - RBC Capital Markets LLC

I think we beat the wallboard horse to death. So I'll leave it by the side of the river.

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

Thanks, Bob.

Robert Wetenhall - RBC Capital Markets LLC

It's all about margin expansion, and you guys are doing a great job with that. You're making large gains in Ceilings. I was hoping, Jim, maybe you could explain, you've got 480 basis points. What's driving this? If you could give us at least directionally whether it's one-third or 50% or two-thirds a price story or a cost story. How should we be thinking about that? And any view directionally on volumes as well, whether they're trending in line with Sheetrock or they're outperforming and you're taking share in the category would be great.

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

Yeah. Thanks, Bob. On Ceilings, what's great about the quarter, it's really spread – price, volume, cost, it's pretty spread out. The team did a wonderful job managing costs. As Matt said, we did some pre-buying on steel. We were looking at the futures of steel and we saw some pretty double-digit increases coming on. So we brought in additional inventory on steel costs to stay ahead of that. That was a really big driver.

And I always say how we manage our strategic sourcing with steel, we see steel costs going up, we want to pass that along and have margin expansion there. And that's really a key component of the Ceilings business. So I'm really proud of our strategic sourcing team and how they work well with the sales organization and really letting our customers know that these big steel increases have a impact on all of our businesses.

The other on volume, you ask about volume, we don't see the overall volume trending at that high-single digit where wallboard is. We're still kind of in that 2% to 3%. But what we are seeing is that 2% to 3% is a different 2% to 3%. You're moving up the food chain, which has higher margin, those are higher-margin, higher-performance products. So that's where you're also seeing some of that margin expansion in the business.

If you go back a couple years ago, we were selling a lot more of just the typical two-by-four fissured panels that you'll see in a lot of the local retailers. But really the market has changed, so strategic sourcing with steel, big component. We're getting some low-single digit volume but different type of volume. And actually our customers, we have a great distribution channel. We have a group of distributors out there that are really out promoting ceilings and really we're hitting the architectural community as well with some new products.

So as I said, this business got us through a recession. They were kind of the heroes through the Great Recession. But now we are at an inflection point with Ceilings, which is really growing the high-end business, managing our costs with steel and really hitting the architectural community with new products. So, it's kind of hitting on all cylinders.

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

Hey Bob, this is Matt. Just to add a few numbers that support what Jim said. Steel helped us about $2 million for the quarter, so if you take out that $2 million, we would have had about 350 basis points of margin expansion. So out of the 500 basis points, 150 basis points was due to kind of, call it steel benefit, and 300 basis points to 350 basis points was really due to kind of margin expansion and some volume, so steel was important in the quarter, but clearly as Jim said that things around getting the higher end ceilings, getting some price in that business has been really helpful as well, so.

Robert Wetenhall - RBC Capital Markets LLC

That's exactly what I was trying to understand.

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

Okay.

Robert Wetenhall - RBC Capital Markets LLC

And thank you for the breakdown. Jim, just follow-up on your question, and then I will pass it over, sorry for sneaking it in. Your comments about the better profitability because you're gaining incremental traction in architectural, is this kind of higher level of profitability, the run rate we should think in the business, if you take out the commodity factor. Thanks and good luck.

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

Thanks. I think to answer that question, we're seeing the trend as I mentioned to the higher end, our higher acoustic values and the typical ceiling, you think about an office, office space now is very different than it was five years or 10 years ago. So, yes, we're going to continue to see that trend and what we also have to do is continue to introduce products that will stay ahead of that trend as well.

Operator

Thank you. Our next question comes from Garik Shmois from Longbow Research. Please go ahead.

Garik S. Shmois - Longbow Research LLC

Thank you. I just have a question on the 8% wallboard volume outlook that you have for the year. I'm assuming that's for the industry and it just backs into somewhere around a low-single digit growth view for the second half of the year, just given the context of your market share position, and understanding you're balancing volume and price, should we expect your share to look closer to the industry in the second half of the year, especially, when considering the first half had some timing issues related to pre-buying and channel fill, as well as the timing around shipments to your large customers in the channel?

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

As we balance our price and volume, that's really important, and industry position is key, but that's more of a – we look at that as an output versus an input. What will probably, you're going to see is the third quarter is typically the strongest quarter for us, from a volume perspective. So, as I said earlier, with our exposure into retail, our retail starts coming back after Labor Day. So we're going to see some growth there.

Along with that, there could be some surge buying through the fourth quarter. So it depends how the – any type of surge buying, how we handle that, if that happens. Over the last few years, we've kind of managed some of the surge buying, so there is always an opportunity to open that up a little more than we have in the past.

So, again, we're going to continue to balance our price and volume, and we think the back half of the year, there's still going to be growth. You can – you pick your number, but we believe our volume is going to have positive comps in the second half of the year as well as the industry. I just can't give you an exact number where it's going to fall.

Garik S. Shmois - Longbow Research LLC

That makes sense. Just a point of clarity and I'll step out. Does the – does your 8% outlook include surge buying in the end of the year? I just want to be clear on that.

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

No, it did not.

Garik S. Shmois - Longbow Research LLC

Okay. Thank you.

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

And Gary, this is Matt. I would just add. We started the year thinking that we were going to be in that mid-single digit 5% growth, right. So if we end the year, call it above that and whether the industry or we're at that 8% or 9% I mean I think that's pretty damn good. And we're really pleased with what the market is doing and how it's growing. And so, we're not into 2017 yet, but we feel good about the construction market across all our segments and how they're growing. So whether it's 8% or 9%, it's a hell of a lot better than what we thought at the beginning of the year and that's good.

Operator

Thank you. Our next question comes from Dennis McGill from Zelman & Associates. Please go ahead.

Dennis Patrick McGill - Zelman Partners LLC

Hi. Good morning, and thanks for taking the question. Matt, I was hoping you could just maybe review what your outlook is for some of the major raw material costs in the second half of the year. And I guess, particularly the steel benefit that you mentioned year-over-year just timing related. Is it fair to assume that that's sort of an equal offset in the second half of the year as the timing balances out?

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

Yeah. I mean I do. I think let me just start with steel. We clearly got a tailwind in the first quarter and second quarter. Steel prices moved up markedly in April. As Jim said, we obviously took advantage of some pre-buy on steel that helped us in the second quarter, but if you look at kind of where we see steel through the second half of the year, we actually think steel will be at a higher cost than last year at that time.

But with that said, I also believe that we'll be able to get price improvement to reflect that commodity going up. So, I don't see it as a net negative to us, but I do think steel costs are going to move up, I just don't think we're going to get quite the big benefit that we got in the first half. If you look at the other input costs and you think about where we were in the first quarter, first quarter we had a phenomenal cost environment right, part of that was nat gas, which carried over into the – into the second quarter, right. We had about a $4 million benefit in the first quarter in nat gas, we had about a $3 million benefit in the second quarter. We've seen nat gas move up just a little bit in the spot market.

But, I don't see if spot stays about where it is right now, I wouldn't see why we wouldn't have a tailwind into the third quarter and fourth quarter like we saw in the first half, I can't tell you exactly what it's going to be, but I think it's around what we incurred in the first – the benefit that we got in the first quarter and second quarter. What we did see in the second quarter was an increase in inflation really across the board, we saw it in labor, part of that is we don't put our salary increases across the board until the beginning of April.

So we did see that from the first quarter into the second quarter, but we did see some labor inflation. We saw paper inflation and you can see paper across the world has been somewhat volatile, but most of our paper that we buy is recycled in the United States. And it's – you know, our plants are more in the Midwest, so we don't get a lot of paper coming in from the coast. So you can get a few small anomalies there.

But we've seen paper move up and, look, I don't think it's going to go crazy. But I think – I don't necessarily seeing it go down. And then the other input costs whether it's synthetic Gypsum or some of our special ingredients that we put in our UltraLight products, we saw a little bit of inflation there. So we are doing things around Lean Six Sigma in our manufacturing and we're doing other things to take costs out.

So I would say my general view on the second half as it comes to cost would be about neutral. I mean, I – plus or minus a little bit, right. I mean we're going to get the benefit in nat gas, but we're also going to see some inflation and it's hard to tell you that there is a real trend there. We had basically zero inflation in the first quarter and a fair amount of inflation in the second quarter. So, I think, we're still going to see some inflation as we move through the second half of the year. So that's – that's kind of how I see the cost. I hope that's helpful.

Dennis Patrick McGill - Zelman Partners LLC

Very helpful. Thank you.

Operator

Thank you. Our next question comes from Jerry Revich from Goldman Sachs. Please go ahead.

Jerry Revich - Goldman Sachs & Co.

Hi. Good morning, everyone.

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

Good morning.

Jerry Revich - Goldman Sachs & Co.

I'm wondering, if you could talk about, in wallboard you've had a meaningful contribution from Six Sigma efforts over the past couple of quarters. I guess, much more meaningfully in the first quarter. I'm wondering, if you could just flesh out for us where are you in the process of rolling out Six Sigma across your footprint? What inning are we in, and you spoke about the material cost expectations from the back half. Can you comment on your expectations for productivity and Six Sigma contributions to profits in the back half of the year on a year-over-year basis, and that's all in wallboard? Thanks.

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

Yeah. This is a very big initiative within the corporation. In fact, Lean Six Sigma, we not only attack at wallboard, but we really attack all of our product categories. Last year, we had approximately $15 million of savings with Lean Six Sigma projects, we have them identified now. We continue to get more Black Belts. We have a – quite a few Green Belts that have joined the ranks. We've also taken Lean Six Sigma into some of our non-manufacturing areas, for example, the Ceilings business has brought some Lean teams in to look at how we can continue to improve our Ceilings business. So, we don't have an exact number for the back half of what our target is, we did $15 million last year, I'd be very disappointed if we didn't do something greater than that this year because of our continued focus. We have a dedicated corporate unit that focuses on lean.

You ask where we are in the innings, we're still early adopters here. We've been in it about five years. We really touch base with industry experts outside of the wallboard industry of how we can move faster. One of the areas, one of the pivot points on Lean Six Sigma is to go to Lean manufacturing. And that's where the advanced manufacturing initiative, I mentioned in my prepared comments.

This is a very exciting initiative to look at how we can lower cost, offset inflation in our network and in our facilities. So we have identified about 20 very talented young engineers. We've pulled them out of their traditional jobs and they are focused on looking at all of our facilities, of really taking work out and lowering our costs. So, we not only have Lean – Lean Six Sigma, we have Lean manufacturing and you're going to be hearing more about our advanced manufacturing initiative as we talk about the business in coming quarters.

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

Yeah. I – and this is Matt, let me just add. I mean, if you think about our SG&A spend, right, coming down substantially from last year. I mean, a big piece of that is Lean Six Sigma and Lean Six Sigma tools and being responsible for finance and IT, I can tell you that it's been really helpful, as we think about the corporate office and how we get smarter and leaner on this stuff. So, as Jim said, it's throughout the whole company, it's in the manufacturing side and on the corporate side as well.

So something we're going to continue and I just reiterate what Jim said, it's hard to give you an exact number what we see in the second half, I would kind of factor that into my overall comment of the benefit of nat gas, the benefit of Lean Six Sigma being offset partly by inflation and so that's kind of how I get the flat costs in the second half of the year. So, I hope that's helpful.

Jerry Revich - Goldman Sachs & Co.

Perfect. Thank you.

Operator

Thank you. Our next question comes from Matt McCall from BB&T Capital Markets. Please go ahead.

Matthew Scott McCall - BB&T Capital Markets

Thanks. Good morning, everybody. So back to the commentary about the wallboard volume. Just trying to clarify something you said. You referenced the potential, I don't think it was in the number, but the potential for some pre-buy, or some surge buying activity. Did I miss it, or is that an indication that you have expectations that the price moves back from the late Q1 period, early Q2 period back into the early Q1 period, therefore, we'd see pre-buy in Q4?

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

Well, we don't have any plans at this point to announce our price increase on this call. But we're always looking at what's best for our customers and offsetting inflation and continue to improve our margins. So I'm not giving any indication that's when a price increase is going to happen. But if you look at the last few years, there have been periods where there have been some surge buying sometime during the year. And I just wanted to make sure that 8% did not include in your model any type of surge that the industry may have.

Again, we could also – as I said, the third quarter is a very strong quarter for the industry. And as Matt and I both have said, the overall demand in each one of the segments is showing some nice growth. So you're going to see some nice organic growth as well separate from the surge.

Matthew Scott McCall - BB&T Capital Markets

Okay. So the comment was not Q4 related, Q3 related? It was just saying our 8%...

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

Somewhere...

Matthew Scott McCall - BB&T Capital Markets

Go ahead.

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

Yeah, it's 8% without surge, correct.

Matthew Scott McCall - BB&T Capital Markets

Okay. Thank you.

Operator

Thank you. Our next question comes from Mike Dahl from Credit Suisse. Please go ahead.

Michael G. Dahl - Credit Suisse Securities (USA) LLC (Broker)

Hi. Thanks for taking my question. Jim, just wanted to ask a question about L&W. I think on the competitive front, we've seen a lot going on in the distribution side, both public and private. And with some of the consolidation, there's also been a greater push into some of the interior products. So just wondering if you could comment on just how you're seeing L&W. Obviously some nice 2Q results, but just how you're seeing L&W from a competitive and strategic standpoint with this evolving landscape.

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

Yeah. Thank you. We're very pleased, not only with the second quarter results of L&W, but if you go back a year or so ago, there's been a nice margin increase from the last five quarters. I think we started out with margin of 1.5 point and we're almost at 4%, where that's not where we need to be, but we have some very specific initiatives, as Matt talked about, around inventory and truck utilization. We've right-sized the organization.

If you look at our overall SG&A, we've right-sized the L&W organization and really we're starting to see some velocity. And that's really what we were missing at L&W two years or three years ago because their footprint is so large in the new commercial and commercial R&R, which just wasn't coming around.

Now obviously, as any CEO would do, you always look at your portfolio, making sure that you have the right parts of your business in your overall portfolio to return to your shareholders. So we have some work to do at L&W. The progress has been good. One quarter doesn't make a year, but if you look at our year-on-year progress, actually we've done everything that we've mentioned to you. And we're pleased with the results.

There is consolidation in the industry. We think that's positive. On a competitive front, you asked about L&W on a competitive front, we have some competitors now that are in the public domain as L&W is and has quarterly calls. And we believe that what we're seeing around us is very positive for the overall distribution business.

Michael G. Dahl - Credit Suisse Securities (USA) LLC (Broker)

Okay. Thank you.

Operator

Thank you. Our next question comes from Philip Ng from Jefferies. Please go ahead.

Philip Ng - Jefferies LLC

Hey, guys. Is your expectation for price cost to be neutral or positive going forward in wallboard at this point in the cycle? The reason why I ask is just because demand seemed pretty strong this year. Thanks.

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

Hey, Phil. How are you?

Philip Ng - Jefferies LLC

Great.

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

You know what, what we've always said is, look, we would expect to have – let's just start with, Jim's talked about getting margin expansion in every business. And so we would expect to have price exceed inflation, and that's the premise that we're working on, knowing that we have to balance price versus volume.

If you think about a percentage in price, it adds twofold to the bottom line compared to a percentage increase in volume. So we're very focused around price and moving price above what we're seeing in inflation.

So, again, I think our expectation is given if nat gas stays low or stays where it is right now, that we're probably cost neutral through the balance of the year. We'll actually be ahead on a year-to-date basis when we finish out the year, but just on the second half. And I think it's too early to get into 2017. There's good and bad on that. I mean, the little bit of inflation is not bad. I mean, it's good for the economy, it says the economy is healthy.

So to the extent that we see some inflation move over into 2017, we aren't going to get into price, but we would expect to get some kind of price increase at some point in the near future to clearly offset cost. But we're aren't scared of a little inflation, we're actually good. It's good for the economy. It's good for our pricing. And we would expect to be able to exceed that. So, we're doing a bunch of things now.

Just one last thing so I don't sound like I'm just droning on is Jim talked about advanced manufacturing and Lean Six Sigma. And I think this is an awesome program. And I hate to keep teasing everybody out there. There's more to come, and we're going to give you some idea of size and shape shortly. But this is a powerful program that is really intended to drive costs out and improve quality in our products and speed up basically delivery time.

So you think about all that and all that we're doing, it would be our expectation over the shorter to mid-term that we would start to get some real benefits flow to the bottom line on that. And so it's too early to get into exactly what that looks like, but I think we're going to be able to deal with the cost side of the equation very effectively over the next couple, two years, three years.

Philip Ng - Jefferies LLC

Will the initiative be pretty broad based across all your segments on the Lean Six Sigma front? Sorry to sneak that in.

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

Look, without getting into too much here, I mean, advanced manufacturing, as Jim said, it's under our roof. It's what we know how to do. We do this every day, except we just haven't had the capital to really put in important stuff. But, this is not high risk; this is not one project or two projects; this is multiple projects across multiple venues that demonstrate benefit.

So, it goes in concert, hand in glove with Lean Six Sigma, you do both of them together. We basically have been doing Lean Six Sigma without the investment of the capital side. And now we get to marry those two together, and it's a pretty powerful combination, and so again, more to come on that, and I feel – I know Jim feels the same way, we feel really good about, what that will do for our cost position, as we move forward.

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

You know, this is a – this is an interesting time in USG's history. We are really at an inflection point. As Matt said, we are repairing our balance sheet. That $500 million is in sight that we'll pay organically at the end of the year. We're getting margin expansion in all of our businesses. We're starting – we're seeing growth, we're seeing demand and really when we talk about initiatives that are new like advanced manufacturing, and we're going to continue to give you more and specific information to quarters to come and we want you to be able to track our progress there. But this is a really exciting time for USG with the great success we're having in Asia and Australasia, which puts an international bend on the portfolio, we're getting some great – we're getting nice progress with our distribution business, we have some work to do there. But this is why we're kind of introducing some of these new projects that are nice returns, as Matt said, low risk, but also it changes the footprint of how we look.

If you look at in the future, production jobs are growing, there is going to be a lack of production workers and we're really trying to stay ahead of this trend and sensors are going to be very important, robotics come into it taking out some jobs that we can get people behind the glass instead of on the line, we want our production workers to continue to work in a more of a technical environment. And these across the system and we're really excited. And as Matt said, we're kind of tickling you with it a little bit, but I just wanted to jump in because we really have started to turn the corner and are turning the corner.

And for the investors that have been hanging in there with us, this has been a long road and we're really excited about not only the end of – back half of this year, but as we get into 2017, we think we're going to be hitting on all cylinders. So, I just wanted to jump in, Phil, on your comment. I think it's a great question, but for everyone listening on the line and on the transcript, we're really excited about this inflection point of where the company is.

Philip Ng - Jefferies LLC

I appreciate that color.

Operator

Thank you. Our next question comes from Mark Weintraub from Buckingham Research. Please go ahead.

Mark A. Weintraub - The Buckingham Research Group, Inc.

Thank you. Well, certainly interested to hear once we get close to that inflection point, what – if there is no use of capital, what the priorities will be? I assume, it's premature to ask that. So, little bit more mundane. Question on the – follow-up really, so when you have the pricing not to exceed, is that through the end of this year or was that – is that 12 months? And so, since it started April it goes to April of next year?

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

It's to – end of the year, end of 2016.

Mark A. Weintraub - The Buckingham Research Group, Inc.

Okay. And then, just curious, any color you can give us as to why you elected to no longer provide info for the PPI index? What the thinking behind that is?

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

Yeah, this is Matt Hilzinger. Because it's a lousy index. I mean, it's really something that we saw people using out there, and it's – I mean, it's kind of meaningless. I mean, I suppose over a four-year or five-year trend it makes some sense, but for folks trying to figure out what's going on in our business to try and take PPI data on a quarter-to-quarter basis, I think, it's misleading. And they don't grab the full thing. I mean they grab just like half inch classic board. I mean, it just – it's not even reflective. So, we've actually talked to them about with a update there, the way that they do the PPI index. There is no real appetite for them to do that right now. They may look at it, but quite frankly it's just crappy. So, that's why we don't give it anymore.

Mark A. Weintraub - The Buckingham Research Group, Inc.

Understood. Any suggestions as to what are better external sources to be using?

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

You know, look, I'm – you guys do channel checks. I can endorse channel checks, right. I mean, I think folks that do channel checks and do channel checks with a broad base of customers and quality customers probably get a better view of what's going on in the industry than folks that call the same people, time and time again, that aren't real players in the industry. And so, I would just – I'm not endorsing channel checks because I do, I think, again you don't get a full sample size, and it's hard to get a statistical view of what's really going on. But that's probably the better way to go about it than trying to use PPI.

But again, I just – if you do it, make sure it's done in a quality way, and you go to quality people, and you really think your way through it.

Ryan Flanagan - Senior Director-Investor Relations

I think, we have time for one other question.

Operator

Thank you. Our last question comes from Jim Barrett from C.L. King & Associates. Please go ahead.

Jim Barrett - C.L. King & Associates, Inc.

Good morning, everyone.

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

Good morning, Jim.

Jim Barrett - C.L. King & Associates, Inc.

Matt, I think, this is a question for you given the fact that demand is exceeding your going in expectations, how close is the company to adding more shifts, and if and when that happens broadly, can you talk about the financial implications especially to incremental margins, near term and longer term?

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

Let me, Jim, this is Jim, then I'll turn it over to Matt.

Jim Barrett - C.L. King & Associates, Inc.

Okay.

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

We're running right now about 83% effective capacity. So, last quarter, we ran about 85% of – when I say effective capacity that's the staffed without adding a shift capacity. What we've chosen to do near term is, is more overtime versus adding a shift because we want to make sure that the demand is durable. We don't want to go, add a shift and then layoff a shift. So we're very – we're very cognizant on doing that. It's anywhere from three months to six months to add a shift.

So, you need to be right on doing that. And you aren't talking about from an incremental margin standpoint, you're getting additional volume that basically pays for itself, I mean that flows through to bottom line. So, actually in lot of respects, when we do this, it should add to the margin expansion target that we set. So, we're very diligent about making sure – we added some shifts in Texas last year, it was very busy there, and the business now there has been very durable. So, it should help margin expansion, but we're very, very cautious before we do it.

Jim Barrett - C.L. King & Associates, Inc.

Thank you very much.

Matthew F. Hilzinger - Chief Financial Officer & Executive Vice President

I have nothing to add. That was well said.

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

So, I appreciate all the questions. So, as we wrap up obviously Matt and I are very encouraged, and really the management team is encouraged about the recovery we're seeing in all segments here in the United States. And as I said a few minutes ago, we are well-positioned to take advantage of these markets.

We're focused on our customers, our customer base is growing their business as well. We're managing our costs, and you have my commitment as the CEO as we talked about not only SG&A, but our manufacturing cost with initiatives like Lean Six Sigma and advanced manufacturing. And really taking a look at our overall SG&A; as Matt said, our SG&A this year is going to be lower than last year. We're very focused on that and we're doing that and growing the business.

So, we're committed to our customers. Innovation is going to be very, very important. We have some great new products in the pipeline that we have not introduced yet that hopefully we'll be able to talk about it in the back half of this year. So, we really appreciate your interest in us today and in USG, and we look forward to giving you an update next quarter.

Ryan Flanagan - Senior Director-Investor Relations

Thanks, Jim. A taped replay of this call will be available until Thursday, August 25, and information is available on usg.com. This 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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