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Executives

James Bencomo - Director of IR and Pension Investments

William C. Foote - Chairman and CEO

James S. Metcalf - President and COO

Richard H. Fleming - EVP and CFO

Rick Lowes - Sr. VP and Controller

Analysts

Michael Rehaut - J.P. Morgan

David Macgregor - Longbow Research

Mark Weintraub - Buckingham Research Group

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

USG Corporation (USG) Q1 FY08 Earnings Call April 22, 2008 11:00 AM ET

Operator

Good morning, ladies and gentlemen, and welcome to the USG Corporation first quarter 2008 earnings conference 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 will now turn the call over to Mr. James Bencomo, Director of Investor Relations and Pension Investments. Mr. Bencomo, you may begin.

James Bencomo – Director of Investor Relations and Pension Investments

Thank you and good morning, everyone. Welcome to USG Corporation's first quarter 2008 earnings conference call and live webcast. We will be using a slide presentation today in conjunction with our call. It's available by going to the investor information section of our website at www.USG.com and clicking on the link to the webcast. You will need to advance the slides as we proceed through our comments.

Before we proceed, let me remind you that certain statements in this conference call may contain 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 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 Bill Foote, USG's Chairman and CEO; Jim Metcalf, President and COO; and Rick Fleming, Executive Vice President and CFO.

First, Bill will comment on market conditions and the outlook for our businesses. Jim will follow with comments on how our operating units are managing in this difficult business environment and our focus on customers, costs and how we are keeping the organization strong. Rick will conclude with some additional details and comments on our results and financial position. We will then open up the call for questions and conclude with a few comments from Bill.

Also present for the Q&A portion of the call will be Rick Lowes, Senior Vice President and Controller. Our goal is to be completed within about an hour, so let us get started. Bill?

William C. Foote – Chairman and Chief Executive Officer

Thank you, Jim, and good morning to all of you, thanks for dialing in. We truly appreciate your support of and interest in the company. I wish I had great news to report today; unfortunately I do not. We reported a loss of $45 million in the quarter. Market conditions continue to be extremely challenging. Both segments of the housing market, new construction and repair and remodel, are weak.

New residential construction eroded further in the first quarter of 2008. Consensus forecasts for housing starts have been revised downward again with projections slightly below 1 million units for the year. It can feel like an eternity, but it wasn't really that long ago that housing starts were at more than 2 million units per year. So as far as new residential construction is concerned, we're dealing with a market segment that has fallen more than 50% from a relatively recent peak in early 2006.

The repair and remodel market has weakened as well. The large national home improvement retailers who are important customers of ours have reported that they expect same-store sales to fall in 2008. The commercial market, which had remained relatively stable during the collapse of the housing market may have reached its peak. So our major market segments are weak, but any further declines are likely to be less severe than that which we've already experienced.

Said another way, we believe the drama is over and it's now about working through the bottom and getting back to a more growing environment. Indeed not all the news, though, I have to share is bad. There are some encouraging signs in the market and some very positive results that we've achieved by focusing on the controllable elements of our business. Some of those achievements are obscured by the recession and the corresponding decline in our results. But these improvements are real and I'd like to highlight some of them before I turn the call over to Jim and Rick.

First, the decline in wallboard prices stopped in the first quarter. As you might recall from our fourth-quarter call, we said that the rate of decline in wallboard prices had slowed. That trend continued early in the first quarter this year and toward the end of the quarter we announced and achieved a price increase. The increase during the quarter was modest, but it is important because it represents the first increase in wallboard prices in more than 15 months.

The second positive. The growth strategy for our distribution business is working well. Last year L&W Supply made two sizable acquisitions that not only increased our market presence, but also favorably altered or product mix toward non-wallboard building materials. CALPLY and AS [ph] both contributed to strong first-quarter sales of complementary products such as metal studs, ceilings and insulation. Those products are directed to the commercial market, which up to this point has performed much, much better than the housing market.

A third positive, our Worldwide Ceilings business followed up a record fourth quarter with another terrific quarter recording net sales of $211 million and operating profit of $22 million, an $8 million increase over the same quarter last year. Lastly, our cost reduction efforts are succeeding. Since the market began to decline in 2006 we moved quickly and aggressively to scale our operations according to market conditions and reduce discretionary spending and staffing. We can see costs coming out of the business and the trends are positive for favorable year-over-year comparisons.

During the first quarter, we curtailed operations at an older less efficient wallboard line in Iowa. That brings our total capacity reduction to 3.5 billion feet since the market decline began. We also closed a paper mill in Ohio in anticipation of the start-up of our new large capacity mill, which is in start-up now in Michigan. And the management team remains keenly focused on overhead costs. On April 1st we announced a salaried workforce reduction program that will eliminate approximately 500 positions. This program is very similar to the salaried workforce reduction program we implemented this time last year, which also eliminated about 500 positions. Since the downturn began we've removed approximately 1,750 positions, both salaried and hourly, from the ranks of the Company. Plant closures and headcount reductions are difficult and painful decisions, but they are necessary for the long-term success of the company.

Let me wrap up by saying that this is a difficult market, but the actions we are taking now to control costs and optimize our manufacturing network are having a positive impact on our results and our efforts will surely be rewarded when the market rebounds. Pendulums do swing. In our case we don't know when the drywall pendulum will swing, but when it does we will be able to capitalize on our terrific customer relationships, our low-cost manufacturing network and our growing distribution business.

I mentioned that there were other positives in the quarter, and for that I'd like to turn the discussion over to Jim who will comment more on operations, both the challenges that we have faced and some of the positives in the quarter. Jim?

James S. Metcalf – President and Chief Operating Officer

Thank you, Bill, good morning. As Bill described, our core markets continue to be very weak and the impact can be seen in our financial results. In markets like this we know that we have to focus on controllable areas like safety, customer relationships, operational efficiency, cost control and innovation. What I'd like to do this morning is briefly touch on each of these areas. First, I'd like to talk about our top two focus areas, employee safety and customer satisfaction.

The safety of our employees is critical to us regardless of market conditions. We had a fantastic year in 2007, in fact, a record performance in safety. I'm pleased to report that our great performance has continued into 2008, but safety is an hourly and daily job and we never stop focusing on it. In the first quarter 97% of our locations have achieved a perfect safety rating and 99% of our locations have operated without a single lost time injury. That is a level we will strive to and expect to maintain throughout 2008.

I've discussed in the past few quarters the importance of controlling costs within our operations. In addition to cost control, many of our efforts are directed at constantly improving our customer satisfaction and growing our position as a preferred supplier. Our customers are dealing with the same difficult market conditions that we are in. To succeed and grow our customer relationships we need to find new ways to help them operate more efficiently. To do that we've made substantial technology investments and we have focused our sales force to better serve our customers and we believe those investments are paying dividends.

For example, our substrates and services business is outperforming the industry. This is in part to recent changes in our sales organization structure that has improved our customer focus. We have also improved key customer requirements such as invoice accuracy and on-time deliveries to the best levels in the industry because of our investment in technology. As I said before, customers have choices, particularly in this market, and we want USG to be their best choice.

We continue to strive to have the lowest delivered wallboard cost. A key component is our focus on operating metrics in our plants that have a strong bearing on our manufacturing costs. This focus is paying off; we see positive trends throughout our operations. In fact, the overall efficiency of our network is at or near historically high levels. We've adapted to the recession in the housing market by curtailing or closing our high cost operations to take advantage of our more efficient plants. Through a combination of plant closures, temporary curtailments and shift reductions we've taken out 3.5 billion feet of capacity, as Bill mentioned earlier. This includes the capacity that's being eliminated by closing our Boston plant and idling our Fort Dodge, Iowa plant, both of which were announced this quarter… or in the first quarter.

We're taking a similar approach for our distribution business, L&W Supply. In the first quarter L&W closed 10 locations. Since late 2006 we have closed a total of 16 centers and reduced staffing accordingly. We're controlling cost in L&W Supply in other ways as well. For example, we reduced the size of our delivery fleet by 150 vehicles with half of the trucks coming out in the first quarter alone. Bill mentioned the modest improvement in wallboard prices during the quarter. This is a positive trend and we will attempt to raise prices as the year unfolds. But price is only part of the equation. We are also aggressively driving costs out of our system. You can see the results of our cost reduction efforts in the wallboard business, which performed better in the first quarter than in the fourth quarter of last year.

This was done despite the fact that raw material costs were up in the first quarter and the price of wallboard was lower. That's a trend we expect to continue throughout the year as we realize the benefits of our cost reduction initiatives. We've addressed cost in many areas and we are seeing the positive results of those efforts. Specifically, overhead in the first quarter was $15 million lower than the first quarter of 2007, that's a sustainable trend that we expect to continue each quarter in 2008.

We've cut costs in other ways as well. For example, we reduced funding for special projects. We expect to save more than $50 million in 2008 by reducing funding for these projects. Since the downturn began we've reduced the number of positions by over 1,700 including the plan that we announced on April 1st. The cost savings from this phase will appear in our results later this year. We have a laser-like focus to lower costs in our manufacturing network, reduce overhead and control discretionary spending. We are not finished challenging our cost structure. We will continue to think critically about our business and how we can operate more efficiently. We will also monitor market conditions to determine if further action is necessary.

Managing through this downturn is more than just reducing costs, it requires building for the future, preparing to take full advantage of the market recovery. As a reminder, industry experts project long-term wallboard industry growth of 2% to 3%. Our company and this management team have managed through downturns before. We know we have to aggressively manage for the current market conditions and at the same time invest for growth. So while we've been closing or idling older assets from our network we have also been building for the future.

Our new wallboard plant in Norfolk, Virginia is now up and running. This plant will operate for decades with the ability to utilize both natural rock and synthetic gypsum, servicing the key mid-Atlantic and Carolina markets. Norfolk to will produce wallboard at a considerably lower cost than the older Norfolk plant it replaced. We also opened a new paper mill in Otsego, Michigan. It is the most technologically advanced paper mill in the wallboard industry. This new state-of-the-art mill will lower our overall network cost for manufacturing wallboard.

As we build for the future, we must remain the innovation leader in our industry. Customers are always interested in and demand exciting new products and systems. One new innovation, dust control joint compound, which is focused on remodelers, has been a success in the US and Canada. In the first quarter, we extended the reach and exposure of dust control with product launches in national big box retailers.

We are also launching Sheetrock tools in the professional paint channel. Sheetrock tools and dust control compound have enabled us to penetrate this important market segment. In our ceilings business, we've introduced the industry's widest selection of ceiling panels to meet the most stringent standards in formaldehyde emissions. This offering is desired by architects and building owners and is one example of our effort to support sustainable design and construction. Innovation is a key to our long-term success. We will continue to explore new products and systems that meet the ever-changing needs of our customers.

As I conclude my comments, I'd like to emphasize we remain focused on the most fundamental aspects of our business; safety, customers, operational efficiency, cost control and innovation. We firmly believe that the keys to success in this market are focus and execution. We have acted decisively to respond to the significant decline in our core market. Our efforts are paying off; we can see cost coming out of the business in numerous areas. At the same time our customer satisfaction ratings remain high and we continue to innovate with new products with the safety of our employees as job number one. By focusing on the basics and successfully executing our strategic plan we will position USG to capitalize on the long-term growth of our industry.

Now I'd like to turn the call over to Rick Fleming who will talk about the financials.

Richard H. Fleming – Executive Vice President and Chief Financial Officer

Thanks, Jim; good morning. As indicated, I'll update you on our first-quarter financial results and provide some details on performance of our core businesses, capital spending and debt and cash management. Jim commented on how we are focusing operationally on those areas we can control, like safety, customer satisfaction, efficiency and innovation. We have a similar focus on our finances and I'll describe what we're doing to manage our financial flexibility during these challenging times, but first I'll recap our first-quarter results.

First quarter 2008 net sales were $1.165 billion, down 7% from net sales level in the first quarter of 2007. We had an operating loss of $65 million compared with last year's first quarter operating profit of $95 million. The first quarter of 2008 net loss was $45 million after-tax versus net earnings of $41 million in last year's first quarter. This loss largely reflects lower levels of wallboard prices combined with higher raw material costs and lower profitability in our distribution business.

The loss also included startup costs for new plants of $12 million pretax or $0.07 per share after-tax and restructuring charges of $4 million or $0.02 per share after-tax primarily associated with severance costs related to the shutdown of several North American gypsum manufacturing facilities and workforce reductions.

I should note that additional startup cost will be incurred primarily in the second and third quarters of this year totaling approximately $15 million for Otsego, Washingtonville and several other projects. And as announced, further restructuring charges of $15 million to $20 million will result from our recently initiated 2008 workforce reduction.

Turning to earnings per share, our loss per diluted share was $0.45 for the first quarter based on average diluted shares outstanding of 99.1 million. Last year's first quarter EPS was a profit of $0.45 per share. Now let's look at the performance of our three core businesses. North American Gypsum, our largest business segment, had an operating loss of $57 million. Canada and Mexico each posted a modest operating profit of $4 million during the quarter, while the U.S. Gypsum company had an operating loss of $64 million compared with an operating profit of $81 million in last year's first quarter.

Lower selling prices and higher production cost per Sheetrock brand gypsum wallboard were the biggest contributors to the decline in U.S. Gypsum's profitability. For example, wallboard-selling prices were down 36% from the first quarter of last year and this alone accounted for $127 million lower profit. But there are some interesting things to note about the U.S. Gypsum results, so let's dig a little deeper.

Wallboard manufacturing costs were up 7%, primarily reflecting the impact of higher prices for raw materials like paper and starch. Paper costs for example were up nearly 14%. Unfortunately raw material cost pressures more than offset the gains we achieved in improved plant operating efficiencies. But it is important to remember that higher raw material costs affect all industry participants. Also, our new low-cost paper mill in Otsego, Michigan will help reduce paper costs once it is fully operational.

Next I'd like to highlight our first-quarter capacity utilization rate. Although it was only 76%, it was up from 75% in the first quarter of last year and this level is much better than the first quarter 2008 estimated industry operating rate of 67%. Another key point to note is that our first-quarter volume was up slightly from the fourth quarter of 2007. The increase was only 1%, but we will take anything we can get. Regarding wallboard prices, there is another interesting aspect to the quarter. As Bill noted, prices showed signs of stabilizing during the quarter and we actually achieved some modest price improvement in February and March.

It's probably too early to call this a trend, but nonetheless we are encouraged to have prices actually go up for a change, albeit modestly. Returning the United States Gypsum company to profitability is a key priority for us. We've been taking cost and capacity out of the system and pushing price increases to recover cost increases. In addition, our new wallboard and papermaking capacity that is starting up this year will help reduce costs and improve service as the year progresses. The final item that I'd like to highlight for you regarding U.S. Gypsum is that its first quarter operating loss narrowed by $10 million versus the fourth quarter of 2007 despite lower wallboard prices and higher manufacturing costs. We still have a long way to go but we are making progress.

L&W Supply, our building products distribution business, reported an operating loss of $1 million versus an operating profit of $26 million in the first quarter of last year. The loss included a $3 million charge for LIFO adjustments. The decline in profitability at L&W is primarily attributable to lower shipments and profit margins on gypsum wallboard, which remains L&W's single largest product category. But efforts to diversify L&W's product offering have been successful and sales of drywall metal, ceilings and insulation were up 24% compared to the first quarter of 2007. These products have less exposure to residential construction and these results were benefited by the favorable impact of our CALPLY and AIS acquisitions.

As Jim mentioned, L&W closed ten centers during the quarter as part of its ongoing efforts to reduce its cost structure in light of the current market conditions. USG's Worldwide Ceilings business reported strong results with first-quarter 2008 operating profit of $22 million, up $8 million compared to the first quarter of last year. USG interiors, USG's domestic ceiling business, achieved operating profit of $15 million which is nearly double from last year's level of $8 million. These results reflect our success in achieving price and volume improvement for both ceiling tile and grid products as well as improved manufacturing efficiencies.

As Bill mentioned, we anticipate that commercial construction has likely peaked and could weaken as the year progresses. We also expect renewed cost pressures in areas such as steel prices. Nonetheless we are very optimistic that our ceilings business is well situated. Our distribution is stronger than ever and we have strengthened our sales and specification activities and introduced exciting new products. Now turning to some additional financial highlights of our consolidated results.

Selling, general and administrative expense, or SG&A, totaled $102 million in the first quarter, a decrease of $15 million or 13% from a year ago due to the cost control measures implemented during the past year including a workforce reduction in the spring of last year. As a percentage of net sales, SG&A was 8.8% compared with 9.3% for the first quarter of 2007. A few weeks ago we announced plans for another salaried workforce reduction, we expect to eliminate about 500 positions. This should produce about $40 million to $50 million in annual savings, similar to the program last year.

As mentioned, we currently estimate the cost of this program to be between $15 million and $20 million and these severance charges are expected to be begin in the second quarter of this year. Interest expense in the first quarter was $17 million, $44 million of expense in the first quarter of last year included the write-off of deferred financing fees and interest on a higher level of debt. The run rate for our annual interest expense is about $82 million per year based on a blended average interest rate of about 7% and capitalized interest of $15 million.

The effective tax benefit rate for the first quarter of 2008 was 43.6% versus a tax rate of 30.2% in the first quarter of 2007. The difference in the three months effective tax rates is primarily attributable to the worldwide mix of income. Specifically, a larger portion of our consolidated operating earnings rose in lower tax foreign jurisdictions, while higher domestic tax rates applied to domestic operating losses. In addition, first-quarter 2007 results included a $6.6 million favorable tax adjustment resulting from a correction of the December 31, 2006 deferred tax balances.

Depending on the mix of worldwide income, we expect that our full-year tax rate will be about the same as the first quarter rate. Regarding our cash and debt situation, our cash balance as of March 31st was $190 million compared with $297 million on December 31, 2007. Total debt was $1.283 billion as of March 31st, compared with $1.238 billion on December 31, 2007, an increase of $45 million.

As of March 31, 2008, the unused borrowing capacity on our revolving credit facility totaled $527 million, and when combined with cash on hand, total liquidity was $717 million. However it is important to note that under our revised credit agreement, which was amended to reflect financial covenants appropriate for the current housing recession, we are required to keep available cash and unused committed borrowing capacity of at least $300 million, including $100 million of unrestricted cash and marketable securities. We believe our liquidity provides us with the financial flexibility to deal with these challenging times and take advantage of strategic opportunities.

We have actively managed our capital structure to position USG for the current downturn. Since emerging from bankruptcy less than two years ago, we have issued $1 billion of ten-year notes, repaid $700 million of floating-rate bank debt, received a $1.1 billion tax refund which was used to pay off the $1.1 billion tax bridge note; issued $422 million of new equity, and as a result we have no term debt maturities until 2016. Even now we continue to explore additional potential sources of liquidity. These may include things such as an Accounts Receivable back credit facility and financing for our fleet of ships that haul gypsum rock to our plants.

Regarding capital spending, capital expenditures totaled $105 million in the first quarter compared to $111 million in the same quarter of last year. For the year we expect CapEx to be approximately $225 million excluding acquisitions versus $460 million last year. This lower-level of capital spending reflects the substantial completion of a number of strategic investments including two new wallboard plants in the U.S., a new paper mill and a new ship that will help strengthen USG's competitive cost position. Now, we will be happy to answer any questions you may have.

Question and Answer

Operator

Thank you. We'll now begin the question-and-answer session. [Operator Instructions]. Our first question comes from Michael Rehaut from J.P. Morgan. Please go ahead.

Michael Rehaut - J.P. Morgan

Hi, good morning everyone. First question is just on pricing which congrats that definitely surprised us and I was just wondering if you can give us a little bit more color as to what the… kind of when it occurred, you said I think you achieved a little bit in February and March. What was the amount of the price increase and have you see any.... have you been able to continue this trend into April?

William C. Foote – Chairman and Chief Executive Officer

Good morning Michael, it's Bill. Congrats you are always first in the queue, I don't know how you do that. But, good to hear your voice. Let me just say something broadly and I will ask Jim to comment more specifically. Given the very soft market and the excess capacity, the one with that originally think that you get the price improvement we're fully... having said that, we have all faced significant cost pressures and given the level of earnings or losses, it's very painful.

So, we need to get paid for what we do, we've announced two much price increases and that's the modest success and we're very focused on what we earn in this business and we'll be vigilant in trying to get paid for what we do. So, we're in a very aggressive posture, which was highly competitive environment and we'll take what we can get and hope that our customers can also improve their results. So, that sort of in broad measure, our thought process, Jim can comment on the specifics.

James S. Metcalf – President and Chief Operating Office

Our first price increase was February 15th and that was announced at 10% increase and we followed up with an April 7th increase of 10%. That is currently in the market. And as we've said in our prepared comments that pricing has trended up during the quarter.

Michael Rehaut - J.P. Morgan

Okay. So is it fair to assume that maybe you're getting, let's say roughly a third of that price increase given that if the trough of pricing in the quarter was may be $100 MSF. Just how to think about the level of realization and I guess the level of realization in the April 7th increase.

William C. Foote – Chairman and Chief Executive Officer

Well, Michael, we don't comment on price, specific pricing during the quarter. So we will have to check with you next quarter on what we actually booked.

Michael Rehaut - J.P. Morgan

Okay. The second question just on the overall expectations for capacity additions throughout the year, granted as you've mentioned, you continue to take capacity offline or more kind of temporarily shedder some capacity, but we were still looking at over 2 billion square feet net addition in '08, some coming from your sales but also good amounts coming from Eagle and BPB. I was wondering if you could update us with that if those numbers have changed at all?

William C. Foote – Chairman and Chief Executive Officer

Well, your number is accurate on the 2 billion, but let me comment on what we're doing. Its kind of interesting the way the shutdowns compared to the... our new capacity. If you take our shutdowns of our plants that, ones that we have mentioned and the ones announced last year. They totaled about 1.9 billion feet of capacity that's been taken out. This is Norfolk, Santa Fe Spring, Jacksonville Detroit, Boston, and Fort Dodge. New capacity coming and that we've added we just mentioned the start-up of our Norfolk, Virginia new plants and our Washingtonville plant, which will be starting up later this year is the net capacity of 1.77. So we've taken out 1.9 and added 1.8 for rounding purposes. So we are balancing on that to have the most efficient and youngest network in the industry.

Michael Rehaut - J.P. Morgan

All right. One last question if I could. Just on L&W, the margins there came in a little bit lower and you had mentioned that you have been accelerating some of the cost reduction. I was wondering if you could give us kind of a give-and-take of perhaps how much the cost reductions help to offset and what were the drivers for the margins fallen off a little bit more than expected.

James S. Metcalf – President and Chief Operating Office

The margins were really on two areas, volume of wallboard and wallboard spread and that's really, basically those two areas. If you look at L&W's overall wallboard shipments compared to the first quarter of last year, they were down about 8% and that has our acquisitions in there. We are taking cost out, as I mentioned about taking… closing locations, we're taking positions out salary positions hourly and contract labor. We' re reducing our fleet and we taken a very aggressive stands on under performing centers. So we are very focused in areas that aren't profitable. If you look at L&W's business as you go across United States, the East Coast is the area that is under the most pressure where profitability is a much better as you go across the United States towards the West, where we made our largest acquisition of CALPLY. So we're going to continue have L&W costs. They are profit centers their costs are under the microscope and where there is under performing centers, those will be on our watch list.

William C. Foote – Chairman and Chief Executive Officer

Michael, this is Bill. I'll just add if you boil down L&W’s revenue stream, we have a very important presence in the wallboard business and a growing presence in our other products. Wallboard understandably is under pressure both manufacturing, distribution and Jim commented on volumes and spreads, but our complimentary products steel studs, ceiling towing grid and the like have been performing extremely well. So, as we've grown the business we've had an eye to that latter category certainly all those bolstering our wallboard business, which is under pressure but achieving even faster growth on those other products both by product category and geographically. So there is a sort of mix shift going on, and I understand that some of the expectations in L&W were greater than what was achieved, but we feel quite confident that what we're doing to drive that business going forward notwithstanding current market pressures.

Michael Rehaut - J.P. Morgan

Great. Thanks gentlemen.

Operator

Our next question comes from David Macgregor from Longbow Research. Please go ahead.

David Macgregor - Longbow Research

Yes, good morning everyone. On the ceilings business, we'll backup one step. You'd mentioned a couple of times in your prepared remarks that the commercial was peaking or it might slow from here, I guess first of all could you remind us just by segment what percentage of revenues are associated with commercial really just sort of decline in ceilings? And then just talk a little bit about how quickly does your order book suggest that business will decline from this point forward across the three segments as a result of this.

William C. Foote – Chairman and Chief Executive Officer

I will ask our Controller Rick Lowes to comment on that.

Rick Lowes - Senior Vice President and Controller

It varies by business but obviously. So just turn the microphone closer to me, It varies by segment obviously in the gypsum business it's much more residential oriented and right now, it is much bigger, it is of a one third of the business. Our commercial being 12% and repayment model being 48%. In the ceilings business obviously it's much more commercial oriented and repayment model and in commercial orient and then you're going to get into the 60% range of their business for that kind of business. So, that it is, I've seen the results at the benefit of having that stronger sector. There is an 18 month lag between when the starts beings and when we… our product was into it, so we are going to actually start to see a little bit of slowdown in that may be into 2009, but this should be strong for the rest of this year.

David Macgregor - Longbow Research

Okay. That's helpful and I guess is there an opportunity to leverage your leadership positions and take share from smaller players with less resources. I know you've gained share in previous downturns, Just wondered if you could talk a little bit about the extent of that possible.

William C. Foote – Chairman and Chief Executive Officer

You are talking about on wallboard?

David Macgregor - Longbow Research

Yes, I am.

William C. Foote – Chairman and Chief Executive Officer

Okay. Yes, there is... there is a fine balance between market share and price improvement and we... that's a delicate balance when we look at every market, but we do have a leadership role, well we'd feel that we can get value from a pricing side. We get price premiums in almost every markets. And we like to grow our market share by our value proposition versus just drop in our price. So, there are opportunities to do that and we are focused on the markets where we can be profitable and do that.

David Macgregor - Longbow Research

Is there any specific goals that you can communicate with this, I mean just as we are trying to model out over '09 and 2010, I mean you're roughly about 34% share right now, I believe, what's achievable in terms of gain?

William C. Foote – Chairman and Chief Executive Officer

This is Bill. We wouldn't comment on a specific target. It's been trending up gently and it's a point here, a point there but I wouldn't comment on any specific targets we have. As Jim said, it is real balance between pricing and volumes and we try to achieve that by serving our customers extremely well.

David Macgregor - Longbow Research

Good. Thanks very much.

Operator

Our next question comes from Peter Wallsroom [ph] from Goldman Sachs. Please go ahead.

Unidentified Analyst

Good morning. Tagging on that last item, it does appear that you're taking some wallboard share. Does this indicate that you maybe... a little bit... that you are little bit too aggressive on price in the quarter, and if not what else would you attribute that to?

William C. Foote - Chairman and Chief Executive Officer

As the low-cost producer, we are well positioned, and we are very comfortable with how we are doing.

Unidentified Analyst

Okay. In the announced price increases, is that enough to offset raw material costs or do you believe that additional price increases are necessary. And maybe an add-on to that is what is your exposure to rising natural gas prices and when do some of those contracts roll off?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

This is Rich Fleming. I will address the natural gas issue for you. Relative to our natural gas situation, we are about 75% effectively hedged for this year, given current operating rates, and we have locked in our gas around $8 of deck of therm. So, we are below the market, our mark-to-market our hedges is about $38 million positive. So, that's actually been a pretty good story for us this year. Other cost pressures, still have been an areas if I mention such as paper and starch, and we all know what's happening in starch, with corn prices. And there we are working aggressively. As Jim has mentioned to recover those costs through our pricing activity.

Unidentified Analyst

Okay. And just to refresh my memory. It was paper cost were up 14%, that’s correct?

William C. Foote – Chairman and Chief Executive Officer

That's correct.

Unidentified Analyst

And what are you budgeting overall for your cost increases over the next couple of quarters, as you do have visibility on the paper said in particular?

Richard H. Fleming - Executive Vice President and Chief Financial Officer

Well, I won't give you specific targets. But what I will say is that as our volumes pickup in the natural course of events during the cycle and during the seasonal pattern, and then as we bring on the new low-cost capacity on the Otsego paper mill, you will see an improvement in costs.

Unidentified Analyst

Okay. And then switching quickly to L&W. Could you just show a little bit more in terms of what led to the operating loss in the quarter, I know that it came down to the wallboard shipments primarily. But a little bit of a surprise given the relative stability of the complementary products business, and also the assumption that you've wouldn’t really choose to sell wallboard at a loss.

William C. Foote – Chairman and Chief Executive Officer

Really, the key area in the first quarter was wallboard volume, but it was also wallboard spread, it's what L&W pays for their wallboard, and what they sell it for. Typically when manufacturers are raising wallboard prices, and we have seen it in past cycles, distribution lags behind, pass it along the price increase into their channel. So, there is a natural lag factor between manufacturers raising price to L&W, as well as to our other customers, and when they can pass it along to their customers, particularly with some of the their customers being on residential side where they are under pressure.

Unidentified Analyst

Okay. So, then if we are to read across that statement, you'd expect the operating margins to rebound fairly quickly, given the lag and ability in timing of their prices?

William C. Foote - Chairman and Chief Executive Officer

This is Bill. I wouldn't give you forecast; they're going to rebound weekly. I mean, it's a timing issue as the manufacturers continue to push prices. L&W has got a lot of work to do push those prices through into the marketplace into contractors, and you can imagine there's some resistance. So, I think they're going to be facing some… they are going to be sailing into some strong winds. But we're like in making sales out of our house, we are very focused on delivering value, and I think overtime L&W will be paid for the work it does.

Unidentified Analyst

Okay. And a final question on that same topic is. What sort of synergies do you see between the wallboard manufacturing and that distribution piece of the business, especially in a challenging pricing environment and where would we see these synergies show up in the financial?

William C. Foote – Chairman and Chief Executive Officer

I wish I had two hours to answer that question, but there is terrific relationship between US Gypsum and LMW and we respect the progress of our other dealers and we try to serve them extraordinarily. LMW serves the contracts in our business and US Gypsum serves LMW

other dealers and that's a terrific one, two combination.

Unidentified Analyst

And where would we see that in kind of a financials, is it just more opaque and drawing the line item?

William C. Foote – Chairman and Chief Executive Officer

Well, overtime LMW has made heck of return on investment and the US Gypsum company while it is simply cyclical also makes very handsome returns on investments. So I think our portfolio of strategy is borne out over time even if in tough markets like this both under pressure.

Unidentified Analyst

Okay. Thank you.

Operator

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

Mark Weintraub - Buckingham Research Group

Thank you. Just following up a little bit more on LMW how much of... how much have been impacted seasonality half on the business, is the first quarter typically weaker and so typically we see second and third quarter getting better or that really was very secondary in this incidence?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

We always have a seasonality and the first quarter is the weaker of the quarter on volume. You have weather factors as well but LMW's portfolio, there're some areas that are heavily waited residential business, which all we know what's happening with the housing markets. So there're some seasonality there but as Bill indicated, all of our distributors are in this market including LMW are under margin pressure.

Mark Weintraub - Buckingham Research Group

Sure. And roughly... it's about roughly a third of your Gypsum that goes through LMW or how much of your Gypsum goes through LMW?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

That's a pretty good estimation.

Mark Weintraub - Buckingham Research Group

And can you give us a census to whether LMW has been able to... I understand there is a lag, but as you know did you put the prices through in February and then some little bit more in March. Are you at least seeing that February increase now being realized up by LMW to its customers?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

We don't comment on specific pricing, but believe me everyone is working very hard to get price improvement in the market.

Mark Weintraub - Buckingham Research Group

Okay. And I guess coming back to the natural gas the energy question. Can you give us sense of how may [inaudible] you buy a year what your usage is roughly?

William C. Foote – Chairman and Chief Executive Officer

Sure. Relative to the overall natural gas cost of the company, it approaches $400 million little bit less than that at today's prices and just to give you the rough rule of thumb, a every dollar decker therm [ph] equals about $2.25 on Wallboard manufacturing cost so that if you go up a dollar deck of therm and basically Wallboard cost go up to $2.25, I mean we are hedged then at today's volumes levels that we close to about almost $18 million of the year. Did that help you?

Mark Weintraub - Buckingham Research Group

Yeah. That's perfect and then just wanted to understand, are you marking to market those energy contracts, so did that run through your quarterly results or not?

William C. Foote – Chairman and Chief Executive Officer

No we have hedge accounting so basically that positive mark-to-market of 38 million I referred to is in OCI.

Mark Weintraub - Buckingham Research Group

Okay. Great. And then lastly, cap spending as you indicated you really finished most of the major projects. I guess you got… bet it 220... 110 order for the back half of or last three quarter of this year. Can you give us sense as to if market conditions remain tough and you were to decide to pull you horns in '09. What type of flexibility you have in bringing cap spending down, what type of levels could you bring it down to?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

Well, you hit a key point of our sort of financial flexibility situation and that a number of the major projects have basically been completed or will be completed this year. The number for the full year will include really the completion of Washingtonville and Otsego paper mill as well as the new ship. So, going into '09, we have much less in terms of commitments, the major decision that we will be taking during the course of this year is the timing on stocking as so far we have not broken ground on stocking or we're still going into for many process. And when that decision is taken, then we will have more clarity on the capital spending level for 2009. But I would say for you modeling process right now you should assume a similar level to 2008.

Mark Weintraub - Buckingham Research Group

So that 220-type level and that take... I think that would assume Stockton is going forward and can you give us... if Stockton want to, should I take off 80 million up of that or what would be a strict standing point to take off that?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

Well, I can't give you specifics because once again so much depends upon when the permits come in and whether we will have a full year capital spending but the plan itself is $220 million, it's not targeted right now to come on stream until 2010 and then the question will be debating as whether we flip that perhaps the 2011, but we haven't taken that decision as of yet.

William C. Foote - Chairman and Chief Executive Officer

This is Bill. we are going to run short of time here, if you could wrap up your questions and we will try to have few more before the hour is over.

Mark Weintraub - Buckingham Research Group

Okay. Just what was total cost for the Stockton facility then?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

That's about $220 million.

Mark Weintraub - Buckingham Research Group

$220?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

Yes.

David Macgregor - Longbow Research

Okay. Thank you.

Richard H. Fleming – Executive Vice President and Chief Financial Officer

Thank you.

Operator

Our next question comes from Jim Barrett from C.L. King & Associates. Please go ahead.

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

Good morning, everyone.

William C. Foote - Chairman and Chief Executive Officer

Good morning, Jim.

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

Bill, given how good your volumes trends appear to be in Q1, do you still believe the industry will be down 10%, 15% this year.

William C. Foote - Chairman and Chief Executive Officer

Yes, the fundamentals of new housing [inaudible] and its a pretty, our sense is refining a bottom we haven't called it yet, I mean it's sort of function of what the broader real economy and the capital markets do. But it's feeling like that or you saw them all starts number and it was a little bit below expectation. And so, we were just long the bottom here. But I don't think, we haven't changed our view of the aggregate market opportunity this year and although let's say, it seems to be sort of as I said in my opening comments, we think the drama is over and just sort of pumping along here and importantly [ph] in the next year. Because we have worked to this inventory and so homes but the worst news is behind us just the matter of… with this bottom.

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

Correct. And then secondly, any sense as to how industry wallboard volume trends were in the March quarter?

William C. Foote – Chairman and Chief Executive Officer

Jim?

James S. Metcalf – President and Chief Operating Office

Yes, the March quarter industry, let me look here 4Q to 1Q, the industry was basically flat and the March numbers, the industry, I believe was down 13%.

William C. Foote – Chairman and Chief Executive Officer

That's correct.

Richard H. Fleming – Executive Vice President and Chief Financial Officer

Versus last year.

William C. Foote – Chairman and Chief Executive Officer

Year-to-year?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

Yes. 1Q07, 1Q08 versus 1Q07 down 13%

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

Okay, well, thank you both.

William C. Foote – Chairman and Chief Executive Officer

Yes, thank you.

Operator

Our next question comes from the Lethan Tahaya [ph] from Lehman Brothers. Please go ahead.

Unidentified Analyst

Hi, Good Morning.

William C. Foote – Chairman and Chief Executive Officer

Good morning.

Unidentified Analyst

On the distribution side, do you think you're seeing any attractive acquisition opportunities right now?

William C. Foote – Chairman and Chief Executive Officer

We have always had our intend up, and their things in the pipeline, but you know I really shouldn't comment as to the timing for all those out there looking for our timing.

Unidentified Analyst

And what gets the antenna buzzing, if you like in terms of size, the geographies or whatever are the criteria?

William C. Foote – Chairman and Chief Executive Officer

Anything that’s going to make us a lot of money is our intention.

Unidentified Analyst

Fair enough. On the financing, you mentioned the AR facility and the ship financing. What is the potential size of the incremental liquidities you like which you could generate from that? I mean just back of the envelope, I kind of get to like a $400 million, $500 million at least?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

Well, without basically having all the details right now because we're working through several transactions. But we are targeting about additional $300 million of liquidity as part of our thought process, target is to obviously give us the opportunity to also pursue some of the strategic possibilities that you will to an L&W acquisitions.

Unidentified Analyst

So, basically, based on your current liquidity you have, if you like 300 million of… if you like excess liquidity in addition to what you are required to maintain and then you are saying in addition, you could do another similar number. So you could… you have a decent kind of a capacity to do something of decent size. Is that right?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

That is correct.

Unidentified Analyst

Okay, fair enough. And lastly, could you quantify the margin impact and again without necessarily looking at the forward-looking guidance, margin benefits from the closing of the older plants and replacing it with the new plants in terms of, I don't know, in percent or dollar or whatever you.

Richard H. Fleming – Executive Vice President and Chief Financial Officer

It's about, just from MSF basis, it's about $4 per MSF to the network.

Unidentified Analyst

Great, thank you very much.

William C. Foote – Chairman and Chief Executive Officer

Thank you. We have time for one more question; we are sort of at the hour. And there are several folks in the queue and apologize for not being able to do in that but certainly you can call Jim and [inaudible]. He'll direct his calls to one of us if necessary and we want to be responsive to your questions. Let’s take one more.

Operator

Our last question comes Ugene Ferai [ph] Exane BNP Paribas. Please go ahead.

Unidentified Analyst

Yes, good afternoon, my question was on your cost structure. What is the impact exactly of the cost increase?

Richard H. Fleming – Executive Vice President and Chief Financial Officer

Well, we've faced factors from as Rick mentioned, waste paper and starch energy costs, we are working hard to control, but it is been an upward pressure of the last year and then surely with lower volumes, we had cost absorbance for the closing capacity. So there is a lot going on our cost structure but we feel we're well in front of it.

William C. Foote – Chairman and Chief Executive Officer

If you look at total raw material cost, it's double-digit as Rick said, paper is 14%. Energy even though this year, is flat… energy costs have gone up to 2x since 2002. So energy continues to be… have winded our face, but this year quarter-on-quarter our biggest variance is wastepaper at 14%.

Unidentified Analyst

Okay. Thank you very much.

William C. Foote - Chairman and Chief Executive Officer

Thank you. Thank you all for dialing in and spending this last hour with us. Market downturns are almost painful in some more than others and this one I think what we could describe is very painful. And as we step back and look over the balance of the year, it is surely going to be a difficult one.

Having said that, we think that we've managed the company very prudently. We been in this situation before, we know what to do, I think we are staying in front of this very difficult market. And in particularly focused on those things we can control, which are... our relationship to their customers, certainly our cost structure, our asset base and our finances. We believe we have the flexibility to manage this downturn and to position the company for growth. Our sharp focus is on operational excellence and staying on top of those things we can control.

I'm very confident that we will weather the storm and position this company for the upside and capitalize on that one to come. So, we press ahead and for today, we thank you for your time and for joining us. Please call if you have other questions.

James Bencomo – Director of Investor Relations and Pension Investments

Thank you, Bill. There is a taped replay of this call that will be available starting this afternoon and number to reach that is 1-888-843-8996 and entering the passcode 21304136. The replay will be available until Wednesday, April 30th. That concludes our call. Thank you again for joining us.

Operator

Thank you, ladies and gentlemen. This concludes the USG Corporation first quarter 2008 earnings conference call. Thank you for participating. You may all disconnect.

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