Battle of the Building Material Makers: Owens Corning vs. USG Corp.

Here are updated thoughts on a few stocks I frequently talk about here.

First, thanks to Jeff Annello for bringing a presentation recently done by Primus Guaranty (PRS) to my attention. I found it to be a very good explanation of some potential sources of the mispricing in the stock, as well as offering a good glimpse into the workings of the CDS market.

Jeff and I have alternately argued that Primus is a very misunderstood company because it is a tiny company operating in the fairly esoteric field of credit default swaps. Add in some accounting standards that make for starkly different presentations of financials, and I believe you have a recipe for an undervalued stock . Jeff seems to feel the same way.

I've copied the two slides I found most concise and relevant below; one discusses Primus' performance since its IPO and the other offers a nice explanation of GAAP vs. Economic accounting. If you'd like to view the entire presentation, follow this link and then view the PDF file.

This article from Prudent Speculations suggested that Owens Corning (OC) was a much better bet on the housing market than USG. While I can agree with Prudent Speculations that the, ahem, generally prudent thing to do is avoid specific homebuilders and focus on the better-positioned upstream materials companies, I feel he knocks USG unnecessarily to try to build Owens Corning up.

He leads off by saying that Owens Corning will rebound more quickly from the housing slump because it is more levered to home renovations than home construction. I did a quick scan of Owens Corning's Investor website, and found the following data:

Compare that to this data on USG's end markets:

If that second image is a bit blurry, the gist of it is that 30% of USG's revenues come from remodeling (both residential and commercial) and 40% of revenues come from non-residential sources – in other words, a very similar makeup to Owens Corning's business mix… although I'll grant that USG doesn't have the same amount of international exposure.

The second questionable point is on drywall, and USG's vulnerability to price declines – could there be a more self-evident statement than a manufacturer's profitability is tied to the prices it realizes on its production? Regardless, it doesn't make much sense to harp on wallboard being a commodity product when USG has THE recognized brand name in the space (i.e. Sheetrock), and Owens Corning can't really claim to have widely known, differentiated products.

The final odd point (I'll ignore the whole outsmarting Buffett thing) is that Prudent Speculations likes Owens Corning because it is at "a discount to book value." This depends on what you could as book value. If we take total equity of $4 billion, that's one thing – but stripping out the intangible assets, or even marking them down, tells a different story. More than half of that equity is a combination of goodwill ($1.17 billion) and intangibles ($1.2 billion), so you're actually paying more than 2x tangible net assets. USG, by comparison, is going for a little under 1.8x net tangible assets…

So what are the pros doing? Marty Whitman's Third Avenue has increased its stake in USG by more than 400k shares, or 8%, in the last quarter, judging from the firm's 13F filings. Additionally, Bruce Berkowitz's Fairholme added nearly 2 million shares in the last quarter, upping his stake by 30%.

On the side of Owens Corning, Harbinger Capital Special Situations has amassed a more than 10% stake, and looks to be buying in the low $20s. While I'm not familiar with the fund, a quick check of their last 13F shows an interesting combination of calls on the bond insurers, puts on Lehman (LEH), and my personal favorite copper producer Freeport McMoRan (FCX) as their second largest long position.

Wrapping this up, those of you who looked at Berkshire Hathaway's 13F released last week may have been disappointed by the lack of any substantial changes or new positions. I will note, however, that the largest percentage increase of any position in Buffett's portfolio was Ingersoll-Rand (IR), another stock I really like.

In unrelated news, it is said that great minds think alike.

Disclosure: I own USG, and am looking to purchase PRS but have not done so yet.

Comments

[Prudent Spe...:]

Great article. USG clearly has a lot of smart people as shareholders but I still think OCs international division and relatively limited exposure to new home construction will help it outperform USG in the long run.

2008 May 23 05:08 PM

[Bud Labitan:]

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2008 May 24 08:57 AM

[Paul Price:]

USG is now expected to show a loss of $1.30 - $1.42/share for 2008 and to lose about $0.26 /share in 2009.

It still sells well above book value of about $21 /share and the entire book value came from their [very smart] 2006 rights offering at $40/share which more than doubled their share count when times were still good. That took BV up from a negative $6.77 due to the anti-dilutive nature of that rights subscription.

USG, with good reason, pays no dividend.

With losses for the next year or two likely and no yield...
What's the appeal?

2008 May 24 08:45 PM

[daver:]

Paul, the appeal would be grounded in the likely cash flows available to USG in years to come. This may come as a surprise to you, but the majority of a company's value is usually not totally captured in the next 2 years of earnings.

2008 May 28 10:38 PM

[daver:]

Regarding PRS I think you are totally missing the point. Market prices on PRS's liabilities reflect somewhat of a market view of the fair price of the risk that they are carrying. When prices fall it means that either expected default rates are increasing or the price of such downside risk has become more expensive. Either way, the value of those contracts is now lower and could be replaced at more favorable prices by competitors.

Additionally, I would not want to rely on the company to give me an unbiased and accurate view of the likelihood of their current contracts costing them a lot of money. All of their incentives point in the other direction. I would be a bit suspect if there is a large gap between what the market is implying and what their management is telling investors.

2008 May 28 10:44 PM

[James Cullen:]

DavidR,
When you look at how the CDS spreads have blown out, I find it hard to believe they accurately reflect the increased intrinsic risk of default. I understand your concerns - I've had them myself - but I really do think that the headline GAAP numbers are creating an inefficiency here.

2008 May 29 07:15 PM

[mcafeejs:]

If PRS really wanted to show its value they would declare a dividend.

2008 May 29 09:05 PM

[James Cullen:]

John,
I strongly disagree. They use the capital retained (at about 30x leverage) to back their credit default swap portfolio. Especially with spreads being elevated right now, I'd rather they retain the cash and use it to write more business at attractive rates.

2008 Jun 02 05:05 PM