USG Should Rise on Homebuilding Pickup, Buffett Effect

Includes: BRK.A, USG
by: Bill Allen

Thursday's rise in shares of USG Corp. (NYSE:USG) warrants some comment. 

Readers know from a prior post on the housing market and Warren Buffett's recent purchases (via Berkshire Hathaway) of the stock that I think that it's a strong buy.  The company, whose core operations include the manufacture of Sheetrock wallboard and ceiling products, may suffer some short-term indigestion as homebuilders work off inventory and cut their home starts.  However, its business fundamentals and valuation remain solid - it currently possesses a free cash flow yield of 8-9%, controls 30+% of the wallboard market, maintains a sizable raw material base, and has reserved nearly $3B for asbestos claims.  Although a Democratic Congress may delay any expected legal settlement, it has enough cash on hand from its recent equity offering to fund core operations and will likely earn $5/share next year.  Sheetrock isn't going away, and USG remains a textbook Buffett business - competitive moat, strong management, financial margin-of-safety, stock price discount to intrinsic value thanks to asbestos liability fears, and at least 10-15% likely growth well through the decade.

USG's share price has been volatile over the past 5 years - surviving a near-bankruptcy experience because of asbestos-related lawsuits, it dropped to the low single digits in late 2002-early 2003, at which time Buffett began to buy.  As I remember, he even loaned the stock to short sellers who believed that litigation would crunch the equity holders completely.  Their bet ended badly as the company benefited from the housing boom of the last few years and hope of a Federal asbestos settlement. 

Momentum buyers and likely short covering pushed the stock to over $120, but it later fell to the low $40's as home building slowed.  Buffett then announced that he would provide a backstop to a USG equity offering (buying any residual shares) that enabled the firm to solidify its capital base, creating a bottom for the stock and then purchasing additional shares in the open market around $47. 

The stock rose Thursday on a homebuilding sector upgrade by Banc of America Securities and rumors that the firm may be taken over. Throughout Berkshire's purchases, Buffett watchers have speculated that he would eventually make a bid for the entire company.  I disagree.  As a shareholder, Berkshire remains legally independent from the firm but can participate in the upside.  If the homebuilding market stabilizes as mortgage rates decline and remodeling picks up some slack as I expect, Berkshire will likely make significant gains on its holdings, and Buffett's actions have prompted other mutual fund firms to make sizable purchases, including Fidelity and Fairholme.   

Fairholme's Bruce Berkowitz has been a staunch Graham-Dodd -Buffett-type investor for several decades and owns nearly $800 million in Berkshire stock through his firm, so it's not surprising that he would buy a chunk of a core Buffett holding.  However, he may be one of several value managers taking large positions in USG as a long-term investment and effectively reduce the pool of USG shares that would be available for shorter-term trading.  It's just a guess, but I would anticipate several multi-dollar, daily pops in USG shares over the next year.  Combined with the firm's aforementioned fundamentals, I also expect some investors to shake their head in frustration for not considering USG while they had the chance to purchase the stock in the $50's.

Disclosure: Author is long FAIRX

USG 1-yr chart: