USG

1
USG

• Stock Pitch
• December 3rd
• By James Cullen

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To Follow Alonghttp//collegeanalysts.com/bcic/u
sg.pdf

• The PDF on my site goes into more detail on USGs
  fundamentals
  
• I also have another article on USG
• -http//collegeanalysts.com/?p151
• Or, Yahoo Finance
• -Blog Watch link - TheStreet.com
• -Is Buffett favorite USG a Buy?

3
The USG Gameplan

• Buy 400 shares of USG
• -Approx. Cost 14,680
• Recognize concept of risk vs. uncertainty
• -Stock trades for 1.7x book
• Ignore media headlines effectively claiming
  nobody will ever buy a house again
  
• Allow demographics, cyclicality to run course and
  turn USG into a profitable investment
  
• -Stock is inexpensive relative to normalized
  earnings

4
What Does USG Do?

• USG is a building materials company
• Products used primarily on interiors of all types
  of construction
  
• Best known for producing wallboard under the
  brand name Sheetrock
  
• Company also makes a wide variety of ceiling,
  tile, and flooring parts in addition to bonding
  and finishing joint compounds
  
• Operates LW Supply, a distributor of building
  products

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Revenue Breakdown

• 30 of revenues are attributable to remodeling
• 40 of revenues come from non-residential users
• USG is not just a residential homebuilding
  supplier

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That Whole Housing Problem
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Has Been Well Documented

• An oversupply created by excessive homebuilding -
  2.1 million starts at peak, compared to long-run
  demand of approx. 1.7 million homes annually
  
• Demand slowed, now we have excess inventories of
  unsold homes
  
• This supply/demand imbalance negatively impacts
  wallboard prices USG can realize

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Housings Impact on USG

• USG is, on average, the low cost producer of
  wallboard
  
• Regionalized distribution model
• Wallboard unit prices have fallen from 188 in Q3
  2006 to 122 in Q3 2007.

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USGs Adjustments

• Phasing out high cost capacity, replacing with
  newer, highly efficient plants
  
• -95 utilization of low cost plants, 49
  utilization of high cost plants in Q3
  
• Excess capacity issues being slowly corrected in
  wallboard industry
  
• Will account for majority of new capacity coming
  online in the next two years
  

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Where Are We in the Housing Cycle?

• Longer term these cycles eventually do come to
  an end. While wallboard prices declined again in
  the third quarter, the rate of decline was slower
  than in earlier parts of the year The industry
  still must absorb new capacity addition in an
  obviously weak situation. So I am not saying we
  are at the bottom. We were certainly beginning to
  see some signs necessary for stabilization in the
  market.
• -Bill Foote, Chairman and CEO of USG
• We actually talked to our dealers and very
  recently we had annual meetings and dealer
  advisory meetings and we surveyed them and they
  feel that their inventories are in alignment with
  the current market outlook.
• -Marie Ziegler, VP Investor Relations at Deere
• But the fact that I differentiate between F,
  F-minus and F-minus-minus, shows you that the
  drop in the market and to the extent that we've
  gone to in order for me to give you gradations, I
  go from miserable to outright purgatory.
• -Robert Toll, Chairman and CEO of Toll Brothers
• I would say to you and I would say to the
  homebuyers in America that if we're not at bottom
  in terms of our pricing, we're really close to it
  and to the extent that you are waiting to buy a
  home because you think prices are going come
  down, you're going to do the same thing you do on
  interest rates most of the time and that is
  you're going to say, gee, we missed the bottom of
  the market So I think we are very close to the
  bottom of the market. And most of our markets,
  some still have some additional deterioration,
  but it's difficult to determine where those are
  at this stage.
• -Sam Fuller, Senior EVP of Finance at D.R. Horton

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In Short, Housing Is Terrible

• But you already knew that

So Why Buy USG Now?
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Historically Speaking
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Philosophical Quotes

• Be fearful when others are greedy. Be greedy
  when others are fearful.
  
• -Warren Buffett
• The intelligent investor is likely to need
  considerable will power to keep from following
  the crowd.
  
• -Benjamin Graham
• We continue to pursue new opportunities,
  recognizing that many of the best come at the
  trough of the market, not the peak.
  
• -USG 2006 Annual Report

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Positives Do Exist

• Downturns arent a new phenomenon
• -USG has a track record of more than 100 years
  of successful operations
  
• -Management averages more than 20 years of
  industry experience
  
• LW Supply is a growth driver
• -Also will shift capital structure should boost
  ROIC
  
• USG is still the best in the industry
• -Continued capital investments to maintain
  industry-leading position and to be ready for
  turnaround

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As People Smarter Than I Know

• Ownership Structure 99 Million Shares Out
• -Berkshire Hathaway Owns 17 Million Shares
• -Knauf Owns 11.84 Million Shares
• -Fairholme C.M. Owns 5.5 Million Shares
• -Third Avenue Owns 4.9 Million Shares
• -Wallace Weitz Owns 3 Million Shares
• -Officers/Directors Own 1 Million Shares
• -This is nearly 45 of Shares Outstanding
• Shares Short on Nov. 15 22.3 Million
• -Trading volume in USG has declined
  dramatically it would now take 23 days for all
  shares short to be covered under normal conditions

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Why 36/share is Significant
-Ive read Fooled by Randomness, even so, this
seems like a legitimate pattern.
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Short-term, Long-term

• Knauf has been a significant buyer at the
  36/share level
  
• Extreme pessimism in housing and related stocks
• Possibility of a short squeeze on good news
• Commercial building remains solid
• Remodeling becomes more attractive

• Exceptionally strong demographic trends from
  echo-boom
  
• -One study predicts that over the next 25 years,
  more than 100 billion square feet of new
  residential space will be needed. Thats more
  than the development seen in any other
  generation.
• Take-out potential from Berkshire Knauf

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Wallboard is Boring Enough Now Valuation?

• The goal is to find out how much USG makes in a
  normal year with no boom/bust conditions
  
• Long-run demand for housing will require approx.
  1.7 million starts annually
  
• USGs products are used in the interior of the
  house so not as things are just getting started
  
• Incorporate a lag period between housing starts
  and when USG will recognize revenues from those
  housing starts (about one year)
  
• Calendar 2003 for Housing Starts - FY2004

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Housing Starts, 2001-Present
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So FY2004 Results

• 312 million in NI translates to 3.18 in present
  day EPS (adj. for share dilution)
  
• One large change is LW Supply
• -Recent LW results show minimal erosions in
  sales
  
• Marginal revenue gains from LW equate to 32.5
  million in additional NI, or 33 cents in EPS
  
• -7 normalized operating margin, 38 tax rate
• 3.18 .33 3.51 in roughly normalized EPS

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Brought to Present

• 3.51 in normalized EPS gives a normalized P/E of
  10.5x (USG closed Friday at 36.69)
  
• Similarly, we can normalize cash flows for FCF
• -Ill spare you the calculations, 320M -
  3.23/share, or the stock trades for 11.3x
  normalized FCF
  
• What is a fair multiple to normalized earnings?
• -I would say somewhere in the mid-teens
• -At 15x normalized EPS, USG is a 53 stock
• -At 16x normalized FCFPS, USG is a 52 stock
• This is more than 40 above Fridays close

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To Recap

• Beaten up cyclical
• Best of breed in its industry
• Proven history of performance
• Compelling long-term growth story
• Smart buyers (and holders) insider ownership
• Large short position
• Attractive valuation
• Significant, committed buyer just under market
• Takeover possibility