Saturday, October 07, 2006

Worst-case Scenario (WCS) Stock Pick - USG

I was initially drawn to USG by the constant news wires about Warren Buffett purchasing boatloads of this stock. His most recent acquisition of 371,200 shares at $46.10 occurred the day after my own purchase of my starter position at $46.84. It appears he is buying this stock whenever it approaches $46. He now owns about 19% of the company, about $800 million of the 4.24B market cap company. Over the last three months, USG grew from a 1% BRK holding to a 3% holding. I think WEB is onto something here and we may have an opportunity to tag along for the ride.

According to the most recent 10Q, USG emerged from bankruptcy on 6/20. This is good news to the company, but the stock price subsequently dropped by over 60% from its highs. No doubt this was because of the announced rights offering to generate cash for the Proposed Plan to emerge from bankruptcy. It was to offer shares to shareholders at an additional $40 per share in order to raise $1.8 billion. After the rights offering, each share is equivalently worth $80 if we are to believe the correct valuation is the previous $120 valuation.

In the most recent 10K discussing the Proposed Plan to emerge from bankruptcy, USG plans to set up a Section 524(g) asbestos personal injury trust fund from which all litigation payouts will be drawn. USG will initially fund it with an $890 million dollar in cash and then write a contingent note for $3.05 billion of additional funds. The note will be cancelled if the Fair Act of 2005 is passed into law and is not challenged as unconstitutional. The note is payable if the Fair Act is not passed into law. In that case, USG's total payout for asbestos litigation will once again be unclear.

Can USG remain solvent if the $3.05 billion note becomes due? My conclusion is that it can. USG's total obligation is $3.95 billion. It raised $1.8 billion from the rights offering, has $1.577 billion in accumulated cash, is owed $1.1 billion in expected tax refunds, and can raise an additional $1 billion in financing. Subtracting the obligations out leaves $1.57 billion in cash, about enough to finance 5 years of capex (~$1 billion), lease obligations ($227 million), and interest payments (~$20 million). Even in the worst-case, this company will remain solvent.

As the cost leader in the wallboard industry, it has a wide moat. This moat allows the company to generate significant cash flow in good years and bad. The average generated free cash flow for the last 5 years totals about $240 million dollars. The projected growth rate of cash flow is about 15% a year. To be conservative, I will use the average cash flow instead of next year's projected free cash flow as input to a 3-stage DCF calculation. Using an 11% discount rate, a 15% growth assumption for the next 5 years, 7% for the following 5 years, and 3% in perpetuity, the estimated intrinsic value of the company is $71 per share. By starting off with a conservative estimate of free cash flow, I allow myself some leeway in adjusting the growth rates. Using even more conservative estimates for growth of 7%, 5%, and 3%, the instrinsic value is $48. In the worst-case, we have a stock trading at fair value.

Some may say that there are two main catalysts for the price to go up. I argue that even without these catalysts, the stock is undervalued. The first catalyst is continued interest from Warren Buffett. From looking at his recent purchase history, I don't see him buying a larger stake unless the stock drops to under $46. The second catalyst is the passing of the FAIR Act of 2005. I don't see our bipartisan Congress passing such a law, but there is still a chance. Because the stock is worth much more even if the FAIR act is not passed, this catalyst comes free. Besides litigation risk if the Fair Act is not passed, there is the risk of a hard landing if/when housing heads south. As the low cost producer, I don't see USG's business being impacted in the long term.

I recommend buying this stock at $46, a 35% discount to my calculated intrinsic value of $71.

Two other bloggers whom I follow have also written about USG. George from FatPitchFinancials thinks that USG is a fat pitch, while F K Soft at Stockblogs.com concludes that we have a great business selling at a good price. Please refer to their posts for their detailed analysis.

Full Disclosure: I picked up a 1/3 starter position at $46.84 two weeks ago, but I wish I had bought more. I am looking to invest more under $46, but will pick up more shares at close to $47.

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