When I was creating my fall outlook in September during the calm before the storm (oh, the days of the S&P 500 above 1,200), one of the more alarming quotes I included was the following from Alan Mullaly, CEO of Ford (F):

“Not only is the U.S. in a recession, but the rest of the world is slowing down… I’ve never seen anything quite like it… We think we’re going to be relatively flat through 2009 and we don’t see the start of a recovery… until the latter half of ‘09 and ‘10…And that’s basically moved out a year, year and a half from what everybody thought about four or five months ago.”

Even with Ford’s languishing share, they are still an important proxy for auto demand, particularly in the area of light trucks, and this makes their forecasts worth listening to (even if the company never seems to be able to capitalize on them). A similar case exists for wallboard maker USG, which provides key building materials to both residential and commercial markets, and thus has a finger on the pulse of economically important construction spending. Digesting their earnings release and conference call transcript doesn’t paint a nice picture for cyclical industrial companies, but it’s necessary to understand how the housing bust has come full circle.

To describe my take on what’s happening in a word: acceleration. The spread of the problem has gone from weak demand for USG’s products to an inability to renew financing, and that’s a theme that has been repeated by a diverse group of companies. CEO Bill Foote said, “We are clearly having a new phase of this economic crisis,” as spending declines accelerate in North America and begin to take place abroad. Further, the deepening of the credit crunch seems to have put a stop to what might otherwise have been the tentative formation of a bottom in residential real estate. That tidbit of information is going to impact other building materials companies like forest products company Weyerhaeuser (WY), climate control company Ingersoll-Rand (IR), and Sherwin-Williams (SHW) – the last being a Todd Sullivan favorite, and a stock that has help up very well.

One longer-term area of concern is that incremental capacity reductions in the industry seem to have come to a halt; COO Jim Metcalf said there was effectively no large capacity shuttering during the last quarter. From an industry-wide perspective, the lack of financing might accelerate closures and bring supply/demand more closely in balance, but as for right now things still appear grim with break-even estimated at $130/msqft and USG’s realized rate at $114; although typically USG is incrementally higher on average realized sales price (+$10/msqft) and lower on break-even. This implies the average plant is selling below cash cost and has for some time; the lack of information that comes from having non-publicly traded competitors is that it’s difficult to say how much longer these conditions can persist. My worry is that, as wallboard prices trend up – which they actually have been, as parts of announced price increases take hold – no real rationalization will take place and the industry will continue to languish with low capacity utilizations. A constant overhang of unused supply capacity would prevent any players from getting into the higher plant utilization rates that let give the benefits of operating leverage.

At face value, the most worrisome item to come out of the call was the disclosure that the EBITDA covenant on their unsecured borrowings may not be met; USG had $69 million in EBITDA in the last four quarters, but the loan covenant calls for $75+ million by the end of 2009. USG maintains that they have sufficient assets and good relations with banks that renegotiating shouldn’t be a problem, though that makes me turn my attention toward forward earnings estimates, which have declined substantially yet again – full year 2009 earnings estimates were revised down roughly 30%, for example, as housing starts are forecast at 800k and commercial construction declines are accelerating. Because we’re far into the housing contraction, it’s surprising that the analyst community as a whole is still so optimistic on the near-term potential of a cyclical industrial like USG. While there are plenty of potential bargains in areas related to construction, the balance sheets tend to be less-than-pristine, and the exacerbating effects from the lack of credit availability serve as a double negative (both for the companies themselves, and their end markets).

If I had to buy something in the space sooner than later, I’d start with a high-yielding company like Weyerhaeuser (6.1% dividend) that also has a reasonable balance sheet (close to $5 billion in cash after the sale of a division), and work from there. Here is a sum of parts valuation on Weyerhaeuser for starters…

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