One aspect of my investing experience I feel I don’t talk about enough is the Boston College Investment Club (BCIC), where I am the Portfolio Manager. With 35 positions totaling about $200,000 and a very democratic process, being nimble is difficult and while that’s frustrating at times, overall we do well. There is always the possibility that a stock lingers in the portfolio too long, and if a position is down substantially there is a bias toward eliminating it, which is especially challenging in a year like this. Starting in October 2008, I tried to address this by creating a re-evaluation pitch format, where specific existing holdings that were down were either sold completely, or brought up to equal weight. The early results have been good, and the process has been adopted by others – something I hope continues, as it reinforces forward-looking thinking and creates a rebalancing discipline.

One stock I did a re-evaluation pitch on in mid-February was building materials company USG, which reported earnings earlier in the week. As would be expected, the headlines numbers were not pretty, as the company continues to struggle with arguably the most difficult housing market conditions ever seen. Two positives: even with higher depreciation and interest expenses, USG has rationalized their cost structure to the point where year-over-year operating income isn’t falling. This stems from a combination of cost savings and the big boost from continued increases in realized wallboard prices, which bottomed in Q1 2008 at just over $104/msqft, and are up more than 15% year-over-year to over $121/msqft for the most recent quarter. Improved pricing comes even as end-use customers are under pressure, and industry capacity utilization is still anemic in the low 50% range.

The trend of price improvement in the face of deteriorating demand also holds for the ceilings market, and I continue to worry that selling prices will hold closely enough to cash costs that capacity will not be taken out, and low return-on-investment metrics will persist across building materials for some time. USG’s management will not name specifics, but they have been giving up market share during the downturn – the figures are a little fuzzy for the industry as a whole, but market share during the peak was about 31%, and that is now down to the low 20% range. On the whole, the conference call was not as encouraging as the transcript might read
– they still expect housing to be very soft into 2010, and commercial real estate to suffer until credit markets normalize. Again, they have taken steps to mitigate exceptionally slow business conditions, but the string of losses continues and is not expected to turn around for at least a few quarters.

So, where does this put USG as an investment? The stock is around 80% of net tangible book value after the recent huge rally, but that same rally has put the $400 million in convertible financing provided by Berkshire Hathaway (BRK) and Fairfax Financial (FFH) into the money, as the strike is $11.40/share. When or if fully converted, that stake will be equivalent to 35 million new shares, relative to an existing base of 99 million shares outstanding. Such dilution has to change estimates of normalized earnings – going off some of the baseline numbers from the conference call, a back-of-the-napkin estimate is about $300 million, or $2.25 in EPR assuming full conversion. Using a range of multiples from 12x EPS to 16x EPS yields a stock price between $27 and $36, or somewhere between double and triple the present price. The big question, obviously, is what it’s going to cost USG to see those days of “normalized” operations in the future – their last liquidity bridge came at 10% interest, along with conversion rights for more than a third of the company. The unwillingness of competitors (or USG themselves) to further remove capacity and firm up pricing power is another concern, so there are no guarantees profitability won’t be cramped for years to come – the previous normalized EPS estimates comes with an approximate ROE of 15%, and I would be remiss if I didn’t give a nod to my accounting professor for drilling literature on the mean-reversion of ROE into my head. Perhaps that ROE is lumpy enough (as we see now in the down cycle) that its size is meant to compensate for variance, but if a 12% ROE is more appropriate, backing into the implied EPS gives a value of $1.70, for a stock price of $20 to $27/share. Again, attractive in numerical terms, but with much uncertainty that warrants a further look.

Ultimately, BCIC voted to bring USG up to equal weight at under $7/share, and that looks like a good move now with the stock above $12. The depressed valuation metrics and USG’s position as an industry leader seemed to win out over near-term concerns about business conditions; in particular, price-to-sales at the time of the re-evaluation pitch (mid-February) was at a low not seen since pre-housing boom times. That has nudged up somewhat, but still remains quite low. Now, a few charts to round this out:

First, quarterly financial results going back to 2003:

Next, pricing trends in wallboard and how it relates to USG’s stock price:

Additionally, wallboard volumes shipped by USG, as well as an estimate of the company’s overall share within the industry – note also, that the most recent quarter displayed the largest percent YoY decline in shipments, while operating loss narrowed and pre-tax loss was flat.

Lastly, a pair of three-year price charts – first for USG, and then for the Homebuilders ETF (XHB):

See the presentation slides.

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Disclosure: BCIC owns shares of USG. Author has no personal position. Some chart data sourced from Gridstone Research. See the quarterly press release here.