Originally Published November 30, 2000
DECADES AGO, employees at USG's (USG: 8.21, +0.09, +1.10%) manufacturing plants would check whether their concoction of baked gypsum was ready to be shaped into drywall for houses by tasting it.
Apparently, investing icon Warren Buffett likes the taste of USG's stock, even though virtually everyone else finds it pretty bitter at the moment. This week, Berkshire Hathaway (BRK.B: 2849.00, -109.00, -3.68%), Buffett's investing company, and National Indemnity, one of Berkshire's captive insurance companies, disclosed they had recently bought 6.5 million shares of USG, or just below 15% of the company. It isn't clear how much Buffett's companies paid for the stock, but they've already made a handsome profit: USG's stock jumped 30% Monday after news of their investments became public.
Buffett's strategy of finding undervalued, brand-name assets is well-known. And he's been on something of a home-improvement binge lately, buying into brick maker Justin Industries in June, carpet company Shaw Industries (SHX) in September and paint manufacturer Benjamin Moore (MBEN) in November. It makes one wonder whether Buffett's been watching too much "This Old House."
Sure, slowing home sales have depressed such stocks, possibly making them look like bargains to the canny value investor. But his latest purchase has analysts scratching their heads. The price of drywall, also called wallboard, has been falling all year, hurting USG's bottom line. But far more ominous, USG faces the prospect of paying out hundreds of millions of dollars in asbestos liability claims over the next few years. No one knows how much it will ultimately shell out, but the shadow of similar asbestos-related damages has forced one company into bankruptcy and caused the stock prices of several others to plummet this year. "The conventional wisdom is that the asbestos problem will only get worse," says John Kasprzak of BB&T Capital Markets, who has a Hold rating on USG stock.
As he said, that's the conventional wisdom. But here's where things get really interesting. Remember that Buffett's Berkshire has extensive insurance holdings. Among them is General Star Indemnity, which underwrote — you guessed it — asbestos policies. It isn't certain whether the underwriters and actuaries who handle General Star's asbestos liability policies talked to anyone who makes Berkshire's investing decisions (and Berkshire doesn't comment on those decisions). But what seems certain is that Buffett must be more comfortable than most analysts with the level of asbestos-related damages USG will ultimately face.
USG never produced asbestos, but used it in joint compounds it sold for interior wall building from the 1930s to the 1970s. The company is part of a group of 15 companies that produced asbestos-containing products and which are now facing thousands of damage claims for diseases and deaths caused by the carcinogenic material. At the end of September, there were approximately 83,800 personal-injury claims pending against USG with the company expecting still more to be filed. Another 65,000 had already been settled. That's on top of a property-damage class-action suit filed on behalf of every college and university in the U.S. against the company. USG already took earnings charges of $26 million in 1998 and $80.5 million in 1999 for asbestos-related costs.
Asbestos-liability fears helped push USG's stock this year to $14.94 from $47.13, a 68% plunge, before news of Buffett's purchase rallied the shares Monday. The stock closed Thursday at $18.31.
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The company cautiously estimates damages for lawsuits filed before Sept. 30 will be between $315 million and $490 million. While that amount is extremely onerous, the company can handle it, between its retained earnings, its still-profitable wallboard operations and a reserve set up for such payouts.
But most analysts think that damage figure is uncertain at best — and several hundred million dollars too low at worst. Companies and investors have looked to Congress to provide some legislation overseeing asbestos lawsuits, which might clarify how much damage a company would be liable for, but lawmakers haven't taken any action.
So analysts are left guessing how much USG will ultimately have to pay. Credit Suisse First Boston analysts expect it to take a $500 million to $700 million charge against earnings within the next six months. The firm estimates the present cost of USG's total asbestos liability at between $15 and $25 a share — or more than the stock is now worth.
The recent bankruptcy of Owens Corning (OWC), a longtime asbestos manufacturer, only made things worse. With Owens Corning insolvent, and fellow building-materials company Armstrong Holdings (ACK) defaulting on $50 million worth of debt, lawyers might try to extract more damages from asbestos-related companies that still have cash, including USG.
And as if the asbestos issue wasn't enough, investors not named Buffett have also been spooked by a 35% drop in wallboard prices since the beginning of the year. Most of the price drop can be attributed to a huge jump in wallboard-making capacity nationwide. And the plunge might not be over, since drywall sales hinge on new home construction and remodeling projects. With housing starts expected to decline over the next two years, many analysts suspect drywall prices to fall even further, hurting USG's sales and profits.
But Goldman Sachs analyst Christopher Winham admits it's tough to argue with Buffett. The Sage of Omaha has built a great track record (excluding 1999) by investing in undervalued companies that have solid businesses. USG seems to fit that category. It's the nation's largest wallboard manufacturer, controlling about one-third of the $3 billion market. It spent the 1990s upgrading plants, and recently introduced new wallboard products. The stock trades at a 20% discount to the book value of its own assets, and less than four times consensus 2001 earnings, according to First Call. Yes, earnings are going down, but they aren't disappearing, and as with all commodity products, the price of wallboard should eventually creep up as some suppliers eliminate inefficient wallboard production lines.
The bond-ratings services don't think USG is going belly up, either. Moody's rates USG's various debt issues around "Baa," meaning the agency thinks there's some risk of default but the company can cover its debt obligations at the moment. However, on Oct. 26, Moody's did announce it might downgrade USG's ratings.
In the end, of course, Warren Buffett isn't someone most of us would feel comfortable betting against. He usually knows more than most investors, and, in the case of USG's liability woes, there's good reason to think that knowledge gap may be even wider than usual.
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