USG Corporation case study questions. Questions and cases are attached.

Assignment In your analysis, you should address the following questions: 1) Review USG's business, it's past performance, and the outlook for the future. Why is USG the target of a hostile takeover? 2) Value USG under its current operating and financial strategies. How does your valuation compare to the current market price? Value USG under the proposed recapitalization plan. 3) How should Day respond to Desert Partners' tender offer? Is the proposed recapitalization the best response? As Desert Partners, how would you respond to the proposed recapitalization plan? Rule: Address the questions above in a memorandum. Notes: At most 8 pages of text (and no less than 3 pages)--double spaced with 10-12 pitch. Calculations and Exhibits can be attached as Exhibits. I expect much more detail and breadth here. Please describe your assumptions. Your paper should address the issues raised in an integrated essay. Harvard Business School 9-297-052 Rev. July 12, 1997 USG Corporation On May 2, 1988, USG Corporation, the world's largest gypsum producer, announced that the board of directors had approved a recapitalization plan. According to the plan, USG would exchange each outstanding share of common stock for $37.00 in cash, $5.00 in stated face amount of 16% junior subordinated pay-in-kind debentures, and one share in the newly recapitalized company. Robert Day, USG 's Chairman and CEO, said the plan "is consistent with our commitment to maximize value for the shareholders while at the same time leaving them with an ongoing equity stake."1 On the day of the announcement, the stock price closed at $41.50, up $0.50. Before the board could implement the recapitalization, shareholders would have to approve it at a special meeting on July 8, 1988. The recapitalization, however, was not the only option available to shareholders. Desert Partners, a Texas-based takeover group, had an outstanding tender offer for $42.00 per share in cash due to expire on June 10, 1988. In a publicly disclosed letter to the board, they had indicated a willingness to increase their offer to $50.00 per share in cash, debt, and stock, but had not officially changed their tender offer. Prior to the expiration of the tender offer, shareholders had to decide whether to tender their shares to Desert Partners or wait and vote for the proposed leveraged recapitalization plan in July. Company History In 1901, thirty-five gypsum companies consolidated to form the USG Company. The resulting entity controlled 50% of the highly competitive and price-sensitive gypsum market. Due to its size, USG had scale advantages in manufacturing and transportation which kept its costs low and helped it survive the Depression. Since its creation, USG had been a vertically integrated company with a commitment to product diversification. It grew steadily from the 1940s through the 1980s by expanding existing businesses and acquiring new businesses For example, USG acquired M asonite Corporation, a manufacturer of wood building products, in May 1984 to expand its product line. Overview of Current Businesses USG manufactured a diverse group of building materials for residential construction (36% of sales), nonresidential construction (29% of sales), building repair and remodeling (25% of sales), and industrial processes (10% of sales). It was vertically integrated and geographically dispersed controlling mines, quarries, transport ships and manufacturing plants in North America, Europe, 1 Anonymous, \"USG Board Announces Recapitalization, Restructuring,\" PR Newswire, May 3, 1988. Research Associate Tara L. Nells prepared this case under the supervision of Professor Benjamin C. Esty as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The case was prepared solely on the basis of public information without USG Corporation's participation. Copyright 1996 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permi ssion of Harvard Business School. 1 297-052 USG Corporation Mexico, and other countries. Despite the foreign operations, 90% of the company's sales were in the United States and Canada. Exhibit 1 gives historical data on the building products industry and the gypsum market. USG divided its operations into four divisions: gypsum, interior systems, wood fiber and other products. The four divisions shared several characteristics: they had strong positions in their primary markets, typically first or second; led in technology, design, and innovation; were low-cost producers; had multiple plant locations and geographic coverage; and were highly integrated. 2 Gypsum United States Gypsum Company was the world's largest manufacturer of gypsum products. Each year the company mined over eight million tons of gypsum and used it primarily to produce wallboard, baseboard, and \"sheetrock\" (USG's trademark product name), the plasterlike materials used to construct ceilings and walls. Besides being the raw material for construction materials, gypsum was also used in road repair, ceramics, and even as a calcium supplement for McDonald's hamburger buns. As of 1987, the company had more than 30 years of proven gypsum reserves. In 1987, US Gypsum was market leader as it had been for decades. It was the largest of 16 domestic producers and controlled one-third of the domestic market, a market where firms competed on price, quality, and service. Currently, gypsum sales accounted for 51% of USG Corporation's total sales though the division was set to expand as it had increased capacity by 893 million square feet over the past five years by constructing five new plants. Interior systems Established in 1986, USG Interiors, Inc. was the largest domestic producer of integrated interior systems. It provided ceiling, wall, and floor systems for office, retail and commercial spaces. The company supplied not only the products, but systems for solving interior spacing projects. It distinguished itself from competitors by possessing the largest variety of products and coordinating them into an overall system. USG also attributed its success to its effective marketing, sales, and distribution. Although its market share varied according to the product, it controlled 35% of the market for acoustical ceiling tile, 50% of the market for ceiling grid suspension systems, and 19% of the market for floor access systems. Wood fiber Masonite Corporation was one of the world's largest manufacturers of wood fiber products including hardboard siding, roofing, and paneling. It produced and marketed a wide variety of products through three units: Hardboard Group, Wood Fiber Industries, and Furniture Components Group. Masonite invented the process for hardboard over fifty years ago and continued to be innovative with its recently developed successful line of molded door facings. In 1987, it was the domestic market leader with 33% of the exterior hardwood siding market. Other products USG Industries supplied building products to the repair and remodeling market through three business units: Kinkead Division, DAP Inc., and Durabond Division. The Kinkead Division was the nation's largest manufacturer of bathtub and shower enclosures. In 1987, it introduced a steam shower and a new line of bath products which resulted in a 19% increase in unit sales. USG acquired the second unit, DAP Inc., in 1987. It produced caulks, glazing and sealing compounds, wood preservatives, and specialty paints. Over 70% of its sales were to the repair and remodel market. And finally, the Durabond Division produced adhesives, mortars and grouts. 2 USG Corporation, 1987 Annual Report, p. 4. 2 USG Corporation 297-052 Current Events at USG In 1985, former CEO Edward Duffy began a major restructuring program beginning with a reorganization into four divisions under the USG holding company. The restructuring was not a reaction to negative performance, as sales and earnings were at record levels in 1984, but rather a continuation of USG's long-term decentralization program and an attempt to get each subsidiary to focus on growth opportunities within their specific markets. When Duffy retired in June 1985, then President Robert Day became CEO and took responsibility for implementing the program. As part of the restructuring, USG closed several plants, eliminated overhead positions, and divested several unprofitable businesses. Management expected these steps to generate $23 million in annual cost savings by 1988. At the same time, the company invested aggressively to improve efficiency and expand capacity at USG's plants. It also announced plans to repurchase 20% of the outstanding common stock because, in management's view, the stock was undervalued.3 Following the implementation of the restructuring program, USG posted record profits in 1985 and 1986. During this period, its stock price outperformed both the S&P 500 and the S&P Building Products Index. By the end of 1986, USG had repurchased almost the full 20% of its stock. Although analysts praised the company's performance, insiders reaped little in the way of financial rewards as they collectively owned only 1.4% of the common stock. They did, however, hold options on another 980,000 shares. Earnings dipped slightly in 1987: USG earned $204 million on $2.9 billion in sales down from $226 million on $2.8 billion in sales the year before. (Exhibits 2, 3, and 4 present historical income statements, balance sheets, and divisional operating results.) Nevertheless, its return on equity, measured on end of year equity, stood at 34%, almost twice the average for comparable building products companies. In fact, its return on equity placed it seventh on the Fortune 500 listing of profitability and fourteenth on the list in terms of 10-year EPS growth. At the annual meeting in May 1987, Day boasted that the stock price was up nearly fivefold over the past decade and the dividend had increased 87% over the past five years. 4 Management attributed much of the success to increased focus on their core building product business: its share of sales from building products increased from 79% in 1985 to over 90% in 1987. Although analysts were expecting strong earnings into the future, they were projecting a slight decline in 1988 earnings per share from $3.96 to $3.46, some of which was attributable to restructuring expenses. Management raised one concern in the 1987 Annual Report which was lawsuits stemming from asbestos-related products. The company had been charged a total of $956,000 in three separate cases all of which were currently under appeal. To cover potential liability stemming from future lawsuits, USG purchased additional liability insurance. Management believed that current and future asbestos litigation would not have a "material adverse affect on the company's operations."5 Recent Takeover Attempts Beginning in 1986, the building products industry became a hotbed for takeover activity. In January, Amsted Industries announced a leveraged buyout after Houston investor Charles Hurwitz made a hostile tender offer. In April 1986, California-based Wickes Corporation made the first of two tender offers for building products companies. First, they bid $1.2 billion for National Gypsum which, like Amsted Industries, fought back with a leveraged buyout; second, they bid $2.2 billion for Owens-Corning Fiberglass Corporation which countered with a leveraged recapitalization plan. 3 USG Corporation, 1987 Annual Report, p. 7. 4 Matt O'Connor, \"Texans Drilling New Well at USG,\" Chicago Tribune , October 11, 1987, p. 1. 5 USG Corporation, 1987 Annual Report, p. 29. 3 297-052 USG Corporation As the leading company in the industry, USG was not immune to the takeover activity. In November 1986, three Canadian brothers, Samuel, William, and Hyman Belzberg, announced they owned just under 5% of USG's stock. Although the Belzbergs were notorious for taking toe-hold positions in firms and seeking greenmail, they did, on occasion, actually follow through and acquire firms. After initially trying to rebuff the Belzbergs, USG eventually agreed to buy back their 3.1 million shares for $45.00 per share. On the day USG announced this deal, its stock price fell $1.87 to close at $43.00 per share. USG spokesman Paul Collitti said \"We definitely would not call it greenmail . . . USG paid the price that prevailed on the New York Stock Exchange . . . the day the deal was consummated.\"6 The Belzbergs netted over $35 million from the transaction. 7 But the interest in USG did not subside. Analysts agreed that "its steady cash flow, low-cost production lines, and commanding market share deemed it a desirable company."8 According to Lawrence Horan, an analyst at Smith Barney, "It's been one of the most attractive targets on the street."9 On October 5, 1987, an investor group named Desert Partners announced that it controlled 9.83% of the company. USG's stock closed up $3.00 at $54.50 that day even though there had been rumors for weeks that someone was acquiring shares. In response to the announcement, one USG executive publicly stated that USG had no intention of participating in any deal with Desert Partners. Desert Partners, an investment partnership formed by Texas oilmen Jack Brown and Cyril Wagner, was an experienced takeover firm having made several attempted acquisitions over the past few years. After acquiring sizable positions in target firms, they often agreed to sell their shares back to the company for a profit. For example, they made $50 million in December 1986 by selling shares back to Lear Siegler and another $77 million in April 1987 from GenCorp. The group had been acquiring shares since August and intended to gain all, or at least a controlling portion, of USG which they saw as undervalued. They had paid an average of $40.00 dollars per share for their shares and were expected to offer significantly more to acquire USG. Jonathan Goldfarb, an analyst at Merrill Lynch, concluded that based on cash flow, an acquirer might pay a price in the $60's for USG.10 However, three weeks after Desert Partners announced their holdings, the stock market crashed and USG fell to a low of $26.50 per share creating a sizable paper loss for the investors. In response, they quickly shelved any thoughts of a takeover. Over the next several months, USG's stock steadily climbed back to the high $30s. On March 1st, Desert Partners announced a tender offer to purchase up 21.5 million shares at price of $42.00 per share in cash. The offer was contingent on the removal of USG's "poison pill" anti-takeover plan which the board had approved in early 1986. USG closed at $40.13 that day, up $2.75 on a day the S&P 500 was flat. After USG's board announced the tender offer was not in the best interest of the Company and recommended that shareholders not tender their shares, Desert Partners upped the ante by announcing a proxy contest for the upcoming annual meeting. Desert Partners would run a slate of six new directors hoping shareholders would replace the existing ones. Again, USG encouraged shareholders to vote for the existing directors as the election of the opposing slate was not in the Company's best interest. "Management is the most qualified to deliver to shareholders the long term value inherent in the corporation and would at the same time be sensitive to the needs of employees, customers and the communities in which it operates, as well as other corporate constituencies." 11 Exhibit 5 shows USG's stock price over this period. 6 Robert J. Bennett, \"USG Buys Belzbergs' Shares,\" The New York Times , December 4, 1986, p. D1. 7 Cal Mankowski, \"USG Seen by Analysts as Tempting Takeover Target,\" Reuters, October 6, 1987. 8 ibid . 9 ibid . 10 ibid . 11 Anonymous, \"USG Board Announces Recapitalization, Restructuring,\" PR Newswire, May 3, 1988. 4 USG Corporation 297-052 Recapitalization Proposal Given the recent takeover attempts, USG's board debated a number of alternatives. They considered repurchasing additional stock, selling equity to a friendly third party, selling the entire company to a friendly acquirer, and completing a leveraged recapitalization. 12 According to market rumors, U.K.-based BPB Industries was a possible "white knight." Analysts saw it as a possible acquirer because the chairmen sat on each other's boards. After debating each of the options, the board decided to proceed with a leveraged recapitalization and announced the plan on May 2, 1988. They described the plan as \"an alternative to an unsolicited, coercive and inadequate tender offer." 13 It was \"intended to provide...shareholders with a significant distribution of cash and securities and permit them to retain their proportionate long-term equity interest in the Company."14 The next day the stock closed at $44.63, up $3.13. According to the plan, shareholders would receive $37.00 in cash, $5.00 in stated face amount of new 16% junior subordinated pay-in-kind debentures due 2008, and one share in the newly recapitalized company for each existing common share. To finance the deal, USG had to raise approximately $2.5 billion which would come from one of three sources (see Exhibit 6a). Citibank, Bankers Trust, and Chemical Bank would coordinate a group of banks to provide $1.6 billion of bank financing and an additional $200 million of revolving credit if it were needed. These loans would be repaid over the next nine years, with $700 million due in the first two years (see Exhibit 6b). Because many of the loans had variable rates, the banks required USG to lock in fixed rates using swaps, caps, or other instruments for a period of four years for 75% of the principal. In addition, USG planned to issue $600 million of senior subordinated debentures. The debentures would have a 12-year maturity and carry a rate of approximately 14%. Finally, USG would issue $259 million of junior subordinated debentures directly to current shareholders. The junior subordinated debentures were pay-in-kind securities with a rate of 16% and a 20-year maturity. For the first five years, the company could either pay cash or issue additional debentures to cover interest payments. After raising this debt and paying the cash dividend, USG would show a negative book value of $1.57 billion, equal to negative $29.06 per share compared to a positive book value of $13.00 per share in June 1988. Goldman Sachs and Salomon Brothers advised USG on evaluating Desert Partner's tender offer, which they said was inadequate, and in developing the recapitalization plan. In formulating the plan, they relied on financial projections, comparable transactions, and trading multiples, all in the context of the current interest rate environment (see Exhibits 7, 8a, 8b, and 9). Total fees for the deal related to advisory work and debt issuance were expected to be $71.2 million. Besides the financial aspects of the deal, the board also highlighted some of the operating changes associated with the recapitalization. They would install a new performance incentive plan for about 215 senior managers and amend the current benefits and stock option plans. They also proposed selling three subsidiaries (Masonite in the Wood Fiber division, Kinkead in the Other Products division, and Marlite in the Interior Systems division) which was expected to generate $519 million after taxes. Collectively, these subsidiaries had $627 million in sales and generated $56 million in operating profit. As part of this restructuring, the company would discontinue any products and distribution channels that failed to pass certain stricter investment criteria. And finally, they would reduce capital expenditures by up to $100 million per year and operating expenses by $70 million per year. Most of the operating savings would come from layoffs and early retirement. 12 Anonymous, \"USG Will Continue to Explore Alternatives,\" Reuters Financial Service, April 13, 1988. 13 Anonymous, \"USG Has Anti-takeover Restructuring Plan,\" Reuters Financial Service, May 2, 1988. 14 USG Corporation, Prospectus, July 7, 1988. 5 297-052 USG Corporation Some analysts suggested that the proposed recapitalization would burden the company with debt, forcing it to sell profitable business units. 15 Day countered this criticism by saying that "Because each USG company is a market leader, USG is well positioned to manage operations with a more leveraged balance sheet." 16 To bolster his point, USG hired American Appraisal Capital Services, Inc. to review the proposed transaction. Their opinion stated that the fair salable value of the company's assets would exceed the company's stated liabilities, that the company would be able to pay its obligations as they became due, and that the company would not have an unreasonably small capital base to conduct business after the recapitalization.17 Conclusion On May 4th, Desert Partners sent a letter to USG's board proposing a two-tiered transaction in which they would pay $50.00 per share in cash for 72% of the shares, and subordinated pay-inkind debentures and new common stock for the remaining 28% of the shares. Although they proposed this transaction, Desert Partners did not amend its tender offer which meant that its cash offer of $42.00 per share remained the only official offer. Once again, Day emphatically rejected the proposed offer. He said, \"Let us make it clear. The company is not for sale.\"18 At the annual meeting, shareholders voted on the competing board slates. Two weeks later, on May 28, 1988, USG announced its slate of directors had won by a margin of 56% to 41% (with 3% abstaining). Following the proxy contest, there was speculation on what Desert Partners might do next. They had indicated a willingness to increase their bid, but had been rejected by management and had lost the proxy contest. With only one week remaining before Desert Partners' tender offer expired, shareholders had to decide whether to tender their shares or wait and vote for the proposed restructuring at the special meeting in July 8th. 15 Julie Siler, \"USG Claims Victory in Desert Proxy Fight,\" The N ew York Times, May 12, 1988, p. 5. 16 Liz Sly, Chicago Tribune, July 9, 1988, p. 6. 17 USG Corporation, Prospectus, July 7, 1988, p. 16. 18 Anonymous, \"USG Rejects Desert Partners Latest Offer,\" Reuters Financial Service , May 4, 1988. 6 297-052 Exhibit 1 Year Building Industry Statistics U.S. Housing Starts (thousands) Construction Data Residential Expenditures New on Maintenance Residential Repairs, and Construction Improvements Put in Place ($ millions) ($ millions) Gypsum Industry Data New Nonresidential Construction Put in Place ($ millions) U.S. Shipments of Gypsum (billion sq. ft.) U.S. Capacity of Gypsum (billion sq. ft.) Average Price/Ton for Crude Gypsum(FOB mine*) (dollars) 1968 1,507.6 $12,703 $ 34,172 $ 23,811 9.55 n/a n/a 1969 1,466.8 13,534 37,214 27,741 10.28 n/a n/a 1970 1,433.6 14,770 35,863 28,171 9.74 n/a n/a 1971 2,052.2 16,300 48,514 29,307 11.94 n/a n/a 1972 2,356.6 17,498 60,693 32,375 14.37 n/a n/a 1973 2,045.3 18,512 65,085 37,639 15.15 n/a $4.18 1974 1,337.7 21,113 55,967 39,889 12.91 n/a 4.41 1975 1,160.4 25,239 51,581 35,409 10.74 n/a 4.58 1976 1,537.5 29,035 68,273 34,628 13.12 n/a 5.00 1977 1,987.1 31,280 92,004 38,245 15.37 16.50 5.55 1978 2,020.3 37,461 109,838 48,824 16.41 17.00 6.23 1979 1,745.1 42,231 116,444 64,765 16.74 17.50 6.83 1980 1,292.2 46,338 100,381 72,480 14.13 18.25 8.33 1981 1,084.2 46,351 99,241 85,569 13.76 18.67 8.53 1982 1,062.2 45,291 84,676 92,690 13.09 19.14 8.46 1983 1,703.0 49,295 125,521 87,069 16.82 18.50 7.87 1984 1,749.5 69,784 153,849 107,680 18.32 20.00 7.94 1985 1,741.8 80,267 158,474 127,466 19.43 20.87 7.76 1986 1,805.4 91,274 187,148 120,917 20.42 21.63 6.46 1987 1,620.5 94,082 194,656 123,247 20.63 23.37 6.85 Sources: U.S. Census; U.S. Bureau of Mines: Mineral Commodity Summaries (1990); and Datastream. *FOB means free on board. It is the price quoted to load a product on board the transporting vehicle, after which the buyer is responsible for all transportation costs. n/a = not available Average Prime Rate 6.31% 7.96 7.91 5.72 5.25 8.03 10.81 7.86 6.84 6.83 9.06 12.67 15.27 18.87 14.84 10.79 12.04 9.93 8.33 8.21 -7- 297-052 Exhibit 2 USG Corporation USG Corporation Consolidated Statement of Earnings for years ended December 31a ($ thousands except per-share figures) 1987 1986 1985 1984 1983 Net sales Cost of products sold $2,898,063 2,114,424 $2,723,664 1,884,596 $2,333,387 1,641,009 $2,318,628 1,712,936 $1,611,071 1,264,569 Gross profit Expenses and other income: Selling and administration expenses Restructuring and early retirement expenses Interest expense Interest income Gain on offering of subsidiary stock Other expense (income), net $ 783,639 $ 839,068 $ 692,378 $ 605,692 $ 346,502 344,410 310,874 251,164 239,644 185,581 53,564 70,257 (6,510) 34,850 (6,949) 27,804 (9,447) 26,475 (7,947) 11,117 (7,392) (43,988) (1,854) 2,534 (3,833) (2,265) 10,152 Earnings from continuing operations before taxes on income Taxes on income Earnings from continuing operations Discounted operations: Operating loss, net of taxes Loss on divestiture, net of taxes Net earnings Earnings (Loss) per common share: Continuing operations Discounted operations Net $ 367,760 163,471 $ 497,759 242,329 $ 426,690 201,443 $ 349,785 163,229 $ 147,044 66,721 204,289 255,430 225,247 - - (3,254) (1,450) - - - (26,668) - - $ 80,323 $ 204,289 $ 225,508 $ 223,797 $ 186,556 $ $ $ $ 3.96 3.96 $ Average # of common shares outstanding (millions) Closing stock price (12/31) Dividends per common share Book value per share - 51.6 $ $ $ 29.13 1.12 11.76 Number of employees 22,200 Equity Beta b 1.37 Source: $ 4.01 (0.47) 3.54 $ 63.6 $ $ $ 37.75 1.04 11.06 21,700 3.38 (0.02) 3.36 66.6 $ $ $ 25.31 0.84 15.08 20,100 USG Corporation Annual Reports aStatement of earnings has been restated to reflect acquisitions and divestitures. bThe beta was estimated using daily data from August 1987 to May 1988. 8 $ 2.82 0.12 2.94 $ $ 66.0 $ $ $ 14.85 0.70 12.87 18,000 1.19 0.01 1.20 66.9 $ $ $ 14.81 0.61 10.97 14,000 USG Corporation Exhibit 3 297-052 USG Corporation Consolidated Balance Sheet (as of December 31) ($ thousands, except per-share figures) 1987 Assets Current assets: Cash (primarily time deposits) Marketable securities, at cost which approximates market value Receivables (net of reserves) Inventories Net assets of discontinued operations Total current assets Property, plant and equipment, net Purchased goodwill Other assets Total assets 1986 $ 31,251 13,417 348,686 215,943 $ 609,297 1,190,470 250,121 44,866 $ 92,370 8,136 324,646 194,574 66,821 $ 686,547 1,104,691 168,021 46,809 $2,094,754 $2,006,068 Liabilities and Stockholder's Equity Current liabilities: Accounts payable Commercial paper and notes payable Accrued expenses: Payrolls Taxes and other than taxes on income Restructuring Other Long-term debt maturing within one year Taxes on income Total current liabilities Long-term debt Deferred income taxes Other obligations $ 166,063 39,049 $ 121,222 246,688 37,187 21,639 47,799 118,976 39,020 18,384 $ 488,097 745,957 221,700 $ 29,167 35,310 14,872 115,070 41,496 42,395 $ 617,053 571,199 216,600 $ 16,601 Stockholder's Equity: Preferred Stock Common Stock Capital received in excess of per value Deferred currency translation Reinvested earnings Total stockholders' equity 68 206,530 5,410 (9,077) 406,902 $ 609,833 129 209,738 (23,263) 398,011 $ 584,615 $2,094,754 $2,006,068 Total liabilities and stockholders' Source: USG Corporation Annual Reports 9 297-052 Exhibit 4 USG Corporation USG CorporationIndustry Segments ($ thousands) 1987 1986 1985 1984 Gypsum Net sales Operating profit Identifiable assets Depreciation and depletion Capital expenditures $1,475,908 317,428 875,732 47,394 93,475 $1,489,537 453,592 816,605 45,949 118,939 $1,380,703 403,761 751,568 42,905 90,050 $1,139,212 339,983 617,392 35,892 58,910 Interior Systems Net sales Operating profit Identifiable assets Depreciation and depletion Capital expenditures 576,860 71,300 394,254 14,286 33,634 479,445 67,275 357,448 10,632 23,864 212,550 41,325 122,795 4,889 24,897 148,115 22,925 90,534 3,375 6,069 Wood Fiber Net sales Operating profit Identifiable assets Depreciation and depletion Capital expenditures 530,242 51,958 456,537 22,243 29,358 497,584 39,854 426,019 19,797 33,450 466,169 20,226 418,189 18,251 22,105 339,414 13,340 424,214 11,816 20,849 Other Products Net sales Operating profit Identifiable assets Depreciation and depletion Capital expenditures 315,053 25,965 102,047 8,662 19,147 257,093 19,757 159,437 7,815 14,883 273,965 21,497 160,861 6,428 11,756 247,190 (7,312) 155,639 7,427 17,877 Source: USG Corporation Annual Reports 10 297-052 Exhibit 5 USG Corporation Stock Price versus S&P Indices: January 1983 to May 1988 USG announces proposed recap $60 Desert Partners announces 9.8% stake $50 $40 Robert Day becomes CEO $30 $20 Belzberg's begin buying stock $10 Desert Partners offers $42/share $0 Jan-83 Jul-83 Jan-84 Jul-84 Jan-85 Jul-85 Jan-86 Jul-86 Jan-87 Jul-87 Jan-88 USG Corp. S&P 500 Index S&P Building Products Index -11- 297-052 Exhibit 6a USG Corporation Sources and Uses of Funds for USG Corporation's Proposed Recapitalization (In Millions) Uses of Funds Cash payments to holders of outstanding commons shares Junior debentures Repayment of existing short-term and long-term debt Cancellation of stock options Estimated fees and expenses Cash (increase firm's cash balances) Total uses $1,924.0 259.8 177.7 17.0 71.2 10.1 $2,459.8 Sources of Funds Term loans (bank debt) Senior subordinated debentures Junior debentures Total sources $2,459.8 Source: USG Corporation, Prospectus dated July 7, 1988. Exhibit 6b Schedule of Term Loan Repayments Year Annual Amortization (millions) 1988 1989 1990 1991 1992 1993 1994 1995 1996 $ 100 600 165 60 155 150 125 155 90 Total $1,600 Source: USG Corporation, Prospectus dated July 7, 1988. 12 $1,600.0 600.0 259.8 USG Corporation Exhibit 7 297-052 Projected Financial Data (in millions) Years Ended December 31 At Closing 1988 1989 1990 1991 1992 $2,098 $2,179 $2,335 $2,433 $2,548 $ 312 (196) 116 (49) (9) 56 22 $ 136 $ $ 479 (276) 203 (84) (8) $ 111 $ 507 (265) 242 (100) (9) $ 133 $ 545 (260) 285 (116) (9) $ 160 $ 80 84 25 189 (104) 519 22 (21) 29 $ 62 79 19 160 (68) 14 47 (18) (5) $ 111 74 23 208 (58) 1 55 (20) (11) $ 133 71 14 218 (89) 1 64 (22) (6) $ 160 72 17 249 (121) 1 74 (22) (21) $ 634 $ 130 $ 175 $ $ 995 $ 975 $ 967 $1,000 $1,075 $1,600 674 600 260 $3,134 $1,014 608 550 281 $2,453 $890 602 550 328 $2,370 $724 593 550 383 $2,250 $666 485 550 447 $2,148 $513 478 550 521 $2,062 ($1,567) ($1,458) ($1,395) ($1,283) ($1,148) $ (987) EARNINGS STATEMENT DATA: Net sales Earnings before interest expense and taxes Interest expense, neta Earnings before taxes Taxes on income b Minority interest, net of tax Gain on asset sales, net of taxc Net income from divested operations d Net earnings CASH FLOW DATA: Net earnings from continuing operations Depreciation and amortization Deferred taxes and other Cash provided by continuing operations Capital expenditures Proceeds from asset sales, net of tax Junior debenture interest expensee Unrepatriated cash of foreign subsidiaries Other changesf Cash available to service principal repayments BALANCE SHEET DATA: Net assets Total debt: g Senior bank debt Existing debt Senior subordinated debentures Junior debenturese Total long-term debt Stockholders' equity (deficit) 405 (282) 123 (53) (8) $ 62 166 $ 160 Source: USG Corporation, Prospectus dated July 7, 1988. aNet of interest income. The average interest rates on the Credit Facility, Senior Subordinated Debentures, Junior Debentures, and existing debt retained are assumed to be 10.50%, 14.00%, 16.00%, and 8.25%. bAssuming a statutory U.S. Federal income tax rate of 34%, a state income tax rate of 6.5%, and a Canadian income tax rate of 42%. c Management estimates a net after-tax gain on businesses and asset sales of approximately $56m in 1988. dNet income from divested operations reflects the contribution to net earnings by exited businesses until the point of divestiture. eReflects the issuance of additional Junior Debentures resulting from pay-in-kind (non-cash) interest incurred on previously issued Junior Debentures. f Other charges includes primarily changes in net working capital. gIncludes the currently maturing portion of long-term debt in each year. 13 297-052 Exhibit 8a USG Corporation Recent Acquisition Announcements in the Building Products Industry Announcement Date Acquirer Target Saint-Gobain Saint-Gobain Southdown Inc. Florida Rock Kohlberg, Kravis Weyerhauser Wolverine Aluminum Certainteed Corp. Moore McCormack Arundel Corp. Jim Walter Corp. Timberland Ind. 4/11/88 2/26/88 2/23/88 11/24/87 7/17/87 7/9/87 Target Sales (millions) $ 111 $1,160 $ 334 $ 82 $1,720 $ 52 Offer Price to Book Value Offer Price to Earnings per Share 2.9 1.8 1.2 1.9 1.4 1.4 13.2 12.8 13.4 11.6 12.8 12.7 Source: Grimm's Mergerstat Review, M&A Sourcebook, casewriter estimates. Note: Sales are for the latest four quarters; earnings per share are estimates for the current year; and book values are from the last quarter before the announcement. Exhibit 8b Trading Multiples for Building Products Companies as of March 31, 1988 Market Price to Book Value Market Price to Earnings per Share Stock Price Sales (millions) Debt to Total Capital Ratio USG Corporation $38.13 $2,920 57% 3.1 12.4 Ameron International Armstrong World Ind. Butler Manufacturing Florida Rock Industries Masco Corp. Ply-Gem Industries Southdown, Inc. $31.63 $34.25 $32.50 $27.63 $26.38 $13.88 $41.50 $ 316 $2,453 $ 635 $ 323 $2,282 $ 332 $ 339 19% 17% 22% 43% 41% 45% 48% 1.0 1.8 1.3 2.0 2.5 1.7 1.4 12.2 10.2 15.7 13.1 11.6 11.6 10.4 Company Source: Compustat Note: Sales and earnings per share are for the latest four quarter. Debt to total capital ratios and book values are from March 31, 1988. 14 USG Corporation Exhibit 9 297-052 Selected Financial Market Data June 24, 1988 Yields on U.S. Treasury Bills, Notes, and Bonds 1 month 6 month 1 - year 2 - year 5 - year 10 - year 30 - year Yields on Long-term Corporate Bonds Aaa Aa A Baa Interest Rates 3 month LIBOR 6 month LIBOR 3 month CD Prime Rate Source: 6.50% 6.78 7.53 8.08 8.52 8.94 8.98 9.79% 10.08 10.37 10.97 7.88% 8.00 7.55 9.00 Federal Reserve Bulletin 15 USG Corporation Executive Summary USG Corporation has been very successful and it innovative nature has led it to achieve a differentiating position in the market, meanwhile, lower cost production and steady cash flows have made it a market leader in the building products industry. Meanwhile, the new CEO has implemented the restructuring plan which has also enhanced the share price of USG but this plan was not started due to the falling performance, but this plan was aimed to achieve continuous improved performance and to encourage the subsidiaries for identifying opportunities contributing toward the achievement of strategic objectives of shareholder value maximization. However, USG Corporation share price do not refelect the actual value of the organization and is undervalued, hence, the under valued share price has attracted the potential acquirer to submit their bid for purchase of USG operations at low price but since the management of USG is aware that the share price of USG Corporation is undervalued therefore, they are considereing a recapitalization plan and have devised different alternatives for implementing the recapitalization plan in order to boost the share price of company and enhance the overall performance of the company so that the potential acquisition can be avoided. Meanwhile the proposal of Desert Partners has also been evaluated using the adjusted present value technique and multiplier technique in order to arrive at the actual and reasonable equity value of USG Corporation. However, based on the analysis of the alternatives the management of USG Corporation has been recommended not to accept the tender offer of Desert Partners for $42 cash per share of USG, meanwhile, the non acceptance of their share price would build pressure on Desert Partners and would strengthen the negotiation position of USG so that Desert Partners submit a solicited offer of $50 cash per share of USG Corporation. Problem Statement The shareholders of USG Corporation are in a dilemma where they have to decide whether to vote in favor of reconstruction plan or in favor of acceptance of the tender offer from Desert Partners for the purchase of USG Corporation. Critical Evaluation USG Corporation has been performing very well since its inception and it had gained a competitive position in the building product market. USG had been an innovative and growing organization and it had acquired several organizations in order to meet its expansion targets. However, USG Corporation became an attractive takeover target, particularly because of its low share prices, which was not reflected its current market value of USG Corporation; hence, the undervalued share price of USG Corporation made it an attractive takeover target. Therefore, in order to come out of this dilemma where the organization is about to be acquired by Desert Partners tender offer the management of USG Corporation has initiated a capital and operational reconstruction program which will not only overcome the financing needs of USG but also it will enable the management to cope with the tender offer received from Desert Partners. Robert has implemented the restructuring plan initiated by the former CEO of USG Corporation and over the vacant of former CEO Robert Day took the responsibility for implementation of a restructuring plan. However, a restructuring plan was aimed to maintain the decentralized program in the long run at the organizational level, meanwhile; the plan was aimed to encourage subsidiaries for the identification and utilization of opportunities within their respective markets. Robert Day performed very well in this role and he achieved some remarkable goals during the restructuring program such as his implemented a plan saved $23 million annual cost savings during the year 1988. In addition to this the restructuring plan helped the stock price not only outperform the benchmark S&P 500 but also the S&P of building an industry index. Further, the repurchase of 20% stock during the year 1987 showed the company is performing very well and with the efforts of new CEO USG were able to achieve a return on equity percentage of 34% which was doubled than the return on equity earned by comparable building products companies. Additionally, the dividends had been increased by 87%, which was the result of Day's efforts as a new CEO of USG; meanwhile, the market share of building products was increased by 11% during the period from 1985 to 1987. However, all these achievements show that the new had performed very well in the capacity of new CEO. The Solomon brothers have had a practice of acquiring a substantial amount of shares in targeted companies and then blackmailing them for acquisition in order to get a high price of their holding in the target company. Similarly, they acquired a substantial amount of holding in USG Corporation and afterward they blackmailed USG for potential acquisition hence USG Corporation had to buy back their share from Solomon Brothers at a price of $45 per share which leads to the fall in its price by $1.87 per share. However, this is not a legal and ethical practice; therefore, there the maximum limit of holding shares in particular organization so that the potential acquirers are identified in advance. Meanwhile, American Appraisal Capital suggested that the leveraged recapitalization would not harm the future position of USG because it has assets in excess of its liability therefore; it can easily pay off its liabilities and interest when they fall due. Analyze USG Corporation has been well performing and it has achieved its growth because of its consistent cash flows, low production cost and a greater market share of the building product's market share. However, the USG's stock price is undervalued and do not represent the fair market value of its operations and this is the reason why USG has become an acquisition target therefore, in order to protect the shareholders interest Day should try to maximize the shareholder value. Meanwhile, the prime objective of the investment by the shareholder is gaining the highest return on their investment and if the offer price is good enough and pays the highest possible return on the invested funds of shareholder than the tender price must be accepted in the best interest of shareholders, but, since it does not pay the fair price of USG business operations, therefore, Day should reject the current tender price. This action of Day will empower the bargaining power of USG for the increase in tender price. However, Desert Partners have shown their willingness to increase the price to $50 per share, which would be a more suitable case in comparison to the restructuring plan but still the official tender has not been revised. In addition to this the USG's board of directors has devised a practical reconstruction plan which is focused on leveraged recapitalization and would pay the shareholders with $37 per share and $5 per share paid in kind, debenture and subordinated bonds. At the end, Day should be more inclined to adopt an alternate who would maximize the shareholder wealth. The USG board is considering a proposed recapitalization plan and for this purpose they are considering four alternatives through which a capitalization process would be completed. The proposed alternative is that the USG should repurchase their ordinary stock, sale of USG equity shares to a friendly third party, sell the entire USG operations to a friendly acquirer and opting for a leveraged recapitalization. However, opting into the leveraged recapitalization would expose USG operations to financial risk because its debt to equity ratio has already crossed the alarming level and leverage recapitalization would further deteriorate its gearing ratio which will lead the selling of profitable business. However, since the USG's gearing ratio is already very much high and its debt to equity ratio is 1.22 that has exposed USG to the risk of not meeting the interest and principle repayments when they fall due, therefore, the leveraged recapitalization does not seem to be a good option hence USG should not opt for a leveraged recapitalization plan. Further, the valuation of USG operations using its future projected cash flows has also been calculated, but this valuation is subject to some assumption that are inherent in the valuation model used and in order to arrive at the valuation of USG adjusted present value model has been used, this model uses the future projected cash flows over the life of the project and then discounts them using the cost of equity of the company which is USG Corporation. Meanwhile, since the business is a going concern, therefore, the valuation of business should include cash flows till infinity hence a terminal value has been calculated using the assumed growth rate of 3% till infinity. Additionally, the cash flows are discounted using the cost equity assuming that there is no debt and the cost of equity is un-levered and in the next step effects using the debt are incorporated into the present value calculated above in order to arrive at the adjusted present value of USG Corporation. However, based on the calculation performed the adjusted present value of USG equity capital has been arrived at $4,546/million. On the other hand USG's valuation has also been calculated using the multiplier approach and for this purpose price to earnings multiplier has been used, however, the price to earnings multiplier gives the value of $32.68/- per share during the year 1988. Meanwhile the comparison of valuation reached through adjusted present value and multiplier gives different valuation and the reason is that APV uses the future cash flows over the life of the project, whereas the multiplier valuation uses only one year results and the multiplier is also based on the past data. Recommendation Based on the analysis of alternates available to USG Corporation, it is clear that both the options are feasible and can be persuaded, but they both need amendments to be made before they can be finally implemented if approved by the shareholders. The first alternate is to accept the offer of $42 per share in the form of cash by Desert Partners but based on the evaluation of USG's project operations and its projected cash flows it can be analyzed that the real value of USG operations are worth more than the tender offer of $42 offered by Desert Partners. Meanwhile the valuation adjusted present value method used to calculate the market value of USG equity reveals USG's shares are highly undervalued hence the offer price of Deset Partners should not be accepted at current level, however, as Desert Partners are willing to increase their offer to $50 per share in this case their price should be accepted but subject to that fact that they also submit their solicited tender offer for this price. On the other hand the leveraged recapitalization plan would not be a suitable option because it will lead to high gearing and the USG is already highly geared and raising more finance would mean that organization's survival is being put at stake, hence USG would be recommended to negotiate with Deser Partners for the submission of soliciting a tender offer for $50 before their offer is accepted. Specific Recommendations Supported by logics Appendix Adjusted Present Value (APV) Year 0 Discount Factor Year 1 Year 2 Year 3 Year 4 1.00 0.75 0.56 0.42 0.31 Free Cash Flow EBIT Less: Taxes EBIAT Plus: D&A Less: Capex Less: Change in NWC FCF TV of FCF Sum of FCF + TV PV of FCF + TV Sum of PV of FCF + TV $788 (276) $2,334 (817) $1,933 (676) $1,991 (697) $2,050 (718) $512 $1,517 $1,256 $1,294 $1,333 2,014 (1,873) (932) 2,123 (481) (550) 2,219 (499) (563) 2,302 (526) (573) 2,398 (552) (581) ($279) $2,609 $2,413 $2,497 $2,598 8,631 ($279) $2,609 $2,413 $2,497 $11,229 ($279) $1,947 $1,344 $1,038 $3,483 $7,533 Interest Tax Shields Interest Expense $316 $124 $25 $0 $0 Total ITS Used TV of ITS Sum of ITS Used + TV ITS $111 $43 $9 $0 $0 $111 $43 $9 $0 $0 $111 $32 $5 $0 $0 PV of ITS Used + TV ITS Sum of PV of ITS Used + TV ITS Adjusted Present Value Less Long Term Debt Equity Value Number of Shares Outstanding Per Share Value Price to Earnings Multiples 0 $148 $7,680 3,134 $4,546 51.6 $88.11 Year Outstanding Shares EPS Price to Earnings Multiplier P/E Ratio Stock Price per Share 1988 51.60 2.64 1989 51.60 1.20 1990 51.60 2.15 1991 51.60 2.58 1992 51.60 3.10 12.40 32.68 12.40 14.90 12.40 26.67 12.40 31.96 12.40 38.45