Monday, July 17, 2006

Is the Tail Wagging the Dog?

USG has emerged from Chapter 11 bankruptcy in part through the issuance of rights that will recapitalize the company. Shareholders received one right to buy a share at $40 for each share they owned on July 3. The rights expire at the end of July. The new capital will help USG fund a trust that will eliminate any asbestos liability. Then why has the stock fallen off of the cliff, given that:

1. USG had been able to accumulate over $1 billion in retained earnings through bankruptcy;

2. The asbestos litigation and bankruptcy proceeding are soon to be in its past; and

3. Management will be able to focus on its operations while having the incentive of equity compensation;

The stock peaked at $94.64 (rights-adjusted) three months after the bankruptcy plan was approved (on 1/30/06); creditors will be repaid in full with accrued interest. It is now trading at $46.95 and, combined with the rights, at $53.94 for a 43% drop. The only fundamental news affecting it are a housing construction slowdown, but that slowdown had already been priced into other housing related stocks long before USG peaked on April 26 and it had been priced into USG's, too. USG is currently trading at approximately six-times this year's "normalized" earnings (minus bankruptcy and asbestos expenses which have already been charged) and its competitors trade at around thirteen-times earnings. Besides, housing only accounts for about half of USG's business.

Perhaps more importantly, why has the stock dropped 17.5% (rights adjusted) since the rights were issued? One theory is that the tail is wagging the dog. Investors looking to shed some housing exposure--or at least unwilling to pay another $40 per share to take on more housing exposure--may be selling the rights at approximately the difference between the stock price and the $40 strike (the "Gap"). An excess supply of rights could force the price of the rights to drop below the Gap, which creates an arbitrage opportunity for someone willing to sell the stock and buy the rights.

That selling of stock for technical reasons--not fundamental ones--results in a drop in stock price and a downward spiral, which should disappear once the rights expire. That should create an opportunity to own the shares at a low price. When investors refocus on fundamentals, the price should go back up.