Ranging on the wall of Rick Fleming’s office at USG Corp. headquarters in Chicago is a mock cover of this year’s annual report. The bold display type features three large B’s and proudly boasts, “Triple B: Big, Bad, and Back.” Although the $2.9 billion building- materials giant ultimately chose a more- traditional design, Fleming was eager to keep the rejected motif.
After all, as CFO, he was the architect of the company’s return from insolvency to investment- grade status. That milestone was finally achieved last December when Standard & Poor’s Corp. raised its ratings on USG’s senior notes, debentures, and corporate credit from BB+ to BBB. “The outlook is now stable,” wrote S&P analyst Wesley E. Chinn. (As expected, Moody’s Investors Service awarded USG an investment-grade rating of Baa3 in March.)
For USG, the upgrade marked the end of a tortuous, 10-year journey that saw it first take on $2.5 billion in debt to rebuff a hostile takeover, then execute the largest consensual debt restructuring ever, to avoid full-fledged bankruptcy proceedings. In the process, USG went from a company that was virtually debt-free to one overburdened by leverage to one that now has the financial flexibility to invest in the future.
The key to remodeling USG’s balance sheet was an aggressive formula for using free cash flow to both reduce debt and spend on capital improvements to its core wallboard and ceiling- tile businesses. In addition, the company chose not to be shy about its goals. It declared it would reach a debt level of $650 million and investment-grade status five years after its major reorganization.
As for Fleming, who is neither flashy nor imposing, driving USG back to investment grade was such an overriding ambition that the goal was literally tattooed on his Oldsmobile Aurora. In 1995, after a successful debt refinancing that marked a major step on the road to recovery, his staff gave him a present of vanity license plates that read “USGBBB.” “We were so visible about our target that we had to hit it,” Fleming says.
Hell-bent and Hyper-leveraged
USG’s troubles date back to 1988, when two Texas corporate raiders made a play for a controlling interest at $42 per share. In response, USG’s board of directors proposed a leveraged recapitalization that would pay a cash dividend of $37 per share, $5 per share in the form of a payment-in-kind debenture and stub stock. Although the package was worth less than the raiders’, shareholders stuck with the current management.
That decision saddled the company with more than $3 billion in debt and interest expenses that amounted to $1 million a day. Overnight, USG became known on Wall Street as the “hyperleveraged wallboard company.” To make matters worse, USG was hit hard by the worst housing market since World War II. In 1990, it posted its first loss in its 88-year history. And as key competitors declared bankruptcy, USG faced that possibility, too. That possibility became a probability as the recession unfolded in 1990 and the price of wallboard, USG’s primary product, started to plummet. Projections for managing the debt load put the price at $97; in reality, it dropped to $79. The difference represented some $126 million less in pretax profits, and USG was running out of cash flow to cover its interest payments. Late in the year, though it had not yet violated its bank covenants, USG pulled down all its lines of credit and switched its lockboxes to noncredit banks. Sensing insolvency, it made a preemptive move to create a war chest of cash and prevent its lenders from seizing deposits.
In the midst of this growing crisis, Fleming got the promotion he had wanted–to treasurer of USG–and found himself center stage. In December 1990, his first official act in that position was to give a talk to representatives of 80 banks. His message: The company was going to default on a $150 million payment due at the end of the month. He and CFO J. Bradford James (now CFO of IMG Global) further explained that USG wanted to negotiate a debt restructuring out of bankruptcy court.
“The business had fallen off, but we had not yet altered our credit agreements,” says Cynthia Berkshire, a former managing director of Chase Securities, one of USG’s lead banks. “They defaulted six months earlier than we thought they would.” As expected, the company was immediately cut off from all credit and had to make its cash horde last until an agreement was reached.
Like USG, its creditors feared the consequences of full-fledged bankruptcy for one simple reason: the company’s asbestos liability. That value would have to be quantified in court, and creditors’ resources would be allocated as part of any settlement. “Out-of-court was best for all parties,” Fleming says, “and it allowed us to forge a consensus that stood the test of time.” Little did he and the USG team realize that it would take two years to put together a plan.
During what became known inside USG as the “dark days,” Fleming, James, and then- chairman Gene Connolly ran a crisis management team that shuttled between three agent banks, seven steering committee banks, and 70 syndicate banks; a senior debt group of five major issuers and four large holders; and two bondholder committees, with four advisers each.
Trade creditors proved to be just as unwieldy. Fleming had to fight off numerous requests for cash-only payments, and had to explain the debt restructuring plan to numerous vendors, including AT&T, IBM, and Owens-Corning. Over one weekend, he even talked to officials at Shell Oil Co., after it had begun to seize the credit cards of USG’s sales force, and persuaded them to stick with the company. Ultimately, all this work paid off. The vendors supported USG, and none ever lost a penny due to the debt restructuring.
The crisis team was also direct with USG’s 13,000 employees, who held about 25 percent of the outstanding stock. Workers were told that their equity would be diluted to almost nothing as part of any deal, and that one- quarter would lose their jobs. However, USG did not freeze salaries and, according to Fleming, the remaining employees took comfort in the notion that USG had a broken balance sheet, not a broken business model.
Negotiations almost blew up on numerous occasions, as each capital class pushed for the best deal possible. But USG was insistent that each group had to take a haircut, based on priority, and that everybody within each group had to be treated equally. And the company held the trump card: haggling in bankruptcy court, it often warned, would unleash the asbestos genie. “There was a real temptation to fix a little bit of the balance sheet and hope everything would get better,” observes Fleming. “We wanted to avoid a Band- Aid solution.”
By April 1993, the parties had reached an out- of-court agreement that required amending bank terms, rescheduling the senior debt, and exchanging $1.4 billion of subordinated debt for 97 percent of the common equity. The result was that USG was able to execute a prepackaged Chapter 11 bankruptcy in near- record time, sailing through court in just 37 days.
Financial Laser Surgery
To avoid “going to Disney World,” as Fleming describes the pitfall of celebrating too soon, he moved immediately to develop a strategy for cleaning up USG’s balance sheet. The company had reduced its debt burden from more than $3 billion to $1.6 billion, but it was still highly leveraged, had almost no net worth, and carried an all-debt capital structure. In addition, because of fresh-start accounting rules, the company was faced with recording a reorganization charge of $851 million that would be amortized over five years. (USG chose five years so that the annual noncash charge would be completed by 1998.)
Just days after the debt restructuring plan was approved, on May 6, 1993, Fleming announced that USG would lower its debt to $650 million and return to investment-grade status by May 1998. It was an ambitious goal, but Fleming had a plan. He wanted to pay down debt quickly to prove to bondholders that the company would honor its postrestructuring obligations, as well as improve its access to the debt and equity markets. But he also recognized the importance of investing in growth to increase earnings for shareholders. New bank covenants on debt/EBITDA (earnings before interest, taxes, debt, and amortization) and interest coverage gave USG some latitude for balancing debt repayment and capital spending, and Fleming devised a simple formula that linked the allocation of free cash flow to the company’s credit rating.
As long as USG was rated B, he explained, it would use 75 percent of its free cash flow to retire debt and 25 percent for capital spending to grow the business. When it reached a BB rating, it would use half for debt repayments and half for capital expenditures. And once USG achieved investment grade and its target debt level, 75 percent of free cash flow would be used to expand and improve operations, with the remaining 25 percent available to fine-tune the balance sheet, including a possible dividend and stock buyback.
“USG is the poster child for the near-death, born-again deleveragers,” says Jerry Paul, a high-yield portfolio manager for Invesco Funds in Denver. “Lots of companies claim they want to be investment grade, but the strategy breaks down. USG clearly articulated how it was going to do it, and it adhered to its plan.”
Coming out of the restructuring, USG had annual debt of about $150 million that matured in 1994, 1995, and 1996. In August 1993, the company was able to clear away all of its capitalized interest and push back those maturities by exchanging $139 million of near- term bank debt for 10.25 percent bonds due in 2002. The new bonds had a belt-bolt maturity, which allowed the banks to list and sell them, and the conversion effort was fully subscribed. A later $18 million sale/leaseback of USG’s research facility raised additional cash.
In January 1994, Fleming was promoted to CFO. One of his first official acts was to take USG back to the capital markets. That March, having demonstrated its commitment to debt reduction and enjoying a surge in its stock price from $12 per share to $30, USG completed a $533 million refinancing. The plan included a new equity offering of 7.9 million shares and new 9.25 percent senior notes, due in 2001. The bulk of the proceeds were used to pay off most of the debt due before December 1999.
The Final Touches
The last major financing piece of the drive to investment grade was put in place in July 1995. That’s when USG resyndicated its bank loan, a new $500 million credit facility with an unusual seven-year maturity, and issued new bonds to eliminate maturities through 2001. Selling $150 million of new 8.5 percent senior notes, due in 2005, the company redeemed the remaining $268 million of 10.25 percent senior notes, due in 2002. Snapped up by investors, the offering was described by the Wall Street Journal as a “crossover credit,” in which a junk or high-yield bond is viewed by buyers as rising to investment grade.
“We were accorded a better set of economics [than our ratings suggest],” argues Fleming. Jerry Paul of Invesco, which still holds a large chunk of the 8.5 percent bonds, concurs. “They were already getting credit for improving the balance sheet,” he says. “The debt cost less than it would have for a similarly rated company. We considered it an investment-grade issue.”
Following a credit upgrade by S&P to BB in 1995, USG was positioned to put more funds into improving operations; Fleming was put in charge of strategic planning; and the investment community began to take notice. While the company had no analyst coverage when it emerged from bankruptcy, it had enough at that time for Fleming to hold quarterly earnings conference calls, and an uptick in the housing market and in wallboard prices contributed to an increase in EBITDA to $417 million in 1995, from $218 million in 1993.
As far as Fleming was concerned, it was only a matter of time before USG would be bumped to investment-grade status. What finally did the trick was the elimination of its fresh-start accounting obligation in September 1997, seven months before the end of the five-year amortization period. Although the $170 million annual charge from the 1993 restructuring had no effect on cash flow, it rippled through the P&L. USG didn’t show a profit until 1996, when it earned a mere $15 million, and its shareholder’s equity showed deficit balances until 1997.
Then, on December 9, 1997, Fleming got the word that S&P had upgraded USG’s credit rating to BBB. There were some celebratory lunches, and CEO William Foote gave Fleming a clock engraved with the date on which USG reached investment grade.
Perhaps Fleming’s low-key attitude is fitting, given that, in his estimation, USG has more work to do to rebuild the equity value of the company. In five years, the company paid off some $936 million in debt, cut its annual interest expense from $334 million to $60 million, spent more than $530 million on capital projects, and saw its shareholder’s equity grow to $342 million (as of June 30). As recently as March, USG’s stock price reached a 10-year high of $56 per share, but with a PE of 8, it trades at a 50 percent discount to its peers.
For the fourth quarter of 1997 and the first three quarters of 1998, USG had shown substantial increases in earnings, in the range of 200 percent each quarter, thanks to the end of the fresh-start accounting charge. But by the fourth quarter of this year, the year-over-year change will reflect a comparison of apples and apples, and Fleming believes that the visibility of USG’s earnings potential will improve.
In addition, Fleming has been working aggressively to broaden USG’s shareholder base by courting brokerage houses, fund managers, and security analysts outside New York and Boston. “Our mission has gone from repairing the balance sheet to enhancing the P/E ratio,” Fleming notes. He has yet, however, to get vanity license plates that read “USG PE12.”