The battle of the billionaires

By Michael Brush

You don't become a billionaire by making a lot of bad bets. But two of the world's richest men are now on opposite sides of a wager that may see one of them lose a fair chunk of change.

The two men: Warren Buffett, whose mastery of value investing has helped him accumulate more than $40 billion, and Carl Icahn, the corporate raider who has earned more than $8 billion with astute and aggressive stock plays.

They are now taking sides over the fate of USG Corp. (USG, news, msgs), the leading gypsum wallboard maker, which just emerged from bankruptcy protection. Which investor turns out to be right will depend in large part on the ultimate health of the U.S. housing market.

Icahn appears to have made money on the stock already by holding a short position as USG has fallen 59%, to $49 from $120, since last spring. (Investors short stock by borrowing shares and then selling them, hoping the stock will decline so they can buy it back cheaper to return it later, pocketing the difference.)

Buffett, meanwhile, plowed $148 million into the stock in August, buying 3.2 million shares at an average price of $45.83. He now owns more than 18% of the stock -- $800 million worth.

A boom ends

Icahn made a bundle in corporate raids of companies like TWA and Texaco. But he also specializes in making big bets when he believes there's an obvious a gap between a stock price and a company's true value, as he told a group of investors earlier this year in New York.

Sources familiar with his holdings confirm the swashbuckling Icahn still has a short position in USG despite the recent decline in the stock. (Unlike most investors, short sellers like Icahn don't have to file any details about their positions.)

To a large degree, short-selling USG is short-selling the U.S. housing market. Thanks to strength in that market, USG's earnings in the second quarter doubled from the previous year. But now housing is crumbling, which bears say will create a supply-demand problem that could see this stock fall much further.

Here's the supply part: Wallboard makers such as USG and National Gypsum -- in response to the huge demand of recent years -- will expand their capacity by 20% over the next two years.

And the demand: New housing starts were down 13.3% in July from the prior year. USG bears say that trend will continue because the economy is softening and mortgage rates have gone up. New homes account for about 50% of the demand for wallboard.

So down go wallboard prices. Right now, wallboard makers can command premium prices of $182 per thousand square feet for wallboard. But prices could fall by $80 or more, if the wallboard downturn of 2001 is any guide. That could wipe out USG's profits for a quarter or more, as happened in 2001. And it would certainly wipe out shareholders.

Walled in

Buffett couldn't be reached for comment. But USG is a typical investment for Berkshire Hathaway (BRK.A, news, msgs), the sprawling conglomerate Buffett oversees. It has a $150 billion market capitalization, meaning that small value investments are nearly meaningless to its performance.

So Buffett needs to make big, bold bets on unloved companies. When the rest of the world thinks a company is doomed, there's opportunity for Buffett -- with his long-term outlook -- to make a smart, contrarian investment. Two examples: His recent outsize bet against the U.S. dollar, and his $2 billion investment last year in Anheuser-Busch (BUD, news, msgs).

Analysts who think Buffett's USG gamble is correct say that the housing downturn is so well known that there's not much downside risk left in the stock. "The whole world has figured that out," says CL King & Associates analyst Jim Barrett. "Everyone knows we are at the top of the cycle, and the stock has sold off severely."

By some measures, USG's stock is clearly a value. Analysts like to evaluate economically sensitive companies by comparing enterprise value (EV) to cash flow. (EV is calculated by adding market cap and debt and subtracting cash.) USG trades for an EV that's about 4.4 times its $1.1 billion in cash flow.

Here's how cheap that looks now. Back in the mid-1990s -- when dreaded asbestos liabilities still hung over USG -- the company had an enterprise value of five times cash flow. A wallboard company called BPB was recently taken private for an enterprise value of 8.4 times cash flow.

And capacity may not be all it's cracked up to be, says Barrett. When wallboard companies build new plants, they will also close older, less efficient ones. And much of the capacity is being built on the East Coast, so it won't affect pricing in other regions (wallboard is so heavy it is hard to ship it long distances). And the new plants are coming on line over two years. By the time they're up and running, the housing market could be back on its feet.

Long and short

In theory, both Buffett and Icahn could wind up making money. Icahn could sell now and reap profits and Buffett could hold on for a decade or more and be proved right.

Buffett has the luxury of a track record and time. His investors trust that he knows what he's doing and that they'll ride out any short-term losses. Ultimately, Buffett may buy USG altogether, adding it to his collection of building-materials companies; Berkshire also owns Johns Manville, which sells insulation and roofing products, and Benjamin Moore & Co., which sells paint.

Right now, though, Icahn apparently has a sizable paper profit in USG and is getting the better of Omaha's Oracle, who has held a stake in USG since it was above $100 a share.

At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column.