1 FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1998 ------------------ OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ----------- ----------- Commission File Number 1-8864 USG CORPORATION - ------------------------------------------------------------------------------ (Exact name of registrant as specified in its charter) Delaware 36-3329400 - ------------------------------------------------------------------------------ (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 125 South Franklin Street, Chicago, Illinois 60606-4678 - ------------------------------------------------------------------------------ (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code (312) 606-4000 -------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes X No ----- ----- As of September 30, 1998, 49,686,878 shares of USG common stock were outstanding. 2 TABLE OF CONTENTS Page ------ PART I FINANCIAL STATEMENTS Item 1. Financial Statements: Consolidated Statement of Earnings: Three Months and Nine Months Ended September 30, 1998 and 1997 3 Consolidated Balance Sheet: As of September 30, 1998 and December 31, 1997 4 Consolidated Statement of Cash Flows: Nine Months Ended September 30, 1998 and 1997 5 Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition 12 Report of Independent Public Accountants 23 PART II OTHER INFORMATION Item 1. Legal Proceedings 24 Item 6. Exhibits and Reports on Form 8-K 28 SIGNATURES 29 -2- 3 PART I FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS USG CORPORATION CONSOLIDATED STATEMENT OF EARNINGS (DOLLARS IN MILLIONS EXCEPT PER SHARE DATA) (UNAUDITED) THREE MONTHS NINE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, ----------------------------- ----------------------------- 1998 1997 1998 1997 ------------ ------------ ------------ ------------ Net sales $ 814 $ 757 $ 2,324 $ 2,153 Cost of products sold 581 547 1,674 1,564 ------------ ------------ ------------ ------------ Gross profit 233 210 650 589 Selling and administrative expenses 75 70 221 208 Amortization of excess reorganization value - 43 - 127 ------------ ------------ ------------ ------------ Operating profit 158 97 429 254 Interest expense 13 16 39 49 Interest income (1) (1) (3) (2) Other expense, net - - 3 1 ------------ ------------ ------------ ------------ Earnings before income taxes 146 82 390 206 Income taxes 55 48 150 130 ------------ ------------ ------------ ------------ Net earnings 91 34 240 76 ============ ============ ============ ============ Basic earnings per common share 1.83 0.74 4.95 1.65 Diluted earnings per common share 1.80 0.70 4.78 1.57 Dividends paid per common share - - - - Average common shares 49,679,544 46,390,846 48,457,527 46,152,837 Average diluted common shares 50,534,500 48,910,230 50,157,495 48,513,412 See accompanying Notes to Consolidated Financial Statements. -3- 4 USG CORPORATION CONSOLIDATED BALANCE SHEET (DOLLARS IN MILLIONS) (UNAUDITED) AS OF AS OF SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------- ------------ ASSETS Current Assets: Cash and cash equivalents $ 102 $ 72 Receivables (net of reserves - $19 and $17) 372 297 Inventories 241 208 Current and deferred income taxes 50 63 ------------- ------------- Total current assets 765 640 Property, plant and equipment (net of reserves for depreciation and depletion - $276 and $236) 1,138 982 Other assets 362 304 ------------- ------------- Total Assets 2,265 1,926 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable 176 146 Dividends payable 5 - Accrued expenses 229 220 Debt maturing within one year 11 10 ------------- ------------- Total current liabilities 421 376 Long-term debt 566 610 Deferred income taxes 161 163 Other liabilities 684 630 Stockholders' Equity: Preferred stock - - Common stock 5 5 Capital received in excess of par value 313 258 Deferred currency translation (29) (25) Reinvested earnings (deficit) 144 (91) ------------- ------------- Total stockholders' equity 433 147 ------------- ------------- Total Liabilities and Stockholders' Equity 2,265 1,926 ============= ============= See accompanying Notes to Consolidated Financial Statements. -4- 5 USG CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS (DOLLARS IN MILLIONS) (UNAUDITED) NINE MONTHS ENDED SEPTEMBER 30, ------------------- 1998 1997 ------- -------- OPERATING ACTIVITIES: Net earnings $ 240 $ 76 Adjustments to reconcile net earnings to net cash: Amortization of excess reorganization value - 127 Depreciation, depletion and other amortization 60 51 Current and deferred income taxes 11 2 (Increase) decrease in working capital: Receivables (75) (61) Inventories (33) (11) Payables 35 20 Accrued expenses 9 9 (Increase) decrease in other assets 1 (2) Increase (decrease) in other liabilities (6) 6 Other, net - (2) ------- -------- Net cash from operating activities 242 215 ------- -------- INVESTING ACTIVITIES: Capital expenditures (214) (96) Net proceeds from asset dispositions 2 2 ------- -------- Net cash to investing activities (212) (94) ------- -------- FINANCING ACTIVITIES: Issuance of debt 60 91 Repayment of debt (107) (181) Short-term borrowings (repayments), net 4 (2) Dividends declared (5) - Issuances of common stock 48 13 ------- -------- Net cash to financing activities - (79) ------- -------- Net increase in cash & cash equivalents 30 42 Cash & cash equivalents at beginning of period 72 44 ------- -------- Cash & cash equivalents at end of period 102 86 ======= ======== SUPPLEMENTAL CASH FLOW DISCLOSURES: Interest paid 49 58 Income taxes paid 134 128 See accompanying Notes to Consolidated Financial Statements. -5- 6 USG CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The consolidated financial statements of USG Corporation and its subsidiaries ("USG" or the "Corporation") included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates. In the opinion of management, the statements reflect all adjustments, which are of a normal recurring nature, necessary to present fairly the Corporation's financial position as of September 30, 1998, and December 31, 1997, results of operations for the three months and nine months ended September 30, 1998 and 1997, and cash flows for the nine months ended September 30, 1998 and 1997. Certain amounts in the prior years' financial statements have been reclassified to conform with the 1998 presentation. While these interim financial statements and accompanying notes are unaudited, they have been reviewed by Arthur Andersen LLP, the Corporation's independent public accountants. These financial statements and notes are to be read in conjunction with the financial statements and notes included in the Corporation's 1997 Annual Report on Form 10-K dated February 20, 1998. 2. COMPREHENSIVE INCOME Total comprehensive income, consisting of net earnings and foreign currency translation adjustments, amounted to $93 million and $236 million in the three months and nine months ended September 30, 1998, respectively. For the respective 1997 periods, total comprehensive income amounted to $32 million and $65 million. There was no tax impact on the foreign currency translation adjustments. -6- 7 3. EARNINGS PER SHARE Basic earnings per share were computed by dividing net earnings by the weighted average number of common shares outstanding for the period. The dilutive effect of the potential exercise of outstanding options and warrants to purchase shares of common stock is calculated using the treasury stock method. The reconciliation of basic earnings per share to diluted earnings per share is shown in the following table (dollars in millions except share data). PERIODS ENDED SEPTEMBER 30 1998 1997 ------------------------- --------------------------------- NET SHARES NET SHARES EARNINGS (000) EPS EARNINGS (000) EPS - --------------------------------------------------------------------------------------------- THREE MONTHS: Basic earnings $ 91 49,680 $ 1.83 $ 34 46,391 $ 0.74 Effect of Dilutive Securities: Options 831 940 Warrants 24 1,579 - --------------------------------------------------------------------------------------------- Diluted Earnings 91 50,535 1.80 34 48,910 0.70 ============================================================================================= NINE MONTHS: Basic earnings 240 48,458 4.95 76 46,153 1.65 Effect of Dilutive Securities: Options 897 889 Warrants 802 1,471 - --------------------------------------------------------------------------------------------- Diluted Earnings 240 50,157 4.78 76 48,513 1.57 ============================================================================================= 4. STOCK OPTIONS As of September 30, 1998, common shares totaling 2,089,325 were reserved for future issuance in conjunction with existing stock option grants. In addition, 1,129,145 common shares were reserved for future grants. -7- 8 5. FINANCIAL INSTRUMENTS The Corporation uses derivative instruments to manage well-defined interest rate, energy cost and foreign currency exposures. The Corporation does not use derivative instruments for trading purposes. The criteria used to determine if hedge accounting treatment is appropriate are: (i) the designation of the hedge to an underlying exposure (ii) whether or not overall uncertainty is being reduced and (iii) if there is a correlation between the value of the derivative instrument and the underlying obligation. Interest Rate Derivative Instruments: The Corporation utilizes interest rate swap agreements to manage the impact of interest rate changes on its underlying floating-rate debt. These agreements are designated as hedges and qualify for hedge accounting. Amounts payable or receivable under these swap agreements are accrued as an increase or decrease to interest expense on a current basis. To the extent the underlying floating-rate debt is reduced, the Corporation terminates swap agreements accordingly so as not to be in an overhedged position. In such cases, the Corporation recognizes gains and/or losses in the period the agreement is terminated. Energy Cost Derivative Instruments: The Corporation uses swap agreements to hedge anticipated purchases of fuel to be utilized in the manufacturing processes for gypsum wallboard and ceiling tile. Under these swap agreements, the Corporation receives or makes payments based on the differential between a specified price and the actual closing price for the current month's energy price contract. These contracts are designated as hedges and qualify for hedge accounting. Amounts payable or receivable under these swap agreements are accrued as an increase or decrease to cost of products sold, along with the actual spot energy cost of the corresponding underlying hedge transaction, the combination of which amounts to the predetermined specified contract price. Foreign Currency Derivative Instruments: The Corporation has operations in a number of countries and has intercompany transactions among them and, as a result, is exposed to changes in foreign currency exchange rates. The Corporation manages most of these exposures on a consolidated basis, which allows netting of certain exposures to take advantage of any natural offsets. To the extent the net exposures are hedged, option and forward contracts are used. The foreign currency options qualify for hedge accounting, under which the option premium is amortized over the life of the option. The -8- 9 forward contracts are marked to market on a current basis with gains and/or losses included in net earnings in the period in which the exchange rates change. 6. RECENTLY ISSUED ACCOUNTING STANDARD In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." Statement 133 is effective for fiscal years beginning after June 15, 1999 and cannot be applied retroactively. The Statement establishes accounting and reporting standards requiring that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. The Statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The Corporation currently plans to adopt Statement 133 effective January 1, 2000, and will determine both the method and impact of adoption prior to that date. 7. EXCESS REORGANIZATION VALUE Excess reorganization value, an intangible asset totaling $851 million, was recorded in 1993 in connection with a comprehensive restructuring of the Corporation's debt and the implementation of fresh start accounting as required by AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"). As of September 30, 1997, the remaining $83 million balance of excess reorganization value was eliminated. This balance, which would have been amortized through April 1998, was offset by the elimination of a valuation allowance in accordance with SOP 90-7. See Note 8 below for additional information. 8. INCOME TAXES Income tax expense amounted to $55 million and $150 million in the three months and nine months ended September 30, 1998, respectively. For the respective 1997 periods, income tax expense amounted to $48 million and $130 million. The Corporation's income tax expense in the -9- 10 third quarter and first nine months of 1997 was computed based on pre-tax earnings excluding the noncash amortization of excess reorganization value, which was not deductible for income tax purposes. In the third quarter of 1997, a valuation allowance of $90 million, which had been provided for deferred tax assets relating to pension and retiree medical benefits prior to the Corporation's financial restructuring in 1993, was eliminated. The elimination of this allowance reflected a change in management's judgment regarding the realizability of these assets in future years as a result of the Corporation's pretax earnings levels and improved capital structure over the prior three years. In accordance with SOP 90-7, the benefit realized from the elimination of this allowance was used to reduce the balance of excess reorganization value to zero as of September 30, 1997. 9. LITIGATION One of the Corporation's subsidiaries, United States Gypsum Company ("U.S. Gypsum"), is a defendant in asbestos lawsuits alleging both property damage and personal injury. See Part II, Item 1. "Legal Proceedings" for information concerning the asbestos litigation. The Corporation and certain of its subsidiaries have been notified by state and federal environmental protection agencies of possible involvement as one of numerous "potentially responsible parties" in a number of so-called "Superfund" sites in the United States. The Corporation believes that neither these matters nor any other known governmental proceeding regarding environmental matters will have a material adverse effect upon its earnings or consolidated financial position. See Part II, Item 1. "Legal Proceedings" for additional information on environmental litigation. 10. ACCOUNTS RECEIVABLE FACILITY Under a revolving accounts receivable facility, the trade receivables of U.S. Gypsum and USG Interiors, Inc. are being purchased by USG Funding Corporation ("USG Funding") and transferred to a trust administered by Chase Manhattan Bank as trustee. Certificates representing an ownership interest of up to $130 million in the trust have been issued to an affiliate of Citicorp North America, Inc. USG -10- 11 Funding, a special-purpose subsidiary of USG Corporation, is a separate corporate entity with its own separate creditors that will be entitled to be satisfied out of USG Funding's assets prior to any value in USG Funding becoming available to its shareholder. Receivables and debt outstanding in connection with the receivables facility remain in receivables and long-term debt, respectively, on the Corporation's consolidated balance sheet. -11- 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION RESULTS OF OPERATIONS USG CORPORATION CONSOLIDATED RESULTS NET SALES - Record shipments of all major product lines and higher selling prices for SHEETROCK brand gypsum wallboard resulted in third quarter 1998 net sales of $814 million, a record level for any quarter in USG's history and an 8% increase compared with net sales of $757 million in the third quarter of 1997. For the first nine months of 1998, net sales totaled $2,324 million, an 8% increase compared with net sales of $2,153 million in the comparable 1997 period. GROSS PROFIT MARGIN - Gross profit as a percentage of net sales was 28.6% and 28.0% in the third quarter and first nine months of 1998, respectively, up from 27.7% and 27.4% in the respective 1997 periods. These increases primarily reflect a higher gross profit margin for SHEETROCK wallboard due to higher realized selling prices and lower unit costs. SELLING AND ADMINISTRATIVE EXPENSES - Third quarter and first nine months 1998 selling and administrative expenses increased 7% and 6%, respectively, over the prior-year periods. However, as a percentage of net sales, these expenses were 9.2% in the third quarter and 9.5% in the first nine months of 1998, compared with 9.2% and 9.7 % in the same 1997 periods. Expense dollars are up in 1998 largely due to marketing and information technology initiatives. AMORTIZATION OF EXCESS REORGANIZATION VALUE - The noncash amortization of excess reorganization value reduced operating profit by $43 million and $127 million in the third quarter and first nine months of 1997. As explained in Notes 7 and 8 of this report, the remaining balance of excess reorganization value was eliminated as of September 30, 1997. INTEREST EXPENSE - As a result of debt reduction during the past year, interest expense in the third quarter and first nine months of 1998 decreased 19% and 20%, respectively, from the corresponding 1997 periods. INCOME TAX - Income tax expense amounted to $55 million and $150 million in the three months and nine months ended September 30, 1998, respectively. For the respective 1997 periods, income tax expense amounted to $48 million and $130 million. The Corporation's income tax expense in the 1997 periods was computed based on pre-tax earnings excluding the noncash amortization of excess reorganization value, which was not deductible for income tax purposes. NET EARNINGS - Third quarter 1998 net earnings were $91 million, or $1.80 per diluted share. Third quarter 1997 net earnings, which amounted to $34 million, or $0.70 per diluted share, were net of the noncash amortization of excess reorganization value of $43 million, or $0.87 per diluted share. For the first nine months of 1998, net earnings were $240 million, or $4.78 per diluted share. Comparable 1997 net earnings, which amounted to $76 million, or $1.57 per diluted share, were net of the noncash amortization of excess reorganization value of $127 million, or $2.61 per diluted share. EBITDA - Earnings before interest, taxes, depreciation, depletion, amortization and certain other income and expense items ("EBITDA") amounted to $177 million in the third quarter and $484 million in the first nine months of 1998. Both amounts represent increases of 13% versus the same periods last year. As a result of the amortization of excess reorganization value through September 30, 1997, USG reports EBITDA to facilitate comparisons of current and historical results. EBITDA is also helpful in understanding cash flow generated from operations that is available for taxes, debt service and capital expenditures. EBITDA should not be considered by investors as an alternative to net earnings as an indicator of the Corporation's operating performance or to cash flows as a measure of its overall liquidity. -12- 13 USG CORPORATION CORE BUSINESS RESULTS (DOLLARS IN MILLIONS) NET SALES EBITDA ------------------------------------------------------------------------------ THREE MONTHS NINE MONTHS THREE MONTHS NINE MONTHS ------------------------------------------------------------------------------ Periods ended Sept 30 1998 1997 1998 1997 1998 1997 1998 1997 - ------------------------------------------------------------------------------------------------------ North American Gypsum: U.S. Gypsum Company $ 441 $ 404 $ 1,279 $ 1,170 $ 139 $ 120 $ 388 $ 341 L&W Supply Corporation 293 263 811 734 14 11 31 27 CGC Inc. (gypsum) 37 31 108 92 6 6 18 15 Other subsidiaries 26 25 69 69 8 9 21 22 Eliminations (128) (108) (362) (314) - - - (1) - ------------------------------------------------------------------------------------------------------ Total 669 615 1,905 1,751 167 146 458 404 - ------------------------------------------------------------------------------------------------------ WORLDWIDE CEILINGS: USG Interiors, Inc. 116 114 337 318 18 19 50 49 USG International 67 59 180 172 4 3 11 10 CGC Inc. (ceilings) 9 9 28 25 1 1 3 3 Eliminations (20) (14) (50) (40) - - - - - ------------------------------------------------------------------------------------------------------ Total 172 168 495 475 23 23 64 62 - ------------------------------------------------------------------------------------------------------ Corporate - - - - (13) (13) (38) (36) Eliminations (27) (26) (76) (73) - - - - - ------------------------------------------------------------------------------------------------------ Total USG Corporation 814 757 2,324 2,153 177 156 484 430 ====================================================================================================== NORTH AMERICAN GYPSUM Third quarter 1998 net sales of $669 million and EBITDA of $167 million increased 9% and 14%, respectively, over third quarter 1997 levels. First nine months 1998 net sales of $1,905 million and EBITDA of $458 million increased 9% and 13%, respectively, versus comparable 1997 levels. UNITED STATES GYPSUM COMPANY - U.S. Gypsum's net sales and EBITDA in the third quarter of 1998 were the highest ever for any quarter. Shipments of SHEETROCK brand gypsum wallboard totaled 2.254 billion square feet, a record for any quarter and a 4% increase over third quarter 1997 shipments -13- 14 of 2.168 billion square feet. Selling prices on SHEETROCK wallboard averaged $130.66 per thousand square feet, a record for any quarter and an increase of 6% versus $123.06 for the third quarter of 1997. Manufacturing unit costs for SHEETROCK wallboard were down from the prior-year period largely due to lower furnish prices for wastepaper, the primary raw material of wallboard paper. U.S. Gypsum's wallboard plants continued to operate at 100% capacity during the third quarter. Third quarter shipments of SHEETROCK brand joint compound and DUROCK brand cement board also reached record levels. L&W SUPPLY CORPORATION - Third quarter 1998 net sales and EBITDA for USG's building products distribution business were records for any quarter and were up 11% and 27%, respectively, from a year ago. This sales and EBITDA performance reflects new quarterly highs for wallboard shipments and selling prices and for sales and gross profit of complementary building products. As of September 30, 1998, L&W Supply operated 181 locations in the United States. CGC INC. - The gypsum business of CGC Inc., USG's wholly owned Canadian subsidiary, reported increased sales in the third quarter of 1998 as a result of higher SHEETROCK wallboard volume and prices. However, EBITDA was unchanged versus the third quarter of 1997 due in part to the declining Canadian dollar. WORLDWIDE CEILINGS Third quarter 1998 net sales of $172 million increased 2% over the third quarter of 1997, while EBITDA of $23 million was unchanged. First nine months 1998 net sales of $495 million and EBITDA of $64 million were up 4% and 3%, respectively, from the comparable 1997 levels. Shipments of AURATONE brand and X-Technology ceiling tile and DONN brand ceiling grid products continued at record levels in the third quarter of 1998 due to growing U.S. demand and steady demand in Western Europe and Latin America. Demand in Asia and Eastern Europe slowed during the quarter as worsening economic conditions impacted construction activity in those regions. EBITDA was flat due in part to higher costs associated with product enhancements, primarily for export products. -14- 15 CONSTRUCTION MARKET OUTLOOK Based on leading indicators, such as new housing starts, existing home sales and nonresidential construction activity, the outlook for the remainder of 1998 continues to be positive. Favorable business trends also are expected to continue well into 1999 as key drivers of demand for USG's products, such as consumer confidence, employment rates and interest rates, all remain at favorable levels. In the United States, 1998 housing starts have been running at an annual rate over 1.5 million units. New nonresidential construction in 1997 is supporting increased demand for this segment in 1998 as the finishing of an interior follows contract awards by about a year or more. Demand for USG's products from the repair and remodel market remains strong, continuing a long-term growth trend. Internationally, construction in Canada is expected to remain at a favorable level. Demand is steady in Western Europe and Latin America. USG's exposure to Asia and Eastern Europe is limited as these markets together represent a relatively minor share of the Corporation's total sales and earnings. USG is currently monitoring the global financial crisis and the influence it may eventually have on the U.S. economy and the Corporation's base of operations in North America. LIQUIDITY AND CAPITAL RESOURCES FINANCIAL STRATEGY USG's financial strategy is focused on building long-term shareholder value through a balanced plan designed to provide immediate returns to investors through dividends and share repurchases and future returns from earnings growth. CASH DIVIDENDS - In September 1998, USG's Board of Directors approved the initiation of a quarterly cash dividend. A dividend of $0.10 per share was declared on September 18, 1998, and will be paid on December 16, 1998, to stockholders of record as of November 27, 1998. This is USG's first cash dividend since 1988. SHARE REPURCHASES - In September 1998, USG's Board of Directors also approved the initiation of a multiyear share repurchase program, under -15- 16 which up to five million shares of common stock may be repurchased. This amount represents approximately 10% of the Corporation's total outstanding common stock. The Corporation plans to acquire shares in a systematic manner to satisfy obligations under USG's long-term equity compensation plans for employees and directors. The Corporation also plans to acquire shares from time to time that will be utilized for general corporate purposes. The volume and timing of the latter purchases will depend on market and business conditions. Share repurchases are being made in the open market or through privately negotiated transactions and are being financed with available cash from operations. As of October 31, 1998, approximately 112,000 shares have been repurchased. EARNINGS GROWTH - The key drivers of USG's earnings growth strategy are its investments in cost-reduction and growth initiatives, which are supported by the financial flexibility of an investment grade capital structure. These initiatives involve replacing high-cost manufacturing capacity with low-cost capacity; adding efficient new capacity to serve customers and thereby increasing market share; and expanding sales internationally through exports and manufacturing overseas. USG anticipates that these initiatives also will serve to reduce the impact of cyclicality on its earnings. CAPITAL EXPENDITURES Capital spending amounted to $214 million in the first nine months of 1998 compared with $96 million in the corresponding 1997 period. As of September 30, 1998, capital expenditure commitments for the replacement, modernization and expansion of operations amounted to $608 million compared with $363 million as of December 31, 1997. WALLBOARD CAPACITY MODERNIZATION - In September 1998, USG announced plans to build state-of-the-art production lines to manufacture SHEETROCK brand gypsum wallboard in Rainier, Ore., and Plaster City, Calif. When fully operational in 2001, these investments, together with the Aliquippa, Pa., Bridgeport, Ala., and East Chicago, Ind., projects discussed below, will complete a strategic renovation of U.S. Gypsum's wallboard capacity that began in 1996. The new $120 million facility to be located in Rainier, Ore., will include a 142,000-square foot manufacturing plant and a 247,000-square foot distribution center and will serve the wallboard needs of the northwestern United States and western Canada. The new facility will provide 700 million square feet of SHEETROCK brand gypsum wallboard capacity. A significant -16- 17 portion of this new capacity will replace existing USG shipments into the region from plants as far away as Iowa, Texas and Ontario, Canada. The new $105 million production line at U.S. Gypsum's plant in Plaster City, Calif., will provide annual capacity of 700 million square feet of wallboard and replace a 41-year-old, high cost production line that has approximately 200 million square feet of annual capacity. Ground was broken in October 1998 for the new $112 million plant in Aliquippa, Pa. The new facility will provide 700 million square feet of SHEETROCK brand gypsum wallboard capacity to replace existing high-cost capacity in the region, improve service and accommodate anticipated strong growth in the Northeast market. The Aliquippa plant will manufacture SHEETROCK wallboard using 100% synthetic gypsum. Construction of this facility is expected to be completed in early 2000. Construction continues on the new $110 million plant in Bridgeport, Ala., that will serve growing markets in the southeastern United States. This facility will also manufacture SHEETROCK brand wallboard using 100% synthetic gypsum and is expected to begin operation in mid-1999. USG is also investing $90 million to rebuild and modernize its wallboard manufacturing line at the East Chicago, Ind., plant. This new line is expected to begin production by the end of 1999. GYPSUM WOOD FIBER PROJECT - Construction is underway to build a $90 million facility to manufacture FIBEROCK brand gypsum wood fiber panels at the Gypsum, Ohio, wallboard plant. The new production line is expected to begin operating by the end of 1999 and will complement the fourth quarter 1997 acquisition of a gypsum fiber panel plant in Port Hawksbury, Nova Scotia. COST REDUCTION PROJECTS - Additional capital investments include cost-reduction projects, such as the installation of stock cleaning equipment to utilize lower grades of recycled paper and the additional installation of processes to accommodate the use of synthetic gypsum at manufacturing facilities where it is more economical than natural gypsum rock. CEILING TILE CAPACITY MODERNIZATION - A $35 million project that included the replacement of two old production lines with one modern, high-speed line at the ceiling tile plant in Cloquet, Minn., was completed during the -17- 18 first quarter of 1998. The start-up process of the new line occurred during the second quarter and the new line is now fully operational. WORKING CAPITAL Working capital (current assets less current liabilities) as of September 30, 1998, amounted to $344 million, and the ratio of current assets to current liabilities was 1.8 to 1. As of December 31, 1997, working capital was $264 million, and the ratio of current assets to current liabilities was 1.7 to 1. Receivables increased to $372 million as of September 30, 1998, from $297 million as of December 31, 1997, while inventories increased to $241 million from $208 million and accounts payable rose to $176 million from $146 million. These variations reflect normal seasonal fluctuations as well as an increased level of business in 1998. Current liabilities as of September 30, 1998, also include $5 million of dividends payable in December 1998. Cash and cash equivalents as of September 30, 1998, amounted to $102 million, an increase of $30 million from the December 31, 1997 level. During the first nine months of 1998, net cash flows from operating activities totaled $242 million, while net cash flows to investing activities were $212 million. Net cash flows related to financing activities during that period netted to zero. Net cash flows related to financing activities included cash proceeds of $40 million from the exercise approximately 2.45 million warrants issued on May 6, 1993, in connection with a debt restructuring. Each warrant entitled the holder to purchase one share of USG common stock at a price of $16.14 any time prior to May 6, 1998. The proceeds from the exercises were added to the cash resources of the Corporation and are being used for general corporate purposes. DEBT As of September 30, 1998, total debt amounted to $577 million compared with $620 million as of December 31, 1997. During the first nine months of 1998, USG retired $67 million of 8.75% senior debentures, and reduced seasonal foreign borrowings by $1 million, while increasing industrial revenue bonds by $22 million and borrowings on its Canadian revolving credit facility by $3 million. During the first quarter of 1998, USG issued $44 million of 5.65% fixed-rate industrial revenue bonds due 2033 to investors, the proceeds of which were deposited into a construction escrow account. These bonds, together with $45 million of variable-rate industrial revenue bonds due -18- 19 2032, issued last year in a related offering, will be used to finance the gypsum wood fiber project. This debt is being recorded incrementally on USG's books as funds are drawn from the escrow accounts throughout the construction process. The variable-rate bonds were converted to 5.60% fixed-rate bonds in the third quarter of 1998. AVAILABLE LIQUIDITY The Corporation has additional liquidity available through several financing arrangements. Revolving credit facilities in the United States, Canada and Europe allow the Corporation to borrow up to an aggregate of $605 million (including a $125 million letter of credit subfacility in the United States), under which, as of September 30, 1998, outstanding revolving loans totaled $99 million and letters of credit issued and outstanding amounted to $21 million, leaving the Corporation with $485 million of unused and available credit. The Corporation had additional borrowing capacity of $50 million as of September 30, 1998, under a revolving accounts receivable facility. (See Note 10.) A shelf registration statement filed with the Securities and Exchange Commission allows the Corporation to offer from time to time debt securities, shares of preferred and common stock or warrants to purchase shares of common stock, all having an aggregate initial offering price not to exceed $300 million. As of the date of this report, no securities had been issued pursuant to this registration. STOCKHOLDER RIGHTS PLAN On March 27, 1998, the Corporation approved the redemption of the preferred share purchase rights declared under a 10-year rights agreement adopted in May 1993 and adopted a new share purchase rights plan. The new plan is designed to strengthen the previous provisions assuring the fair and equal treatment for all stockholders in the event of any unsolicited attempt to acquire the Corporation. The new rights plan, which became effective on April 15, 1998, and will expire on March 27, 2008, has four basic provisions. First, if an acquirer buys 15% or more of USG's outstanding common stock, the plan allows other stockholders to buy, with each right, additional USG shares at a 50% discount. Second, if USG is acquired in a merger or other business combination transaction, rights holders will be entitled to buy shares of the acquiring company at a 50% discount. Third, if an acquirer buys between 15% and 50% of USG's outstanding common stock, the company can exchange part or all of the rights of the other holders for shares of the company's stock on a one-for-one basis, or shares of the new junior preferred stock on a one-for-one-hundredth basis. Fourth, before an acquirer buys 15% or more of USG's outstanding common stock, the rights are redeemable for one cent per right at the option of the board of directors. -19- 20 This provision permits the board to enter into an acquisition transaction that is determined to be in the best interests of stockholders. The board is authorized to reduce the 15% threshold to not less than 10%. YEAR 2000 ISSUE In 1996, USG began an evaluation of its computer-based systems to determine the extent of the modifications required to make those systems Year 2000 compliant and to devise a plan to complete such modifications prior to January 1, 2000. The plan that was devised is divided into five phases: identification (a basic inventory of all systems), assessment, remediation, testing and completion. The plan encompasses all of the Corporation's computer systems including mainframe, mid-range, client server and desktop systems as well as all specialized control systems for plant operations or other facilities including those which are considered embedded systems. The Corporation's mainframe systems are responsible for most of the information processing done by the Corporation and will receive a majority of the efforts dedicated to this project as well as a majority of the budget allocated to it. Of the plan phases, identification and assessment are essentially completed and the process of modification encompassing the three phases of remediation, testing and completion is substantially underway. As of September 30, 1998, approximately 49% of the planned modifications to the Corporation's mainframe systems had been completed. Fifty-one percent of the modifications are currently in the process of remediation, testing and completion of which 39% are expected to be completed by December 31, 1998, with the remaining 12% to be completed by the second quarter of 1999. With respect to the mid-range, client server and desktop systems, upgrading to these systems is expected to be completed by mid-1999. With respect to embedded systems, all U.S. and Canadian operations have been assessed and remediation plans, where necessary, are underway. Embedded systems in other operations are currently being assessed, with assessment scheduled to be complete in the fourth quarter of 1998. All necessary upgrades will be scheduled for completion by the middle of 1999. For purposes of this description, embedded systems are intended to cover manufacturing plant control equipment and building information and mechanical systems such as telecommunication systems, HVAC, security systems, and other monitoring equipment. The Corporation's Year 2000 compliance plan also includes an analysis of critical third-party suppliers of material and services to determine their year 2000 compliance status. Virtually all critical suppliers to U.S. and Canadian operations, with the exception of those to L&W Supply, have been -20- 21 surveyed regarding their compliance status. Any remaining unsurveyed critical suppliers and those supporting other operations, including L&W Supply, will be contacted by early 1999. At this point, based on responses received to date, it is not possible to forecast whether there will be, or the extent of, any significant disruption due to third-party supplier failures. However, the plan contemplates that the Corporation will be in continuous contact with its critical suppliers through at least January 1, 2000, to assure that those suppliers are either able to continue to perform without disruption or where feasible are replaced by ones which can so perform. The Corporation has also been in contact with most of its major customers on the status of each party's year 2000 compliance plans and expects to continue such information exchanges through January 1, 2000, in order to maintain those business relationships and to obtain updated information for its own on-going contingency planning. The cost of carrying out the Corporation's compliance plan is currently budgeted at approximately $12 million. About 43% of this cost had been incurred as of September 30, 1998 with another 21% to be incurred in the fourth quarter of 1998. Most of the remainder will be spent in the first half of 1999 with a small portion thereafter. At this time, USG expects to be internally compliant with respect to Year 2000 issues by the middle of 1999. It is too soon to know whether it might experience significant disruptions due to Year 2000 problems that affect the operating environment in which it conducts business such as disruptions to transportation, communications and electric power or other energy systems or due to other similar causes. However, the inability of the Corporation or its critical suppliers and customers to effectuate solutions to their respective Year 2000 issues on a timely and cost effective basis may have a material adverse effect on the Corporation. In view of the uncertainties that the Corporation faces with respect to Year 2000 issues, it has begun to formulate contingency plans to provide for continuation of its operations in spite of possible Year 2000 disruptions. It expects to complete an initial version of its contingency planning by mid-year 1999, but its plans will be continually evaluated and modified as required by developments and circumstances which may emerge between now and January 1, 2000. EURO CURRENCY ISSUE Effective January 1, 1999, 11 of the 15 countries that are members of the European Union are scheduled to introduce a new, single currency unit, the euro. Prior to full implementation of the new currency for the participating countries on January 1, 2002, there will be a three-year transition period during which parties may use either the existing currencies or the euro. However, during the transition period, all exchanges between currencies of the participating countries are required to be first converted through the euro. -21- 22 USG has conducted a comprehensive analysis to address the euro currency issue. USG's efforts are focused on two phases: the first phase addresses USG's European operations during the transition period, while the second phase covers the full conversion of these operations to the euro. The Corporation expects to be ready for the transition period by January 1, 1999, and for the full conversion by January 1, 2001, one year ahead of the mandatory conversion date. USG is also preparing to deal with its critical suppliers and customers during the transition period and will communicate with them as appropriate. The Corporation does not expect the introduction of the euro currency to have a material impact on its earnings or consolidated financial position. LEGAL CONTINGENCIES One of the Corporation's subsidiaries, U.S. Gypsum, is a defendant in asbestos lawsuits alleging both property damage and personal injury. See Part II, Item 1. "Legal Proceedings" for information concerning the asbestos litigation. The Corporation and certain of its subsidiaries have been notified by state and federal environmental protection agencies of possible involvement as one of numerous "potentially responsible parties" in a number of so-called "Superfund" sites in the United States. The Corporation believes that neither these matters nor any other known governmental proceeding regarding environmental matters will have a material adverse effect upon its earnings or consolidated financial position. See Part II, Item 1. "Legal Proceedings" for additional information on environmental litigation. FORWARD-LOOKING STATEMENTS This report contains forward-looking statements related to management's expectations about future conditions. Actual business or other conditions may differ significantly from management's expectations and accordingly affect the Corporation's sales and profitability or other results. Actual results may differ due to factors over which the Corporation has no control, including economic activity, such as new housing construction, interest rates, and consumer confidence; competitive activity such as price and product competition; increases in raw material and energy costs; risk of disruption due to year 2000 issues such as those described above; euro currency issues such as the ability and willingness of third parties to convert affected systems in a timely manner and the actions of governmental agencies or other third parties; and the outcome of contested litigation. The Corporation assumes no obligation to update any forward-looking information contained in this report. -22- 23 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of USG Corporation: We have reviewed the accompanying condensed consolidated balance sheet of USG CORPORATION (a Delaware corporation) AND SUBSIDIARIES as of September 30, 1998, and the related condensed consolidated statement of earnings for the three-month and nine-month periods ended September 30, 1998 and 1997 and the condensed consolidated statement of cash flows for the nine months ended September 30, 1998 and 1997. These financial statements are the responsibility of the Corporation's management. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the financial statements referred to above for them to be in conformity with generally accepted accounting principles. /s/ ARTHUR ANDERSEN LLP ---------------------------- ARTHUR ANDERSEN LLP Chicago, Illinois October 19, 1998 -23- 24 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS ASBESTOS AND RELATED INSURANCE LITIGATION One of the Corporation's subsidiaries, U.S. Gypsum, is among many defendants in lawsuits arising out of the manufacture and sale of asbestos-containing materials. U.S. Gypsum sold certain asbestos- containing products beginning in the 1930's; in most cases, the products were discontinued or asbestos was removed from the formula by 1972, and no asbestos-containing products were produced after 1977. Some of these lawsuits seek to recover compensatory and in many cases punitive damages for costs associated with the maintenance or removal and replacement of asbestos-containing products in buildings (the "Property Damage Cases"). Others seek compensatory and in many cases punitive damages for personal injury allegedly resulting from exposure to asbestos-containing products (the "Personal Injury Cases"). It is anticipated that additional asbestos-related suits will be filed. SUMMARY - The following is a brief summary; see Note 16 to the financial statements in the Corporation's 1997 Annual Report for additional information on the asbestos litigation. U.S. Gypsum is a defendant in 15 Property Damage Cases, many of which involve multiple buildings. One of the cases is a conditionally certified class action comprised of all colleges and universities in the United States, which certification is presently limited to the resolution of certain allegedly "common" liability issues. (Central Wesleyan College v. W.R. Grace & Co., et al., U.S.D.C.S.C.). Fourteen additional property damage claims have been threatened against U.S. Gypsum. During the years 1995-1997, 6 new Property Damage Cases were filed against U.S. Gypsum while 32 were closed; the Company spent an average of $25 million per year on the defense and settlement of Property Damage Cases, but received a total of $148 million over the three-year period from insurance carriers, including reimbursement for expenditures in prior years. U.S. Gypsum's estimated cost of resolving pending Property Damage Cases is discussed below. (See "Estimated Cost.") -24- 25 U.S. Gypsum is also a defendant in Personal Injury Cases brought by approximately 89,000 claimants, as well as an additional 43,000 claims that have been settled but will be closed over time. Filings of new Personal Injury Cases totaled approximately 64,000 new claims in the first nine months of 1998, compared to 23,500 claims in 1997, 28,000 claims in 1996 and 14,000 in 1995. Filings of Personal Injury Cases have increased substantially as a result of rulings by a Federal appellate court and the U.S. Supreme Court rejecting the Georgine v. Amchem class action settlement, in which U.S. Gypsum had participated as a member of the Center for Claims Resolution, referred to below. U.S. Gypsum's average cost to resolve Personal Injury Cases during the years 1995-1997 was approximately $1,600 per claim. Over that period, U.S. Gypsum expended an average of $30 million per year on Personal Injury Cases, of which an average of $26 million was paid by insurance. U.S. Gypsum is a member, together with 19 other former producers of asbestos-containing products, of the Center for Claims Resolution (the "Center"), which has assumed the handling of all Personal Injury Cases pending against U.S. Gypsum and the other members of the Center. Costs of defense and settlement are shared among the members of the Center pursuant to predetermined sharing formulae. Virtually all of U.S. Gypsum's personal injury liability and defense costs are paid by its insurance carriers, including those insurance carriers that in 1985 signed an Agreement Concerning Asbestos-Related Claims (the "Wellington Agreement"), obligating them to provide coverage for the defense and indemnity costs incurred by U.S. Gypsum in Personal Injury Cases. Punitive damages have never been awarded against U.S. Gypsum in a Personal Injury Case; whether such an award would be covered by insurance under the Wellington Agreement would depend on state law and the terms of the individual policies. U.S. Gypsum's estimated cost of resolving pending Personal Injury Cases is discussed below. (See "Estimated Cost.") U.S. Gypsum sued its insurance carriers in 1983 to obtain coverage for asbestos cases (the "Coverage Action") and has settled all disputes with 12 of its 17 solvent carriers. As of December 31, 1997, after deducting insolvent coverage and insurance paid out to date, approximately $325 million of potential insurance remained, including approximately $140 million of insurance from five carriers that have agreed, subject to certain limitations and conditions, to cover both property damage and personal injury costs; $140 million from two carriers that have agreed, subject to certain limitations and conditions, to cover personal injury but not yet property damage; and approximately $45 million from three carriers that have not yet agreed to cover either. U.S. Gypsum is attempting to negotiate a resolution of the Coverage Action with the five remaining defendant carriers, but may be required to litigate additional issues in -25- 26 its effort to secure the contested coverage. Aggregate insurance payments exceeded U.S. Gypsum's total expenditures for all asbestos-related matters, including property damage, personal injury, insurance coverage litigation and related expenses, by $2.3 million for 1997, $41 million in 1996 and $10 million in 1995, due primarily to nonrecurring reimbursement for amounts expended in prior years. ESTIMATED COST - The asbestos litigation involves numerous uncertainties that affect U.S. Gypsum's ability to estimate reliably its probable liability in the Personal Injury and Property Damage Cases. In the Property Damage Cases, such uncertainties include the identification and volume of asbestos-containing products in the buildings at issue in each case, which is often disputed; the claimed damages associated therewith; the viability of statute of limitations, product identification and other defenses, which varies depending upon the facts and jurisdiction of each case; the amount for which such cases can be resolved, which has normally (but not uniformly) been substantially lower than the claimed damages; and the viability of claims for punitive and other forms of multiple damages. Uncertainties in the Personal Injury Cases include the number, characteristics and venue of Personal Injury Cases that are filed against U.S. Gypsum; the Center's ability to continue to negotiate pre-trial settlements at historical or acceptable levels; the level of physical impairment of claimants; the viability of claims for punitive damages; and the Center's ability to develop an alternate claims-handling vehicle that retains the key benefits of the Georgine settlement. As a result, any estimate of U.S. Gypsum's liability, while based upon the best information currently available, may not be an accurate prediction of actual costs and is subject to revision as additional information becomes available and developments occur. Pending Cases: Subject to the above uncertainties, and based in part on information provided by the Center, U.S. Gypsum estimates that it is probable that Property Damage and Personal Injury Cases were pending on June 30, 1998, can be resolved for an amount totaling between $265 million and $340 million, including defense costs. These amounts are expected to be expended over the next five years. The estimated cost of resolving pending cases has increased since December 31, 1997, reflecting the increased number of pending Personal Injury Cases resulting from the rejection of the Georgine settlement referred to above. Significant insurance funding is available for these costs, as detailed below. Future Cases: U. S. Gypsum is unable to reasonably estimate the cost of resolving Property Damage Cases and Personal Injury Cases that will be filed in the future. The Company anticipates that few additional Property Damage Cases will be filed, as a result of the operation of statutes of -26- 27 limitations and the impact of certain other factors, although it is possible that any cases that are filed may seek substantial damages. It is anticipated that Personal Injury Cases will continue to be filed in substantial numbers for the foreseeable future, although the percentage of such cases filed by claimants with little or no physical impairment is expected to remain high. However, the Company does not believe that the number and severity of future cases can be predicted with sufficient accuracy to provide the basis for a reasonable estimate of the liability that will be associated with such cases. Accounting for Asbestos Liability: As of June 30, 1998, U.S. Gypsum had reserved $265 million for liability from pending Property Damage and Personal Injury Cases (equaling the lower end of the estimated range of costs provided above). U.S. Gypsum had a corresponding receivable from insurance carriers of approximately $220 million, the estimated portion of the reserved amount that is expected to be paid or reimbursed by committed insurance. Additional amounts may be reimbursed by insurance depending upon the outcome of litigation and negotiations relating to insurance that is presently disputed. U.S. Gypsum had an additional reserve of $105 million as of June 30, 1998, that was available for future asbestos liabilities and asbestos- related expenses. The Company continues to accrue $18 million per year for asbestos costs and will periodically compare its estimates of liability to then-existing reserves and available insurance assets and adjust its reserves as appropriate. It is possible that U.S. Gypsum will determine in the future that additional charges to results of operations are necessary, although whether additional charges will be required and, if so, the timing and amount of such charges, cannot presently be predicted. CONCLUSION - The above estimates and reserves will be reevaluated periodically as additional information becomes available. It is possible that additional charges to earnings may be necessary in the future if the amounts reflected above prove insufficient in light of future events, and that any such charge could be material to results of operations in the period in which it is taken. However, it is management's opinion, taking into account all of the above information and uncertainties, including currently available information concerning U.S. Gypsum's liabilities, reserves, and probable insurance coverage, that the asbestos litigation will not have a material adverse effect on the liquidity or consolidated financial position of the Corporation. ENVIRONMENTAL LITIGATION The Corporation and certain of its subsidiaries have been notified by state -27- 28 and federal environmental protection agencies of possible involvement as one of numerous "potentially responsible parties" in a number of so-called "Superfund" sites in the United States. In most of these sites, the involvement of the Corporation or its subsidiaries is expected to be minimal. The Corporation believes that appropriate reserves have been established for its potential liability in connection with all "Superfund" sites but is continuing to review its accruals as additional information becomes available. Such reserves take into account all known or estimated costs associated with these sites, including site investigations and feasibility costs, site cleanup and remediation, legal costs, and fines and penalties, if any. In addition, environmental costs connected with site cleanups on USG-owned property are also covered by reserves established in accordance with the foregoing. The Corporation believes that neither these matters nor any other known governmental proceeding regarding environmental matters will have a material adverse effect upon its earnings or consolidated financial position. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a)(15) Letter of Arthur Andersen LLP regarding unaudited financial information. (27) Financial Data Schedule (electronic filing only). (b) There were no reports on Form 8-K filed during the third quarter of 1998. -28- 29 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. USG CORPORATION By /s/ DEAN H. GOOSSEN ------------------------------------- Dean H. Goossen, Corporate Secretary, USG Corporation By /s/ RAYMOND T. BELZ ----------------------------------- Raymond T. Belz, Vice President and Controller, USG Corporation November 5, 1998 -29-