Insulate Your Fixed-Income Portfolio With These Bonds

Jeremy Glasser: For Morningstar, I'm Jeremy Glaser. I'm here today with Senior Credit Analyst, Rick Tauber, to take a look at Owens Corning, and see if their bonds look attractive today.

Rick, thanks for joining me.

Rick Tauber: Thank you.

Glaser: So let's just start off on a high level. I think a lot of people are familiar with Owens Corning insulation, but can you give us a little bit of background about what else the company does?

Tauber: Sure. Actually the insulation, which people know was kind of the pink and Pink Panther product. It's actually the smallest of the company's three business units. They also have a roofing business, which is actually their highest margin business and a glass composites business, which is their biggest unit and has really a strong global presence. So, insulation is actually the smallest piece of the company's operations.

Glaser: Certainly it's a lot of building materials. When we think about housing right now, it might not be the brightest spot in the economic recovery. Without a lot of new construction, is that been a big drag on their results?

Tauber: It's definitely been a drag on the insulation unit, which is most tied to new residential construction and has actually been generating operating losses. So that's an impact primarily in that unit. The roofing business tends to be more repair and remodel, which is a little bit less cyclical than something tied directly to new housing. Composites is really tied to global industrials and industrial production, and it's got a number of different uses.

So, that's actually catching the front end of a strong global uptrend in industrial production. So overall, the trends look favorable with the exception possibly of the residential construction which we think is going to really ramp-up probably more in 2012 and beyond.

Glaser: That's certainly having trouble in the United States, but other parts of the world are building a lot faster. Have they been able to tap into some of that emerging market growth?

Tauber: They have and particularly on the composites business. In fact, they opened up a new facility in China and they are also expanding in Russia, for example. So, some of those emerging markets in that business are certainly some of the growth drivers going forward for the company.

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Glaser: And this is a company that in 2006 had a run through bankruptcy court and emerged stronger. Can you talk a little bit about what their financial position is today then?

Tauber: Sure. They actually have a real strong financial position. They have three bond issues, which comprise the bulk of their about $1.6 billion of debt. They don't carry a lot of cash, but they have about an $800 million revolving facility. So, liquidity is good. With their operating improvements – 2010, they just wrapped up with about 10% growth in EBITDA, debt to EBITDA declined from about 3.6 times in '09 down to about 2.3 times in 2010. And they are generating pretty healthy positive free cash flow.

So with no debt maturities until 2016, they have a pretty clear runway ahead of them of where we're forecasting good cash generation. And they can do a lot of different things with the cash without getting into any kind of financial trouble.

Glaser: Where does our corporate credit rating shake out then?

Tauber: We've had a BBB credit rating, which is one to two notches higher than the rating agencies. They actually have a junk rating at Moody's, which maybe one reason why the bonds trade cheap in our opinion. But our view is again based in large part on our five-year forecast and expectations for strong growth in operating margins and EBITDA and free cash flow.

Glaser: You mentioned the bonds were looking cheap. What about them that makes them attractive for investors right now?

Tauber: Well, there are three different bonds 2016 issue, 2019 issue and a 2036 issue. So they are trading at levels from the low 200s for the 2016s up to north of 300 on the 2019s. BBBs, if you look at sort of broad index, they should be probably more in the 150 to 160 area.

So I think there is a few things keeping them back at the level. One is the actual ratings, potentially from the NRSROs. And two is maybe a bit of a taint on some of the things you alluded to. Being tied  to residential housing construction versus what their business is much more diversified globally. And then three is actually the firm has started to ramp up share repurchases again, which we have already factored into our rating and again there is not any low hanging fruit or debt to pay down with their free cash flow.

So I think it's appropriate in a moderate amount to buy back shares. So for all three issues, we think there is substantial room to improve and spreads to tighten over the next year or two.

Glaser: What are some of the risks that investors should keep in mind?

Tauber: Sure. As a bond investor, of course, the share repurchases is a financial risk and if the company wants to tap into the revolver say and lever back up to some degree to buy back stock that would certainly raise a caution flag. We don't expect them to do that, but something to keep an eye on.

And then the fundamentals, we talked about some of the emerging markets that they are in and exposed if those turned into no-growth situations or negative growth, that would be a problem for their business. And then just on the roofing business, they do have some meaningful commodity exposure, so increasing commodity prices could become a headwind for them.

And then finally, if new residential construction never comes out of this trough that we're in then that would tamp any growth opportunities going forward as well.

Glaser: Rick, thanks so much for joining me today.

Tauber: You bet.

Glaser: For Morningstar, I'm Jeremy Glaser.