Armstrong World Industries, Inc. (AWI): Armstrong World Industries: There Is A … – Seeking Alpha

Armstrong World Industries, Inc. (AWI) is currently depressed by two one-time events. The first is the secondary stock offering of shares owned by asbestos-claims beneficiaries. The second is the retirement of the CEO and his replacement by the current CFO.

The effect of the large sales and price being drawn to $51 per share as a result of the secondary stock offering will subside by the middle of December 2013, and the effect of a CEO change will wane gradually as the new CEO takes his first successful steps. As the effects of these one-time events subside, Armstrong’s stock price will be lifted. The stock has a roughly 44% upside with a fair value of $74.94, offering very strong short-term as well as long-term upside potential on the back of the strong underlying growth expected to hit 19% in the next couple years and as the 2012 refocusing and restructuring starts to bear fruit. Additionally, the recent large $260M share repurchase will increase all future EPS incrementally by roughly 8.5%. Increasing new factory utilization will lead to improved 2014 EPS, with full positive effects from recent years of heavy investments to materialize in 2015 and 2016.

Nevertheless, the downside risks are large in magnitude due to the company’s very cyclical nature of business and very low book value. Even the share of tangible assets on the book value is low. Furthermore, the company’s debt has been increasing lately. As a conclusion, Armstrong is definitely a sound company worth holding for the long haul with a strong upside but also a large downside risk, so hedging of positions is recommended, through options for example.

Company background

Through 120 years of experience, Armstrong World Industries has become a diversified global building products company with $2.6B in sales and No. 1 market share positions in most key markets and products. Primarily, Armstrong is a global producer of flooring products and ceiling systems for use in the construction and renovation of residential, commercial and institutional buildings. Armstrong designs, manufactures and sells flooring products (primarily resilient and wood) and ceiling systems (primarily mineral fiber, fiberglass and metal) around the world. The majority of the company’s revenues come from renovations as opposed to new construction. Half of the sales and three quarters of EBITDA come from the ceilings segment, and a large part of the remaining sales comes from resilient flooring. Most of the sales and even higher share of profits are generated within the U.S.

In 2000, the company filed for bankruptcy as a result of AWI’s serious personal-injury, asbestos-related liabilities. Throughout the years, the company issued shares to the Asbestos Personal Injury Settlement Trust and Armor TPG Holdings LP as a compensation for these claims. In the most recent development, the company conducted a secondary stock offering on November 7 that closed on November 13, with an additional 30-day option to purchase more stock at $51 per share, which followed a similar share offering and a share repurchase in September 2013.

Positive catalyst will permanently boost future EPS

In the latest round, after being granted additional shares, the Asbestos Personal Injury Trust and Armor TPG Holdings together sold 12,057,382 of their remaining shares in the secondary public offering. During this transaction, Armstrong World Industries paid roughly $260M to repurchase more than 5M shares to be held in treasury to help mitigate the impact of this large sale. The treasury share purchase was funded by existing cash and borrowings under the company’s credit and securitization facilities. As a result of these transactions, the Asbestos PI Trust and TPG together now hold approximately 35% of AWI’s outstanding shares.

Current financial situation: Sales weakness returns after strong Q2

For the nine months ending on September 30, 2013, Armstrong reported sales growth of roughly 2.5% YoY, with sales in the building product segment showing a modest 2% growth though accounting for almost half the total sales. The resilient flooring segment was not so resilient, as the sales fell slightly YoY. The best-performing segment of the wood flooring grew more than 12% YoY to now account for more than 20% of revenues. Nevertheless, the margins in this segment fell substantially, hence the sales growth was achieved at the expense of margins, and the segment hardly contributed to total operating income. Sound margins on building products helped the bottom line.

Due to substantially higher debt-restructuring costs and interest expenses caused by additional debt needed to finance the share repurchase related to asbestos liabilities mentioned above, net earnings dropped significantly. The company’s cash dropped substantially to $137.7M but remains on an acceptable level. Net debt increased to $930M. Operating income, adjusted EBITDA and EPS are all down year-to-date. The outsized drop in EPS relative to EBITDA and operating income is driven by the release of foreign tax credit valuation allowances in 2012 and the headwind of higher unbenefited foreign losses in 2013 due to the company’s Russia and China investments.

As a demonstration of its ability to cut costs, the company reported record global ceilings business EBITDA on sales that were 20% lower than peak revenues. This positive result was partly achieved thanks to the joint venture with WAWE. The wooden flooring business continued to be a challenge due to several factors including increasing prices of wood that the company was not fully able to reflect in prices of its products. The price of wood resumed its upward trajectory in Q3 and the challenging situation in the wooden flooring segment continues, with an immediate turnaround not expected. Architectural segment sales were up with YoY growth in mid-teen numbers.

In terms of overall segments, the majority of the company’s sales are to commercial markets in sectors dependent on public spending. The company’s sales reflect this weak overall public spending. In terms of specific markets, the American market witnessed softness in commercial markets, particularly education and, to a lesser extent, health care, as public spending remained constrained. On the other hand, residential markets continued to improve, driven primarily by strength in builder activity while renovation activity increased slightly. Softness in the key commercial markets, such as office, education and health care, continued amid sluggish public spending. Within the Asia/Pacific region, the softness in the Australian commercial construction continued while India and Southeast Asia grew, with China experiencing positive results in the office, education and health-care segments.

Financial outlook

For the fourth quarter of 2013, the company expects sales in the range of $645M to $685M and EBITDA of $70 to $90 million. For the full 2013, the company lowered its outlook a bit on signs of renewed sales weakness in September after a strong second quarter, strong July/August months and ongoing troubles in the wood floor business. Armstrong now expects sales in the range of $2.7B to $2.74B, operating income between $260M and $280M, EBITDA of $370 to $390M, EPS of $2 to $2.20 and free cash flow between $80M and $110M.

The company expects an accelerated 19% annual sales growth between now and 2016, compared to 12% sales CAGR between 2009 and 2013, and a vast improvement in EBITDA.

Divestitures and restructuring set to focus on the core ceiling and flooring business to drive future growth

In order to focus on its core business of flooring and ceilings worldwide, Armstrong performed several asset sales and restructuring throughout 2012, including a sale of its cabinets business to American Industrial Partners for $27M, losing roughly $136M in annual sales and 750 employees. The selling price seems abnormally low, until we realize that the unit actually was losing money. For just the nine months ending September 2013 alone, the business lost a net $6.4M, including tax loss benefits. In a separate transaction, the company sold one of its subsidiaries, Patriot Flooring Supply, Inc, to Belknap White Group.

Onshoring investments in growing luxury segments to drive future growth

In October, Armstrong announced a selection of a Lancaster, Pa., floor plant for its $41M investment in the manufacture of luxury vinyl tile, which was announced in July 2013. This is an interesting onshoring activity of relocating production back from China on the back of a 20% annual growth in the luxury vinyl market that requires shorter lead times and improved customer service.

Three new factories to profit from the emerging markets fast growth

On the other hand, Armstrong also continues to invest heavily in cheaper manufacturing capacity for the lower segment by opening two new factories in China and finishing another one in Russia. August 2013 marked the launch of production in one of its new Chinese factories for manufacturing of heterogeneous flooring. This positions the company extremely well to benefit from the future growth that is expected in this region, especially in the company’s traditionally strong core vertical markets of health care and education.

New product development, innovation and venturing into adjacent high-growth markets to maintain competitive edge

There are great opportunities in some of the adjacent markets that are very close to the company’s core segments. The architectural specialties market and emerging markets are especially expected to grow at roughly 15% to 20% per year.

Continued emphasis on lean operations and margin improvement, with margins expected to grow in 2014 to 2016

The company is currently at the stage when sales grow, thanks to new plants opening and new investments being made. However, margins and profits have suffered as a result of these investments and new plant openings. Nevertheless, for the period of 2014 to 2016, the company’s strategy is to monetize these past investments and achieve a substantial EBITDA growth as factory utilizations rise.

Armstrong will enjoy continued market share leadership

The company is already No. 1 in all its key segments of the ceilings and floors business: commercial, residential and wood. In EMEA, the situation is virtually the same in the ceilings sector, with room to improve in the floors business from its top-five spot. In the Asia/Pacific, the company is again No. 1 in ceilings and floors, with the exception of China, where it needs some improvement in the floors segment but is still in a top-five position. Overall, Armstrong’s competitive position is extremely strong, especially in the ceilings segment, with some room for improvement in the floors area. The market shares are very high and provide ground for sound future growth.

Valuation

With generally weak top-line growth in companies around the world and their subdued capital expenditures, as they are in a now-permanent state of cost-efficiencies rather than growth, I expect the future sales growth for Armstrong to reach rates roughly in line with the growth of the worldwide GDP .It could be slightly less if the U.S. lags this worldwide growth as I expect, because Armstrong is predominantly dependent on U.S. sales. Furthermore, the public sector that drives a significant portion of the company’s revenues is mired with debt and constrained budgets. Hence, growth of the public segment is likely to lag GDP growth as well.

As a result, I expect a strong 19% top line growth over the next three years, in line with the company’s projections, followed by a more moderate 3% top line growth in dollar terms for the subsequent 7 years, and then reaching flat sales. Margins are likely to improve substantially as the company lowers its own capital spending due to having three almost-finished, major new factories, which will ramp up their production to reach optimal utilization levels. External pricing and competitive pressures are likely to remain the same as today; the company generally has a strong No. 1 market position to withstand them as successfully as today as some price erosion will continue into the future. As a result, I expect long-term net profit margin to fluctuate around 8% throughout the full cycle.

Using the above assumptions, my 2014 sales and EPS estimates in line with the above described trend and the company’s 2013 full year predictions, the 2014 sales should reach $3.17B and EPS should be around $3.20. These assumptions give us a fair value of Armstrong at around $74.94 per share, meaning the company has a roughly 44% upside.

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Major risks are looming, and the magnitude of a potential downside risk is substantial

The company trades at more than five times its book value. Moreover, it has a relatively high share of intangible assets, mostly in the form of brand names, trademarks and customer relationships. Also, the company’s debt has risen to almost $1B recently as a result of the massive share repurchase, and the company operates in a highly cyclical business. This makes me cautious about the magnitude of a possible downside risk, especially if the macroeconomic situation deteriorates, affecting the new housing and reconstruction markets. Although new home sales are nowhere near their previous-cycle peaks, estimates vary wildly as to whether the U.S. and other countries around the world will be able to reach such high levels again during this cycle. All in all, the maximum worst-case, bankruptcy scenario would mean a hefty 84% downside. However, even under a mere change in the industry cycle to the downside, the share price would be hit.

Within ceiling systems, Owens Corning (OC), which I recently analyzed, is one of the company’s competitors, primarily in the fiberglass segment. Pricing pressures also continue, as the company was only able to adjust prices partially upward for rising commodity and other input costs due to market conditions and competitive pressures.

Conclusion

Armstrong World Industries is a sound business for the long-term investors to hold with a strong 44% upside potential as the short-term negative effects wane. Nevertheless, due to high magnitude of the downside risks, I recommend investors to at least partly hedge their positions, for example through the use of call options instead of buying the stock or by using put options to accompany a long stock position.