Description

Armstrong World Industries (AWI) – Long, Target: $82/share

Market Cap: $3.1bln (Last Sale: $56/share; Shares Outstanding: 55mm)

TEV: $3.9bln (Net Debt $850mm)

3-month Avg Daily Volume: 700k shares/day ($40mm)

Event Type: Spinoff of AWI’s Flooring business (est. Q1’16)

Investment Horizon: ~12 months

I.         Overview

      Armstrong World Industries (AWI) is the dominant manufacturer of ceilings (~75%% of EBITDA) and a leading producer of resilient and wood flooring (25%).  On the surface it may seem like Ceilings and Flooring are complementary businesses; the reality, however, is quite different, and given differences in the relative quality of the two businesses (and the fact that they are relatively easily separable) I believe the planned Q1’16 spinoff of Flooring will help unlock considerable shareholder value.  Frankly, I’m not aware of many cyclical businesses that have the ability to raise prices and realize record profitability at the trough of the cycle; over the last several years Ceilings has demonstrated that it is a business of such quality. Despite running capacity at a relatively depressed levels (~70% utilization in North America), Ceilings earnings came in at a record level in 2014, demonstrating its dominant market position and the resulting pricing power that AWI enjoys.  Assuming Ceilings trades at multiple in-range with other high quality building products/materials peers, I derive a sum-of-the-parts target of ~$82/share.

II.        Valuation

•       Base Case: $82/share – Sum-of-the-parts on 2016 Base Case; Ceilings valued at 11.5x EV/EBITDA; Floorings at 8x
•       Down Case: $48-$50/share – Stock trades at 8.7x EV/EBITDA (avg 1-yr fwd mult of last 5 years) on a 2016 no-growth scenario
•       Bull Case: >$115/share with an above-consensus pick-up in nonresidential construction and renovation

III.       Why This Opportunity Exists

          In my view, AWI has underperformed the market and associated comps over the last 12-24 months for several basic reasons:

•       Management has consistently had to downgrade guidance over the last several years.  This has mainly been a result of overly aggressive initial guidance by management coupled with a generally challenging operating environment given the dormant nature of the nonresidential construction cycle.
•       Strategic missteps by management including ill-timed capex spent to build a ceilings plant in Russia and both a flooring plant and ceiling plant in China.
•       Increased competitive pressures in their Wood Flooring business in 2014.

IV.       Risk / Reward

           A) Reward

        The main tenets of my long AWI case are:

-          AWI is a quality company with established market positions.

o    Armstrong is a well-known brand in both ceilings and floorings with more than 100 years of operating history.

o    Ceilings is a top-notch franchise that is on par with just about any perceived peer in the building materials/products complex.

§  50% market share in the US.  Leading positions in international markets as well, including China and Russia.

§  Demonstrated pricing power throughout the cycle.  Impressively, AWI has continued to post record margins/profitability in Ceilings despite falling volumes.

§  Ceilings is currently operating at ~70% capacity utilization in North America.  Incremental margins on just volume (so ex. price increases) are 35%-45% - whenever demand picks up, the flow-through to operating profit will be tremendous.

§  Strong barriers to entry including established strong relationships with architects, broad product offering, and a large distribution network.

§  Despite dominating this segment there remains substantial growth opportunities, particularly in growing their presence in the Architectural Specialties market.  This business focuses on ceilings for higher profile structures (i.e. a building lobby).  The overall market opportunity is ~$2bln, and AWI has <10% market share currently.

o    Floorings, while challenged in the current operating environment, is an established and well-entrenched business.

§  Trends in Resilient Flooring in Q4 were somewhat heartening – despite lower volumes and flat pricing, sales and profits actually increased given improved mix of sales in the US and Asia.

§  AWI’s Wood Flooring businesses faced a highly competitive environment in 2014, as the company noted sustained pricing pressure from competitors throughout the year that led to a loss in market share.  Management noted on their last conf call that the environment had somewhat stabilized by year-end, however, heightened competition remains a noted risk into 2015.

§  2015 won’t be pretty as management ramps up on investment/marketing spending that it had deferred in previous years.  This, in my estimation, will translate to ~$15-$20mm in increased costs, a portion of which will be one-time in nature.

§  Nevertheless, with the opening of a new LVT (luxury vinyl tile) plant this year, and a probable step-down in investment/marketing spend, management believes Flooring profitability in 2016 will get back to, if not exceed, 2014 levels.

-          Improving nonresidential construction fundamentals.

o    Construction Cycle – While I don't expect an immediate breakout in commercial trends, I think it’s reasonable to think that activity levels will continue to pick up from its current relatively subdued level.

§  In simple terms, over the last several decades domestic nonresidential construction has averaged ~1.3bln square feet annually (peaking at ~1.7bln square feet last cycle and troughing at ~700mm square feet in 2010).  Nonresidential construction in 2014 was ~900mm square feet, so there remains plenty of runway ahead in getting back to an average historical level.

§  Lead indicators point to a continued improvement and underpin expectations for nonresidential construction spend to increase at a high-single-digit rate in each of the next couple of years.

·         The ABI remains above 50, and the Dodge Momentum Index increased 12% in Q1’15 – this rising trend in the Momentum Index points to increased nonresidential construction starts through at least early 2016.

·         After a 6% increase in 2014 the AIA Consensus Construction Forecast panel expects nonresidential construction spending to accelerate in 2015 (+7.7%) and 2016 (+8.2%), aided by the recovery in the institutional categories, which have yet to recover since the downturn.

§  New commercial construction trends take ~18-24 months to hit the income statement for AWI.

o    Renovation Cycle – I’m not calling for a huge ramp in renovation and remodeling spend, though given decent macro conditions it seems like this cycle has at least bottomed.

§  Per AWI, renovation is largely driven by corporate profitability and GDP growth.  At ~3% GDP growth management believes renovation volumes would begin to increase.  USG Corp (USG) has also been optimistic in their outlook for renovation volumes in 2015.

§  Additionally, I believe there is pent up demand for renovation/remodeling.  Interface (TILE) has been more vocal about seeing pent up demand for commercial renovation.  Their view is that the commercial renovation typically follows a 7-9 year cycle.  Given this dynamic TILE sees “a lot of pent-up demand in commercial renovation, particularly in mature office markets.”

o    Overall, I believe my top-line assumptions for AWI are generally conservative:

§  In Ceilings I’m calling for low-single-digit % price increases, 0%-2% increases in renovation volumes, and a mid-single-digit increase in new commercial volumes.

§  In Flooring I’m largely calling for flat pricing (or increases in out-years to cover increased materials/energy costs) and 0%-3% increases in volumes across products.

-          Costs should be a tailwind in 2015 (though timing of any benefit is a bit uncertain) – AWI is quite guarded about the information pertaining to their operating cost structure, though it’s clear that costs for certain raw materials and energy will be lower.

o    Raw Materials account for 40% and 60% of COGS for Ceilings and Floorings, respectively.  The key raw materials for AWI are all about flat or down substantially this year.  Key raw mats include lumber, PVC, and steel.

o    Energy accounts for account for 10% and 5% of COGS for Ceilings and Floorings, respectively.  As is widely known, energy prices have cratered in recent months.

-          Management decisions seem to be improving.  Key decisions over the last 6-months include:

o    The decision to completely exit European Flooring in Q4’14 was wise as AWI has consistently lost money in this business.

o    Spinoff of Flooring (discussed below) makes very good strategic sense.

o    And (hopefully), mgmt has set their initial 2015 guidance at a level that should be very achievable.

-          Spinoff of Flooring

o    Spinoff is set for Q1’16.  In the meantime, mgmt is working out key details relating to the spinoff, such as capital structure, allocation of corp expenses (I assume 55% allocated to Ceilings), and incremental operating costs incurred by Flooring as a standalone business (I assume $5mm).

o    By all accounts, the separation of Flooring should be achievable by the target date.  AWI will spend ~$20-$40mm in spinoff-related expenses in 2015, with more to follow next year.

o    The spinoff should help unlock shareholder value, as I believe Ceilings on a stand-alone basis should trade at a meaningfully higher multiple than where AWI currently trades.

-          Improved cash flow conversion / Potential for return of cash program(s) being instituted

o    Capex has run $200-$220mm per annum over the last three years as AWI has spent to build out their international presence in Russia and China and to expand their US LVT flooring business.  Capex will come down materially starting this year, as mgmt has guided for total capex of $125-$150mm.

o    By the end of 2015 AWI will be at the low end of their targeted debt level (2x-3x net debt to EBITDA).  As such (and obviously depending on the details of the spin), each business could potentially begin a capital return program in 2016.

-          Valuation – giving the pending spinoff I believe it’s appropriate to value AWI on a sum-of-the-parts basis.  My base case value is $82/share.

o    Ceilings – should clearly trade at a premium multiple given: a) high quality business, b) though profits are at a record level, Ceilings’ earnings power is much greater than what is being realized today given that utilization rates are only 70%.  I use 11.5x ’16 EV/EBITDA in my sotp calculation – this mult is in between Mohawk Industries (MHK, 10x ’16 EV/EBITDA) and James Hardie Industries (JHX.AU, 13.5x ’16 EV/EBITDA); both are high quality businesses that I view as reasonable comps to Ceilings.

o    Flooring – I use 8x ’16 EV/EBITDA as I believe Flooring should trade at a material discount to MHK.  As ’15 moves on, and should Flooring demonstrate any improvement, 8x EV/EBITDA could prove conservative as earnings could ramp materially into 2016 given a step-down in investment related costs.

o    Also, to be sure, my $82/share target equates to about a 5% 2017 fcf yield for consolidated AWI – this is basically in-line with peers like  MHK, JHX.AU, TILE, and Forbo Holdings (FORN.SW).

AWI management has laid out a mid-cycle scenario which essentially calls for EBITDA of ~$750mm.  This is unquestionably a debatable scenario (and it’s really anyone’s guess as to when we get back to a mid-cycle type of year again), though I think the takeaway should be that even with a sustained modest pickup in nonresidential construction spend dedicated to new buildings and/or renovation/remodeling then earnings have a very long runway to grow.  If you choose to believe management’s mid-cycle scenario then it’s not difficult to derive a target price of >$115/share (10x EV/EBITDA for Ceilings, 8x for Flooring).

A.               B) Risk

  The main risks to AWI are:

-          Ceilings and Flooring volumes are generally tied to macro indicators (GDP, employment, construction, etc.).  In particular, a reversal in the nonresidential construction recovery would certainly be detrimental.

-          Increased competitive pressures, particularly in Wood Flooring.  2014 was a challenging environment for Wood Flooring and AWI faced sustained pricing pressure from peers who undercut on price.

-          Pricing pressure – Typically, AWI is able to recover 40-60% of its announced price increases, with the most success in Ceilings and least success in Flooring (in part because HD & LOW are demanding).

-          F/x – ~30% of sales are outside of the US, thus AWI has some exposure to currency movements, most notably CAD, CNY, GBP, EUR, and AUD.

-          Changes in energy and raw materials (most notably lumber and PVC) prices. 

-          Geopolitical risk given AWI’s moderate exposure to Russia (4% of ’14 sales that should increase this year).

-          New entrant(s) in Ceilings.  AWI traditionally defends their market position incredibly well, however.

-          AWI abandons their plan to spinoff Flooring.

-       ValueAct decides to exit their position.

The bear case on AWI is largely based on:  a) a general deterioration in spending on both commercial renovation/remodeling and new construction, and b) continued deterioration in their Flooring market positions.  Using a 8.7x EV/EBITDA target mult (which is the stocks 5-year avg mult and 10%-30% cheap to where most similar quality stocks trade) on a 2016 no-growth scenario, my downside target for AWI is $48/share (-15%). 

V.     Catalysts / Event Path

The AWI-specific event path over the next year will be:

-          AWI reports Q1’15 report on 4/30/15 – I believe the bar on AWI is set low, so just meeting guidance should be greeted warmly by the market.  Management is very cognizant of the disappointing earnings reports over the last several years, and, as a result, it seems like they may have set 2015 guidance conservatively.  Pasted below are a couple of comments from AWI’s 2/23/15 conference call that demonstrate this dynamic:

o    CEO: “We have hopefully adopted a fairly modest outlook in the market conditions for 2015. Our experience in the last three years to five years have been significantly downward revisions in the market opportunity as we move through the year. And in many cases, that's caused us to revise our guidance and outlook as we go through the year. Most of the revisions we've experienced have been directly related to a softening in the environment as it relates to the original outlooks by many of the traditional sources that people use.”

o    Head of Ceilings: “I mean for three years in a row, I don't think anybody in this industry has called this recovery right. So yeah, you are probably detecting a little bit of conservatism in our outlook. But as I mentioned earlier, I think the office segment is definitely showing some good traction in the recovery, both on new construction side as well as some of the renovation activity. So, we're optimistic about that continuing.”

-          Spinoff of Flooring – the separation of these two distinct businesses will help unlock equity value in my opinion.

o    Spinoff estimated in Q1’16.

o    In the interim (more likely in H2’15) we should start to get further details around the separation (i.e. capital structures, allocation of corporate expenses, incremental costs Flooring will incur as a standalone company, etc.)

-          Capital return program – in all likelihood this will not be an event until after the spinoff.  Post-spinoff, attention will focus on capital structure and potential return of capital, especially for Ceilings.

-          Post-spinoff, I believe both Ceilings and Floorings are potential takeout candidates. 

-          Macro datapoints (ABI Index, Dodge Momentum Index, Census construction data) that point to a continued improvement in the nonresidential construction cycle.

VI.    Variant Perception

My variant view of AWI is based upon:

-          AWI appears to be a classic spinoff opportunity, whereby separating a very good business from an average business should help unlock shareholder value.

-          Trading at ~8x 2016 EV/EBITDA under my base case scenario, AWI is trading more in line with where its Flooring business should trade, not its higher quality Ceilings business which generates ~75% of earnings. 

-          Lower energy and raw materials costs will be a tailwind for AWI in 2015.  I do not believe this is factored into guidance or sell-side estimates.

-          Management decisions seem to be improving as evidenced by recent strategic actions.

-          Post spinoff, both businesses are takeout candidates in my opinion.

VII.     Capital Structure / Capital Allocation

Off balance sheet, the company is modestly underfunded on their pension plans.

-          US pension plan that was $84mm underfunded at 12/31/14

-          Non-US pension plan that was $29mm underfunded at 12/31/14

-          OPEB that was unfunded at $221mm

AWI is a business of average capital intensity, and maintenance capex runs ~$110-120mm per annum.  Total capex will step down this year to $125-$150mm.  Going forward, management has given all indications that there are no huge projects on the horizon and that total capex will run around 2015 levels.

AWI does not pay a dividend and is expected to use excess cash to delever in the near term.  Post-spinoff, I believe cash return programs could be established at both Ceilings and Flooring.

VIII.   Business Overview

AWI is the dominant global maker of ceilings and a leading producer of resilient and wood floorings.  The company has a history dating back to the 1800’s, and, through to today, the Armstrong namesake is a premier worldwide brand in both flooring and ceilings.  AWI, saddled with asbestos lawsuits stemming from its earlier roots in insulation, filed for bankruptcy in 2000.  The company emerged from bankruptcy in 2006, and as 2/3rds owned by an asbestos trust.  Today, the Trust has sold down their stake considerably, and the stock trades much more liquid.

                     A)   Segments

Today, the company currently operates under three business segments – Building Products (which is their Ceilings business), Resilient Flooring, and Wood flooring.  The latter two will be spunoff and form Armstrong Flooring.         

-        Building Products (Ceilings)

AWI’s Building Products division manufactures and sells ceilings in the US and abroad.  In terms of product, the vast majority of sales in this segment are mineral fiber tiles (85%).  Commercial renovation at 60% of sales is the largest end market, followed by new commercial construction at 35% and residential renovation (basement ceilings etc.) at 5%.  About 2/3rds of this segments sales are in North America, 25% in EMEA, and the remainder in Asia.

In the US, Ceilings is an oligopolistic industry, and AWI’s ceiling tiles are a staple in most office buildings throughout the country, with the firm’s market share at ~50%.  USG is the #2 player, with ~30% market share.  Given this highly concentrated industry structure, AWI enjoys a great deal of pricing power.

Also accounted for in the Building Products segment is AWI’s WAVE joint venture with Worthington Industries (WOR). This JV makes steel ceiling suspension systems, which are essentially the grid that holds AWI’s ceiling tiles.  When a customer buys AWI ceilings, this typically includes the ceiling suspension system too.

-        Resilient Flooring

Resilient Flooring manufactures a broad range of floor coverings primarily for homes and commercial and institutional buildings. Manufactured products in this segment include vinyl sheet, vinyl tile and linoleum flooring. In addition, the Resilient Flooring segment sources and sells laminate flooring products, ceramic tile products, adhesives, and installation and maintenance materials and accessories.  Commercial renovation at 45% of sales is the largest end market, followed by new residential renovation at 30% and new commercial construction at 20%.  And, about 5% of sales is tied to new housing. 

AWI, announced it would close down its money-losing European flooring business in Q4’14.  As such, the vast majority of Resilient sales are derived in North America, while Asia makes up ~10% of sales.

-        Wood Flooring

AWI’s Wood Flooring business makes engineered and solid wood flooring almost exclusively for residential end use. And, virtually all sales in this segment are derived in North America.  For AWI, renovation/remodeling is the primary end market, accounting for 65% of sales while new construction accounts for the remaining 35%.  Product wise, sales are roughly evenly split between solid wood and engineered wood.

                    B)   Management

-          CEO – Matt Espe has been running AWI since July 2010.  Prior to assuming the CEO role at AWI he was the Chairman and CEO of Ricoh America Corporation, IKON Office Solutions Inc. and the President and CEO of GE Lighting.

-          CFO – Dave Schulz has been CFO of AWI since November 2013.  He joined the company in 2011 as vice president, Finance for Armstrong Building Products.  Before coming to AWI, he served as CFO of Procter & Gamble Company Americas’ snacks division, and from 2008 to 2009 as the finance director of the J.M. Smucker Company coffee business unit following its merger with the P&G Folgers Coffee Company.

-          Performance Based Compensation – AWI execs earn bonuses under both short and long term plans.

o    Short term – the key figure in calculating annual bonuses is EBITDA as the compensation committee sets EBITDA targets for each division.

o    Long term – execs are incentivized to achieve predetermined ROIC targets over three-year period.

-          Currently, management owns <1% of shares outstanding.

                    C)   Key Shareholders

-          ValueAct – the activist fund disclosed a 17% equity stake in AWI in August 2014. Since acquiring this stake (and adding a ValueAct partner to the Board of Directors), AWI has closed down their money-losing European Flooring business and also announced the spinoff of its Flooring business; so it seems like the funds presence is helping to improve/accelerate strategic decision making.

-          Armstrong Injury Trust – As mentioned, coming out of bankruptcy in 2006 the Trust owned approximately 2/3rds of shares outstanding.  The Trust has consistently sold down it stake, and today holds 6.8mm shares, about 12% of shares outstanding.

IX.        Financials

*Note that 2010-2012 figures include results from AWI's discontinued European Flooring business

Catalyst

•        Earnings reports - AWI reports Q1’15 on 4/30/15. Also, USG reports on 4/23, will provide for a read on Ceilings.
•       Spinoff of Flooring – the spin is set for Q1'16, though we should be receiving key details in the coming quarters.
•       Capital return program – in all likelihood this will not be an event until after the spinoff.
•       Post-spinoff, I believe both Ceilings and Floorings are potential takeout candidates. 
•       Macro datapoints (ABI Index, Dodge Momentum Index, Census construction data) that point to a continued improvement in the nonresidential construction cycle.