Description

American Woodmark is a small cap building products company that I believe should double in the coming years as the housing cycle unfolds. 

Per the 10-K filing: “American Woodmark Corporation (“American Woodmark” or the Company”) manufactures and distributes kitchen cabinets and vanities for the remodeling and new home construction markets.  American Woodmark was incorporated in 1980 by the four principal managers of the Boise Cascade Cabinet Division through a leveraged buyout of that division.  American Woodmark was operated privately until 1986 when it became a public company through a registered public offering of its common stock.

“American Woodmark currently offers framed stock cabinets in approximately 550 different cabinet lines, ranging in price from relatively inexpensive to medium-priced styles.  Styles vary by design and color from natural wood finishes to low-pressure laminate surfaces.  The product offering of stock cabinets includes 86 door designs in 18 colors. Stock cabinets consist of a common box with standard interior components and a maple, oak, cherry, or hickory front frame, door and/or drawer front.

“Products are primarily sold under the brand names of American Woodmark®, Timberlake®, Shenandoah Cabinetry®, Potomac®, and Waypoint Living Spaces ®.”

The company is simple (in a good way) – just reading through the filings, transcripts, and annual letters demonstrates a straightforward business and a management team that seems quite direct.

The thesis here is also pretty basic.  The cabinets business is extremely depressed.  Nearly 1/3 of AMWD’s business goes into new construction (primarily single family) and SF starts are still down ~70% from the peak.  The other 2/3 of the business is repair and remodel (“R&R”).  Since cabinets are a bigger-ticket, more discretionary purchase, cabinets R&R volumes have fallen more than many other building products of a smaller ticket and less discretionary nature.  Industry volumes in cabinets are estimated to be down ~40%+ from peak levels and industry revenues are down nearly 50%.  As cabinets volumes rebound, the increase in revenues should provide significant operating leverage on fixed costs.

With cyclical investments of this type I believe that being overly precise is just false precision.  But for simplicity, I am looking at AMWD’s fiscal year ended April 2012 as the base from which to make projections.  I then look out to the fiscal year ended April 2016 and arrive at the following representative base, upside, and downside cases as shown in the table below.

In short, in the base case I believe the stock should double as revenues grow at an 11% CAGR, gross margins reach 22%, and SG&A hits 13% of revenues.  This represents incremental pretax margins of 20% off of fy12 and produces EPS of $3.22.  The 11% annual revenue growth I am assuming is driven by several factors.  First is SF new home construction, which has of late been growing at >20% rates off of extremely depressed levels.  AMWD’s revenues last quarter in this channel were up over 40% yoy while market wide SF starts that were up ~20%, due to some share gains.  Second, repair and remodel volumes should rebound as home prices rise, reducing the number and magnitude of negative equity positions among homeowners, eliciting some loosening of underwriting standards from banks and other lenders, increasing existing home sales, and driving increased confidence among homeowners to get back to making investments in their homes.  While I expect the rebound in R&R in cabinets to lag smaller ticket items in timing, ultimately the rebound should be greater in magnitude given the more depressed base.  Third, while AMWD has historically not participated in the dealer channel which serves roughly half of the R&R market, it has begun to increase its focus on that channel and should see increased penetration over time from the present negligible levels.  The company expects its remodeling revenues overall to slightly exceed the market.

AMWD is targeting returning to a gross margin of 21-23% vs just 13% in fy12 and 14.9% last quarter.  I would note that gross margins averaged 22.5% over 1997-2007.  The company has begun to see fixed cost leverage within COGS.  In fy12, overall gross margins were up ~120 bps, driven by:  a 370 bps improvement in labor and overhead; partially offset by a 180 bps headwind from materials and freight; along with a 70 bps headwind from increased sales promotion costs.  Similarly, last quarter, overall gross margins were up 90 bps, driven by: a 330 bps improvement in labor and overhead; partially offset by a 240 bps headwind from increased materials and freight costs.  While materials and freight cost increases can be difficult to recover over the short term, especially at a time of depressed industry utilization, I expect they can be recovered over time as they should affect all competitors and historically have been successfully recovered with a 6-18 month lag.

SG&A is comprised of sales and marketing and G&A.  These expenses should also be leveraged as volumes rebound and have in fact begun to do so already.  In total, SG&A improved 230 bps yoy in fy12 and 340 bps yoy in the most recent quarter.  The company’s decision to freeze its remaining defined benefit pension plans at the end of fy12 should assist in keeping SG&A in check in fy13 in particular.

I believe AMWD has done a good job in taking costs out of the business without sacrificing quality.  Its JD Power rankings exceed its top competitors.  As just noted, the company has frozen its remaining defined benefit pension plans.  It also closed another 2 manufacturing plants in April and May, bringing its operating manufacturing footprint down to 9 plants.  Yet AMWD believes it still has the hard footprint in place to handle a ~50% increase in volumes.

AMWD was LBO’d out of Boise Cascade in 1980 and IPO’d in 1986, led by former Chairman & CEO William Brandt.  Brandt still owns 23% of the company. 

AMWD has maintained a very conservative balance sheet.  It has been in a net cash position for 28 consecutive quarters, most recently registering a net cash balance of $43 million.  (It does, however, have a pretax pension funding gap of $50 million as of the fiscal year end).  While AMWD discontinued its dividend in late 2011, it has noted that future cash returns to shareholders should come via share repurchases.  There is a $93 million share repurchase authorization outstanding, and given the strong free cash flow dynamics of the business and the balance sheet, I would expect it will simply be a matter of time before it is utilized.

The outstanding stock options are nearly all struck at higher levels than the current share price.  While less than 1% of employees are unionized, 64% of employees are shareholders.

I don’t think current numbers are terribly relevant to the longer term thesis and valuation given such a depressed current base and the significant operating leverage that should be seen.  Even so, operations are facing some current headwinds from temporary overtime (relating to a short term bounce in demand materializing around the same time as the implementation of the restructuring program) along with raw material and freight cost inflation.  But these should abate and be recovered over time.

While I’m not banking on it, I think there is the potential for some improvement in industry competitive dynamics.  Masco has been particularly aggressive on promotions in recent years in the wake of weak demand, persistent market share losses, and a less aggressive and more delayed restructuring effort than FBHS and AMWD.  But Masco recently replaced its operating management in the cabinets business.  Moreover, now that FBHS was spun off from Fortune Brands, its success and tremendous restructuring are even more visible and obvious, which ought to be focusing more attention on Masco’s underperformance.  It seems at least plausible that Masco may now start to “play better in the sandbox” going forward.

In my upside case, I assume gross margin expands to 24% (still well below prior peak levels), SG&A falls to 12% of revenues (close to, but not better than prior best levels), revenues grow at a 2% higher CAGR, and the share count is shrunk by ~20%.  This yields $5.36 in EPS and nearly a triple in the stock price.

My downside case is meant to be realistic, but not overly draconian.  For instance, I assume a 30% cumulative increase in revenues by fy16, which would be very weak considering where we are coming from, but would prove to be optimistic should the nascent housing market rebound turn out to be a head fake. 

I believe the risk reward is extremely favorable in owning AMWD here, looking out over the next few years, despite the stock being near its current 52 week high.  The story is a simple one, but I think the magnitude of the upside potential and the lack of massive longer term impairment risk makes it compelling.

Risks

Raw material and freight/diesel cost inflation can take 6-18 months to recover.  Next quarter in particular may see a larger headwind from lumber inflation.  Given the level of upside and being this early in a cycle that is unfolding positively, this shorter term risk seems to be one worth taking.

Concentration risk with HD/LOW combined representing 68% of revenues.  This is clearly the greatest longer term concern as HD and LOW are notoriously difficult in negotiating with suppliers.  But this is not at all a new phenomenon -- AMWD has successfully managed this risk for years.  AMWD should never have industry leading gross margins amongst its building products peers.  But AMWD’s lower margins than many other building products companies have been more than offset by its higher asset turns, leading to some of the highest ROICs in the group over the cycle.

Catalysts

Cabinet volumes rebound more than expected, driving greater than expected fixed cost leverage.

Material and freight cost inflation get recovered over time.

Catalyst