Description

Background

Armstrong World Industries (“AWI”) has a market cap of $3.1bn and TEV of $4.0bn. AWI has 3 segments: i) Ceilings (75% of EBITDA), ii) Resilient Flooring (“RF”; 20% of EBITDA; vinyl, linoleum, laminate), and iii) Wood Flooring (“WF”; 5% of EBITDA). AWI has the #1 position in all 3 units, with particularly dominant share (50-60%) in the highly-consolidated Ceilings industry (where the top 2 industry players control almost 90%). Ceilings and Resilient Flooring are much more levered to commercial construction (particularly repair & remodel, vs. new starts) and non-US geographies (30-40% of those segments), whereas Wood Flooring is entirely US residential (35% is housing starts; rest is R&R). In aggregate, only 9% and 6% of revenue is levered to new US resi and cmm’l construction, respectively (15% total). 56% of revenue is U.S. renovation (split btwn cmm’l and resi), and 28% is international (mostly Europe).

Due to the consolidated nature of the Ceilings industry, the influence of architects in the buying process, and exclusive distribution networks, AWI is able to implement 5% price increases every 6 months like clockwork, even as volumes have been declining – a testament to the quality of this business. Incremental margins are >30% for AWI all-in. Management executes very well and is highly shareholder-friendly. They have returned capital through buybacks / special dividends and managed to grow EBITDA amidst declining volumes through cost cuts (EBITDA is nearly back to peak levels despite volumes which are 30-40% below the peak).

25% of AWI is owned by TPG (4%) and the Asbestos Trust (21%). The Trust took 66% of the equity after AWI’s 2006 emergence from Chapter 11, and TPG bought 15% of this in Aug 2009 (at $22.31), but they have recently been selling down their stakes and are both on their way out.

Executive Summary

AWI offers an opportunity to buy a very high-quality business (LDD% ROIC at trough vols; high teens normalized) at 8x 2014 EBITDA, when EBITDA has the potential double in a few years. AWI trades at 9-10x 2015 FCF/shr. However, the quality of the business and its leverage to the recovery have been masked by: i) the stock’s illiquidity (which is changing), ii) lagging volume trends due to AWI’s later-cycle exposures (expectations have continually been too high), and iii) substantial raw materials inflation and isolated manufacturing hiccups within AWI’s smallest business, Wood Flooring (5% of EBITDA). As a result of these factors, the stock has done nothing over past 2 years, and it trades at a big discount to peers (2-3x cheaper than MHK).

Taken in order, after 2 recent equity offerings, TPG and the Trust have trimmed their stake to 25% from >50% this summer, and liquidity has picked up from $10-15mm/day to ~$40mm/day, which should help investor interest. As a result, management has been able to better utilize its balance sheet, buying back 8% of the market cap in conjunction with the Sep offering. Expect more of this to come; management also paid $22/share in special dividends in 2011 and 2012.

Additionally, we are now starting to see the turn in AWI’s end-markets, with some signs of growth over the past 2 quarters. However, this has yet to take off (consistently), and investors remain highly distracted by AWI’s Wood Flooring (WF) problems (new labor force, limited supply of the specific lumber species required, hardwood lumber inflation, lag of price increases required to offset inflation). Volume growth will highlight AWI’s high incremental margins and the quality of the Ceilings business (price increases will only accelerate from the current pace of 5% every 6 months).

WF EBITDA margins have declined from 11% in 2012 to 4% in 2013, but should bounce back to mid-teens relatively quickly. WF issues will normalize, helping profitability, but more importantly, removing an unnecessary distraction (AWI trades at 9x 2014 excluding Wood Flooring entirely). Investors will then look to AWI’s “mid-cycle” earnings power (>2x current EBITDA and $8-11/shr of FCF), rather than applying multiples to 2013/2014 EBITDA (trough volumes).

AWI is worth $110-160 at mid-cycle (2-3x the current price of ~$55) based on 8-9x EBITDA, or 13-14x mid-cycle FCF/share. This implies ~$70-105 discounted back 3 years (to today) at 15%. Conversely, 2015 figures imply $75-80 based on 8.5x Base Case EBITDA or 14x FCF/shr ($5.50). Limited downside exists – $48 (~10-15%) at 8x Bear Case 2014 EBITDA. It is difficult to pencil out downside much below the high $40s, where the stock has seen very strong support. The biggest risk is that this is dead-money for another 6-9 months.

Topline Trends and Expectations

Despite revenue that is ~20% below peak levels (and volumes off 30-40%), AWI’s management has returned EBITDA to 2007-2008 levels through successful cost cutting and continued price increases. The management team came in during late 2010 / early 2011 and has executed very well through a difficult environment, showing their ability to continually offset volume pressures and deliver on those items within their control.

Because of its end-market mix, AWI has not seen the same recovery as other building products companies, which are more levered to residential. Volumes continually declined within Ceilings and Resilient Flooring (mostly commercial) until finally turning in 2Q13. AWI management is finally turning more positive on commercial R&R, led by their retail and office end-markets and a bottoming in Europe (seeing flat volumes the past 2 quarters despite YOY comps down 23-25% in Resilient Flooring, for example). Checks with Ceilings distributors indicate quote/bid activity has improved markedly since the spring, setting up for a very strong 2014. Conversely, Wood Flooring has seen ~20% volume growth thus far in 2013 due to its 35% new resi exposure. Additionally, recent commentary from HD/LOW suggests that big ticket resi R&R projects are returning, which will help both volumes and mix for Wood/Resilient Flooring. Mix is also a positive contributor within Ceilings, due to AWI’s push into higher-end Architectural Specialties (10% of Ceilings segment and growing).

The continued implementation of price increases will also propel revenue. In Ceilings, the exclusive distribution channel and competitive landscape allow AWI to consistently capture additional margin (5% price increases every 6 months like clockwork). In Resilient Flooring, price increases are very achievable, but have not been necessary due to raw materials deflation in that business. In Wood Flooring, AWI has negotiated substantial price increases to offset hardwood lumber inflation, but pricing lags by 1-2 quarters (but was up nearly 10% YOY in 3Q13).

Sell-side topline growth expectations are quite modest (+6.7% in 4Q13, +6.2% in 2014). After being overly-optimistic for the past 18-months, the Street is anchored to the low-end of guidance (the midpoint calls for 8.5% 4Q13 growth). However, price actions already negotiated will add 4.2% to total AWI topline in 4Q13 (and ~400bps for 2014). New plants in China will add another 120bps to 2014 growth. Also, comps are relatively easy (+1.1% and down 4.4% for Ceilings and RF, respectively). European comps are particularly easy, with EU Ceilings down 5% in 4Q12 and RF down 15%. Because of these factors and the mix/volume recovery noted above, topline numbers look very beatable.

It should be noted that AWI’s sell-side coverage is somewhat sloppy, and little attention is generally paid to this smaller-cap name. 4 of the analysts initiated in 2013, and most cover it only to gain future equity offering business. For example, no analysts model out the impact of pricing. Mgmt announces headline sequential price increases, but analysts would need to go into finer detail with much help from mgmt in order to capture the appropriate timing lags and actual realizations.

Wood Flooring Issues

Wood Flooring margins are very depressed and should normalize over the next several quarters. WF EBITDA margins have declined from 11% in 2012 to 4% in 2013, despite volumes being 20% higher. Margins should be low-teens at this volume level and >15% at mid-cycle, according to mgmt. This underperformance is due to several factors. First, hardwood lumber prices are up 50-60% YOY. This has been magnified by restricted supply of Green Appalachian Lumber, which forces AWI to use kiln-dried lumber, which is 30-50% more expensive than Green Appalachian and also more difficult to use in the manufacturing process (negatively impacting yields and productivity). As supply of Green Appalachian comes online, prices and availability will improve. Second, AWI’s price increases (to offset this raw materials inflation) tend to take 60-90 days to flow through, but this lag has been stretched even further due to AWI’s stand-off with HD/LOW (which AWI ultimately won) and pushback from homebuilders. Recent channel checks indicate that price increases are flowing through and sticking, however. Price in 3Q13 was up “nearly 10%”, and is set to exceed 11-12% over the next several quarters. Therefore, pricing vs. raws will improve from a negative $2mm impact in 3Q13 to a tailwind of several million in the coming quarters (potentially better if hardwood lumber prices actually decline). Third, AWI had to add 400 new employees to meet surging demand, and ramping up capacity has proved more difficult than expected (hiring and retaining new employees). Labor productivity should also improve over the coming quarters. Lastly, mix is atypically concentrated in the builder channel (far lower margin), and margins should improve as resi R&R activity picks up (margins of ~2x builder business). Given external data points from HD/LOW and the Harvard LIRA study, resi R&R seems to be at an inflection point and poised for a big 2014.

As a result of these factors normalizing, 2014 margins should improve considerably from the recent 3-4% level to 12-13% by 2Q14 and further to 13-14% after 2014. This results in $50-60mm of incremental YOY EBITDA. However, after disappointing over the past several quarters, the Street has taken a “wait and see” approach on this segment. Most analysts are assuming a margin recovery to only HSD% in 2014.

Most importantly, this is a very small piece of the AWI story, yet it garners the vast majority of investor and analyst attention in meetings and on conference calls. Even if WF EBITDA were to fall to zero, AWI would trade at 9.5x 2014 EBITDA – still cheap for such a high-quality company at trough volumes.

Ceilings Pricing Dynamics

In Ceilings, AWI announces +5% pricing every 6 months (like clockwork) with 50-60% realization (AWI needs to honor pricing promised for larger jobs). As demand improves, these price increases will only come more frequently (perhaps 3x per year) and with greater realization (perhaps ~75%). The constructive pricing environment within Ceilings is due to: i) the consolidated competitive landscape (top 2 players control 86%; top 3 control 94%), ii) the fact that the distributors are exclusive to AWI products and are able to expand their own margins when AWI raises prices, iii) the influence of architects & designers in the specification process (relatively price-insensitive buyers “spec out” the exact type of AWI product they desire and builders follow the specs), iv) new product introductions (able to command higher prices with improvements such as energy efficiency, aesthetics, air purity, etc.), v) the presence of a wide variety of raw material inputs that are difficult to observe externally (inevitably the cost of one of AWI’s raw materials increases, justifying a price increase), and vi) the fact that Ceilings are a small component of the total construction / renovation bill.

However, given the fact that AWI was in bankruptcy (due to asbestos) during the last cycle, the pricing and margin potential of the Ceilings business throughout the cycle is not readily observable, and therefore not well appreciated.

New Plants and Other Initiatives

AWI is in the process of building 5 new plants: 3 in China (1 Ceilings and 2 RF, completed this year), 1 in Russia (Ceilings, shipping in early 2015), and 1 in the US (“LVT” or luxury vinyl tile, shipping in early 2015). Capex for these plants totals ~$300mm. Importantly, only ~50% of the revenue from these plants (~$400mm total) will be incremental. The rest of production will be reducing AWI’s cost structure in these markets, by replacing imports (and avoiding freight/duties) and gaining a local presence. For example, AWI pays 20-25% duties to import into Russia. For LVT, they can expand margins by ~20-30 pct-pts by shipping locally (from a lower cost plant), vs. sourcing from external European manufacturers. After-tax ROIC on these plants appears to be 30% or better. However, in the meantime, AWI is incurring substantial start-up costs ($15-25mm) in 2013, which tail off going forward and be better leveraged as these plants ramp up to more optimal utilizations. This will be another earnings lever going forward (particularly benefitting 2015).

Additionally, AWI could potentially double the size of its traditional Ceilings business (in ~5 years) by taking market share in the high-margin Architectural Specialties market. This market focuses on high-end ceilings used in “statement spaces”, such as building lobbies and airports (with special design/aesthetic requirements). Until recently, AWI neglected this highly-fragmented $2bn market, and their share stands at a paltry 6%. Given AWI’s technological expertise, leading distribution network, and their relationships with designers and architects, there is no reason AWI can’t hit 50-60% mkt shr over time (same as their US Ceilings market share). This would add ~$1bn of revenue at ~30% EBITDA margins, nearly doubling EBITDA alone.

Lastly, AWI’s Flooring business will eventually be sold, with the EU RF Flooring business as most near-term candidate. The EU RF business has ~$300mm in sales and no earnings, due to its more fragmented competitive landscape.  Potential flooring acquirors include: MHK, Tarkett, Beaulieu, Mannington, Forbo, and Kronotex.  There are also many diversified acquirers who would be interested, such as Xelia and St. Gobain.  Management is vocal about not being married to this business, and the industry is in need of further consolidation.

Capital Deployment

AWI is levered 2.5x today, but it generates $250-300mm of FCF excluding growth capex. As a result, even with ~$80mm of growth capex in 2014, AWI should delever to ~1.5x by 2H14. This compares to management’s comfort level of up to 3x. Mgmt has proven their willingness in the past to lever to ~2.8x on several occasions for special dividends and (more recently) buybacks. AWI’s $260mm buyback in Sep (done in conjunction with a TPG/Trust equity offering) was the first of its kind, as management was previously hamstrung by the stock’s illiquidity (did not want to further reduce the float). Expect more of these to come, with capacity reaching ~$700mm in 2H14. Leverage to 2x adds ~60 cents to 2015 Base Case FCF/shr (to ~$5.70) and 3x lvg adds ~$1.20/shr (to ~$6.50).

Valuation

At ~$55, AWI trades at 8.9x and 7.6x 2014 and 2015 Consensus EBITDA, respectively. This reflects very modest EBITDA growth assumed by the Street. This compares to 8.0x and 6.7x implied by the Base Case, respectively. On a P/E basis, AWI trades at 13.6x 2015 Street and 11.1x Base Case. Most importantly, AWI trades at only 9.7x Base Case 2015 FCF (conversion of ~115%).

AWI has substantial overlap with MHK, but it trades ~2x cheaper on both EPS/EBITDA. MHK is 100% Flooring, vs. AWI at ~50% Flooring and 50% Ceilings. Overall, AWI is less exposed to NA resi (35% vs. 45%) and slightly less exposed to Europe/Russia (20% vs. 30%). Within Europe, AWI is 100% cmm’l and MHK is mostly resi. Their market positions and industry constructs are relatively similar. Ceilings is a much better business than Flooring, but it is less exposed to resi. Also, MHK has a much smaller hardwood flooring exposure (~2-3% vs. 20%), which has been exposed to substantial raw material inflation (and other mfg issues at AWI). MHK’s stock is more liquid (~$125mm/day vs. ~$40-50mm/day). Importantly, AWI doesn’t have MHK’s M&A capabilities, and MHK is far better at communicating with the Street and executing on a quarterly basis.

AWI is worth $110-160 at mid-cycle (2-3x the current price of ~$55) based on 8-9x EBITDA, or 13-14x mid-cycle FCF/share. 2017 is assumed to be mid-cycle. This implies ~$70-105 discounted back 3 years (to today) at 15%. Conversely, 2015 figures imply $75-80 based on 8.5x Base Case EBITDA or 14x FCF/shr ($5.50). This assumes very modest buybacks (up to 2x). Upside is closer to $100 (in 1 yr) on 2015 Bull Case EBITDA and FCF (still assuming 2x lvg). These multiples are still very conservative relative to MHK at 10.7x and 9.5x 2014 and 2015 EBITDA, respectively, and 17.6x and 15.2x P/E.

The Bear Case assumes 2014 EBITDA is relatively stagnant, and the multiple contracts to 7.5x. This implies downside to ~$48 (~10-15%). It is difficult to pencil out downside much below the high $40s. This compares to AWI’s 2-year low seen last July of ~$39. The stock has seen very strong support at $48 since then. (See tables below).

Catalysts

• AWI’s end-markets accelerate, namely non-res R&R, leading investors to focus on AWI’s normalized earnings power and highlighting the quality of its businesses
• Wood Flooring issues are resolved, removing a big investor distraction and adding $50-60mm of incremental YOY EBITDA
• The overhang from TPG & the Trust is removed and the stock’s liquidity improves further
• As a result of the above 3 things, AWI’s multiple catches up to its peers
• AWI continues to return capital to shareholders, namely through buybacks
• New plants (China, Russia, LVT) are opened, lowering costs and leveraging up-front investments
• AWI takes market share in Architectural Specialties (6% today with 50-60% achievable)
• Management sells one of the following: i) EU Resilient Flooring,  ii) all of Flooring (WF and RF), or iii) the entire company (this last one seems to be their eventual end game)

Risks

• Overhang from future equity offerings
• Continued issues in Wood Flooring (further lumber inflation and availability issues, labor force attrition, problems implementing price increases, etc.)
• Continued stagnation in AWI's end-markets, with the most troublesome areas likely to be Education and Healthcare (rely on gov't funding) and Europe - downside from this is more likely dead-money rather than a big correction in the stock, given how little seems to be priced in the stock for any end-market recovery

Catalyst

• AWI’s end-markets accelerate, namely non-res R&R, leading investors to focus on AWI’s normalized earnings power and highlighting the quality of its businesses
• Wood Flooring issues are resolved, removing a big investor distraction and adding $50-60mm of incremental YOY EBITDA
• The overhang from TPG & the Trust is removed and the stock’s liquidity improves further
• AWI continues to return capital to shareholders, namely through buybacks
• New plants (China, Russia, LVT) are opened, lowering costs and leveraging up-front investments
• AWI takes market share in Architectural Specialties (6% today with 50-60% achievable)
• Management sells one of the following: i) EU Resilient Flooring,  ii) all of Flooring (WF and RF), or iii) the entire company (this last one seems to be their eventual end game)