Description

American Woodmark is a manufacturer of kitchen cabinets and vanities for the remodeling and new home construction markets.  The company currently offers framed stock cabinets ranging from relatively inexpensive to medium-priced styles.  The products are sold primarily under the American Woodmark, Timberlake, Shenandoah Cabinetry and Potomac brands.  The company sells its products primarily through three channels of distribution: 1) home centers, 2) major builders, and 3) independent dealers and distributors.  The company’s two largest customers are Home Depot and Lowes which together accounted for approximately 69% of the company’s fiscal 2008 sales.

Our thesis is that AMWD is a short as the stock is very overvalued and even the current low earnings estimates may not be achievable.  Here are some of the valuation statistics based on consensus estimates:

                                    FY 2008A                               FY 2009E                                FY 2010E

PE                                83x                                          96x                                          36x

EV / EBITDA*            11x                                          11x                                          9x

*Our definition of EBITDA is EBIT plus D&A less promotional display amortization which we are assuming is $11mln for FY 2009 and 2010 ($11mln was the promotional display capex in FY 2008).   We believe that this is the proper way to look at EBITDA for this company as promotional display capex has approximated promotional display amortization over the last few years.  As such, we believe that promotional display capex should be treated as an expense.

We think that the company will miss estimates for the following reasons:

1)      Weak housing markets.  Existing home sales continue to decline with the June 2008 SAAR coming in at 15.5% below the June 2007 number.  Remodeling expenditures, which drive the company’s home center business, are tied to existing home sales with a lag.  In addition, housing starts continue to deteriorate as well with current numbers showing declines of approximately 30% so far in 2008 versus 2007.  The recent rise in mortgage rates does not likely bode well for either metric.  New home sales were down 33% in June followed by a down 38% May.  House price depreciation continues unabated with the average nationwide monthly decline in existing home prices for the first six months of 2008 at around 7% with price declines of double that in the top 20 metro markets.  Given the level of home inventories and the amount of foreclosures in the pipeline, house price depreciation is likely to continue.

2)      Credit is tight.  Cabinets are a big-ticket item and thus most cabinet purchases are financed.  It’s pretty clear that the easy money days are gone (for now at least).  Refinancing has become much more difficult and banks are terminating home equity lines.  In addition, the cost of money to the typical consumer has risen substantially; even more so in the last month or so with mortgage rates approaching 52-week highs.

3)      Weak consumer/demand.  This one is fairly obvious so I won’t go into much detail.  The key point we would like to make here is that kitchen remodels are expensive and discretionary for the most part.  Kitchen remodels during the housing boom were a relatively attractive proposition with rising real estate prices, abundant home equity, easy and cheap financing, and the notion that you will get the money that you spent on the remodel back if you sell the house.  Well, so much for that.  We now have declining real estate prices, negative home equity, difficult and expensive financing and the notion that you probably won’t get the money that you spent on the remodel back if you sell the house.  The situation is now reversed and the notion of sinking more money into an asset whose price is declining doesn’t seem to be that smart.  Add to that the weak economy, tenuous jobs picture, massive increases in energy and food prices and you have a situation where a discretionary kitchen remodel is at best a very low priority.

4)      Home centers having a tough time.  Home Depot and Lowes are expected to put up high single digit negative comps in their 2Q and the 2H of 2008 is expected to be weaker than the first half.  From the Home Depot Q1 08 conference call, “As expected, the significant weakness in the quarter came from continued softness in big-ticket and construction departments.  Building materials, electrical, millwork, and kitchens all had double-digit comp declines.”  Weak results at the home centers do not bode well for AMWD as they represent nearly 70% of the company’s sales.

5)      Masco (Ticker: MAS) cabinet sales down 17.5% in June 08 quarter.  In Masco’s most recent quarter, cabinet sales were off 17.5%.  In the March quarter Masco’s cabinet sales were off 13.7%, so the situation has deteriorated.  AMWD’s core cabinet sales growth over the last five quarters was worse than Masco’s for the last four of those five quarters.  Given the fairly strong correlation between AMWD’s and Masco’s cabinet sales we believe that it is safe to assume a high-teens sales decline at AMWD for the 7/08 quarter.  In addition, given the state of the company's end markets and its customers, we feel that it is probably safe to assume a mid-teens sales decline for the entire year especially in light of the fact that AMWD core sales were down 17% in FY 08 and the market appears to have deteriorated.  Assuming AMWD’s sales decline 15% for the year and gross margin compresses by only 100bps (it dropped by 300bps last year on a 21% drop in sales even as the company was exiting low-margin product lines and commodity costs have risen this year) and SG&A comes in at $92mln (annualized Q4 FY08 rate) earnings will come in at approximately $-0.46 versus current consensus estimates of $0.25.  Regarding the fiscal first quarter (ends 7/31/08), if the company’s sales decline maintains its apparent relationship with Masco’s cabinet sales then, even assuming an 18% sales decline and minimal fixed cost deleveraging, the company will miss the quarter as well.

Q107   Q207   Q307   Q407   Q108   Q208

Masco Cabinet sales decline (yoy):                   -19%   -15%   -11%   -11%   -14%   -18%

AMWD “Core” sales decline (yoy)**:             -15%   -19%   -17%   -14%   -16%   ???

**AMWD’s fiscal year ends in April.  Core sales represent sales excluding certain low margin product sales that the company exited as of the third quarter in FY 2007.

                                                FY 08A           FY 09E            Q1FY08A       Q1FY09E

Sales                            $602.4             $512.0             $166.1             $136.2

Gross Profit                  $103.1             $82.4               $34.3               $23.2

Gross Margin               17.1%              16.1%              20.7%              17%

            SG&A                         $98.8               $92.0               $26.9               $23.0

            Op Inc                         $4.4                 -$9.6                $7.4                 $0.2

            Int Exp                         $0.8                 $0.8                 $0.2                 $0.2

            Other Inc                      $2.1                 $2.1                 $0.7                 $0.5

            Pre-Tax Income           $5.7                 -$8.3                $7.9                 $0.5

            Taxes                           $1.4                 -$2.1                $2.8                 $0.1

            Net Income                  $4.3                 -$6.2                $5.1                 $0.4

            Shares                          14.5                 13.5                 15.1                 14.0

            EPS                             $0.29               -$0.46              $0.34               $0.03

            Consensus                                          $0.25                                       $0.11

Catalyst