Armstrong World Industries, Inc. — 2016 Q3 Form 10-Q Summary
Business context and reporting period
Unaudited quarterly report for the three and nine months ended September 30, 2016. AWI is a global producer of ceiling systems serving commercial, institutional and residential markets. On April 1, 2016, AWI separated and distributed Armstrong Flooring, Inc. (AFI); flooring results are presented as discontinued operations for all periods shown. Continuing operations comprise the Americas, EMEA and Pacific Rim ceiling businesses, including AWI’s 50% interest in the WAVE joint venture.
Key financial metrics
| Metric | Q3 2016 | Q3 2015 | 9M 2016 | 9M 2015 |
|---|---|---|---|---|
| Net sales | $334.9 million | $335.9 million | $936.6 million | $934.0 million |
| Gross profit | $109.7 million | $111.1 million | $285.5 million | $291.7 million |
| Gross margin | 32.8% | 33.1% | 30.5% | 31.2% |
| Operating income | $71.0 million | $59.3 million | $144.3 million | $134.6 million |
| Operating margin | 21.2% | 17.7% | 15.4% | 14.4% |
| Earnings from continuing operations | $55.9 million | $19.7 million | $65.4 million | $40.5 million |
| Net earnings | $70.6 million | $31.8 million | $77.6 million | $108.0 million |
| Diluted EPS from continuing operations | $0.99 | $0.35 | $1.16 | $0.72 |
| Diluted net EPS | $1.26 | $0.56 | $1.38 | $1.92 |
Q3 sales were essentially flat year over year. Excluding $7 million of unfavorable foreign exchange, sales increased approximately 1.7%, reflecting $7 million of favorable average unit value and $2 million of lower volume. For the first nine months, excluding $18 million of foreign exchange headwinds, sales increased approximately 2.2%.
Q3 operating income increased 19.7%, while nine-month operating income increased 7.2%. SG&A declined to $55.7 million from $64.0 million in Q3 and to $165.2 million from $189.9 million for the nine months. Cost of goods sold increased to 67.2% of sales in Q3 and 69.5% for the nine months, versus 66.9% and 68.8%, respectively, in the prior-year periods.
Cash flow from operating activities was an outflow of $2.6 million for the first nine months of 2016, compared with $144.0 million of cash provided in the prior-year period. Investing activities used $6.9 million, including $75.7 million of capital expenditures and a $68.5 million return of investment from WAVE. Financing activities used $88.2 million.
At September 30, 2016, cash and cash equivalents were $142.5 million, including $54.0 million in the U.S. and $88.5 million in foreign jurisdictions. Total debt was $873.7 million, compared with $988.3 million at December 31, 2015. No borrowings were outstanding under the $200 million revolving credit facility or the $40 million accounts receivable securitization facility. Outstanding letters of credit totaled $55.5 million.
Material changes versus the prior comparable period
- The AFI separation materially changed the company’s composition, with flooring removed from continuing operations and prior periods recast accordingly.
- Americas sales increased 2.0% in Q3 and 4.1% for the nine months, but segment operating income declined 22.7% and 16.0%, respectively, primarily because of separation-related SG&A and higher manufacturing costs.
- EMEA sales declined 5.1% in Q3 and 8.2% for the nine months, largely reflecting foreign exchange and weak commercial activity; operating results improved modestly.
- Pacific Rim sales declined 4.1% in Q3 and 4.8% for the nine months, while operating results improved due to pricing, lower input costs and lower SG&A.
- WAVE equity earnings increased to $57.0 million for the nine months from $49.6 million, although Q3 earnings declined slightly to $19.0 million from $19.6 million.
- Separation costs were $2.0 million in Q3 and $33.0 million for the nine months, compared with $7.4 million and $16.8 million, respectively, in 2015.
- Interest expense declined in Q3 following the April refinancing, but increased for the nine months because of a $10.7 million loss reclassified from accumulated other comprehensive income when interest-rate swaps were settled.
- Net earnings and net EPS declined for the nine months because 2015 included substantially higher discontinued-operation earnings and disposal gains. Q3 2016 included a $14.7 million after-tax gain from discontinued operations.
Guidance, outlook, risks and unusual items
Management stated that Americas activity was broadly flat, with improvement in new construction but moderated renovation activity. EMEA continued to face weak commercial markets and lower project funding in the Middle East. China’s commercial office market remained challenging, and India was affected by tight project financing. Management’s stated priorities are profitable global volume growth and improved returns in international operations.
The company implemented pricing increases during 2016 and reported favorable raw-material, sourced-product and energy costs of approximately $2 million in Q3 and $8 million for the first nine months versus the prior year. AWI planned to idle a China plant in the fourth quarter of 2016 and recorded related severance charges.
AWI refinanced its senior credit facility on April 1, 2016 with a $1.05 billion facility consisting of a $200 million revolver, a $600 million Term Loan A and a $250 million Term Loan B. Maturities were extended to 2021 and 2023. The company was in compliance with all debt covenants at September 30, 2016 and stated that available cash, operating cash flow and committed facilities should meet foreseeable liquidity needs.
Material risks include global economic and construction conditions, foreign exchange, raw-material and energy costs, international operations, leverage and debt covenants, the AFI separation and related tax treatment, WAVE performance, environmental liabilities, defined-benefit obligations, litigation and the China plant idling. Environmental liabilities recorded were $4.8 million at September 30, 2016, but potential costs at several sites, particularly St. Helens, Oregon, Macon, Georgia and Elizabeth City, North Carolina, could exceed recorded amounts. Kaiser’s September 2016 bankruptcy could increase AWI’s share of St. Helens costs.
The separation and distribution received a tax opinion supporting tax-free treatment, but the IRS or courts are not bound by that opinion. A contrary determination could create significant tax liabilities for AWI and shareholders. AWI authorized a $150 million share-repurchase program through July 31, 2018 and repurchased 187,331 shares for $7.8 million during Q3.
Important facts for investors to verify
- Reconcile continuing-operations performance after the AFI separation with the company’s prior-year recast presentation.
- Assess the sustainability of operating-margin gains given higher cost-of-goods-sold percentages and separation-related cost allocations.
- Review operating cash flow, working-capital changes and the effect of separation payments on liquidity.
- Verify debt maturities, covenant calculations, interest-rate swaps and remaining revolver and securitization availability.
- Evaluate exposure to weak EMEA and Pacific Rim markets, foreign exchange and unhedged intercompany loans.
- Monitor the China plant idling, environmental contingencies and the potential effect of Kaiser’s bankruptcy on St. Helens obligations.
- Separate recurring earnings from the $14.7 million discontinued-operation tax gain and other unusual items, including the $10.7 million swap-settlement loss.
- Confirm the tax-free status and ongoing obligations under the AFI separation and tax matters agreements.