Earnings Call Transcript - AWI Q2 2020

Operator, Operator

Thank you for joining us for the Second Quarter 2020 Armstrong World Industries Inc. Earnings Conference Call. All participants are currently in listen-only mode. Following the presentations, we will have a question-and-answer session. I would now like to turn it over to Mr. Tom Waters, VP of Corporate Finance. Please proceed.

Tom Waters, VP of Corporate Finance

Thank you. Good morning and welcome. Please note that members of the media have been invited to listen to this call and the call is being broadcast live on our website at armstrongceilings.com. With me on the call today are Vic Grizzle, our CEO; and Brian MacNeal, our CFO. Hopefully, you have seen our press release this morning and both the release and the presentation Brian will reference during this call are posted on our website in the Investor Relations section. I advise you that during this call, we will be making forward-looking statements that involve risks and uncertainties. Actual outcomes may differ materially from those expected or implied. For a more detailed discussion of the risks and uncertainties that may affect Armstrong World Industries, please review our SEC filings, including the 10-Q filed earlier this morning. Forward-looking statements speak only as of the date they are made. We undertake no obligation to update any forward-looking statement beyond what is required by applicable securities law. In addition, our discussion of operating performance will include non-GAAP financial measures within the meaning of SEC Regulation G. A reconciliation of these measures with the most directly comparable GAAP measures is included in the press release and in the appendix of the presentation. Both are available on our website. With that, I’ll turn the call over to Vic.

Vic Grizzle, CEO

Thanks, Tom, and good morning, everyone. As you all know, these are very unusual and extraordinary times, and I hope that everyone on this call, along with your families and your colleagues, are staying safe and well. This most recent quarter was challenging in many unique ways, but I'm extremely proud of how the Armstrong team has rallied in the face of this challenge. Safety has always been a non-negotiable at Armstrong, and this virus has been and will continue to be a significant challenge. But when you are accustomed to operating at world-class performance levels of safety, you find a lot of energy to innovate and to unique challenges like these, and our team has done just that. In our manufacturing and distribution facilities, our teams have created and installed barriers, altered operating processes, installed new methods of cleaning, and adopted numerous new practices and procedures to create a safe working environment. The organization has continued to demonstrate a passion for customer service, problem-solving, and innovation like these. As of today, all of our plants and distribution centers are up and running and meeting the needs of our customers. Output has been aligned to meet demand and our inventory levels are well positioned. Since the middle of March, I've been closely monitoring one of our most important customer service metrics, our perfect order measure. It's a multi-factor gauge of service quality. I've been pleased that despite the required changes in our factories to maintain safety, the remote working conditions, and unpredictable order patterns, we have maintained customer service levels at very high pre-COVID levels. Our headquarters and sales staff continue to work remotely and have become increasingly adept at remote work. Our digital toolset is now more important than ever, allowing us to remain fully engaged with our customers and our partners. We have seen significant usage of our self-service digital platforms, one-quote and quote to order. And during this pandemic, we have continued to expand our capabilities in these areas. For example, our project works platform, which creates drawings, installation instructions, and concurrent bill of materials was initially launched as a support tool for the DESIGNFlex family of products. But during this pandemic, we've rolled out project works capabilities in an expanded format to cover all core products, enabling us to automate more design and quoting work for architects, designers, and contractors, which has been a major productivity enhancer in these remote working conditions. Also, our product innovation efforts have intensified during this pandemic with heightened need for healthy interior spaces driving our efforts. In the quarter, the demand environment evolved much as we expected with sequential improvement from the low point in April. As we discussed on our last call, by late April, we were seeing significant drops in demand in key territories such as New York City, Northern California, and Boston. In the quarter, in our top seven territories, which includes these key territories, sales were down more than 40% as 6 of the 7 territories were subject to government-mandated shutdowns. Collectively, sales in all other territories were down 20%. These 7 top regions have an AUV premium to the rest of the country, so they are especially impactful. These territories and the construction sites are reopening now, albeit slowly, given the new required safety protocols are now tracking in line with the rest of the country. We have seen very few cancellations and most of the cancellations we are seeing tend to be relatively small remodel projects. In the quarter, sales of $203 million were down 25% versus the prior year. This represents the largest year-on-year quarterly decline that we have experienced in decades. Within the quarter, we saw each month getting progressively better from April's minus 30% result. Volume declines from government shutdowns, project delays, and distributor inventory reductions drove the year-on-year decline. AUV was flat in the quarter, with positive like-for-like pricing offset by the territory mix issues I mentioned earlier. Price is positive for the first half of the year as well as the quarter. The territory/mix headwind moderated as we moved throughout the quarter, and we continue to expect mix to be positive for the full year with the continued reopening of our key territories. At the product level, we continued to see positive mix trends as our high-end product offerings, including Total Acoustics and Sustain continue to outpace the lower end of the portfolio. Adjusted EBITDA in the quarter of $69 million was down 36%. Despite these volume headwinds, cash generation was positive, and our liquidity position improved by $35 million from the end of the first quarter, driven primarily by positive earnings and working capital. Commercial construction activity is a long way from where we were at the beginning of the year, but the pace is improving, albeit slower, as contractors learn to work within the new safety guidelines. Over the second half of the year, we expect that they will continue to improve their levels of productivity, and I'm encouraged by the trajectory of sales we are seeing on a weekly basis. Month-to-date sales in July are showing sequential improvement over June. And while we are encouraged by these trends, the marketplace remains uncertain. As such, we are not yet reinstating our normal detailed guidance for 2020. However, we are providing an outlook on the range of outcomes and possibilities we think is likely, assuming continued sequential improvement and no second wave of shutdowns. Brian will provide details in a moment, but I will note that we are now expecting sales to be down in the 10% to 18% range for the full year. As you've seen in our press release this morning, we are excited to announce another acquisition in our Architectural Specialties segment, Chicago-based Turf Design. This is our sixth acquisition in the past three years and further enhances our leading position in specialty ceilings and walls. With approximately $25 million in annual sales, Turf is the leading provider of custom-designed felt-based ceilings, walls, and barrier solutions. And felt is a fast-growing category within the architectural specialty space. It provides acoustical performance and enormous design flexibility. Given the increasing need for interior barriers due to COVID-19, this is an especially on-trend product. Turf's leading custom capabilities combined with Armstrong's existing offerings in an unmatched portfolio of felt products and solutions, and especially for healthy spaces. Turf brings to the table not just manufacturing capabilities but also a skilled and respected design team working out of the renovation center and design showroom called the Fire House in downtown Chicago. In addition, Turf brings a proven and complementary go-to-market approach to Armstrong with an established network of specialized independent sales firms focused on driving specifications within the interior design community. This further strengthens Armstrong's already leading go-to-market position and specification-writing capabilities. Turf felt products contain up to 60% recycled material and are 100% recyclable at the end of their useful life, further strengthening our leadership position in sustainable ceiling and wall products. Turf is also profitable and will be accretive to the overall Architectural Specialties segment. We are delighted to welcome the Turf team to Armstrong. Now this would be a great transaction to announce at any time. But given the current environment, I'm even more pleased to announce this acquisition. It demonstrates the financial strength of Armstrong and the fact that we are open for business. Our sights are set on the future as we continue to invest to build on the strongest specialty ceilings and walls platform in the industry. Our M&A pipeline is growing and remains active as we continue to pursue strategically important opportunities. And our financial strength allows us to do so. Our digitalization investments continue as we strive to become the easiest building products company to do business with and to drive efficiencies within our operations. And our R&D efforts are ongoing as we pivot to meet the newly required healthy space requirements in commercial interior spaces. We just completed our annual strategic planning process and reviewed the plan with our Board of Directors last week. The plan builds on our current financial strength as well as numerous exciting strategic priorities that we believe will drive profitable growth and cash flow in the coming years. As a result of this review and as a further acknowledgment of our strong free cash flow generation, our Board increased our share repurchase program by $500 million to $1.2 billion and extended the maturity of the program to December 2023. Given the current uncertainty in the commercial construction market and our desire to conserve cash, we expect to proceed with prudent caution in the short term, but we look forward to executing against this upsized authorization as we gain more clarity on the recovery and the overall demand environment. Now with that, I will turn the call over to Brian to review our financial results and guidance, and then I will come back to talk about the trends we are beginning to see.

Brian MacNeal, CFO

Thanks, Vic. Good morning to everyone on the call. Today, I will be reviewing our second quarter results. But before I begin, as a friendly reminder, I will be referring to the slides available on our website and Slide 3 details our basis of presentation. Beginning on Slide 4 for our second quarter results. Sales of $203 million were down 25% versus prior year, our largest quarterly decline since at least the '70s. Adjusted EBITDA fell 36%, and margins contracted 590 basis points. Adjusted diluted earnings per share of $0.75 fell 41%, driven by lower earnings. Adjusted free cash flow improved by $8 million or 15% over the prior year. Our cash balance at quarter-end is $117 million. Our revolver availability of $370 million is up $170 million as a result of our refinancing in September of 2019. This positions us with $487 million of available liquidity, up $35 million from last quarter and up $47 million from last year. Net debt is $18 million lower than last year, driven by cash earnings. As of the quarter end, our net debt to EBITDA ratio is 1.5x versus 1.6x last year as calculated under the terms of our credit agreement. Our covenant threshold is 3.75x. So we have considerable headroom in this measure. In the quarter, we did not repurchase any shares as we suspended our repurchase activity to preserve liquidity in light of the COVID-19 impact on the market. Since the inception of the repurchase program, we have bought back 9.6 million shares at a cost of $596 million for an average price of $62.13. As Vic mentioned, this program has been increased and extended. We now have $604 million remaining under our repurchase program, which now expires in December 2023. Turning now to Slide 5, adjusted EBITDA was down 36% as COVID-19 related lockdowns drove sharp volume declines in both of our segments and our customers reduced their inventories. AUV, while flat on the top line, was a headwind to EBITDA as the territory mix impact of the key seven markets falls through at a higher decremental rate. Raw material and energy costs were favorable, and we continued to get strong manufacturing performance from our plants despite a disruptive quarter. These manufacturing productivity gains have been aided by our ongoing digitalization investments as we now have more than 2,000 sensors deployed in our factories. SG&A was favorable as we were managing expenses in light of the demand outlook. While we are prudently managing our costs in the short term, we are continuing to make investments for the long term. I will address our cost reduction initiatives in more detail when I review our 2020 outlook. Slide 6 shows adjusted free cash flow performance in the quarter versus the second quarter of 2019. Cash from operations was up $11 million, aided by favorable working capital versus 2019. Capital expenditures were lower year-on-year as we are prioritizing our capital spend as a result of COVID-19. Interest expense was lower as a result of our refinancing in September 2019. WAVE's cash distribution was down, impacted by the same volume issues we were facing in our mineral fiber business. Adjusted free cash flow was up 15% versus 2019 and is a strong testament to Armstrong's best-in-class free cash flow generation capabilities, even under challenging circumstances. Slide 7 begins our segment reporting. In the quarter, Mineral Fiber sales were down 26% versus prior year. Pandemic related volume declines were essentially the entire story with regards to the sales decline. As Vic mentioned, AUV was flat on the top line, with like-for-like pricing up and territory mix down. Adjusted EBITDA was down $33 million as the volume decline fell through to the bottom line. As I mentioned, territory mix had an even greater negative impact on EBITDA than on our sales and contributed to margin contraction. Manufacturing productivity and cost controls, input cost deflation, and reduced SG&A spending were all positive contributors in the quarter. WAVE earnings were impacted by the same volume headwinds that affected mineral fiber demand. Moving to Architectural Specialties segment on Slide 8. The story is essentially the same. As large construction sites were shut down, Architectural Specialties shipments were delayed and the volume declines fell through to the bottom line. As Vic mentioned, we are encouraged that the vast majority of jobs that were stopped are delays and not cancellations. Starting in May, we have seen job sites reopening and shipments picking up. Slide 9 shows our year-to-date results. The combination of a good first quarter and a historically bad second quarter results in sales down 12% year-to-date and EBITDA down 17%. Of note, adjusted free cash flow was up 36%. Slide 10 is our year-to-date bridge. And although less dramatic than our second quarter bridge, you can clearly see the impact of the volume decline for the first half as well as our year-to-date favorability of input costs, productivity, and SG&A. Slide 11 reflects our year-to-date free cash flow, which is up $26 million, driven by operating cash flow, including working capital. Capital expenditures reflect the delaying actions we are taking to prioritize cash in the near-term. Interest expense is lower as a result of our refinancing in September 2019. WAVE earnings are impacted by the pandemic, in line with Mineral Fiber. Slide 12 is where we normally provide guidance. As Vic mentioned, given the lack of clarity in the market, our detailed financial guidance remains suspended. We do however want to provide some insights into how we are thinking about 2020. Given the trajectory of sales and the bid activity we are seeing, we currently believe full-year sales will be down 10% to 18%. With continued AUV growth, favorable input costs, ongoing manufacturing productivity, and SG&A reductions, we expect an adjusted EBITDA margin in the range of 35% to 37% and EPS down 20% to 35%. We've instituted actions that will drive $45 million to $50 million of savings in manufacturing and SG&A, primarily in the second half of the year. These cost reduction actions, coupled with our reduction of capital expenditures to a range of $50 million to $55 million, will drive a strong adjusted free cash flow margin of 22% to 25%. This excludes additional free cash flow benefits of $50 million from the sale of our Qingpu plant in China, which we will receive shortly, and the use of tax losses related to last year's sale of our international business, which will be applied to our third-quarter and fourth-quarter tax bill. As Vic mentioned, we are excited that we've completed the acquisition of Turf. This action is reflected in this updated outlook for 2020, and I want to provide a little more detail on the earn-out feature of this transaction that has been designed similar to our long-term incentive plan. The total cash consideration is $70 million or just under an 8x multiple of last 12 months' EBITDA. Our agreement also includes contingent consideration payable upon achievement of certain future performance objectives through 2022. The contingent consideration includes up to $24 million in additional cash consideration for performance at certain revenue and EBITDA growth targets. Full payout for target performance requires compound annual growth rates in excess of 23% for each measure through 2022. Similarly, there is an additional contingent consideration for performance above target and is capped at a total additional cash of $48 million. This maximum payout requires compound annual growth rates in excess of 38% for each measure through 2022. If this maximum payout is achieved, the resulting multiple based on 2022 EBITDA would be just under 6x. Turf is a strong business with a strong management team, and we'd be very happy if they achieve this level of performance. Slide 13 is borrowed from our investor deck and is our medium to long-term value creation model. 2020 aside, we believe we have a foundation that is built to grow sales in the high single digits every year, to expand margins, drive greater than 10% EBITDA growth annually, and grow EPS even faster; finally, from a value creation standpoint, taking already best-in-class adjusted free cash flow and grow it 10% to 15% per year. This model is unchanged by the coronavirus. These are challenging times, but I have no doubt that Armstrong is uniquely positioned to succeed. We have the leading brand, the best products, the best innovation pipeline, best distribution in the industry, best service, unparalleled industry margins, return on invested capital and best-in-class free cash flow generation. We fully expect to emerge on the other side of this crisis with our value creation model intact. With that, I will turn it back to Vic.

Vic Grizzle, CEO

Thanks, Brian. As I mentioned, I want to take a few minutes and discuss what we are seeing as we look ahead to an evolving new normal environment. Generally we're seeing improving construction activity, sequentially improving as we talked about and as we expected. Projects that were there before the economic shutdown are still there, and we have seen very few cancellations. These projects are ramping back up, but have done so more slowly than originally imagined due to their adoption of the CDC guidelines and new safety protocols, as I mentioned. Bidding activity declined significantly in April as you would imagine, but bounced back in May and has improved from there to its current level of down 13% month-to-date in July versus last year. Education bidding activity has actually turned positive in the past four weeks, and this is an encouraging sign for commercial construction activity. New construction projects that were started are going to get completed as will most major renovation work. With that said, it's reasonable to expect that there will be likely a pause in new office construction beyond the current project pipeline as companies need to assess new space and design requirements and education activity started earlier than prior years as schools took advantage of empty classrooms to make repairs and planned renovations. We expect this to continue into the summer months as normal. The big question will be how much money school systems will get from the federal government to make renovations in an effort to get kids safely back in the classrooms in the fall. In our view, whatever they get will be a net positive for additional renovation activity in schools. There remain significant market uncertainty over the next six months and maybe until there is a vaccine for COVID-19. So we are staying vigilant on the potential regional ups and downs created by outbreaks that are likely to continue in the various parts of the country. In our outlook, we are not expecting government-mandated shutdowns like we experienced in the second quarter. Now, as we think beyond the next 6-month period, the impact of this virus on how we think and behave will still be with us. Health and safety in commercial spaces is being redefined as we speak. One thing is certain. The old definition of what safe or healthy means will no longer be true. Therefore, changes in commercial spaces will be required to meet this new definition. The new expectations are what constitutes a healthy and safe space for office workers, students, patients, customers, etc. Upgraded HVAC systems, enhanced cleanability, increased spacing and flexibility to accommodate hybrid work from home, learn from home modes within offices and schools will become increasingly prevalent. Existing products like our antimicrobial Health Zone family of ceilings and our gasketed clean room suspension systems which control airflow and pressure in data centers and labs will now have applications in offices and schools, retail settings and other. Today, more than 90% of these products are sold into healthcare facilities and clean rooms, so the opportunity in these other verticals is significant. We are also working to develop additional ceiling solutions to better manage airflow and create more healthy spaces. These changes are likely to come in phases over the next few years. The first phase will require quick and makeshift changes to get workers, students, and customers back in these spaces as soon as possible. The second phase is likely to focus on making many of these changes more permanent and will involve systems and layout changes. And finally, the third phase is a phase of reimagining the spaces and optimizing for how students best learn and how office workers best collaborate. Now, the first phase is underway now. And as we are at AWI, many commercial space operators are already thinking about what the options are in a phase two and a phase three view of their situations. Commercial renovation has not seen a catalyst like this in decades. Making these kinds of changes in commercial spaces has been largely discretionary and subject to the financial health of the organization or state-local budgets. Because this catalyst has been borne of a health crisis, these changes may no longer be as discretionary. At AWI, we have a large and diverse installed base of 38 billion square feet of existing suspended ceilings in the U.S. alone. This space is composed of roughly 30% office, 20% schools, and mid-teens REITs or healthcare, retail, and transportation. Each of these verticals have their own mix of new and repair and remodel activity. But on average, 70% of our sales are tied to repair and remodel projects. Therefore we're especially excited about this renovation renaissance coming to commercial spaces. We are well-positioned as the leading ceiling brand with the most sustainable solutions for healthy commercial spaces. Our solutions are timely for what the market will require over the coming years and is a pillar of our strategic plan reviewed with our Board of Directors in our July Board Meeting. The excitement around this opportunity and the confidence in our ability to continue our industry-leading cash generation has motivated our Board to increase the authorization of our share repurchase plan that we mentioned earlier, to $1.2 billion over the next three years. This new catalyst for renovation activity is unlike anything we've seen in decades, and this catalyst for renovating commercial spaces is likely to be with us for years to come. Armstrong is a clear leader in the commercial construction market, and we’ve been for many, many years. We supply the highest quality, most innovative ceiling and wall products to our customers. We have strong distribution partners and great relationships with the leading architects, contractors, and developers. As the commercial construction market evolves out of this crisis, we will evolve also, and we will drive positive change in this industry. For example, we believe we will take a leadership role in promoting greater usage of digitalization by our customers to make the commercial design, ordering, and product delivery process much more efficient. As the commercial construction market will now require healthier buildings, we will also be at the forefront of this. We believe these changes in the long run will allow a market leader like Armstrong to further grow our business and further cement our industry leadership position. So with this new catalyst for renovation, along with our continued penetration into the architectural specialties segment, Armstrong is well positioned to resume profitable top-line growth. We are ready for these changes, and we will adapt and grow and continue to deliver strong returns for our shareholders through the continuation of making a positive difference in spaces where people live, work, learn, heal, and play. And with that, we will be happy to take your questions.

Operator, Operator

Your first question comes from the line of John Lovallo from Bank of America. Your line is open.

John Lovallo, Analyst

Hey, guys. Thank you for taking my questions. The first one on decremental margins, Brian. In Mineral Fiber, it looked about 60% in 2Q. Should this improve though as regional mix improves in the back half of the year? And then on the Architectural Specialties side, the 40% was a little bit higher than we would have expected. Maybe help us understand what drove that and how should we think about decrementals to the remainder of the year?

Vic Grizzle, CEO

Go ahead, Brian.

Brian MacNeal, CFO

Yes, John, it's a great question. As we look at our cost-out actions, a good majority of them are in the back half. So we should see that decremental hit come down from what we saw in Q2, and so we're in that 55% to 60% range.

John Lovallo, Analyst

Got it. Okay. Thank you. And then, Vic, maybe if we just think about your thoughts post Q1 and then sort of evolved over Q2, what was sort of the biggest delta in your thought process? I mean, is it just really as simple as things being slower to reopen? Any thoughts there would be helpful.

Vic Grizzle, CEO

Yes, there was a significant amount of uncertainty back in April regarding how long and how deeply this situation would persist. However, we believed that the cities would eventually reopen and that work would resume. One of the things that surprised us the most was the loss of productivity related to adapting to the new CDC guidelines on spacing and elevator capacity. For instance, when we had restrictions stating that only one person could ride in an elevator, it was challenging to transport entire crews to job sites efficiently, which caused delays in reopening those sites and the flow of materials. Throughout the quarter, I was monitoring a hypothesis about whether the jobs we had in our pipeline would still be available as mandates were lifted. I was relieved to see that we did not face significant cancellations. In fact, very few projects were canceled, and most of the work that was in progress before the shutdown remained in place, which was encouraging.