Earnings Call Transcript - AWI Q3 2022

Operator, Operator

Ladies and gentlemen, thank you for being here and welcome to the Q3 2022 Armstrong World Industries Inc. Earnings Call. All participants are currently in listen-only mode. Following the presentation, we will have a question-and-answer session. I will now hand over the call to your host, Theresa Womble, Vice President of Investor Relations. You may begin.

Theresa Womble, Vice President, Investor Relations

Thank you, Kevin, and welcome everyone on the call this morning. Today we'll hear from Vic Grizzle, our CEO; and Chris Calzaretta, our CFO, who will discuss Armstrong World Industries' third quarter 2022 results and rest-of-year outlook, along with some progress on our growth initiatives. Our discussion of operating and financial performance will include non-GAAP financial measures within the meaning of SEC Reg G. A reconciliation of these measures with the most directly comparable GAAP measure is included in the earnings press release and in the appendix of the presentation, also issued this morning. Both of these are available on the Investor Relations website. During this call, we will be making forward-looking statements that represent the view we have of our financial and operational performance as of today's date, October 25th, 2022. These statements involve risks and uncertainties that may differ materially from those expected or implied. We provide a detailed discussion of the risks and uncertainties in our SEC filings, including the 10-Q filed earlier this morning. We undertake no obligation to update any forward-looking statements beyond what is required by applicable securities law. For those of you now following along, please turn to slide four on our presentation as we turn the call over to Vic.

Vic Grizzle, CEO

Thanks, Theresa, and good morning everyone. Today we reported solid topline growth of 11% for the third quarter versus the prior year, with Mineral Fiber net sales increasing 9% and Architectural Specialties net sales up 18%. Adjusted EBITDA increased 5% year-over-year and our consolidated EBITDA margin performance improved sequentially. As we noted in our press release this morning, we achieved this growth while facing continued headwinds on input costs and softening market conditions. This softening was primarily felt in discretionary renovation work that limited our Mineral Fiber unit sales growth to just 1%. This pause in discretionary work developed throughout the quarter and was experienced mostly in our independent distribution sales channel. We saw impacts on both Mineral Fiber and grid sales. In contrast, we had good performance in our retail and Latin America channels, which resulted in an unfavorable mix that pressured AUV performance in the Mineral Fiber segment. Supply chain issues improved in the quarter, but labor constraints continued, constraining construction capacity and perpetuating elongated project timelines. And as expected, new construction activity remained a headwind in the quarter. However, as the quarter progressed, we experienced the impact of greater economic uncertainty and higher interest rates on commercial construction activity. This unexpected slowdown appeared to track the decline in overall economic sentiment, such as weaker GDP estimates, a deceleration in commercial construction indicators, and expected further moderated inflation. This backdrop presented opportunities for projects to pause, and many did. Despite softer than expected market conditions, however, I’m very pleased with how our teams are executing and how our plants are operating. Their efforts are responsible for driving strong productivity as we continue on our lean manufacturing journey. Our teams are also maintaining a best-in-class customer service level, and our sales teams have worked diligently to execute well on our pricing initiatives. In the Architectural Specialties segment, we continue to generate strong topline and bottom-line performance in the quarter. Our team delivered a third consecutive quarter of record-setting sales and generated $16 million of EBITDA. This was the highest earnings quarter on record for the segment and a 20% increase from last year's result. Importantly, EBITDA margins expanded above 17%, continuing its sequential margin improvement on our way back to 20%. Although sales strength was broad-based across all material groups and verticals within Architectural Specialties, we are particularly pleased with the growth achieved by our most recent acquisitions; Turf, Arktura, and Moz, each generated double-digit sales growth in the quarter. Turf, specifically, delivered year-over-year sales growth of more than 40% in the quarter while expanding our margins. These are outstanding results and further demonstrate the synergies possible for these smaller but highly capable companies on the Armstrong platform. New order intake in the quarter remains strong also and supportive of our double-digit growth expectation for the full year and continued strength in 2023. We've seen robust quoting activity in education and transportation with solid wins in both of these verticals. The activity on transportation projects includes a mix of new construction and major renovation projects. Our recent investments in new product development in metal, wood, and Tectum have also strengthened our ability to get specified into more projects, into more spaces, and ultimately, drive additional growth. The breadth of our portfolio with our expanded design capabilities and now our size and scale, we're clearly establishing our leadership in this most important growth segment. With that, I'll pause and hand it over to Chris for some more details on our financial results. Chris.

Chris Calzaretta, CFO

Thanks, Vic, and good morning to everyone on the call. I'm very excited to be in my new role as CFO, and I'm grateful to have this opportunity to lead such a talented team. Having spent the past four and a half years here at Armstrong, I continue to be impressed with this organization and I'm excited about the future of this company. As I review our third quarter 2022 results as well as our updated 2022 guidance, please keep in mind that I'll be referring to the slides available on our website and slide three that details our basis of presentation. On slide five, we begin with our consolidated third quarter results. As Vic mentioned, net sales of $325 million were up 11% versus the prior year, driven by sales growth in both segments. Adjusted EBITDA increased 5% and adjusted EBITDA margin contracted 180 basis points. Adjusted diluted earnings per share increased to $1.36, or 16%, driven by higher adjusted earnings, a decrease in the effective tax rate, and a reduced share count from the prior year. I'm happy to report that in the third quarter, we repurchased $60 million of shares. This represents a continued step-up of the increased buybacks we made in the second quarter and brings our year-to-date share repurchase total to $145 million. Last week, we also announced a 10% increase in our quarterly dividend, which marks our fourth annual increase in our quarterly dividend since we instituted the dividend in 2018. This recent increase in share repurchase and dividend activity reflects our commitment to our capital allocation priorities, which remain unchanged. First, reinvesting into the business; second, strategic acquisitions and partnerships; and third, returning cash to shareholders via a stable dividend and a flexible repurchase program. Since the inception of the share program in 2016, we have repurchased 12.1 million shares for a total of about $831 million. As of the end of Q3 2022, we have $369 million remaining under our repurchase program, which runs through December 2023. When including our dividend payments, we have returned just shy of $1 billion to shareholders through both repurchases and dividends since 2016. Slide five also shows our third quarter adjusted EBITDA bridge versus the prior year. The 5% increase in adjusted EBITDA was driven primarily by favorable AUV performance, and an increase in sales volumes, which was partially offset by increased levels of inflation. Favorable AUV was driven primarily by positive like-for-like pricing and partially offset by negative Mineral Fiber channel mix. Both Mineral Fiber volume and AS sales growth contributed in the quarter, with Mineral Fiber volume growth driven by year-over-year increases in our retail and Latin America channels, which partially offset decelerating market conditions. EBITDA margin was compressed by continued inflation on raw material, energy, and freight costs. WAVE equity earnings remained under pressure by lower volumes during the quarter due to inventory destocking in grid and softer market conditions. On slide six, we summarize our Mineral Fiber segment results. Third quarter net sales increased 9% year-over-year, driven by favorable AUV of 8% and 1% of volume growth. First, on AUV, we experienced double-digit like-for-like pricing in the quarter versus prior year on the heels of our July 1st price increase. This was offset by negative channel mix. And while we were pleased that Mineral Fiber volumes were positive in the quarter, we were disappointed by the deceleration of demand in certain key markets, which contributed to the negative channel mix. On a positive note, we saw sequential improvement in our price over inflation dollar realization, an important step to expanding Mineral Fiber margins. We talked last quarter about a temporary squeeze on Mineral Fiber margins as the rate and pace of inflation hindered our ability to maintain our gross margins. We expect to get back to our historical realization rate in the coming quarters as the rate and pace of inflation moderates compared to what we experienced this year. These factors also impacted our Mineral Fiber EBITDA results, which increased by $3 million, or 3% year-over-year. While AUV was a strong contributor of $16 million to EBITDA results, it was lower than our expectations and sequentially lower than Q2 results due to the negative channel mix we experienced. Inflation remained a headwind for us. The two biggest drivers of that input cost inflation were raw materials and natural gas within our energy spend. We are hopeful that inflation overall will continue to moderate in the coming months, but natural gas prices specifically have been volatile, and such volatility could continue into the winter. And lastly, WAVE equity earnings were negative in the quarter compared to the prior year, driven by weaker volumes. The team at WAVE continued to price ahead of inflation during the quarter. While steel costs have leveled off over the past several months, we expect these lower steel price levels to flow through our results starting in Q4.

Vic Grizzle, CEO

Thank you, Chris. And before we move to the Q&A session, I'd like to provide a few additional thoughts on our digital and Healthy Spaces initiatives. Momentum for the Canopy by Armstrong, our online end-to-end platform continues to build. It's been two years now since we launched the platform and the breadth of capability added in just a short amount of time is simply impressive. The results are demonstrating the platform's ability to attract new repair and replace customers. Year-to-date sales through Canopy have increased nearly 400% from the prior year. The number of orders on the site has increased at a similar rate and we're up 44% sequentially from the second quarter. And we're also pleased to see new users continue to grow with more double the number of users from 2021. ProjectWorks, our automated design service continued to make progress as well. With ProjectWorks, we're further building customer loyalty and trust by offering this unique capability to streamline the entire design to pre-construction process, all-in on average in 48 hours. We're providing this service to more and more architects and contractors and achieving higher win rates as a result of this. What's exciting to see from these digital initiatives is how they're further differentiating us in the ceilings category, enabling the next level of innovation and are creating higher levels of customer loyalty. And most importantly, these initiatives are adding incremental sales for both our Mineral Fiber and Architectural Specialties segments. Trying to help the spaces, we continue to get confirmation of the need and desire for healthy indoor spaces as broadly defined as healthier air, comfort, and sustainability. High performing healthy buildings offer occupants high indoor environmental quality while reducing energy usage and carbon footprints. We believe our ceiling solutions have an important role to play in helping owners and occupants achieve healthier spaces. We're tackling this opportunity through our own innovative products like Health Zone, AirAssure, and Total Acoustics, and we're engaging in partnerships to enhance our product development efforts and extend our reach into this new space. On this front, I'm excited to announce a new partnership with a leading air quality sensors company called Aware. Aware is a developer of innovative indoor environmental quality sensors that empower users to monitor and mitigate risks to indoor environmental quality. Their sensors can measure seven key indoor environmental quality parameters, such as particulates and VOCs, acoustics, light, and others. We've been using Aware sensors and dashboards in our Living Lab at our corporate headquarters for some time now and are excited about the value this data provides in solving for healthier spaces. We're now in the process of conducting pilot programs with a variety of school districts where Aware sensors will help schools identify and improve indoor environments and overall enhance the learning experience for their students. We believe this tool is critical to the customer education process and ultimately, should help spur demand for our Healthy Spaces solutions. This partnership adds to those we've announced earlier in 2022 such as our expanded relationship with price industries and our partnership with 9 Foundations. I look forward to updating you on our progress with all of these efforts in the coming quarters. Now, before getting to your questions, I'd like to take a step back and just share how we think about our business in light of the macroeconomic conditions we are about to face. Our business is steady and resilient. This comes from a variety of factors, including the portfolio effect of both the diverse set of vertical markets we serve and the types of projects that make up the demand profile for our products. Our vertical span from education to office to healthcare, retail, and transportation, and very rarely are all of these verticals moving in the same direction at the same time. Add to that the various project types from new construction to large renovation to smaller repair jobs, all on different time schedules. The dynamics of this diverse set of factors dampen the peaks and the troughs throughout the cycle, providing for a steady stable business. Longer term, our targets remain unchanged. We have an attractive set of growth initiatives, including our Digital and Healthy Spaces initiatives that are driving incremental growth for both Mineral Fiber and Architectural Specialties. We see opportunities for continued growth in the Mineral Fiber AUV rates above our historical rate of 5%, supported by our innovation and our new specification work. And we expect market tailwinds for delayed renovation activity due to the pandemic and now recessionary pressures that should propel Mineral Fiber volumes back to 2019 levels. Aside from the timing of the market tailwinds, we believe our long-term value creation targets are achievable. As we always do, we will continue to assess and evaluate our macroeconomic conditions and make adjustments. But all in all, I remain excited about the long-term growth potential for Armstrong. And with that, we'll turn the call over to the operator and open it up for questions.

Operator, Operator

Our first question comes from Joe Ahlersmeyer with Deutsche Bank. Your line is open.

Joe Ahlersmeyer, Analyst

Yes, good morning, everybody. Thanks for taking my question.

Vic Grizzle, CEO

Good morning, Joe.

Joe Ahlersmeyer, Analyst

Yes, so within Mineral Fiber, wondering if we could just put a finer point on the AUV, talk about double-digit like-for-like price? Is there a way we can get a little closer on what that number is? And maybe what the negative customer and channel mix was? And then just secondarily, did you see any noteworthy product mix within that as well?

Vic Grizzle, CEO

Our product mix remained largely unchanged, aligning with our expectations, and showed a slightly positive trend during the quarter. There was no significant impact from product mix on the overall results. Architects and contractors are increasingly requesting our latest products, which typically come with higher price points. Regarding the average unit value, we maintained double-digit like-for-like pricing in the quarter and benefited from the price increase implemented on July 1st. The overall mix was influenced primarily by channel mix; our retail and Latin America channels operate at much lower price points, which offset the positive pricing we achieved. I would estimate the impact of that channel mix in the middle single-digit range, aiding in understanding the price realization from the July increase. Overall, we are satisfied with our price realization, even though some unexpected channel mix offset those gains.

Joe Ahlersmeyer, Analyst

Okay, great. That's encouraging. Just based on those recent price increases, and the healthy AUV guide for 4Q as well as your expectation for moderating inflation from here. Do you have an estimate, maybe on EBITDA, of how much price/cost favorability you could be carrying into the first half of next year?

Vic Grizzle, CEO

You want to comment on that, Chris or do you want me to take it?

Chris Calzaretta, CFO

You want to take it?

Vic Grizzle, CEO

Okay. From the second quarter to the third quarter, we are aligning our pricing with inflation. I anticipate this will continue into the fourth quarter, which should lead to some margin growth then. It’s challenging to predict the inflation trends for next year at this time. However, we generally maintain our pricing throughout various market conditions, and I expect we will do the same next year. The answer to your question will depend on your inflation expectations. Currently, we expect inflation to begin to decrease and become more favorable in the fourth quarter. The extent to which this impacts next year will require us to wait until February for a clearer assessment.

Joe Ahlersmeyer, Analyst

Okay, understood. Thanks a lot.

Vic Grizzle, CEO

You bet.

Operator, Operator

One moment for our next question. Next question comes from Keith Hughes with Truist. Your line is open.

Keith Hughes, Analyst

Thank you. I want to get some more detail on your commentary of deceleration in the quarter, it's obviously going to show up in your full quarter volume guide. Can you talk a little more about these projects just being delayed or you seeing outright cancellations? And if there's any sub-segment that really stands out where this is most pervasive?

Vic Grizzle, CEO

Yes, that's a relevant question as we focus on distinguishing between delays and cancellations. We haven't observed any cancellations and have been monitoring this aspect since the pandemic began. In May and June, we experienced mid to upper single-digit volume growth, and we anticipated that growth trajectory would continue into the third quarter. However, it did moderate over the quarter, particularly evident in discretionary projects where people could easily choose to pause or delay. Major renovation, new construction, and ongoing midsize projects continued to progress as planned. The downturn we noticed in our business came primarily from this flow segment, which softened significantly throughout the quarter. I attribute this to two main factors: the prevailing uncertainty, prompting those who can wait to do so, and the realization that inflation is stabilizing. Individuals who received quotes and were surprised by the costs of their renovation projects might now be considering waiting an additional three to six months or even a year for better pricing. It seems that those who could afford to delay opted to wait, which was particularly felt in the third quarter.

Keith Hughes, Analyst

For your next quarter production, do you anticipate needing to reduce production below demand to avoid excess inventory, especially since there isn't much Mineral Fiber inventory in the market?

Vic Grizzle, CEO

Only on the edges here. I think the type of adjustments we're talking about from the third quarter to the fourth quarter are really around the fringes of our production cycle. We can manage this on a day-to-day basis. So, I don't see any major corrections on the manufacturing floor at this point.

Keith Hughes, Analyst

Okay. Thank you.

Operator, Operator

One moment for our next question. Next question comes from Kathryn Thompson with Thompson Research Group. Your line is open.

Brian Biros, Analyst

Hey, good morning. This is actually Brian Biros on for Kathryn. Thank you for taking my questions today. First one, I guess, building on the question from previously, I guess, when did you really see the pace change in growth? And I guess what are you seeing going forward into Q4 and early 2023? It seems like maybe July timeframe was when you started to see the deceleration really start facing earlier comments; I guess just since then, has it accelerated or has it kind of just all come at once and it's kind of steadied out? How's it trended since July?

Vic Grizzle, CEO

Yes, really decelerated throughout the quarter. We had a really strong first half of July, which, by the way, was coming off of a July 1 price increase. So, there was some pretty good strength in the first part of July in the face of that price increase. That was encouraging. So, I would really put it on toward the end of July, and then a little more in August and then a little more in September, kind of again, it follows a bit of the sentiment curve that we were all kind of experiencing with the reductions in economic activity outlook and the deceleration of some of these indicators that we've all been watching. Although they stay positive, they were decelerating. So, I hope that answered your question, but I would say really toward the end of July, and then we saw our first signal, but then in August and September is where we got the validation of that.

Brian Biros, Analyst

That answers the question. Thank you. And as a follow-up, how is the retail channel reacting to the deceleration you've been talking about in the independent distribution channel? Is it kind of isolated over in the independent one, and probably won't bleed into the retail side? Or is it maybe a leading indicator of things that happened in the first tier, but then it'll bleed into the rest of the channels going forward? What are you hearing from the retail side?

Vic Grizzle, CEO

It kind of moved together typically. What makes it choppy on the retail side, as you've heard before, is some of these load-ins and inventory drawdowns, that we get a little bit more lumpiness in the retail channel. But the retail channel for the most part is serving the small contractor, as you know, so really, the lighter contractor work. So, they kind of move together, and I wouldn't try to separate that they're seeing one market versus another market, but it can be more lumpy quarter to quarter.

Brian Biros, Analyst

Okay. Thank you.

Operator, Operator

One moment for our next question. Our next question comes from Garik Shmois with Loop Capital. Your line is open.

Garik Shmois, Analyst

Hi, thanks for taking my question. I just wonder if you could speak a little bit more broadly, just in prior periods of economic deceleration, I think you mentioned that your volumes tend to remain relatively stable. So, I'm just kind of curious. I know we're not talking about 2023 formally, but in this new period, how do you anticipate your volumes in Mineral Fiber generally to behave? Would you expect it to be relatively stable? Or does the recent deceleration give you some pause to that outlook?

Vic Grizzle, CEO

Despite the deceleration, Mineral Fiber volume growth remained positive this quarter. Looking back over the past decade, 95% of the data points have stayed within a plus or minus 2% range. As I mentioned earlier, the peaks and troughs are mitigated by the diversity of projects in our portfolio and the verticals we operate in. This consistency is not expected to change. However, during the pandemic, everything was shut down, eliminating any portfolio effect. In a typical recession, we would anticipate some verticals to remain positive while others might perform worse. I believe the portfolio effect will still apply, and I expect our diverse end markets and project types to continue contributing positively.

Garik Shmois, Analyst

Got it. Thanks for that. I just wanted to ask on your Architectural Specialties, if you've noticed any change in the bidding environment there?

Vic Grizzle, CEO

Well, that market, as you know, is they being specialty incentives, but very much a project-based business. So, I think the difference in that business, frankly, is not so much on the market side, but I think where Armstrong is playing, we're playing in so many different spaces within the same commercial buildings. We're playing in more of the commercial buildings, and we're winning more work. I think those are the real drivers behind Architectural Specialties business. Again, our breadth of our portfolio and the capability we have there is just pulling us into more areas. So, again, the project nature of that business will give us a little bit more visibility in what's going on in that business than some of the flow parts of the Mineral Fiber business that I would contrast that with.

Garik Shmois, Analyst

Understood. Thank you.

Operator, Operator

One moment for our next question. Our next question comes from Phil Ng with Jefferies. Your line is open.

Phil Ng, Analyst

Good morning, everyone. You've mentioned consistently high bidding activity for quite some time, possibly since last year, but this year has seen some volatility in demand due to a challenging macroeconomic environment. What is your current visibility for 2023? Are you confident that with the existing backlog, volumes could increase next year in Mineral Fibers, or how should we approach this situation?

Vic Grizzle, CEO

Yes, the bidding activity you mentioned is a first-time occurrence, which indicates promising potential for future projects, possibly within the next 18 to 24 months. However, we observed that this data hasn't translated into actual projects yet; there hasn't been much reflected in the Department of Defense start data or in the emergence of new projects. This situation highlights the existing constraints in the marketplace, particularly related to supply chain and labor challenges, or possibly the effects of high inflation, which have impeded business execution. Despite this, I believe that there is strong market demand for commercial construction activity. The actual impact in 2023 or 2024 remains uncertain, but I find the indicators encouraging. We'll need to monitor how supply chain and labor issues evolve, along with the effects of rolling inflation, as these factors will significantly influence the realization of projects in 2023. By February, we should have a clearer picture of the situation.

Phil Ng, Analyst

Got you. And with growth coming through a little slower than expected, how much of a lever is throttling back investments, which you've been investing in the last few years to come? And when you expect that to kind of come through? Certainly, your 4Q implied guidance is encouraging. I mean, demand down and Mineral Fibers still expecting margins to be up to par that assumes price costs, but help us think through maybe next year if demand is weaker again, your ability to kind of drive margin expansion throttling back investments and price costs?

Vic Grizzle, CEO

Yes. I believe that while we might reduce our expenses, we are unlikely to cut back on our investments. Instead, we may look to lower costs in other areas. Overall, I think we excel at identifying opportunities to manage our costs so that we can align ourselves with the current market conditions, allowing us to improve our margins and effectively pass through price increases over inflation within the business. Moving forward, we will remain cautious in managing our expenses to ensure that we are positioning the business for margin growth, which we have consistently achieved throughout different phases of the economic cycle.

Phil Ng, Analyst

Yes. Thanks.

Operator, Operator

One moment for our next question. Our next question comes from Susan Maklari with Goldman Sachs. Your line is open.

Susan Maklari, Analyst

Thank you. Good morning, everyone.

Vic Grizzle, CEO

Hi Susan.

Chris Calzaretta, CFO

Hi Susan.

Susan Maklari, Analyst

My first question is, as we do think about the setup into 2023, and the potential that some of this inflation does roll over, and perhaps some of your underlying customers are waiting for that to come through, help me in thinking about price versus volume in Mineral Fiber, understanding that there's no precedent necessarily to take that pricing down. But given the magnitude and the number of increases that we've seen in the last two years, how do you think about the trade-off between those two?

Vic Grizzle, CEO

I view the situation like this: our teams have done an excellent job managing the gross margin spread. As you know, we've maintained our prices even during deflationary periods, and we need to increase them during inflationary times. We focus on the gross margin spread to fund our investments and sustain our business model. That's our approach. We plan to continue managing this next year depending on the macroeconomic conditions, ensuring we balance pricing and costs to enhance gross margins.

Susan Maklari, Analyst

Okay. And then, as we think about capital allocation, can you give just an update on the M&A pipeline, anything that you're seeing there? And changes? And then how are you thinking overall, just about capital allocation, your interest in buybacks versus perhaps some of the other opportunities?

Vic Grizzle, CEO

Yes, I think, Chris, I'll let you comment on this, but just in terms of the business development effort, again, we have a fully staffed team, and they're hard-charging it every day. I review this periodically with the team, so I'm very engaged in what they're working on. I'm very encouraged by what they're working on. I still am hopeful that even some of the smaller deals we're working on, we can get done here in the near future. So, we're active here. Susan, I think this is a timing thing that we don't control. Frankly, these companies are not on the market for sale in a bidding process on a timeline; we really are working the relationships and partnerships as precursors to buying these companies, but we continue to be active here. Our pipeline continues to be robust and healthy here. I think it's fair to expect more from us in this area.

Susan Maklari, Analyst

Okay, thank you and good luck.

Vic Grizzle, CEO

Thanks, Susan.

Chris Calzaretta, CFO

Thanks, Susan.

Operator, Operator

One moment for our next question. Our next question comes from Rafe Jadrosich with Bank of America. Your line is open.

Rafe Jadrosich, Analyst

Hi, good morning. It's Rafe. Thanks for taking my question. Vic, I wanted to follow up on your comment about pricing. Historically, you have consistently increased pricing on Mineral Fibers. You mentioned raising prices each year to maintain a certain gross margin level. I just want to clarify if there is a change in how you're thinking about pricing going forward in relation to cost, or if you plan to continue with the same frequency of price increases moving ahead.

Vic Grizzle, CEO

Yes, no change. To be really clear, there's no change in how we're thinking about that. And how we expect to manage it.

Rafe Jadrosich, Analyst

Okay, I appreciate the clarification. And then just what's the outlook for inflation for this year, maybe like relative to where it was a quarter ago? And then you've commented that natural gas materials have been the biggest headwind for your input cost; you can obviously see that natural gas prices have come down quite a bit in the last 90 days. So, when would we start to see some of this — some of the relief on input costs start to flow through your P&L?

Chris Calzaretta, CFO

Yes, Chris here. Thanks for the question. For Mineral Fiber, we are anticipating high single-digit inflation for the year. You pointed out the key uncertainty around natural gas pricing. We expect overall inflation to moderate slightly as we approach the end of the year, but volatility will continue to depend on natural gas prices, which spiked in the latter part of the third quarter. If prices keep declining, there could be some upside potential for us. That remains the main uncertainty which we are closely monitoring.

Rafe Jadrosich, Analyst

If natural gas prices kind of stay, when would you expect that to start to be a benefit to your margins?

Chris Calzaretta, CFO

Yes, I think that'd be part of something that we'd look at as we head into 2023. And again, there's a lot of variability in that natural gas market. So, I'd say as we finish out the year and head into 2023, that'll give us a better insight into your overall inflation profile.

Rafe Jadrosich, Analyst

Great. Thanks.

Operator, Operator

One moment for our next question. Our next question comes from John Lovallo with UBS. Your line is open.

John Lovallo, Analyst

Hey, guys, thank you for taking my questions. The first one is it seems like the 4Q guide may be implying an improvement in channel mix. Are you seeing that already? Or if not, what sort of gives you the confidence that that's going to happen?

Vic Grizzle, CEO

Yes, I think in October we can say that what we are experiencing aligns with our expectations for the month. So again, as you've heard us mention before, certain fluctuations and orders don't typically occur two quarters in a row. What we encountered in the third quarter was somewhat unusual, and what we're observing in October supports that.

John Lovallo, Analyst

Got you. Okay. You mentioned that education was one of the strong parts of the business this quarter. I'm curious if you're seeing any increased interest or penetration for Healthy Spaces in that education segment.

Vic Grizzle, CEO

Overall, our activity in the summer and the third quarter was very strong. We closed many deals during that time. We are tracking twice the number of projects in Healthy Spaces compared to before. This area has a lot of potential, especially with current needs beyond COVID that our Healthy Space solutions can address in classrooms, and we are excited about it. Engagement has increased significantly. Additionally, there is still a substantial amount of funding available—less than 20% of the extra funds have been utilized so far. Thus, there are ample resources for educational support and upgrades related to Healthy Spaces specifically.

John Lovallo, Analyst

Thanks, Vic.

Vic Grizzle, CEO

Yes, thank you.

Operator, Operator

One moment for our next question. Our next question comes from Dan Oppenheim with Credit Suisse. Your line is open.

Dan Oppenheim, Analyst

Thank you very much. Could you discuss the specialty side a bit more? You've mentioned winning additional buildings and we've observed an increase in margins, which clearly reflects your offerings. I'm curious about the margins concerning further expansion in the fourth quarter. What are your thoughts on the potential developments in that area for 2023?

Vic Grizzle, CEO

Yes, I think our teams are doing a great job selling the new design capability we have, as well as the depth and breadth of our portfolio to cater to more spaces within these buildings for architects. It's really exciting. We're gaining good leverage with the increased activity in our plants. Our teams are effectively managing costs and enhancing productivity, which is essential for achieving good operating leverage at the plant level. Both of these factors are significant drivers for us to continue expanding our margins. We're on track to return to our goal of a 20% EBITDA level, which we’ve established as the target for running this business. I'm not focused on maximizing margins too quickly at the expense of growth; this is a strong growth engine for us. However, that 20% EBITDA level reflects the quality of that growth, and we're making good progress towards reaching that target.

Dan Oppenheim, Analyst

Great. Thanks.

Vic Grizzle, CEO

And that should continue into 2023. I guess that was your question, right? That should continue into 2023.

Dan Oppenheim, Analyst

Great, thanks.

Operator, Operator

One moment for our next question. Our next question comes from Stephen Kim with Evercore ISI.

Stephen Kim, Analyst

Thank you very much. You mentioned that the segments of retail, LatAm, education, and transportation are performing strongly. I was interested in how those specific segments have trended throughout the quarter and as we enter the fourth quarter. Did they continue to show strength, or was there a widening weakness across categories or segments as the quarter went on?

Vic Grizzle, CEO

We usually observe a decline in education toward the end of the quarter, making it difficult to determine how much of that was due to the seasonal return of students to classrooms in September. However, I would highlight that the most notable areas were office and healthcare, where we experienced some of the weakest activity in renovation work. Overall, from the start to the end of the quarter, those areas seemed to stand out the most.

Stephen Kim, Analyst

Understood. That makes sense. Additionally, you mentioned inventory levels, particularly noting some destocking in grid. Is there anything else to highlight regarding that? Do you have any concerns? In Q2, you indicated that your inventory distribution appeared to be quite normal. I'm curious if you've observed any changes since then.

Vic Grizzle, CEO

No, I think inventory levels from our distribution partners are at comfortable levels. In the third quarter, everyone felt positive about their inventory levels due to expectations of stronger volume growth. However, when the market signaled less volume growth, especially in the grid part of the business, they ended up destocking more than anticipated in a weaker market condition. Throughout last year and 2021, there were nine price increases due to steel inflation, leading to higher accumulation of volume on the grid side compared to the tile side. Overall, I remain comfortable with the outlook for growth in the third quarter, although that outlook moderated throughout the quarter, particularly impacting the grid business as it experienced a bit of destocking.

Stephen Kim, Analyst

Yes, that makes sense. Okay, thanks a lot.

Vic Grizzle, CEO

Yes. Thank you.

Operator, Operator

One moment for our next question. Our next question comes from Adam Baumgarten with Zelman Associates. Your line is open.

Adam Baumgarten, Analyst

Hey, good morning, everyone. Maybe just sticking with Mineral Fiber volumes in October, are they consistent with the implied mid to high single-digit decline for 4Q as a whole? Are you expecting November and December to decelerate further in that guide?

Vic Grizzle, CEO

Yes, I think the key point here is what we experienced last year. We shifted our price increase from February to January this year, which resulted in higher buy-ahead volume in December than usual. Therefore, we will be comparing that event in December, and I anticipate that there will be more of that year-over-year difference in December.

Adam Baumgarten, Analyst

Okay, got it. You mentioned that new construction was still a challenge in the quarter. Do you anticipate it turning into a benefit at some point in 2023?

Vic Grizzle, CEO

The actual starts this year are expected to be positive, but they are significantly below the original mid-single-digit forecast. We believe that the actual figures are even lower, though still in the positive range. It's uncertain how macro conditions will influence the actual start and continuation of this activity next year. As of now, it seems unlikely that there will be any significant tailwind next year.

Adam Baumgarten, Analyst

Okay, got it. And then just maybe one more quick one. In the presentation, you called out on the Mineral Fiber margin bridge inventory valuation as a headwind; can you just give some more detail around that?

Chris Calzaretta, CFO

Yes. Hey, Adam, this is Chris. Yes, inventory valuation; think about it more in terms of, call it, inflation running through inventory levels and flushing through on the P&L due to valves.

Adam Baumgarten, Analyst

Okay. Got it. Thank you.

Chris Calzaretta, CFO

So, really more inflation timing related. Yes.

Operator, Operator

One moment for our next question. Our next question comes from Kenneth Zener with KeyBanc Capital Markets. Your line is open.

Kenneth Zener, Analyst

Good morning, Vic, Chris.

Vic Grizzle, CEO

Hi, Ken.

Chris Calzaretta, CFO

Hey, good morning.

Kenneth Zener, Analyst

Your business appears to be more stable compared to the broader economic concerns. However, it seems that the regional dynamics have changed since COVID, especially in the Northeast where you're prominent. For example, in San Francisco, where the Salesforce tower, a significant client of yours, has seen a decrease in occupancy. Can you provide insight into the differences in occupancy rates by region, particularly regarding the strong growth noticed in areas like Texas and Florida compared to traditional markets? I know there's been a lot of replacement in your portfolio, but could you share your thoughts on the larger geographic trends we are observing in the country? Thank you.

Vic Grizzle, CEO

Yes, I believe the back-to-office rate and overall pace nationally has come to a halt, as we've all observed closely. However, it's important to note that this varies by region. In Canada West, for example, the recovery is noticeably slower compared to cities like New York, Boston, and Dallas. There is definitely an inconsistency there. The key question is not just whether these buildings will be occupied, but when that will happen and how significant the delay will be. This timing affects the tenant improvement work that relates to our demand outlook for office spaces. We've noted that in different areas, the pace picks up more quickly, influencing the tenant improvement activities that are crucial to our overall demand profile. We anticipate this trend will continue to progress and gain momentum, similar to what we have experienced in other regions of the country, especially in the West where there's still a lag. We are not dismissing this market opportunity due to the delays; we see strong renovation prospects. The challenge lies in timing – how long it will take for these buildings to be reoccupied, whether by existing tenants or new ones. This mirrors what we've observed in cities like New York. So, we view this renovation activity as reflecting pent-up demand rather than lost demand.

Kenneth Zener, Analyst

Right. No, that makes sense. Just the footprint of buildings you're servicing in place already, but it's noticeable the regional differences. I guess, excuse me, obviously, we had some mix in the quarter and stuff, and you guided for mineral wool in the fourth quarter to be down, but from the pricing perspective, which is a larger component, does it seem as though because we've constantly had these price increases that we're basically going to just be all else equal from today, it'll really have price increases through decelerating from where we are now into the back half of next year, would be a reasonable assumption, not making any inflation forecast?

Vic Grizzle, CEO

I think it's reasonable to expect that we've experienced two years of unprecedented inflation, leading to significant price increases. If inflation levels off next year and returns to a more typical rate, then our pricing strategies should align with a more standard inflationary environment. This seems like a fair assumption to make.

Kenneth Zener, Analyst

Yes, just trying to normalize the strong pricing that we've had. Thank you very much.

Vic Grizzle, CEO

Yes. Thank you, Ken.

Operator, Operator

And I'm not sure any further questions. At this time, I'd like to turn the call back over to Vic Grizzle, President and CEO for any closing remarks.

Vic Grizzle, CEO

Yes, thank you. Again, thank you all for joining us. Again just pointing to third quarter results for us, but as I said, I'm proud of our team and how we're executing. We're executing well on those things we can control. I believe we're over the right initiatives for the long-term success of the company. And thank you for joining us today. We'll look at value creation opportunities that are in front of us. So, again, thank you for joining us today and we'll look forward to talking to you at our next call.

Operator, Operator

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect and have a wonderful day.