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American Woodmark Corporation (NASDAQ:AMWD) is the third largest manufacturer of kitchen and household cabinets in the U.S. under the brand names American Woodmark, Shenandoah Cabinetry, and Timberlake Cabinetry. The Company’s products are utilized in both the remodeling and new home construction markets and are sold through home/building product retailers, major builders, and independent dealers and distributors.

Investment Rationale

Masco (NYSE:MAS) and Fortune Brands (FO) are the only companies that maintain more market share than AMWD’s 7% share, with MAS and FO controlling 26% and 16%, respectively. The rest of the industry is filled with much smaller operations and AMWD’s strong management team and balance sheet will help further its competitive position during the current weakness in the housing market. However, while the Company could be an attractive longer-term investment, current expectations impounded into the stock price may not fully address the true downside facing AMWD in the coming year.

Pros to Short

Remodeling is not “Safe”:
AMWD’s stock has appeared to be more resilient over the past 18 months, due not only to its execution of operational improvements but also to the belief that the Company’s exposure to remodeling as opposed to new home sales may somewhat insulate it from a potential slowdown in housing. The market may be willing to support AMWD’s current valuation because while new home cabinet installations may tumble, remodeling accounts for nearly 70% of cabinet demand and thus AMWD is fairly valued at $35 per share. In addition, the latest information (March 5th, 2007 Press Release) from the National Association of Home Builders (“NAHB”) indicates that remodeling activity remained steady through 2006.

Nonetheless, other recent news suggests a home remodeling slowdown is underway. The Dow Jones Newswires covered a study by Harvard University on the slowing home remodeling market on February 8th, 2007, concluding that homeowners have delayed remodeling projects due to weakness in home prices. The study did expect that home remodeling activity would recover quickly because certain remodeling projects were necessary irrespective of economic conditions. A variety of other secular trends such as the general age of existing homes and increased demand for energy efficiency would prompt a faster turnaround in home renovation projects.

While these are material trends, AMWD’s products are not comprised of insulated doors to address energy efficiency or patches for leaky roofs to make “necessary” renovations. Cabinetry is one of the main remodeling items used to quickly enhance a home’s value and because of this exposure, the Company may have less stability than the market currently is pricing into AMWD’s valuation. Chart I is from the NAHB’s Remodeling Outlook presentation on February 9th, 2007 and clearly illustrates the prevalence of kitchen and bathroom remodeling projects in one of the headier years.

AMWD 1

According to Remodeling magazine, kitchen remodeling projects are now expected to recoup 80.4% of costs compared to a 91% cost recoup rate in 2005. The reduction in cost recovery is prevalent in other remodeling projects as well. Bathroom remodels are expected to recoup 85% of costs while in 2005 a bathroom remodeling project could recoup 102%. This is consistent with what Kermit Baker, director of the Remodeling Futures Program at Harvard’s housing center mentioned in an article in the San Antonio Express-News on January 28th, 2007: Maintenance and repairs continue, but high-end bathroom and kitchen remodels slow down. If that statement is realized this year, then AMWD could experience much more pressure on its earnings estimates and stock price than expected.

Gross Margin Pressure: AMWD’s gross margin has always been a focal point for management. Through the first half of fiscal 2007 the Company’s gross margins improved into the 20% range but Q3 resulted in gross margins closer to 18%, primarily due to both seasonality as well as a weaker general market. Nonetheless, AMWD has maintained its expectations to achieve a 21% gross margin for Q4, roughly the equivalent of what it achieved in Q4 2006. According to the Q3 conference call, management believes that Q4 volume will pick up enough to drive stronger gross profit margins.

The reason for skepticism stems from the expectation that Q4 sales will be down significantly against 2006 numbers. While AMWD has already executed a variety of processes to streamline operations and eliminate some lower margin products, the real EPS driver is getting into that top line range that can drive gross margins. Management also missed its own top line and gross margin targets for Q3 which could suggest that degradation in home remodeling is occurring at a faster pace than they have anticipated. Management was expecting a flat to mid single digit Q3 top line improvement but core sales were actually down 7%, which resulted in a gross profit below expectations. While management did reduce full year EPS estimates down to $2.10-$2.20 from the initial $2.45 estimate, it could be conceivable that full year EPS is below that $2.10 estimate.

Through the three quarters of fiscal 2007, total EPS is $1.63, meaning the Company must achieve $0.47 in Q4 EPS to “make” the bottom range of its estimate. The reason this may be difficult to achieve is because Q4 top line estimates may be too optimistic. Table I tries to approximate where management is guiding the market in terms of expectations. Q4 2006PF is a pro forma figure that takes into account approximately $22MM in sales that are now discontinued due to AMWD exiting these lower margin cabinets. The top row below the percentages calculates Q4 2007 sales based on a drop in Q4 2006PF sales and the highlighted area infers the general range of sales and operating income management is expecting in providing its Q4 guidance.

AMWD 2

As Table I illustrates, assuming the 21% gross margin is achieved and sales fall just 5-10% from Q4 2006PF levels, management will reach their estimates. However, as previously stated, management missed its own estimates for Q3 by a fairly wide margin in regards to sales, as the actual result was a 7% decline (core sales, not total sales which included the elimination of the lower margin cabinet business AMWD is exiting) compared to the flat to small gain management was expecting. This sales miss contributed to a miss in management’s gross margin expectations as well, showing how sensitive the Company’s operating model is to top line figures. Consequently, if Q4 revenues come in slightly under management’s expectations or if material costs and inputs are slightly above management’s expectations, AMWD’s gross margins could come in below the 21% target rate. Table II presents a sensitivity analysis for the Company’s EPS based on 25 basis point (“bp”), 75 bp, and 125 bp decreases in the targeted gross margin rate.

AMWD 3

Table II demonstrates that even if management is correct on the sales figure, any relatively small change in gross margin will have a significant impact on the Company’s EPS. Assuming we have a similar sales performance to Q3 2007 with a 7% drop, even a 25 basis point “miss” on the Company’s gross margin could result in an EPS figure that falls short of AMWD’s estimates.

Sell Short off 2008 Outlook: Even a beat for Q4 2007 and fiscal 2007 is not likely to significantly propel AMWD’s stock given the larger backdrop concerning the housing. Management has stated that it will provide 2008 guidance at the 2007 fiscal year-end and the current trend in housing suggests management could guide well below current analyst estimates of $2.27.

Weak Institutional Holders: There are no notable investors of significance in AMWD. Firms like Barclays, Wellington Management (“Wellington”), Franklin Resources, Royce & Associates (“Royce”), etc. own significant stakes in the Company and while some firms like Wellington and Royce are well regarded, these asset management firms are typical of many large firms that have capital spread across a large universe of ideas. As a result, their presence in any stock is not really worth noting and the lack of a more focused, concentrated value investor is a positive when contemplating a short position.

Cons to Short

AMWD Revised Estimates Downwards at Q3: Management revised its 2007 estimates downwards after missing its own targets for Q3. The range provided allows for substantial variance in Q4 EPS, giving AMWD a fair amount of breathing room with respect to hitting its EPS target. Consequently, management’s earlier revision may have priced most of the downside into AMWD and given the team a low enough hurdle to hit their estimates.

Reasonable Valuation: While AMWD may not be dirt cheap on a forward looking basis, the Company may look like an attractive enough bargain for value investors. The Company maintains a solid market position, is well run, and has a history of generating acceptable return on equity and return on invested capital figures. The inconsistency of these figures makes the return metrics “acceptable” versus impressive, but even in a weak industry year like 2007 and possibly 2008, achieving ROE and ROIC figures in the 15+% and 12+% range, respectively, is realistic. In addition, with 40% of shares held by insiders and a $500MM market cap, AMWD could be a potential buyout candidate. Even with the drop off in remodeling and new home cabinet installations, the Company is managed well enough to consistently squeeze out cash, which would be the main focus of any LBO firm.

Short Squeeze

The short case on AMWD is not a very original idea based on the percent of the float that’s been shorted. With 37.4% of the float sold short, AMWD’s stock could be subject to a short squeeze which could be triggered by not only AMWD-specific news, but also any positive news concerning housing or the economy or M&A activity in the broader industry.

Disclosure: Author manages a hedge fund that is short AMWD

Source: The Short Case on American Woodmark Corporation