Investors in Armstrong World Industries (NYSE:AWI) have been very pleased with the company's decision to exit its European flooring business.
Armstrong is a producer of both floors and ceiling systems which are used across the world in the construction or remodeling of industrial, commercial and residential property. While the ceiling systems is performing very well, the floor systems business has been a drag on the company's performance, with the company now finally announcing some drastic measures in Europe.
Despite the restructuring efforts, I remain very cautious on the back of the premium valuation after adjusting for the restructuring efforts as well as the very poor longer-term track record.
Ending The Losses
Armstrong has reviewed the alternatives for its European flooring business and decided to cease operations, after it appears it has not been able to find a buyer.
Following this decision, the DLW subsidiary in Germany has filed for insolvency. CEO Matthew Espe commented on the difficult but much needed decision after the company has been reporting losses for years despite multiple efforts to restructure the business as well as having made additional investments in the European business.
The results of the business are now classified as discontinued operations. For your information, the business reported sales of $144.7 million in the first three quarters of this year on which it reported a rather steep operating loss of $23.2 million.
Assets of the to-be-closed activities totaled $152.0 million, of which $57.1 million in inventories. Of course, a liquidation of these assets could result in some impairment charges, with assets most likely being sold below their appraised value. Liabilities of the European assets totaled $171.3 million, exceeding the total assets reported by the unit. As such, Armstrong most likely has to take quite some charges to close the business in the upcoming quarters.
Espe has been disappointed with the continued losses, especially considering that the company made some $150 million in investments in the business since 2007.
Pro Forma Impact
For the first three quarters of this year, Armstrong posted sales of $2.07 billion, which was up just 0.7% compared to last year. Adjusting for the lost revenues after closing the European operations, revenues came in at roughly $1.93 billion.
The business posted operating earnings of $179 million for the period, including $23 million losses in Europe. Adding those earnings back in would result in earnings of some $202 million.
Full-year sales are seen around $2.5 billion this year on a pro forma basis, as the European losses would be on track to reduce operating earnings by some $30 million per year at the current trajectory. Adding those earnings back in going forward, following the decision to shut the operations, after-tax earnings could see a $25-$30 million boost.
Based on adjusted earnings and 55 million shares outstanding, Armstrong has guided for earnings of $2.00 to $2.15 per share, which translates into earnings of $110-$120 million. Excluding the European losses, earnings could come in much closer to the $130-$140 million mark.
More Restructuring Work Ahead
The operations which the company is quitting today were part of the resilient flooring segment of the business which has been underperforming, just like the wood flooring segment.
The building products segment remains the largest and most profitable segment. It posted sales of little over $983 million for the first nine months, on which it posted operating earnings of little over $209 million, for margins of more than 21%.
Resilient flooring sales of $695 million will take a beating, as a result of Armstrong's decision, as reported operating earnings of nearly $23 million will see a big boost. As a result, reported margins of little over 3% of sales will improve to little over 8% adjusting for the closure of the activities.
Another troubled business remains the wood flooring segment which generated $395 million in sales so far this year, reported earnings of a paltry $4.5 million, for margins just above the 1% level. After allocating unallocated expenses, the contribution of the unit will undoubtedly be negative.
Armstrong has sufficient reasons to cut the losses in the European segment, allowing the firm to reduce the asset base, stop the bleeding and cut its debt load. Armstrong ended the third quarter with $148 million in cash and equivalents while having $1.05 billion in debt outstanding for a net debt position of roughly $900 million. The business has posted EBITDA of $300 million on an adjusted basis so far at a run rate of roughly $400 million per year, which translates into a net debt to EBITDA ratio of around 2.2 times.
55 million shares outstanding gives the company a market valuation of nearly $2.8 billion at a little over $50 per share. Adding back the net debt position yields an enterprise valuation of $3.6 billion.
This values the business at nearly 1.5 times sales, roughly 9 times EBITDA and equity in the business at roughly 20-21 times adjusted earnings after backing out the European losses. Notably, the earnings multiples are quite high, especially considering that the overall market is valued at a multiple in the high-teens.
Corporate Presentation Reveals That More Floor Work Is Ahead
Armstrong has 35 facilities in 8 countries, which does not factor in the impact of the European closure yet. The company is the number one producer in both ceilings and floors in the US, having dominant positions in Europe, China and other regions as well.
The big problem is that while ceilings are very profitable, the performance of the resilient wood floors is very soft. While the performance of the resilient floor business will improve markedly following the exit in Europe, wood remains a big issue which needs to be tackled as well.
While ceilings is already very strong in the US, the company remains very well positioned to benefit from a further recovery in the commercial business with its factories running at just 70% of capacity, with a 10% jump in production requiring just 2% more workers. In terms of international growth, the company relies heavily on growth in the Chinese business, having already three plants up and running.
The floor segment is much more difficult, typically being focused on remodeling as well as the residential market. Armstrong has already shrank the business in terms of sales in recent years, and despite paltry margins, it has already improved the margins versus those reported in recent years amidst multiple restructuring efforts and closure of unprofitable business units.
To differentiate, the company has relied on innovation in recent times, filing many more patents, as products being developed over the past five years already make up 30% of sales, with these innovations pushing pricing power as well.
Even after the recent announced restructuring, Armstrong's shares trade around 20-21 times earnings, which is not very cheap. Part of this premium valuation results from the fact that the company has much more potential to improve margins at its floor business, with investors undoubtedly hoping for further restructuring efforts being taken.
These efforts are welcomed by investors who have not seen capital gains over the past decade, nor have seen regular dividends. In the company's defense, Armstrong has paid out three special dividends between 2008 and 2012, totaling roughly $28 per share in total.
Yet, I remain unimpressed with the long term value creation potential of the business. Sales have been flat for years now, actually being down compared to 10 years ago with a similar trend applying for the earnings. At the same time, the total number of shares outstanding has been flat at best, or actually increased as the business has been increasing leverage to finance the large special dividends of course.
You get the point; the restructuring efforts are to be applauded, as probably more actions are required. Amidst the fair to fairly high valuation, I see few triggers beside further restructuring efforts which could really cause enthusiasm among investors, therefore remaining very cautious at current levels.
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