Avoid Armstrong Flooring: More Downside Ahead

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About: Armstrong Flooring, Inc. (AFI)
by: John N. Lenz
Summary

Near-term weakness, lowered EBITDA guidance.

Legacy Product Portfolio dragging the business.

Rising lumber costs threaten profitability.

Turnaround in jeopardy - more downside ahead.

Quarter 2 2017 Results:

The Q2 2017 earnings announcement included a few key points. In the Wood Flooring segment, sales were down year over year again, due to declining volumes and declining prices. This indicates continued decreasing consumer demand for wood flooring and possibly declining pricing power.

In addition, Armstrong Flooring also announced the closure of two manufacturing plants in its Wood Flooring segment, estimating that the decision will result in a one-time charge of approximately $3-$5 Million related to the closure of these facilities. Additionally, the firm also disclosed the probability of up to $26 Million of asset writedowns if the facility assets are either sold or disposed of. In response to the news, the stock fell 17% following the announcement.

Assessment Of The Turnaround:

The results of the quarter have implications for the turnaround. Management has now reduced its EBITDA guidance for the year from $75-85 Million down to $60-$70 Million. This now means that if management were to achieve the middle range of its guidance, it would earn $65 Million in EBITDA vs. the $73 Million it earned last year.

Additionally, the third consecutive quarter of disappointing results seems to point to a troubling pattern that threatens the viability of the turnaround: the drag imposed by the firm’s legacy portfolio. This is the second disappointing quarter in a row negatively impacted by the firm’s legacy portfolio. All this leads one to be skeptical regarding the 2020 EBITDA margin targets.

In addition, this quarter also raised some additional issues. The firm failed to realize the benefit from its planned price increases on its commercial products, raising questions about the strength of competitive pressures on the firm. The move to eliminate two wood flooring plants by the management team has also made clear, that management team is examining a more extensive restructuring. Given management's projections of $8-$10 Million in annual EBITDA savings from the elimination of these two plants, this is likely to be a smart move in the long term.

However, with further potential divestitures of underperforming assets, it has become clear that the restructuring will be ongoing, and the stock may have further to fall. As part of its restructuring efforts, management announced it is on track to deliver $6-$7 Million in annual cost savings. The firm has been successful in consolidating its Residential and Commercial divisions, aiming to achieve SG&A synergies estimated around $6-$7 Million. While this is a move in the right direction, the impact of the expense savings does not materially change my thesis on the viability of the turnaround.

The resilient segment seems approximately stable, with growth rates below the rate of inflation for a past few years. As outlined above, this segment is the stronger segment with more stable revenues, and is currently generating approximately $15-20 million in operating profits. In contrast, the wood flooring segment has been consistently troubled, posting negative operating profits. The main problem with the segment has been declining revenues due to changing consumer preferences away from wood flooring products and towards LVT products, coupled with poor expense management.

Overall, the wood segment needs to cut its expenses while maintain its revenues to become additive to the profitability of the business. Given that the segment is host to the troubled legacy portfolio, this is highly improbable. With sales falling approximately 1.5%-2% per year, and very limited pricing power, I find it unlikely that revenues can grow. In addition, the firm must cut its expenses by at least 1.5-2% per year just to keep up with the decline in revenues.

This is before taking into account the cost of inflation and various input costs, which can easily add 1.5-2% per year to annual expenses. When one accounts for this, the firm actually needs to reduce its expenses by approximately twice the rate of its sales reductions in order to avoid additional declines in the operating profitability of the segment. This is tough to justify by itself. Improving the situation to the point where segment profitability can be established could be significantly more difficult.

The table below shows the 3-year average trend in each segment's sales and the overall expenses for the firm as well as the reduction in expenses required to reach its 10% adjusted EBITDA margin targets. This assumes management meets the midpoint of its current revised guidance range this year.

https://static.seekingalpha.com/uploads/2017/8/23/46015676-15035025474569464.png

https://static.seekingalpha.com/uploads/2017/8/23/46015676-15035025960563018.png

https://static.seekingalpha.com/uploads/2017/8/23/46015676-1503503568654106.png

The most recent cuts to SG&A the firm realized in 2017 were the cost savings from improving its go-to market strategy. As you can see below, while these are significant annual savings, it only contributes about a third towards the required SG&A annual reduction. The most likely path left for meeting EBITDA margin guidance is therefore a combination of decreases in SG&A and improvements in gross margins. However, the firm's gross margin is temporarily inflated by falling lumber costs. Of course, without significant expense reductions, the firm will be unable to deliver on its 2020 EBITDA margin forecast.

Lower Lumber Prices Temporarily Depressing Cost Of Goods Sold, And Creating An Illusion Of A Turnaround:

In the firm’s annual 10-K filings, the CEO said the following about its 2016 operating results:

“The increase in operating income primarily reflected lower raw material costs in our Wood Flooring segment, which resulted from lower purchase prices of lumber for products sold in 2016. “

-Annual 10-K SEC filings for 2016 operating results

The main indicators of a turnaround are built on improvements in adjusted EBITDA due to improved gross margins, a significant reduction in SG&A expenses after a couple of years of poor expense management, and the first increase in sales after three consecutive years of declines. Much of the improvement in its adjusted EBITDA is due to the significant improvement in its gross margins, which are significantly impacted by lumber price trends.

Given this, the firm has benefited from the realization of lower lumber costs. As you can see from the chart below, lumber prices, a major input cost for the firm, declined significantly from 2014-2016.

https://static.seekingalpha.com/uploads/2017/8/22/46015676-15034219136445818.png

Management admits in its 2016 10-K filings that “there is a lag of 5 to 6 months before price changes are reflected in our results of operations.”

Given this data, I wanted to evaluate the impact of lower lumber prices on the firm’s COGS. Due to the lack of availability of historical spot price data, I decided to use historical lumber futures price data, which is justified since both spot and future prices are highly correlated and move in lock step. Given the firm’s lag time, the firm will recognize its COGS for the year based on the last 5-6 months of the previous year’s lumber prices and the first 6-7 months of the current year.

I therefore derived the average lumber prices the firm paid for each year using this methodology, including an estimate of realized lumber costs for the current year, and used regression to determine the relationship between lumber futures prices and the firm’s COGS. The charts below display my results and this relationship.

https://static.seekingalpha.com/uploads/2017/8/23/46015676-1503504261017033.png

https://static.seekingalpha.com/uploads/2017/8/22/46015676-1503421914138112.png

It appears lumber prices have had a significant impact on the firm’s COGS, with approximately 98% of the changes in COGS over the past few years being explained by falling lumber prices.

To evaluate the impact of the realization of lower lumber costs on the financial statements and the turnaround, I decided to reconcile the adjusted EBITDA, using the firm’s reconciliation, but while holding gross margin constant, in order to remove the impact of the lower realized lumber prices.

I re-calculated the firm’s net income with the change and then reconciled the results to adjusted EBITDA using the format provided by the company below.

The results are shown below:

https://static.seekingalpha.com/uploads/2017/8/22/46015676-1503421914959127.png

Source: 2016 Quarter 4 Investor Presentation Slides

https://static.seekingalpha.com/uploads/2017/8/23/46015676-15035032481730688.png

As shown above, if Armstrong Flooring did not have the benefit of realizing lower lumber costs in 2016, and its gross margins were in line with 2015 results, it would have reported just $42.8 Million in adjusted EBITDA in 2016.

The primary driver of the turnaround appears to be lower lumber prices, a trend that is not easily sustainable. From a review of the filings, it appears that management does not hedge the costs of lumber, and thus cannot easily control its COGS. Furthermore, these results show that once you remove the effects of artificially inflated gross margins, there was no real turnaround in terms of impact on adjusted EBITDA.

Conclusions:

In conclusion, the turnaround appears largely illusory, based primarily upon the realization of lower lumber prices for the firm. Other than this, the only real signs of a turnaround is a slight improvement in sales growth, and the improvements in SG&A expense management, neither of which can be linked to lumber prices, but are not significant enough to lead to a turnaround.

Further, now that input prices for lumber have rebounded, the firm could begin to have significant problems managing the turnaround, and will likely continue to disappoint on its earnings and EBITDA guidance. Another troubling trend that came out of this quarter’s earnings report is the inability for Armstrong to be able to realize the benefits of its previously announced price increases on residential sheet products. This raises significant questions about the firm's ability to successfully realize the benefits of its announced price increases on legacy commercial products announced this quarter.

Additionally, the elimination of two of its underperforming wood plants begins to raise questions regarding the sustainability of the balance sheet, and the possible magnitude of its underperforming assets. I would therefore also question the ability of tangible book value to act as a floor on the stock.

Lastly, I expect management will eventually revise down its 2020 EBITDA margin forecast now that it is no longer reaping the temporary benefits of reductions in lumber prices. As I have shown extensively, this forecast is a near mathematical impossibility, and management will surely realize this as lumber prices continue to hike, and results continue to disappoint investors.

In summary, I recommend investors go short this stock, the combination of rising costs, possibly diminishing pricing power, and a management team that appears to show a pattern of overpromising and under delivering, indicates further downside is likely ahead.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in AFI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.