American Woodmark: Profitability And Growth Look Bleak
- Pricing pressures from declining real estate demand will worsen margins and give competitors more opportunities.
- Management's lack of a unified capital allocation strategy will worsen the debt structure and worsen growth in the future.
- Poor brand positioning and a lack of competitive advantage will result in declining revenue and margins.
American Woodmark (NASDAQ:AMWD) has fallen over 50% in the past 5 years and fallen over 10% in the past month. While the valuation looks cheaper, don’t go catching the fallen knife, as this company has more to fall. American Woodmark is facing macroeconomic headwinds consisting of a high-interest rate environment, lingering inflationary pressures, and elevated competition. Based on these headwinds, I derived 4 key theses:
- Declining real estate demand is amplifying pricing pressures and declining overall cabinetry demand,
- Contradictory capital allocation strategy will worsen the debt structure and put pressure on future capital deployment
- The absence of competitive advantages will result in customer migration to competitor brands and worsening profit margins.
- A combination of intrinsic and relative valuation methodologies, the price target of $46.85 represents more downside.
American Woodmark is an American-based manufacturer and distributor of kitchen, bath, office cabinetry, home organization, and hardware products. American Woodmark has become the third largest U.S. cabinetry manufacturer, holding nearly 15% market share. It operates in three segments: home center, builder, and dealer/distributor. American Woodmark sells stock (predesigned) and made-to-order (personalization options) cabinetry. The home center segment is comprised of stock cabinetry explicitly sold at Home Depot and Lowes. In contrast, the other segments are mainly made-to-order cabinetry sold directly to 18 of the largest 19 builders and over 1800 dealers. American Woodmark operates entirely in North America, with 50% of its manufacturing & distribution facilities operating on the east coast, 17% in Texas, 17% on the west coast, and 16% in Mexico.
American Woodmark operates in the kitchen cabinetry and vanity industry. The cabinet industry is highly dispersed, with many local, regional, and national competitors. The industry is driven by four critical factors: housing prices, mortgage rates, housing starts, and building permits. Housing prices and mortgages have significantly increased this year, ultimately reducing customer affordability, and thus decreasing housing demand. This decrease is shown by over 20% decreases in housing starts and building permits.
American Woodmark operates in a highly fragmented industry, with over 45% controlled by over 1000 competitors. As shown below, American Woodmark controls around 15% market share, significantly less than Cabinetworks (16%) and MasterBrand (24%). MasterBrand has been the dominant manufacturer for years and continues to grow its market share.
Based on a market share analysis by revenue, MasterBrand and Cabinetworks continue to gain market share, while American Woodmark has stayed stagnant since 2019. MasterBrand’s pricing advantages and economies of scale will continue to retain customers and grow its market share. The competitive pressures make it unlikely that American Woodmark will be able to expand its market share further.
The macroeconomic environment is exceptionally unfavorable for a cyclical company such as American Woodmark. As stated earlier, housing starts and mortgage rates drive growth within the cabinetry industry. With mortgage rates hitting 7% levels and housing starts dropping over 20%, this puts extreme headwinds on cabinetry demand. Currently, cabinetry demand is experiencing a 120-day backlog in demand. The delay has led to increased inventory for American Woodmark and further decreased its margins. The most recent quarter reflects these falls as year-over-year growth slowed from nearly 30% to 5%. The declines are only beginning as American Woodmark hasn’t faced pricing pressure and hasn’t felt the full effect of housing slowing due to inventory delays. On top of these problems, management has stated that builders are beginning to ask for pricing discounts, further damaging American Woodmark’s low margins. Economic pressure will impact American Woodmark’s lower-quality brands as weaker margins and home center demand fuel completive pressures. These pricing pressures will greatly benefit MasterBrand as they have the margin advantage to undercut American Woodmark’s pricing and gain market share.
Raw Material Issues
American Woodmark has also been facing significant raw material and logistics costs. Significant disruptions within their supply chain increased delivery time, and substantial price hikes in plywood, maple, oak, and medium-density fiberboard [MDF] pressured margins. American Woodmark is seeing a considerable price reduction in plywood, resulting in near-term stability on its premium brands. However, margins continued to drop in Q3, showing that this stability will not greatly affect earnings. Additionally, the increase in Maple and Oak prices will severely affect these premium brands due to ongoing supply issues resulting in contraction. Low-margin brands will continue to see critical material pricing pressures contracting margins in the near term.
During times of economic trouble, companies that can generate greater margins and ROE tend to outperform. Based on the graph below, American Woodmark returns the worst ROE out of the competitor group, and American Woodmark has gross margins 7% worse than its biggest competitor Masterbrand. The competitor group is drawn from direct competitors of American Woodmark and companies that have a similar timeline and customer base. The competitor group contains Caesarstone (CSTE), JELD-WEN Holding (JELD), Masonite (DOOR), Quanex Building Products (NX), and Mohawk Industries (MHK).
Management has had a reputation for poor capital management. The RSI merger in 2018 resulted in weakening margins and terrible stock performance. In response, American Woodmark has focused on boosting capex investments in long-term growth initiatives. To achieve this, the company has invested heavily in its Enterprise Resource Platform and growth capex. The company began by announcing a $65 million expansion of its North Carolina distribution center and establishing a fourth facility in Mexico. American Woodmark plans to pay using the limited cash on its balance sheet and borrowing from its revolving credit facility. Management also forecasted over $500 million in growth capex through 2028 and planned to continue borrowing from its revolving credit facility. However, management has also emphasized the repayment of its debt and returning value to shareholders through share repurchases. The strategy is extremely divided for a company with limited cash on the balance sheet and heading into a poor economic environment.
Notably, this is extremely worrisome from a debt perspective. Currently, American Woodmark has a term loan A for $250 million and over $230 million borrowed from the credit facility. Both of these have floating interest rates based on LIBOR and, therefore, a significant rise in interest expenses. As stated on American Woodmark’s 10-k, a 100-bps increase in interest rates would equate to a $2.8 million increase in interest expense.
On top of this problem, American Woodmark continued to borrow during high borrowing costs. The main issue with this strategy is the financial covenants attached to these loans. American Woodmark is forced to retain a leverage ratio (Net Debt/ EBITDA) below 4. As EBITDA drops due to decreased demand and higher costs, American Woodmark is continuing to borrow and increase its debt load. This combination creates a higher risk of breaking its financial covenants and an overall increased risk of a solid investment.
Lack of a Competitive Advantage
American Woodmark has built a portfolio of 15 brands, with 12 representing low-quality, low-price cabinetry. These brands are more expensive than competing brands such as MasterBrand's Aristocrat brand. Breaking down the materials these brands use, Oak, Maple, and Duraform are considered higher-quality materials according to professionals and American Woodmark. However, the majority of American Woodmark's brands lack these materials, as well as, according to customer reviews on websites such as Home Depot, Lowe's, and Kitchen Reviews, American Woodmark's products are considered worse in quality than its competitors.
Specifically, stock brands lack a competitive advantage and fight for demand through pricing. Lower-quality cabinetry outperforms when demand within the remodeling & renovation market outpaces supply. American Woodmark benefited from high demand in 2020 and 2021 when pricing could be passed onto customers. However, Home Depot and Lowes have extreme pricing power and low switching costs, forcing American Woodmark to lower pricing in economic downturns. As demand continues to weaken and pricing becomes more relevant, American Woodmark will significantly underperform its peers.
Additionally, American Woodmark will face extreme pressure from competitors with better margins and competitive advantages. As shown in the graph below, competitors have a marginal cushion to undercut American Woodmark’s pricing, resulting in significant customer migration. Specifically, MasterBrand has gross margins 7% better than American Woodmark in the recent quarter. This margin advantage will allow MasterBrand to capitalize on the incoming downturn and gain market share from American Woodmark.
I issue a sell recommendation for American Woodmark with a 12-month price target of $46.85 derived from a weighted average of an FCF to equity valuation (40%), EBITDA exit multiple valuation (40%), relative valuation (15%), and a residual income model (5%).
I forecasted American Woodmark’s revenues for each segment and further simplified its home center segment by customer. I estimated the home center segment using the 15-year average growth rate and historical growth rates of Lowe’s and Home Depot’s Kitchen & Bath sales. Within the builder segment, I forecasted based on the average growth rate (2012-2019) in housing starts and building permits in the south region. I also based estimates on rebounding growth after the 2008 financial crisis. In the dealer/distributor segment, I had more optimistic forecasts due to price increases and market share potential. To reflect these estimates, I forecast a 4.54% 5-year compound annual growth rate from 2022 revenues. This revenue growth captures the risky economic environment of 2023 and early 2024. Additionally, I remain optimistic outside of 2024 as capex investments will create underlying growth.
I estimated that American Woodmark would significantly improve its margins (GPM increase of 630 bps), reflecting macroeconomic improvements in late 2024 and logistical improvements. I estimate a slight margin decrease in the short term (2023-2024) and significant margin expansion in the latter (2025-2027). I expect American Woodmark to significantly ramp up capex in the near term. I estimated the near-term capex to be 3.5% of revenue due to American Woodmark’s investments in North Carolina and Mexico. Over the long term, I expect capex to fall to 2.5% of revenue, slightly above the historical averages. Overall, capex estimates are slightly below management’s guidance.
I used a terminal growth rate of 2.36% based on the 5-year average U.S. GDP growth excluding 2020 and 2021. For the WACC calculation, I arrived at a WACC of 8.9%. I calculated the risk-free rate by using the 10-year treasury. The cost of equity was 11.3% generated from the CAPM formula. The cost of debt was calculated by adding American Woodmark’s debt rating implied corporate spread to the risk-free rate.
For the exit multiple, I used a multiple of 5.3x which is the competitor group average and near the overall industry average. Due to the lack of publicly listed companies in the cabinetry industry, I compared American Woodmark to companies with similar customers. When cabinets are bought and installed, flooring, indoor doors, countertops, and backsplash are purchased and installed during the same window.
For the relative valuation, I arrived at a price of $39.85 derived from the EV/EBIT multiple. For the other multiplies, I computed a tornado analysis (graph below) which reemphasis the sell recommendation. For the residual income model, I arrived at a price of $40.50, which used both the same cost of equity and sustainable growth rate as the FCF to equity valuation.
In addition to the valuation, I ran a 10,000 Monte Carlo simulation to determine the probability distribution of American Woodmark’s stock price. I varied many variables, including the terminal growth rate, WACC, COGS, capex, and each segment’s revenue. The simulation produced a 68% probability that the stock will be trading less than its current value, reaffirming the sell recommendation.
I also ran a sensitivity analysis for the FCF to valuation and EBITDA exit multiple (graphs below). I varied the WACC, exit multiple, and terminal growth rate. Again, this reaffirms the sell recommendation, as most outcomes come in less than the latest closing price.
American Woodmark has significant headwinds arising from macroeconomic conditions and poor management choices. All of the valuation methods produce a lower price than where the company is currently trading, signifying the company is overvalued. As well as, the company is trading at higher multiples relative to peers. Considering the macroeconomic headwinds, relative and intrinsic valuation, and the critical risk associated with American Woodmark, I recommend that you don't catch the falling knife and stay away from this company.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.