Armstrong World Industries, Inc.
Q2 2008 Earnings Call Transcript

Published: 30 Jul 2008

[Operator:]

Welcome to Armstrong World Industries second quarter 2008 Earnings Call. As a reminder, this conference is being recorded. Turning the conference over to our host, Ms. Beth Riley, Director of Investor Relations.

[Beth Riley:]

Please note that members of the media have been invited to listen to this call, and the call is being broadcasted live on our website, armstrong.com. With me this morning are Mike Lockhart, our Chairman and CEO and Nick Grasberger, our Senior Vice President and CFO. Hopefully, you've seen our press release this morning, and both the release and the presentation Nick will reference during this call are posted on our website in the Investor Relations section. In keeping with SEC requirements, I advise that during this call we will be making forward-looking statements that involve risks and uncertainties. Actual outcomes may differ materially from those expected or implied. For a more detailed discussion of the risks and uncertainties that may affect Armstrong, please review our SEC filings, including the 10-Q filed later night. In addition, our discussion of operative performance will include non-GAAP financial measures within the meaning of SEC Regulation G. A reconciliation of these measures with the most directly comparable GAAP measures is included in the press release and in the appendix of the presentation. Both are available on our website. Over to Mike.

[Mike Lockhart:]

Thanks for participating in today's call. Everybody is well aware of the weak US residential housing market. Both the new construction and the repair and remodel markets are well below what we anticipated. US commercial markets are weakening more so for ceilings than for floor, although we think that will change in 2009, when we expect state and local governments spending pressures to hurt school spending which is one of the major markets for floors. In this increasingly difficult environment, we are pleased that excluding the benefit of foreign exchange, sales declined only 3% and the second quarter operating income was leveled with the prior year, $99 million. Volume declines of high single digit percents reduced income. That was partially offset by lower manufacturing and SG&A costs. The majority of the volume decline was in the businesses serving the US housing market, Resilient and Wood Flooring and Cabinets. Price increases largely offset raw material and energy inflation. Our second quarter results benefited from higher WAVE income. WAVE operating income benefited from higher sales due to customers buying ahead of July 1st price increase. This will result in lower sales in the second half. Some of the steel cost inflation we saw during the quarter when on the balance sheet. This too will reduce operating income in the second half. The combined effect of both higher sales and lower steel inflation was approximately $5 million of operating income. North American Resilient sales were about flat in the second quarter. Improved product mix and better price realization offset high single digit volume declines, particularly in residential products. Operating income declined about 30% primarily due to the lower volume and raw material cost inflation, partially offset by better price realization and lower manufacturing cost. We have generally been able to raise prices in our commercial businesses but not in our residential businesses. Ignoring currency effects, European Resilient sales increased 7% on higher volume, improved product mix and modest price increases. Higher sales helped the business to reduce its operating loss, compared to the prior year by about 30%, this despite significant raw material inflation. Wood Flooring, our US residential business saw 20% lower sales in the quarter. The margin effect of lower volume more than offset reduced manufacturing cost and lower SG&A expense. Cabinets, also a US residential business experienced similar volume declines. We recorded modest income for the quarter which stands in sharp contrast with very profitable second quarter in 2007. In the first half, we performed about as we expected. Looking at the year, we find that the residential market outlook is weaker than expected and inflation higher than we anticipated. As a result, we believe our operating earnings income this year will be toward the lower end of our original range. Our cash flow forecast remains unchanged and we will continue to have a very strong balance sheet. In the fourth quarter, the AWI Board will evaluate the desirability of paying a second special dividend. This will be done in light of year-to-date operating results and the medium-term outlook for the company. Our current guidance for the year assumes a 30% to 35% decline in housing starts and a 10% to 15% decline in residential renovation, up from our previous assumption of 25% to 30% and 5% to 10% respectively. We still expect our domestic ceiling commercial markets to decline at a mid-single digit rate and our commercial flooring business which has a difference mix of markets to be approximately flat. Our European ceilings business is performing at all-time highs, but the pace of growth is expected to slow in the second half. Our European Floor business will continue to be challenged. Our problems in Europe are a function of structural product cost disadvantages and high SG&A cost. We are investing a couple of million euros in our Linoleum plant to address the small disadvantage we have relative to Forbo and Linoleum. We have begun negotiations with our Works Council on transferring SG&A jobs from Germany to our Customer Order Service Center in Prague and an outsourcing German SG&A jobs to Eastern Europe and India. We are in the process of selling access properties in Europe which will help us pay for the restructuring. We are moving in the right direction in Europe. We were actually profitable in June, but we do not yet have a plan to permanently fix the issues in the European Floor business. We remain committed to having one by year-end and we are actively evaluating all of our options. For the full year, we expect to continue to outperform our markets. At the midpoint of our range, adjusted operating income is expected to decline about 10%. This is the result of mid-single digit volume declines and a significant inflation in raw materials and energy more than offsetting improved price realization, manufacturing productivity, and reduced SG&A spending. In this tough environment, our objective remains to use innovation and quality, to deliver increased value to our customers, permitting us to improve mix and increase share. We will continue to control cost and to improve productivity. Now Nick will take you through the numbers.

[Nick Grasberge:]

Thank you, Mike. My comments will refer first to page three, the key metrics chart for the second quarter of 2008. You will see the sales were down for the quarter when you exclude foreign currency about 2.9%. That breaks down as follows

[Operator:]

Thank you. (Operator Instructions). We will take our first question from John Baugh of Stifel Nicolaus.

[John Baugh:]

Good morning. Nice quarter.

[Mike Lockhart:]

Hi, John.

[John Baugh:]

I wonder if you could delve into the Building Products segment, both domestically and abroad, and refresh us on sort of the end market exposures you mentioned, such as school versus the office? And give us some color on what you are seeing in the pipeline, as you look forward not just to the second half of this year but may be in '09?

[Mike Lockhart:]

I think we will probably team this one. But when I mentioned schools, the comment about schools was more related to our Flooring business. We don't disclose the breakdown in percentage terms of the various markets, but clearly the biggest outlet for ceilings is the office market and we deep ended again in the US. I mean, we don't expect that. You expect that to decline in sort of mid-single digits. Now the outlook for Europe is slowing considerably in terms of the outlook for office, particularly in the UK where we would expect to see next year the UK would be down in the office segment by 10%, and that's the current outlook for that. Now it depends on where you are. You are up at the UK, and Spain has fallen down a lot and Germany is a little bit slower, not dramatically, so, and Eastern Europe continues to grow at remarkable rates. Now the other things we serve would be healthcare, retail, and education, and those are ones we really think about. And in the context of ceilings business, that's really the sequence. Let's make sure it's healthcare, education, and then retail. Whereas when we look at the Floor business, we start with the education, retail, healthcare and office- that would be the relative size of those. We have very little exposure to office and the floor business, which is really the difference between the two markets today. But in the US, we expect to see kind of mid-single digit decline in the markets and then in Europe, we expect in the aggregate to grow but we have a differential exposure to the office market in the UK, should be down double digits.

[John Baugh:]

Okay, thank you. And then could you just provide a little color on, I don't know, the decision we made to the fourth quarter? But I think the commentary related to the dividend was that we look to pay a similar amount in the fourth quarter if we more or less hit our earnings and you lower the high end of your range slightly. Does that color you are thinking at all about paying a dividend at all or the similar magnitude or lower? Any color there?

[Mike Lockhart:]

We intended to say nothing different than we have said and asked about the dividend and if I were you, I would conclude that our results would have to be outside the range that we gave you for guidance before we felt differently about it. But at the end of the day, the thing that's going to affect us is going to be less this year than what the outlook is for the next year. And we have Board who will take it under consideration. We know how everybody feels about it and our results to-date are as good or better than we have thought they were going to be. And I am really at the point today where -- I think minus 10 for the year will be a pretty good result for us. So, I think we would go into that discussion feeling pretty good about the operations of the company.

[John Baugh:]

I agree. Thank you.

[Operator:]

We will go next to Jim Barrett, C.L. King & Associates.

[Jim Barrett:]

Good morning, everyone.

[Mike Lockhart:]

Hi, Jim.

[Jim Barrett:]

Mike, in ceilings, USG indicated on their call a week or so ago that they thought in the upcoming downturn, they would actually able to improve their operating margins in their ceiling business. Can you give us a broad sense as to what you think Armstrong could do in that division?

[Mike Lockhart:]

We generally have been able to certainly hold our margins. We started at a little higher level than USG does. So it would be a little bit more challenging for us to improve margins. But we don't expect to see a great deal of margin deterioration. We have been under downturn now for at least 12 months. And so margins have gotten a little better. So we are pretty optimistic about where the margins are going to be and we think of a peak to trough of about a 15% volume decline as kind of where we are thinking about. And in that context, we expect ceilings to be able to hold its margins in that thing. Clearly, the Wave has become such an important part of our thing that their ability to hold their margins and the influence that the steel price has on that will be important to us.

[Jim Barrett:]

Okay. Understand. And your ability to hold margins I take it is predicated on mix pricing manufacturing efficiencies?

[Mike Lockhart:]

We get sort of low single digit manufacturing productivity each year in the ceilings business. We have some mix improvement and we generally have been able to get price increases. I think the question is, will that continue? And if you look at the question about the outlook for the construction industry, and if you look at the increase in construction costs that are existing in the United States now, something like 10%, what's happening to the unit construction costs. So there does become a limit on how much you can raise price. But those are the factors that we have. We have been fortunate to be able to get price. We've gotten some mix improvements that may slow down as office takes a differential, declines more than other segments and the manufacturing productivity which we expect to be able to continue to get.

[Nick Grasberger:]

The only comment I would add is from a geographic mix standpoint. Certainly as the US and the UK decline and Russia and Asia continue to grow double-digit rates that will put some pressure on the consolidated profit margin of ABP.

[Jim Barrett:]

Okay. And on a different subject Resilient Flooring, I think you mentioned that there was no pricing being realized on the residential side?

[Mike Lockhart:]

I would say it differently. If I did say that, I think probably more accurate as we get very little price increase. We have seen some small increases in there, but nothing approximating inflation and certainly nothing that would be material to our results.

[Jim Barrett:]

I mean, can you elaborate on that? Do you envision that continuing, if input costs continue to rise, and is Armstrong attempting to get price or is the strategy to take share in this environment?

[Mike Lockhart:]

We are attempting to get price and we are always looking for share improvements, but price, obviously the input cost is one element of it. Industry capacity utilization is another element of it. And in the vinyl business, industry capacity utilization is relatively low and getting lower. And in the Wood business, people have relatively low capacity utilization. So it's a tough environment competitively to get price. We have seen very significant, and will continue to see very significant, raw material inflation in the Resilient business. We are actually seeing slightly lower wood prices now. So it is taking some pressure off of the need for wood prices. But it's all a function of what competitors are doing. And I think we have said before that there needs to be some consolidation in the vinyl business and these days something will happen to make that happen.

[Jim Barrett:]

Okay. Thank you very much.

[Operator:]

We will go next to Keith Hughes, SunTrust.

[Judy:]

Hi, this is Judy for Keith. Our questions have been answered. Thank you.

[Operator:]

(Operator Instructions). We will go to Matt Sherwood, ZS Fund.

[Matt Sherwood:]

Hi, good quarter. Just had a of couple quick questions. First of all, you touched on it a little bit, but could you provide more color on your plans for the European Resilient business?

[Mike Lockhart:]

Matt, the thing that everybody would like to know about us is, are we going to do something from an M&A point of view with Europe, and we won't comment on that. From a structural point of view, we think most of the problems are mostly in the commercial business. We have three products linoleum, homogeneous, and heterogeneous- produced in different plants. The heterogeneous and homogeneous plants are high cost, and that's only going to be fixed by some combination of investment and outsourcing the products and those things we're looking at. But we do have a problem with an under leverage with SG&A structure. We're going to reduce SG&A by outsourcing. In the context, remember the commercial sales. However, there are a couple of hundred million euros and we're looking at moving sort of a third of our SG&A structure out of Germany and to Eastern Europe and India. We're just on the midst of talking with the Works Council about it which will have a significant impact on our SG&A cost. And where we think that that is possible with no M&A activity to get the business, the way it's profitable at very modest cash cost to the business, is a part of disposing of excess of surplus assets and that stuff. And we're looking at all the alternatives we have with the business. And by the end of the year, we'll make a commitment one way or another with what we're going to do with it.

[Matt Sherwood:]

Okay, great. That's helpful. Then a question on WAVE

[Mike Lockhart:]

We are taking about 75% to 80% of their earnings every quarter. So they really don't have much cash.

[Matt Sherwood:]

Okay.

[Mike Lockhart:]

I would say for the full year, we've something in the $50 million range assume from WAVE.

[Matt Sherwood:]

Okay.

[Nick Grasberger:]

But the point is the pattern the 75% to 80%.

[Matt Sherwood:]

Yeah.

[Nick Grasberger:]

So that would be a good basis to plan in terms of cash we get from WAVE, as we get three quarters of the current earnings.

[Matt Sherwood:]

Okay. So the real point I was trying to understand is, you are not looking to do a special dividend from WAVE?

[Mike Lockhart:]

No. Again, we've been taking most of the cash they've generated the last several quarters.

[Nick Grasberger:]

As part of a normal dividend?

[Matt Sherwood:]

Right.

[Nick Grasberger:]

We are not going to lever it up anymore.

[Matt Sherwood:]

Okay. And so the last question is

[Mike Lockhart:]

We don't see any significant opportunity for us today. We've said before that we are going to -- we'd be interested in the right wood assets other than that we don't see much that would make sense for us in North America.

[Matt Sherwood:]

Thanks a lot.

[Operator:]

And Mr. Lockhart, it appears we have no additional questions. At this time, I would like to turn it back over to junior management team for any additional or closing remarks.

[Beth Riley:]

Thank you, Margaret. This is Beth. Thank you again everybody for joining us and look forward to follow-up calls. Have a good day.

[Operator:]

Ladies and gentlemen, that does conclude today's conference. You may now disconnect.