Armstrong World Industries Inc (AWI) 2008 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to Armstrong World Industries Second Quarter 2008 Earnings conference call. (Operator Instructions). I would now like to turn the conference over to our host, Ms. Beth Riley, Director of Investor Relations. Please go ahead, ma'am.

Thank you, Margaret. Good morning, and welcome. Please note that members of the media have been invited to listen to this call, and the call is being broadcast live on our website at www.armstrong.com. With me this morning are Mike Lockhart, our Chairman and CEO, and Nick Grasberger our Senior VP and CFO. Hopefully you have 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 today. In addition, our discussion of operating performance will include a non-GAAP financial measure 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. With that, I would like to turn the call over to Mike.

Thanks, Beth. Good morning everybody, and 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 government 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 level with the prior year, $99 million.

Volume declines of high single-digits percent reduced income. That was partially offset by lower manufacturing and SG&A costs. The majority of the volume decline was in 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 benefitted from higher WAVE income. WAVE operating income benefitted from higher sales, due to customer buying ahead of a 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 went on the balance sheet. This too, will reduce operating income in the second half. The combined affect 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 lower volume and raw material cost inflation, partially offset by better price realization and lower manufacturing costs. 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 help the business to reduce its operating loss compared to the prior year by about 30%, this despite significant raw material inflation.

Wood Flooring, a US residential business saw 20% lower sales in the quarter. The margin effect of lower volume, more than offset, reduced manufacturing costs, and lowered 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 to a 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 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 different 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 costs. We are investing a couple of million Euros in our linoleum plant to address the small disadvantage we have relative to [Floorbo] in linoleum. We have begun negotiations with our works counsel on transferring SG&A jobs from Germany to our customer order service center in Prague, and in outsourcing German SG&A jobs to Eastern Europe and India. We are in the process of selling excess 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 out-perform 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 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.

Okay, thank you, Mike. My comments will refer first to page 3, the key metrics chart for the second quarter of 2008. You see the sales were down for the quarter, when you exclude foreign currency by 2.9%, that breaks down as follows: volume-- unit volume was down about 650 basis points; price was up about 250 basis points; and mix was up about 100 basis points.

As Mike noted, operating income was roughly flat with a year ago, this was somewhat better than we anticipated, largely due to the European floor business, the Building products business, and WAVE doing better than we thought. If you note the-- operating margin here in the quarter of 10.9%, that is actually the highest operating margin that we have seen in the business for about 10 years.

Our earnings per share down $0.05 or about 5%,-- what is happening here is, interest expense is down-- a good bit versus year ago, but the tax rate is up. Our cash flow is $78 million, was $75 million or so lower than a year ago, really driven by some special dividends we received from WAVE in the second quarter of last year, as well as a tax refund we received in the second quarter of last year.

Look at net debt-- at about $125 million, is about $100 million lower than a year ago. In rough numbers, we have generated about $350 million of cash flow in the last 12 months, offset by a $250 million dividend payment in the first quarter. So this net debt figure is just netting out domestic cash, if you net out foreign cash as well, that net debt figure declines to about $275 million at the end of the quarter.

Next chart, page 4, is the operating income bridge for the quarter versus the same quarter last year. You can see the relationship between price and raw material and energy inflation, they are roughly equal-- most of the price realization was in the commercial businesses although all of the major businesses either had pricing flat with year ago or higher. The inflation of $21 million breaks down as follows-- about 80% of that is in raw materials; about 20% is in energy; and of the 80% in raw materials, about 75% of that would be raw materials for the vinyl business both in the US and in Europe.

The volume mix impact there of $24 million of operating income is really due to the North American residential markets, all the other businesses and markets were up year-over-year in terms of volume and mix. Manufacturing costs improved by about $10 million year-over-year, again this is true of all business units, SG&A was down $5 million or about 4%, and Mike noted the impact of WAVE for the quarter, WAVE contributed an additional $7 million of operating income to Armstrong in the quarter, sales were up about 30% and profit was up about 50% in WAVE.

So year-to-date in WAVE, we have picked up about $9 million of operating income versus year ago, for the full year we expect that figure to be $5 million, so we do expect the earnings to be down $4 million to $5 million in WAVE versus the second half of last year.

Turning to page 5, this breaks down the sales and earnings growth by business for the quarter. Starting on the left, with sales, Resilient Flooring as a segment was up about 2% in sales; North America was down 1%; International was up about 7%; Wood Flooring sales down 21%, this is really all volume; building Products up about 8%; price and mix were about 6% and volume was up 2%. Although if you look at the core North America commercial market, the volume was down about 3.5%, consistent with our expectations. Cabinets' sales down 23%, again all due to volume.

Turning to earnings, the Resilient Flooring business saw a decline of $6 million of operating income in the quarter. This is really all North America, mostly due to volume declines as well as price-- not quite covering inflation. Offsetting this in part were lower manufacturing and SG&A costs.

In Wood Flooring, operating income was down $9 million for the quarter; again this is due to unit volume offsetting the benefits of lower manufacturing SG&A costs. Building Products operating income up $14 million versus year ago; Price and Mix combined to offset-- more than offset inflation. We also had lower manufacturing costs in Building Products, and then the WAVE earnings that we just talked about.

Cabinets' earnings were down $4 million, all due to volume. Corporate costs were down $4 million due to lower costs both in the staff departments as well as the benefit plans.

Okay, chart 6 bridges the year-to-date operating income versus year ago on a reported versus adjusted basis, and you can see that the adjusted number of $144 million is about $9 million higher than the reported figure. In the first two columns there, the non-recurring expenses related mostly to severance in the first quarter, as did the strategic review expense of $1 million. What's ongoing for the rest of the year, as it was in the first two quarters, was higher depreciation and amortization related to a fresh start accounting adjustment that was made at the end of 2007.

The next chart, page 7, just updates the key metrics for the first 6 months of the year, compared to year ago. Sales down 5% for the first 6 months; volume was down about 800 basis points; price and mix were up about 300 basis points. Operating income down 13% through the first 6 months; the first quarter, as you may recall was down 30%; second quarter was roughly level with a year ago. Earnings per share down $0.26 or 17% versus year ago; cash flow is off $164 million versus year ago, but $100 million of that is due to a tax refund last year, as well as the extraordinary dividends from WAVE last year. The balance would be lower cash earnings and higher working capital.

Okay, page 8 is the year-to-date cash flow view versus last year, and it just simply reconciles on the far right there, the $164 million change in free cash flow through the first 6 months, and I think reflects the comments I just made.

So, on chart 9, this is the updated guidance for the year from a sales standpoint. We are now looking at sales in the range of $3.5 billion to $3.6 billion. The top end of that range is down about $50 million versus the previous estimate, and that translates into full year sales change of-- a range of down 1% to up 1%.

Operating income, the previous guidance was a range of $260 million to $320 million. We have brought that down by $30 million; the top end of the range is now $290 million. So the midpoint of the range before was $290 million. It is now $275 million. That $15 million decline is really all due to the North American residential market impact, as well as price being a little bit lower relative to inflation than we had thought. So that translates into, for the full year, operating income being down in a range of 5% to 15% versus year ago.

EPS, the previous range was $2.30 to $2.90 (Sic - see press release), we have also taken $0.30 off the top end of that range; and cash flow, we have remained consistent with our previous guidance of $175 million to $200 million for the year.

Okay, chart 10 is just a view of our outlook for the second half of the year by segment. In Resilient Flooring, we do expect sales to grow about 3% or 4% in the second half of the year, due mostly to Europe and Asia. We also expect the North American commercial market from a sales standpoint to be slightly higher although, of course, the residential market we expect to be down slightly. From a margin standpoint, we do expect margins in the second half to be up 1 point to 2 points versus last year, driven mostly by the volume gains and mix.

In Wood Flooring, the volume in the second half of the year we expect to be down about 10% and that translates into a decline in margins versus year ago of 3 points to 4 points.

In Building Products, we expect sales to be up low to mid single-digits on a worldwide basis. The residential market in the US, of course, will be soft. We do expect sales growth in commercial in North America as well as in Europe and double-digit growth in Asia. And what that translates into from a margin standpoint is actually a decline of 1 point to 2 points year-over-year, due mostly to the impact of WAVE. Again we expect the WAVE earnings to decline in the second half of the year versus year ago, and of course the sales of WAVE are not included in these figures, just the earnings, so it has a significant effect on the margins.

In the Cabinets, we expect continued kind of double-digit declines in volume, kind of in line with the wood business down 10% or so in the second half. So from a margin standpoint, what that means is on a consolidated basis, we would expect operating margins to be down 50 basis points to 100 basis points in the second half of the year versus the second half last year.

Okay, so a little more color on the outlook for the balance of the year, and in fact these are full-year numbers. Starting with raw material and energy inflation, the previous guidance was an increase in inflation year-over-year of $75 million to $85 million. We have now increased that on a full-year basis to $95 million to $100 million, and we expect price to offset about 80% of that.

Just a quick breakdown of that $100 million or so of inflation for the year. About $40 million of that is due to a higher input cost for the vinyl businesses; $30 million is due to energy inflation; the ABP raw material inflation is about $15 million; and the balance would be inflation in products that we source.

SG&A, the outlook for the year, we had been assuming that SG&A would be roughly flat with a year ago. We now expect SG&A to be down 3% to 5% or $20 million to $25 million year-over-year, mostly due to reductions in North American floor business and in corporate. The guidance from that interest expense has not changed. It is about $20 million, which is about half of what it was in 2007, due both to higher cash balances as well as a reduction in interest rates.

Of cash taxes and the effect of tax rate, that guidance also remains unchanged. We expect to pay about $20 million of cash taxes globally. The effect of tax rate, we expect it to be in the 44% to 45% range, and I know many of our peers are somewhat below that so let me just quickly remind you why we expect the tax rate to be that high. You start with a federal rate of about 35%, state taxes are about 3%, so you have 38% to start. The non-deductible losses that we have in our European floor business add about 3 points to our tax rate. We have talked before about-- we are accruing interest through the tax rate on our ten year carry-back election on our NOL; that adds about 2 points to the tax rate; and then we are also accruing for the tax cost of repatriating foreign cash to the US at some point, and that adds about 2 points to the tax rate. So add all that up, you get about a 45% effective tax rate for the full year.

Capital spending, we have not changed this view as well. We expect to spend about $100 million for the year. The share count also remains unchanged at about $57 million, as does the exclusions from reported earnings will be about $15 million for the full year, about $10 million from the fresh start accounting adjustment I mentioned earlier due to higher depreciation and the one time expense related to severance of about $5 million.

Okay, so that is a review of the charts. Mike and I will be happy to respond to any questions that you may have.

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

Good morning. Nice quarter.

Hi, John.

I wonder if you could delve into the building products segment, both domestically and abroad, and refresh us on sort of the in-market exposures. You mentioned school; of course, there is office; and give us some color on what you are seeing in the pipeline as you look out, not just the second half of this year but maybe in '09.

Well, 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 breakdowns in percentage terms of the various markets, but clearly the biggest outlet for ceilings is the office market. And-- we-- in the US-- you know that we don't expect that-- we expect that to decline in sort of mid single-digits.

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 is the current outlook for that. It depends on where you are in Europe, but the UK and Spain are slowing down a lot. Germany is a little bit slower, not dramatically so; and Eastern Europe continues to grow at remarkable rates, so--

Now the other things we serve would be healthcare, retail and education, and those are the ones we really think about. And in the context of ceilings business, that is really the sequence-- (inaudible) is it in healthcare, education and then retail; whereas when we look at the floor business, we start with the-- education, retail, healthcare and office would be the relative size of those. We have very little exposure to office in the floor business, which is really the difference between the two markets today. In the US, we expect to see kind of mid single-digit decline in the markets; and then in Europe, we expect them in the aggregate to grow but that we have a differential exposure to the office market in the UK, which would be down double-digits.

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

I think we-- we intended to say nothing different than we have said in the past about the dividend. I would-- 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-- maybe before we felt differently about it; but at the end of the day, the thing that is going to affect us is going to be less this year than what the outlook is for next year, and so-- the board will take it under consideration. We know how everybody feels about it, and our results to date are as good or better than we 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.

Great, thank you.

We will go next to Jim Barrett, CL King and Associates.

Good morning, everyone.

Hi, Jim.

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

We generally have been able to certainly hold our margins. We start at a little higher level than USG does so it will 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 in a downturn now for at least 12 months, and so margins have gotten a little better. I think that-- we are pretty optimistic about where the margins are going to be, and we think that-- we think of a peak-to-trough of about a 15% volume decline is kind of what we are thinking about, and in that context, we expect Ceilings to be able to hold its margins. 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.

Understand, and your ability to hold margins, I take it that is predicated on mixed pricing manufacturing efficiencies?

Yes, 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. The question is will that continue? If you look at the question about the outlook for the construction industry and if you look at the increase in construction costs that exist in the United States now -- it is something like 10% -- what is happening to unit construction cost, so there does become a limit on how much you can raise price, but we-- it is a-- those are the factors. We have been fortunate to be able to get price, we have gotten some mix improvements, that may slow down as office takes a differential decline more than other segments, and the manufacturing productivity which we expect to be able to continue to get.

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

Right.

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

I would say it differently. If I did say that, I think it probably more accurate is we can 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.

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

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, and industry capacity utilization is another element of it, and in our-- 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 is a tough environment competitively to get price.

Now, 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-- not a-- it's all a function of what competitors are doing. We have said-- I think we have said before, there needs to be some consolidation in the vinyl business, and one of these days something will happen to make that happen.

Right. Okay, well thank you very much.

We will go next to Keith Hughes, SunTrust.

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

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

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

Actually, the thing that everybody would like to know about is are we going to do something for a laminate point of view with Europe, and we won't comment on that. From a structural point of view, we have-- 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 is only going to be fixed by some combination of investment and/or sourcing the products and those things we are looking at.

The -- we do have a problem with an underleveraged SG&A structure. We are going to reduce SG&A by outsourcing, and in the context of-- remember that the commercial sales over there is a couple hundred million Euros, and we are looking at moving sort of a third of our SG&A structure out of Germany into Eastern Europe and India. We are just in the midst of talking to [works] counsel about it, which will have a significant impact on our SG&A cost, and where we think that-- there is possible, and with no M&A activity to get the business where it's profitable, at a very modest cash cost to the business, is a part of disposing of excess of surplus assets and that stuff. And-- but we are looking at all the alternatives we have with the business and by the end of the year, we will make a commitment one way or another about what we are going to do with it.

Okay, great, that is helpful. Then, a question on WAVE. It's performing extremely well. How much in the way of dividends do you have banked into your free cash flow forecast from WAVE?

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

Okay.

I would say for the full year we have something in the $50 million range assumed from WAVE.

Okay.

But the point is the pattern is the 75% to 80%. That would be a good basis to plan in terms of the cash that we get from WAVE is three-quarters of the current earnings.

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

No, again, we have been taking most of the cash they have generated the last several quarters as part of the normal dividend.

Right, we are not going to lever it up anymore.

Okay, and then, so the last question is, what are you seeing in the M&A environment in the US? Is there more opportunity there, or are you still--

We don't see any significant opportunity for us today? We have said before that we would be interested in the right wood assets. Other than that we don't see much that would make sense for us in North America.

Thanks a lot.

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

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

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