Armstrong World (AWI) leveraged for non-residential recovery and pricing
Write about Armstrong World Industries (NYSE: AWI) in August, I was ambivalent about this leading manufacturer of commercial ceiling tiles and specialty ceiling materials, as I believed the company’s strong leadership in its core market was offset by stock valuation and prospect of weaker renovation activity in 2022 before the recovery in non-residential construction.
Since then, shares have fallen more than 10% and management’s forecast for margins in 2022 has been weaker than expected. At the same time, however, the company is showing exceptional pricing power and the company is still being leveraged for what I anticipate will be a significant renovation cycle targeting “healthy building” initiatives. If Armstrong can deliver long-term mid-single-digit revenue growth, high-single-digit free cash flow growth, and adjusted operating margins of about 20%, I see about 20% upside from from here.
Awards can drive business forward
I was concerned that the heavy renovation activity in the non-residential construction sector, coupled with a temporary halt to new construction projects, was creating an “air pocket” in Armstrong’s business, and I have always these concerns to some extent.
Volumes were not strong in Q4’21, with overall volumes up around 3% and volumes in the mineral fiber core business up just 1%. What I didn’t expect was the extent of Armstrong’s pricing power, as the company imposed multiple price increases in 2021, including a 12% year-end increase. which entered into force at the beginning of 2022.
Given management’s comments, I think additional price action beyond input cost inflation is a definite possibility as the company capitalizes on its very strong market share and the fact that ceiling tile prices are not really a go/no-go driver for commercial renovation or new construction projects.
Mixed trends in end markets
Renovation represents more than two-thirds of Armstrong’s business, and I see continued short-term weakness. It looks like office renovation activity has definitely slowed, and while education has remained stronger than expected, I wonder if the lack of meaningful stimulus in the infrastructure bill will limit the upside short term.
That said, HVAC companies like Trane (TT) have spoken at length about the opportunities in education (and health care) generated by inadequate legacy systems and clean build initiatives, and HVAC projects often lead to ceiling retrofit projects. Along those lines, I would note that the health and education sectors make up about a third of Armstrong’s revenue base.
The extent to which commercial and institutional building operators follow an indoor air quality initiative is really a key variable here. Armstrong management estimated a $250-350 million opportunity tied to its Healthy Spaces portfolio, with “Health Zone AirAssure” carrying a 100% premium and “Health Zone AirAssure + VidaShield” carrying a 300% premium per compared to standard ceilings.
In the meantime, I see more and more reasons to be optimistic about new construction. Indicators such as the Architectural Billings Index and Dodge Momentum Index show improving activity in new construction, and given the typical lags between these indicators and Armstrong’s revenue opportunities, the outlook for 2023/24 are improving.
Opportunities beyond price
I have doubts about the duration of this robust price environment; this kind of price leverage has been rare in the company’s history, and I don’t think it will be a new norm. Fortunately, there are factors beyond pricing.
Architectural Specialties has lagged for a while, but I can see how product innovation, some acquisitions, and further progress with cross-selling could improve results here down the line. I don’t count on it in my model, but it’s a “nice to have” that I don’t necessarily consider a long shot.
I also see continued opportunities on the digital side. Armstrong has invested in digital tools that make it easier to do business with Armstrong, including automating and simplifying planning/design and construction/installation. These tools make Armstrong more attractive to architects and contractors, while expanding the company’s ability to do business with smaller commercial customers.
Management set impressive targets at its recent Investor Day, including annualized revenue growth of more than 10% over five years, EBITDA margin leverage and FCF growth of more than 15%.
I’m skeptical of the revenue growth target. The company has definitely impressed with its pricing power, but I’ve already mentioned my doubts that pricing power will persist.
On the other hand, if the company can continue to leverage its proven product development capabilities to introduce more higher value products and/or truly see significant adoption of Healthy Space products, my growth rate of 8 % over the next five years might be too conservative.
I’m more optimistic about margin opportunities, as I believe Armstrong will retain at least some of that price leverage, even as input costs and other supply chain costs decline. I also expect to see increased volumes of higher value products, which will lead to better margins. All told, I expect FCF margins in the low 20s to drive high single-digit FCF growth over the long term.
Discounting these cash flows, I believe Armstrong is valued to generate a high single-digit long-term annualized return today. I also use a margin/yield driven EV/EBITDA approach, and believe a forward multiple of 14.75x is appropriate, supporting a fair value in the $110s.
The market correction has led many stocks to more attractive valuations, so investors certainly have more choice now than six months ago. As mentioned, I think there could be some volume-based weakness in Armstrong’s end markets this year, but prices are likely to mask that. Longer term, I’m not as optimistic as Armstrong’s management, but optimistic enough to see some interesting upside in these actions.