ARMSTRONG WORLD INDUSTRIES INC 10-Q

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS O F FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forward-looking statements and risk factors included in this report and our Annual Report on Form 10-K for the year ended December 31, 2021. OVERVIEW AWI is a leader in the design, innovation and manufacture of ceiling and wall solutions in the Americas. Our products primarily include mineral fiber, fiberglass wool, metal, wood, wood fiber, glass-reinforced-gypsum and felt. We also manufacture ceiling suspension system (grid) products through a joint venture with Worthington Industries, Inc. ("Worthington") called Worthington Armstrong Venture ("WAVE"). COVID-19 The impact of the COVID-19 pandemic on our future consolidated results of operations remains uncertain. During 2020, we noted delays in construction driven by temporary closures of non-essential businesses, with the most significant impacts in certain major metropolitan areas impacted by COVID-19. Beginning in 2021, market conditions began to improve and continued to do so in the first quarter of 2022, although the improvement was tempered by an uneven market recovery. We continue to monitor and manage the impact of COVID-19 and its potential impacts to our business. As of March 31, 2022, all of our manufacturing facilities were operational, excluding our St. Helens, Oregon facility which was idled in the second quarter of 2018. In an effort to operate safely and responsibly, we continue to follow guidelines from governmental health authorities across all our facilities. We did not record any asset impairments, inventory charges or material bad debt reserves related to COVID-19 during the first quarter of 2022 or 2021, although future events may require such charges. We will continue to evaluate the nature and extent of the COVID-19 pandemic’s impact on our financial condition, results of operations and cash flows. Manufacturing Plants As of March 31, 2022, we operated 16 manufacturing plants in two countries, with 14 plants located within the U.S. and two plants in Canada. We closed our St. Helens, Oregon mineral fiber manufacturing plant in the second quarter of 2018, and the facility was classified as an asset held for sale as of March 31, 2022. WAVE operates six additional plants in the U.S. to produce suspension system (grid) products, which we use and sell in our ceiling systems. Reportable Segments Our operating segments are as follows: Mineral Fiber, Architectural Specialties and Unallocated Corporate. Mineral Fiber – produces suspended mineral fiber and soft fiber ceiling systems. Our mineral fiber products offer various performance attributes such as acoustical control, rated fire protection, aesthetic appeal, and health and sustainability features. Ceiling products are sold to resale distributors, ceiling systems contractors and wholesalers and retailers (including large home centers). The Mineral Fiber segment also includes the results of WAVE, which manufactures and sells suspension system (grid) products and ceiling component products that are invoiced by both AWI and WAVE. Segment results relating to WAVE consist primarily of equity earnings and reflect our 50% equity interest in the joint venture. Ceiling component products consist of ceiling perimeters and trim, in addition to grid products that support drywall ceiling systems. For some customers, WAVE sells its suspension systems products to AWI for resale to customers. Mineral Fiber segment results reflect those sales transactions. The Mineral Fiber segment also includes all assets and liabilities not specifically allocated to our Architectural Specialties or Unallocated Corporate segment, including all property and related depreciation associated with our Lancaster, PA headquarters. Operating results for the Mineral Fiber segment include a significant majority of allocated Corporate administrative expenses that represent a reasonable allocation of general services to support its operations. Architectural Specialties – produces, designs and sources ceilings and walls for use in commercial settings. Products are available in numerous materials, such as metal, felt and wood, in addition to various colors, shapes and designs. Products offer various performance attributes such as acoustical control, rated fire protection and aesthetic appeal. We sell standard, premium and customized products, a portion of which are derived from sourced products. Architectural Specialties products are sold primarily to 22 Management’s Discussion and Analysis of Financial Condition and Results of Operations resale distributors and direct customers, primarily ceiling systems contractors. The majority of this segment's revenues are project driven, which can lead to more volatile sales patterns due to project scheduling uncertainty. Operating results for the Architectural Specialties segment include a portion of allocated Corporate administrative expenses that represent a reasonable allocation of general services to support its operations. Unallocated Corporate – includes assets, liabilities, income and expenses that have not been allocated to our other business segments and consists of: cash and cash equivalents, the net funded status of our U.S. Retirement Income Plan (“RIP”), the estimated fair value of interest rate swap contracts, outstanding borrowings under our senior credit facility and income tax balances. Our Unallocated Corporate segment also includes all income and expenses formerly reported in our Europe, the Middle East and Africa (including Russia) ("EMEA") and Pacific Rim segments that were not included in the sale of certain subsidiaries comprising our businesses and operations in EMEA and the Pacific Rim to Knauf International GmbH ("Knauf"), including the corresponding businesses and operations conducted by WAVE, our joint venture with Worthington in which AWI holds a 50% interest (collectively, the “Sale”). Factors Affecting Revenues For information on our segments' 2022 net sales by segment, see Notes 2 and 3 to the Condensed Consolidated Financial Statements. Markets. We compete in the building product construction markets of the Americas. We closely monitor publicly available macroeconomic trends that provide insight into construction market activity, including GDP, office vacancy rates, the Architecture Billings Index, new commercial construction starts, state and local government spending, corporate profits and retail sales. The company continues to monitor the impacts of global events, including the conflict in Ukraine, which due to our Americas-only geography, did not impact our results of operations during the first quarter of 2022. We noted several factors and trends within our markets that directly affected our business performance during the first quarter of 2022 compared to the first quarter of 2021, most importantly the continuing recovery from the COVID-19 pandemic in terms of business and commercial construction activity, partially offset by continued challenges to global supply chains and labor availability, and improved performance within our Architectural Specialties segment, partially driven by our recent acquisitions. Demand continues to be tempered by delays in construction starts and extended project timelines, which, in addition to the inflationary environment, has impacted inventory levels within our distributor customer channel. In addition, the uneven market recovery has resulted in variability in demand increases across different geographies. For the three months ended March 31, 2022, increased sales volumes contributed $8 million to revenue compared to the same period in 2021. Average Unit Value . We periodically modify sales prices of our products due to changes in costs for raw materials and energy, market conditions and the competitive environment. Typically, realized price increases are less than the announced price increases because of project pricing, competitive adjustments and changing market conditions. We also offer a wide assortment of products that are differentiated by style, design and performance attributes. Pricing and margins for products within the assortment vary. In addition, changes in the relative quantity of products purchased at different price points can impact year-to-year comparisons of net sales and operating income. Within our Mineral Fiber segment, we focus on improving sales dollars per unit sold, or average unit value (“AUV”), as a measure that accounts for the varying assortment of products and like-for-like pricing impacting our revenues. We estimate that favorable AUV increased our total consolidated net sales for the three months ended March 31, 2022 by approximately $23 million compared to the same period in 2021. Our Architectural Specialties segment generates revenues that are primarily earned based on individual contracts that include a mix of products, both manufactured by us and sourced from third parties, that vary by project. As such, we do not track AUV performance for this segment, but rather attribute most changes in sales to volume. During the first quarter of 2022, we implemented price increases on Mineral Fiber ceiling, grid products and certain Architectural Specialties products. We may implement future pricing actions based on numerous factors, namely the rate and pace of inflation impact on our business. Seasonality . Historically, our sales tend to be stronger in the second and the third quarters of our fiscal year due to more favorable weather conditions, customer business cycles and the timing of renovation and new construction. Factors Affecting Operating Costs Operating Expenses. Our operating expenses are comprised of direct production costs (principally raw materials, labor and energy), manufacturing overhead costs, freight, costs to purchase sourced products and selling, general, and administrative (“SG&A”) expenses. Our largest raw material expenditures are primarily for fiberglass, perlite, recycled paper and starch. Other raw materials include aluminum, clays, felt, pigment, steel, wood and wood fiber. We manufacture most of our mineral wool needs at one of our 23 Management’s Discussion and Analysis of Financial Condition and Results of Operations manufacturing facilities. Natural gas and packaging materials are also significant input costs. Fluctuations in the prices of these inputs are generally beyond our control and have a direct impact on our financial results. Global supply chain and labor disruptions have contributed to raw material and transportation cost inflation. In the first quarter of 2022, higher costs for raw materials and energy negatively impacted operating income by $7 million compared to the same period in 2021. 2020 Acquisition-Related Expenses and Losses In connection with our acquisitions of TURF Design, Inc. ("Turf") in July 2020, Moz Designs, Inc. ("Moz") in August 2020, and Arktura LLC ("Arktura") in December 2020, we recorded certain acquisition-related expenses and losses to operating income in the three months ended March 31, 2022 and 2021, summarized as follows (dollar amounts in millions): Three Months Ended March 31, 2022 2021 Affected Line Item in the Condensed Consolidated Statement of Earnings and Comprehensive Income Deferred revenue $ - $ 0.7 Net sales Loss related to change in fair value of contingent consideration 0.1 0.2 Loss related to change in fair value of contingent consideration Deferred cash and restricted stock expenses 2.0 2.8 SG&A expenses Inventory - 0.3 Cost of goods sold Net negative impact to operating income $ 2.1 $ 4.0 The deferred revenue and inventory amounts above reflect the post-acquisition expenses associated with recording these liabilities and assets at fair value as part of purchase accounting. The change in fair value of contingent consideration is related to our Moz and Turf acquisitions and is remeasured quarterly during each acquisition's respective earn-out period. See Note 14 to the Condensed Consolidated Financial Statements for further information. Expenses related to the deferred cash and restricted stock awards for Arktura’s former owners and employees are recorded over their respective service periods, as such payments are subject to the awardees’ continued employment with AWI. Depreciation of fixed assets acquired and amortization of intangible assets acquired have been excluded from the table above. Employees As of March 31, 2022 and December 31, 2021, we had approximately 2,900 and 2,800 full-time and part-time employees, respectively. RESULTS OF CONTINUING OPERATIONS Please refer to Notes 2 and 4 to the Condensed Consolidated Financial Statements for a reconciliation of operating income to consolidated earnings from continuing operations before income taxes and additional financial information related to discontinued operations. CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) Three Months Ended March 31, 2022 2021 Change is Favorable Total consolidated net sales $ 282.6 $ 251.9 12.2 % Operating income $ 63.2 $ 54.1 16.8 % Consolidated net sales for the first quarter of 2022 increased 12.2% over the prior-year period as favorable AUV contributed $23 million and higher volumes contributed $8 million. Mineral Fiber net sales increased $15 million and Architectural Specialties net sales increased $16 million over the pri or-year period. The increase in Mineral Fiber segment net sales was driven by improved AUV, partially offset by lower volumes resulting primarily from a reduction of inventory levels at certain distributor customers. Architectural Specialties segment net sales improved due to an increase in custom project sales, improved performance from our recent acquisitions compared to the same period in 2021 and positive impacts from price increases. 24 Management’s Discussion and Analysis of Financial Condition and Results of Operations Cost of goods sold in the first quarter of 2022 was 63.8% of net sales, compared to 65.3% for the same period in 2021. The decrease in cost of goods sold as a percent of net sales for the first quarter of 2022 was driven by favorable AUV performance and improved manufacturing productivity, partially offset by higher inflation. SG&A expenses in the first quarter of 2022 were $57.1 million, or 20.2% of net sales, compared to $54.2 million, or 21.5% of net sales, for the same period in 2021. The increase in SG&A expenses for the first quarter of 2022 compared to the same period in 2021 was driven primarily by a $7 million increase in selling expenses which was partially offset by a $4 million decrease in intangible asset amortization related to the Architectural Specialties segment. Equity earnings from our WAVE joint venture were $18.2 million in the first quarter of 2022, compared to $21.0 million in the first quarter of 2021. The decrease in WAVE earnings was primarily related to lower volumes, also resulting primarily from a reduction of inventory levels at certain distributor customers, and increased SG&A expenses. See Note 8 to the Condensed Consolidated Financial Statements for further information. Interest expense was $5.1 million in the first quarter of 2022 compared to $5.7 million in the first quarter of 2021. The decrease was primarily due to lower average borrowings and lower effective interest rates. Other non-operating income, net, was $1.3 million in the first quarter of 2022 and 2021. Income tax expense was $15.0 million in the first quarter of 2022 compared to $12.2 million in the first quarter of 2021. The effective tax rate for the first quarter of 2022 was 25.3% compared to 24.6% for the same period of 2021. The effective tax rate for the first quarter of 2022 was higher compared to the same period in 2021 due primarily to a reduced benefit from share-based compensation. Total Other Comprehensive Income (“OCI”) was $11.9 million in the first quarter of 2022 compared to $4.6 million in the first quarter of 2021. The change in OCI in the first quarter of 2022 compared to the same period in 2021 was primarily driven by derivative gains/losses. Derivative gain/loss represents the mark-to-market value adjustments of our derivative assets and liabilities and the recognition of gains and losses previously deferred in OCI. Also impacting the change in OCI were pension and postretirement adjustments and foreign currency translation adjustments. Pension and postretirement adjustments represent the amortization of actuarial gains and losses related to our defined benefit pension and postretirement plans. Foreign currency translation adjustments represent the change in the U.S. dollar value of assets and liabilities denominated in foreign currencies. Amounts in the first quarter of 2022 and 2021 were driven primarily by changes in the Canadian dollar. REPORTABLE SEGMENT RESULTS Mineral Fiber (dollar amounts in millions) Three Months Ended March 31, 2022 2021 Change is Favorable/(Unfavorable) Total segment net sales $ 203.2 $ 188.7 7.7 % Operating income $ 57.6 $ 60.6 (5.0 )% Net sales increased in the first quarter of 2022 due to $23 million of favorable AUV, partially offset by lower sales volumes of $8 million. The improvement in AUV was driven primarily by favorable price. The decrease in volumes was primarily driven by a reduction of inventory levels at certain distributor customers. Operating income decreased in the first quarter of 2022 primarily due to a $7 million increase in manufacturing costs, primarily increased raw material and energy costs, a $6 million decrease resulting from lower sales volumes, a $5 million increase in selling expenses, primarily related to investments in growth initiatives and incentive compensation, and a $3 million decrease in equity earnings driven by lower volumes. These costs were partially offset by $18 million of favorable AUV. 25 Management’s Discussion and Analysis of Financial Condition and Results of Operations Architectural Specialties (dollar amounts in millions) Three Months Ended March 31, 2022 2021 Change is Favorable/(Unfavorable) Total segment net sales $ 79.4 $ 63.2 25.6 % Operating income (loss) $ 6.5 $ (4.9 ) (232.7 )% Net sales increased $16 million in the first quarter of 2022 primarily due to an increase in custom project sales, improved performance from our recent acquisitions compared to the same period in 2021 and positive impacts from price increases. Operating income increased in the first quarter of 2022 primarily due to a $9 million benefit from net sales growth and a $4 million reduction in intangible asset amortization. These benefits were partially offset by a $2 million increase in selling expenses, primarily related to additional investments in selling capabilities and incentive compensation. Unallocated Corporate Unallocated Corporate operating loss was $1 million in the first quarter of 2022, compared to $2 million in the first quarter of 2021. FINANCIAL CONDITION AND LIQUIDITY Cash Flow Operating activities for the first three months of 2022 provided $16.7 million of cash, compared to $19.6 million in the first three months of 2021. The decrease was primarily due to negative working capital changes in inventory and accounts payable and accrued expenses, partially offset by higher cash earnings and a decrease in income tax payments. Net cash provided by investing activities was $0.2 million in the first three months of 2022, compared to $8.8 million of cash used in the first three months of 2021. The favorable change in cash in the first quarter of 2022 compared to the same period in 2021 was primarily due to the absence of the purchase price adjustments paid to Knauf, partially offset by a decrease in dividends from WAVE. Net cash used for financing activities was $39.2 million in the first three months of 2022, compared to $26.2 million in the first three months of 2021. The unfavorable change in cash was primarily due to a decrease in proceeds from borrowings, higher repurchases of outstanding common stock, and payments of acquisition-related contingent consideration in 2022, partially offset by decreased payments on borrowings. Liquidity Our liquidity needs for operations vary throughout the year. We retain lines of credit to facilitate our seasonal cash flow needs, since cash flow is historically lower during the first and fourth quarters of our fiscal year. We have a $1,000.0 million variable rate senior credit facility, which is comprised of a $500.0 million revolving credit facility (with a $150.0 million sublimit for letters of credit) and a $500.0 million Term Loan A. The revolving credit facility and Term Loan A are currently priced at 1.25% over LIBOR. The senior credit facility also has a $25.0 million letter of credit facility, also known as our bi-lateral facility. The revolving credit facility and Term Loan A mature in September 2024. The $1,000.0 million senior credit facility is secured by the capital stock of material U.S. subsidiaries and a pledge of 65% of the stock of our material first-tier foreign subsidiary in Canada. The unpaid balances of the revolving credit facility and Term Loan A may be prepaid without penalty at the maturity of their respective interest reset periods. Any principal amounts paid on the Term Loan A may not be re-borrowed. As of March 31, 2022, total borrowings outstanding under our senior credit facility were $462.5 million under Term Loan A and $180.0 million under the revolving credit facility. The senior credit facility includes two financial covenants that require the ratio of consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”) to consolidated cash interest expense minus cash consolidated interest income to be greater than or equal to 3.0 to 1.0 and requires the ratio of consolidated funded indebtedness, minus AWI and domestic subsidiary unrestricted cash and cash equivalents up to $100 million, to EBITDA to be less than or equal to 3.75 to 1.0. As of March 31, 2022, we were in compliance with all covenants of the senior credit facility. 26 Management’s Discussion and Analysis of Financial Condition and Results of Operations The Term Loan A is currently priced on a variable interest rate basis. The following table summarizes our interest rate swaps (dollar amounts in millions): Trade Date Notional Amount Coverage Period Risk Coverage November 28, 2018 $ 200.0 November 2018 to November 2023 USD-LIBOR November 28, 2018 $ 100.0 March 2021 to March 2025 USD-LIBOR March 10, 2020 $ 50.0 March 2021 to March 2024 USD-LIBOR March 11, 2020 $ 50.0 March 2021 to March 2024 USD-LIBOR Under the terms of our interest rate swaps above, we pay a fixed rate monthly and receive 1-month LIBOR, inclusive of a 0% floor. These swaps are designated as cash flow hedges against changes in LIBOR for a portion of our variable rate debt. We utilize lines of credit and other commercial commitments to ensure that adequate funds are available to meet operating requirements. Letters of credit are currently arranged through our revolving credit facility and our bi-lateral facility. Letters of credit may be issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table presents details related to our letters of credit facilities (dollar amounts in millions): March 31, 2022 Financing Arrangements Limit Used Available Bi-lateral facility $ 25.0 $ 8.1 $ 16.9 Revolving credit facility 150.0 - 150.0 Total $ 175.0 $ 8.1 $ 166.9 As of March 31, 2022, we had $76.1 million of cash and cash equivalents, $63.8 million in the U.S. and $12.3 million in various foreign jurisdictions, primarily Canada. As of March 31, 2022, we also had $320.0 million available under our revolving credit facility. We believe cash on hand and cash generated from operations, together with borrowing capacity under our credit facility, will be adequate to address our near-term liquidity needs based on current expectations of our business operations, capital expenditures and scheduled payments of debt obligations. CRITICAL ACCOUNTING ESTIMATES There have been no material changes to our critical accounting estimates disclosed in our 2021 Annual Report on Form 10-K. 27 ITEM 3. QUANTITATIVE AND QUALITAT IVE DISCLOSURES ABOUT MARKET RISK For information regarding our exposure to certain market risks, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” in our Annual Report on Form 10-K for the year ended December 31, 2021.