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, 2022. 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"). Acquisitions In November 2022, we acquired the business and assets of GC Products, Inc. (“GC Products”), based in Lincoln, CA. GC Products is a designer and manufacturer of glass-reinforced-gypsum, glass-reinforced-cement, molded ceiling and specialty wall products with one manufacturing facility. The operations, assets and liabilities of GC Products are included in our Architectural Specialties segment. The acquisition of GC Products did not have a material impact on our results of operations for the three months ended March 31, 2023. Manufacturing Plants As of March 31, 2023, we operated 16 manufacturing plants, with 14 plants located within the U.S. and two plants in Canada. This excludes our St. Helens, Oregon mineral fiber manufacturing plant, which was closed in the second quarter of 2018, and was classified as an asset held for sale as of March 31, 2023. WAVE operates seven 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 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 certain 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 secured credit facility and income tax balances. 22 Management’s Discussion and Analysis of Financial Condition and Results of Operations Factors Affecting Revenues For information on our segments' 2023 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 commercial construction market activity, including, but not limited to, 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 COVID-19 and other global events, including the conflict in Ukraine, both of which had minimal direct impacts on our results of operations during the first quarter of 2023 and 2022. Additionally, we have monitored, and will continue to monitor, the impact of domestic and international bank failures, which had no direct impact on our results of operations, financial condition and results of operations during the first quarter of 2023. Several factors and trends within our markets affected our business performance during the first quarter of 2023 compared to the first quarter of 2022, most importantly rising interest rates, lower inflation on certain input costs, and the lessening impact of supply chain and labor availability constraints, all of which resulted in uneven market demand. For the three months ended March 31, 2023, increased sales volumes contributed $21 million to net sales compared to the same period in 2022, primarily in our Mineral Fiber segment. The increase in Mineral Fiber sales volumes was primarily driven by comparison to a weaker prior-year period due to reductions of inventory levels at certain customers, and partially due to current-year inventory level increases at our home center customers. 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 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, 2023 by approximately $6 million compared to the same period in 2022. Our Architectural Specialties segment revenues are primarily earned based on individual contracts that include a mix of products, both manufactured by us and sourced from third parties, which varies 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 2023, 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 and its 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 projects. 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 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 at one of our manufacturing facilities. Natural gas and packaging materials are also significant input costs. Fluctuations in the prices of these inputs have an impact on our financial results. In the first quarter of 2023, higher costs for raw materials and energy negatively impacted operating income by $4 million compared to the same period in 2022. 2020 Acquisition-Related Expenses and Losses In connection with our acquisitions of Turf in July 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, 2023 and 2022, summarized as 23 Management’s Discussion and Analysis of Financial Condition and Results of Operations follows (dollar amounts in millions): Three Months Ended March 31, 2023 2022 Affected Line Item in the Condensed Consolidated Statements of Earnings and Comprehensive Income Loss related to change in fair value of contingent consideration - 0.1 Loss related to change in fair value of contingent consideration Deferred cash and restricted stock expenses 1.3 2.0 SG&A expenses Net negative impact to operating income $ 1.3 $ 2.1 The change in fair value of contingent consideration was related to our Turf acquisition and was remeasured quarterly during the acquisition's earn-out period which was completed on December 31, 2022. See Note 15 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, 2023 and December 31, 2022, we had approximately 3,000 full-time and part-time employees. RESULTS OF OPERATIONS Please refer to Note 2 to the Condensed Consolidated Financial Statements for a reconciliation of operating income to consolidated net earnings before income taxes. CONSOLIDATED RESULTS (dollar amounts in millions) Three Months Ended March 31, 2023 2022 Change is Favorable Total consolidated net sales $ 310.2 $ 282.6 9.8 % Operating income $ 70.2 $ 63.2 11.1 % Consolidated net sales for the first quarter of 2023 increased 9.8% over the prior-year period as higher volumes contributed $21 million and favorable AUV contributed $6 million. Mineral Fiber net sales increased $25 million and Architectural Specialties net sales increased $2 million over the prior-year period. The increase in Mineral Fiber segment net sales was primarily driven by higher volumes, and partially due to improved AUV. The increase in Mineral Fiber segment sales volumes was primarily driven by a recovery of sales volumes compared to a weaker prior-year period due to inventory level reductions at certain customers and partially due to current-year inventory level increases at our home center customers. The favorable AUV was primarily driven by positive like-for-like pricing, partially offset by unfavorable geographic mix. Architectural Specialties segment net sales improved due to growth across most product categories, partially offset by lower metal product sales. Cost of goods sold in the first quarter of 2023 was 63.9% of net sales, compared to 63.8% for the same period in 2022. The increase in cost of goods sold as a percent of net sales for the first quarter of 2023 was driven by raw material and energy inflation and inventory valuation impacts, partially offset by favorable AUV performance and improved manufacturing productivity. SG&A expenses in the first quarter of 2023 were $62.7 million, or 20.2% of net sales, compared to $57.1 million, or 20.2% of net sales, for the same period in 2022. The year-over-year increase in SG&A expenses was driven primarily by a $5 million increase in selling expenses, primarily related to investments in our Architectural Specialties segment and higher costs in support of our digital selling initiatives, in addition to $3 million in severance costs related to cost savings initiatives in the current-year quarter, partially offset by a $1 million reduction in acquisition-related expenses. Equity earnings from our WAVE joint venture were $20.8 million in the first quarter of 2023, compared to $18.2 million in the first quarter of 2022. WAVE earnings growth was primarily driven by lower steel costs and the benefits of a recovery of sales volumes compared to a weaker prior-year period due to inventory level reductions at certain customers. These benefits were partially offset by the impact of unfavorable AUV. See Note 7 to the Condensed Consolidated Financial Statements for further information. 24 Management’s Discussion and Analysis of Financial Condition and Results of Operations Interest expense was $8.7 million in the first quarter of 2023 compared to $5.1 million in the first quarter of 2022. The increase was primarily due to higher interest rates on floating rate debt. Other non-operating income, net, was $2.4 million in the first quarter of 2023 compared to $1.3 million in the first quarter of 2022. Other non-operating income, net, is primarily comprised of the non-service cost components of pension and postretirement net periodic benefit costs. Income tax expense was $16.6 million in the first quarter of 2023 compared to $15.0 million in the first quarter of 2022. The effective tax rate for the first quarter of 2023 was 26.0% compared to 25.3% for the same period of 2022. The increase in the effective tax rate for the first quarter of 2023 was primarily due to an increase in our valuation allowance for capital loss carryforwards recorded in the current quarter. Total Other Comprehensive Loss (“OCL”) was $2.1 million in the first quarter of 2023 compared to Other Comprehensive Income (“OCI”) of $11.9 million in the first quarter of 2022. The change in OCL in the first quarter of 2023 compared to the same period in 2022 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 OCL 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 2023 and 2022 were driven primarily by changes in the Canadian dollar. REPORTABLE SEGMENT RESULTS Mineral Fiber (dollar amounts in millions) Three Months Ended March 31, 2023 2022 Change is Favorable Total segment net sales $ 228.4 $ 203.2 12.4 % Operating income $ 63.8 $ 57.6 10.8 % Net sales increased in the first quarter of 2023 due to $19 million of higher sales volumes and $6 million of favorable AUV. The increase in volumes was driven primarily by a recovery of sales volumes compared to a weaker prior-year period due to inventory level reductions at certain customers, and partially due to current-year inventory level increases at our home center customers. The improvement in AUV was driven by favorable like-for-like price, partially offset by unfavorable geographic mix. Operating income increased in the first quarter of 2023 primarily due to a $12 million benefit from higher sales volumes, a $5 million benefit from favorable AUV and a $3 million increase in equity earnings. These benefits were partially offset by an $8 million increase in manufacturing costs, primarily driven by raw material and energy inflation, and inventory valuation impacts, partially offset by improved manufacturing productivity. Also partially offsetting the favorability was $3 million in severance costs related to cost savings initiatives in the current-year quarter and a $3 million increase in selling expenses, partially in support of digital growth initiatives. Architectural Specialties (dollar amounts in millions) Three Months Ended March 31, 2023 2022 Change is Favorable Total segment net sales $ 81.8 $ 79.4 3.0 % Operating income (loss) $ 7.2 $ 6.5 10.8 % Net sales increased $2 million in the first quarter of 2023 compared to the same period in 2022, driven by growth across most product categories, partially offset by lower metal product sales. Net sales growth was also negatively impacted by the timing of custom project sales. Operating income increased in the first quarter of 2023 primarily due to a $2 million margin benefit from increased sales and favorable project mix and a $1 million reduction in acquisition-related expenses, partially offset by a $2 million increase in selling expenses. 25 Management’s Discussion and Analysis of Financial Condition and Results of Operations Unallocated Corporate Unallocated Corporate operating loss was $1 million in the first quarter of 2023 and 2022. FINANCIAL CONDITION AND LIQUIDITY Cash Flow Operating activities for the first three months of 2023 provided $26.2 million of cash, compared to $16.7 million in the first three months of 2022. The increase was primarily due to favorable working capital changes, most notably in inventory. Net cash used in investing activities was $1.5 million in the first three months of 2023, compared to $0.2 million of cash provided in the first three months of 2022. The unfavorable change in cash in the first quarter of 2023 compared to the same period in 2022 was primarily due to increased purchases of property, plant and equipment, partially offset by an increase in dividends from WAVE. Net cash used for financing activities was $34.7 million in the first three months of 2023, compared to $39.2 million in the first three months of 2022. The favorable change in cash was primarily due to decreased payments on borrowings and a decrease in repurchases of outstanding common stock, partially offset by higher payments of acquisition-related contingent consideration in 2023. 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 $950.0 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 $450.0 million Term Loan A. The revolving credit facility and Term Loan A are currently priced at 1.625% over SOFR, plus a 10-basis point adjustment. The revolving credit facility and Term Loan A mature in December 2027. We also have a $25.0 million bi-lateral letter of credit facility separate from the senior secured credit facility. As of March 31, 2023, total borrowings outstanding under our senior credit facility were $450.0 million under Term Loan A and $220.0 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 (subject to certain exceptions for certain acquisitions). As of March 31, 2023, we were in compliance with all covenants of the senior credit facility. In July 2017, the Financial Conduct Authority (the authority that regulates LIBOR) announced it intends to replace LIBOR rates with the SOFR effective in mid-2023. The Alternative Reference Rates Committee (“ARRC”) has proposed that the SOFR rate represents best practice as the alternative to USD-LIBOR for use in derivatives and other financial contracts that are currently indexed to USD-LIBOR. ARRC has proposed a paced market transition plan to SOFR from USD-LIBOR. In the second quarter of 2020, we adopted Accounting Standards Update 2020-04, “Facilitation of the Effects of Reference Rate Reform on Financial Reporting,” ("ASU 2020-04") which provides optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships and other transactions affected by the discontinuation of LIBOR. In March 2023, we amended our interest rate swaps in accordance with ASU 2020-04, changing our hedged interest rate from LIBOR to SOFR. 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-SOFR September 19, 2022 $ 25.0 September 2022 to December 2023 USD-SOFR March 10, 2020 $ 50.0 March 2021 to March 2024 USD-SOFR March 11, 2020 $ 50.0 March 2021 to March 2024 USD-SOFR November 28, 2018 $ 100.0 March 2021 to March 2025 USD-SOFR Under the terms of our interest rate swaps above, we pay a fixed rate monthly and receive 1-month SOFR, inclusive of a 0% floor. 26 Management’s Discussion and Analysis of Financial Condition and Results of Operations As of March 31, 2023, these swaps are designated as cash flow hedges against changes in SOFR 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, 2023 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, 2023, we had $96.0 million of cash and cash equivalents, $80.7 million in the U.S. and $15.3 million in foreign jurisdictions, primarily Canada. As of March 31, 2023, we also had $280.0 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 Annual Report on Form 10-K for the year ended December 31, 2022. 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, 2022.