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. We manufacture and source products made of numerous materials, including mineral fiber, fiberglass wool, metal, wood, felt, wood fiber, and glass-reinforced-gypsum. 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 and six months ended June 30, 2023. Manufacturing Plants As of June 30, 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 June 30, 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, wood and felt, 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 2023 net sales by segment, see Notes 2 and 3 to the Condensed Consolidated Financial Statements. Markets. We compete in the building product 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 global events, including the conflict in Ukraine, which had minimal direct impacts on our results of operations during the first half of 2023 and 2022. Additionally, we have monitored, and will continue to monitor, the impact of domestic and international bank failures, which had no material direct impact on our results of operations, financial condition and results of operations during the first half of 2023. Several factors and trends within our markets affected our business performance during the second quarter of 2023 compared to the second quarter of 2022, most importantly softer demand, and an increase in interest rates, partially offset by a lower rate of inflation on certain input costs and the lessening impact of supply chain and labor availability constraints. For the three months ended June 30, 2023, sales volumes decreased $12 million compared to the same period in 2022. For the six months ended June 30, 2023, sales volumes increased $9 million compared to the same period in 2022 primarily due to a weaker prior-year period driven by reductions of inventory levels at certain customers in early 2022 and current-year inventory level increases at our home center customers in the first quarter of 2023, partially offset by softer demand in the second quarter of 2023. 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. Favorable AUV increased our total consolidated net sales for the three and six months ended June 30, 2023 by approximately $17 million and $23 million, respectively, compared to the same periods 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 products. In addition, during the first and second quarters price increases were implemented on grid products. In the second quarter of 2023, we also announced price increases on Mineral Fiber products that will become effective in the third quarter of 2023. 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 clays, felt, pigment, wood and wood fiber. We manufacture most of our mineral wool at one of our manufacturing facilities. We use aluminum and steel in the production of metal ceilings by us and by WAVE. Finally, natural gas and packaging materials are also significant input costs. Fluctuations in the prices of these inputs impact our financial results. In the three and six months ended June 30, 2023, higher costs for raw materials, partially offset by lower costs for energy, negatively impacted operating income by $1 million and $6 million, respectively, compared to the same periods 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 and six months ended June 30, 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 Six Months Ended June 30, June 30, 2023 2022 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 $ - $ 6.1 $ - $ 6.2 Loss related to change in fair value of contingent consideration Deferred cash and restricted stock expenses 1.4 2.0 2.7 4.0 SG&A expenses Net negative impact to operating income $ 1.4 $ 8.1 $ 2.7 $ 10.2 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 June 30, 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) 2023 2022 Change is Favorable Three Months Ended June 30, Total consolidated net sales $ 325.4 $ 321.0 1.4 % Operating income $ 87.0 $ 71.6 21.5 % Six Months Ended June 30, Total consolidated net sales $ 635.6 $ 603.6 5.3 % Operating income $ 157.2 $ 134.8 16.6 % Consolidated net sales for the second quarter of 2023 increased 1.4% over the prior-year period driven by favorable AUV of $17 million, partially offset by lower sales volumes of $12 million. Mineral Fiber net sales decreased slightly from the prior-year period while Architectural Specialties net sales increased $5 million compared to prior-year period results. The change in Mineral Fiber net sales was primarily driven by improved AUV that was more than offset by lower sales volumes. Architectural Specialties net sales improved due to growth across most product categories. Consolidated net sales for the first six months of 2023 increased 5.3% over the prior-year period as favorable AUV contributed $23 million and higher volumes contributed $9 million. Mineral Fiber net sales increased $25 million and Architectural Specialties net sales increased $7 million over the prior-year period. The increase in Mineral Fiber net sales was primarily driven by favorable AUV and to a lesser extent, higher volumes. 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 second quarter of 2023 was 61.9% of net sales, compared to 63.3% for the same period in 2022. Cost of goods sold in the first six months of 2023 was 62.9% of net sales, compared to 63.5% for the same period in 2022. The decreases in cost of goods sold as a percentage of net sales for the second quarter and first six months of 2023 compared to the same periods in 2022 were driven primarily by a favorable AUV benefit due to the rate and pace of raw material and energy cost increases in the prior-year periods, in addition to current-year improved manufacturing productivity. 24 Management’s Discussion and Analysis of Financial Condition and Results of Operations SG&A expenses in the second quarter of 2023 were $61.9 million, or 19.0% of net sales, compared to $61.5 million, or 19.2% of net sales, for the same period in 2022. The year-over-year increase in SG&A expenses was driven primarily by a $3 million increase in selling expenses, primarily related to investments in support of our digital initiatives and higher costs in our Architectural Specialties segment, partially offset by a reduction in acquisition-related expenses and a benefit from current cost savings initiatives implemented in the first quarter of 2023. SG&A expenses in the first six months of 2023 were $124.6 million, or 19.6% of net sales, compared to $118.6 million or 19.6% of net sales, for the same period in 2022. The year-over-year increase in SG&A expenses was driven primarily by an $8 million increase in selling expenses, primarily related to investments in support of our digital initiatives and higher costs in our Architectural Specialties segment, in addition to $3 million in severance costs related to current-year cost savings initiatives. These increased costs were partially offset by savings from current year cost savings initiatives and lower acquisition-related expenses. Equity earnings from our WAVE joint venture were $24.9 million in the second quarter of 2023, compared to $21.3 million in the second quarter of 2022 and were $45.7 million in the first six months of 2023 compared to $39.5 million in the same period of 2023. The increase in WAVE earnings during the second quarter of 2023 compared to the same period in 2022 was primarily driven by the benefits of lower steel costs, partially offset by lower volumes due to softer demand. The increase in WAVE earnings during the first six months of 2023 compared to the same period in 2022 was primarily due to the benefits of lower steel costs, partially offset by lower volumes due to softer demand and unfavorable AUV due to negative mix. See Note 7 to the Condensed Consolidated Financial Statements for further information. Interest expense was $9.2 million in the second quarter of 2023 compared to $5.8 million in the second quarter of 2022. Interest expense was $17.9 million in the first six months of 2023 compared to $10.9 million in the first six months of 2022. The increases for the second quarter and first six months of 2023 in comparison to the same periods in 2022 were due to slightly higher average debt coupled with higher interest rates on floating rate debt. Other non-operating income, net, was $2.2 million in the second quarter of 2023 compared to $1.4 million in the second quarter of 2022. Other non-operating income, net was $4.6 million in the first six months of 2023 compared to $2.7 million in the first six months 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 $19.8 million in the second quarter of 2023 compared to $15.0 million in the second quarter of 2022. The effective tax rate for the second quarter of 2023 was 24.8% compared to 22.3% for the same period of 2022. Income tax expense was $36.4 million in the first six months of 2023 compared to $30.0 million in the first six months of 2022. The effective tax rate was 25.3% in the first six months of 2023 compared to 23.7% in the same period of 2022. The effective tax rates for the second quarter and first six months of 2023 were higher compared to the same periods in 2022 due primarily to a reduction in our valuation allowance for capital loss carryforwards recorded in 2022. Total Other Comprehensive Income (“OCI”) was $0.4 million in the second quarter of 2023 compared to OCI of $2.2 million in the second quarter of 2022. Total Other Comprehensive Loss (“OCL”) was $1.7 million for the first six months of 2023 compared to OCI of $14.1 million in the first six months of 2022. The change in OCI in the second quarter and first six months of 2023 compared to the same periods in 2022 were primarily driven by derivative gains/losses, partially offset by foreign currency translation adjustments. 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. Foreign currency translation adjustments represent the change in the U.S. dollar value of assets and liabilities denominated in foreign currencies. Amounts in the second quarter and first six months of 2023 and 2022 were driven primarily by changes in the Canadian dollar. Also impacting the change in OCI were pension and postretirement adjustments, which represented the amortization of actuarial gains and losses related to our defined benefit pension and postretirement plans. 25 Management’s Discussion and Analysis of Financial Condition and Results of Operations REPORTABLE SEGMENT RESULTS Mineral Fiber (dollar amounts in millions) 2023 2022 Change is (Unfavorable)/Favorable Three Months Ended June 30, Total segment net sales $ 234.0 $ 234.5 (0.2 )% Operating income $ 75.5 $ 71.4 5.7 % Six Months Ended June 30, Total segment net sales $ 462.4 $ 437.7 5.6 % Operating income $ 139.3 $ 129.1 7.9 % Mineral Fiber net sales decreased in the second quarter of 2023 due to $17 million of lower sales volumes, partially offset by $16 million of favorable AUV. The decrease in volumes in the second quarter was driven primarily by softer market demand. The increase in AUV in the second quarter was driven primarily by favorable price, while mix was essentially unchanged as positive product mix was offset by unfavorable channel mix. For the first six months of 2023, net sales improved by $25 million from the prior-year, primarily due to $22 million of favorable AUV and $3 million of increased sales volumes. The favorable AUV was driven primarily by positive like-for-like pricing, partially offset by unfavorable mix. The increase in volumes primarily resulted from a recovery of sales volumes compared to a weaker prior-year period due to inventory level reductions at certain customers in early 2022 and partially due to current-year inventory level increases at our home center customers during the first quarter of 2023, partially offset by softer demand. Second-quarter 2023 operating income increased primarily due to a $14 million benefit from favorable AUV, a $4 million increase in WAVE equity earnings and benefits driven by current year cost savings initiatives. These increases were partially offset by a $12 million decrease from lower sales volumes, and a $2 million increase in selling expenses, primarily in support of our digital initiatives. Operating income for the first six months of 2023 increased primarily due to a $19 million benefit from favorable AUV, a $6 million increase in WAVE equity earnings and a benefit driven by current year cost savings initiatives. These benefits were partially offset by a $9 million increase in manufacturing costs, primarily driven by input cost inflation and inventory valuation impacts, partially offset by improved manufacturing productivity, a $5 million increase in selling expenses, primarily in support of our digital initiatives and $3 million in severance costs related to current-year cost savings initiatives. Architectural Specialties (dollar amounts in millions) 2023 2022 Change is Favorable Three Months Ended June 30, Total segment net sales $ 91.4 $ 86.5 5.7 % Operating income $ 12.2 $ 1.1 Favorable Six Months Ended June 30, Total segment net sales $ 173.2 $ 165.9 4.4 % Operating income $ 19.4 $ 7.6 155.3 % Net sales increased $5 million in the second quarter of 2023 compared to the same period in 2022 due to growth across most product categories and favorable project mix. Net sales increased $7 million in the first six months of 2023 compared to the same period in 2022, driven by growth across most product categories and favorable project mix, partially offset by lower metal product sales. Operating income increased in the second quarter of 2023 due to a $7 million benefit from increased sales volumes and improved project margins. Also contributing to the increase in operating income was a $7 million reduction in acquisition-related expenses, primarily due to the absence of the change in fair value of contingent consideration related to the acquisition of Turf, which was recorded in the prior-year period. These benefits were partially offset by a $2 million increase in manufacturing costs and a $1 million increase in selling expenses. Operating income for the first six months of 2023 compared to the same period in 2022 was positively impacted by a $9 million benefit from increased sales volumes and improved project margins, in addition to an $8 million reduction in acquisition-related expenses, primarily due to the absence of the change in fair value of contingent consideration related to the acquisition of Turf, which 26 Management’s Discussion and Analysis of Financial Condition and Results of Operations was recorded in the prior-year period. These benefits were partially offset by a $3 million increase in manufacturing costs and a $2 million increase in selling expenses. Unallocated Corporate Unallocated Corporate operating loss was $1 million in the second quarter of 2023 and 2022. Unallocated Corporate operating loss was $2 million in the first six months of 2023 and 2022. FINANCIAL CONDITION AND LIQUIDITY Cash Flow Operating activities for the first six months of 2023 provided $93.9 million of cash, compared to $63.1 million in the first six months of 2022. The increase was primarily due to favorable working capital changes, most notably in inventories and receivables. Net cash used in investing activities was $6.0 million in the first six months of 2023, compared to $1.6 million in the first six months of 2022. The unfavorable change in cash in the first six months of 2023 compared to the same period in 2022 was primarily due to increased purchases of property, plant and equipment and cash paid for the acquisition of a co-ownership interest in certain software-related intellectual property, partially offset by an increase in dividends from WAVE. Net cash used for financing activities was $92.6 million in the first six months of 2023, compared to $80.2 million in the first six months of 2022. The unfavorable change in cash was primarily due to a decrease in net borrowings under our revolving credit facility, partially offset by a decrease in repurchases of outstanding common stock and a decrease in debt payments. 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 1.375% 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 June 30, 2023, total borrowings outstanding under our senior credit facility were $450.0 million under Term Loan A and $205.0 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 June 30, 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 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. 27 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-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. As of June 30, 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): June 30, 2023 Financing Arrangements Limit Used Available Bi-lateral facility $ 25.0 $ 7.7 $ 17.3 Revolving credit facility 150.0 - 150.0 Total $ 175.0 $ 7.7 $ 167.3 As of June 30, 2023, we had $101.6 million of cash and cash equivalents, $84.8 million in the U.S. and $16.8 million in foreign jurisdictions, primarily Canada. As of June 30, 2023, we also had $295.0 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. 28 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.