ARMSTRONG WORLD INDUSTRIES INC 10-Q

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF 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, 2020. OVERVIEW We are a leading producer of ceiling systems for use in the construction and renovation of commercial and residential buildings. We design, manufacture and sell ceiling and wall systems ( primarily mineral fiber, fiberglass wool, metal, wood, wood fiber, glass-reinforced-gypsum and felt ) throughout the Americas. COVID-19 The impact of the COVID-19 outbreak on our future consolidated results of operations remains uncertain. In 2020, we experienced a significant decrease in customer demand within both segments during the second through fourth quarters due to COVID-19. Specifically, we noted delays in construction driven by temporary closures of non-life sustaining businesses, with the most significant impacts in major metropolitan areas impacted by COVID-19. We experienced less of a comparative decline in net sales during the second half of 2020 compared to the second quarter of 2020, as construction resumed across many parts of the U.S. Customer demand continued to improve in the first quarter of 2021 but remained lower than pre-pandemic levels. In response to COVID-19, we reduced capital expenditures and discretionary spending including compensation, travel and marketing expenses temporarily in 2020. As of March 31, 2021, all of our manufacturing facilities were operational, excluding the St. Helens, Oregon facility which was idled prior to the COVID-19 outbreak. In an effort to operate safely and responsibly, we continue to follow guidelines from governmental and local health authorities across all our facilities and have implemented preventative measures that include working remotely, providing personal protective equipment, limiting group meetings, enhancing cleaning and sanitizing procedures, and social distancing. We did not record any asset impairments, inventory charges or material bad debt reserves related to COVID-19 during the first quarters of 2021 and 2020 but future events may require such charges. We will continue to evaluate the nature and extent of the COVID-19 outbreak’s impact on our financial condition, results of operations and cash flows. Acquisitions In December 2020, we acquired all of the issued and outstanding equity of Arktura LLC (“Arktura”) and certain subsidiaries with operations in the United States and Argentina. Arktura is a designer and fabricator of metal and felt ceilings, walls, partitions and facades with one manufacturing facility based in Los Angeles, California. In August 2020, we acquired the business and assets of Moz Designs, Inc. (“Moz”), based in Oakland, California. Moz is a designer and fabricator of custom architectural metal ceilings, walls, dividers and column covers for interior and exterior applications with one manufacturing facility. In July 2020, we acquired all the issued and outstanding capital stock of TURF Design, Inc. (“Turf”), with one manufacturing facility in Elgin, Illinois and a design center in Chicago, Illinois. Turf is a designer and manufacturer of acoustic felt ceilings and wall products. The operations, assets and liabilities of these acquisitions are included in our Architectural Specialties segment. See Note 4 to the Condensed Consolidated Financial Statements for additional information related to our acquisitions. Discontinued Operations In 2019, we completed the sale of certain subsidiaries comprising our businesses and operations in Europe, the Middle East and Africa (including Russia) (“EMEA”) and the Pacific Rim, including the corresponding businesses and operations conducted by Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc. (“Worthington”) in which AWI holds a 50% interest (collectively, the “Sale”), to Knauf International GmbH (“Knauf”). In January 2021, we finalized the post-closing adjustments to purchase price related to certain pension liabilities assumed by Knauf in the Sale. During the first quarter of 2021, we paid $11.8 million to Knauf related to this purchase price adjustment. 25 Management’s Discussion and Analysis of Financial Condition and Results of Operations See Note 5 to the Condensed Consolidated Financial Statements for additional information related to our discontinued operations. Manufacturing Plants As of March 31, 2021, we had 16 manufacturing plants in two countries, with 14 plants located within the U.S. and two plants located 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, 2021. We entered into a sale agreement for the property during the first quarter of 2021, with closing expected during 2021 . 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 for use in commercial and residential settings. Products offer various performance attributes such as acoustical control, rated fire protection, aesthetic appeal and health attributes. Commercial ceiling products are sold to resale distributors and to ceiling systems contractors. Residential ceiling products are sold primarily to 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. To a lesser extent, however, in some geographies and 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 and sources ceilings and walls for use in commercial settings. Products are available in numerous materials, such as metal 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 and customized products, and a portion of our Architectural Specialties revenues are derived from sourced products. Architectural Specialties products are sold primarily to resale distributors and ceiling systems contractors. The majority of 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 assets, liabilities, income and expenses formerly reported in our EMEA and Pacific Rim segments that were not included in the Sale. Factors Affecting Revenues For information on our 2021 net sales by segment, see Notes 2 and 3 to the Condensed Consolidated Financial Statements included in this Form 10-Q. Markets. We compete in the commercial and residential construction markets. We closely monitor publicly available macroeconomic trends that provide insight into commercial and residential 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. We noted several factors and trends within our markets that directly affected our business performance during the first quarter of 2021 compared to the first quarter of 2020, most importantly the aforementioned decrease in demand as a result of COVID-19. For the three months ended March 31, 2021, we experienced a significant reduction in volumes of $17 million in comparison to the same period in 2020. Revenues for our Architectural Specialties segment were positively impacted by $17 million due to our 2020 acquisitions of Turf, Moz and Arktura (collectively, the “2020 Acquisitions”). 26 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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. In certain cases, realized price increases are less than the announced price increases because of project pricing, competitive reactions 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 impacting our revenues. We estimate that favorable AUV increased our total consolidated net sales for the three months ended March 31, 2021 by approximately $ 5 million, compared to the same period in 20 20 . Our Architectural Specialties segment generates revenues that are generally 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 rat her attribute most changes in sales to volume. During the first quarter of 2021, we implemented price increases on certain Mineral Fiber ceiling and grid products. In the first quarter of 2021, we announced a price increase on Mineral Fiber ceiling tile and grid products and certain Architectural Specialties products to be effective in the second quarter of 2021. We may implement future pricing actions based on numerous factors. 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 for aluminum, clays, felt, fiberglass, perlite, pigment, recycled paper, starch, steel, wood and wood fiber. We manufacture most of the production needs for 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 are generally beyond our control and have a direct impact on our financial results. For the three months ended March 31, 2021, higher costs for raw materials and energy negatively impacted operating income by $1 million compared to the same period in 2020. 2020 Acquisition-Related Charges In connection with the 2020 Acquisitions, we incurred certain acquisition-related charges in the first quarter of 2021, summarized as follows (dollar amounts in millions): Three Months Ended March 31, 2021 Affected Line Item in the Condensed Consolidated Statement of Operations and Comprehensive Income Deferred revenue $ 0.7 Net sales Change in fair value of contingent consideration 0.2 SG&A expenses Deferred cash arrangements 2.8 SG&A expenses Inventory step-up 0.3 Cost of goods sold $ 4.0 The deferred revenue and inventory amounts reflect the post-acquisition charges associated with recording these liabilities and assets at fair value as part of purchase accounting. The estimated fair value of contingent consideration for Moz and Turf is remeasured at each reporting period. Expenses related to the deferred cash arrangements for Arktura’s former owners and employees are recorded over their respective service periods, as such payments are subject to the former owners’ and employees’ continued employment with AWI. Purchase accounting expenses related to depreciation of fixed asset fair value adjustments and intangible asset amortization expenses have been excluded from the table above. See Note 4 to the Condensed Consolidated Financial Statements for further information. Employees As of March 31, 2021 and December 31, 2020, we had approximately 2,800 and 2,700 full-time and part-time employees, respectively. 27 Management’s Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF CONTINUING OPERATIONS Please refer to Notes 2 and 5 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, 2021 2020 Change is Favorable/(Unfavorable) Total consolidated net sales $ 251.9 $ 248.7 1.3 % Operating income $ 54.1 $ 76.0 (28.8 )% Consolidated net sales for the first quarter of 2021 increased 1.3% over the same period in 2020 due to favorable AUV of $5 million, partially offset by lower volumes of $2 million. Mineral Fiber net sales decreased by $9 million and Architectural Specialties net sales increased by $12 million. As previously noted, decreases in volumes for both our Mineral Fiber and Architectural Specialties segments were a result of lower market demand due to COVID-19, offset by the $17 million increase in net sales due to our 2020 Acquisitions in the Architectural Specialties Segment. Cost of goods sold in the first quarter of 2021 was 65.3% of net sales, compared to 63.3% for the same period in 2020. The increase in cost of goods sold as a percent of net sales for the first quarter of 2021 was primarily due to the impact of the 2020 Acquisitions, most notably the impact of post-acquisition expenses, in addition to the impact of lower mix due to changes in sales by customer group, which was impacted by COVID-19. The increases in cost of goods sold as a percent of net sales in comparison to 2020 were partially offset by manufacturing productivity. SG&A expenses in the first quarter of 2021 were $54.4 million, or 21.6% of net sales, compared to $34.8 million, or 14.0% of net sales, for the same period in 2020. The increase in SG&A expenses for the first quarter of 2021 as compared to the same period in 2020 was driven primarily by a $12 million increase in SG&A expenses due to the impact of the 2020 Acquisitions, including intangible asset amortization, and a $7 million increase in incentive and deferred compensation expenses. Equity earnings from our WAVE joint venture were $21.0 million in the first quarter of 2021, compared to $19.5 million in the first quarter of 2020. The increase in WAVE earnings was primarily related to favorable AUV and higher volumes, partially offset by higher steel costs and an increase in SG&A expenses. See Note 9 to the Condensed Consolidated Financial Statements for further information. Interest expense was $5.7 million in the first quarter of 2021, compared to $6.7 million in the first quarter of 2020. The decrease in the first quarter of 2021 was primarily due to lower interest rates. Other non-operating income, net, was $1.3 million in the first quarter of 2021 compared to $369.4 million of expense in the first quarter of 2020. The decrease in expense was primarily related to the absence of the $374.4 million settlement related to our RIP, partially offset by lower credits from non-service cost components of pension and postretirement net period benefit costs. See Note 14 to the Condensed Consolidated Financial Statements for further information. Income tax expense was $12.2 million in the first quarter of 2021 compared to an income tax benefit of $77.5 million in the first quarter of 2020. The effective tax rate for the first quarter of 2021 was 24.6% as compared to 25.8% for the same period of 2020. Excluding the tax impact of the pension settlement recorded in the first quarter of 2020, the effective tax rate was flat in the first quarter of 2021 compared to the same period of 2020. Total Other Comprehensive Income (“OCI”) was $4.6 million in the first quarter of 2021 compared to $274.4 million in the first quarter of 2020. The change in OCI in the first quarter of 2021 compared to the same period in 2020 was driven by pension and postretirement adjustments, primarily related to the absence of the $278.6 settlement loss, net of taxes, related to our RIP. Pension and postretirement adjustments represent the amortization of actuarial gains and losses related to our defined benefit pension and postretirement plans. Also impacting the change in OCI was derivative gains/losses and 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 28 Management’s Discussion and Analysis of Financial Condition and Results of Operations assets and liabilities denominated in foreign currencies. Amounts in the first quarter of 2021 and 2020 were driven primarily by changes in the Canadian dollar. REPORTABLE SEGMENT RESULTS Mineral Fiber (dollar amounts in millions) Three Months Ended March 31, 2021 2020 Change is (Unfavorable) Total segment net sales $ 188.7 $ 197.7 (4.6 )% Operating income $ 60.6 $ 70.0 (13.4 )% Net sales decreased in the first quarter of 2021 due to lower volumes of $14 million, partially offset by favorable AUV of $5 million. The decreases in volumes were driven by a decrease in demand due to COVID-19. The favorable AUV was driven by favorable price and mix due to the sale of higher end ceiling products. Operating income decreased in the first quarter of 2021 primarily due to a $9 million negative impact from lower volumes and a $7 million increase in incentive and deferred compensation expenses, partially offset by a $2 million increase in operating income from favorable AUV, a $2 million reduction in manufacturing costs and a $2 million increase in WAVE equity earnings. Architectural Specialties (dollar amounts in millions) Three Months Ended March 31, 2021 2020 Change is Favorable/(Unfavorable) Total segment net sales $ 63.2 $ 51.0 23.9 % Operating (loss) income $ (4.9 ) $ 7.5 (165.2 )% Net sales increased $12 million in the first quarter of 2021 due to a $17 million contribution from the 2020 Acquisitions, partially offset by a reduction in demand due to COVID-19. Operating loss for the first quarter of 2021 was primarily due to a $4 million increase in acquisition-related expenses and a $6 million increase in amortization expense related to the 2020 Acquisitions. The decrease in operating income in comparison to the first quarter of 2020 was also impacted by lower sales excluding the 2020 Acquisitions and an increase in manufacturing and SG&A expenses due to additional investments in manufacturing capacity and selling and design capabilities. Unallocated Corporate Unallocated corporate operating loss was $2 million in the first quarter of 2021 and 2020. FINANCIAL CONDITION AND LIQUIDITY Cash Flow Operating activities for the first three months of 2021 provided $19.6 million of cash, compared to $25.7 million in the first three months of 2020. The decrease was primarily due to lower cash earnings, partially offset by positive working capital changes, primarily from accounts payable and accrued expenses. Net cash used for investing activities was $8.8 million in the first three months of 2021, compared to $9.9 million of cash provided in the first three months of 2020. The unfavorable change of cash in comparison to 2020 was primarily due to purchase price adjustments paid to Knauf in 2021. Net cash used for financing activities was $26.2 million in the first three months of 2021, compared to $66.8 million of cash provided in the first three months of 2020. The unfavorable change of cash was primarily due to a decrease in proceeds from borrowings and higher debt payments, partially offset by lower repurchases of outstanding common stock. 29 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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 $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, 2021, total borrowings outstanding under our senior credit facility were $225.0 million under the revolving credit facility and $487.4 million under Term Loan A. We also have a $25.0 million letter of credit facility, also known as our bi-lateral 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, 2021, we were in compliance with all covenants of the senior credit facility. 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 6, 2020 $ 50.0 March 2020 to March 2022 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 the November 2018 swap maturing in 2023, we pay a fixed rate monthly and receive a 1-month LIBOR. This is inclusive of a 0% floor. Under the terms of the November 2018 swap maturing in 2025, we pay a fixed rate monthly and receive 1-month LIBOR. This is inclusive of a 0% floor. Under the terms of the March 2020 swap maturing in 2022, we pay a fixed rate monthly and receive 1-month LIBOR. This is inclusive of a 0% floor. Under the terms of the March 2020 swaps maturing in 2024, we pay a fixed rate monthly and receive 1-month LIBOR. These are 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. As of March 31, 2021, we had $121.6 million of cash and cash equivalents, $108.6 million in the U.S and $13.0 million in various foreign jurisdictions, primarily Canada. We utilize lines of credit and other commercial commitments in order 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, 2021 Financing Arrangements Limit Used Available Bi-lateral facility $ 25.0 $ 10.3 $ 14.7 Revolving credit facility 150.0 - 150.0 Total $ 175.0 $ 10.3 $ 164.7 30 Management’s Discussion and Analysis of Financial Condition and Results of Operations As of March 31, 2021, we had $121.6 million of cash and cash equivalents and $275.0 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. The impacts of COVID-19 could create volatility in financial markets which may impact the terms under which we access capital. We continue to evaluate reductions in discretionary spending, capital expenditures and other costs. 31 ITEM 3. QUANTITATIVE AND QUALITATIVE 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, 2020.