Armstrong World (AWI) Leveraged To Non-Residential Recovery And Pricing

Writing about Armstrong World Industries (NYSE:AWI) in August, I was ambivalent on this leading manufacturer of commercial ceiling tiles and specialty ceiling materials, as I thought the company’s strong leadership in its core market was offset by the share valuation and the prospect of weaker renovation activity in 2022 ahead of recovery in non-residential construction.

Since then, the shares have fallen more than 10%, and management’s guidance for margins in 2022 was softer than the Street had expected. At the same time, though, the company is showing exceptional pricing power and the company is still leveraged to what I expect will be a meaningful renovation cycle targeting “healthy building” initiatives. If Armstrong can generate long-term revenue growth in the mid-single-digits, free cash flow growth in the high single-digits, and mid-20%’s adjusted operating margins, I see upside of around 20% from here.

Pricing Can Tide The Business Over

I was concerned that the significant renovation activity in the non-residential construction sector, coupled with a temporary halt to new construction projects, was going to create an “air pocket” in Armstrong’s business, and I still have those concerns to some extent.

Volumes were not strong in Q4’21, with overall volumes up about 3% and volumes in the core Mineral Fiber business up just 1%. What I didn’t expect was the extent of Armstrong’s pricing power, with the company pushing through multiple price increases in 2021, including a 12% increase late in the year that went into effect early in 2022.

Given management commentary, I think further pricing action above and beyond input cost inflation is a definite possibility, as the company leverages its very strong share in the market and the fact that ceiling tile prices aren’t really a go/no-go driver for commercial renovation or new construction projects.

Mixed Trends In The End-Markets

Renovation drives more than two-thirds of Armstrong’s business, and I do see some ongoing weakness in the near term. It looks like office renovation activity has definitely slowed, and while education has stayed stronger than I expected, I wonder if the lack of meaningful stimulus in the infrastructure bill will limit near-term upside.

That said, HVAC companies like Trane (TT) have talked at length about opportunities in education (and healthcare) driven by inadequate legacy systems and clean building initiatives, and HVAC projects often drive ceiling renovation projects. Along those lines, I’d note that the healthcare and education verticals are about a third of Armstrong’s revenue base.

The extent to which commercial and institutional building operators follow through an indoor air quality initiatives really is a key variable here. Armstrong management has estimated an opportunity of $250M to $350M tied to its Healthy Spaces portfolio, with “Health Zone AirAssure” carrying a 100% premium and “Health Zone AirAssure + VidaShield” carrying a 300% premium relative to standard ceilings.

In the meantime, I do see increasing reasons for bullishness on the new construction side. Indicators like the Architectural Billings Index and the Dodge Momentum Index show improving activity in new construction, and given typical lags between these indicators and Armstrong’s revenue opportunities, the outlook for 2023/24 is improving.

Opportunities Beyond Price

I have my doubts about how long this robust pricing environment will last; this kind of pricing leverage has been rare in the company’s history, and I don’t think it’s going to be a new normal. Fortunately, there are drivers beyond pricing.

Architectural Specialties has been a laggard for some time, but I can see how product innovation, select acquisitions, and further progress with cross-selling could drive improved results here down the line. I’m not counting on this in my model, but it’s a “nice to have” that I don’t necessarily view as a long shot.

I also see ongoing opportunities on the digital side. Armstrong has been investing in digital tools that make it easier to do business with Armstrong, including automating and simplifying planning/design and construction/installation. These tools make Armstrong stickier with architects and contractors, while also expanding the company’s ability to do business with smaller commercial customers.

The Outlook

Management laid out some impressive targets at its recent investor day, including over 10% annualized five-year revenue growth, EBITDA margin leverage, and FCF growth in excess of 15%.

I’m skeptical on the revenue growth target. The company has definitely impressed with its pricing power, but I previously discussed my doubts about the persistence of that pricing power.

On the other hand, if the company can continue to harness its proven product development capabilities to introduce more higher-value products and/or really sees a meaningful uptake of Healthy Space products, my 8% growth rate over the next five years could be too conservative.

I am more bullish on the margin opportunities, as I think Armstrong will hold on to at least some of this price leverage even when input costs and other supply chain costs ease. I also do expect to see increased volumes of higher-value products, which will drive better margins. All told, I expect FCF margins in the low 20%’s to drive high single-digit FCF growth over the long term.

Discounting those cash flows back, I believe Armstrong is priced to generate a high single-digit long-term annualized return today. I also use a margin/return-driven EV/EBITDA approach, and I believe a 14.75x forward multiple is appropriate, supporting a fair value in the $110’s.

The Bottom Line

The correction in the markets has driven a lot of stocks to more interesting valuations, so investors certainly have more choices now than six months ago. As mentioned, I think there could be some volume-based weakness in Armstrong’s end-markets this year, but pricing will likely paper over that. Longer term, I’m not as bullish as Armstrong’s management, but bullish enough to see worthwhile upside in these shares.