May 4, 2008
Executives
Michael D. Lockhart – Chairman of the Board, President and Chief Executive Officer Beth A.
Riley – Director of Investor Relations F. Nicholas Grasberger, III – Senior Vice President and Chief Financial Officer
Analysts
Keith Hughes – SunTrust Robinson Humphrey Jim [Barrettson] – CLT Associates Ben Wanger – [Telec Investments] John Baugh – Stifel Nicolaus
Operator
Welcome to Armstrong World Industries’ first quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to your host, Beth Riley, Director of Investor Relations.
Beth Riley
With me this morning are Mike Lockhart, our Chairman and CEO, and Nick Grasberger, our Senior Vice President and CFO. Hopefully, you’ve seen our press release this morning and both the release and the presentation Nick will reference during this call are posted on our website in the Investor Relations section.
In keeping with SEC requirements, I advise that during this call, we will be making forward-looking statements that involve risks and uncertainties. Actual outcomes may differ materially from those expected or implied.
For more detailed discussions of the risks and uncertainties that may affect Armstrong, please review our SEC filings including the 10-Q filed last night. In addition, our discussion of operative performance will include non-GAAP financial measures within the meaning of SEC Regulation G.
A reconciliation of these measures with the most directly comparable GAAP measures is included in the press release and in the impending presentation. Again, those are available on our website.
And with that, I’d like to turn the call over to Mike.
Michael Lockhart
Thanks for participating in today’s earnings call. As we’ve expected, the first quarter was a challenge but we’re please that our results are at the high end of guidance.
If we exclude the benefit of foreign exchange, sales declined 7%; adjusted operating income declined 30% to $46 million. We have modest improvements in price and mix but those were not enough to offset lower volume.
The majority of the volume declines were in the businesses most dependent on housing, Wood Flooring and Cabinets. Another problem in the comparison is that we had great results in the first quarter of 2007.
In 2007, the Wood Flooring had significant growth from a Big Box promotional [inaudible]. And Cabinets grew because of our lack of exposure to large builders and Big Box customers.
Last year’s results also benefited from Floor Europe sharing costs with the Textile business that we sold in the second quarter of 2007. But the earnings decline was not all that mattered for the top comparison.
It was also due to SG&A spending weighted to work the first quarter. We increased commercial spending and Wood Flooring to support special order sales growth later in 2008 and SG&A spending in European Flooring increased due to the normal tri-annual new products introduction cycle.
During the first quarter, we returned nearly $260 million to shareholders through a special dividend. Building products, or Ceilings business, continues to perform well despite declines in the US commercial markets.
European markets show growth and that helps sales and operating income to grow modestly. Product mix improved and price realization increased.
We continue to see gains in the Ceilings business from increasing manufacturing efficiency. North American Resilience sales declined about 2% in the first quarter.
Volumes were down high single digits. Improved product mix and commercial price realization only partially offset lower volume.
Operating income declined nearly 50% due to the lower volume. Price realization offset while material costs increases.
SG&A was flat and manufacturing cost declined. Ignoring currency effects, European Resilience sales decreased about 4%.
The operating loss increased significantly due to lower volume, raw material inflation and increased SG&A expense. Wood Flooring is a US residential business.
In normal times, we expected approximately 55% of sales went to new home construction. The remainder was used in residential renovations.
This exposure was particularly challenging in the first quarter. The renovation market declined to the double-digit range and, of course, the travails of the new housing market are well publicized.
The result: Wood Flooring declined about 20%. About a third of the decline related to the Big Box Promotion that we talked about earlier so it’s not repeated in 2008.
Lower volume and increased promotional spending more than offset substantial manufacturing productivity to reduce [inaudible] income. Cabinets, also a US residential business, experienced similar volume declines.
The operating loss for the quarter stands in contrast to a modest income of 2007. This was largely due to reduced volume.
We performed as expected in the first quarter and anticipate a year over year comparison will improve throughout the year. We’re confirming our guidance for 2008.
Obviously, we’re retaining a broad range to reflect the challenges that this year of declining US in residential and commercial markets. Our guidance assumes a 25 to 30% decline in housing starts and high single digit decline in residential renovation.
But clearly, conditions quickly worse than we expect. We expect our domestic Ceilings markets to decline at a mid-single digit rate.
Our Commercial Flooring business, which has a different mix of markets, is expected to be approximately flat. There is risk here but less so than in the residential markets.
Our European Ceilings business is performing at all time highs and has a strong outlook. Our European Floor business had a difficult first quarter and will likely to continue to be challenged through the year.
We’re not happy with the performance in Europe. There are some market issues but our poor performance is largely the result of structural problems: Scale and process disadvantages, which affect production costs and SG&A.
We’re committed to develop an incredible plan to address these issues and to begin implementation of this plan by year-end. This plan is likely to involve a mix of plan closures, sourcing products, outsourcing administrative work, and plan investment.
We’re actively evaluating many different options. For the full year, we expect to continue to outperform our markets.
But if a good point of our range adjusted operating income is still expected to decline about 5%. These expectations are the results of several largely offsetting factors: Improved product mix partially offsetting mid-single digit volume declines; price realization and manufacturing productivity offsetting inflation; and flat G&A spending.
In this tough environment, our objective remains to use product that serve centralization and quality to deliver increased value to our customers, permitting us to improve mix and increase share. We will continue to control cost and to improve productivity.
Now, Nick will take you through the numbers.
Nicholas Grasberger
Now the first triumph that I’ll refer to is Page 3 on the presentation that’s posted on the website. This is the operating income bridge for the first quarter from the reported figure of $39 million to the adjusted figure of $46 million.
The reported figure of $39 million compares to the guidance we had provided of a range of $27 to $32 million, and the adjusted figure of $46 million compares to our guidance for the quarter of $40 to $45 million. And you can see on the chart, the components of the change between recorded and adjusted.
We had $5 million of expenses related to corporate severance. We had about $1 million of fees related to our advisors and the strategic review process.
We had an incremental $2 million of depreciation and amortization related to a Fresh Start adjustment and then we had about $1 million of benefits related mostly to the Chapter 11. Our next chart looks at the key financial metrics for the quarter and these are adjusted for non-recurring items and for foreign exchange.
Starting with sales, sales on an adjusted basis were down about 7%. The reported figure was down 4%.
The difference was foreign exchange. Year volume was down about 10%, price was up about 2% and mix was up about 1%.
Looking at gross profits, down 9%. The margin was relatively unchanged at down 40 basis points.
For manufacturing, our gross profit margins standpoint of the ABP businesses and the Wood business were up in the markets and the margins in the Resilience and Cabinets were down. SG&A expense for the quarter was up about 4%, really driven by the investments that Mike mentioned in the European Floor business as well as the Wood business.
Collectively, the other businesses were flat to down in SG&A spending year over year. Operating income down about 30%.
This is the first decline we’ve seen in the quarter since the second quarter of 2005. We were up 30% in the first quarter of 2007 so we do have a difficult comparison.
And the margin declined about 2 points. Looking at cash flow, cash flow was a use of $93 million.
This is compared to a $5 million use in 2007 at the differences, and I’ll talk through this in a minute, but largely cash earnings were in capital and the extraordinary dividend that we received from WAVE in the first quarter of last year. Looking at the debt balance and this is not on the chart, you may recall that we ended 2007 with about a half a billion dollars of debt and a half a billion dollars of cash.
At the end of the first quarter that cash balance had declined by $350 million to about $150 million and we still have the debt of a half a billion. So the net debt now is $350 million.
So we had cash flow for the business of about $100 million negative and then the dividend about $250 million. So that accounts for the $350 million change in cash for the quarter.
Page 5 is the Adjusted Operating Income Bridge for the first quarter from 2007 to 2008. Looking at the components, price was up about $16 million and though as every increased price, some modestly, some a bit more, but this is mostly the commercial businesses that were successful increasing price in the quarter.
And you’ll see compared to the raw material and energy inflation of $15 million we just offset. That inflation was price.
Operating income was negatively affected by $33 million due to volume and mix. Mix was a slight positive.
Volume was down significantly. Again, 10% in units and about 90% of that was due to declines in the US residential businesses.
Yes, the business that had a notable decline in volume was the Ceilings business in North America which was down about 7%. So inflation we saw in raw materials and energy was split about 90% raw materials, 20% energy.
And of the raw material inflation, about three quarters of that was related to our Vinyl businesses and to Linoleum. The balance, the 25%, was in the EVP businesses and Cabinets.
We had another strong quarter in manufacturing, especially in the Wood business and in Ceilings North America. So we generated $14 million of incremental earnings year over year to reduced manufacturing costs.
SG&A, I mentioned before, was up about $6 million. Again, this is accounted for by the Wood business and for Europe.
Europe businesses were flat to down including corporate. And then WAVE; WAVE contributed about $3 million of incremental earnings for the quarter.
WAVE sales were up 5%, their profits were up about 20%, driven by the margin’s first quarter foot, and WAVE were up about 20% versus the end of the first quarter last year. Turning to Page 6, looking at the sales and operating income by segments for the first quarter versus last year.
This chart really reflects the comments we’ve already made. Resilient Flooring is a category that sales were down about 3%.
Unit volume was down 7% and price and mix were both positive and about equal to each other. Wood Flooring down 20% in sales, that’s really all volume.
Building products was up 1%. On a global basis, volume was down about 3%.
Price and mix collectively up about 4%. And then Cabinets, the 26% decline in that category is fairly all due to unit volume.
Turning to operating income, the Resilient Flooring segment saw a $17 million decline in operating income year over year. About 65% of this was due to the European Resilient business with downs in North America.
And really, the dynamics here where we had price realization less than inflation of about $5 million. Unit volume declines affected earnings by about $10 million.
SG&A, another negative $5 million, and then manufacturing was actually positive in both the US and European Resilient businesses. Wood Flooring earnings were down $6 million year over year.
This is mainly due to volume and SG&A, even though manufacturing was a significantly positive. It was not sufficient to offset the impact of volume and SG&A.
Building products earnings were up on a global basis about $4 million year over year. Price and manufacturing efficiency were higher than inflation and then the WAVE business had a nice contribution to growth as well.
Cabinets was down $5 million. This is really all due to unit volume declines.
Both manufacturing costs and SG&A spending were down or improved year over year. And finally, corporate expenses were $3 million lower year over year, due mostly to salaries and benefit programs.
I’d like to show a chart on cash flow for the first quarter of ’08 versus ’07 because there was a significant decline. On the far right hand side of this chart, certainly you can see the variance by category that comprised to $88 million shortfall relative to last year in free cash flow.
The components really are our cash earnings were down $27 million. Working capital was up about $60 million relative to the change in working capital in Q1 of last year, and that’s due mostly to inventory and accounts payable.
Inventory was up about $20 million in the quarter relative to last year and it’s really a timing issue. This is not a permanent incremental investment in inventory.
We had a very strong quarter last year in the Wood business. Inventories were driven down at the end of the first quarter last year further than we anticipated.
And on the flip side this year, the Wood business was a bit weaker so we ended the quarter with higher inventory. So again, the business is really related to timing issue.
Accounts payables net of receivables was a use of about $30 million relative to last year’s first quarter and this is really all around the decrease from activity in the business. We had an extraordinary dividend of $50 million from WAVE in the first quarter of last year.
This first quarter in ’08 was a more normal dividend so we had a negative [inaudible] year over year due to the WAVE dividend. So you can see the free cash flow was an $88 million unfavorable variance to the same quarter last year.
You then step down and see the impact of the dividend that we paid. You see the net change in cash was $350 million.
Chart 8 is just simply restating the guidance for the full year. Mike mentioned that we’re not changing the guidance.
This is the same chart that we showed in late February. Sales down 1% to up 3% for the year and so forth.
So we’re not changing our sales order or earnings guidance and cash flow still continue to be in the range of $175 to $200 million for the year. Chart 9 just shows in a picture our view of the markets and margins for each of the businesses through the last nine months of the year.
Starting with the Resilience, sales we expect for the full year to be flat to maybe slightly up. Of course, down in residential in North America.
Sales in the commercial business flat to maybe slightly up and then in Europe and Asia, we expect growth in Resilient Flooring. But the margin for the full year for this segment we expect to be down versus 2007 a point or two.
Wood Flooring, in terms of sales of course mostly exposed to residential, the [inaudible] will get easier as the year progresses and we also have some promotional activities going on in the Big Box channels that should help somewhat offset the weakness in residential. So we do expect a high single digit decline for the full year in volume and the Wood Flooring business.
In terms of margins, we would expect Wood Flooring margins to be off about 2 points versus the margins of last year. Building products, globally we expect low single digit growth in volume and sales.
Obviously the residential market in North America is weak but that’s a small portion of the business. We do expect North American commercial to grow in sales with price and mix more than offsetting a 4% to 5% decline in unit volume.
Then we expect our growth in price, volume and mix in Europe and Asia. So for the full year, we would anticipate the margins for the Building products segment to be flat to maybe up a point.
In Cabinets, the story is clear. We expect significant decline in unit volume and sales in 2008, and the margin to contract 3 to 4 points.
Corporate expenses, we now estimate will be down $10 to $15 million for the full year. This is the corporate unallocated segment that we report in our filings.
This $10 to $15 million decline is really drawn from a lower staff cost, improve benefit costs, and the higher pension credit year over year of about $5 million. So the last slide here is just a bit more commentary on the outlook for the full year.
Starting with raw material and energy inflation, we had provided guidance back in late February; we were looking at inflation in these categories to be about $55 to $65 million year over year. Now, increase that by about $20 million to $75 to $85 million.
And the assumption is that we’ll offset about 75% of this inflation with price. When you factor in the manufacturing efficiencies, we will be 110 to 120% above inflation.
SG&A, as Mike mentioned, we expect to be roughly unchanged for the year. Interest expense at a range of $20 to $25 million.
This is net interest expense because we do have sizable cash balance and that will go throughout the balance of the year. So $20 to $25 million versus about $40 million last year.
Most of that is due to volume. Of course, we’re also getting some benefit in rate.
Cash taxes should be about $20 million for the year. This is down about $5 million from the previous estimate, but the effective tax rate, we’re staying with the original guidance of 44 to 45%.
And this is to remind you the components of that rate because it is somewhat high optically. The accelerated portion is 35%.
We’re looking at about a 3 to 4% state tax rate. The non-benefited foreign losses in European Floor negatively impact the effective tax rate by about 5 points.
We’re also accruing interest on the portion of our 10-year carry back from the [inaudible] that we are reserving on the balance sheet. And that interest that we accrue negatively affects the tax rate by about 3 points.
Then we have some other favorable impacts that collectively are helping us by about 2 points in the tax rate. So, 44 to 45% on the effective tax rate for the year.
You saw it was 52% for the first quarter. So we’re not going to get into specific guidance on earnings for the second quarter but let me just help you understand phasing for the balance of the year.
As you saw, the first quarter earnings were down about 30%. We expect the second quarter earnings to also be down year over year but less than what we saw in the first quarter.
And then for the balance of the year, the last six months, we would expect to actually increase earnings in the latter part of the year, not for the full second half that we’ll see some growth later in the year. Capital spending, we’re staying with the original estimate of about $100 million.
The share account is unchanged at about $57 million. We had discussed in late February about $20 million of exclusions from reported earnings, that figure for the full year now is down to $15 million.
So we had assumed some higher cost related to ending our strategic review that we now believe we will not incur. Well, that ends my comments on the figures.
So, we’ll open the line for questions.
Operator
(Operator Instructions) Your first question comes from Keith Hughes - SunTrust.
Keith Hughes – SunTrust Robinson Humphrey
On the payables, is that something that is going to correct itself as the year goes along? Is that going to be a timing issue like inventory?
Nicholas Grasberger
Yes, it should. Certainly will have probably not to the same degree but a further negative on payables in the second quarter but then as we begin to lapse the weakness in our businesses in the second half of the year, it should level.
Keith Hughes – SunTrust Robinson Humphrey
Within the revenues in the Hardwood, you talked about the macro stuff going on. That’s what’s going on most of last year though and your results have been pretty impressive.
Was there anything specific in the quarter, a program you were getting out of that you had to sell at a discount or anything along those lines that made it specifically worse in the first quarter in Hardwoods?
Michael Lockhart
First quarter of last year or just first quarter?
Keith Hughes – SunTrust Robinson Humphrey
First quarter of this year.
Michael Lockhart
The one thing we had this year is we’ve been investing in putting our displays with more than Big Box customers, special order displays, and we’re continuing that process. Otherwise, the business performs as you would expect.
I think the North American Floor business suffered both Resilient and Wood from inventory adjustments by our customers. So both our distributors and our retailers have adjusted inventory and that had a significant impact in the first quarter which we would expect to lessen.
You listen to the calls by the Big Box guys, they’re all pushing on inventory and so we would expect to see that continue to push on ours but there’s a couple of mid-single digit effect on sales from inventory declines in both Resilience and Domestic Resilience and the Wood business.
Keith Hughes – SunTrust Robinson Humphrey
Are you taking some pricing actions in Vinyl and Laminate in the second quarter in response to the Raw Materials we discussed earlier?
Michael Lockhart
Yes, we’re seeing some higher prices in the Vinyl businesses and the Laminate business are average on its values up substantially due to mix. And so if you look at the break down of our business, we actually see substantially higher sales of Laminate in the first quarter this year than we did last year.
We will see some pricing actions. On the other hand on Wood, we have the opposite of that.
One of the advantages we have in the Flooring business and in the Ceilings business too, we have several different facilities and as a result, as we lose volume we can take out plants and maintain a relatively high level of capacity [utilization]. Some of our competitors have one or maybe two facilities and as this comes down, they wind up trying to keep the plant [all] through price reduction.
So we expect to see some price pressures, particularly in the Wood business, and throughout the rest of the year. Hopefully offset by somewhat better Raw Material prices.
We’re finally beginning to see some better lumpier prices in those businesses.
Nicholas Grasberger
So Keith, for the full year we expect to offset in the North American Resilience business about 80% of the inflation, a little more in commercial. A little less in residential and actually less than that in the European businesses.
If you look at one of the issues we have in the Resilient business, we’re having a difficult time offsetting inflations prices.
Operator
Your next question comes from Jim [Barrettson] - CLT Associates.
Jim [Barrettson] – CLT Associates
Could you talk about the preliminary announcement relating to the second special dividend and is the assumption that that will be paid for earning and cash flows fall within the stated guidance range? Or how should investors probably look at that?
Michael Lockhart
I think what we said the last time, it was to be the same thing we’d say today, is that we broke it into two pieces because we say it was imprudent to put that much pressure on a cash situation in the first half of the year given the uncertainties that if our performance is within the range of what we think it’s going to be where the Board is going to consider the dividend and we wouldn’t have said it if we didn’t think they would do it. So rewording our guidance I would expect the Board to favorably do that.
Saying that, it’s up to the Board and all [inaudible] to be contingent with that but we’re sticking with our view that our performance in the first quarter was a little better than we thought it was going to be. Performance in the second, third quarter, we think they’re going to be over our expectations and with that dividend.
Keith Hughes – SunTrust Robinson Humphrey
Where do you see pricing in the Cabinet business for the remainder of the year?
Michael Lockhart
We expect to see no change. Maybe in the first quarter, I think we picked up about $1 million in price.
So I would see prices declining but nor do we expect to see much by the way it increases.
Operator
Your next question comes from Ben Wanger - Telec Investment.
Ben Wanger – Telec Investment
Could you just remind us on your cash flow guidance for the year, the $175 to $200 million is that pre-dividend?
Michael Lockhart
Yes, that is pre-dividend.
Ben Wanger – Telec Investment
With regard to the dividend guide itself, cash flow come in meaningful lower than that, but we see a rationally down of the dividend or reduction of it all together. How should we think about that?
Michael Lockhart
I think if it was meaningfully lower, we would have to look at that. We obviously don’t think that’s the case or we wouldn’t have been so positive in our statements with respect to the dividend.
We believe that if we achieve what we’re looking at in terms of range that we should be able to pay that dividend as sufficient debt capacity and cash to do everything we want to do in 2009. In part because we think we’re going to generate a bunch of cash in 2009.
So, we think its okay now or say that we have a $200 million swing in cash for some reason. We obviously have to look at it.
That’ll be a pretty unusual thing in our world, to get that swing in cash.
Ben Wanger – Telec Investment
And the dividend is predicated on the capital markets being one way or the other. Is that right?
Nicholas Grasberger
Right. We will always pay the dividend out of cash.
Ben Wanger – Telec Investment
And if you see any improvements in the capital markets, would that change your views on leverage?
Michael Lockhart
Not short term.
Operator
Your last question comes from John Baugh - Stifel Nicolaus.
John Baugh – Stifel Nicolaus
On the cash flow again, was this first quarter performance in line with your thinking in terms of the use of that many and if not, you have a change of guidance for the year, what areas do you expect to see it jump to come back?
Nicholas Grasberger
We did a little better in the first quarter than we thought largely around slower spending on capital in the plants. Did a little bit better in cash earnings and working capitals a little bit better, but not in the significant way that would prompt us to change in fully our guidance.
It was actually a little better than our plan. Yes.
But the balance of the year it’s really more seasonality that’s going to lead to a pick up than working capital. We typically have a significant use of cash in the first quarter.
Q’s 2, 3, and actually 4 as well are then quite strong so we will be looking for cash flow roughly in each of the remaining three quarters to be about $100 million.
Michael Lockhart
I don’t want to leave you with the impression though that we’re going to under spend our targeted CapEx as we were a little slower in the first quarter. Our forecast do anticipate spending the targeted amount of CapEx.
John Baugh – Stifel Nicolaus
Great. And then Mike, help us with the mix.
We’ve been feeling…we’ve seen that get better and better and now we’re facing declining unit demand. Typically, in the environment that we’re in, you see a big trade down.
So to speak to what you’re doing and what’s going on and how sustainable that is for the balance of the year.
Michael Lockhart
We haven’t seen anything. We haven’t seen the value engineering that you’re talking about.
Now if you go back to 2001, 2002 and 2003, we saw some negative mix as a result of value engineering. People were doing rehabs.
They took a look at it. Stretch was down other stuff and so they trade it down from our high end products to medium or low end products.
We haven’t seen that yet. Our strategy has all been around introducing higher products and so some of our mix is coming from products you can’t do an easy trade down from.
So we’ve architectural specialties where we’re selling metal ceilings, wooden ceilings, and other types of non-fiber materials. People aren’t going trade from that to a mineral fiber mix.
So that’s going to help us. And that business continues to be pretty strong.
The other part of it is in our product innovations has always been a target towards that end of it. And to some extent, our pricing strategy has been towards that end of it and that’s one of the reasons that we said that we expected to see slightly maybe some small share losses towards the bottom end of the segment of our Ceilings market because of that strategy.
So, we think it’s going to hold up. We haven’t seen anything that suggests it won’t.
Now when you see a real downturn in the Office market, particular in high mix area like New York City and places like that, you might see that. We just haven’t seen that happen quite yet.
John Baugh – Stifel Nicolaus
On the European Flooring, I know you’re working on that, I believe you talked about a $20 million, give or take, swing in EBITDA all on that’s adjusted from whatever it is you decide to do. Is that still on the plan, and the timing of that, has that changed?
Michael Lockhart
I think that when we look at that, we hesitate to predict how much of a swing there’s going to be when we get it done. But obviously, it hurts us by a lot today.
I don’t think there’s any change in the timing. However, as we talk about structural change in Europe, it’s going to take some time.
And so we wouldn’t expect to see real significant benefits from that until 2010 because of the time it takes to close plans. The good thing about Europe is it’s very integrated into our worldwide Commercial Flooring flow.
More like Flooring strategy. We take a fair amount of residential products and an awful lot of commercial products out of there and so as the United States.
So we got to figure out what we’re going to do to replace that source if we were to eliminate the source in Europe. So I don’t think so but nobody should look for substantial results out of that until 2010 because of the lengthy transition.
And I said we know some of the things we need to do but we’re actively engaged in outsourcing SG&A and so we’ve got some things underway. The structural stuff, we haven’t thought of it and decided yet.
Operator
And it appears there are no further questions today.
Beth Riley
Thanks everybody for joining us this morning and I’ll be available all day for your follow up questions. Thank you.