If you believe that corporate managers should only be judged by the variables they can control, Armstrong Worldwide (NYSE:AWI) has done quite well. While the declines in the residential and commercial building and remodeling markets have hamstrung sales growth, the company's expense structure has been slimmed down and the company maintains strong share in many of its markets. The question now, however, is whether or not the market has already factored in a significant recovery ahead of real improvements in building and remodeling activity.

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Mixed Results for the Third Quarter
This was a good news/bad news quarter for Armstrong. Sales disappointed again, as construction activity (particularly that tied to public spending/budgets) remains sluggish. But Armstrong also delivered substantially better earnings, as margins in the two largest businesses improved significantly.

Revenue fell 10% as reported, or 5% if the divested cabinets business is excluded from the comparisons. On a constant currency basis, sales were down about 2%. Building products saw a 3% reported revenue decline, while wood flooring slipped 4% and resilient flooring sales dropped 9%.

Margins definitely improved, as aggressive cost-cutting measures have taken hold. Gross margin improved by almost a point from last year and about 130 basis points from the second quarter. Reported operating income (adjusting out equity earnings) rose 12%, while stripping out the cabinets segment reduces that growth to about 1%. Both building products and resilient flooring showed significant margin improvement (about four and three points, respectively), while the wood flooring margin declined about two points.

SEE: Analyzing Operating Margins

Selling the Cabinets Business was Addition by Subtraction
In a long-awaited move, Armstrong announced in late September that it had reached an agreement to sell its cabinets business to American Industrial Partners for $27 million. That's certainly not a lot for a business that generated $136 million in revenue in 2011, but it was nevertheless addition by subtraction. Not only has the cabinets industry in general continued to suffer through a sluggish recovery, but Armstrong was never really able to make headway against rivals like American Woodmark (Nasdaq:AMWD) or Fortune Brands (NYSE:FBHS) and it was frankly a value-destroying business for the company.

SEE: Mergers And Acquisitions: Understanding Takeovers

Just Waiting for the Turn
While there are signs here and there that building activity is turning, it is hard to call it a real recovery just yet. Results from Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) have backed up the notion that strong results in the Spring had more to do with unusually good weather than any real recovery. At the same time, while some categories of building have gotten better (multi-family residential, for instance), Armstrong's core residential and commercial markets continue to see a great deal of hesitancy and "wait and see" behavior.

Sooner or later, however, this will change and Armstrong should be in a position to deliver better results. The company remains the world leader in suspended ceiling systems (with 50% share in the U.S., well ahead of #2 USG (NYSE:USG) at 35%), and is the world's largest manufacturer of vinyl and wood flooring (ahead of companies such as Congoleum, Mohawk (NYSE:MHK) and Berkshire Hathaway's (NYSE:BRK.A) Shaw Industries). With 70% or so of revenue coming from residential and commercial remodeling/refurbishing, the eventual catch-up spending in these markets should enable Armstrong to post significantly better free cash flow in the years to come.

There's an emerging market angle to consider as well. While Armstrong's market presence in countries such as China, Brazil and Russia is relatively limited, the company has been building factories and laying the groundwork. Armstrong is looking to lead the conversion in China away from traditional ceramic and stone building materials to modern materials, and while that transition will take time, the same arguments regarding weight, cost, safety and performance apply here as well.

SEE: What Is An Emerging Market Economy?

The Bottom Line
The problem for investors considering Armstrong shares is the extent to which a North American recovery and emerging market growth is already factored into the valuation. Even if Armstrong ends the next five years with new records in revenue and free cash flow margin, the stock is already well ahead of the implied fair value.

Even if investors choose to ignore the sizable debt load, Armstrong needs to produce free cash flow almost 50% above prior peaks to justify today's price. While I'm absolutely willing to believe that Armstrong's market share, combined with pent-up demand and improved operating margin, will lead to improved results in a year or two, those expectations already seem aggressive enough and I think the shares look more vulnerable to disappointment than outperformance today.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.