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.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

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.

Related Articles
  1. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  2. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  3. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  4. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  5. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  6. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  7. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  8. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  9. Stock Analysis

    Is Walmart's Rally Sustainable? (WMT)

    Walmart is enjoying a short-term rally. Is it sustainable? Is Amazon still a better bet?
  10. Stock Analysis

    GoPro's Stock: Can it Fall Much Further? (GPRO)

    As a company that primarily sells discretionary products, GoPro and its potential falls right in line with consumer trends. Is that good or bad?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center