Two of the most common (and logical) questions we get from new, prospective investors are: 1) is there a template you follow when choosing investments, and 2) how do you source your ideas? The story of our new investment in Armstrong World Industries (ticker AWI) is an excellent illustration of the answer to those two questions.
Answer number 1 – yes. The best mouse trap in the industry. The uniqueness, durability, and expansibility of the superior mouse trap, which is verifiable through scores of phone calls and meetings with competitors, suppliers, distributors, former executives, influencers, and most importantly customers. An “Aha!” moment when we realize why the company’s structural advantages effectively make it impossible for existing competitors to catch up. A liquid and underleveraged balance sheet providing downside protection to investors, but more significantly allowing the company to go on offense during a downturn when competitors have to cut back and when return on those investments (acquisitions, hiring talent, new product innovation) are the highest. Respect for what Ben Graham identified as the worst mistake an investor could make (Chapter 20 of Intelligent Investor) – buying a
company’s securities while it enjoys an unsustainable tailwind. The unsustainable headwind on the other hand allows for buying companies when their moat is expanding rapidly, and when fundamentals and market sentiment are coiled providing protection and the full upside potential. Note, however, that this approach requires copious un-automatable “pick and shovel” work, brings abundant tracking error and necessitates a modest degree of patience, so it is not for everyone. Which is fine by us.
Answer number 2 – we find ideas in many ways including the standard processes of running screens, sifting through Wall Street research, and relentless networking. After all, it is important to keep systematically expanding the universe of researched potential investments. But the best source of new ideas is the scuttlebutt method borrowed from Phil Fisher (Common Stocks, Uncommon Profits). All our efforts are focused on finding great companies uniquely solving large problems through the lens of real economy customers. We are not ivory tower analysts. So nothing sets our heart a flutter, as much as, “well, I have this new supplier who is doing amazing things and lowering my costs dramatically and solving my problems in ways no one else could and I expect they will continue to do so for a long time.” That’s our definition of striking gold, and it is why every conversation we have, whether with an Uber driver or CEO, always includes the question: “who out there is
doing anything special for you?”
Two years ago, while doing the work on Floor and Decor, we had to talk to various flooring manufacturers as part of our diligence. Armstrong used to have a significant flooring business which it spun out as a separate public company, Armstrong Flooring Inc., in 2016. Our thesis was that flooring manufacturing was a tough business with tremendous global competition, no pricing power, and little brand equity – which plays perfectly into the hands of the person selling the product to the tens of millions of Americans fixing up their homes in any given year. Everyone we talked to who knew the flooring business – including a very honest C-Level executive at Armstrong Flooring – said two things. “Your thesis is valid. This is a tough business. Floor and Decor will kill it and seize much of the profitability in distribution of flooring like Google does in the connecting of people with information.” Then they added, “This is why Armstrong World Industries was brilliant to spin out their flooring segment, even though it is a difficult decision to jettison your oldest line of business. Now they can focus entirely on the ceiling business where they dominate, and which is an absolutely amazing business.” Eureka! There’s gold in them thar words. Now we had to understand, further verify, and wait for the unsustainable headwind.
Armstrong’s business consists of two primary parts: mineral fiber ceilings, which are the standard tiles resting in a suspended grid; and specialty ceilings, which are the stylized ceilings you might see in lobby areas made of wood, steel, felt, or other materials. Armstrong is also the leader in ceiling grid systems through their WAVE joint venture with Worthington Industries. Specialty is a newer business and an important incremental long-term growth driver, but the primary business is mineral fiber where Armstrong is by far the U.S. leader in suspended ceiling systems for commercial applications. This is a very unsexy business, unless you get excited by things like greater than 50% market share, 35%+ returns on tangible investable capital, and a 21 billion (yes, with a B) square foot installed base fueling a never ending repair and remodel annuity stream.
The main drivers of their superior economics are four-fold. First, every new commercial building involves an architect that specifies what goes into the space including the ceiling manufacturer and even the tile number. Price of course, matters, but end customers understand the value in paying a modest premium for leading features, functionality, quality and durability especially as the cost of a ceiling in the grand scheme of a project is almost insignificant. And with his reputation at stake, the architect wants to work with the undisputed leader who invests the most into product innovation, territory service coverage, digitalization (to make the architect’s life easier), and the broadest product portfolio. Second, Armstrong controls distributions through exclusive dealers. In fact, a foreign company trying to break into the U.S. market some years ago failed so badly in their
attempt to get meaningful distribution that in desperation they chose to launch an ultimately unsuccessful suit against Armstrong on anti-trust grounds. The upstart remains a bit player, and their travails continue to warn others of the challenges of competing with Armstrong. Third, with their focus narrowed to ceilings Armstrong has been on a relentless drive to innovate and drive lower costs. With their scale, they can invest in R&D like no one else, and the evidence of their success is that the share of their sales from products introduced in last 5 years has grown to 40% from less than 10% a decade ago. New features, mix changes, and market position strength have also driven increased pricing which has risen roughly 6% per year since 2006. Similarly, investing in manufacturing and operational efficiencies has allowed operating margins to expand from 13% to 23%.
Lastly, the heart of the business and the characteristic that appears least understood today is that this is primarily a repair and remodel business. The vast majority of that massive installed base will need to be replaced at some point, and because the Armstrong product was specified to begin with and because the replacement product needs to fit into an Armstrong grid system, Armstrong enjoys a growing and predictable replacement revenue
stream which allows them to maintain the investment in innovation and exclusivity of their distribution network. This, in turn, continually widens their moat.
Great business, sure. But why now? COVID is a very significant headwind to the business, and it will continue to be for some time. New construction of commercial space will be on an extended pause as developers let the dust settle to see what the world looks like post COVID. The repair and remodel business has slowed for the same reasons and because of the inability to safely schedule contractors to get work done. No wonder AWI shares closed out Q3 still down 1/3 from their price immediately before COVID.
But the downturn also accelerates Armstrong’s ability to seize long-term opportunities in all areas of its business. Whereas Armstrong dominates mineral fiber ceilings, the specialty ceiling market is extremely fragmented consisting mostly of family run businesses with less than $25M in revenue. The specialty ceiling industry is roughly the same size as mineral fiber (measured in dollars as opposed to square feet), and while Armstrong has many leverageable advantages including distribution, technology and relationships with architects, its ownership of less than 20% of the market at this time gives it huge growth opportunities. Armstrong is growing their specialty business organically, but they are also growing rapidly by deploying their significant free cash flow in acquisitions of smaller specialty ceiling designers and manufacturers who have been successful with developing a unique product and who have earned a good reputation and market presence, but who have maxed out what is realistically achievable with current managerial and financial resources. Win-win deals allow these businesses to operate as part of the Armstrong family and allow Armstrong to take these businesses to the next level as Armstrong invests in their capabilities and plugs them into their distribution network. This strategy even helps the mineral fiber ceiling business as Armstrong can increasingly be a one-stop shop with the broadest offering of ceilings of all types. With advent of COVID, many entrepreneurs are losing the stamina needed to wait for the market recovery, and the acquisition opportunity set is rapidly expanding and terms are improving. In fact, Armstrong has already made three acquisitions, including their largest ever, since the pandemic began. As such, their ability to grow their specialty ceiling business is greatly benefitting from this downturn.
COVID will also greatly accelerate the existing trend toward more feature-rich, higher-priced and more profitable mineral fiber ceilings. Put yourself in the position of the commercial property owner. Your number one goal has to be to convince people it is safe to use your space, whether it is an office, healthcare facility, educational facility or retail store. Additionally, you have to proactively work with clients to reconfigure the space for new use cases and deal with the inevitable great reshuffling of space. The alternative is maintaining status quo and hoping for the best, and that is not an option.
One of the most cost-effective ways to convince tenants that it is safe to return is to replace the ceiling. For most applications, ceiling innovation has mostly been about acoustical control where it is essential and easing the design and installation process. However, Armstrong has extensive and technical leadership in much more demanding environments like operating rooms and clean rooms for pharmaceutical and semiconductor manufacturers. As a result, they have a portfolio of products that are antimicrobial and easy to clean, that seal rooms to prevent air and pathogens flowing from one room to another, or that dramatically increase fresh air flow and HVAC efficiency.
For example, in almost all instances it is prohibitively expensive to replace windows with new windows that open or to upgrade existing HVAC systems to significantly increase fresh air flow. But Armstrong’s new AirAssure product provides a significantly tighter seal and can increase fresh airflow by 40% without any changes to the HVAC system. It can also be integrated to include their UV light system to kill pathogens. Thanks to COVID, products such as these and others currently in design will soon go mainstream and the implications for pricing, margins, and earnings are extremely positive.
We want to own companies that are solving large complicated and difficult problems in ways no one else can. American commercial landlords, their tenants, healthcare facility operators, high-tech manufacturers, all face new and daunting, even existential issues with design, efficiency, and safety of their facilities. Armstrong uniquely provides an integral part of this solution.
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