UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2017

OR

For the transition period from                   to                  

Commission File Number 1-2116

ARMSTRONG WORLD INDUSTRIES, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Registrant’s telephone number, including area code (717) 397-0611

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

Common Stock ($0.01 par value)

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ☒    No  ☐

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ☐    No  ☒

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter time period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ☐    No  ☒

The aggregate market value of the Common Stock of Armstrong World Industries, Inc. held by non-affiliates based on the closing price ($46.00 per share) on the New York Stock Exchange (trading symbol AWI) of June 30, 2017 was approximately $2.0 billion.  As of February 21, 2018, the number of shares outstanding of the registrant's Common Stock was 53,105,216.

Documents Incorporated by Reference

Certain sections of Armstrong World Industries, Inc.’s definitive Proxy Statement for use in connection with its 2018 annual meeting of shareholders, to be filed no later than April 30, 2018 (120 days after the last day of our 2017 fiscal year), are incorporated by reference into Part III of this Form 10-K Report where indicated.

 

 

 

 

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TABLE OF CONTENTS

 

 

 

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When we refer to “AWI,” the “Company,” “we,” “our” and “us”, we are referring to Armstrong World Industries, Inc. and its subsidiaries.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements in this Annual Report on Form 10-K and the documents incorporated by reference may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Those forward-looking statements are subject to various risks and uncertainties and include all statements that are not historical statements of fact and those regarding our intent, belief or expectations, including, but not limited to, our expectations concerning our residential and commercial markets and their effect on our operating results; our expectations regarding the payment of dividends; and our ability to increase revenues, earnings and EBITDA (as discussed below). Words such as “anticipate,” “expect,” “intend,” “plan,” “target,” “project,” “predict,” “believe,” “may,” “will,” “would,” “could,” “should,” “seek,” “estimate” and similar expressions are intended to identify such forward-looking statements. These statements are based on management’s current expectations and beliefs and are subject to a number of factors that could lead to actual results materially different from those described in the forward-looking statements. Although we believe that the assumptions underlying the forward-looking statements are reasonable, we can give no assurance that our expectations will be attained. Factors that could have a material adverse effect on our financial condition, liquidity, results of operations or future prospects or which could cause actual results to differ materially from our expectations include, but are not limited to:

Such forward-looking statements speak only as of the date they are made.  We expressly disclaim any obligation to release publicly any updates or revisions to any forward-looking statements to reflect any change in our expectations with regard thereto or change in events, conditions or circumstances on which any statement is based.

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PART I

Armstrong World Industries, Inc. (“AWI” or the “Company”) is a Pennsylvania corporation incorporated in 1891.  When we refer to “we,” “our” and “us” in this report, we are referring to AWI and its subsidiaries.

We are a global leader in the design, innovation and manufacture of commercial and residential ceiling, wall and suspension system solutions. We design, manufacture and sell ceiling systems (primarily mineral fiber, fiberglass wool and metal) throughout the Americas.

On November 17, 2017, we entered into a Share Purchase Agreement (the “Purchase Agreement”) with Knauf International GmbH (“Knauf”), to sell certain subsidiaries comprising our business in Europe, the Middle East and Africa (including Russia) (“EMEA”) and the Pacific Rim, including the corresponding businesses and operations conducted by Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc., in which AWI holds a 50% interest. The consideration to be paid by Knauf in connection with the sale is $330.0 million in cash, inclusive of amounts due to WAVE, subject to certain adjustments as provided in the Purchase Agreement, including adjustments based on the economic impact of any required regulatory remedies and a working capital adjustment.  The transaction, which is subject to regulatory approvals and other customary conditions, is currently anticipated to close in mid-2018. Our EMEA and Pacific Rim segment’s historical financial results have been reflected in AWI’s Consolidated Financial Statements as a discontinued operation for all periods presented.  

On January 13, 2017, we acquired the business and assets of Tectum, Inc. (“Tectum”), based in Newark, Ohio.  Tectum is a manufacturer of acoustical ceiling, wall and structural solutions for commercial building applications with two manufacturing facilities.  Tectum’s operations from the date of acquisition, and its assets and liabilities as of December 31, 2017, have been included as a component of our Architectural Specialties segment.  

On April 1, 2016, we completed our separation of Armstrong Flooring, Inc. (“AFI”).  AFI’s historical financial results have been reflected in AWI’s Consolidated Financial Statements as a discontinued operation for all periods presented.  

See Note 4 to the Consolidated Financial Statements for additional information related to our acquisition and discontinued operations.

We are focused on driving sustainable shareholder value creation. Our strategic priority is to accelerate profitable sales and earnings growth.  Our goal is to expand into new markets and grow in existing markets in the Americas by selling a broader array of products and solutions into those markets.  

Reportable Segments

Effective December 31, 2017 and in connection with the announced sale of our EMEA and Pacific Rim businesses, our historical EMEA and Pacific Rim segments have been excluded from our results of continuing operations.  As a result, effective December 31, 2017 and for all periods presented, our operating segments are as follows:  Mineral Fiber, Architectural Specialties and Unallocated Corporate.  See Note 3 to the Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this Form 10-K for additional financial information.

Markets

We are well positioned in the industry segments and markets in which we operate, often holding a leadership or significant market share position. The major markets in which we compete are:

Commercial.  Our revenue opportunities come from new construction as well as renovation of existing buildings.  Renovation work is estimated to represent the majority of the commercial market opportunity.  Most of our revenue comes from the following sectors of commercial building – office, education, transportation, healthcare and retail.  We monitor U.S. construction starts and follow project activity.  Our revenue from new construction can lag behind construction starts by as much as 18 to 24 months.  We also monitor office vacancy rates, the Architecture Billings Index, state and local government spending, gross domestic product (“GDP”) and general employment levels, which can indicate movement in renovation and new construction opportunities.  We believe that these statistics, taking into account the time-lag effect, provide a reasonable indication of our future revenue opportunity from commercial renovation and new construction.  Additionally, we believe that customer preferences for product type, style, color, availability, affordability and ease of installation also affect our revenue.

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In our Mineral Fiber segment, we estimate that a majority of our commercial market sales are used for renovation purposes by end-users of our products.  The end-use of our products is based on management estimates as such information is not easily determinable.  

Residential.  We also sell mineral fiber products for use in single and multi-family housing.  These products compete against mineral fiber and fiberglass products from other manufacturers, as well as drywall.  We compete directly with other domestic and international suppliers of these products.  We estimate that existing home renovation (also known as replacement / remodel) work represents the majority of the residential market opportunity.  Key U.S. statistics that indicate market opportunity include existing home sales (a key indicator for renovation opportunity), housing starts, housing completions, home prices, interest rates and consumer confidence.  

Approximately 75% of our consolidated net sales are to distributors.  Sales to large home centers account for slightly less than 10% of our consolidated sales.  Our remaining sales are to contractors and retailers.  

Geographic Areas

See Note 3 to the Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this Form 10-K for additional financial information by geographic areas.

Customers

We use our reputation, capabilities, service and brand recognition to develop long-standing relationships with our customers.  We principally sell commercial products to building materials distributors, who re-sell our products to contractors, subcontractors’ alliances, large architect and design firms, and major facility owners. We have important relationships with national home centers such as Lowe’s Companies, Inc. and The Home Depot, Inc., as well as wholesalers who re-sell our products to dealers who service builders, contractors and consumers.

Net sales to three commercial distributors totaling $426.1 million, included within our Mineral Fiber and Architectural Specialties segments, individually exceeded 10% of our consolidated net sales in 2017.  

Working Capital

We produce goods for inventory and sell on credit to our customers.  Generally, our distributors carry inventory as needed to meet local or rapid delivery requirements.  We sell our products to select, pre-approved customers using customary trade terms that allow for payment in the future.  These practices are typical within the industry.  

Competition

We face strong competition in all of our businesses.  Principal attributes of competition include product performance, product styling, service and price.  Competition comes from both domestic and international manufacturers.  Additionally, some of our products compete with alternative products or finishing solutions, namely, drywall and exposed structure (also known as open plenum).  Excess industry capacity exists for certain products, which tends to increase price competition.  The following companies are our primary competitors:

CertainTeed Corporation (a subsidiary of Saint-Gobain), Chicago Metallic Corporation (owned by ROCKWOOL International A/S), Georgia-Pacific Corporation, Rockfon A/S (owned by ROCKWOOL International A/S), USG Corporation, Ceilings Plus (owned by USG Corporation), Rulon International, and 9Wood.

Raw Materials

We purchase raw materials from numerous suppliers worldwide in the ordinary course of business.  The principal raw materials include: fiberglass, perlite, starch, waste paper, pigments and clays.  We manufacture most of the production needs for mineral wool at one of our manufacturing facilities.  Finally, we use aluminum and steel in the production of metal ceilings by us and by WAVE, our joint venture that manufactures ceiling grid.

We also purchase significant amounts of packaging materials and consume substantial amounts of energy, such as electricity and natural gas and water.

In general, adequate supplies of raw materials are available to all of our operations.  However, availability can change for a number of reasons, including environmental conditions, laws and regulations, shifts in demand by other industries competing for the same

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materials, transportation disruptions and/or business decisions made by, or events that affect, our suppliers.  There is no assurance that these raw materials will remain in adequate supply to us.

Prices for certain high usage raw materials can fluctuate dramatically.  Cost increases for these materials can have a significant adverse impact on our manufacturing costs.  Given the competitiveness of our markets, we may not be able to recover the increased manufacturing costs through increasing selling prices to our customers.

Sourced Products

Some of the products that we sell are sourced from third parties.  Our primary sourced products include specialty ceiling products.  We purchase some of our sourced products from suppliers that are located outside of the U.S., primarily from the Pacific Rim and Europe.  Sales of sourced products represented approximately 15% of our total consolidated revenue in 2017.

In general, we believe we have adequate supplies of sourced products.  However, we cannot guarantee that the supply will remain adequate.

Seasonality

Generally, our sales tend to be stronger in the second and third quarters of our fiscal year due to more favorable weather conditions, customer business cycles and the timing of renovation and new construction.  

Patent and Intellectual Property Rights

Patent protection is important to our business.  Our competitive position has been enhanced by patents on products and processes developed or perfected within AWI or obtained through acquisitions and licenses.  In addition, we benefit from our trade secrets for certain products and processes.

Patent protection extends for varying periods according to the date of patent filing or grant and the legal term of a patent in the various countries where patent protection is obtained.  The actual protection afforded by a patent, which can vary from country to country, depends upon the type of patent, the scope of its coverage and the availability of legal remedies.  Although we consider that, in the aggregate, our patents, licenses and trade secrets constitute a valuable asset of material importance to our business, we do not believe we are materially dependent upon any single patent or trade secret, or any group of related patents or trade secrets.

Certain of our trademarks, including without limitation,  , Armstrong®, Calla®, Cirrus®, Cortega®, Dune™, Humiguard®, Infusions®, Lyra®, MetalWorks™,  Optima®, Perla™, Soundscapes®, Sustain®, Tectum®, Total Acoustics®,  Ultima®, and WoodWorks®, are important to our business because of their significant brand name recognition.  Registrations are generally for fixed, but renewable, terms.

In connection with the separation and distribution of AFI, we entered into several agreements with AFI that, together with a plan of division, provided for the separation and allocation of assets between AWI and AFI.  These agreements include a Trademark License Agreement and a Transition Trademark License Agreement.  Pursuant to the Trademark License Agreement, AWI provided AFI with a perpetual, royalty-free license to utilize the “Armstrong” trade name and logo.  Pursuant to the Transition Trademark License Agreement, AFI provided us with a five-year royalty-free license to utilize the “Inspiring Great Spaces” tagline, logo and related color scheme.

Pursuant to our Purchase Agreement with Knauf related to the sale of our EMEA and Pacific Rim businesses and prior to the closing, AWI anticipates entering into an agreement with Knauf relating to the use of certain intellectual property by Knauf after the closing, including the Armstrong trade name.

We review the carrying value of trademarks annually for potential impairment.  See the “Critical Accounting Estimates” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this Form 10-K for further information.

Employees

As of December 31, 2017, we had approximately 3,900 full-time and part-time employees worldwide compared to approximately 3,700 as of December 31, 2016.  The increase in total worldwide employees as of December 31, 2017 in comparison to December 31, 2016 was primarily due to our addition of Tectum employees, partially offset by a reduction of employees related to the closure of one

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of our plants in China.  Excluding our EMEA and Pacific Rim businesses, we had approximately 2,200 employees as of December 31, 2017 compared to approximately 2,000 as of December 31, 2016.  

As of December 31, 2017, approximately 75% of our 1,100 production employees in the U.S. were represented by labor unions.  Collective bargaining agreements covering approximately 460 employees at two U.S. plants will expire during 2018.  Outside the U.S., most of our production employees are covered by either industry-sponsored and/or state-sponsored collective bargaining mechanisms.  We believe that our relations with our employees are satisfactory.

Research & Development

Research and development (“R&D”) activities are important and necessary in helping us improve our products’ competitiveness.  Principal R&D functions include the development and improvement of products and manufacturing processes.  We incurred $17.4 million in 2017, $17.8 million in 2016 and $18.7 million in 2015 of R&D expenses.

Sustainability and Environmental Matters

The adoption of environmentally responsible building codes and standards such as the Leadership in Energy and Environmental Design (“LEED”) rating system established by the U.S. Green Building Council, has the potential to increase demand for products, systems and services that contribute to building sustainable spaces. Many of our products meet the requirements for the award of LEED credits, and we are continuing to develop new products, systems and services to address market demand for products that enable construction of buildings that require fewer natural resources to build, operate and maintain. Our competitors also have developed and introduced to the market products with an increased focus on sustainability.

We expect that there will be increased demand over time for products, systems and services that meet evolving regulatory and customer sustainability standards and preferences and decreased demand for products that produce significant greenhouse gas emissions. We also believe that our ability to continue to provide these products, systems and services to our customers will be necessary to maintain our competitive position in the marketplace.  We are committed to complying with all environmental laws and regulations that are applicable to our operations.

Legal and Regulatory Proceedings

Regulatory activities of particular importance to our operations include proceedings under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), and state Superfund and similar type environmental laws governing existing or potential environmental contamination at several domestically owned, formerly owned and non-owned locations allegedly resulting from past industrial activity.  In a few cases, we are one of several potentially responsible parties and have agreed to jointly fund required investigation, while preserving our defenses to the liability.  We may also have rights of contribution or reimbursement from other parties or coverage under applicable insurance policies.  

Most of our facilities are affected by various federal, state and local environmental requirements relating to the discharge of materials or the protection of the environment.  We make expenditures necessary for compliance with applicable environmental requirements at each of our operating facilities. We have not experienced a material adverse effect upon our capital expenditures or competitive position as a result of environmental control legislation and regulations.

On September 8, 2017, Roxul USA, Inc. (d/b/a Rockfon) filed litigation against us in the United States District Court for the District of Delaware alleging anticompetitive conduct seeking remedial measures and unspecified damages.  Roxul USA, Inc. is a significant ceilings systems competitor with global headquarters in Europe and expanding operations in the Americas.  We believe the allegations are without merit and are vigorously defending the matter.

We are involved in various other lawsuits, claims, investigations and other legal matters from time to time that arise in the ordinary course of business, including matters involving our products, intellectual property, relationships with suppliers, relationships with distributors, relationships with competitors, employees and other matters. From time to time, for example, we may be a party to various litigation matters that involve product liability, tort liability and other claims under various allegations, including illness due to exposure to certain chemicals used in the workplace; or medical conditions arising from exposure to product ingredients or the presence of trace contaminants.  Such allegations may involve multiple defendants and relate to legacy products that we and other defendants purportedly manufactured or sold. We believe that any current claims are without merit and intend to defend them vigorously. For these matters, we also may have rights of contribution or reimbursement from other parties or coverage under applicable insurance policies.  When applicable and appropriate, we will pursue coverage and recoveries under those policies, but are unable to predict the outcome of those demands.  While complete assurance cannot be given to the outcome of these proceedings, we

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do not believe that any current claims, individually or in the aggregate, will have a material adverse effect on our financial condition, liquidity or results of operations.

Liabilities of $13.5 million and $4.7 million as of December 31, 2017 and December 31, 2016, respectively, were recorded for environmental liabilities that we consider probable and for which a reasonable estimate of the probable liability could be made.  See Note 27 to the Consolidated Financial Statements and Risk Factors in Item 1A of this Form 10-K, for information regarding the possible effects that compliance with environmental laws and regulations may have on our businesses and operating results.

Website

We maintain a website at http://www.armstrongceilings.com.  Information contained on our website is not incorporated into this document.  Annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, all amendments to those reports and other information about us are available free of charge through this website as soon as reasonably practicable after the reports are electronically filed with the SEC.  Reference in this Form 10-K to our website and the SEC’s website is an inactive text reference only.  

Unstable market and economic conditions could have a material adverse impact on our financial condition, liquidity or results of operations.

Our business is influenced by market and economic conditions, including inflation, deflation, interest rates, availability and cost of capital, consumer spending rates, energy availability and the effects of governmental initiatives to manage economic conditions.  Volatility in financial markets and the continued softness or further deterioration of national and global economic conditions could have a material adverse effect on our financial condition, liquidity or results of operations, including as follows:

Continued or sustained deterioration of economic conditions would likely exacerbate and prolong these adverse effects.

Our business is dependent on construction activity. Downturns in construction activity could adversely affect our financial condition, liquidity or results of operations.

Our businesses have greater sales opportunities when construction activity is strong and, conversely, have fewer opportunities when such activity declines.  The cyclical nature of commercial and residential construction activity, including construction activity funded by the public sector, tends to be influenced by prevailing economic conditions, including the rate of growth in gross domestic product, prevailing interest rates, government spending patterns, business, investor and consumer confidence and other factors beyond our control.  Prolonged downturns in construction activity could have a material adverse effect on our financial condition, liquidity or results of operations.

Our business could be adversely impacted as a result of uncertainty related to the proposed disposition of our EMEA and Pacific Rim businesses.

The proposed disposition of our EMEA and Pacific Rim businesses to Knauf could cause disruptions to our business or our business relationships, which could have an adverse impact on our results of operations. For example, our employees may experience uncertainty about their future roles with us, which may adversely affect our ability to hire and retain key personnel, and parties with which we have business relationships may experience uncertainty as to the future of such relationships and seek alternative relationships with third parties or seek to alter their present business relationships with us. In addition, our management team and other employees are devoting significant time and effort to activities related to the proposed disposition.

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We have incurred and will continue to incur significant costs, expenses and fees for professional services and other transaction costs in connection with the proposed disposition, and many of these fees and costs are payable regardless of whether or not the disposition is completed. In the event the disposition is not completed for any reason, or the timing of its consummation is delayed, our operating results may be adversely affected as a result of the incurring of these significant additional expenses and the diversion of management’s attention.

The proposed disposition of our EMEA and Pacific Rim businesses is subject to the receipt of consents and clearances from regulatory authorities that may impose conditions that could have an adverse effect on us or Knauf or, if not obtained, could prevent the completion of the proposed disposition.

Before the proposed disposition of our EMEA and Pacific Rim businesses to Knauf may be completed, applicable waiting periods must expire or terminate under antitrust and competition laws and clearances or approvals must be obtained from various regulatory entities. In deciding whether to grant antitrust or regulatory clearances, the relevant governmental entities will consider the effect of the disposition on competition within their relevant jurisdiction.

There can be no assurance that regulators will not impose conditions, terms, obligations or restrictions to the consummation of the disposition and that such conditions, terms, obligations or restrictions will not have the effect of delaying the completion of the disposition, or resulting in additional material costs to us. In addition, we cannot provide assurance that any such conditions, terms, obligations or restrictions will not result in the delay or abandonment of the disposition. Additionally, the completion of the disposition is conditioned on the absence of certain restraining orders or injunctions by judgment, court order or law that would prohibit the completion of the disposition.

Our markets are highly competitive. Competition can reduce demand for our products or cause us to lower prices. Failure to compete effectively by meeting consumer preferences, developing and marketing innovative solutions, maintaining strong customer service and distribution relationships, growing market share, and expanding our solutions capabilities and reach could adversely affect our results.

Our markets are highly competitive.  Competition can reduce demand for our products, negatively affect our product sales mix or cause us to lower prices. Failure to compete effectively by meeting consumer preferences, developing and marketing innovative solutions, maintaining strong customer service and distribution relationships, growing market share and expanding our solutions capabilities and reach could have a material adverse effect on our financial condition, liquidity or results of operations.  Our customers consider our products’ performance, product styling, customer service and price when deciding whether to purchase our products.  Shifting consumer preference in our highly competitive markets, from acoustical solutions to other ceiling and wall products, for example, whether for performance or styling preferences or our inability to develop and offer new competitive performance features could have an adverse effect on our sales.  Similarly, our ability to identify, protect and market new and innovative solutions is critical to our long-term growth strategy, namely to sell into more spaces and sell more solutions in every space.  In addition, excess industry capacity for certain products in several geographic markets could lead to industry consolidation and/or increased price competition.  In certain local markets, we are also subject to potential increased price competition from foreign competitors, which may have lower cost structures.

Sales fluctuations to and changes in our relationships with key customers could have a material adverse effect on our financial condition, liquidity or results of operations.

Some of our markets are dependent on certain key customers, including independent distributors.   The loss, reduction, or fluctuation of sales to key customers, or any adverse change in our business relationship with them, whether as a result of competition, industry consolidation or otherwise, could have a material adverse effect on our financial condition, liquidity or results of operations.

Customer consolidation, and competitive, economic and other pressures facing our customers, may put pressure on our operating margins and profitability.

A number of our customers, including distributors and contractors, have consolidated in recent years and consolidation could continue. Such consolidation could impact margin growth and profitability as larger customers may realize benefits of scale with increased buying power and reduced inventories. The economic and competitive landscape for our customers is constantly changing, and our customers' responses to those changes could impact our business. These factors and others could have an adverse impact on our business, financial condition or results of operations.

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If the availability of raw materials or energy decreases, or the costs increase, and we are unable to pass along increased costs, our financial condition, liquidity or results of operations could be adversely affected.

The availability and cost of raw materials, packaging materials, energy and sourced products are critical to our operations.  For example, we use substantial quantities of natural gas and petroleum-based raw materials in our manufacturing operations.  The cost of some of these items has been volatile in recent years and availability has been limited at times.  We source some materials from a limited number of suppliers, which, among other things, increases the risk of unavailability.  Limited availability could cause us to reformulate products or limit our production.  Decreased access to raw materials and energy or significant increased cost to purchase these items and any corresponding inability to pass along such costs through price increases could have a material adverse effect on our financial condition, liquidity or results of operations.

The performance of our WAVE joint venture is important to our financial results.  Changes in the demand for, or quality of, WAVE products, or in the operational or financial performance of the WAVE joint venture, could have a material adverse effect on our financial condition, liquidity or results of operations.  Similarly, if there is a change with respect to our joint venture partner that adversely impacts its relationship with us, WAVE’s performance could be adversely impacted.

Our equity investment in our WAVE joint venture remains important to our financial results.  We believe an important element in the success of this joint venture is the relationship with our partner, Worthington Industries, Inc.  If there is a change in ownership, a change of control, a change in management or management philosophy, a change in business strategy or another event with respect to our partner that adversely impacts our relationship, WAVE’s performance could be adversely impacted.  In addition, our partner may have economic or business interests or goals that are different from or inconsistent with our interests or goals, which may impact our ability to influence or align WAVE’s strategy and operations.

We may be subject to liability under, and may make substantial future expenditures to comply with, environmental laws and regulations, which could materially adversely affect our financial condition, liquidity or results of operations.

We are actively involved in environmental investigation and remediation activities relating to several domestically owned, formerly owned and non-owned locations allegedly resulting from past industrial activity, for which our ultimate liability may exceed the currently estimated and accrued amounts.  See Note 27 to the Consolidated Financial Statements for further information related to our current environmental matters and the potential liabilities associated therewith. It is also possible that we could become subject to additional environmental matters and corresponding liabilities in the future.

The building materials industry has been subject to claims relating to raw materials such as silicates, polychlorinated biphenyl (“PCB”), PVC, formaldehyde, fire-retardants and claims relating to other issues such as mold and toxic fumes, as well as claims for incidents of catastrophic loss, such as building fires.  We have not received any significant claims involving our raw materials or our product performance; however, product liability insurance coverage may not be available or adequate in all circumstances to cover claims that may arise in the future.

In addition, our operations are subject to various environmental, health, and safety laws and regulations.  These laws and regulations not only govern our current operations and products, but also impose potential liability on us for our past operations.  Our costs to comply with these laws and regulations may increase as these requirements become more stringent in the future, and these increased costs may materially adversely affect our financial condition, liquidity or results of operations.

The agreements that govern our indebtedness contain a number of covenants that impose significant operating and financial restrictions, including restrictions on our ability to engage in activities that may be in our best long-term interests.

The agreements that govern our indebtedness include covenants that, among other things, may impose significant operating and financial restrictions, including restrictions on our ability to engage in activities that may be in our best long-term interests.  These covenants may restrict our ability to:

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Under the terms of our senior secured credit facility, we are required to maintain specified leverage and interest coverage ratios.  Our ability to meet these ratios could be affected by events beyond our control, and we cannot assure that we will meet them.  A breach of any of the restrictive covenants or ratios would result in a default under the senior secured credit facility.  If any such default occurs, the lenders under the senior secured credit facility may be able to elect to declare all outstanding borrowings under our facilities, together with accrued interest and other fees, to be immediately due and payable, or enforce their security interest.  The lenders may also have the right in these circumstances to terminate commitments to provide further borrowings.

Our indebtedness may adversely affect our cash flow and our ability to operate our business, make payments on our indebtedness and declare dividends on our capital stock.

Our level of indebtedness and degree of leverage could:

We may also incur additional indebtedness, which could exacerbate the risks described above.  In addition, to the extent that our indebtedness bears interest at floating rates, our sensitivity to interest rate fluctuations will increase.

Any of the above listed factors could materially adversely affect our financial condition, liquidity or results of operations.

We require a significant amount of liquidity to fund our operations, and borrowing has increased our vulnerability to negative unforeseen events.

Our liquidity needs vary throughout the year.  If our business experiences materially negative unforeseen events, we may be unable to generate sufficient cash flow from operations to fund our needs or maintain sufficient liquidity to operate and remain in compliance with our debt covenants, which could result in reduced or delayed planned capital expenditures and other investments and adversely affect our financial condition or results of operations.

We are subject to risks associated with our international operations in both established and emerging markets. Legislative, political, regulatory and economic volatility, as well as vulnerability to infrastructure and labor disruptions, could have an adverse effect on our financial condition, liquidity or results of operations.

On November 20, 2017, we announced that we had entered into a definitive agreement with Knauf to sell our EMEA and Pacific Rim businesses. This transaction, which is subject to regulatory approvals and other customary conditions, is currently anticipated to close in mid-2018.

A significant portion of our products move in international trade.  See Notes 3 and 4 to the Consolidated Financial Statements for further information.  Our international trade is subject to currency exchange fluctuations, trade regulations, import duties, logistics costs, delays and other related risks.  Our international operations are also subject to various tax rates, credit risks in emerging markets, political risks, uncertain legal systems, high costs in repatriating profits to the United States from some countries, and loss of sales to local competitors following currency devaluations in countries where we import products for sale.  In addition, our international growth strategy depends, in part, on our ability to expand our operations in certain emerging markets.  However, some emerging markets have greater political and economic volatility and greater vulnerability to infrastructure and labor disruptions than established markets.  Similarly, our efforts to enhance the profitability or accelerate the growth of our operations in certain markets depends largely on the economic and geopolitical conditions in those local or regional markets.

In addition, in many countries outside of the United States, particularly in those with developing economies, it may be common for others to engage in business practices prohibited by laws and regulations applicable to us, such as the Foreign Corrupt Practices Act or

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similar local anti-corruption or anti-bribery laws.  These laws generally prohibit companies and their employees, contractors or agents from making improper payments to government officials for the purpose of obtaining or retaining business.  Failure to comply with these laws, as well as U.S. and foreign export and trading laws, could subject us to civil and criminal penalties.  As we continue to expand our business, we may have difficulty anticipating and effectively managing these and other risks that our operations may face, which may adversely affect our business outside the United States and our financial condition, liquidity or results of operations.

We may pursue strategic transactions that could create risks and present unforeseen integration obstacles or costs, any of which could materially adversely affect our financial condition, liquidity or results of operations.

We have evaluated, and expect to continue to evaluate, potential strategic transactions as opportunities arise.  We routinely engage in discussions with third parties regarding potential transactions, including joint ventures, which could be significant.  Any such strategic transaction involves a number of risks, including potential disruption of our ongoing business and distraction of management, difficulty with integrating or separating personnel and business operations and infrastructure, and increasing or decreasing the scope, geographic diversity and complexity of our operations.  Strategic transactions could involve payment by us of a substantial amount of cash, assumption of liabilities and indemnification obligations, regulatory requirements, incurrence of a substantial amount of debt or issuance of a substantial amount of equity.  Certain strategic opportunities may not result in the consummation of a transaction or may fail to realize the intended benefits and synergies.  If we fail to consummate and integrate our strategic transactions in a timely and cost-effective manner, our financial condition, liquidity or results of operation could be materially and adversely affected.

Negative tax consequences can have an unanticipated effect on our financial results.

We are subject to the tax laws of the many jurisdictions in which we operate.  The tax laws are complex, and the manner in which they apply to our operations and results is sometimes open to interpretation.  Because our income tax expense for any period depends heavily on the mix of income derived from the various taxing jurisdictions, our income tax expense and reported net income may fluctuate significantly, and may be materially different than forecasted or experienced in the past.  Our financial condition, liquidity, results of operations or tax liability could be adversely affected by changes in the effective tax rate as a result of a change in the mix of earnings in countries with differing statutory tax rates, changes in our overall profitability, changes in tax legislation and rates, changes in the amount of earnings permanently reinvested offshore, the results of examinations of previously filed tax returns, and ongoing assessments of our tax exposures.

Our financial condition, liquidity, results of operations or tax liability could also be adversely affected by changes in the valuation of deferred tax assets and liabilities. We have substantial deferred tax assets related to U.S. domestic foreign tax credits, or FTCs, and state net operating losses, or NOLs, which are available to reduce our U.S. income tax liability and to offset future state taxable income.  However, our ability to utilize the current carrying value of these deferred tax assets may be impacted as a result of certain future events, such as changes in tax legislation and insufficient future taxable income prior to expiration of the FTCs and NOLs.

If the separation and distribution of Armstrong Flooring, Inc. (“AFI”) fails to qualify as a tax-free transaction for U.S. federal income tax purposes, then AFI, AWI and AWI’s shareholders could be subject to significant tax liability or tax indemnity obligations.

On April 1, 2016, we completed our previously announced separation of AFI by allocating the assets and liabilities related primarily to the Resilient Flooring and Wood Flooring segments to AFI and then distributing the common stock of AFI to our shareholders at a ratio of one share of AFI common stock for every two shares of AWI common stock.  In connection with the distribution, we received an opinion from our special tax counsel, on the basis of certain facts, representations, covenants and assumptions set forth in such opinion, substantially to the effect that, for U.S. federal income tax purposes, the separation and distribution should qualify as a transaction that generally is tax-free to us and our shareholders under Sections 355 and 368(a)(1)(D) of the Internal Revenue Code.

Notwithstanding the tax opinion, the Internal Revenue Service (“IRS”) could determine on audit that the distribution should be treated as a taxable transaction if it determines that any of the facts, assumptions, representations or covenants set forth in the tax opinion is not correct or has been violated, or that the distribution should be taxable for other reasons, including as a result of a significant change in stock or asset ownership after the distribution, or if the IRS were to disagree with the conclusions of the tax opinion. If the distribution is ultimately determined to be taxable, the distribution could be treated as a taxable dividend to each U.S. holder of our common shares who receives shares of AFI in connection with the spinoff for U.S. federal income tax purposes, and such shareholders could incur significant U.S. federal income tax liabilities. In addition, we and/or AFI could incur significant U.S. federal income tax liabilities or tax indemnification obligations, whether under applicable law or the Tax Matters Agreement that we entered into with AFI, if it is ultimately determined that certain related transactions undertaken in anticipation of the distribution are taxable.

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Significant changes in factors and assumptions used to measure our defined benefit plan obligations, actual investment returns on pension assets and other factors could negatively impact our operating results and cash flows.

We maintain pension and postretirement plans throughout the world, with the most significant plans located in the U.S.  The recognition of costs and liabilities associated with these plans for financial reporting purposes is affected by assumptions made by management and used by actuaries engaged by us to calculate the benefit obligations and the expenses recognized for these plans.

The inputs used in developing the required estimates are calculated using a number of assumptions, which represent management’s best estimate of the future.  The assumptions that have the most significant impact on reported results are the discount rate, the estimated long-term return on plan assets for the funded plans, retirement rates, and mortality rates and, for postretirement plans, the estimated inflation in health care costs.  These assumptions are generally updated annually.

Our U.S. pension plans were overfunded by $29.6 million as of December 31, 2017.  Our unfunded U.S. postretirement plan liabilities were $86.6 million as of December 31, 2017.  If our cash flows and capital resources are insufficient to fund our pension and postretirement plans obligations, we could be forced to reduce or delay investments and capital expenditures, seek additional capital, or restructure or refinance our indebtedness.

A disruption in our information technology systems due to a catastrophic event or security breach could interrupt or damage our operations.

In the conduct of our business, we collect, use, transmit and store data on information systems, which are vulnerable to an increasing threat of continually evolving cyber security risks. Any security breach or compromise of our information systems could significantly damage our reputation, cause the disclosure of confidential customer, employee, supplier or company information, including our intellectual property, and result in significant losses, litigation, fines and costs. The security measures we have implemented to protect against unauthorized access to our information systems and data may not be sufficient to prevent breaches. The regulatory environment related to information security, data collection and privacy is evolving, with new and constantly changing requirements applicable to our business, and compliance with those requirements could result in additional costs.

We also compete through our use and improvement of information technology. In order to remain competitive, we need to provide customers with timely, accurate, easy-to-access information about product availability, orders and delivery status using state-of-the-art systems. While we have processes for short-term failures and disaster recovery capability, a prolonged disruption of systems or other failure to meet customers’ expectations regarding the capabilities and reliability of our systems may materially and adversely affect our operating results.

Adverse judgments in regulatory actions, product claims, environmental claims and other litigation could be costly.  Insurance coverage may not be available or adequate in all circumstances.

In the ordinary course of business, we are subject to various claims and litigation.  Any such claims, whether with or without merit, could be time consuming and expensive to defend and could divert management’s attention and resources.  While we strive to ensure that our products comply with applicable government regulatory standards and internal requirements, and that our products perform effectively and safely, customers from time to time could claim that our products do not meet warranty or contractual requirements, and users could claim to be harmed by use or misuse of our products.  These claims could give rise to breach of contract, warranty or recall claims, or claims for negligence, product liability, strict liability, personal injury or property damage.  They could also result in negative publicity.

In addition, claims and investigations may arise related to patent infringement, distributor relationships, commercial contracts, antitrust or competition law requirements, employment matters, employee benefits issues, and other compliance and regulatory matters, including anti-corruption and anti-bribery matters.  While we have processes and policies designed to mitigate these risks and to investigate and address such claims as they arise, we cannot predict or, in some cases, control the costs to defend or resolve such claims.

We currently maintain insurance against some, but not all, of these potential claims. In the future, we may not be able to maintain insurance at commercially acceptable premium levels.  In addition, the levels of insurance we maintain may not be adequate to fully cover any and all losses or liabilities.  If any significant judgment or claim is not fully insured or indemnified against, it could have a material adverse impact. We cannot assure that the outcome of all current or future litigation will not have a material adverse effect on our financial condition, liquidity or results of operations.

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Increased costs of labor, labor disputes, work stoppages or union organizing activity could delay or impede production and could have a material adverse effect on our financial condition, liquidity or results of operations.

Increased costs of labor, including the costs of employee benefits plans, labor disputes, work stoppages or union organizing activity could delay or impede production and have a material adverse effect on our financial condition, liquidity or results of operations.  As the majority of our manufacturing employees are represented by unions and covered by collective bargaining or similar agreements, we often incur costs attributable to periodic renegotiation of those agreements, which may be difficult to project.  We are also subject to the risk that strikes or other conflicts with organized personnel may arise or that we may become the subject of union organizing activity at our facilities that do not currently have union representation.  Prolonged negotiations, conflicts or related activities could also lead to costly work stoppages and loss of productivity.

Our intellectual property rights may not provide meaningful commercial protection for our products or brands, which could adversely impact our financial condition, liquidity or results of operations.

We rely on our proprietary intellectual property, including numerous patents and registered trademarks, as well as our licensed intellectual property to market, promote and sell our products.  We monitor and protect against activities that might infringe, dilute, or otherwise harm our patents, trademarks and other intellectual property and rely on the patent, trademark and other laws of the U.S. and other countries.  However, we may be unable to prevent third parties from using our intellectual property without our authorization.  In addition, the laws of some non-U.S. jurisdictions, particularly those of certain emerging markets, provide less protection for our proprietary rights than the laws of the U.S. and present greater risks of counterfeiting and other infringement.  To the extent we cannot protect our intellectual property, unauthorized use and misuse of our intellectual property could harm our competitive position and have a material adverse effect on our financial condition, liquidity or results of operations.

Our cost-saving and productivity initiatives may not achieve expected savings in our operating costs or improved operating results.

We aggressively look for ways to make our operations more efficient and effective.  We reduce, move, modify and expand our plants and operations, as well as our sourcing and supply chain arrangements, as needed, to control costs and improve productivity.  Such actions involve substantial planning, often require capital investments and may result in charges for fixed asset impairments or obsolescence and substantial severance costs.  Our ability to achieve cost savings and other benefits within expected time frames is subject to many estimates and assumptions.  These estimates and assumptions are subject to significant economic, competitive and other uncertainties, some of which are beyond our control.  If these estimates and assumptions are incorrect, if we experience delays, or if other unforeseen events occur, our financial condition, liquidity or results of operations could be materially and adversely affected.

None.

We own a 100-acre, multi-building campus in Lancaster, Pennsylvania comprising the site of our corporate headquarters and most of our non-manufacturing operations.

As of December 31, 2017, we had 16 manufacturing plants in eight countries.  Three of our plants are leased and the remaining 13 are owned.  We operate eight plants located throughout the United States.  In addition, our WAVE joint venture operates nine additional plants in five countries.

Upon closure of the sale of our EMEA and Pacific Rim businesses, we will have ten plants, including eight plants in the U.S.  One of our plants will be leased and the remaining nine will be owned.  

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During the fourth quarter of 2016, we idled one of our plants in China, which is reported as a component of our Unallocated Corporate segment as it will be retained by AWI after the sale of our Pacific Rim business.  During the fourth quarter of 2017, we announced the closing of our St. Helens, Oregon mineral fiber manufacturing facility, expected to occur in the first half of 2018.  

Sales and administrative offices are leased and/or owned worldwide, and leased facilities are utilized to supplement our owned warehousing facilities.

Production capacity and the extent of utilization of our facilities are difficult to quantify with certainty.  In any one facility, utilization of our capacity varies periodically depending upon demand for the product that is being manufactured.  We believe our facilities are adequate and suitable to support the business.  Additional incremental investments in plant facilities are made as appropriate to balance capacity with anticipated demand, improve quality and service, and reduce costs.

See the “Specific Material Events” section of the “Environmental Matters” section of Note 27 to the Consolidated Financial Statements, which is incorporated herein by reference, for a description of our significant legal proceedings.

Not applicable.

 

 

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PART II

AWI’s common shares trade on the New York Stock Exchange under the ticker symbol “AWI.”  As of February 21, 2018, there were approximately 270 holders of record of AWI’s common stock.

 

 

The above figures represent the high and low intra-day sale prices for our common stock as reported by the New York Stock Exchange.  Historical prices have not been restated as a result of our separation of AFI on April 1, 2016.

There were no cash dividends declared during 2017 or 2016.

Dividends are paid when declared by our Board of Directors and in accordance with restrictions set forth in our debt agreements. In general, our debt agreements allow us to make “restricted payments,” which include dividends and stock repurchases, subject to certain limitations and other restrictions and provided that we are in compliance with the financial and other covenants of our debt agreements and meet certain liquidity requirements after giving effect to the restricted payment.   For further discussion of the debt agreements, see the Financial Condition and Liquidity section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 and Risk Factors in Item 1A in this Form 10-K.

Issuer Purchases of Equity Securities

 

 

On July 29, 2016, the Company announced that its Board of Directors had approved a share repurchase program pursuant to which the Company is authorized to repurchase up to $150.0 million of its outstanding shares of common stock through July 31, 2018 (the “Program”).  On October 31, 2017, we announced that our Board of Directors had approved an additional $250.0 million authorization to repurchase shares of our outstanding common stock under the Program.  The Program was also extended to October 31, 2020.  Repurchases under the Program may be made through open market, block and privately-negotiated transactions, including Rule 10b5-1 plans, at times and in such amounts as management deems appropriate, subject to market and business conditions, regulatory requirements and other factors. The Program does not obligate the Company to repurchase any particular amount of common stock and may be suspended or discontinued at any time without notice.  During 2017, 1.8 million shares were repurchased under the Program for a total cost of $80.4 million, or an average price of $43.58 per share.  Since inception of the Program, we have repurchased 2.95 million shares under the Program for a total cost of $124.2 million, or an average price of $42.03 per share.

 

 

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The following selected historical consolidated financial data should be read in conjunction with our audited consolidated financial statements, the accompanying notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-K.  The selected historical consolidated financial data for the periods presented have been derived from our audited consolidated financial statements.

 

 

Notes:

 

 

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Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891.

This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forward-looking statements and risk factors included in this Form 10-K.

Overview

We are a global leader in the design, innovation and manufacture of commercial and residential ceiling, wall and suspension system solutions. We design, manufacture and sell ceiling systems (primarily mineral fiber, fiberglass wool and metal) throughout the Americas.

On November 17, 2017, we entered into a Share Purchase Agreement (the “Purchase Agreement”) with Knauf International GmbH (“Knauf”), to sell certain subsidiaries comprising our business in Europe, the Middle East and Africa (including Russia) (“EMEA”) and the Pacific Rim, including the corresponding businesses and operations conducted by Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc., in which AWI holds a 50% interest. The total consideration to be paid by Knauf in connection with the sale is $330 million in cash, inclusive of amounts due to WAVE, subject to certain adjustments as provided in the Purchase Agreement, including adjustments based on the economic impact of any required regulatory remedies and a working capital adjustment.  The transaction, which is subject to regulatory approvals and other customary conditions, is currently anticipated to close in mid-2018.  EMEA and Pacific Rim segment historical financial results have been reflected in AWI’s Consolidated Financial Statements as discontinued operations for all periods presented.  

In January 2017, we acquired the business and assets of Tectum, Inc. (“Tectum”), based in Newark, Ohio.  Tectum is a manufacturer of acoustical ceiling, wall and structural solutions for commercial building applications with two manufacturing facilities.  Tectum’s operations from the date of acquisition, and its assets and liabilities as of December 31, 2017, have been included as a component of our Architectural Specialties segment.  

On April 1, 2016, we completed our separation of Armstrong Flooring, Inc. (“AFI”).  AFI’s historical financial results have been reflected in AWI’s Consolidated Financial Statements as a discontinued operation for all periods presented.  

See Note 4 to the Consolidated Financial Statements for additional information related to our acquisitions and discontinued operations.

As of December 31, 2017, we had 16 manufacturing plants in eight countries, including eight plants located throughout the U.S.  During the fourth quarter of 2016 we idled one of our mineral fiber plants in China, reported as a component of our Unallocated Corporate segment as it will be retained by AWI after the sale of the Pacific Rim business.  Upon closure of the sale of our EMEA and Pacific Rim businesses, we will have ten plants, including eight plants in the U.S.

During the fourth quarter of 2017, we announced the closing of our St. Helens, Oregon mineral fiber manufacturing facility, expected to occur in the first half of 2018.  

WAVE operates 9 additional plants in five countries to produce suspension system (grid) products, which we use and sell in our ceiling systems. Upon closure of the sale of its corresponding EMEA and Pacific Rim businesses, WAVE will operate five plants in the U.S.

Reportable Segments 

Effective December 31, 2017 and in connection with the anticipated sale of our EMEA and Pacific Rim businesses, our EMEA and Pacific Rim segments have been excluded from our results of continuing operations.  As a result, effective December 31, 2017 and for all periods presented, our operating segments are as follows:  Mineral Fiber, Architectural Specialties and Unallocated Corporate.  

Mineral Fiber – produces suspended mineral fiber and soft fiber ceiling systems for use in commercial and residential settings.  Products offer various performance attributes such as acoustical control, rated fire protection and aesthetic appeal.  Commercial ceiling products are sold to resale distributors and to ceiling systems contractors.  Residential ceiling products are sold primarily to wholesalers and retailers (including large home centers).  The Mineral Fiber segment also includes the results of WAVE, which manufactures suspension system (grid) products and ceiling component products that are invoiced by both us and WAVE.  Segment results relating to WAVE consist primarily of equity earnings and reflect our 50% equity interest in the joint venture.  Ceiling component products consist of ceiling perimeters and trim, in addition to grid products that support drywall ceiling systems.  To a

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

lesser extent, however, in some markets, WAVE sells its suspension systems products to us for resale to customers.  Mineral Fiber segment results reflect those sales transactions.

 

Architectural Specialties – produces and sources ceilings and walls for use in commercial settings.  Products are available in numerous materials, such as metal and wood, in addition to various colors, shapes and designs.  Products offer various performance attributes such as acoustical control, rated fire protection and aesthetic appeal.  We produce standard and customized products, with the majority of Architectural Specialties revenues derived from sourced products. Architectural Specialties products are sold to resale distributors and ceiling systems contractors.  The majority of revenues are project driven, which can lead to more volatile sales patterns due to project scheduling.

 

Unallocated Corporate – includes assets, liabilities, income and expenses that have not been allocated to our other business segments and consist of: cash and cash equivalents, the net funded status of our U.S. Retirement Income Plan (“RIP”), the estimated fair value of interest rate swap contracts, outstanding borrowings under our senior credit facilities and income tax balances.  Effective December 31, 2017 and for all periods presented, our Unallocated Corporate segment also includes all assets, liabilities, income and expenses formerly reported in our EMEA and Pacific Rim segments that are not included in the pending sale to Knauf.  

Factors Affecting Revenues

For information on our segments’ 2017 net sales by geography, see Note 3 to the Consolidated Financial Statements included in this Form 10-K.

Markets. We compete in building material markets in the Americas.  We closely monitor publicly available macroeconomic trends that provide insight into commercial and residential market activity, including GDP, office vacancy rates, the Architecture Billings Index, new commercial construction starts, state and local government spending, corporate profits and retail sales.  

In addition, we noted several factors and trends within our markets that directly affected our business performance during 2017, including: 

Mineral Fiber

We experienced lower renovation activity, partially offset by growth from new construction, leading to a slight overall decline in volume.  

Architectural Specialties

We experienced strong growth due to new commercial construction activity and increased market penetration, partially driven by the acquisition of Tectum. 

Average Unit Value.  We periodically modify sales prices of our products due to changes in costs for raw materials and energy, market conditions and the competitive environment.  In certain cases, realized price increases are less than the announced price increases because of project pricing, competitive reactions and changing market conditions.  Additionally, we offer a wide assortment of products that are differentiated by style, design and performance attributes.  Pricing and margins for products within the assortment vary.   In addition, changes in the relative quantity of products purchased at different price points can impact year-to-year comparisons of net sales and operating income. We focus on improving sales dollars per unit sold, or average unit value (“AUV”), as a measure that accounts for the varying assortment of products and geographic mix impacting our revenues.  We estimate that favorable AUV increased our Mineral Fiber and total consolidated net sales for 2017 by approximately $29 million compared to 2016.  Architectural Specialties revenues are generally earned based on individual contracts that include a mix of products, manufactured by us and sourced, that vary by project.  As such, we do not track AUV performance for this segment, but rather attribute all changes in net sales to volume.  

In the first and fourth quarters of 2017, we implemented ceiling tile pricing increases.  We also implemented a pricing increase on grid products in the third quarter of 2017.   Finally, in the fourth quarter of 2017 we also announced price increases on certain architectural specialties products, ceiling tile and grid products effective in the first quarter of 2018.  We may implement additional pricing actions based on numerous factors, most notably upon future movements in raw material prices.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Factors Affecting Operating Costs

Operating Expenses.  Our operating expenses are comprised of direct production costs (principally raw materials, labor and energy), manufacturing overhead costs, freight, costs to purchase sourced products and selling, general, and administrative (“SG&A”) expenses. 

Our largest individual raw material expenditures are for fiberglass, perlite, starch, waste paper, pigments and clays.  We manufacture most of the production needs for mineral wool at one of our manufacturing facilities.  Natural gas and packaging materials are also significant input costs.  Fluctuations in the prices of these inputs are generally beyond our control and have a direct impact on our financial results.  In 2017, the costs for raw materials, sourced products and energy negatively impacted operating income by approximately $3 million, compared to 2016.

During the fourth quarter of 2017, we announced the closing of our St. Helens, Oregon mineral fiber manufacturing facility, expected to occur in the first half of 2018.  Production activity will move to existing facilities in the U.S.  We will continue to evaluate the efficiency of our manufacturing footprint and may take additional actions in support of our cost and standardization initiatives.  The charges associated with any additional cost reduction initiatives could include severance and related termination benefits, fixed asset write-downs, asset impairments and accelerated depreciation and may be material to our financial statements.

See also “Results of Operations” for further discussion of other significant items affecting operating costs.

Employees

As of December 31, 2017, we had approximately 3,900 full-time and part-time employees worldwide compared to approximately 3,700 as of December 31, 2016.  Excluding our EMEA and Pacific Rim businesses, we had approximately 2,200 employees as of December 31, 2017 compared to approximately 2,000 as of December 31, 2016.  The increase in total worldwide employees as of December 31, 2017 in comparison to December 31, 2016 was primarily due to our addition of Tectum employees, partially offset by a reduction of employees related to the closure of one of our plants in China.  

Collective bargaining agreements covering approximately 460 employees at two U.S. plants will expire during 2018.  We believe that our relations with our employees are satisfactory.

CRITICAL ACCOUNTING ESTIMATES

In preparing our consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”), we are required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period.  We evaluate our estimates and assumptions on an on-going basis, using relevant internal and external information.  We believe that our estimates and assumptions are reasonable.  However, actual results may differ from what was estimated and could have a significant impact on the financial statements.

We have identified the following as our critical accounting estimates.  We have discussed these critical accounting estimates with our Audit Committee.

U.S. Pension Credit and Postretirement Benefit Costs – We maintain pension and postretirement plans throughout the world, with the most significant plans located in the U.S.  Our defined benefit pension and postretirement benefit costs are developed from actuarial valuations.  These valuations are calculated using a number of assumptions, which represent management’s best estimate of the future.  The assumptions that have the most significant impact on reported results are the discount rate, the estimated long-term return on plan assets and the estimated inflation in health care costs.  These assumptions are generally updated annually.

Management utilizes the Aon Hewitt AA only above median yield curve, which is a hypothetical AA yield curve comprised of a series of annualized individual discount rates, as the primary basis for determining discount rates.  As of December 31, 2017 and 2016, we assumed discount rates of 3.63% and 4.12%, respectively, for the U.S. defined benefit pension plans.  As of December 31, 2017 and 2016, we assumed a discount rates of 3.60% and 4.10%, respectively, for the U.S. postretirement plan.  The effects of the change in discount rate will be amortized into earnings as described below.  Absent any other changes, a one-quarter percentage point increase or decrease in the discount rates for the U.S. pension and postretirement plans would not have a material impact on 2018 operating income.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

We manage two U.S. defined benefit pension plans, our RIP, which is a qualified funded plan, and a nonqualified unfunded plan.  For the RIP, the expected long-term return on plan assets represents a long-term view of the future estimated investment return on plan assets.  This estimate is determined based on the target allocation of plan assets among asset classes and input from investment professionals on the expected performance of the asset classes over 10 to 30 years.  Historical asset returns are monitored and considered when we develop our expected long-term return on plan assets.  An incremental component is added for the expected return from active management based on historical information obtained from the plan’s investment consultants.  These forecasted gross returns are reduced by estimated management fees and expenses.  Over the 10 year period ended December 31, 2017, the historical annualized return was approximately 5.5% compared to an average expected return of 7.1%.  The actual gain on plan assets achieved for 2017 was 12.4%. The difference between the actual and expected rate of return on plan assets will be amortized into earnings as described below.

The expected long-term return on plan assets used in determining our 2017 U.S. pension cost was 6.50%.  We have assumed a return on plan assets for 2018 of 6.50%.  The 2018 expected return on assets was calculated in a manner consistent with 2017.  A one-quarter percentage point increase or decrease in this assumption would increase or decrease 2018 operating income by approximately $3.7 million.

Contributions to the unfunded plan were $3.9 million in 2017 and were made on a monthly basis to fund benefit payments.  We estimate the 2018 contributions will be approximately $4.0 million.  See Note 16 to the Consolidated Financial Statements for more information.

The estimated inflation in health care costs represents a 5-10 year view of the expected inflation in our postretirement health care costs.  We separately estimate expected health care cost increases for pre-65 retirees and post-65 retirees due to the influence of Medicare coverage at age 65, as illustrated below:

 

 

The difference between the actual and expected health care costs is amortized into earnings as described below.  As of December 31, 2017, health care cost increases are estimated to decrease ratably until 2026, after which they are estimated to be constant at 4.5%.  A one percentage point increase or decrease in the assumed health care cost trend rate would not have a material impact on 2018 operating income.  See Note 16 to the Consolidated Financial Statements for more information.

Actual results that differ from our various pension and postretirement plan estimates are captured as actuarial gains/losses.  When certain thresholds are met, the gains and losses are amortized into future earnings over the remaining life expectancy of participants.  Changes in assumptions could have significant effects on earnings in future years.

We recognized a decrease in net actuarial losses related to our U.S. pension benefit plans of $34.8 million in 2017 primarily due to a better than expected return on assets and a partial settlement of the RIP in 2017, partially offset by changes in actuarial assumptions (most significantly a 49 basis point decrease in the discount rate).  The $34.8 million actuarial gain impacting our U.S. pension plans is reflected as a component of other comprehensive income in our Consolidated Statement of Earnings and Comprehensive Income along with actuarial gains and losses from our foreign pension plan and our U.S. postretirement benefit plan.

Income Taxes – Our effective tax rate is primarily determined based on our pre-tax income and the statutory income tax rates in the jurisdictions in which we operate.  The effective tax rate also reflects the tax impacts of items treated differently for tax purposes than for financial reporting purposes.  Some of these differences are permanent, such as expenses that are not deductible in our tax returns, and some differences are temporary, reversing over time, such as depreciation expense.  These temporary differences create deferred income tax assets and liabilities.  Deferred income tax assets are also recorded for net operating loss (“NOL”) and foreign tax credit (“FTC”) carryforwards.

Deferred income tax assets and liabilities are recognized by applying enacted tax rates to temporary differences that exist as of the balance sheet date.  We reduce the carrying amounts of deferred tax assets by a valuation allowance if, based on the available evidence, it is more likely than not that such assets will not be realized.  The need to establish valuation allowances for deferred tax assets is assessed quarterly. In assessing the requirement for, and amount of, a valuation allowance in accordance with the more likely than not standard, we give appropriate consideration to all positive and negative evidence related to the realization of the deferred tax assets.  This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

of future profitability and foreign source income (“FSI”), the duration of statutory carryforward periods, and our experience with operating loss and tax credit carryforward expirations.  A history of cumulative losses is a significant piece of negative evidence used in our assessment.  If a history of cumulative losses is incurred for a tax jurisdiction, forecasts of future profitability are not used as positive evidence related to the realization of the deferred tax assets in the assessment.

As of December 31, 2017, we have recorded valuation allowances totaling $47.4 million for various federal, state, and foreign deferred tax assets.  While we have considered future taxable income in assessing the need for the valuation allowances based on our best available projections, if these estimates and assumptions change in the future or if actual results differ from our projections, we may be required to adjust our valuation allowances accordingly.  Such adjustments could be material to our Consolidated Financial Statements.

As further described in Note 14 to the Consolidated Financial Statements, our Consolidated Balance Sheet as of December 31, 2017 includes net deferred income tax assets of $96.8 million.  Included in this amount are deferred federal income tax assets for FTC carryforwards of $15.7 million, and state NOL deferred income tax assets of $35.6 million. We have established valuation allowances in the amount of $47.4 million consisting of $10.3 million for federal deferred tax assets related to FTC carryovers, $17.7 million for differences between book and tax basis of undistributed foreign earnings, and $19.4 million for state deferred tax assets, primarily operating loss carryovers.

Inherent in determining our effective tax rate are judgments regarding business plans and expectations about future operations.  These judgments include the amount and geographic mix of future taxable income, the amount of FSI, limitations on usage of NOL carryforwards, the impact of ongoing or potential tax audits, and other future tax consequences.

We estimate we will need to generate future U.S. taxable income of approximately $506.8 million for state income tax purposes during the respective realization periods (ranging from 2018 to 2036) in order to fully realize the net deferred income tax assets.

As previously disclosed in prior SEC filings, our ability to utilize deferred tax assets may be impacted by certain future events, such as changes in tax legislation and insufficient future taxable income prior to expiration of certain deferred tax assets.

We recognize the tax benefits of an uncertain tax position if those benefits are more likely than not to be sustained based on existing tax law.  Additionally, we establish a reserve for tax positions that are more likely than not to be sustained based on existing tax law, but uncertain in the ultimate benefit to be sustained upon examination by the relevant taxing authorities.  Unrecognized tax benefits are subsequently recognized at the time the more likely than not recognition threshold is met, the tax matter is effectively settled or the statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired, whichever is earlier.

Impairments of Long-Lived Tangible and Intangible Assets – Our indefinite-lived intangibles are primarily trademarks and brand names, which are integral to our corporate identity and expected to contribute indefinitely to our corporate cash flows.  Accordingly, they have been assigned an indefinite life.  We conduct our annual impairment test for non-amortizable intangible assets during the fourth quarter, although we conduct interim impairment tests if events or circumstances indicate the asset might be impaired.   We conduct impairment tests for tangible assets and amortizable intangible assets when indicators of impairment exist, such as operating losses and/or negative cash flows.  If an indication of impairment exists, we compare the carrying amount of the asset group to the estimated undiscounted future cash flows expected to be generated by the assets.  If the undiscounted cash flows of an impaired asset are less than the carrying value, an estimate of an asset group’s fair value is based on discounted future cash flows expected to be generated by the asset group, or based on management’s estimated exit price assuming the assets could be sold in an orderly transaction between market participants or estimated salvage value if no sale is assumed.  If the fair value is less than the carrying value of the asset group, we record an impairment charge equal to the difference between the fair value and carrying value of the asset group.

The principal assumption utilized in our impairment tests for definite-lived intangible assets is operating profit adjusted for depreciation and amortization.  The principal assumptions utilized in our impairment tests for indefinite-lived intangible assets include revenue growth rate, discount rate and royalty rate.  Revenue growth rate and operating profit assumptions are primarily derived from those utilized in our operating plan and strategic planning processes.  The discount rate assumption is calculated based upon an estimated weighted average cost of equity which reflects the overall level of inherent risk and the rate of return a market participant would expect to achieve.  The royalty rate assumption represents the estimated contribution of the intangible assets to the overall profits of the reporting unit.

In 2017, indefinite-lived intangibles were tested for impairment based on our existing reporting units, which changed as a result of the announced future sale of our EMEA and Pacific Rim segments.  No other methodologies used for valuing our intangible assets changed from prior periods.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The cash flow estimates used in applying our impairment tests are based on management’s analysis of information available at the time of the impairment test.  Actual cash flows lower than the estimate could lead to significant future impairments.  If subsequent testing indicates that fair values have declined, the carrying values would be reduced and our future statements of income would be affected.

There were no material impairment charges recorded in 2017, 2016 or 2015 related to intangible assets.

We did not test tangible assets within our continuing operations for impairment in 2017, 2016 or 2015 as no indicators of impairment existed.

We cannot predict the occurrence of certain events that might lead to material impairment charges in the future.  Such events may include, but are not limited to, the impact of economic environments, particularly related to the commercial and residential construction industries, material adverse changes in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions.

See Notes 3 and 10 to the Consolidated Financial Statements for further information.

Environmental Liabilities – We are actively involved in the investigation, closure and/or remediation of existing or potential environmental contamination under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), and state Superfund and similar type environmental laws at several domestically owned, formerly owned and non-owned locations allegedly resulting from past industrial activity.  In a few cases, we are one of several potentially responsible parties and have agreed to jointly fund the required investigation, while preserving our defenses to the liability.  We may also have rights of contribution or reimbursement from other parties or coverage under applicable insurance policies.  

We provide for environmental remediation costs and penalties when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable.  Accruals are estimates based on the judgment of management related to ongoing proceedings.  Estimates of our future liability at the environmental sites are based on evaluations of currently available facts regarding each individual site.  In determining the probability of contribution, we consider the solvency of other parties, the site activities of other parties, whether liability is being disputed, the terms of any existing agreements and experience with similar matters, and the effect of our October 2006 Chapter 11 reorganization upon the validity of the claim.  

We evaluate the measurement of recorded liabilities each reporting period based on current facts and circumstances specific to each matter.  The ultimate losses incurred upon final resolution may materially differ from the estimated liability recorded.  Changes in estimates are recorded in earnings in the period in which such changes occur.

We are unable to predict the extent to which any recoveries from other parties or coverage under insurance policies might cover our final share of costs for these sites.  Our final share of investigation and remediation costs may exceed any such recoveries, and such amounts net of insurance recoveries may be material.

ACCOUNTING PRONOUNCEMENTS EFFECTIVE IN FUTURE PERIODS

See Note 2 to the Consolidated Financial Statements for further information.

RESULTS OF OPERATIONS

Unless otherwise indicated, net sales in these results of operations are reported based upon the AWI location where the sale was made.  Please refer to Notes 3 and 4 to the Consolidated Financial Statements for a reconciliation of segment operating income to consolidated earnings from continuing operations before income taxes and additional financial information related to discontinued operations.

2017 COMPARED TO 2016

CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS

(dollar amounts in millions)

 

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

Consolidated net sales increased due to favorable AUV of $29 million and higher volumes of $27 million.

Cost of goods sold was 63.8% of net sales in 2017, compared to 63.5% in 2016 due to higher manufacturing and input costs.  The increase in cost of goods sold as a percentage of sales in comparison to 2016 was impacted by $10 million of accelerated depreciation charges due to management’s decision to permanently close a plant in China that will be retained by AWI after the sale of our Pacific Rim business and management’s decision to close our St. Helens, Oregon plant.  Cost of goods sold for 2017 were also impacted by an increase in manufacturing and input costs and $3 million of severance and other charges associated with the announced closure of our St. Helens, Oregon plant.  Partially offsetting these increases was a $10 million reduction in RIP expense and a $10 million reduction of cost of goods sold related to environmental insurance settlements recorded in 2017.

SG&A expenses in 2017 were $135.7 million, or 15.2% of net sales, compared to $155.5 million, or 18.6% of net sales, in 2016.  The decrease in SG&A expenses was impacted by a $7 million decrease in the RIP expense, a $6 million reduction in expenses resulting from an increase in certain selling, promotional and administrative processing service reimbursements from WAVE and a $5 million reduction related to environmental insurance settlements, net of charges.  These decreases in SG&A expenses were partially offset by higher SG&A expenses as a result of the Tectum acquisition and $2 million of severance related to cost control measures in the U.S.  

Separation costs of $34.5 million in 2016 were primarily related to outside professional services and employee retention and severance accruals incurred in conjunction with our initiative to separate our flooring business from our ceilings business.

Equity earnings from our WAVE joint venture were $67.0 million in 2017, compared to $73.1 million in 2016.  The decrease in WAVE earnings was primarily driven by an increase in selling and administrative processing charges from AWI and Worthington Industries, Inc.  WAVE earnings were also negatively impacted by higher input costs, particularly steel.  See Note 9 to the Consolidated Financial Statements for further information.  

Interest expense was $35.4 million in 2017, compared to $49.5 million in 2016. Interest expense in 2016 included higher debt financing costs as a result of the refinancing of our credit facilities in April 2016 and $8.3 million of net losses that were reclassified from accumulated other comprehensive income as a result of the settlement of interest rate swaps which occurred in April 2016 and in connection with our entering into $450.0 million of notional amount of basis rate swaps during the fourth quarter of 2016.  Also contributing to the decrease in interest expense was a reduction in total debt outstanding and a lower interest rate spread in comparison to 2016.

Other non-operating income was $2.4 million in 2017 and $11.2 million in 2016.  The changes in other non-operating income were primarily due to foreign exchange rate gains on the translation of unhedged cross-currency intercompany loans in 2016.  

Income tax expense was $1.5 million and $51.3 million in 2017 and 2016, respectively.  The effective tax rate for 2017 was 0.7% as compared to a rate of 34.1% for 2016.  On December 22, 2017, the U.S. federal government enacted the Tax Cut and Jobs Act of 2017 (the “2017 Tax Act”), resulting in significant changes from previous tax law.  Effective January 1, 2018, the 2017 Tax Act reduces the federal corporate income tax rate from 35% to 21%.  As a result, we recorded a net $82.5 million income tax benefit in the fourth quarter of 2017.  Excluding the impact of the 2017 Tax Act, income tax expense for 2017 increased in comparison to 2016 due to an increase in pre-tax income, a decrease in reversals of reserves for uncertain tax positions from the expiration of the federal statute of limitations and an increase to the valuation allowance on foreign tax credits due to the anticipated sale of our EMEA and Pacific Rim businesses.

Total other comprehensive income (“OCI”) was $57.9 million for 2017 compared to $23.6 million for 2016.  Foreign currency translation adjustments represent the change in the U.S. dollar value of assets and liabilities denominated in foreign currencies. Foreign currency translation adjustments in 2017 were driven primarily by changes in the exchange rates of the British pound, the Chinese renminbi, the Russian ruble and the Canadian dollar.  Derivative gain/loss represents the mark to market value adjustments of our derivative assets and liabilities and the recognition of gains and losses previously deferred in OCI.  Derivative gains in 2016 were impacted by $8.3 million of net losses related to settlements of interest rates swaps.  Pension and postretirement adjustments represent actuarial gains and losses related to our defined benefit pension and postretirement plans and amortization of net losses on the U.S. pension plans.  Increases in OCI in 2017 primarily related to our U.S. pension plans.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

REPORTABLE SEGMENT RESULTS

Mineral Fiber

(dollar amounts in millions)

 

 

Net sales increased due to favorable AUV of $29 million, partially offset by lower volumes of $10 million. The favorable AUV was primarily due to improved mix from the sale of higher end ceiling tile products, while the decrease in volumes was primarily in lower end ceiling tile products.    

Operating income increased due to lower SG&A expenses of $20 million and the favorable margin impact of higher AUV of $12 million, partially offset by higher manufacturing and input costs of $13 million, lower earnings from WAVE of $6 million and the negative impact of lower volumes of $2 million.  The reduction in SG&A expenses was impacted by $6 million of additional expense reimbursements from WAVE and $5 million of environmental insurance settlements, net of charges, both recorded in 2017.  The increase in manufacturing costs was impacted by higher costs associated with planned enhancements to our manufacturing footprint to produce high end products and $7 million of severance and accelerated depreciation charges, primarily associated with the announced closure of our St. Helens manufacturing plant, partially offset by a $10 million reduction in costs related to environmental insurance settlements, net of charges, in 2017.  

Architectural Specialties

(dollar amounts in millions)

 

 

Net sales increased due to higher volumes, partially as a result of our acquisition of Tectum and increased new construction activity.

Operating income increased due to the positive impact of higher volumes, partially offset by an increase in SG&A expenses due primarily to the acquisition of Tectum and investments in selling and design capabilities.

Unallocated Corporate

Unallocated Corporate expense of $5 million decreased from $54 million in the prior year, due to $35 million of charges incurred in connection with our separation of AFI in 2016 and a $17 million decrease in RIP expense.  

FINANCIAL CONDITION AND LIQUIDITY

Cash Flow

The discussion that follows includes cash flows related to discontinued operations.

Operating activities for 2017 provided $170.4 million of cash, compared to $49.3 million of cash provided in 2016.  The increase was primarily due to changes in working capital, most notably a decrease accounts payable and accrued expenses related to the separation of AFI.  

Net cash used for investing activities was $54.2 million in 2017, compared to $17.0 million in 2016. The change in investing activities cash flows was primarily due to the acquisition of Tectum and lower dividends from our WAVE joint venture, partially offset by decreased purchases of property, plant and equipment.

Net cash used by financing activities was $102.7 million in 2017, compared to $128.9 million in 2016.  The favorable change in use of cash was primarily the result of lower payments of debt, partially offset by higher repurchases of outstanding common stock.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Liquidity

Our liquidity needs for operations vary throughout the year.  We retain lines of credit to facilitate our seasonal cash flow needs, since cash flow is generally lower during the first and fourth quarters of our fiscal year.  

We have a $1,050.0 million senior credit facility which is comprised of a $200.0 million revolving credit facility (with a $150.0 million sublimit for letters of credit), a $600.0 million Term Loan A and a $250.0 million Term Loan B.  The revolving credit facility and Term Loan A are currently priced at 2.00% over LIBOR and the Term Loan B portion is priced at 2.75% over LIBOR with a 0.75% floor.  The senior credit facility also has a $25.0 million letter of credit facility, also known as our bi-lateral facility.  The revolving credit facility and Term Loan A mature in March 2021 and Term Loan B matures in November 2023.  This $1,050.0 million senior credit facility is secured by U.S. personal property, the capital stock of material U.S. subsidiaries and a pledge of 65% of the stock of our material first tier foreign subsidiaries.  

As of December 31, 2017, total borrowings outstanding under our senior credit facility were $577.5 million under Term Loan A and $245.6 million under Term Loan B.  There were no borrowings outstanding under the revolving credit facility.  

In February 2017, we repriced the interest rate of our Term Loan B borrowing, resulting in a lower LIBOR spread (2.75% vs. 3.25%).  The maturity date remained unchanged along with all other terms and conditions.  In connection with the repricing we paid $0.6 million of bank, legal and other fees, the majority of which were capitalized.  

Under our senior credit facility we are subject to year-end leverage tests that may trigger mandatory prepayments.  If our ratio of consolidated funded indebtedness minus AWI and domestic subsidiary unrestricted cash and cash equivalents up to $100 million to consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”) (“Consolidated Net Leverage Ratio”) is greater than 3.5 to 1.0, the prepayment amount would be based on a computation of 50% of Consolidated Excess Cash Flow, as defined by the credit agreement.  These annual payments would be made in the first quarter of the following year.  No payment was made in 2017 or will be required in 2018.

The senior credit facility includes two financial covenants that require the ratio of consolidated EBITDA to consolidated cash interest expense minus cash consolidated interest income to be greater than or equal to 3.0 to 1.0 and requires the Consolidated Net Leverage Ratio to be less than or equal to 3.75 to 1.0.  As of December 31, 2017, we were in compliance with all covenants of the senior credit facility.

The Term Loan A and Term Loan B were both fully drawn and are currently priced on a variable interest rate basis.  The following table summarizes our interest rate swaps (dollar amounts in millions):

 

 

These swaps are designated as cash flow hedges against changes in LIBOR for a portion of our variable rate debt.  The unpaid balances of Term Loan A, the Revolving Credit Facility and Term Loan B may be prepaid without penalty at the maturity of their respective interest reset periods.  Any amounts prepaid on the Term Loan A or Term Loan B may not be re-borrowed.  

In connection with the refinancing of our credit facilities in April 2016, $450.0 million of notional amount Term Loan B swaps with a trade date of March 27, 2012 were settled and $10.7 million of losses previously recorded as a component of accumulated other comprehensive income were reclassified to interest expense in 2016.  

As of December 31, 2017, we had $450.0 million notional Term A swaps (the “Term Loan A Swaps”), in which we received 1-month LIBOR and paid a fixed rate over the hedged period.  

During the fourth quarter of 2016, we elected to change the basis for interest payments due under our Term Loan A Swaps from 3-month LIBOR to 1-month LIBOR.  In connection with the change in our underlying interest payments, in November 2016 we entered into $450.0 million forward-starting notional amount basis rate swaps to convert the floating rate risk under our Term Loan A Swaps from 3-month LIBOR to 1-month LIBOR and jointly designated the basis swaps with our Term Loan A Swaps in cash flow hedging relationships.  As a result of this transaction, $2.4 million of gains previously recorded as a component of accumulated other comprehensive income were reclassified as a reduction to interest expense during the fourth quarter of 2016.  Since the basis rate

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

swaps had a non-zero fair value upon designation as cash flow hedges, mark-to-market gains or losses on ineffective portions of these hedges are recorded as a component of interest expense.  

As of December 31, 2017, we had a $100.0 million notional Term Loan B swap in which we receive the greater of 3-month LIBOR or a 0.75% LIBOR Floor and pay a fixed rate over the hedged period.  

As of December 31, 2017 our outstanding long-term debt included a $35.0 million variable rate, tax-exempt industrial development bond that financed the construction of a plant in prior years. This bond has a scheduled final maturity of 2041 and is remarketed by an agent on a regular basis at a market-clearing interest rate. Any portion of the bond that is not successfully remarketed by the agent is required to be repurchased. This bond is backed by letters of credit which will be drawn if a portion of the bond is not successfully remarketed.  We have not had to repurchase the bond.

As of December 31, 2017, we had $159.6 million of cash and cash equivalents, $81.0 million in the U.S and $78.6 million in various foreign jurisdictions.  Upon completion of the sale of our EMEA and Pacific Rim businesses, it is our intention to repatriate a significant majority of the $78.6 million of cash held in various foreign jurisdictions; however our Purchase Agreement with Knauf allows AWI to transfer any cash balances held in our EMEA and Pacific Rim businesses to Knauf up to $10.0 million.  See Note 4 to the Consolidated Financial Statements for additional information.

We have a $40.0 million Accounts Receivable Securitization Facility (the “funding entity”) that matures in March 2019.  Under our Accounts Receivable Securitization Facility we sell accounts receivables to Armstrong Receivables Company, LLC (“ARC”), a Delaware entity that is consolidated in these financial statements.  ARC is a 100% wholly owned single member LLC special purpose entity created specifically for this transaction; therefore, any receivables sold to ARC are not available to the general creditors of AWI.  ARC then sells an undivided interest in the purchased accounts receivables to the funding entity.  This undivided interest acts as collateral for drawings on the facility.  Any borrowings under this facility are obligations of ARC and not AWI.  ARC contracts with and pays a servicing fee to AWI to manage, collect and service the purchased accounts receivables.  All new receivables under the program are continuously purchased by ARC with the proceeds from collections of receivables previously purchased.  As of December 31, 2017 we had no borrowings under this facility.

We utilize lines of credit and other commercial commitments in order to ensure that adequate funds are available to meet operating requirements.  Letters of credit are currently arranged through our revolving credit facility, our bi-lateral facility and our securitization facility.  Letters of credit may be issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table presents details related to our letters of credit (dollar amounts in millions):

 

 

As of December 31, 2017 and 2016, $6.6 million and $4.0 million, respectively, of letters of credit issued under our accounts receivable securitization facility in excess of our maximum limit were classified as restricted cash and reported as a component of Cash and cash equivalents on our Consolidated Balance Sheets.  This restriction will lapse upon replacement of collateral with accounts receivables and/or upon a change in the letter of credit limit as a result of higher securitized accounts receivable balances.  

We believe that cash on hand and cash generated from operations, together with lines of credit, availability under our revolving credit facility, will be adequate to address our foreseeable liquidity needs based on current expectations of our business operations, capital expenditures and scheduled payments of debt obligations.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

2016 COMPARED TO 2015

CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS

(dollar amounts in millions)

 

 

Consolidated net sales for 2016 increased due to higher volumes of $20 million and favorable AUV of $15 million.  

Cost of goods sold was 63.5% of net sales in 2016, compared to 62.0% in 2015.  Compared to the prior year, the increase was due to higher manufacturing and input costs.  

SG&A expenses in 2016 were $155.5 million, or 18.6% of net sales, compared to $180.8 million, or 22.5% of net sales in 2015.  The decrease was the result of the AFI separation and a decrease in RIP expense.  

Separation costs of $34.5 million in 2016 and $34.3 million in 2015 were primarily related to outside professional services and employee retention and severance accruals incurred in conjunction with our initiative to separate our flooring business from our ceilings business.

Equity earnings from our WAVE joint venture were $73.1 million in 2016, compared to $66.1 million in 2015. The increase was due to higher sales volumes, favorable AUV and lower manufacturing input costs, partially offset by higher SG&A expenses for go-to-market investments.  

Interest expense was $49.5 million in 2016, compared to $44.6 million in 2015. The increase in interest expense was due to $10.7 million of losses that were reclassified from accumulated other comprehensive income to interest expense during 2016 as a result of the settlement of $450.0 million of notional amount interest rate swaps which occurred in connection with the refinancing of our credit facilities, partially offset by lower costs due to a reduction in total debt outstanding and a lower interest rate spread and $2.4 million of gains that were reclassified from accumulated other comprehensive income to interest expense during 2016 in connection with our entering into $450.0 million of notional amount of basis rate swaps.  

Other non-operating income was $11.2 million in 2016, compared to other non-operating expense of $17.8 million in 2015.  The changes in other non-operating income were primarily due to foreign exchange rate gains on the translation of unhedged cross-currency intercompany loans.  Expenses in 2015 were primarily due to foreign exchange rate losses on the translation of unhedged cross-currency intercompany loans denominated in Russian rubles, related to the construction of our Russian mineral fiber ceiling plant that was completed in the first quarter of 2015.  During the fourth quarter of 2016, all Russian ruble denominated intercompany loans were settled with intercompany capital contributions.  

Income tax expense was $51.3 million and $36.7 million in 2016 and 2015, respectively.  The effective tax rate for 2016 was 34.1% as compared to a rate of 38.8% for 2015.  The effective tax rate for 2016 was lower than 2015 primarily due to income tax benefits recorded during the second half of 2016 resulting from the reversal of reserves for uncertain tax positions as a result of an expiration of the federal statute of limitations to review previously filed income tax returns.

REPORTABLE SEGMENT RESULTS

Mineral Fiber

(dollar amounts in millions)

 

 

Net sales increased due to favorable AUV of $15 million, while volume was flat.

Operating income decreased due to higher SG&A expenses of $50 million, the margin impact of lower volumes of $5 million and an increase manufacturing and input costs of $4 million, partially offset by the margin impact of favorable AUV of $8 million and higher

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

earnings from WAVE of $7 million.  The increase in SG&A expenses in 2016 was primarily a result of the inclusion of costs formally assigned to our Unallocated Corporate segment prior to the separation of AFI, partially offset by a reduction in costs primarily due to the separation of AFI.

Architectural Specialties

(dollar amounts in millions)

 

 

Net sales and operating income both increased due to higher volumes. The increase in operating income was partially offset by a $4 million increase in SG&A expenses, due to investments in selling and design capabilities.  

Unallocated Corporate

Unallocated Corporate expense of $54.2 million decreased from $129.8 million in the prior year. The decrease was due to the inclusion of most of the Corporate functions within the Mineral Fiber and Architectural Specialties segments starting in 2016 as a result of the AFI separation.

Cash Flow

The discussion that follows includes cash flows related to discontinued operations.

Operating activities for 2016 provided $49.3 million of cash, compared to $203.7 million of cash provided in 2015.  The decrease was primarily due to change in working capital, most notably a decrease in accounts payable and accrued expenses related to the separation of AFI.  The decrease due to the change in working capital was partially offset by higher cash earnings partially offset by a reduction in depreciation and amortization.

Net cash used for investing activities was $17.0 million in 2016, compared to $101.5 million in 2015. The change in investing activities cash flows was primarily due to decreased purchases of property, plant and equipment, partially offset by higher dividends from our WAVE joint venture.

Net cash used by financing activities was $128.9 million in 2016, compared to $32.3 million in 2015.  The unfavorable use of cash was primarily the result of higher payments of debt and repurchase of outstanding common stock.

OFF-BALANCE SHEET ARRANGEMENTS

No disclosures are required pursuant to Item 303(a)(4) of Regulation S-K.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

CONTRACTUAL OBLIGATIONS

As part of our normal operations, we enter into numerous contractual obligations that require specific payments during the term of the various agreements.  The following table includes amounts ongoing under contractual obligations existing as of December 31, 2017.  Only known payments that are dependent solely on the passage of time are included.  Obligations under contracts that contain minimum payment amounts are shown at the minimum payment amount.  Contracts that contain variable payment structures without minimum payments are excluded.  Purchase orders that are entered into in the normal course of business are also excluded because they are generally cancelable and not legally binding.  Amounts are presented below based upon the currently scheduled payment terms.  Actual future payments may differ from the amounts presented below due to changes in payment terms or events affecting the payments.

 

 

This table excludes obligations related to postretirement benefits (retiree health care and life insurance) since we voluntarily provide these benefits.  The amount of benefit payments we made in 2017 was $10.3 million.  See Note 16 to the Consolidated Financial Statements for additional information regarding future expected cash payments for postretirement benefits.

We are party to supply agreements, some of which require the purchase of inventory remaining at the supplier upon termination of the agreement.  Had these agreements terminated at December 31, 2017, we would have been obligated to purchase approximately $0.6 million of inventory.  Historically, due to production planning, we have not had to purchase material amounts of product at the end of similar contracts.  Accordingly, no liability has been recorded for these guarantees.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Letters of credit are currently arranged through our revolving credit facility, our bi-lateral facility and our securitization facility. Letters of credit may be issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table summarizes the commitments we have available for use as of December 31, 2017.  

 

 

In connection with our disposition of certain assets through a variety of unrelated transactions, we have entered into contracts that included various indemnity provisions, some of which are customary for such transactions, while others hold the acquirer of the assets harmless with respect to liabilities relating to such matters as taxes, environmental and other litigation.  Some of these provisions include exposure limits, but many do not.  Due to the nature of the indemnities, it is not possible to estimate the potential maximum exposure under these contractual provisions.  As of December 31, 2017, we had no liabilities recorded for which an indemnity claim had been received.

 

 

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Market Risk

We are exposed to market risk from changes in foreign currency exchange rates, interest rates and commodity prices that could impact our results of operations, cash flows and financial condition.  We use forward swaps and option contracts to hedge these exposures, which are entered into for periods consistent with underlying exposure and do not constitute positions independent of those exposures.  We use derivative financial instruments as risk management tools and not for speculative trading purposes.  In addition, derivative financial instruments are entered into with a diversified group of major financial institutions in order to manage our exposure to potential nonperformance on such instruments.  We regularly monitor developments in the capital markets.

Counterparty Risk

We only enter into derivative transactions with established counterparties having an investment grade or better.  We monitor counterparty credit default swap levels and credit ratings on a regular basis.  All of our derivative transactions with counterparties are governed by master International Swap and Derivatives Association agreements (“ISDAs”) with netting arrangements.  These agreements can limit our exposure in situations where we have gain and loss positions outstanding with a single counterparty. We do not post nor receive cash collateral with any counterparty for our derivative transactions.  These ISDAs do not contain any credit contingent features other than those contained in our bank credit facility.  Exposure to individual counterparties is controlled, and thus we consider the risk of counterparty default to be negligible.

Interest Rate Sensitivity

We are subject to interest rate variability on our Term Loan A, Term Loan B, revolving credit facility and other borrowings.  A hypothetical increase of one-quarter percentage point in LIBOR interest rates from December 31, 2017 levels would increase 2018 interest expense by approximately $1.4 million.  As of December 31, 2017, $245.6 million of our debt has a 0.75% LIBOR floor, which would not be affected by a one-quarter percentage point move in LIBOR given the current interest rate environment. We also have $550.0 million of interest rate swaps outstanding, which fix the interest rates for a portion of our debt. The current portion of the interest rate swaps is included in this calculation.  

As of December 31, 2017, we had interest rate swaps outstanding on Term Loan A and on Term Loan B, with notional amounts of $450.0 million and $100.0 million, respectively.  We utilize interest rate swaps to minimize the fluctuations in earnings caused by interest rate volatility.  Under the terms of the Term Loan A swaps we receive 1-month LIBOR and pay a fixed rate over the hedged period.  Under the terms of our Term Loan B, we receive the greater of 3-month LIBOR or a 0.75% LIBOR Floor and pay a fixed rate over the hedged period.  The following table summarizes our interest rate swaps as of December 31, 2017 (dollar amounts in millions):

 

 

These swaps are designated as cash flow hedges against changes in LIBOR for a portion of our variable rate debt. The net asset measured at fair value was $8.9 million at December 31, 2017.

The table below provides information about our long-term debt obligations as of December 31, 2017, including payment requirements and related weighted-average interest rates by scheduled maturity dates.  Weighted average variable rates are based on implied forward rates in the yield curve and are exclusive of our interest rate swaps.

 

 

Variable rate principle payments reflected in the preceding table exclude $7.9 million of unamortized debt financing costs as of December 31, 2017.  

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Exchange Rate Sensitivity

We manufacture and sell our products in a number of countries throughout the world and, as a result, are exposed to movements in foreign currency exchange rates.  To a large extent, our global manufacturing and sales provide a natural hedge of foreign currency exchange rate movement.  Upon completion of the sale of our EMEA and Pacific Rim businesses, and on a continuing operations basis as of December 31, 2017, our only major foreign currency exposure is to the Canadian dollar. A 10% strengthening of the Canadian dollar against the U.S. dollar compared to December 31, 2017 levels would increase our 2018 earnings before income taxes by approximately $0.5 million, including the impact of current foreign currency forward exchange contracts.

The table below details our outstanding currency instruments as of December 31, 2017.

 

 

Natural Gas Price Sensitivity

We purchase natural gas for use in the manufacturing process and to heat many of our facilities.  As a result, we are exposed to fluctuations in the price of natural gas.  We have a policy of reducing North American natural gas volatility through derivative instruments, including forward contracts and swaps, purchased call options, and zero-cost collars up to 24 months forward.  As of December 31, 2017, we had contracts to hedge approximately $9.2 million (notional amounts) of natural gas. All of these contracts mature by November 2019.  A 10% increase in North American natural gas prices compared to December 31, 2017 prices would increase our 2018 expenses by approximately $0.5 million including the impact of current hedging contracts.  As of December 31, 2017 we had recorded net liabilities of $0.6 million related to these contracts. 

 

 

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SUPPLEMENTARY DATA

Quarterly Financial Information for the Years Ended December 31, 2017 and 2016 (Unaudited)

The following consolidated financial statements are filed as part of this Annual Report on Form 10-K:

Reports of Independent Registered Public Accounting Firm.

Consolidated Statements of Earnings and Comprehensive Income for the Years Ended December 31, 2017, 2016 and 2015.

Consolidated Balance Sheets as of December 31, 2017 and 2016.

Consolidated Statements of Equity for the Years Ended December 31, 2017, 2016 and 2015.

Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016 and 2015.

Notes to Consolidated Financial Statements.

Schedule II for the Years Ended December 31, 2017, 2016 and 2015.

 

 

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Armstrong World Industries, Inc., and Subsidiaries

Quarterly Financial Information (unaudited)

(dollar amounts in millions, except for per share data)