AWI - Why do Ceiling Tiles Have Ferrari-like Margins?

This post will focus on a company with incredible pricing power: Armstrong World Industries (NYSE: AWI).  AWI is the leading manufacturer of acoustical ceilings and walls in North America.  Now established as the “Kleenex” of ceilings, the company’s history dates back more than 160 years, and it has evolved through many phases over time.  In the last ten years, it spun off Flooring (AFI) from Ceilings and the successor AWI (Ceilings) sold off its European and Asian assets, focusing its operations on the Americas.  The North American business always has been the crown jewel asset, with 60% incumbent market share and a go-to-market strategy that supports continued market share gains and some of the best pricing dynamics we’ve ever found.   

Surely every reader has seen Armstrong’s (NYSE: AWI) products, but you may not have noticed them.  Its most recognizable form factors are 2x2 square or 2x4 rectangle Mineral Fiber acoustical ceiling tile installed into a suspended steel ceiling.  See below:

Source: Armstrong World Industries

These look like commoditized products, but they perform quite differently.  Although they are only about 3-5% of costs, ceilings are important for managing the acoustics of spaces which make them one of the most technically specified areas of a project.  Ceilings can be specified with products that absorb, block and/or shape sound according to the space’s needs. 

Before Covid disrupted construction activity and created price/cost distortions, AWI generated mid-40s EBITDA margins from these products.  We would put AWI’s margins and pricing power against anyone’s.  Let’s dive into pricing in more detail.

The chart below shows AWI’s average unit value (AUV) from 2005 to 2018, whereby pricing roughly doubled. 

Source: AWI Investor Presentation, February 2019

AWI always raises prices in excess of inflation, which makes the last 5 years more interesting.  In a typical year, Armstrong raises prices twice: in February and in August.  In years with abnormal cost inflation, the company makes adjustments as necessary to ensure its prices keep up, as we saw in 2021 and 2022.  The chart below shows AWI’s methodical pricing adjustments during normal inflation periods (2019/2020), followed by more sizable adjustments in 2021, 2022, and 2023.  It’s important to note that these are list prices, not fully realized prices (as are shown above).  Typically, AWI recognizes about 30% of its price increases (e.g. if it raises prices 15% per year, it expects to land about 5% in realized price increases).  Nonetheless, list pricing from year-end 2020 to Q3 2023 has about doubled, which means realized pricing has been about +30% - well above trendline. 

Source: Recurve Capital Estimates

The question we will explore in this post is: why does a product that looks like a cheap commodity enjoy Ferrari-like margins and some of the best pricing power we’ve ever found?

Spec, Track, and Close

Working backwards, Armstrong generates strong margins and pricing power because it has significant (~60%) market share, because it has tight control over its specifications and distribution, and because it operates in a duopoly-like market structure (USG is #2 with about 25-30% market share).  With repairs and renovations comprising 70-80% of industry volumes, AWI’s incumbency advantage creates a recurring-like revenue stream that all distributors want.  But how did the company get to this dominant position? 

Armstrong’s go-to-market strategy was described to me by former employees as a three-step process called “Spec, Track, and Close.”  We describe this process in more detail below:

1.      Spec = Specification.  AWI has a seasoned internal sales team that works with architects and designers to get its products specified into a project’s plans.  As mentioned above, acoustical ceilings are low-value but high-impact to spaces and tend to be specified by product SKU.  From our conversations with industry participants, once the specification is made, AWI retains that business about 85% of the time.

2.      Ceilings are one of the last elements to be installed in a new building or major renovation project.  AWI tracks all the projects in its specification pipeline and others under construction to ensure they are on top of any changes to the specifications and to enhance its visibility of when product should be ready to ship.  Tracking is done via its in-house sales team and by monitoring developments among its exclusive metro-area distributors and with contractors to ensure they are following the specification. 

3.      Finally, AWI Closes on deals when its products are shipped to contractors, who then install them.  Typically, AWI bundles its tile with steel grid provided by WAVE, AWI’s joint venture with Worthington. WAVE is one of the most successful joint ventures we’ve seen, but a topic for another day.

Importantly, AWI utilizes exclusive relationships with distributors in each metro area.  Because of its high market share in the R&R market and its higher market share in new construction—powered by its innovative products and specification efforts—every distributor wants the Armstrong relationship.  Once they have it, Armstrong enforces exclusivity, i.e. those distributors can only sell and distribute Armstrong’s products in its categories.  If AWI catches a distributor selling other manufacturers’ products, they can and will swiftly move their relationship to another distributor, whose ceiling business would then experience significant growth by adding Armstrong.  This structure creates significant incentives for AWI and distributors to work together in a stable and exclusive relationship so that each can maximize profits in the market by optimizing pricing and market share gains .

AWI’s two-tiered go-to-market strategy—using its internal teams and leveraging distributors—allows for a full-court press on the entire ecosystem, including architects, designers, and contractors, to ensure that Armstrong’s sales teams and its distributors originate and retain specifications, leading to significant market share for all construction projects.  AWI’s competitors have not invested in all these elements of its go-to-market strategy, preferring instead (and we believe optimally) to ride on AWI’s pricing coattails to grow revenue and profitability rather than competing aggressively on price for a few points of market share - a dynamic in which everyone would lose.  Even though AWI has about 60% market share already, we believe they are continuing to gain share from its product and technology innovation, both of which strengthen its competitive differentiation it in the market. 

Growth Areas

Armstrong has invested in product R&D to improve acoustical performance, design elements (size, shape, color, etc.), sustainability metrics, and more.  It’s also invested in front-end technology tools to help customers design their spaces and generate real-time, dynamic quotes as they make changes.  Armstrong’s commitment to investing in new products and capabilities further separates it from other ceiling competitors.  In fact, its product vitality index (share of products introduced in the last 5 years) has risen from <10% in 2012 to over 30% currently. 

New products aren’t just good for market share – they’re also good for pricing.  As discussed above, Armstrong always prices above inflation on a like-for-like basis, but it also generates weighted-average price increases from a long-term mix-shift to newer, higher end products.  Historically, about half of AWI’s 6% CAGR in average unit value has come from like-for-like price increases and half has come from a mix benefit.  In the post-Covid period, AWI has generated about a 6-7% CAGR in like-for-like pricing, but also has continued to benefit from favorable mix shifts, resulting in higher-than-normal AUV growth.

AWI also has been investing in a segment called Architectural Specialties.  These are ceiling and wall installations made of wood, metal, felt, and other non-mineral fiber materials that are often more stylistic and which are highly specified – a natural fit for Armstrong’s go-to-market strategy.  Spaces appropriate for Architectural Specialties were largely inaccessible to Armstrong’s core Mineral Fiber business.  The image below shows one example of Armstrong’s many capabilities in this growth area.  With a comprehensive portfolio of specialty substrates at its disposal, AWI leverages its ability to perform in these showcase spaces to get specifications across an entire project or building – including the areas requiring acoustical ceiling tiles. 

Source: Armstrong World Industries

To summarize, we believe AWI can price above inflation sustainably because:

1.      It has the largest share of installed ceilings in a >70% replace/repair market.

2.      It works tirelessly via its “Spec, Track and Close” process to win and retain specifications for its products into major construction projects.

3.      It manages exclusive distribution agreements in almost all metro areas, reducing price competition in the market.

4.      It invests in new product innovation and in technology tools to offer customers the best and highest-quality products and service in the industry, driving further share gains.

5.      It leverages its Specialties business to access more areas of each building, and to increase its success in winning Mineral Fiber specifications in the same projects.   

AWI’s entire focus is on highly specified ceiling and wall products that leverage its manufacturing, sales, and distribution infrastructure and processes that the company has developed over >100 years.  Armstrong pursued its strategy while nurturing a duopoly-like industry structure that has fostered healthy pricing and margin dynamics. 

How Did Inflation Impact AWI?

With Armstrong’s history of >20 years of ~6% AUV increases powered by its product innovation and its go-to-market strategies, it shouldn’t be surprising that the post-Covid bubble of inflation has increased our assessment of AWI’s long-term value.  AWI gets to capture all the upside on pricing, but never gives that pricing back when its costs normalize. 

To that point, below we show a chart that demonstrates these dynamics.  The solid lines are actual and future price per unit and cost per unit trends from year 0 onward (in practical terms, we are in year 3).  The dotted lines are the normalized trend lines for price and cost per unit, if inflation never occurred.  We believe that in almost all reasonable cases, AWI’s year 5 and year 10 Gross Profit will be greater than the normalized, no-inflation scenario, due to its ability to extract strong like-for-like pricing during the inflationary period, creating a permanent and material step-up in price per unit, accompanied by a reversion to normalized cost curves over time. 

Source: Recurve Capital LLC Estimates

Even if cost inflation is stickier and more persistent going forward, we trust that AWI will adjust its pricing to create a similar price/cost spread expansion vs. the normalized path.  AWI will almost always be better off because of inflation. 

The primary swing variable for the magnitude of AWI’s absolute accretion to Gross Profit from inflation is its volume growth.  In recent years, higher inflation and higher interest rates have suppressed construction activity and, subsequently, ceiling & wall industry volumes.  If the industry and company can regain footing on volumes and recapture what was delayed or pushed out during the inflationary spike, we estimate that AWI stands to generate more than 20% Gross Profit accretion compared to its already healthy normalized outcome.

Summary and Closing

AWI has among the best control over its distribution and pricing dynamics that we’ve studied.  Its ~60% market share comprised of 39 billion square feet of installed square feet, combined with its >70% replace & repair mix and its “Spec, Track and Close” strategies make AWI the preferred ceiling provider for every distributor, enabling exclusive relationships and healthy competitive and pricing dynamics across its industry. 

While new construction and significant remodeling activity remain depressed and choppy due to high interest rates, we feel confident in Armstrong’s long-term growth formula, consisting of:

• Low-single digit Mineral Fiber industry volume growth.

• 1-2% excess Mineral Fiber volume growth from AWI-specific product and technology initiatives.

• Like-for-like pricing above inflation, as discussed above.

• Positive mix shift toward newer, premium products. 

In a normal environment, this growth formula should produce high-single digit/low-double digit revenue growth, expanding gross margins, and expanding EBITDA margins in Mineral Fiber.  Additionally, AWI will continue to grow its less mature Architectural Specialties business, which generates incremental margins well above current profitability.  Augmented by its share repurchase program, Armstrong has a nice path to generate >15% annual growth in EPS and free cash flow per share over a medium- to long-term horizon.  However, we believe the current inflationary environment offers potential for results above these “normalized” expectations in the medium-term.